UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

OR

[   ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 000-25120

RSA Security Inc.

174 Middlesex Turnpike
Bedford, Massachusetts 01730
(Address of Principal Executive Offices)

Registrant’s Telephone Number, Including Area Code: (781) 515-5000

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 Exchange Act Rule 12b-2). Yes [X] No [   ]

As of November 1, 2004, there were outstanding 69,544,913 shares of the Registrant’s Common Stock, $0.01 par value per share.

RSA SECURITY INC.
FORM 10-Q
For the Quarter Ended September 30, 2004

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

See notes to condensed consolidated financial statements.

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RSA SECURITY INC. AND SUBSIDIARIES

See notes to condensed consolidated financial statements.

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RSA SECURITY INC. AND SUBSIDIARIES

Supplemental disclosure of cash flow information:

Cash payments for income taxes were $1,137 and $1,181 for the nine months ended September 30, 2004 and 2003, respectively. Cash payments for interest expense were $5,673 and $5,699 for the nine months ended September 30, 2004 and 2003, respectively.

Supplemental disclosure of non-cash financing activities:

In June 2004, a holder of a convertible debenture with a principal amount of $10,000 converted the full amount of this debenture into shares of our common stock. These conversions resulted in the issuance of an aggregate of 727,537 shares of our common stock and the cancellation of the holder’s debenture. We made no principal payment in connection with the conversions. These conversions resulted in the increase of additional paid in capital of $9,993 and an increase in the value of our common stock of $7 for the nine months ending September 30, 2004.

See notes to condensed consolidated financial statements.

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RSA SECURITY INC. AND SUBSIDIARIES

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of RSA Security Inc. (“The Company”) and its wholly owned subsidiaries and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements and should be read in conjunction with the audited consolidated financial statements included in our Annual Report on Form 10-K filed for the year ended December 31, 2003.

In the opinion of our management, the accompanying unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements, and reflect all adjustments of a normal recurring nature considered necessary to present fairly results of the interim periods presented. The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year. We have reclassified certain prior period amounts to conform to the current period presentation.

Principles of Consolidation — The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Use of Estimates — The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires our management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. Our actual results could differ from those estimates.

Cash Equivalents — All highly liquid investments purchased with an original maturity of three months or less are considered cash equivalents.

Marketable Securities — Marketable securities are classified as “available for sale” and recorded at market value using the specific identification method. Unrealized gains and losses are included in accumulated other comprehensive income, net of tax effects. Realized gains or losses are determined based on the specific identified cost of the securities. Any unrealized losses that are considered to be “other than temporary” are charged immediately to the income statement. We believe that the clarification of “other than temporary” set forth in the Emerging Issues Task Force (“EITF”) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” will have no current impact on our results of operations or financial position.

Revenue Recognition — Revenue is recognized when earned. Our revenue recognition policies are in compliance with all applicable accounting principles generally accepted in the United States of America, including the American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” and SOP 98-9, “Modification of SOP 97-2 With Respect to Certain Transactions.” We recognize revenue from the sale of products when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is considered probable. We recognize revenue from licensing other intellectual property when evidence of an arrangement exists, the fee is fixed or determinable and collection is considered probable. We reduce revenue by provisions for estimated returns. When arrangements contain multiple elements and vendor specific objective evidence of fair value exists for all undelivered elements, we recognize revenue for the delivered elements using the residual method. For arrangements containing multiple elements where vendor specific objective evidence of fair value does not exist for all undelivered elements, we defer revenue for the delivered and undelivered elements until vendor specific objective evidence of fair value exists or all elements have been delivered. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 48, “Revenue Recognition when Right of Return Exists,” we recognize revenue upon shipment of product to our stocking distributors, net of estimated returns. We defer maintenance services revenue, whether sold separately or as part of a multiple element arrangement, and recognize it ratably over the term of the maintenance contract, generally twelve months.

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Some of our arrangements contain bundled products which include a term software license, an RSA SecurID® authenticator and support for the term of the license. As these arrangements contain multiple elements where vendor specific objective evidence of fair value does not exist for all undelivered elements, we record these arrangements as deferred revenue and recognize revenue ratably on a monthly basis over the term of the license agreement.

For arrangements that contain an initial prepaid license fee with the payment of ongoing royalties, we recognize revenue on the initial prepaid license fee when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collection is considered probable. We recognize the ongoing royalties at the time we can make a reliable estimate of the actual usage that has occurred, provided collection is probable. Annual license fees or one time license fee arrangements typically contain non-refundable terms; therefore we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collection is considered probable.

We recognize revenue allocated to professional service elements as the services are performed. When customization is essential to the functionality of the licensed software, then both the software license and professional services revenue are recognized under the percentage of completion method, which requires revenue to be recognized as a percentage of the project completed. We recognize revenue and gross profit using labor hours as an input measure of progress to completion on these arrangements.

Allowance for Sales Returns — We record allowances for estimated sales returns and allowances on products and maintenance and professional service revenue in the same period as we record the related revenue. We base these estimates on historical sales returns, analysis of credit memo data, current economic trends, product line and customer industry and other known factors.

Allowance for Doubtful Accounts — We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We analyze accounts receivable and the composition of the accounts receivable aging, historical bad debts, customer creditworthiness, concentration levels, current economic trends, regional factors, other known factors, and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Bad debt expense, if any, is included in marketing and selling expenses in the condensed consolidated statements of income. The allowance for doubtful accounts is included in accounts receivable in the condensed consolidated balance sheets and was as follows:

Allowance for Warranty Obligations — Our standard practice is to provide a warranty on all RSA SecurID hardware authenticators for the customer selected programmed life of the authenticator (generally two to five years) and to replace any defective authenticators (other than authenticators damaged by a user’s abuse or alteration) free of charge. We sell our other products to customers with a warranty for product defects for a specified period, generally ninety days. Reserves are provided for warranty expenses based upon historical experience and estimates of future liabilities. We provide reserves for warranty obligations based on historical failure and defective return rates and include these costs as a component of product cost of revenue. We reevaluate the estimate of warranty and defective return obligations, including the assumptions about estimated failure and return rates, each quarter.

During 2002 and 2003, our quarterly analysis of historical failure and defective return rates indicated that certain authenticators produced between 2000 and 2002 were subject to higher defect and failure rates. We increased our provisions for warranty expense accordingly. We will continue to monitor warranty claims and reevaluate our estimate of warranty and defective return obligations in future periods, which may result in our recording additional warranty expense.

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Accrued warranty reserve obligation is included in accrued expenses and other liabilities in the condensed consolidated balance sheets and was as follows:

Income Taxes — We provide for income taxes for interim periods based on the estimated effective tax rate for the full year. We record cumulative adjustments to tax provisions in the interim period in which a change in the estimated annual effective rate is determined.

Earnings Per Share — We compute basic earnings per share using the weighted average number of common shares outstanding. We compute diluted earnings per share using the weighted average number of common shares outstanding plus the effect of potential outstanding shares, including options and warrants, using the “treasury stock” method. Diluted loss per share excludes the effect of equity instruments including convertible debentures, options and warrants, when such instruments are antidilutive.

Equity instruments that were considered antidilutive and therefore were not included in the computation of diluted earnings per share include the following shares of our common stock:

Stock-Based Compensation Plans - We account for stock-based compensation cost using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Under the intrinsic value method, compensation associated with stock awards to employees is determined as the difference, if any, between the current fair value of the underlying common stock on the date compensation is measured and the price an employee must pay to exercise the award. Under the fair value method, the impact of which is disclosed below, compensation associated with stock awards to employees is determined based on the estimated fair value of the award itself, measured using either current market data or the Black-Scholes option pricing model. The measurement date for employee awards for both the intrinsic and fair value methods is generally the date of grant.

Upon exercise of an award, net proceeds, including the tax benefits realized, if any, are credited to shareholders’ equity.

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Stock-Based Compensation Plans Pro Forma Disclosure — Had we recognized compensation expense for our stock option and purchase plans based on the fair value for awards under our plans, pro forma net income (loss) and pro forma net income (loss) per share would have been as follows:

We estimated the fair values at the grant date used to compute pro forma net income (loss) and pro forma net income (loss) per share using the Black-Scholes option-pricing model with the following weighted average assumptions:

Share Repurchase Authorization — We announced in September 2004 that our Board of Directors authorized the repurchase of up to 6,700,000 shares of our common stock during 2004 and 2005. We may make repurchases in the open market or through negotiated transactions from time to time depending on market conditions. We have repurchased an aggregate of 50,000 shares for $911 as of September 30, 2004, which are reflected as treasury stock on the condensed consolidated balance sheet.

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2. Investments and Financial Instruments

Our marketable securities were as follows:

Income (loss) from investing activities includes the following gains (losses):

We hold a 99% interest in Crosby Finance, LLC, a bankruptcy-remote, qualified special purpose entity, established specifically to securitize shares of VeriSign, Inc. (“VeriSign”) common stock. At September 30, 2004, Crosby held 2,027,325 shares of VeriSign common stock and a variable delivery forward contract (“VDF”). The VDF contract entitles Crosby to receive cash proceeds of up to $35,336 if the market price per share of VeriSign common stock on January 3, 2006 is at least $87.16. The closing price of VeriSign’s common stock on The NASDAQ National Market on September 30, 2004 was $19.88 per share.

The carrying amount of our 99% interest in Crosby was $102 and $208 at September 30, 2004 and December 31, 2003, respectively, and is included in other assets on the condensed consolidated balance sheets. We are carrying our interest at fair value with all changes in fair value reported in income (loss) from investing activities in the condensed consolidated statements of income. We determine the fair value of our interest in Crosby based on the fair value of Crosby’s right to potentially receive additional cash proceeds upon maturity of the VDF.

Crosby has no liability or obligation to its members or to the counterparty to the VDF contract other than to deliver the shares of VeriSign common stock to the counterparty upon maturity of the VDF contract and to distribute the cash proceeds, if any, to its members. After settlement of the VDF in January 2006, Crosby will dissolve.

3. Convertible Debentures

During October and November 2001, we issued 7% convertible debentures with an aggregate principal amount of $80,000, together with warrants to purchase an aggregate of 873,045 shares of our common stock.

In June 2004, a holder of a debenture with a principal amount of $10,000 converted the full amount of this debenture into shares of our common stock. These conversions resulted in the issuance of an aggregate of 727,537 shares of our common stock and the cancellation of the holder’s debenture. We made no principal payment in connection with the conversions. After these conversions the remaining aggregate principal amount of the 7% convertible debentures was $70,000.

The remaining debentures were scheduled to mature on October 17, 2004, unless redeemed earlier by us or converted into shares of our common stock at the holder’s option. In October 2004, the holders of our outstanding 7% convertible debentures converted the full amount of the debentures in several tranches over the course of two weeks: $750 of the debentures were converted on October 5, 2004, $50,500 of the debentures were converted on October 13, 2004, and the remaining $18,750 of the debentures were converted on October 15,

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2004. These conversions resulted in the issuance of an aggregate of 5,092,760 shares of our common stock and the cancellation of all of our outstanding 7% convertible subordinated debentures. We made no principal payment in connection with any of the conversions.

4. Comprehensive Income

Comprehensive income was as follows:

The tax benefit (provision) of unrealized holding gains (losses) on marketable securities were $(101) and $56 for the three and nine months ended September 30, 2004.

5. Restructurings

During 2002 and 2001, we evaluated and initiated restructuring actions in order to consolidate some of our operations, enhance operational efficiency and reduce expenses. These actions resulted in total restructuring charges of $56,036 and $19,956 for the years ended December 31, 2002 and 2001, respectively.

Restructuring charges recorded during 2002 and 2001 consist of facility exit costs, costs associated with the sale and liquidation of our Swedish development operations, and severance and other costs associated with the reduction of employee headcount.

In the second quarter of 2004, we recorded a charge of $1,601 related to revised estimates of facility exit costs. We revised estimates of facility exit costs based upon the terms of finalized subleases obtained and associated costs incurred during the second quarter of 2004.

Restructuring charges accrued and unpaid at September 30, 2004 were as follows:

We expect to pay the remaining restructuring costs accrued at September 30, 2004 as follows:

6. Segments

We have one reportable segment, e-Security Solutions. The operations of the e-Security Solutions segment consist of the sale of software licenses, hardware, maintenance and professional services through two product groups, Enterprise solutions and Developer solutions. Enterprise solutions include sales of RSA SecurID® authenticators, RSA® Authentication Manager (formerly known as

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RSA ACE/Server®) software, RSA Keon® software, RSA ClearTrust® software, and maintenance and professional services associated with these products. Developer solutions include sales of RSA BSAFE® encryption software and protocol products, RSA Keon components, and maintenance and professional services associated with these products. The segment was determined primarily by how management views and evaluates our operations.

Our operations are conducted throughout the world. Operations in the United States represent approximately 56% of total revenue. Our operations in other countries have been grouped by regional area below. The following tables present information about e-Security Solutions revenue:

Except for Tech Data Corporation, one of our distributors, no single customer accounted for more than 10% of our total revenue for the three and nine months ended September 30, 2004 and 2003. Revenue from Tech Data Corporation accounted for 10% and 11% of our total revenue for the three and nine months ended September 30, 2004, respectively. During 2003, Tech Data Corporation merged with Azlan Group Plc (also a distributor). Had this merger been completed as of January 1, 2003, revenue from the combined entity, on a pro forma basis, would have accounted for 9% and 11% of our total revenue for the three months and nine months ended September 30, 2003, respectively.

The tables below present information about our long- lived assets by region:

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7. Litigation

On or about February 2, 2001, Leon Stambler filed a complaint for patent infringement in U.S. District Court for the District of Delaware against RSA Security, VeriSign, Inc., First Data Corporation, Openwave Systems Inc., and Omnisky Corporation, Case Number 01-0065. In his complaint, Mr. Stambler alleged that certain products marketed by each of the defendants infringed various patents that he owns, and he sought unspecified damages as well as a preliminary and permanent injunction enjoining the defendants from infringing the claims asserted. The trial took place in March 2003, and the jury determined that our products did not infringe Mr. Stambler’s patents. On April 17, 2003, the court entered final judgment in our favor on all claims of non-infringement. On or about December 8, 2003, Mr. Stambler filed a notice of appeal to the United States Court of Appeals. We are vigorously defending the appeal. We believe that the final disposition of this matter will not have a material adverse effect on our continuing operations and consolidated financial position.

On or about December 20, 2001, France Telecom and Telediffusion de France (“FT”) filed a Request for Arbitration with the International Court of Arbitration. FT claimed that we breached a license agreement with FT and sought unspecified damages including a payment in excess of $110,000 plus the legal fees and other costs associated with the arbitration. The arbitration took place in June 2003. On March 27, 2004, the arbitrator ruled in our favor, denying all of FT’s claims, and ordered FT to pay us approximately $1,639 in reimbursement of our legal fees and other expenses associated with the arbitration. Due to FT’s many procedural objections, we believed that FT might contest the ruling. To eliminate this uncertainty, in April 2004, we requested that FT confirm to us in writing that they intended to comply with the arbitrator’s ruling. On April 15, 2004, FT confirmed to us in writing that it would accept the arbitrator’s ruling. In April, we received the cash payment, and we recorded this $1,639 receipt in general and administrative expenses for the three and six months ended June 30, 2004.

In a related matter, FT had also filed a patent infringement suit in Delaware against Novell, Inc., one of our licensees. On or about April 22, 2004, the court dismissed the case at the joint request of FT and Novell.

On or about April 15, 2004, Ursus, Inc., a former reseller of our products, filed a complaint against us in U.S. District Court for the Eastern District of Pennsylvania, alleging that we had violated the U.S. Clayton Act, tortiously interfered with Ursus’ contractual relationships and disseminated false and defamatory statements about Ursus. In its complaint, Ursus seeks unspecified damages, but on or about August 10, 2004, Ursus’ legal counsel sent us a confidential demand letter providing more specificity. On September 30, 2004, the court scheduled a mediation conference for the parties, which conference is expected to take place in November 2004. We are vigorously defending this lawsuit and believe that Ursus’ claims are without merit. We believe that the final disposition of this matter will not have a material adverse effect on our continuing operations and consolidated financial position.

From time to time, we have been named as a defendant in other legal actions arising from our normal business activities, which we believe will not have a material adverse effect on us or our business.

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

We make statements in this Report that are forward looking, that is, statements that are not historical facts but that convey projections about the future. For example, statements containing the words “believes,” “anticipates,” “plans,” “expects,” and similar expressions may be forward-looking statements. However, we caution investors not to place undue reliance on any forward-looking statements in this Report because these statements speak only as of the date when made. Furthermore, we are not obligated to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. There are a number of factors that could cause our actual results to differ materially from those indicated by these forward-looking statements, including without limitation the factors described below under the caption “Certain Factors That May Affect Future Results.”

Overview

RSA Security Inc. helps organizations protect private information and manage the identities of people and applications accessing and exchanging that information. With thousands of customers around the globe, our portfolio of solutions — including identity and access management, secure mobile and remote access, secure enterprise access, secure transactions and consumer identity protection — are all designed to provide seamless e-security. We sell our two-factor user authentication, certificate processing, Web access management and encryption products and solutions to corporate enterprise users seeking turnkey security solutions, and to original equipment manufacturers, developers and corporate enterprise users seeking software development components for embedding security in a range of software applications or hardware devices.

We derive our operating revenue primarily from two distinct product groups: Enterprise solutions, which includes RSA SecurID® authenticators, RSA® Authentication Manager (formerly known as RSA ACE/Server®) software, RSA ClearTrust® software, RSA Keon® software, and maintenance and professional services associated with those products; and Developer solutions, which includes RSA BSAFE® encryption software and protocol products, RSA Keon components, and maintenance and professional services associated with those products.

We believe sales of our products will be driven by the trend towards Web-enabling of existing applications and of enterprises permitting secure and efficient access to internal resources whether remotely or within the enterprise. Sales of our RSA SecurID authenticator products continue to generate substantial revenue for us, while our less mature Enterprise software products are building revenue. We believe the availability of free, “open source” products that compete with our RSA BSAFE product line continue to put pressure on our Developer solutions revenue. We believe our product line synergies and the strength of our customer base create opportunities to sell additional products to existing customers. However, we have observed that information technology budgets remain constrained, which has had and could continue to have a direct effect on the sale of our products.

We continue to explore opportunities to sell our products into new markets, and we are currently focusing on two new market opportunities. First, although most of our customers continue to use our products to authenticate users accessing electronic resources remotely, from outside the enterprise, with the launch of our RSA SecurID for Microsoft Windows solution, some of our customers are using our products to authenticate users within the enterprise. Second, although the majority of our customers utilize our products to secure and to manage network and application access for their employees and partners, we have recently seen increased sales to customers, including internet service providers and financial institutions, who are also using our products to secure and manage access for their customers, including consumer customers. Today we see interest in consumer authentication broadening to many more types of consumer-facing applications, which we believe is driven by concerns about identity theft and privacy, and the desire to comply with information protection regulations. While still early, we believe that these expanded markets have the potential to generate incremental demand for our products.

Our Enterprise solutions customers typically place an initial order for a limited number of users, for either our RSA SecurID authenticators or any of our software products, and deploy additional authenticators or software licenses as their need for our products within their enterprise increases. Authenticators have a programmed life of two to five years, and as they expire, our customers typically place additional orders for replacement authenticators. We typically base our RSA Authentication Manager, RSA Keon and RSA ClearTrust software license fees on the number of users authorized under each customer’s license. In most cases, customers will also enter into an annual customer support agreement for their software license at the time of initial purchase and renew this support agreement annually. Our support agreement entitles our customers to license software upgrades and telephone support.

Our Developer solutions software licensing terms vary by product and customer. Typical licensing terms may include an initial prepaid license fee and ongoing royalties paid as a percentage of the developer’s product or service revenue, or payment of annual

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license fees, or a single fully paid-up license fee. Often, our existing developer customers go on to license new software or technology from us or wish to increase the field of use rights for the technology they have already licensed. In such a case, we amend our license agreement with the customer and charge additional licensing fees, thus deriving additional revenue.

Our professional services group provides customers with project management, architecture and design, physical deployment, custom development, education and practitioner certification services. Customers typically pay for professional services either at a fixed price or at hourly or daily rates for the time it takes us to complete the project.

We have contracted with outside manufacturing organizations to produce our RSA SecurID authenticators, and some of our products contain technology that is licensed from third parties. Our cost of revenue consists primarily of costs associated with the manufacture and delivery of RSA SecurID authenticators and royalty fees that we pay for the licensed technology. Cost of revenue also includes warranty obligation expense and labor and overhead costs associated with professional services, customer support, and production activities. Production costs include the programming labor, shipping, inspection and quality control functions associated with the RSA SecurID authenticators. We continue to work to establish new supplier relationships in order to increase the number of vendors from which we buy our authenticators and authenticator components, in order to reduce our vulnerability to potential supply problems.

We distribute our products through direct sales to end user customers, and through indirect sales, including sales to resellers and distributors that we ship directly to the end user customer and sales to distributors for stocking purposes. For the three months ended September 30, 2004, approximately 57% of our revenue was from sales to distributors shipped directly to the end user and resellers, approximately 35% of our revenue was from direct sales to end user customers, and approximately 8% of our revenue was from sales to stocking distributors. Our stocking distributors provide us with inventory level and point of sale reports on a monthly basis. Based upon these reports, we estimate that our stocking distributors typically hold approximately four weeks of inventory on hand in the distribution channel. Generally our arrangements with our distributors and resellers are non-exclusive. We currently have arrangements with more than 1,000 distributors and resellers and are constantly seeking to expand our distributor and reseller program in terms of number of participants and volume of sales.

Our direct sales to our customers in countries outside of the United States are denominated in either U.S. dollars or local currency, with the majority of our sales denominated in U.S. dollars. Our sales through indirect distribution channels are generally denominated in U.S. dollars. Our operations outside the United States generally pay operating expenses in local currency. Where we do invoice customers in local currency, we are exposed to foreign exchange rate fluctuations from the time of invoice until collection occurs. We are also exposed to foreign currency fluctuations between the time we collect in U.S. dollars and the time we pay our operating expenses in local currency. Fluctuations in currency exchange rates could affect the profitability and cash flows in U.S. dollars of our products sold in international markets.

Application of Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenue and expense during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, sales returns, allowance for doubtful accounts, intangible assets, income taxes, financing operations, warranty obligations, restructurings, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. However, our actual results could differ from those estimates.

We believe the following critical accounting policies affect our significant estimates and assumptions used in the preparation of our condensed consolidated financial statements.

Revenue Recognition — We derive our revenue primarily from two sources: sales of products, including hardware and software licenses, and services, including maintenance, support and professional services. Our management must make and use judgments and estimates in connection with the revenue recognized in any reporting period. We recognize revenue from the sale of products when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is considered probable. We reduce revenue by provisions for estimated sales returns. The amount and timing of our revenue for any period may materially differ if our management made different judgments or utilized different estimates in establishing our allowance for sales returns. An increase in our allowance for sales returns would reduce our revenue in the period for which the increase is recorded.

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For all sales, we use a binding contract, purchase order or another form of documented agreement as evidence of an arrangement with the customer. Sales to our distributors are evidenced by a master agreement governing the relationship, together with binding purchase orders on a transaction-by-transaction basis. We consider delivery to occur when we ship the product, so long as title and risk of loss have passed to the customer.

At the time of a transaction, we assess whether the sale amount is fixed or determinable based upon the terms of the documented agreement. If we determine the fee is not fixed or determinable, we recognize revenue when the fee is fixed. We assess if collection is probable based on a number of factors, including past transaction history with the customer and the creditworthiness of the customer. If we determine that collection is not probable, we do not record revenue until such time as collection becomes probable, which is generally upon the receipt of cash.

We do not generally include acceptance provisions in arrangements with our customers; however, if an arrangement includes an acceptance provision, we recognize revenue upon the customer’s acceptance of the product, which occurs upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 48, “Revenue Recognition when Right of Return Exists,” we recognize revenue upon shipment of product to stocking distributors who have only limited return rights, and record a sales return reserve to provide for estimated product returns. We estimate product returns from distributors based upon historical experience.

When arrangements contain multiple elements and vendor specific objective evidence (“VSOE”) of fair value exists for all undelivered elements, we recognize revenue for the delivered elements using the residual method. We base our determination of VSOE of fair value of each of the undelivered elements in multi-element arrangements on either the price we charge when the same element is sold separately or the price established by the members of our management, who have the relevant authority to set prices for an element not yet sold separately. For arrangements containing multiple elements where VSOE of fair value does not exist for all undelivered elements, we defer revenue for the delivered and undelivered elements until VSOE of fair value exists or all elements have been delivered.

Some of our arrangements contain bundled products which include a term software license, an RSA SecurID® authenticator and support for the term of the license. As these arrangements contain multiple elements where vendor specific objective evidence of fair value does not exist for all undelivered elements, we record these arrangements as deferred revenue and recognize revenue ratably on a monthly basis over the term of the license agreement.

We defer maintenance service revenue, whether sold separately or as part of a multiple element arrangement, and recognize it ratably over the term of the maintenance contract, generally twelve months.

We recognize revenue allocated to professional service elements as the services are performed. When the customization is essential to the functionality of the licensed software, then both the software license and professional services revenue are recognized under the percentage of completion method, which requires revenue to be recognized as a percentage of the project completed. We recognize revenue and gross profit using labor hours as an input measure of progress to completion on these arrangements.

Allowance for Sales Returns - We record allowances for estimated sales returns and allowances on products and maintenance and professional service related revenue in the same period as the related revenue is recorded. We base these estimates on historical sales returns, analysis of credit memo data, current economic trends, product line and customer industry data and other known factors. Our historical experience with sales returns varies by product line depending on the customer, industry and market. We must make judgments and estimates in connection with establishing the allowances for estimated sales returns in any reporting period. The amount and timing of our revenue for any reporting period may materially differ if actual sales returns and allowances differ from our estimates.

Allowance for Doubtful Accounts - We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We analyze accounts receivable and the composition of the accounts receivable aging, historical bad debts, customer creditworthiness, concentration levels, current economic trends, regional factors, other known factors, and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Based upon the analysis and estimates of the uncollectibility of our accounts receivable, we record an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. Actual results could differ from the allowances for

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doubtful accounts recorded, and this difference may have a material effect on our financial position and results of operations. We record recoveries of accounts previously written off as uncollectible as increases to the allowance for doubtful accounts.

Allowance for Warranty Obligations - Our standard practice is to provide a warranty on all RSA SecurID hardware authenticators for the customer selected programmed life of the authenticator (generally two to five years) and to replace any defective authenticators (other than authenticators damaged by a user’s abuse or alteration) free of charge. We sell our other products to customers with a warranty for product defects for a specified period, generally ninety days. We provide reserves for warranty obligations based on historical failure and defective return rates, and include these costs as a component of product cost of revenue. We reevaluate the estimate of warranty and defective return obligations, including the assumptions about estimated failure and return rates, each quarter.

During 2002 and 2003, our analysis of historical failure and defective return rates indicated that certain authenticators produced between 2000 and 2002 were subject to higher defect and failure rates than we had previously experienced. Accordingly, we increased our provisions for warranty obligations by $4.6 million and $2.8 million for the years ended December 31, 2003 and 2002, respectively. We continue to monitor warranty claims and reevaluate our estimate of warranty and defective return obligations in future periods, which may result in our recording additional warranty expense. Actual warranty returns could differ from the allowance for warranty obligations recorded.

We monitor warranty claims and address defects through our quality and design processes, which are managed by our product engineering, quality control and technical support organizations. During the last several years, we have increased programs and initiated new programs to build an expanded family of high performance authentication solutions. These programs have resulted in the redesign and reengineering of authenticator products to improve performance and reliability by incorporating new microprocessors, electronics, firmware and batteries with longer life.

Income Taxes - The preparation of our consolidated financial statements requires us to estimate our income taxes in each of the jurisdictions in which we operate, including those outside the United States, which may be subject to certain risks that ordinarily would not be expected in the United States. A change in our estimate of income by jurisdiction could cause a change in our annual effective tax rate. The income tax accounting process involves our estimating our actual current exposure together with assessing temporary differences resulting from differing treatment of certain items for tax and accounting purposes. These differences result in the recognition of deferred tax assets and liabilities. We must then record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized.

Management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against deferred tax assets. As of September 30, 2004 we have a valuation allowance of $25.4 million due to uncertainties related to our ability to utilize some of our deferred tax assets, primarily consisting of acquisition related net operating losses carried forward. We base the valuation allowance on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. If actual results differ from these estimates or we adjust these estimates in future periods, we may need to adjust our valuation allowance, which could materially impact our consolidated financial position and results of operations.

Valuation of Goodwill and Other Intangible Assets - In assessing the recoverability of our intangible assets, we must make assumptions regarding estimated future cash flows and earnings and other factors used to determine the fair value of the respective assets. We will record an impairment charge in the amount by which the carrying value of the assets exceeds their fair value. We generally determine fair value based on estimated discounted future cash flows. If these estimates or their related assumptions change in the future, we may be required to record impairment charges against these assets in the reporting period in which the impairment is determined. Any such impairment charge could be significant and could have a material adverse effect on our consolidated financial position and results of operations. We perform an annual test for impairment of our goodwill as of November 30 of each year, and if events or circumstances occur that would more likely than not reduce the fair value of the goodwill below its carrying amount, will perform an interim impairment test. We completed the required annual goodwill impairment test as of November 30, 2003, by comparing the carrying amount of the enterprise to the estimated fair value of the enterprise. Estimated fair value of the enterprise was determined based upon the market multiple valuation method, which requires that we utilize estimates of future cash flows, revenue and earnings. As of November 30, 2003, the fair value of the enterprise was greater than the carrying amount of the enterprise. Therefore, our annual goodwill impairment test performed as of November 30, 2003 did not result in an impairment of our goodwill. No events have occurred since November 2003 that would suggest that an impairment of our intangibles assets exists. At September 30, 2004, we had approximately $189.3 million of goodwill, which accounted for approximately 33% of our total assets. Any future adverse event could cause our intangible assets to become impaired which would result in a decrease to the carrying value of our intangible assets and could have a material effect on our results of operations and consolidated financial position.

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Restructurings-During 2002 and 2001, we initiated consolidation of certain operations in order to enhance operational efficiency and reduce expenses, and recorded significant restructuring charges in connection with these actions. Restructuring charges totaled $56.0 million in 2002 and $20.0 million in 2001. These restructuring charges and our continued analysis of our facilities require us to make estimates based upon real estate market conditions, rental rates, future corporate requirements, general economic conditions and future estimated cash flows. Included in the restructuring charges recorded in 2002 were facility exit costs of $44.0 million, which represented estimated shortfalls of sublease rental income compared to lease payments due through 2009 under certain exited facilities lease agreements, impaired leasehold improvements and furniture and fixtures, and other associated facilities expenses. We based our initial estimates related to anticipated sublease market rates for excess facilities on assumptions regarding the time period required to locate and contract with suitable subtenants and base these assumptions on market trend information analysis. During the second quarter of 2004 we recorded a charge of $1.6 million related to revised estimates of facility exit costs. We revised this estimate of facility exit costs based upon the terms of finalized subleases and associated costs obtained during the second quarter of 2004.

We continue to monitor and assess our facility obligations, real estate markets and our operating expenses. If the assumptions for the estimates used in our restructuring reserve change due to changes in the real estate and sublease markets, or due to the terms of sublease agreements that we have obtained, or the ability of our subtenants to meet their obligations the ultimate restructuring expenses for these facilities could vary by material amounts, and could cause us to record additional or revise previously recorded restructuring charges in future reporting periods which could have a material effect on our results of operations and consolidated financial position.

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Results of Operations

The following table sets forth certain consolidated financial data as a percentage of our total revenue:

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Revenue

The following tables set forth the amount, percentage of total revenue and percentage increase of our revenue by product group, product type and product line:

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The following tables set forth the amount, percentage of total revenue and percentage increase of revenue by region:

We believe the increase in our total revenue in the third quarter of 2004, as compared to the third quarter of 2003, was primarily attributable to businesses continuing the trend toward permitting remote access to internal resources and Web-enabling existing applications. We believe our identity and access management solutions promote our product synergies and enable us to generate additional revenue by selling additional products to existing customers. We also believe that as new, lower cost remote access technologies become available and as employment rates increase, we will benefit with increased total product revenue. We believe that governmental regulations regarding access and distribution of private information will also drive demand for our products. However, information technology budgets continue to be constrained, and the continued uncertainty in the economy and global affairs may affect revenue generated from the sales of our products in future quarters.

Our RSA SecurID authentication product line generates a substantial portion of our revenue. The below authenticator units sold and average selling prices do not include consumer authenticator shipments. Authenticator units sold to enterprise customers, in thousands of units, were as follows:

The increase in number of units sold, partially offset by a decrease in the average selling price in the three months ended September 30, 2004 as compared to the comparable period in 2003, contributed to the increased revenue from our RSA SecurID authentication product line. The decrease in the average selling price can be attributed to expanded deployments by existing customers that benefit from volume discounts during the three months ended September 30, 2004 as compared to the comparable period in 2003. We continue to sell substantial amounts of product to small to mid size companies, which tend to have lower volume but higher unit pricing. We believe our RSA SecurID authentication products generate and will continue to generate substantial revenue.

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We believe the increase in our total revenue can be attributed in part to the continued adoption of our authentication products by an increasing number of small and mid size businesses, as well as expanded deployments of our products by some of our existing larger customers.

We sell to a number of vertical markets, including the financial services and telecommunications vertical markets which continue to provide increased revenue for us. We believe our revenue from the healthcare and financial services markets will continue to increase due to required compliance with industry-specific privacy and security laws and standards.

We believe the increase in our Web access management revenue is due in part to an increase in the number of companies allowing access of their information and applications by internal and external users. We believe that our Web access management revenue will continue to grow due to introductions of new enhancements to our products, including the RSA Federal Identity Manager, strong technology and strategic partnerships. In addition, we have dedicated a portion of our sales force to focus on selling our emerging products.

The decrease in Developer solutions and encryption revenue during the three months ended September 30, 2004 as compared to the comparable period in 2003 was primarily due to a decline in sales in the technology vertical. We believe that Developer solutions revenue may benefit from companies’ needs to secure their transactions due to various regulatory requirements. We currently believe our Developer solutions revenue will represent 8% to 10% of total revenue over the next twelve months.

The increase in service revenue for the three months ended September 30, 2004, as compared to the comparable period in 2003 is primarily attributed to purchases by new customers coupled with a high rate of renewals of annual maintenance contracts related to sale of products in prior periods.

We believe that as the United States government proceeds with its agenda of increasing awareness and funding of cyber-security issues and focusing on homeland security, we may benefit with increased revenue. We believe the government sector of our business may increase in the future as government agencies seek e-security partners in order to execute their cyber-security agenda. However, revenue from the government sector of our business was consistent during the three months ended September 30, 2004 as compared to the comparable period in 2003.

Gross Profit

The following tables set forth the gross profit and gross margin for products and maintenance and professional services:

The increase in total gross margin for the third quarter of 2004, as compared to the third quarter of 2003, was primarily a result of our efforts to reduce costs and improve operating efficiencies, and an increase in total revenue.

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The increase in gross margin for products for the third quarter of 2004, as compared to the same period of 2003, was primarily attributable to an increase in software revenue year over year, which typically has higher margin than other products combined with a decrease of $1.0 million in our warranty obligation expense in the third quarter of 2004, as compared to the third quarter of 2003.

The increase in gross profit margin from maintenance and professional services in the third quarter of 2004, as compared to third quarter of 2003, was primarily attributable to increased maintenance revenue achieved on decreased customer support costs.

We expect to maintain total gross margins of between 80% and 82% during the next twelve months.

Research and Development

Total research and development expenses increased 16.9% in the third quarter of 2004 to $15.9 million from $13.6 million in the third quarter of 2003, and represented 20.8% and 21.1% of total revenue for the third quarter of 2004 and 2003, respectively. Total research and development expenses increased 16.6% in the first nine months of 2004 to $46.1 million from $39.5 million in the first nine months of 2003, and represented 20.6% and 20.9% of the total revenue for the first nine months of 2004 and 2003, respectively. The increase in research and development expenses of $2.3 million for the third quarter of 2004 as compared to the third quarter of 2003 resulted from increased payroll, overhead and consulting expenses associated with our continued allocation of resources towards investing in our future product offerings. We believe research and development expenditures will be approximately 19% to 21% of total revenue during the next twelve months.

Marketing and Selling

Total marketing and selling expenses increased 15.4% in the third quarter of 2004 to $26.9 million from $23.3 million in the third quarter of 2003, and represented 35.1% and 36.2% of total revenue for the third quarter of 2004 and 2003, respectively. Total marketing and selling expenses increased 15.5% in the first nine months of 2004 to $80.2 million from $69.4 million in the first nine months of 2003, and represented 35.7% and 36.7% of the total revenue for the first nine months of 2004 and 2003, respectively. For the third quarter of 2004, as compared to the third quarter of 2003, approximately $2.7 million of the increase in marketing and selling expenses was due to increased labor and overhead costs and approximately $0.9 million for commission expenses on increased revenue. We believe marketing and selling expenditures will be approximately 32% to 35% of total revenue during the next twelve months.

General and Administrative

Total general and administrative expenses increased 5.2% in the third quarter of 2004 to $8.4 million from $8.0 million in the third quarter of 2003, and represented 10.9% and 12.4% of total revenue for the third quarter of 2004 and 2003, respectively. Total general and administrative expenses decreased 12.9% in the first nine months of 2004 to $22.6 million from $25.9 million in the first nine months of 2003, and represented 10.1% and 13.7% of the total revenue for the first nine months of 2004 and 2003, respectively. The increase in general and administrative expenses of $0.4 million for the third quarter of 2004 as compared to the third quarter of 2003 was due to increased payroll and consulting fees of $1.3 million, partially offset by decreased legal expenses of approximately $0.6 million and decreased overhead expenses of $0.2 million. We believe general and administrative expenditures will be approximately 10% to 12% of total revenue during the next 12 months.

Restructurings

During 2002 and 2001, we evaluated and initiated restructuring actions in order to consolidate some of our operations, enhance operational efficiency and reduce expenses. These actions resulted in total restructuring charges of $56.0 million and $20.0 million for the years ended December 31, 2002 and 2001, respectively. We continue to monitor and assess the real estate market and our operating expenses. Based upon our ongoing assessments of our facility obligations and the rental real estate market we may have to record additional restructuring charges or revise previously recorded restructuring charges in future reporting periods.

Restructuring charges recorded during 2002 and 2001 consist of facility exit costs, costs associated with the sale and liquidation of our Swedish development operations, and severance and other costs associated with the reduction of employee headcount.

In the three months ended June 30, 2004, we recorded a restructuring charge of $1.6 million related to revised estimates of facility exit costs. We revised estimates of facility exit costs based upon the terms of finalized subleases obtained and associated costs incurred during the second quarter of 2004. There were no restructuring costs recorded in the three months ended September 30, 2004.

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Restructuring charges accrued and unpaid at September 30, 2004 were as follows: