UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

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, 2004

Commission File Number 0-20842

PLATO LEARNING, INC.

Registrant’s telephone number, including area code: (952)832-1000

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 by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act:  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.

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PLATO Learning, Inc.
Form 10-Q

INDEX

2

PLATO Learning, Inc. and Subsidiaries

See Notes to Consolidated Financial Statements

3

PLATO Learning, Inc. and Subsidiaries

Note: The balance sheet at October 31, 2003 has been derived from our audited
financial statements at that date. See Notes to Consolidated Financial Statements.

4

PLATO Learning, Inc. and Subsidiaries

See Notes to Consolidated Financial Statements

5

PLATO Learning, Inc. and Subsidiaries

1.

Business

We enhance the learning process by providing computer-based and e-learning instruction software for kindergarten through adult learners, offering curricula in reading, writing, mathematics, science, social studies and life and job skills. We also offer innovative online assessment and accountability solutions and standards-based professional development services. With over 6,000 hours of objective-based, problem-solving courseware, plus assessment, alignment and curriculum management tools, we create standards-based curricula that facilitate learning and school improvement. 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 primarily to K-12 schools and colleges. We also sell to job training programs, correctional institutions, military education programs, corporations and individuals.

We are subject to risks and uncertainties including, but not limited to, dependence on information technology spending by our customers, well-established competitors, customers dependent on government funding, fluctuations of our quarterly results, a lengthy and variable sales cycle, dependence on key personnel, dependence on our intellectual property rights, rapid technological change and our ability to integrate acquisitions.

2.

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, and other adjustments specifically relating to goodwill as discussed in Note 6, 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, 2003.

The accompanying unaudited consolidated financial statements include the accounts of PLATO Learning, Inc. and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Certain reclassifications of previously reported amounts have been made to conform to the current period presentation in the consolidated statements of operations. These reclassifications did not change previously reported revenues, operating loss or net loss and related per share amounts. For more information on these reclassifications, refer to Note 3 to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended October 31, 2003.

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

3.

Summary of Significant Accounting Policies

For more information on our significant accounting policies, refer to Note 2 to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended October 31, 2003.

Stock-Based Compensation

We account for our stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” and comply with the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148 “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of Financial Accounting Standards Board (“FASB”) Statement No. 123.”

We have adopted the disclosure-only provisions of SFAS No. 123. For purposes of the pro forma disclosures below, the estimated fair value of stock-based employee compensation is amortized to expense over the vesting period of the related arrangement. Had compensation expense for the stock-based employee compensation been recognized based on the fair value at the grant date consistent with the provisions of SFAS No. 123, reported results would have been adjusted to the pro forma amounts presented below:

New Accounting Pronouncements

In January 2003, the FASB issued FASB Interpretation No. (“FIN”) 46, “Consolidation of Variable Interest Entities.” In December 2003, the FASB issued a revised version of this Interpretation, FIN 46®. FIN 46® addresses the requirements for business enterprises to consolidate related entities, in which they do not have controlling interests through voting or other rights, if they are determined to be the primary beneficiary of these entities as a result of variable economic interests. FIN 46 or FIN 46® must be applied to Special Purpose Entities (“SPEs”) created prior to February 1, 2003 and all entities, including SPEs, created subsequent to

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

January 31, 2003 in our first quarter of fiscal year 2004. FIN 46® also must be applied for all entities created prior to February 1, 2003 in our second quarter of fiscal year 2004.

We adopted FIN 46® beginning in our first quarter of fiscal year 2004, and no variable interests with SPEs or entities created prior to February 1, 2003 or subsequent to January 31, 2003 have been identified; therefore, there was no impact on our consolidated financial statements, and no disclosures were required. While we currently have no arrangements of this nature, if we enter into any such arrangements in the future, our consolidated financial statements may be adversely affected.

4.

Acquisitions

We account for business combinations in accordance with SFAS No. 141, “Business Combinations.” All of our acquisitions, including those prior to the adoption of SFAS No. 141, were accounted for using the purchase method of accounting. The assets and liabilities acquired were recorded at their estimated fair values on the dates of acquisition. Operating results of the acquired companies were included in our consolidated financial statements from the dates of acquisition. Acquisition-related goodwill and identified intangible assets are subject to the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets”, which require goodwill to be tested periodically for impairment, but not be amortized. Identified intangible assets are amortized over their estimated lives. See Note 6 for additional information regarding goodwill and identified intangible assets.

