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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

OR

               Commission File Number: 0-9233

American Management Systems, Incorporated
(Exact name of registrant as specified in its charter)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X   No     

Indicate by check mark whether registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X    No    

The number of shares of the registrant’s common stock outstanding as of July 31, 2003 was 42,344,320.

CONTENTS

Part I. FINANCIAL INFORMATION

Item 1. Unaudited Consolidated Condensed Financial Statements and Notes

American Management Systems, Incorporated
CONSOLIDATED CONDENSED INCOME STATEMENTS

               
See Accompanying Notes to Unaudited Consolidated Condensed Financial Statements.

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American Management Systems, Incorporated
CONSOLIDATED CONDENSED BALANCE SHEETS
(In thousands)

____________
See Accompanying Notes to Unaudited Consolidated Condensed Financial Statements.

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American Management Systems, Incorporated
CONSOLIDATED CONDENSED BALANCE SHEETS — continued
(In thousands, except share data)

____________
See Accompanying Notes to Unaudited Consolidated Condensed Financial Statements.

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American Management Systems, Incorporated
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
Unaudited
(In thousands)

____________
See Accompanying Notes to Unaudited Consolidated Condensed Financial Statements.

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American Management Systems, Incorporated
SUPPLEMENTAL CONSOLIDATED REVENUES BY MARKET

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American Management Systems, Incorporated
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
Unaudited
(In thousands, except per share amounts)

NOTE 1 – BASIS OF PRESENTATION

The accompanying unaudited interim consolidated condensed financial statements of American Management Systems, Incorporated (“AMS” or “the Company”) have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) for quarterly reports on Form 10-Q and do not include all of the information and note disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. These financial statements should therefore be read in conjunction with the consolidated financial statements and notes for the fiscal year ended December 31, 2002, included in the Company’s Annual Report on Form 10-K filed with the SEC on March 31, 2003. The accompanying unaudited interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and reflect all adjustments that are, in the opinion of management, necessary for a fair presentation of results for these interim periods. The results of operations for the three and six months ended June 30, 2003 are not necessarily indicative of the results that may be expected for the full year. Certain prior period amounts have been reclassified to conform to the current period presentation.

New Accounting Pronouncements

In June 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” This Statement requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by the statement include certain employee severance costs that are associated with a restructuring, lease termination costs, costs to close or consolidate facilities, or other exit or disposal activities. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The provisions of SFAS No. 146 were applied to the Company’s restructuring charge taken in the second quarter of 2003 but did not represent a material change in the accounting for restructuring costs when compared to the charge taken in the second quarter of 2002.

In November 2002, the Emerging Issues Task Force issued a final consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” Issue No. 00-21 provides guidance on how and when to recognize revenues from arrangements requiring delivery of more than one product or service. It also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in an arrangement. To the extent that a deliverable in an arrangement is within the scope of other existing higher level authoritative literature, Issue No. 00-21 does not apply. Issue No. 00-21 is effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of Issue No. 00-21 is not expected to have a significant effect on the Company’s financial statements.

In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees. It also requires that a guarantor recognize, at the inception of certain guarantees, a liability for the fair value of the obligation undertaken in issuing the guarantee.

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American Management Systems, Incorporated
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS — continued
Unaudited
(In thousands, except per share amounts)

The initial recognition and measurement provisions of FIN 45 are applicable only on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN 45 did not have a material effect on the Company’s financial statements.

In December 2002, AMS adopted SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.

The effect of the adoption of SFAS No. 148 was the addition of a significant accounting policy in Note 1 of the consolidated financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002. In addition, see Note 2 of this Report for the required quarterly disclosures.

In January 2003, the FASB issued Interpretation No. 46 “Consolidation of Variable Interest Entities — an Interpretation of Accounting Research Bulletin (“ARB”) No. 51.” Interpretation No. 46 requires the primary beneficiary to consolidate a variable interest entity (“VIE”) if it has a variable interest that will absorb a majority of the entity’s expected losses, receive a majority of the entity’s expected residual returns, or both. The Interpretation applies immediately to VIEs created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to VIEs in which an enterprise holds a variable interest that it acquired before February 1, 2003. AMS does not have any VIEs.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of SFAS No. 149 will not have a material impact on the Company’s financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. Some of the provisions of this Statement are consistent with the current definition of liabilities in FASB Concepts Statement No. 6, “Elements of Financial Statements.” The remaining provisions of this Statement are consistent with the FASB’s proposal to revise that definition to encompass certain obligations that a reporting entity can or must settle by issuing its own equity shares, depending on the nature of the relationship established between the holder and the issuer. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of

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American Management Systems, Incorporated
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS – continued
Unaudited
(In thousands, except per share amounts)

the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have any effect on AMS’s financial statements.

NOTE 2 – STOCK-BASED COMPENSATION

At June 30, 2003, the Company accounts for its stock-based compensation plans using the intrinsic value method in accordance with the recognition and measurement principles of the Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. Accordingly, no stock-based employee compensation cost was reflected in net income, as all options granted under those plans had an exercise price equal to the fair market value of the underlying common stock on the date of grant. The following table illustrates, in accordance with the provisions of SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation.

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American Management Systems, Incorporated
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS – continued
Unaudited
(In thousands, except per share amounts)

NOTE 3 – COMPREHENSIVE INCOME

     In accordance with SFAS No. 130, “Reporting Comprehensive Income,” the components of comprehensive income are as follows:

NOTE 4 – EARNINGS PER SHARE RECONCILIATION

Basic earnings per share is computed by dividing net income or loss by the weighted average shares outstanding during the period. Diluted earnings per share is computed similarly to basic earnings per share except that the weighted average shares outstanding are increased to include equivalents, when their effect is dilutive.

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American Management Systems, Incorporated
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS – continued
Unaudited
(In thousands, except per share amounts)

     The computations for basic and dilutive EPS are as follows:

NOTE 5 – RESTRUCTURING CHARGE

(Staff reductions reported in actual amounts, dollars in thousands)

Severance and Benefits

In an effort to achieve cost reductions and align its work force with changing market conditions and revenue outlook, the Company recorded a charge of $18,689 for the three months ended June 30, 2003 for severance and severance-related costs. The severance costs primarily relate to a reduction in senior level staff and management positions. In total, 241 employees are being separated in the U.S. and Europe. In addition, during 2002 and 2001, the Company implemented restructuring plans and recorded charges totaling $54,781 for severance and severance-related costs related to a total of 2,128 staff reductions. Of the 2,369 total staff reductions related to the 2003, 2002, and 2001 plans, 105 individuals remain to be separated at June 30, 2003. The remaining $15,578 liability as of June 30, 2003 for severance and severance-related costs is expected to be paid over the next year.

Facilities

During 2002 and 2001, the Company recorded charges totaling $25,481 for the closure and consolidation of facilities. During the three months ended June 30, 2003, the Company recorded a charge of $2,642 related to changes in estimates of the timing and amount of anticipated subtenant rental payments associated with the prior facility restructuring plan. The Company also recorded an additional charge of $3,454 for the three months ended June 30, 2003 related to the closure and consolidation of additional

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American Management Systems, Incorporated
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS – continued
Unaudited
(In thousands, except per share amounts)

facilities. Of the remaining $16,709 total liability at June 30, 2003, $8,337 represents a noncurrent liability for costs to be incurred through 2010.

Restructuring reserve activities as of and for the six months ended June 30, 2003 were as follows:

NOTE 6 – INCOME TAXES

During the six months ended June 30, 2003 the Company’s annual effective tax rate was 36.6% as compared to 41.0% for the six months ended June 30, 2002. As of December 31, 2002, the annual effective tax rate was 33.0% and reflected the expected value of tax refunds due from amending prior years’ federal income tax returns to claim additional research and experimentation tax credits.

NOTE 7 – COMMITMENTS AND CONTINGENCIES

As further discussed below, on June 20, 2003, the Company entered into a written settlement agreement which resolved all outstanding claims and litigation related to its contract with the Federal Retirement Thrift Investment Board (the “Thrift Board”). The Thrift Board also agreed to a no-fault termination of the contract. Under the terms of the settlement agreement, the Thrift Board agreed to pay the Company $10,000 for work performed under the contract for which payment remained outstanding. The remaining $30,489 contract receivable was written-off in the second quarter of 2003. In addition, the Company agreed to pay $15,000 to the Thrift Savings Plan as partial reimbursement of the $31,000 the Company previously had received for other work it had performed under the Thrift Board contract. Accordingly, the Company recorded a contract litigation settlement expense of $45,489 for the three months ended June 30, 2003.

On July 17, 2001, the Thrift Board terminated for default its contract with AMS for development and implementation of an automated record-keeping system. On the same date, the Thrift Board’s Executive Director, Roger W. Mehle, purporting to act as “managing fiduciary” of the Thrift Savings Fund, filed a lawsuit against AMS relating to AMS’s performance of the contract seeking compensatory damages of

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American Management Systems, Incorporated
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS – continued
Unaudited
(In thousands, except per share amounts)

$50,000 and punitive damages of $300,000, plus re-procurement costs, costs and expenses of litigation (including reasonable attorneys’ fees) and prejudgment interest.

AMS moved to dismiss Mr. Mehle’s lawsuit. On November 30, 2001, the United States District Court for the District of Columbia dismissed Mr. Mehle’s lawsuit for lack of jurisdiction. Mr. Mehle appealed that dismissal order. AMS filed both procedural and dispositive motions in the United States Court of Appeals for the District of Columbia Circuit. On January 25, 2002, the U.S. Department of Justice filed a motion on behalf of the U.S. Government to intervene in the appeal, which was granted, and concurrently filed a motion to dismiss Mr. Mehle’s appeal. Mr. Mehle opposed both the Government’s motion to dismiss the appeal and AMS’s motion to dismiss the appeal. On March 7, 2003, the United States Court of Appeals for the District of Columbia Circuit heard oral argument and the case was submitted for decision.

Separately, on October 10, 2001, AMS filed suit in the United States Court of Federal Claims (“CFC”) against the United States, which was the contracting party in the Thrift Board contract, seeking reversal of the Thrift Board’s decision terminating the contract for default and asking the CFC to convert the termination into a termination for convenience. The U.S. Department of Justice defended the United States in this case and moved to dismiss AMS’s complaint on jurisdictional grounds. By written opinion and order dated August 30, 2002, the CFC denied the United States’ motion to dismiss AMS’s complaint. The United States sought an immediate appeal of the CFC’s jurisdictional ruling. On February 26, 2003, by written order, the United States Court of Appeals for the Federal Circuit denied the United States’ request for an immediate appeal.

In addition to the CFC proceeding, on July 16, 2002, AMS submitted a contract termination settlement proposal and claim to the Thrift Board seeking recovery of approximately $58,500 of unpaid costs and fees incurred in performing the contract and winding it down in accordance with the termination for convenience provisions of the contract. The proposal was submitted pursuant to the instructions given by the Thrift Board’s contracting officer at the time of termination and in accordance with the terms of the contract and the Federal Acquisition Regulations. On August 16, 2002, the Thrift Board denied any liability to pay the settlement proposal and claim. AMS expressed its intention to amend its complaint in the CFC and thereby challenge the Thrift Board’s decision with respect to these matters.

On June 20, 2003, AMS, the Thrift Board and the United States entered into a written settlement agreement (“Settlement Agreement”) resolving all outstanding litigation and claims among them relating to AMS’s work on the Thrift Board contract. The Thrift Board also agreed to a no-fault termination of the contract. Under the terms of the Settlement Agreement, the Thrift Board agreed to pay AMS $10,000 for certain work AMS previously had performed, but for which payment remained outstanding. In turn, AMS agreed to pay $15,000 to the Thrift Savings Plan as partial reimbursement of the $31,000 AMS previously had received for other work it had performed under the Thrift Board contract. All parties to the case — Gary A. Amelio, the current Executive Director of the Thrift Board, AMS, and the United States — further agreed to dismiss and terminate all litigation and claims relating to the Thrift Board contract.

Five days later, on June 25, 2003, Thrift Savings Plan participant Roger W. Mehle (the former Executive Director of Thrift Board) filed in the United States Court of Appeals for the District of Columbia Circuit, as a non-party, a Motion for Leave to Intervene. Among other things, Mr. Mehle requested that the Court

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American Management Systems, Incorporated
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS – continued
Unaudited
(In thousands, except per share amounts)

of Appeals issue its ruling in the case, notwithstanding the settlement that had been reached by all parties to the case.

On July 1, 2003, the parties exchanged the payments contemplated under the Settlement Agreement and filed Stipulations of Dismissal in the CFC and the United States Court of Appeals for the District of Columbia Circuit. On July 8, 2003, Appellant Gary A. Amelio, the United States, and AMS each filed separate Oppositions to Mr. Mehle’s Motion for Leave to Intervene. On July 15, 2003, Mr. Mehle filed his initial Reply to all three opposition briefs, followed on July 17, 2003 by an Amended/Corrected Reply. By order filed on August 11, 2003, the United States Court of Appeals for the District of Columbia Circuit denied Mr. Mehle’s Motion for Leave to Intervene and dismissed the case. On July 7, 2003, in accordance with the Settlement Agreement reached by the parties, the CFC entered final dismissal of the action which had been pending in that court.

NOTE 8 – SOFTWARE ASSET IMPAIRMENTS

For the three months ended June 30, 2003 the Company recorded a software asset impairment charge of $9,555. This charge was for the write-off of certain non-performing purchased and developed software assets that are no longer expected to provide future value. The Company incurred no software asset impairment charge for the three months ended June 30, 2002.

NOTE 9 – SUBSEQUENT EVENTS

On July 15, 2003, the Company announced that it signed a definitive agreement to purchase the equity of privately-owned R.M. Vredenburg & Co., a leading provider of professional and technical services to the Department of Defense and U.S. Intelligence communities. The transaction closed on August 1, 2003 for approximately $42,700 in cash and also includes the assumption of certain liabilities, including approximately $2,700 in debt and executive management retention agreements of up to $4,300. The agreement also includes additional contingent payments of up to $4,000 if certain performance conditions are met.

On July 16, 2003, the Company announced the award of a subcontractor agreement (the “IBM Contract”) with IBM Global Services to build a statewide computer network to track child support payments for the California Department of Child Support Services. The AMS portion of the eight-year IBM Contract is valued at approximately $223,500. Under the terms of an asset purchase agreement dated August 21, 2000 between Synergy Consulting, Inc. (a wholly-owned subsidiary of AMS) and GLMRR Corp., the Company is obligated to make two additional purchase price payments totaling 3.5% of the amounts received for services under the IBM Contract. These payments, totaling no more than $7,824, are to be paid 50% upon execution of the IBM Contract and 50% after two years from the date the IBM Contract is executed or work commences, whichever is later, and will be recorded as additional goodwill.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with our unaudited consolidated condensed financial statements and notes included in this Quarterly Report on Form 10-Q and our consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2002. We use the terms “AMS,” “we,” “our,” and “us” to refer to American Management Systems, Incorporated and its subsidiaries.

DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS

Investors are cautioned that this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, relating to our operations that are based on our current expectations, estimates and projections. Words such as “anticipates,” “believes,” “expects,” “estimates,” “intends,” and similar expressions are used to identify these forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Actual results may differ materially from what is expressed or forecast in these forward-looking statements. The reasons for this include changes in general economic and political conditions, including fluctuations in exchange rates and the following factors:

•

The current economic downturn has caused, and future economic downturns may cause, our revenues to decline.

•

Our business may be negatively affected if we are not able to anticipate and keep pace with rapid changes in technology.

•

The consulting, technology and outsourcing markets are highly competitive, and we may not be able to compete effectively.

•

Our success is highly dependent on our ability to recruit and retain talented employees.

•

We rely on relatively few customers for a significant portion of our business.

•

Adverse changes in government spending could have a negative effect on our business.

•

Profitability on our contracts may be adversely affected by project-related risks.

•

Our profitability will suffer if we are not able to maintain our pricing and utilization rates and control our costs.

•

Our profitability may decline due to financial and operational risks inherent in worldwide operations.

•

There are risks inherent in a strategy that includes the acquisition of other businesses.

•

We may face legal liabilities or damage to our professional reputation from claims made against our work.

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•

Our services or solutions may infringe on the intellectual property rights of others.

•

Despite our efforts, our ability to fully protect our intellectual property rights is limited.

For a more detailed discussion of these factors, see the information under the heading “Business – Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2002. We specifically disclaim any obligation to update these forward-looking statements. These forward-looking statements should not be relied on as representing our estimates or views as of any subsequent date.

OVERVIEW

AMS is a premier business and IT consulting firm to the government, financial services, and communications industries around the globe. We combine our IT and industry subject matter expertise and knowledge to drive high-performance results. Our mission is to improve business performance for our customers through the intelligent use of technology.

Known for our delivery and service excellence for more than 30 years, we specialize in enterprise resource planning, credit risk management, customer relationship management, and enterprise security. AMS applies both proprietary and partner technologies, and provides solutions through business consulting, systems integration, and outsourcing.

We engage in business activities as one operating segment and we deliver our services through five target markets where we have significant industry knowledge. This knowledge has been gained through technology ingenuity, experience, and commitment. Our focus on specific industries allows us to tailor our offerings to reflect an understanding of the markets in which our customers operate.

We derive our revenues primarily from contracts for business and IT solutions. The economic environment and level of business activity from our customers affect our revenues. Due to the slowdown in the economy, political uncertainty and weak IT market during 2001 through the first half of 2003, customers reduced or postponed their spending on IT and consulting services, slowing down the number of new contracts into which we entered.

PRESENTATION

Revenues
Our contracts are generally on a fixed-price, time-and-materials or cost-reimbursable basis. With our fixed-price contracts, we believe that we have the ability to produce reasonably dependable estimates regarding the extent of progress toward completion. As such, revenues from these contracts are recognized using the percentage-of-completion basis of accounting based on the percentage of costs incurred in relation to total estimated costs to be incurred over the duration of the contract. These estimates are continually reviewed during the term of the contract and may result in our revision of recognized revenues and estimated total costs during the period when changes in circumstances are identified. Revenues from time-and-materials contracts are recognized to the extent of billable rates times hours delivered plus reimbursable expenses incurred. Revenues from cost-reimbursable contracts are recognized to the extent of costs incurred plus a proportionate amount of the fees earned.

Significant portions of our revenues are from contracts that include the sale of our proprietary software solutions. The majority of these contracts relate to large systems integration projects that provide for the

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integration and customization of our core software. These long-term production-type contracts generally include the delivery of software, integration and customization services, training and maintenance. For these contracts, the entire contract value is generally recognized as revenue using the percentage-of-completion basis of accounting. Large systems integration projects with certain federal customers are structured in phases (e.g., base contract period plus option periods). Option periods for federal customers’ contracts are typically exercised on government appropriations and at the customers’ discretion. These federal contracts require formal acceptance at the end of each phase. Phases may be on a time-and-materials and/or fixed-price basis. Since these federal customers only commit to one phase at a time, we recognize revenues by phase for these contracts.

We also enter into contracts for business purposes that we refer to as benefits-funded contracts. These contracts are similar to our other large systems integration fixed-price contracts; however, the amounts due to us are payable from actual monetary benefits derived by the customer. Benefits-funded contracts are used solely in situations where the customer receives tangible and quantifiable monetary benefits directly from the new system and processes we implemented. These customers have historically been state or city departments of revenue or taxation, with the systems implemented consisting of new integrated tax systems that enable the organizations to find incremental lost tax revenues. For these contracts, we recognize revenues only to the extent that we can predict, with reasonable certainty, that the benefit stream will generate amounts sufficient to fund the value on which revenue recognition is based.

Less than 5% of our revenues include the sale of off-the-shelf software for which there are no significant integration or modification services necessary. These contracts often bundle maintenance or other services along with the sale of the software. Maintenance and product support services sold with software generally provide for minor programming corrections, new releases and help-desk support. The terms of the maintenance agreements vary with each customer but maintenance is generally sold for a twelve-month period, with renewals occurring annually, based on renewal rates stated in the original contract. For contracts that include off-the-shelf software and maintenance or other services, we assign part of the contract value to each element of the contract based on its relative fair value and recognize revenues for the license fee once the software has been delivered. Maintenance revenues are recognized ratably over the maintenance period and service revenues are recognized as services are delivered.

Additionally, we enter into contracts with customers that do not include the sale or integration of software. These contracts offer general consulting or training services and are typically performed on a time-and-materials or cost-reimbursable basis.

Certain of our contracts relate to systems that we implement and host for customers. Revenues are recognized from these contracts in accordance with the contractual terms on a straight-line or transaction-volume basis, as appropriate.

On all of our contracts, expense reimbursements, including those relating to travel and out-of-pocket expenses, are included in Revenues, and an equivalent amount of reimbursable expenses are included in Cost of Revenues.

Operating Expenses
Our major types of operating expenses comprise the following:

•

Cost of Revenues include direct expenses to provide products and services to our customers such as compensation costs, travel and out-of-pocket expenses, costs for subcontractors, amortization of purchased and developed software for external sale to customers, product support and

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maintenance costs.

•

Selling, General and Administrative (“SG&A”) expenses include expenses not directly related to the delivery of products or services such as compensation for support personnel, rent expense, costs for information systems, selling and marketing expenses, recruiting and training expenses, depreciation expense, and amortization expense for internal-use software.

•

Research and Development expenses include expenses incurred as part of the software development cycle that are not capitalized.

•

Restructuring Charge includes expenses associated with employee severance and abandoned facilities.

•

Software Asset Impairments include significant expenses associated with the write-down of certain software assets to net realizable value.

•

Contract Litigation Settlement Expense includes costs associated with the settlement of litigation with the Federal Retirement Thrift Investment Board.

Interest Expense
Interest expense (net of interest income) is related to interest incurred on borrowings and fees on our revolving credit facility. It also includes interest expense related to our deferred compensation plans.

Other Income
Other income (net of other expense) contains activity not related to our primary business. For example, other income includes gains and losses on the disposal of assets and market gains and losses and premium expense on company-owned life insurance policies.

CRITICAL ACCOUNTING POLICIES

The discussion and analysis of our financial condition and results of operations is based on our unaudited consolidated condensed financial statements. The preparation of these interim financial statements requires management to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses. Actual results may differ from these estimates under different assumptions or conditions.

Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. Application of these policies is particularly important to the portrayal of our financial condition and results of operations. Accounting policies and estimates that management believes are most critical to our financial condition and operating results pertain to revenue recognition, net realizable value of software, income taxes and variable compensation. We have discussed the application of these critical accounting policies with the Audit Committee of our Board of Directors.

Revenue Recognition
Most of our revenues are generated from contractual arrangements, some of which are complex in nature. Many of these contracts require significant revenue recognition judgments, particularly in the areas of progress toward completion, multiple-element arrangements and, primarily with respect to our benefits-funded contracts, collectibility. Our contracts are generally on a fixed-price, time-and-materials or cost-

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reimbursable basis. Revenues from fixed-price contracts are recognized using the percentage-of-completion basis of accounting based on the percentage of costs incurred in relation to total estimated costs to be incurred over the duration of the contract. Revenues from time-and-materials contracts are recognized to the extent of billable rates times hours delivered plus reimbursable expenses incurred. Revenues from cost-reimbursable contracts are recognized to the extent of costs incurred plus a proportionate amount of the fee earned.

In using the percentage-of-completion basis of accounting for our fixed-price (including benefits-funded) contracts, we make important judgments in estimating total costs to complete the contracts in determining revenue recognition. These judgments underlie our determinations regarding overall contract value and contract profitability. As such, these estimates are continually reviewed during the term of the contract and may result in our revision of recognized revenues and estimated total costs during the period when changes in circumstances are identified. Circumstances that may result in changes to recognized revenues include changes in estimates of costs required to complete an engagement, changes in staffing mix and changes in customer participation, as well as other factors.

Our benefits-funded contracts are similar to our other large systems integration fixed-price contracts with the exception that the amounts due to us are payable from actual monetary benefits derived by the customer. As such, these contracts require us to apply judgments in determining whether the full contract value will be funded and what the expected profitability on the contract will be. Benefits-funded contracts are used solely in situations where the customer receives tangible and quantifiable monetary benefits directly from the new system and processes we implemented. For these contracts, we recognize revenues only to the extent that we can predict, with reasonable certainty, that the benefit stream will generate amounts sufficient to fund the value on which revenue recognition is based.

Net Realizable Value of Software
We develop software for external sale and capitalize the associated software development costs once technological feasibility has been established. We regularly evaluate the net realizable value of capitalized software using the estimated, undiscounted, net cash flows of the underlying products. Asset balances that exceed the expected net realizable value are written off as Software Asset Impairments.

Income Taxes
Determining the consolidated provision for income tax expense, deferred tax assets and liabilities and related valuation allowance involves judgments. As a global company with subsidiaries in 16 foreign countries and the U.S., we are required to calculate and provide for income taxes in each of the tax jurisdictions where we operate. This involves estimating current tax exposures in each jurisdiction as well as making judgments regarding the recoverability of deferred tax assets. Tax exposures can involve complex issues and may require an extended period to resolve. Changes in the geographic mix or estimated levels of annual pre-tax income can affect our overall effective tax rate.

Variable Compensation
Variable compensation is a significant discretionary expense that is highly dependent on management estimates and judgments, particularly at each interim reporting date. In arriving at the amount of expense to recognize, management believes it makes reasonable estimates and judgments using all significant information available. Expenses accrued for variable compensation are based on actual quarterly and annual performance versus plan targets and other factors. Amounts accrued are subject to change in future periods until annual results are finalized.

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HISTORICAL RESULTS OF OPERATIONS

The following table sets forth the unaudited percentage of revenues represented by items in our unaudited consolidated condensed income statements for the periods presented.