UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

OR

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

For the transition period from                      to                     

Commission File number # 000-24547

Scientific Learning Corporation

300 Frank H. Ogawa Plaza, Suite 600
Oakland, California 94612
(510) 444-3500
(Address of Registrants principal executive offices, including zip code, and
telephone number, including area code)

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 þ No o

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

The number of shares of the Registrant’s Common Stock, $.001 par value per share, outstanding at April 30, 2005 was 16,683,898.

SCIENTIFIC LEARNING CORPORATION

INDEX TO FORM 10-Q
FOR THE QUARTER ENDED March 31, 2005

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SCIENTIFIC LEARNING CORPORATION

See accompanying notes to condensed financial statements

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SCIENTIFIC LEARNING CORPORATION

See accompanying notes.

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SCIENTIFIC LEARNING CORPORATION

See accompanying notes.

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Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies

Description of Business

Scientific Learning Corporation (the “Company”) provides neuroscience-based software products that develop underlying cognitive skills required for reading and learning. The Company’s Fast ForWord^® products are a series of reading intervention products for children, adolescents and adults. We sell primarily to K-12 schools through a direct sales force. The Company also sells to speech and language professionals. To support our products, we provide on-site and remote training and implementation services, as well as technical, professional and customer support and a wide variety of Web-based resources.

Use of Estimates

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States, requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. To the extent that there are material differences between these estimates and actual results, our financial statements could be affected.

Interim Financial Information

The interim financial information as of March 31, 2005 and for the three months ended March 31, 2005 and 2004 is unaudited, but includes all normal recurring adjustments that the Company considers necessary for a fair presentation of its financial position at such date and its results of operations and cash flows for those periods.

These condensed financial statements and notes should be read in conjunction with the Company’s audited financial statements and notes thereto, together with management’s discussion and analysis of financial condition and results of operations, contained in the Company’s Annual Report on Forms 10-K and 10-K/A for the year ended December 31, 2004, filed with the Securities and Exchange Commission.

Revenue Recognition

We derive revenue from the sale of licenses to our software and from service and support fees. Software license revenue is recognized in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9 (SOP 97-2). SOP 97-2 provides specific industry guidance and four basic criteria, which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement; 2) delivery of the product; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected. The application of SOP 97-2 requires us to exercise significant judgments related to our specific transactions and transaction types.

Sales to our school customers typically include multiple elements (e.g. Fast ForWord software licenses, Progress Tracker, our Internet-based participant tracking service, support, training, implementation management, and other services). The Company allocates revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor specific objective evidence” (“VSOE”). VSOE of fair value for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for support services, is also measured by the renewal price. We are required to exercise judgment in determining whether VSOE exists for each undelivered element based on whether our pricing for these elements is sufficiently consistent.

The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized. All revenue from transactions that include new products that have not yet been delivered is deferred until the delivery of all products.

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Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

Deferred revenue is recognized as revenue as discussed below.

Product revenue

Product revenue is primarily derived from the licensing of software and is recognized as follows:

Perpetual licenses – software licensed on a perpetual basis. Revenue is recognized at the later of product delivery date or contract start date using the residual method. If VSOE does not exist for all the undelivered elements, all revenue is deferred and recognized ratably over the service period if the undelivered element is services or when all elements have been delivered.

Term licenses – software licensed for a specific time period, generally three to twelve months. Revenue is recognized ratably over the license term.

Individual participant licenses – software licensed for a single participant. Revenue is recognized over the average period of use, typically six weeks.

Service and support revenue

Service and support revenue is derived from a combination of training, implementation, technical and professional services, online services and customer support. Training, technical and other professional services are typically sold on a per day basis. If VSOE exists for all elements of an arrangement or all elements except software licenses, services revenue is recognized as performed. If VSOE does not exist for all the elements in an arrangement except software licenses, service revenue is recognized over the longest contractual period in an arrangement. Revenue from services sold alone or with support is recognized as performed.

Other Assets

Other assets consist of the following (in thousands):

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Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

Net Income (Loss) Per Share

Basic net income (loss) per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted average number of common shares outstanding during the period and, when dilutive, includes potential common shares from options and warrants calculated using the treasury stock method.

Stock-Based Compensation

The Company has elected to use the intrinsic value method in accounting for its employee stock options because the alternative, fair value accounting, requires the use of option valuation models that were not developed for use in valuing employee stock options. Under the intrinsic value method, when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.

Had compensation cost for the Company’s stock-based compensation plans been determined using the fair value at the grant dates for awards under those plans calculated using the Black-Scholes valuation model, the Company’s pro forma net income (loss) and basic and diluted net income (loss) per share would have been as follows (in thousands, except per share amounts):

The fair value of the employee stock options was estimated using the following assumptions:

The fair value of employee stock purchase plan stock issued was estimated using the following assumptions:

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Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

The pro forma impact of options on net income (loss) for the three months ended March 31, 2005 and 2004 is not representative of the effects on net income for future periods, as future years will include the effects of additional periods of stock option grants.

SFAS 123(R), “Share-Based Payment”

On December 16, 2004 the FASB issued SFAS 123 (revised 2004), “Share-Based Payment,” which is a revision of SFAS 123, “Accounting for Stock-Based Compensation.” Statement 123(R) supercedes APB 25, “Accounting for Stock Issued to Employees,” and amends SFAS 95, “Statement of Cash Flows.” Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options and purchases under employee stock purchase plans, to be recognized in the statement of operations based on their fair values. Pro forma disclosure of fair value recognition will no longer be an alternative. SFAS 123(R) is effective for public companies for annual periods beginning after June 15, 2005, with earlier adoption permitted. We are required to adopt this new standard no later than our fiscal year beginning January 1, 2006. We have not determined a date for adoption of SFAS 123(R).

Although the adoption of SFAS 123(R)’s fair value method will have no adverse impact on our balance sheet or net cash flows, it will have a significant adverse impact on our net income and net income per share. The pro forma effects on net income and earnings per share if we had applied the fair value recognition provisions of SFAS 123 to share-based payments to employees in prior periods are disclosed in Note 1 under “Stock-Based Incentive Programs.” Although the pro forma effects of applying SFAS 123 may be indicative of the effects of applying SFAS 123(R), the provisions of these two statements differ in some important respects. The actual effects of adopting SFAS 123(R) will depend on numerous factors including the valuation model we use to value future share-based payments to employees, estimated forfeiture rates and the accounting policies we adopt concerning the method of recognizing the fair value of awards over the requisite service period.

2. Comprehensive Income

The Company has no items of other comprehensive income, and accordingly the comprehensive income is equal to the net income for all periods reported.

3. Warranties; Indemnification

The Company generally provides a warranty that its software products substantially operate as described in the manuals and guides that accompany the software for a period of 90 days. The warranty does not apply in the event of misuse, accident, and certain other circumstances. To date, the Company has not incurred any material costs associated with these warranties and has no accrual for such items at March 31, 2005.

From time to time, the Company enters into contracts that require the Company, upon the occurrence of certain contingencies, to indemnify parties against third party claims. These contingent obligations primarily relate to (i) claims against the Company’s customers for violation of third party intellectual property rights caused by the Company’s products; (ii) claims resulting from personal injury or property damage resulting from the Company’s activities or products; (iii) claims by the Company’s office lessor arising out of the Company’s use of the premises; and (iv) agreements with the Company’s officers and directors under which the Company may be required to indemnify such persons for liabilities arising out of their activities on behalf of the Company. Because the obligated amounts for these types of agreements usually are not explicitly stated, the overall maximum amount of these obligations cannot be reasonably estimated. No liabilities have been recorded for these obligations on the Company’s balance sheet as of March 31, 2005 or 2004.

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Notes to Condensed Financial Statements (continued)

4. Related Party Transaction

In September 2003 the Company entered into an agreement with Posit Science Corporation (“PSC”), formerly Neuroscience Solutions Corporation (“NSC”) to provide PSC with exclusive rights in the healthcare field to certain intellectual property owned or licensed by the Company, along with transfer of certain healthcare research projects. A co-founder, substantial shareholder, and member of the Board of Directors of the Company is a co-founder, officer, director and substantial shareholder of PSC.

For the three months ended March 31, 2005 and 2004 the Company recognized $12,500 and $35,000 respectively, in other income for service provided to PSC and royalties for product licenses.

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

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are not historical facts but rather are based on current expectations about our business and industry, as well as our beliefs and assumptions. Words such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue” and variations and negatives of these words and similar expressions are used to identify forward-looking statements. All forward-looking statements, including but not limited to those identified with asterisks (*) in this report are not guarantees of future performance or events, and are subject to risks, uncertainties and other factors, many of which are beyond our control and some of which we may not even be presently aware. As a result, our future results and other future events or trends may differ materially from those anticipated in our forward-looking statements. Specific factors that might cause such a difference include, but are not limited to, the risks and uncertainties discussed in this Management’s Discussion, in particular but not limited to those factors discussed under the caption “Factors That May Affect our Results or Stock Price.” We also refer you to the risk factors that are or may be discussed from time to time in our public announcements and filings with the SEC, including our future Forms 8-K, 10-Q and 10-K. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our view only as of the date of this report. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this report.

Overview

We develop and distribute the Fast ForWord^® family of reading intervention software. Our innovative products apply advances in neuroscience and cognitive research to build the fundamental cognitive skills required to read and learn. Extensive outcomes research by independent researchers, our founding scientists, and our company demonstrates that the Fast ForWord products help students attain rapid, lasting gains in the skills critical for reading. To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support. Our primary market is K-12 schools in the United States, to which we sell using a direct sales force. For the three months ended March 31, 2005, K-12 schools accounted for 90% of booked sales. By the end of March 2005, approximately 3,400 schools had purchased at least $10,000 of our Fast ForWord product licenses and services, and approximately 515,000 individuals had enrolled in one of our products. As of March 31, 2005 we had 166 full-time employees, compared to 132 at March 31, 2004.

Business Highlights

Market Trends

The education market is growing.* Eduventures, a strategic consulting firm in the education industry, has estimated that in 2003, K-12 schools spent $3.3 billion on supplemental content, 4.5% more than in 2002, and projects that in 2005, K-12 schools will spend 7% more on supplemental content than in 2004.* The federal No Child Left Behind (NCLB) Act of 2001 established reading achievement, grade level

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proficiency, and accountability through assessment as important national priorities. NCLB also emphasizes the need to use proven practices and products grounded in scientifically based research to improve student performance. Our products align well with the emphases of NCLB, and we believe that this alignment assists us in marketing and selling our products.

The general availability of funding for public schools fluctuates from time to time. In recent years state and local education funding has been negatively affected by reduced levels of tax revenues due to the economic slowdown, and the education technology industry has generally experienced soft sales, typically attributed to tight funding. However, substantial federal funding resources remain, and many of those resources are focused on reading improvement. Eduventures estimates that total spending in the broad K-12 learning market increased by 4.8% during 2004. In fiscal 2005, state revenue is generally improving, according to a recent survey by the National Conference of State Legislatures, although states also face increasing budget pressures.*

Company Highlights

Our first quarter 2005 total booked sales increased by 8% over the corresponding quarter of 2004, and K-12 booked sales increased 6%. (Booked sales is a non-GAAP financial measure. For more information on booked sales and its reconciliation to revenue, see Revenue below.) These results were lower than our expectations. However, because the first quarter is typically our smallest sales quarter, we do not believe that our first quarter sales shortfall is indicative of our sales outlook for the year.* We expect booked sales to grow in the 18% to 24% range in 2005.*

We attribute our sales growth in a difficult market to our emphasis on reading improvement and measurable results, emphases which are shared by our K-12 customers and aligned with NCLB. One of our major goals is to increase the number of large sales, which we believe to be an important indicator of mainstream education industry acceptance and an important factor in continuing to increase the productivity of our sales force.* In the first quarter of 2005, we closed ten transactions in excess of $100,000 compared to four in the same period in 2004. Our goal is to continue to increase this number in the balance of 2005.* Larger sales tend to have a longer sales cycle and involve more political influences and can be more unpredictable. Increases in the proportion of our business from these large sales may cause increased fluctuations and unpredictability in the timing of our sales and revenue.*

For the three months ended March 31, 2005, our revenue grew 46% compared to the same period in 2004. This reflected a substantial increase in both product and service and support revenues. A significant factor in the increase in revenue was a change in our pricing structure. As a result of this pricing change, we now recognize revenue for most sales of perpetual licenses at delivery, rather than ratably over the period of related service revenue. Because of this change in the timing of revenue recognition from perpetual license sales, we expect that in 2005, total revenue will be higher and grow at a more rapid rate than booked sales.* Revenue also increased due to sales increases in 2004 and the first quarter of 2005.

For the three months ended March 31, 2005, gross margins increased primarily due to improved margins in services and support. Operating expenses were higher in the three months ended March 31, 2005 compared to the same period in 2004 mainly due to staff additions and consultants.

We recorded net income in the three months ended March 31, 2005 compared to a net loss in the comparable period in 2004 due to improved margins and higher revenues. In 2005, our goals include increasing both our net income and our profit margin.* To achieve these goals, we must increase our sales, achieve the necessary product mix, and improve sales force productivity.

While our goals for 2005 include increasing sales, revenue, profit and cash flow, we cannot assure you that we will achieve these goals. See Unpredictability and Business — Factors That May Affect Results of Operations and Stock Price below.

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At March 31, 2005 and December 31, 2004, we had no outstanding debt.

Results of Operations

Revenues

Revenues

Product revenues, which comprise the bulk of our revenue, increased substantially during the three months ended March 31, 2005 compared to the same period of 2004. The change in revenue was primarily due to three factors. First, during the fourth quarter of 2004, we made a pricing change for our Progress Tracker on line service. Prior to this change, we recognized revenue for sales of most perpetual licenses ratably over the period of related service revenue. As a result of the change, we now typically recognize perpetual license revenue at delivery. Second, our revenue was positively impacted by sales increases in 2004 and in the first quarter of 2005. (See Booked sales). These increases were partially offset by a deferral of revenue into the second and third quarters of 2005 for transactions that include new products that have not yet been delivered.

Our service and support revenue increased during the three months ended March 31, 2005, compared to the same period in 2004 primarily due to growth in on-site services. Support revenue is also growing, due to an increased number of customers.*

Future revenue: As a result of our December 2004 strategic pricing change, in 2005 we expect to recognize current sales into revenue substantially more quickly than we did in 2004.* See Revenue Recognition below for more detail about our revenue recognition practices. At the same time, we will also be recognizing deferred revenue from earlier years’ perpetual license sales into current revenue.* We expect that this non-recurring impact from our transition to a different pricing structure will result in 2005 revenue exceeding 2005 booked sales and that the 2005 revenue growth rate will exceed the revenue growth we currently project for 2006.

Booked sales and selling activity: Because a significant portion of our software, services and support revenue is recognized in periods after the invoice date, management uses booked sales to evaluate current selling activity. Booked sales is a non-GAAP financial measure that we believe is useful for investors as well as management as a measure of current demand for our products and services. Booked sales equals the total value (net of allowances) of software, services and support invoiced in the period. We record booked sales and deferred revenue when all of the requirements for revenue recognition have been met, other than the requirement that the revenue for software licenses and services has been earned. We use booked sales information for resource allocation, planning, compensation and other management purposes. We believe that revenues are the GAAP measure most comparable to booked sales. However, booked sales should not be considered in isolation from revenues, and is not intended to represent a substitute measure of revenues or any other performance measure calculated under GAAP.

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The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue for the three months ended March 31, 2005 and 2004.

Booked sales in the K-12 sector, which accounted for 90% of booked sales in the first quarter of 2005, increased 6% to $4.2 million, compared to $4.0 million in the same period in 2004 This performance was below our long-term target growth range of 20%-30%. However, since the first quarter is historically our smallest sales quarter, we believe we are still on track for full year sales growth in our target range.*

Going forward, we plan to continue to concentrate our sales effort on large multiple-site opportunities in the K-12 market.* We believe large sales are an important indicator of mainstream education industry acceptance and an important factor in continuing to increase the productivity of our sales force. During the first quarter of 2005, we closed ten sales that had a contract value in excess of $100,000 compared to four during the same period in 2004.

Booked sales to non-school customers, primarily private practice clinicians, grew by 28% for the three months ending March 31, 2005 compared to 2004. This followed modest growth in 2004. We do not expect growth in this sector to continue at the rate of the 2005 first quarter, but we do expect modest growth in 2005 due to new product offerings and increased disposable income due to improvements in the overall economy.*

Unpredictability:

Since 2002, K-12 educational software sales have generally been soft across the industry. This trend has typically been attributed to federal, state and local budget pressures which make for an uncertain funding environment for our customers. We nevertheless believe that we are positioned to achieve continued growth in the K-12 market.* However, achieving our sales growth objectives will depend on increasing mainstream customer acceptance of our products, which requires us to continue to focus on improving our products’ ease of use, their fit with school requirements, and the engagement of classroom teachers and administrators with product implementations. For a discussion of some of the other important factors that affect our results, see “Factors that May Affect Results of Operations or Stock Price.” In addition, the timing of a single large order or its implementation can significantly impact the level of sales and revenue at any given time. We expect that our December 2004 pricing change, which will cause us to recognize revenue more quickly, will make our quarterly revenue more unpredictable.*

Gross Profit and Cost of Revenues

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The overall gross profit margin increased for the three months ended March 31, 2005 compared to the same period in 2004. The primary reason was an increase in margins for service and support. For the three months ended March 31, 2005, margins in services and support improved due to increased operating leverage. In addition, margins improved because much of our service revenue is recognized on a ratable basis and we perform relatively few trainings in the first quarter, resulting in lower expenses associated with that revenue. Further, we had higher service and support expenses in 2004 due to the introduction of our Gateway Edition. Compared to the prior year period, product margins remained unchanged in the three months ending March 31, 2005.

Profit margins also improved due to a higher proportion of product revenue which has a better margin than service and support. For the three months ended March 31, 2005 and 2004, product revenues represented 76% of total revenues compared to 75% in the first quarter of 2004..

Operating Expenses

Sales and Marketing Expenses: For the three months ended March 31, 2005, our sales and marketing expenses increased due to additional staff, use of consultants, temporary staff, and marketing expenses. At March 31, 2005, we had 35 quota-bearing field sales personnel selling to public schools compared to 27 at March 31, 2004. We expect to increase our investment in sales and marketing as we focus on increasing sales in the K-12 market and adding additional sales people.*

Research and Development Expenses: Research and development expenses increased in the three months ended March 31, 2005 compared to the same period in 2004, primarily due to increased compensation expenses for staff and outside consultants. Research and development expenses principally consist of compensation paid to employees and consultants engaged in research and product development activities and product testing, together with software and equipment costs.

General and Administrative Expenses: General and administrative expenses increased for the three months ended March 31, 2005 primarily due to an increase of $156,000 in accounting expenses, pay increases and additional staff.

Other Income from Related Party

     In September 2003, we signed an agreement with Posit Science Corporation (“PSC”), formerly Neuroscience Solutions Corporation (“NSC”), transferring technology to PSC for use in the health field. For the first quarter of 2005, we have recorded $12,500 in royalties and services provided. For the three months ended March 31, 2004, $35,000 was recorded as other income. Amounts received to date and any future receipts are being reported as other income as we do not consider the sale of these rights to be part of recurring operations.

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Interest Income (Expense), net

Interest income (expense), net increased for the three months ended March 31, 2005 compared to the same period in 2004 primarily because of the absence of amortization of deferred financing charges related to warrants issued in connection with earlier borrowing, higher cash balances and lower borrowing in 2005 compared to 2004. The amortization of deferred financing charges was $0 for the three months ended March 31, 2005 compared to $99,000 for the same period in 2004. The amortization of deferred financing charges was completed in the quarter ending September 30, 2004.

Provision for Income Taxes

In the three months ended March 31, 2005, we recorded a tax provision in the amount of $26,000, 2% of pretax income, relating to federal alternative minimum tax compared to no provision for the same period in 2004. This differed from the federal statutory rate due to the utilization of net operating losses in previous periods.

Liquidity and Capital Resources

Our cash and cash equivalents were $6.8 million at March 31, 2005, compared to $10.3 million at December 31, 2004. We expect that, during 2005, our cash flow from operations and our current cash balances will be the primary source of liquidity and will be sufficient to provide the necessary funds for our operations and capital expenditures.* Accomplishing this, however, will require us to meet specific sales targets in the K-12 market. We cannot assure you that we will meet our targets with respect to sales, revenues, expenses or operating results.

If the Company is unable to achieve sufficient cash flow from operations, the Company may seek other sources of debt or equity financing, or may be required to reduce expenses.* Reducing the Company’s expenses could adversely affect operations by reducing the resources available for sales, marketing, research or product development.* We cannot assure you that we will be able to secure additional debt or equity financing on acceptable terms.

Net cash used by operating activities for the three months ended March 31, 2005, was $3.5 million versus $3.0 million during the same period in 2004. Historically, our first quarter is our lowest sales quarter, reflecting school purchasing cycles and a trend in our industry. Therefore, we frequently have negative cash flow from operations in the first quarter. Payments for previously expensed restructuring charges were $0 for the three months ended March 31, 2005 and $445,000 for the same period in 2004. All restructuring charges were paid as of December 31, 2004.

Net cash used in investing activities for the three months ended March 31, 2005 was $0.1 million compared to $0.2 million for the same period in 2004, primarily for purchases of computer hardware and software.

For the three months ended March 31, 2005 we had no borrowing. During the three months ended March 31, 2004 we borrowed $2.6 million. As of March 31, 2005 we had approximately $6.8 million of cash and no borrowings outstanding under the line of credit.

We have a line of credit with Comerica Bank totaling $5.0 million, which expires on July 14, 2005. The line is subject to limitations based on our accounts receivable balance. Borrowings under the line are subject to various covenants, which may limit our financial and operating flexibility.

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Contractual Obligations and Commitments

We have a non-cancelable lease agreement for our corporate office facilities. The minimum lease payment is approximately $78,000 per month through 2008. After 2008 the base lease payment increases at a compound annual rate of approximately 5%. The lease terminates in December 2013.

The following table summarizes our outstanding contractual obligations at March 31, 2005 and the effects such obligations are expected to have on our liquidity and cash flow in future periods.

Our purchase order commitments at March 31, 2005 are not material.

Loans to Current and Former Officers

In March 2001 we made full recourse loans to certain of our officers, in amounts totaling $3.1 million. The total receivable including accrued interest at March 31, 2005 was $3.7 million. Principal and interest on these loans is reflected in Notes and interest receivable from current and former officers on the Balance Sheet. In 2002 some of these officers left our Company. The Notes are full recourse loans secured by shares of our Common Stock owned by the current and former officers. The loans bear interest at 4.94%. Principal and interest are due December 31, 2005.

Application of Critical Accounting Policies

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). These accounting principles require us to make certain estimates, assumptions and judgments. We believe that the estimates, assumptions and judgments upon which we rely are reasonable based upon information available to us at the time. The estimates, assumptions and judgments that we make can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates and actual results, our financial statements would be affected.

We believe that the estimates, assumptions and judgments pertaining to revenue recognition, allowance for doubtful accounts, software development costs and long-lived assets are the most critical assumptions to understand in order to evaluate our reported financial results. A detailed discussion of our use of estimates, assumptions and judgments as they relate to these polices is presented below. We have discussed the application of these critical accounting policies with the Audit Committee of the Board of Directors.

Revenue Recognition

     We derive revenue from the sale of licenses to our software and from service and support fees. Software license revenue is recognized in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9 (SOP 97-2). SOP 97-2 provides specific industry guidance and four basic criteria, which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement; 2) delivery of the product; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected. The application of SOP 97-2 requires us to exercise significant judgments related to our specific transactions and transaction types.

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Sales to our school customers typically include multiple elements (e.g. Fast ForWord software licenses, Progress Tracker, our Internet-based participant tracking service, support, training, implementation management, and other services). The Company allocates revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor specific objective evidence” (“VSOE”). VSOE of fair value for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for support services, is also measured by the renewal price. We are required to exercise judgment in determining whether VSOE exists for each undelivered element based on whether our pricing for these elements is sufficiently consistent.

The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized. All revenue from transactions that include new products that have not yet been delivered is deferred until the delivery of all products.

Deferred revenue is recognized as revenue as discussed below.

Product revenue

Product revenue is primarily derived from the licensing of software and is recognized as follows:

Perpetual licenses – software licensed on a perpetual basis. Revenue is recognized at the later of product delivery date or contract start date using the residual method. If VSOE does not exist for all the undelivered elements, all revenue is deferred and recognized ratably over the service period if the undelivered element is services or when all elements have been delivered.

Term licenses – software licensed for a specific time period, generally three to twelve months. Revenue is recognized ratably over the license term.

Individual participant licenses – software licensed for a single participant. Revenue is recognized over the average period of use, typically six weeks.

Service and support revenue

Service and support revenue is derived from a combination of training, implementation, technical and professional services, online services and customer support. Training, technical and other professional services are typically sold on a per day basis. If VSOE exists for all elements of an arrangement or all elements except software licenses, services revenue is recognized as performed. If VSOE does not exist for all the elements in an arrangement except software licenses, service revenue is recognized over the longest contractual period in an arrangement. Revenue from services sold alone or with support is recognized as performed.

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Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses due to the inability of customers to make payments. These estimates are based on historical experience. For the past three years our bad debt experience has been minimal. To the extent experience requires it, we may in the future adjust this reserve. Cancellations and refunds are allowed in limited circumstances, and such amounts have not been significant.

Software Development Costs

We capitalize software development cost in accordance with Financial Accounting Standards Board (FASB) No. 86 “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,” under which software development costs incurred subsequent to the establishment of technological feasibility are capitalized and amortized over the estimated life of the related product.

Prior to the establishment of technological feasibility we expense all software development cost associated with a product. Technological feasibility is deemed established upon completion of a working version. Assessment of technological feasibility is an area of significant management judgment. We estimate the useful life of our developed products to be three years.

On an ongoing basis, we evaluate the net realizable value of the capitalized software development cost by estimating the future revenue to be generated from the product and compare this estimate to the unamortized cost of the product. To the extent that sales either exceed or are below our estimates, we may be required to adjust the amortization of capitalized software development costs. At March 31, 2005 future revenues from sale of products for which development costs remain on the balance sheet are anticipated to exceed the unamortized development costs.* No software development costs were capitalized in the three months ended March 31, 2005 or 2004.

Impairment of Long-Lived Assets

We regularly review the carrying value of capitalized software development costs and property and equipment. We continually make estimates regarding the probability of future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, the Company may be required to record impairment charges for these assets.

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FACTORS THAT MAY AFFECT RESULTS OF OPERATIONS OR STOCK PRICE

Our results are impacted by a variety of factors, many of which are beyond our control. The following factors, as well as other information discussed in this quarterly report on Form 10-Q and in our Annual Report on Form 10-K for the year ended December 31, 2004 (under the headings “Business – Factors that May Affect our Results or Stock Price” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”), and other documents filed with the Securities and Exchange Commission should be carefully considered in evaluating our results and our business. If any of the following risks actually occurs, our business, financial condition and results of operations could be materially and adversely affected and the trading price of our common stock could decline.

To grow our business, we need to increase acceptance of our products by mainstream K-12 education purchasers. Failure to do so would materially and adversely impact our revenue, profitability and growth prospects.

We believe that to date most educators who have used Fast ForWord products are “early adopters.” We believe that our ability to penetrate the mainstream market will depend largely on the critical factors discussed below.

Our Fast ForWord products differ from the approaches that schools have traditionally used to address reading problems. In particular, our products are based on neuroscience research and focus on the development of cognitive skills, both of which may not be familiar to educators. K-12 educational practices are slow to change, and it can be difficult to convince educators of the value of a substantially different approach. If we are unable to do so, it will slow our growth.

Using our products in schools requires educators to devote a substantial amount of time to Fast ForWord use out of a limited and crowded school day. While our new protocols have greatly reduced the daily time required to use our products, the product use protocol still requires a substantial time commitment from students and educators. If the products are not used correctly, they may not produce the expected student results, which may lead to customer dissatisfaction and decreased sales.

Our products are generally implemented in a computer lab with a lab coach or teacher rather than in the classroom with the students’ regular classroom teachers. To better reach mainstream customers, facilitate expansion sales and improve results, we need to better engage classroom teachers in the products’ implementation, in an effective and efficient manner. Failing to do so may impede sales.

We encourage our customers to purchase significant levels of field service because we believe that these services enable more effective product use and lead to stronger student achievement gains. If we are unable to continue to convince customers to purchase these levels of service, we may experience pressures on our service margins or our customers may be dissatisfied with their implementations. This may lead to decreased profitability or slower growth.

It is difficult for us to predict our financial results accurately and our quarterly results have fluctuated significantly because, among other factors, our business has a long sales cycle, the timing of a single large sale can significantly impact a quarter’s results and our sales and implementations tend to be seasonal. Inaccuracy in estimating future results may cause the price of our stock to decline.

Since our formation, our quarterly operating results have fluctuated significantly, and we expect these fluctuations to continue. In December 2004, we changed our pricing structure. Prior to this change, we recognized revenue from sales of perpetual license packages that included our Internet reporting tools over the longest service period included in the contract. As a result of the December 2004 change, we now generally recognize revenue from perpetual software licenses at the later of product delivery or the contract start date. We expect that this change will cause us to recognize into revenue a greater proportion of sales in the quarter in which the sale is made, and that our revenue will therefore become less predictable and more volatile. See Management’s Discussion and Analysis, Revenue Recognition for more detail about our revenue recognition practices.

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In 2005, we will also continue to recognize into revenue significant amounts of deferred revenue from perpetual license sales made in prior years under the earlier pricing structure. We expect that the non-recurring impact of this transition to a different pricing structure will result in 2005 revenue growing at a faster rate than 2005 booked sales and at a faster rate than we currently project for revenue growth in 2006.

Like other companies in the instructional market, our sales to K-12 schools are affected by school purchasing cycles and procedures. Consistent with the industry pattern, our sales are typically particularly slow in the first calendar quarter. In addition, the cost of some of our K-12 license packages requires multiple levels of approval in a political environment, which results in a time-consuming sales cycle that can be difficult to predict. When a district decides to finance its license purchase, the time required to obtain these approvals can be extended even further. In addition, sales to schools are subject to budgeting constraints, which may require schools to find available discretionary funds, obtain grants or wait until subsequent budget cycles. As a result, our sales cycle generally takes several months, and in some cases, can take a year or longer.

Some of our sales are significantly larger than others, and our sales strategy emphasizes district-level, multi-site transactions. The timing of a single large order or its implementation can significantly impact the level of sales and revenue in a given quarter. To the extent that we are successful in implementing our large transaction strategy, our results may become more unpredictable and may fluctuate to a greater extent.

Our expense levels are based on our expectations of future sales and are primarily fixed in the short term. We may not be able to adjust spending in a timely manner to compensate for any unexpected sales shortfall.

All of the above factors may cause our operating results in future quarters to fail to meet the expectations of investors, which could cause an immediate and significant decline in the trading price of our common stock.

The restatement of our financial statements has had a material adverse impact on us, including increased costs and the increased possibility of legal or administrative proceedings, and reflected a material weakness in our internal controls and disclosure controls and procedures.

In December 2004, as a result of a reconsideration of our revenue recognition practices, our management and Audit Committee concluded that we should correct our revenue recognition practices for most of the Company’s K-12 school contracts. As a result, we restated our financial statements for the period from 2000 through June 30, 2004, as described in more detail in our Report on Form 10-K/A for the year ended December 31, 2003, our Reports on Form 10-Q/A for the quarters ended March 31, 2004 and June 30, 2004 and our Report on Form 10-Q for the quarter ended September 30, 2004, all filed February 15, 2005.

In May 2005 our management determined that a portion of 2004 deferred revenue had been misclassified as long-term deferred revenue when it should have been classified as current deferred revenue. As a result, we restated our balance sheet as of December 31, 2004 in our Report on Form 10-K/A for the year ended December 31, 2004, filed at the same date as this Report.

As a result of these events, we have become subject to the following risks:

	•	We have incurred substantial unanticipated costs for accounting and legal fees.
	•	It is not uncommon for lawsuits claiming to be class actions to be brought against companies that restate their historical financial statements and their directors and officers. If such actions were to be brought, it is likely that we would incur substantial defense costs regardless of their outcome. Likewise, such actions might cause a diversion of our management’s time and attention. If such actions were brought and we did not prevail, we could be required to pay substantial damages or settlement costs.

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	•	It is also not uncommon for the Securities and Exchange Commission to investigate companies that restate their historical financial statements. If any such investigation were commenced, it would likely divert more of our management’s time and attention and cause us to incur substantial costs. Such investigations could also lead to fines or injunctions or orders with respect to future activities.
	•	The restatement of our historical financial statements and the resulting delay in the preparation of our financial statements resulted in events of default under our credit agreement. Our lender waived those defaults.
	•	The restatement reflected a material weakness in our internal controls and disclosure controls and procedures. We are committed to implementing changes in our internal controls over financial reporting with respect to revenue and deferred revenue. We have hired additional accounting staff and we are in the process of evaluating what changes should be made in our controls.

We rely on studies of student results to demonstrate the effectiveness of our products; if these studies are challenged, it might harm our reputation and impede our business.

We rely heavily on statistical studies of student results to demonstrate that our Fast ForWord products lead to improved student achievement. We believe that these studies accurately reflect the performance of our products. However, these studies involve the following risks:

	•	The results of studies depend on schools’ appropriately implementing the products and adhering to the product protocol. If a school does not do so, the study may not show that our products produce substantial student improvements.
	•	Some studies of our products have limited sample sizes and/or lack a randomly selected control group. These study characteristics may lead to criticism of the studies.
	•	Schools studying the effectiveness of our products use the product with different types of students and use different assessments, sometimes making it difficult to aggregate or compare results.
	•	We facilitate the collection and analysis of data for some of these studies and sometimes support academic studies of our products.

Our sales and marketing efforts, as well as our reputation, could be adversely impacted if our studies are seen to be insufficient. This adverse effect could be compounded to the extent that scientifically-based studies of effectiveness become increasingly important because of the NCLB legislation or for other reasons.

Claims relating to data collection from our user base may subject us to liabilities and additional expense.

Schools and clinicians that use our products frequently use students’ names to register them in our products and enter into our database academic, diagnostic and/or demographic information about the students. In addition, student results on our products are uploaded to our database. We have designed our system to safeguard this personally-identifiable information, but the protection of such information is an area of increasing public concern and significant government regulation, including but not limited to the Children’s Online Privacy Protection Act. If our privacy protection measures were ineffective, we could be subject to liability claims for unauthorized access to or misuses of personally-identifiable information stored in our database. We may also face additional expenses to analyze and comply with increasing regulation in this area.

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We may experience difficulties in launching new products efficiently, without significant technical issues, and on schedule. This could materially slow sales or decrease profitability.

We are developing additional products in our Fast ForWord to Reading series as part of our strategy to reach mainstream reading intervention customers. We expect to ship Fast ForWord to Reading Prep, Fast ForWord to Reading 5 and Fast ForWord Language Basics in 2005. Unexpected challenges could make these development projects longer or more expensive. In addition, we cannot be certain of market acceptance of our new products.

New technology products usually contain bugs that are not discovered in the testing process, and tend to be more challenging to implement when they are first introduced, especially in the diverse and challenging K-12 technology environment. Any significant defect or deficiency in our products could cause customers to cancel or delay orders, cause us to incur significant expenses remedying the problem, and harm our reputation.

During the second quarter of 2003, we launched the new Gateway Edition of our major products. We encountered technical issues with the new release that required significant time from our sales and service teams. This led to additional service and support costs, and slowed the purchasing decisions for a number of transactions, resulting in lower than expected sales in the fourth quarter of 2003.

Sales of our products depend on the availability of government funding for public school reading intervention purchases, which is variable and outside our control. If such funding becomes less available, our public school customers may be unable to purchase our products and services on a scale or at prices that we anticipate, which would materially and adversely impact our revenue and profitability.

We believe that the funding for a substantial portion of our K-12 sales comes from federal funding, so continuing to qualify for major sources of federal funding is critical to our sales success. In addition, the current federal budget deficit may impact the availability of federal education funding. A cutback in federal education funding, or failing to continue to qualify for major sources of that funding, could slow our sales.

State and local school funding can be significantly impacted by fluctuations in tax revenues due to changing economic conditions. From 2002 to 2004, the education technology industry has generally experienced soft sales, frequently attributed to tight funding. We expect that future levels of state and local school spending will be significantly affected by the economic conditions and outlook. A downturn or continued softness in the economy might slow our sales.

We compete for sales with companies that have longer histories and greater resources than we do. We may not be able to compete effectively in the education market.

The market in which we operate is very competitive. While our products are highly differentiated by their neuroscience basis and their focus on the development of cognitive skills, we nevertheless compete vigorously for available funding against other companies offering educational software and other language and reading programs, as well as with providers of traditional methods of teaching language and reading. Many of the companies providing these competitive offerings are much larger than Scientific Learning, are more established in the school market than we are, offer a broader range of products to schools, and have greater financial, technical, marketing and distribution resources than we do. Encouraged by the No Child Left Behind Act, competitors may enter our market segment and offer actual or claimed results similar to those achieved by our products. In addition, although traditional approaches to language and reading are fundamentally different from our approach, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.

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We have only recently become profitable.

We started operations in February 1996 and through 2002 incurred significant operating losses. We first became profitable in 2003 and first generated positive cash flow from operating activities in 2002. At December 31, 2004, we had an accumulated deficit of approximately $81 million from inception. Increasing our cash flow will require us to achieve higher sales goals in a soft K-12 market. Our ability to achieve these goals depends on many factors, some of which are outside of our control. To meet our sales targets, we will need to make substantial expenditures. We cannot assure you that we will meet our targets with respect to sales, revenues or operating results.

We have not yet been required to comply with Sarbanes-Oxley Section 404. We are presently engaged in a process of evaluating and documenting our internal controls looking towards compliance no later than the end of 2006. The process is very costly and requires significant internal resources. Failure to comply with Section 404 could have a material adverse effect.

Under Sarbanes-Oxley Section 404, as implemented by the PCAOB, we will be required to provide a management report and auditors’ attestation and report on our internal control over financial reporting. We have not previously been subject to this requirement. Our deadline for compliance will be no later than December 31, 2006, but depending on our stock price we could be required to comply at our 2005 year end.

Historically, we have understood the importance of internal control over financial reporting, and on an on-going basis, we evaluate our controls, assess whether we should improve them and when appropriate, implement improvements. In connection with our restatements at the beginning of 2005, we concluded that we had a material weakness in our internal controls relating to revenue and deferred revenue. We are committed to implementing changes in our internal controls over financial reporting with respect to revenue and deferred revenue. We have hired additional accounting staff and we are in the process of evaluating what changes should be made in our controls. In order to achieve compliance with Section 404 specifically, we are now also engaged in a costly and challenging process to document and evaluate our internal control over financial reporting. This is requiring us to dedicate internal resources and engage outside consultants to (i) assess and document the adequacy of internal control over financial reporting, (ii) take steps to improve control processes where appropriate, (iii) validate through testing that controls are functioning as documented, and (iv) implement a continuous reporting and improvement process for internal control. Despite our efforts, we can not assure you that we and our independent auditors will conclude that, as of the deadline, our internal control over financial reporting will be effective under Section 404. If we are not able to so conclude, the financial markets could lose confidence in the reliability of our financial statements, which might materially and adversely affect our stock price.

If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to achieve our business goals, which could materially and adversely affect our financial results and share price.

We depend on the performance of Robert Bowen, our Chairman and Chief Executive Officer, and on other senior management, sales, marketing, development, research, educational, finance and other administrative personnel with extensive experience in our industry and with our Company. The loss of key personnel could harm our ability to execute our business strategy, which could adversely affect our financial results and share price. In addition, we believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand. We cannot assure you that we will be able to do so.

If we are unable to adequately protect our intellectual property rights or if we infringe on the rights of others, we could become subject to significant liabilities, need to seek licenses or lose our rights to sell our products.

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Our ability to compete effectively depends in part on whether we are able to maintain the proprietary aspects of our technology and to operate without infringing on the proprietary rights of others. It is possible that our issued patents will not offer sufficient protection against competitors with similar technology, that our trademarks will be challenged or infringed by competitors, or that our pending patent applications will not result in the issuance of patents. In addition, we could become party to patent or trademark infringement claims, litigation or interference proceedings. These proceedings could result from claims that we are violating the rights of others or may be necessary to enforce our own rights. Any such proceedings would result in substantial expense and significant diversion of management effort. An adverse determination in such proceedings could subject us to significant liabilities or require us to seek licenses from third parties, which may not be available on commercially reasonable terms or at all.

Our most important products are based on licensed inventions owned by two universities. If we were to lose our rights under this license, it would materially harm our business. The licensor may terminate the license if we fail to perform our obligations and do not timely cure the violation. We believe that we are currently in compliance with the license in all material respects.

Our directors and executive officers and their affiliates effectively control the voting power of our company.

At December 31, 2004, Warburg, Pincus Ventures, our largest shareholder, owned approximately 46% of the Company’s outstanding stock and, in the aggregate, our directors and executive officers and their affiliates held more than 60% of the outstanding stock. As a result, these stockholders are able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, and may have interests that diverge from those of other stockholders. This concentration of ownership may also delay, prevent or deter a change in control of our company.

Our common stock is thinly traded and its price is volatile.

Our common stock presently trades on the Nasdaq National Market, and our trading volume is low. For example, during the first quarter of 2005, our average daily trading volume was approximately 8,900 shares. The market price of our common stock has been highly volatile since our July 1999 initial public offering and could continue to be subject to wide fluctuations.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Our exposure to market risk for changes in interest rates relates primarily to the rate of interest we would pay on our revolving credit facility with Comerica Bank. Interest rates on loans extended under that facility are at the bank’s prime rate plus 0.5%. A hypothetical increase or decrease in market interest rates by 10% from the market interest rates at March 31, 2005 would not have a material affect on our results of operations.

Item 4. Controls and Procedures

In December 2004, the Company’s management and the Audit Committee of the Company’s Board of Directors concluded that the Company should change its revenue recognition method for most of the Company’s K-12 school contracts. This issue surfaced in the course of the review of our financial statements for the third quarter of 2004. As a result, the Company restated its historical financial statements for the period from 2000 through June 30, 2004.

In May 2005, in the course of preparing the first quarter 2005 financial statements, the Company’s management determined that the balance sheets at June 30, September 30, and December 31, 2004, incorrectly classified a portion of deferred revenue as long term deferred revenue when it should have been classified as current deferred revenue. As a result, the Company’s management and the Audit Committee of the Company’s Board of Directors concluded that the Company should, and the Company has, restated its balance sheet at December 31, 2004.

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As a result of these circumstances, management has concluded that there is a material weakness in the Company’s internal controls, as defined by the Public Company Accounting Oversight Board.

As required under Rule 13a-15(b) of the Exchange Act, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Because of the revenue and deferred revenue issues discussed above, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were not effective as of March 31, 2005. We are committed to implementing changes in our internal controls over financial reporting with respect to revenue and deferred revenue. We have hired additional accounting staff and we are in the process of evaluating what changes should be made in our controls. Except for these changes, during the quarter ended March 31, 2005, there were no changes in the Company’s internal controls over financial reporting that materially affected, or are reasonably likely to materially affect the Company’s internal control over financial reporting.

It should be noted that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. As a result, there can be no assurance that a control system will succeed in preventing all possible instances of error and fraud. The Company’s disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and the conclusions of our Chief Executive Officer and the Chief Financial Officer are made at the “reasonable assurance” level.

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PART II. OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

(a)

Exhibits

(b)

Reports on Form 8-K

	i.	On February 22, 2005, the Company filed a Report on Form 8-K furnishing its press release announcing its financial results for the quarter ended September 30, 2004 and the transcript of its conference call discussing those earnings.
	ii.	On March 25, 2005, the Company filed a Report on Form 8-K disclosing information about changes in management compensation.

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SIGNATURE

     Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated: May 25, 2005

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