Lightspan, Inc.

On November 17, 2003, we acquired Lightspan, Inc. (“Lightspan”), a publicly-held corporation and provider of curriculum-based educational software and online assessment products used in schools, at home and in community colleges. This acquisition is expected to strengthen our product offerings in the K-8 and post-secondary markets and enhance our ability to provide comprehensive solutions to K-12 and adult learning institutions.

We acquired all of the outstanding shares of Lightspan for 6,576,129 shares of our common stock valued at $52,082 for accounting purposes, $23,361 for estimated assumed liabilities, $2,700 for estimated severance payments, $900 for estimated lease termination costs, and direct acquisition fees of $1,931. Of the 6,576,129 shares issued, 1,301,692 were from our treasury stock. Direct acquisition fees consisted primarily of investment banking, legal and professional fees. The number of shares issued included shares issued for Lightspan’s in-the-money stock options. The fair value of the Lightspan options and warrants assumed in connection with the merger and converted to PLATO options and warrants was not significant.

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

The purchase price consisted of the following components:

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

An appraisal firm assisted us with the valuation of identified intangible assets, consisting of $19,800 for customer relationships, $7,300 for developed content and technology, $2,300 for trademarks and trade names and $1,000 for a non-compete agreement. These identified intangible assets are being amortized over periods of seven years for customer relationships, nine years for developed content and technology, four and one-half years for trademarks and trade names and two years for the non-compete agreement.

In connection with this acquisition, we developed plans for workforce and facility reductions. The aggregate estimated costs of these plans is $3,700, which consisted of $2,700 related to the elimination of 144 positions in the United States and $900 related to lease termination, which ends October 31, 2004 and has a minimum monthly lease payment of $106. As of July 31, 2004, approximately $2,390 of the estimated $2,700 of severance costs have been paid. We expect to complete these activities within one year from the acquisition date. Until the lesser of one year or when these activities are completed, the allocation of the purchase price is preliminary and subject to adjustment.

See Note 6 for discussion of purchase price adjustments made subsequent to the acquisition date.

New Media (Holdings) Limited

On December 17, 2003, we acquired New Media (Holdings) Limited (“New Media”), a United Kingdom (“U.K.”) based publisher of curriculum-focused software primarily for teaching secondary school science and math, for approximately $6,800 in cash. This acquisition enhances our science offering, provides a science simulation development capability that we did not previously have and will allow us to introduce New Media’s products to markets in the United States for the first time. Additionally, this acquisition is expected to provide critical mass and revenue diversification in the U.K. and strengthen our relationships with the U.K. Education Department.

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

The purchase price consisted of the following components:

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

An appraisal firm assisted us with the valuation of identified intangible assets, consisting of $1,804 for developed content and technology and $135 for customer relationships. These identified intangible assets are being amortized over periods of four to seven years for developed content and technology and one to five years for customer relationships.

Unaudited Pro Forma Data

Our unaudited pro forma consolidated results of operations, as if the Lightspan acquisition had occurred at the beginning of the periods presented, were as follows:

The unaudited pro forma data gives effect to actual operating results prior to the acquisition and adjustments to reflect increased identified intangible asset amortization and the current accounting treatment of income taxes. No effect has been given to cost reductions or operating synergies in this presentation. 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 acquisition occurred at the beginning of the periods presented or the results which may occur in the future. The pro forma data does not include New Media, as the effects of this acquisition were not material on a pro forma basis.

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

5.

Accounts Receivable

The components of accounts receivable were as follows:

The provision for doubtful accounts, included in general and administrative expense on the consolidated statements of operations, was $695 and $555 for the three months and $1,522 and $1,607 for the nine months ended July 31, 2004 and 2003, respectively.

6.

Goodwill and Identified Intangible Assets

We account for goodwill and identified intangible assets in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized to expense and must be periodically reviewed for impairment. If such review indicates that the carrying amount of an intangible asset exceeds its fair value, an impairment loss would be recognized equal to that excess amount.

