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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 31, 2002

Commission File Number 0-20842

PLATO LEARNING, INC.

Not Applicable

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 the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

(This document contains 30 pages)

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PLATO Learning, Inc. and Subsidiaries

INDEX

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PART I. FINANCIAL INFORMATION

PLATO LEARNING, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share amounts)

See Notes to Consolidated Financial Statements

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PLATO LEARNING, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)

Note: The balance sheet at October 31, 2001 has been derived from the audited financial
statements at that date. See Notes to Consolidated Financial Statements.

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PLATO LEARNING, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)

See Notes to Consolidated Financial Statements

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)

Nature of Business

PLATO Learning, Inc. and its subsidiaries provide computer-based and e-learning instruction software and related services, offering basic to advanced level courseware in reading, writing, math, science, social studies and life and job skills. Our PLATO® Learning System and PLATO® Web Learning Network provide more than 3,500 hours of objective-based, problem solving courseware and include assessment, alignment and management tools to create standards-based curricula and facilitate the learning process. PLATO courseware is delivered via networks, CD-ROM, private intranets and the Internet. In addition, single topic PLATO courseware is available through our e-commerce Web site and distributors. We market our courseware products and services to K-12 schools, colleges, job training programs, correctional institutions, military education programs, corporations and individuals.

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. We have included all normal recurring adjustments considered necessary to give a fair presentation of our operating results for the interim periods shown. Operating results for these interim periods are not necessarily indicative of the results to be expected for the full fiscal year. For further information, refer to the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the fiscal year ended October 31, 2001.

Certain reclassifications of previously reported amounts have been made to conform to the current year presentation and had no impact on net earnings (loss), cash flows or stockholders’ equity.

Revenue Recognition

We recognize revenue in accordance with the provisions of Statement of Position No. 97-2, “Software Revenue Recognition”, as amended and modified, as well as Technical Practice Aids issued from time to time by the American Institute of Certified Public Accountants, and Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements”.

Revenue from the sale of courseware licenses and computer hardware is recognized upon meeting the following criteria: (i) a written customer order is executed, (ii) courseware and hardware are delivered, (iii) the license fee is fixed or determinable and (iv) collectibility of the

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)

Revenue Recognition, Continued

proceeds is probable. For software arrangements that include more than one element, we allocate the total arrangement fee among each deliverable based on vendor-specific objective evidence of the relative fair value of each deliverable. Vendor-specific objective evidence of fair value is determined using the price charged when that element is sold separately. Upon delivery, future service costs, if any, are accrued. Future service costs represent our problem resolution and support “hotline” services for a one-year period. Service revenue includes software support, which is deferred and recognized ratably over the support period, and revenue from installation and training services, which is recognized as services are performed. Installation and training services are customarily billed at a fixed daily rate. Deferred revenue represents the portion of billings made or payments received in advance of services being performed or products being delivered.

Product Development, Enhancement and Maintenance Costs

Costs incurred in the development, enhancement and routine maintenance of our current generation courseware products are expensed as incurred. Costs incurred in establishing the technological feasibility of new courseware products are expensed as incurred. Once technological feasibility has been established, costs incurred in the development of new generation courseware products are capitalized. Technological feasibility is established when we have completed all planning, designing, coding and testing activities necessary to establish that a product can be produced to meet its design specifications.

Capitalized costs are amortized to product development and customer support expense over the estimated useful life of the new courseware products, which is generally three years. Amortization begins when the product is available for general release to our customers. Unamortized costs determined to be in excess of the net realizable value of the product, if any, are expensed at the date of such determination.

Amortization expense related to capitalized product development costs was $1,066 and $863 for the three months and $3,006 and $2,114 for the nine months ended July 31, 2002 and 2001, respectively.

Earnings (Loss) Per Share

Basic earnings (loss) per share is calculated by dividing net earnings (loss) by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share is calculated by dividing net earnings (loss) by the weighted average number of common and, where dilutive, potential common shares outstanding during the period. Potential common shares include options and warrants.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)

NetSchools Corporation

In May 2002, we acquired NetSchools Corporation (“NetSchools”), a provider of Internet-based e-learning software and services solutions for the K-12 market. NetSchools offers a web-based curriculum and instructional management delivery platform that facilitates delivery of school curriculum aligned to local, state and national standards and facilitates online assessment, lesson planning and content delivery. This acquisition will enhance our ability to provide enterprise-wide solutions that align classroom education across all standards and deliver compelling and effective content through NetSchools’ instructional management platform.

We acquired all the shares of NetSchools for $6,050 in cash; 800,000 shares of our common stock; 200,000 warrants to purchase shares of our common stock at $17.00 per share through May 9, 2007; assumed liabilities and transaction expenses; and additional consideration of up to approximately $6,000, contingent on the NetSchools’ product and services revenues generated through October 2004. If earned, any additional consideration will be recorded as additional goodwill.

The purchase price consisted of the following components:

The allocation of the total purchase price, including acquisition fees, was as follows:

The NetSchools acquisition was accounted for under SFAS 141 using the purchase method of accounting and, accordingly, the assets and liabilities acquired were recorded at their estimated fair values on the acquisition date.

Direct acquisition fees consisted of $1,700 for investment banking, legal and professional fees, $1,125 for NetSchools change-in-control and management incentive payments, and $750 for lease termination costs. Substantially all of these fees have been paid as of July 31, 2002.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)

NetSchools Corporation, Continued

In connection with this acquisition, we developed plans for employee relocations and workforce and facility reductions. The aggregate estimated costs of these plans are $767 which consisted of $315 related to the elimination of 39 positions, $282 related to lease termination and $170 related to employee relocation. As of July 31, 2002, severance payments of $79 had been made related to the termination of ten of these employees, and payments of $137 and $20 had been made related to lease termination and employee relocation, respectively. We expect to complete these activities within one year from the acquisition date. Until these activities are completed, the allocation of the purchase price is preliminary and subject to adjustment.

Total cash usage related to this acquisition in 2002 is expected to be approximately $12,000 which includes $6,050 cash paid as part of the purchase price, $3,575 in direct acquisition fees, and $2,366 of NetSchools bank debt repaid subsequent to the closing date of the acquisition.

The valuation of identified intangible assets, consisting of a customer list, acquired technology and in-process research and development, was performed by an independent appraisal firm. Goodwill and intangible assets are subject to the provisions of SFAS 142. Goodwill will not be amortized; however, it will be tested for impairment on an annual basis. The customer list and acquired technology are being amortized over five to seven years.

At the date of acquisition, $360 of the purchase price was expensed for purchased in-process research and development related to a new version of NetSchools’ Orion product, which had not yet reached technological feasibility and had no alternative future use. The Orion product is an online tool for curriculum management and correlation to state education standards. The value assigned to this in-process research and development was determined by estimating the total costs required to develop the new product. At the acquisition date, the new Orion product was approximately 67% complete and is expected to be completed in 2002 at an estimated cost of approximately $200.

Unaudited ProForma Data

In April 2001, we acquired Wasatch Interactive Learning Corporation (“Wasatch”). For further information regarding this acquisition, refer to Note 2 of Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended October 31, 2001.

The operating results of Wasatch and NetSchools were included in our consolidated statements of operations from the date of acquisition. Our unaudited pro forma consolidated results of

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)

Unaudited ProForma Data, Continued

operations, as if the Wasatch and NetSchools acquisitions had occurred at the beginning of the periods presented, were as follows:

		Nine Months Ended July 31,
		2002				2001
Revenues		$	56,302			$	60,887
Net loss			(6,017	)			(9,951	)
Diluted loss per share			(0.35	)			(0.73	)

The unaudited pro forma consolidated results of operations are for comparative purposes only and do not necessarily reflect the results that would have occurred had the acquisitions occurred at the beginning of the periods presented or the results which may occur in the future.

Accounts receivable include installment receivables of $17,460 and $16,087 at July 31, 2002 and October 31, 2001, respectively. Installment receivables to be billed beyond one year from the balance sheet date were $1,622 and $2,021 at July 31, 2002 and October 31, 2001, respectively, and are included in other assets on the consolidated balance sheets.

Effective November 1, 2001, we adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”).

Goodwill

Under SFAS 142, goodwill is no longer amortized to expense and must be periodically reviewed for impairment with any related losses recognized when incurred. We have completed the transitional impairment test of goodwill as of November 1, 2001 and the carrying value of goodwill was not impaired. The carrying value of our goodwill was $16,152 at November 1, 2001 and $38,486 at July 31, 2002. At July 31, 2002, our goodwill was not impaired; however, subsequent to that date, the market value of our common stock had declined to a point where our market capitalization was below our net book value. This may indicate a potential impairment of our goodwill if the market value of our common stock does not increase.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)

Goodwill, Continued

For the three and nine months ended July 31, 2001, $663 and $1,077 of goodwill amortization expense was recorded. The following table presents the impact of SFAS 142 on net income (loss) and the related per share amounts as if it had been in effect for the three and nine months ended July 31, 2001:

Other Intangible Assets

Acquired intangible assets subject to amortization at July 31, 2002 were as follows:

Amortization expense for intangible assets was $418 and $930 for the three and nine months ended July 31, 2002, respectively, of which $75 and $225 was included in product development and customer support expense for each period. Amortization expense for the three and nine months ended July 31, 2001 was $230 and $435, respectively, of which $75 and $100 was included in product development and customer support expense for each period.

The estimated annual amortization expense for intangible assets is as follows:

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)

Revolving Loan

We closed a new revolving loan agreement on December 20, 2001 that provides for a maximum $12,500 line of credit through July 1, 2003. Substantially all of our assets are pledged as collateral under the agreement.

Borrowings are limited by the available borrowing base, as defined, consisting of certain accounts receivable and bear interest at the prime rate plus 0.25% or the London Interbank Offered Rate (LIBOR) plus 1.75 to 2.75%, depending on cash flow leverage, as defined, at our option pursuant to the agreement. A commitment fee is payable quarterly based on the unused portion of the line of credit.

The agreement contains restrictive financial covenants (including Minimum Tangible Net Worth, Minimum Debt Service Coverage, Maximum Leverage, Maximum Cash Flow Leverage, Minimum Current Ratio and Maximum Annual Capital Expenditures) and restrictions on additional borrowings, asset sales and dividends, as defined. We did not comply with the Minimum Debt Coverage covenant for the period ended July 31, 2002 and we received a waiver from our lender covering this noncompliance for such period.

At July 31, 2002, there were no borrowings outstanding under the revolving loan agreement and our unused borrowing capacity was $12,500.

Capital Lease Obligations

At July 31, 2002, our only debt consisted of various capital lease obligations for equipment. Amounts due in the next twelve months under these leases are classified as a current liability in the consolidated balance sheets.

We issued approximately 166,000 shares of our common stock upon the exercise of outstanding stock options during the nine months ended July 31, 2002.

In May 2002, we issued 800,000 shares of our common stock and warrants to purchase 200,000 shares of our common stock at $17.00 per share through May 9, 2007 in connection with the acquisition of NetSchools (see Note 2). The warrants were assigned a value of $969 using the Black-Scholes option pricing model.

In December 2001, our Board of Directors approved a stock repurchase plan that authorizes us to repurchase up to $15,000 of our common stock in the open market and in privately negotiated transactions. The plan has no set termination date and the timing of any repurchases will be dependent on prevailing market conditions and alternative uses of capital. For the nine months

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)

ended July 31, 2002, we repurchased approximately 953,000 shares of our common stock for $11,089 and these shares were reflected as treasury stock in the consolidated balance sheet. The repurchase of these shares had no significant impact on our reported net earnings (loss) per share.

Diluted loss per share is the same as basic loss per share for each of the three and nine months ended July 31, 2002 as approximately 2,421,000 potential shares of common stock from conversion of outstanding stock options and warrants were anti-dilutive. The impact on weighted average shares outstanding related to these potential common shares was approximately 369,000 and 568,000 for the three and nine months ended July 31, 2002, respectively.

Total comprehensive income (loss) was as follows:

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share amounts)

Acquisition of LearningElements

In August 2002, we acquired LearningElements, a privately-held corporation and Maryland-based provider of comprehensive K-3 reading curriculum, for $2,950 in cash and $3,050 of our common stock. This acquisition will enhance our growing curriculum solution for elementary schools by providing a research-based early reading product line that meets new federal education guidelines.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
(Dollars in thousands, except per share amounts)

OVERVIEW

We enhance the learning process by providing computer-based and e-learning instruction software and related services, offering basic to advanced level courseware in reading, writing, math, science, social studies and life and job skills. Our PLATO® Learning System and PLATO® Web Learning Network provide more than 3,500 hours of objective-based, problem solving courseware and include assessment, alignment and management tools to create standards-based curricula and facilitate the learning process. PLATO courseware is delivered via networks, CD-ROM, private intranets and the Internet. In addition, single topic PLATO courseware is available through our e-commerce web site and distributors. We market our courseware products and services to K-12 schools, colleges, job training programs, correctional institutions, military education programs, corporations and individuals.

CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of results of operations and financial condition is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We continually evaluate our critical accounting policies and have identified revenue recognition, the valuation of accounts receivable, the capitalization of product development costs and the valuation of our deferred tax asset as the critical accounting policies that are significant to the financial statement presentation and require difficult, subjective and complex judgments.

Revenue Recognition

Revenue recognition rules for software companies are very complex. We follow specific and detailed guidelines in determining the proper amount of revenue to be recorded; however, certain judgments affect the application of our revenue recognition policy. Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter.

The most significant judgments for revenue recognition typically involve whether there are any significant uncertainties regarding customer acceptance and whether collectibility can be considered probable. In addition, our transactions often consist of multiple element arrangements which must be analyzed to determine the relative fair value of each element, the amount of revenue to be recognized upon shipment, if any, and the period and conditions under which deferred revenue should be recognized.

For additional description of our revenue recognition policy, see Note 1 to Consolidated Financial Statements.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
(Dollars in thousands, except per share amounts)

CRITICAL ACCOUNTING POLICIES, Continued

Allowance for Doubtful Accounts

We determine an allowance for doubtful accounts based upon an analysis of the collectibility of specific accounts, historical experience and the aging of the accounts receivable. Bad debt expense is recorded as an operating expense in our consolidated statement of earnings. The assumptions and estimates used to determine the allowance are subject to constant revision. The primary factors that impact these assumptions include the efficiency and effectiveness of our billing and collection functions and our credit assessment process. Actual collection results could differ materially from those estimated and have a significant impact on our results of operations and financial condition.

Capitalization of Product Development Costs

Our product development expense includes costs related to the development, enhancement and maintenance of our courseware products, and the effect of product development cost capitalization and amortization. We capitalize our product development costs when the projects under development reach technological feasibility, as defined by the accounting standards, and amortize these costs over the estimated useful lives of the courseware products.

The most significant judgments regarding capitalization of product development costs typically involve the determination of when development efforts reach technological feasibility and the recoverability of capitalized costs. We continually evaluate our capitalized costs to determine if the unamortized balance related to any given product exceeds the estimated net realizable value of that product. Estimating net realizable value requires us to estimate future cash flows to be generated by the product and to use judgment in quantifying the amount, if any, to be written off. Actual cash flows and amounts realized from the courseware products could differ materially from those estimated. In addition, any future changes to our courseware product offerings could result in write-offs of previously capitalized costs and have a significant impact on our results of operations and financial condition.

For additional description of our policy regarding product development, enhancement and maintenance costs, see Note 1 to Consolidated Financial Statements.

Deferred Tax Asset

We account for deferred income taxes based upon differences between the financial reporting and income tax bases of our assets and liabilities. The measurement of the deferred tax asset is adjusted by a valuation allowance, if necessary, to recognize the extent to which the future tax benefits will be recognized.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
(Dollars in thousands, except per share amounts)

CRITICAL ACCOUNTING POLICIES, Continued

Deferred Tax Asset, Continued

At July 31, 2002 we had a net deferred tax asset of approximately $10,843. This deferred tax asset is net of a valuation allowance related to a foreign net operating loss carryforward. A substantial portion of the deferred tax asset relates to our net operating loss carryforward in the United States. We have recorded the net deferred tax asset as we believe that it is more likely than not that we will be able to realize the asset through generation of future taxable income in the United States. We base this belief upon the levels of taxable income generated historically as well as projections of future taxable income. If future levels of taxable income in the United States are not consistent with our expectations, we may be required to record a valuation allowance, which could reduce our net income by a material amount.

ACQUISITION

In May 2002, we acquired NetSchools Corporation (“NetSchools”), a provider of Internet-based e-learning software and services solutions for the K-12 market. NetSchools offers a web-based curriculum and instructional management delivery platform that facilitates delivery of school curriculum aligned to local, state and national standards and facilitates online assessment, lesson planning and content delivery. This acquisition will enhance our ability to provide enterprise-wide solutions that align classroom education across all standards and deliver compelling and effective content through NetSchools’ instructional management platform.

We acquired all the shares of NetSchools for $6,050 in cash; 800,000 shares of our common stock; 200,000 warrants to purchase shares of our common stock at $17.00 per share through May 9, 2007; assumed liabilities and transaction expenses; and additional consideration of up to approximately $6,000, contingent on the NetSchools’ product and services revenues generated through October 2004. If earned, any additional consideration will be recorded as additional goodwill.

The NetSchools acquisition was accounted for using the purchase method of accounting (see Note 2 to Consolidated Financial Statements) and the operating results of NetSchools were included in our financial statements from the date of acquisition.

Direct acquisition fees consisted of $1,700 for investment banking, legal and professional fees, $1,125 for NetSchools change-in-control and management incentive payments, and $750 for lease termination costs. Substantially all of these fees have been paid as of July 31, 2002.

In connection with this acquisition, we developed plans for employee relocations and workforce and facility reductions. The aggregate estimated costs of these plans are $767 which consisted of $315 related to the elimination of 39 positions, $282 related to lease termination and $170 related to employee relocation. As of July 31, 2002, severance payments of $79 had been made related to the termination of ten of these employees, and payments of $137 and $20 had been made related to lease termination and employee relocation, respectively. We expect to complete these activities within one year from

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
(Dollars in thousands, except per share amounts)

ACQUISITION, Continued

the acquisition date. Until these activities are completed, the allocation of the purchase price is preliminary and subject to adjustment.

Total cash usage related to this acquisition in 2002 is expected to be approximately $12,000 which includes $6,050 cash paid as part of the purchase price, $3,575 in direct acquisition fees, and $2,366 of NetSchools bank debt repaid subsequent to the closing date of the acquisition.

The valuation of identified intangible assets, consisting of a customer list, acquired technology and in-process research and development, was performed by an independent appraisal firm. Goodwill and intangible assets are subject to the provisions of SFAS 142. Goodwill will not be amortized; however, it will be tested for impairment on an annual basis. The customer list and acquired technology are being amortized over five to seven years.

At the date of acquisition, $360 of the purchase price was expensed for purchased in-process research and development related to a new version of NetSchools’ Orion product, which had not yet reached technological feasibility and had no alternative future use. The Orion product is an online tool for curriculum management and correlation to state education standards. The value assigned to this in-process research and development was determined by estimating the total costs required to develop the new product. At the acquisition date, the new Orion product was approximately 67% complete and is expected to be completed in 2002 at an estimated cost of approximately $200.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
(Dollars in thousands, except per share amounts)

RESULTS OF OPERATIONS

Operating Results as a Percentage of Revenue