Goodwill

The changes in goodwill from October 31, 2003 were as follows:

Goodwill was decreased by $2,895 during the three months ended January 31, 2004 as a result of the release of escrow shares relating to the NetSchools acquisition in 2002. As of July 31, 2004, 100,000 shares remained in escrow relating to this acquisition.

Goodwill was decreased by $1,943 during the three months ended July 31, 2004 as a result of adjustments to the purchase price allocation for the Lightspan acquisition. Estimated lease termination costs were reduced by $100, liabilities assumed relating to commissions and bonuses were reduced by $2,670 and the fair value of tangible assets acquired relating to pre-acquisition

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

directors and officers insurance was reduced by $827. Additional adjustments to the purchase price allocation may be necessary as we finalize the purchase accounting for this acquisition.

Identified Intangible Assets

Identified intangible assets subject to amortization were as follows:

Amortization expense for identified intangible assets was $1,943 and $525 for the three months ended July 31, 2004 and 2003, respectively, of which $831 and $378 was included in cost of revenues for each period. Amortization expense was $5,706 and $1,495 for the nine months ended July 31, 2004 and 2003, respectively, of which $2,509 and $1,054 was included in cost of revenues for each period.

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

7.

Debt

Revolving Loan

On June 10, 2004, we extended our revolving loan agreement with Wells Fargo Bank, N.A. through July 1, 2005. The revolving loan agreement provides for a maximum $12,500 line of credit. Substantially all of our assets are pledged as collateral under the agreement. There were no borrowings outstanding at July 31, 2004 or October 31, 2003.

The agreement contains restrictive financial covenants (including Minimum Tangible Net Worth, Minimum Debt Service Coverage, Maximum Leverage, Maximum Cash Flow Leverage and

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

Maximum Annual Capital Expenditures) and restrictions on additional borrowings, asset sales and dividends, as defined. All applicable covenants were satisfied as of and for the twelve-month period ended July 31, 2004.

8.

Deferred Revenue

The components of deferred revenue were as follows:

9.

Restructuring Charges

In May 2003, we replaced our Managing Director of operations in the United Kingdom, and severed relationships with two senior executives (our Chief Operating Officer and a co-founder of NetSchools) and three other employees in connection with a restructuring plan to align our cost structure with future expectations. The consolidated statement of operations for 2003 included a restructuring charge of $422 recorded in the third quarter for severance costs related to this action. As of October 31, 2003, approximately $252 of these severance costs had been paid and as of July 31, 2004 substantially all of these severance costs had been paid.

In December 2002, we reduced the size of our workforce by approximately 30 positions and closed approximately 30 open job requisitions, all in the United States, which together represented about 10% of our planned workforce, in connection with a restructuring plan to align our cost structure with future expectations. The consolidated statement of operations for 2003 included a restructuring charge of $380 recorded in the first quarter for severance costs related to this reduction. All of these severance costs were paid as of October 31, 2003.

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

10.

Income Taxes

At October 31, 2003, we had a net deferred income tax asset of $2,218. Approximately $7,377 of the deferred tax asset related to our net operating loss carryforwards in the United States of approximately $18,500, which expire in varying amounts between 2004 and 2023. We also had net operating loss carryforwards of approximately $3,000 related to our foreign subsidiaries. We provided a full valuation allowance related to these foreign deferred tax assets due to the uncertainty in realization of future taxable income in these foreign jurisdictions.

Realization of our deferred tax asset is dependent on generating sufficient taxable income in the United States prior to expiration of these loss carryforwards. Although realization was not assured at October 31, 2003, we believed it was more likely than not that all of the deferred tax asset would be realized. We based this belief upon the levels of taxable income generated historically, as well as projections of future taxable income. However, our merger with Lightspan in the first quarter of fiscal 2004 impacted our assessment of the realization of deferred tax assets because the merged company is considered one consolidated taxable entity. As a result of the merger, we acquired approximately $290,000 of Lightspan’s net operating loss carryforwards. Based on a preliminary Section 382 limitation analysis, the usage of these net operating loss carryforwards is limited to approximately $2,500 per year and, therefore, approximately $35,000 of the acquired net operating loss carryforwards are available to the combined entity. These amounts are preliminary and may change as the Section 382 limitation analysis is finalized.

Our combined net operating loss carryforwards as of the acquisition date were approximately $57,000. The combined net operating loss carryforwards, which represent the majority of the merged company’s deferred tax assets, must be reviewed for realization primarily based upon historical results and secondarily upon projected results. Although we expect taxable income in 2004, this expectation is highly dependent on the integration of the Lightspan acquisition. Lightspan has historically incurred significant operating losses which carry more weight than the projected results. Consequently, it is our current view that, while we had cumulative taxable income for the last three fiscal years, our combined historical operating results were insufficient to support the combined post-merger deferred tax assets. As a result, net deferred tax assets, excluding the deferred tax liability relating to tax deductible goodwill, which cannot be used to support realization of the other net deferred tax assets, were fully reserved for in the purchase accounting for the Lightspan acquisition in our first quarter of 2004 thereby increasing goodwill. Any subsequent reversal of the valuation allowance recorded on the combined entity’s pre-acquisition deferred tax assets will be recorded as income tax expense and a reduction of goodwill.

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

11.

Per Share Data

Basic loss per share is calculated by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted loss per share is calculated by dividing net 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.

The calculation of basic and diluted earnings (loss) per share was as follows:

The calculation of diluted loss per share for the three and nine months ended July 31, 2004 and 2003 excluded the effect of approximately 3,472,000 and 3,050,000 potential common shares from the conversion of outstanding options and warrants and common shares held in escrow, respectively, as they were antidilutive.

12.

Comprehensive Earnings (Loss)

Total comprehensive earnings (loss) was as follows:

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PLATO Learning, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)

13.

Segment and Geographic Information

We operate and manage our business as one segment, the development and marketing of educational software and related services.

We have foreign subsidiaries in Canada and the United Kingdom. Our foreign operations are not significant to our consolidated business. At July 31, 2004, less than 1% of our long-term assets are located in foreign countries, and for the nine months ended July 31, 2004, approximately 3% of our revenues are from foreign countries.

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PLATO Learning, Inc. and Subsidiaries

OVERVIEW

We enhance the learning process by providing computer-based and e-learning instruction software for kindergarten through adult learners, offering curricula in reading, writing, mathematics, science, social studies and life and job skills. We also offer innovative online assessment and accountability solutions and standards-based professional development services. With over 6,000 hours of objective-based, problem-solving courseware, plus assessment, alignment and curriculum management tools, we create standards-based curricula that facilitate learning and school improvement. PLATO courseware is delivered via networks, CD-ROM, private intranets and the Internet. We market our courseware products and services primarily to K-12 schools and colleges. We also sell to job training programs, correctional institutions, military education programs, corporations and individuals.

In November 2003, we acquired Lightspan, Inc. (“Lightspan”), a provider of curriculum-based educational software and on-line assessment products and services that increase student achievement and enhance teacher professional development. These products are used in schools and homes and align all key federal reform initiatives, offering school districts a comprehensive achievement and accountability system to assess, align, instruct and evaluate. This acquisition is expected to strengthen our product offerings, with two strong and complimentary brands, in the K-8 and post secondary markets. We also expect this acquisition to enhance our ability to provide comprehensive solutions to K-12 and adult learning institutions.

The combination of Lightspan and PLATO also unites Lightspan’s Academic Systems products with our community college products to establish the largest provider of on-line content for under-prepared college students. In addition, the merger of sales forces will provide critical mass for servicing elementary, secondary, district level, and colleges across all product lines and services. We believe these advantages, plus the elimination of significant duplicate costs, will provide greater earnings and cash flow potential for the combined company, and ultimately a greater valuation.

Lightspan generated revenues of approximately $50,000 in its fiscal year ended January 31, 2003. We expect to achieve approximately $17,500 of cost reductions in 2004 and annualized cost reductions of between $20,000 and $25,000 thereafter, primarily through workforce reductions and the elimination of duplicate costs. The acquisition is expected to be modestly dilutive to our earnings per share for fiscal year 2004. Earnings per share will be impacted by non-cash charges for the amortization of identified intangible assets acquired with this transaction.

In December 2003, we acquired New Media (Holdings) Limited (“New Media”), a United Kingdom (“U.K.”) based publisher of curriculum-focused software primarily for teaching secondary school science and math. This acquisition enhances our science offering, provides a science simulation development capability that we did not previously have and will allow us to introduce New Media’s products to markets in the United States for the first time. Additionally,

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PLATO Learning, Inc. and Subsidiaries
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands)

this acquisition is expected to provide critical mass and revenue diversification in the U.K. and strengthen our relationships with the U.K. Education Department.

We are subject to risks and uncertainties including, but not limited to, dependence on information technology spending by our customers, well-established competitors, customers dependent on government funding, fluctuations of our quarterly results, a lengthy and variable sales cycle, dependence on key personnel, dependence on our intellectual property rights, rapid technological change and our ability to integrate acquisitions. As provided for in the Private Securities Litigation Reform Act of 1995, we caution investors that these factors could cause our future results of operations to vary from those anticipated in previously made forward-looking statements and any other forward-looking statements made in this document and elsewhere by or on behalf of us.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

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. 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 estimates, and have identified revenue recognition, the allowance for doubtful accounts, capitalized product development costs, the valuation of our deferred income taxes, and the valuation and impairment analysis of goodwill and identified intangible assets as the critical accounting policies and estimates that are significant to the financial statement presentation and that require difficult, subjective and complex judgments.

See Note 2 to Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year ended October 31, 2003 for additional discussion on these and other accounting policies and disclosures required by accounting principles generally accepted in the United States of America.

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 significant judgments for revenue recognition typically involve whether collectibility can be considered probable and whether fees are fixed or determinable. In addition, our transactions often consist of multiple element arrangements, which must be analyzed to determine the relative

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PLATO Learning, Inc. and Subsidiaries
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands)

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.

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. 104, “Revenue Recognition in Financial Statements.” We license software under non-cancelable license and subscription agreements. We also provide related professional services, including consulting, training and implementation services, as well as ongoing customer support and maintenance. Consulting, training and implementation services are not essential to the functionality of our software products. Accordingly, revenues from these services are recognized separately.

Revenue from the sale of courseware licenses is recognized upon meeting the following criteria: (i) a written customer order has been executed, (ii) courseware has been delivered, (iii) the license fee is fixed or determinable and (iv) collectibility of the fee is probable. We do not generally provide acceptance clauses to our customers. In situations where we do provide acceptance clauses, revenue is deferred until the clause expires or acceptance criteria are met.

For software arrangements that include more than one element, we allocate the total arrangement fee among each deliverable based on vendor-specific objective evidence (“VSOE”) of the relative fair value of each deliverable. VSOE is determined using the price charged when that element is sold separately. For software arrangements in which we do not have VSOE for undelivered elements, revenue is deferred until the earlier of when VSOE is determined for the undelivered elements or when all elements for which we do not have VSOE have been delivered.

If collectibility of the fee is not probable, revenue is recognized as payments are received from the customer provided all other revenue recognition criteria have been met. If the fee due from the customer is not fixed or determinable, revenue is recognized as the payments become due provided all other revenue recognition criteria have been met.

Subscription revenue, primarily fees charged for our on-line subscription products, is recognized on a ratable basis as the products are delivered over the subscription period.

Services revenue consists of software support and maintenance, which is deferred and recognized ratably over the support period, and consulting, training and implementation services, which are recognized as the services are performed.

Other revenue, primarily from hardware and third-party software products, is recognized as the products are delivered and all other revenue recognition criteria are met.

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PLATO Learning, Inc. and Subsidiaries
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands)

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 trade and installment accounts receivable. Bad debt expense is included in general and administrative expense in our consolidated statement of operations. The assumptions and estimates used to determine the allowance are subject to constant revision and involve significant assumptions and judgment. The primary factors that impact these assumptions include the efficiency and effectiveness of our billing and collection functions, our historical experience and our credit assessment process. We believe that the current budget difficulties facing many states will not have a significant impact on the collection of our accounts receivable. However, a change in the underlying conditions contributing to our belief could impact our assessment of collectibility and, therefore, require a change in the allowance for doubtful accounts and the amount of bad debt expense. Actual collection results could differ materially from those estimated and have a significant impact on our consolidated results of operations. Our provision for bad debts is based on our historical experience using a detailed analysis of customer-specific activity and receivable balances performed on a quarterly basis. Our allowance for doubtful accounts was $4,382, or 8.6% of gross accounts receivable, at July 31, 2004, as compared to $4,254, or 9.8%, at October 31, 2003.

Capitalized Product Development Costs

Our product development costs relate to the research, development, enhancement and maintenance of our courseware products. The amortization of capitalized product development costs is included in cost of revenues. Research and development costs, relating principally to the design and development of new products, and the routine enhancement and maintenance of existing products are expensed as incurred. We capitalize product development costs when the projects under development reach technological feasibility. A significant portion of our product development costs qualify for capitalization due to the concentration of our development efforts on the content of our courseware. Capitalization ends when a product is available for general release to our customers, at which time amortization of the capitalized costs begins. We amortize these costs using the greater of: (a) the amount determined by the ratio of the product’s current revenue to total expected future revenue, or (b) the straight-line method over the estimated useful life of the product, which is generally three years. During all periods presented, we used the straight-line method to amortize the capitalized costs as this method resulted in greater amortization.

The significant judgment regarding capitalization of product development costs involves the recoverability of capitalized costs. We evaluate our capitalized costs at least annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired, 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 revenues and 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

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PLATO Learning, Inc. and Subsidiaries
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands)

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 consolidated results of operations.

Valuation of Deferred Income Taxes

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 deferred taxes is adjusted by a valuation allowance, if necessary, to recognize the extent to which the future tax benefits will be recognized.

At October 31, 2003, we had a net deferred tax asset of $2,218. Approximately $7,377 of the deferred tax asset relates to our net operating loss carryforwards in the United States of approximately $18,500, which expire in varying amounts between 2004 and 2023. We also had net operating loss carryforwards of approximately $3,000 related to our foreign subsidiaries. We provided a full valuation allowance related to these foreign deferred income tax assets due to the uncertainty in realization of future taxable income in these foreign jurisdictions.

Realization of our deferred tax asset is dependent on generating sufficient taxable income in the United States prior to expiration of these loss carryforwards. Although realization was not assured at October 31, 2003, we believed it was more likely than not that all of the deferred tax asset would be realized. We based this belief upon the levels of taxable income generated historically, as well as projections of future taxable income. However, our merger with Lightspan in the first quarter of fiscal 2004 impacted our assessment of the realization of deferred tax assets because the merged company is considered one consolidated taxable entity.

As a result of the merger, we acquired approximately $290,000 of Lightspan’s net operating loss carryforwards. Based on a preliminary Section 382 limitation analysis, the usage of these net operating loss carryforwards is limited to approximately $2,500 per year and, therefore, approximately $35,000 of the acquired net operating loss carryforwards are available to the combined entity.

Our combined net operating loss carryforwards as of the acquisition date were approximately $57,000 at April 30, 2004. The combined net operating loss carryforwards, which represent the majority of the merged company’s deferred tax assets, must be reviewed for realization primarily based upon historical results and secondarily upon projected results. Although we expect taxable income in 2004, this expectation is highly dependent on the integration of the Lightspan acquisition. Lightspan has historically incurred significant operating losses which carry more weight than the projected results. Consequently, it is our current view that, while we had cumulative taxable income for the last three fiscal years, our historical operating results were insufficient to support the combined post-merger deferred tax assets. As a result, net deferred tax assets, excluding the deferred tax liability relating to tax deductible goodwill, which cannot be used to support realization of the other net deferred tax assets, were fully reserved for in the

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PLATO Learning, Inc. and Subsidiaries
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands)

purchase accounting for the Lightspan acquisition in our first quarter of 2004 thereby increasing goodwill. Any subsequent reversal of the valuation allowance recorded on the combined entity’s pre-acquisition deferred tax assets will be recorded as income tax expense and a reduction of goodwill.

Goodwill and Identified Intangible Assets

We record our acquisitions in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations.” We allocate the cost of acquired companies to the tangible and identified intangible assets and liabilities acquired, with the remaining amount being recorded as goodwill. Certain intangible assets, such as acquired technology, are amortized to expense over their estimated useful lives, while in-process research and development, if any, is recorded as a one-time charge at the acquisition date.

Most of the companies we acquire do not have significant tangible assets and, as a result, the majority of the purchase price is typically allocated to identified intangible assets and/or goodwill, which increases future amortization expense of identified intangible assets and the potential for impairment charges that we may incur. Accordingly, the allocation of the purchase price to intangible assets may have a significant impact on our future operating results. In addition, the allocation of the purchase price requires that we make significant assumptions and estimates, including estimates of future cash flows expected to be generated by the acquired assets. Should different conditions prevail, we may have to record impairment charges, which may have a significant impact on our consolidated financial statements.

We account for goodwill and other intangible assets in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, goodwill and intangible assets with indefinite lives are not amortized to expense and must be reviewed for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. We operate as one reporting unit and therefore compare our book value to market value (market capitalization plus a control premium). If our fair value exceeds our book value, goodwill is considered not impaired, thus the second step of the impairment test is unnecessary. If our book value exceeds our market value, the second step of the goodwill impairment test shall be performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of the goodwill with the book value of the goodwill. If the carrying amount of the goodwill exceeds the implied fair value of the goodwill, an impairment loss would be recognized in an amount equal to that excess. Any loss recognized cannot exceed the carrying amount of goodwill. After a goodwill impairment loss is recognized, the adjusted carrying amount of goodwill is its new accounting basis. Subsequent reversal of a previously recognized goodwill impairment loss is prohibited once the measurement of that loss is completed. We completed our annual

22

PLATO Learning, Inc. and Subsidiaries
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands)

goodwill impairment assessment as of October 31, 2003, upon which no impairment charge was recorded.

ACQUISITIONS

Our acquisition strategy is to acquire complementary products or businesses that will enable us to achieve our strategic goals, including market leadership, growth rates that exceed the market, and providing innovative, leading and distinct products and services. During the three months ended January 31, 2004, we acquired Lightspan, Inc. and New Media (Holdings) Limited. Lightspan was acquired in a stock transaction where we issued approximately 6.6 million shares of our common stock, valued at approximately $52,000 for accounting purposes, for all of Lightspan’s outstanding stock. We acquired New Media for approximately $6,800 in cash. See Note 4 to Consolidated Financial Statements for more information on these strategic acquisitions.

23

PLATO Learning, Inc. and Subsidiaries
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands)

RESULTS OF OPERATIONS

Operating Results as a Percentage of Revenue

Certain reclassifications of previously reported amounts have been made to conform to the current period presentation in the consolidated statements of operations. These reclassifications did not change previously reported revenues, operating loss or net loss and related per share amounts. For more information on these reclassifications, refer to Note 3 to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended October 31, 2003.

24

PLATO Learning, Inc. and Subsidiaries
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands)

Revenues

Total Revenues. Total reported revenues increased 70.7% to $40,613 for the three months ended July 31, 2004 from $23,793 for the same period in 2003. Total reported revenues increased 81.6% to $99,381 for the nine months ended July 31, 2004 from $54,717 for the same period in 2003. Our significant revenue growth in 2004 reflected the acquisition of Lightspan, and, while impacted by the economic conditions discussed below, also reflected the impact of large orders and our increased focus on subscriptions revenue, and correlation and professional development services. We currently expect our total revenues for fiscal year 2004 to be in the range of $143,000 to $147,000. The mid point of this range would produce pro forma revenue growth of about 10.5%.

The following tables present total revenues, as reported and on a pro forma basis, as if Lightspan revenues prior to the acquisition had been included for all periods presented:

On a pro forma basis, assuming Lightspan had been included for all periods presented, we executed 70 orders of $100 or greater during the three months ended July 31, 2004, as compared to 81 for the same period in 2003. The average size of orders between $100 and $249 decreased from $157 to $148, while the average size of orders of $250 and greater increased 47.8% from $508 to $750. The number and magnitude of these larger orders can have a significant impact on our operating results. Information regarding these orders was as follows:

25

PLATO Learning, Inc. and Subsidiaries
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands)

(1)

2004 excludes amounts related to the Idaho Department of Education contract signed in Q2-2004.

(2)

2003 include both PLATO Learning and Lightspan.

License Fees. The following table presents license fees revenues, as reported and on a pro forma basis, as if Lightspan revenues prior to the acquisition had been included for all periods presented:

The increase in reported license fees revenues for the three and nine months ended July 31, 2004, as compared to the same periods in 2003, was primarily due to the Lightspan acquisition. We continue to feel the effects of federal funding delays and economic uncertainties, particularly state budget difficulties, which significantly impacted the level of purchasing done by our customers. While there continues to be some improvement in the flow of federal funds to education, as evidenced by the increases in pro forma license fees revenue for the three and nine months ended July 31, 2004 and 2004, these conditions are expected to continue to impact our revenues during the remainder of 2004. As a percentage of total revenues, pro forma license fees revenues decreased slightly for the three and nine months ended July 31, 2004 from the same periods in 2003, reflecting the increase in subscriptions and services revenues as discussed below.

26

PLATO Learning, Inc. and Subsidiaries
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands)

Subscriptions. The following table presents subscriptions revenues, as reported and on a pro forma basis, as if Lightspan revenues prior to the acquisition had been included for all periods presented:

Reported revenues from subscriptions increased for the three and nine months ended July 31, 2004, as compared to the same periods in 2003, primarily due to the Lightspan acquisition and secondarily due to the growth in PLATO subscriptions revenue. This also contributed to the growth in pro forma subscriptions revenues, which comprised 49% and 27% of total pro forma revenue growth for the three and nine months ended July 31, 2004, respectively, from the same periods in 2003. We are experiencing an increasing shift away from perpetual license sales and a growing customer desire to license our products on a subscription basis. Orders for our subscription-based products continue to grow, and, while this has a negative impact on revenues in the short-term, it has positive implications for the longer term, including greater predictability of future revenues. This growth trend is further demonstrated by an increase in subscriptions revenues as a percentage of total revenues to 14.4% and 15.8% for the three and nine months ended July 31, 2004, respectively, compared to 12.4% and 15.2% for the same periods in 2003.

Services. The following table presents services revenues, as reported and on a pro forma basis, as if Lightspan revenues prior to the acquisition had been included for all periods presented:

27

PLATO Learning, Inc. and Subsidiaries
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands)

Reported revenues from services increased for the three and nine months ended July 31, 2004, as compared to the same periods in 2003, due primarily to the Lightspan acquisition and secondarily due to the increase in PLATO services revenues, resulting from increased correlation and professional development services and the continued growth in customer demand for our training and technical support services. This also contributed to the growth in pro forma services revenue. As a percentage of total revenues, pro forma services revenues increased slightly for the three and nine months ended July 31, 2004 compared to the same periods in 2003.

Other. The following table presents other revenues, as reported and on a pro forma basis, as if Lightspan revenues prior to the acquisition had been included for all periods presented:

Other revenues, consisting primarily of hardware and third-party courseware products, increased principally due to the Lightspan acquisition. The elementary grade products acquired from Lightspan run on PlayStation® game consoles, which, along with the sale of related accessories, are a component of other revenues.

Backlog. Our deferred revenue was $42,944 and $26,564 at July 31, 2004 and October 31, 2003, respectively. In addition, we have orders for approximately $15,400 related to an Idaho Department of Education contract and approximately $14,000 from a contract with the U.S. Department of the Navy. Ultimate realization of these contracts is dependent on delivery of services, accomplishment of milestones and customer acceptance. We also have orders for

28

PLATO Learning, Inc. and Subsidiaries
Management’s Discussion and Analysis of Results of
Operations and Financial Condition
(Dollars in thousands)

approximately $6,600 of products and services from multiple customers that have not met various revenue recognition criteria and for which we are not yet able to bill customers. No assurances exist regarding when or if revenue will be recorded or customers billed for these products or services. All contracts and agreements are subject to the delivery of products and services, collection and other conditions.

Cost of Revenues

The following table presents our total cost of revenues, as reported and on a pro forma basis, as if Lightspan cost of revenues prior to the acquisition had been included for all periods presented: