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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

For the Fiscal Year Ended December 31, 2003

OR

For the Transition Period from              to             .

Commission File No. 000-26937

QUEST SOFTWARE, INC.

(Exact Name of Registrant as Specified in its Charter)

Registrant’s Telephone Number, Including Area Code: (949) 754-8000

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Act: Common Stock

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

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

The aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $593.9 million as of June 30, 2003, based upon the closing sale price reported for that date on the NASDAQ National Market. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded because such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily conclusive for other purposes.

As of March 1, 2004, 93,973,422 shares of the Registrant’s common stock were outstanding.

Documents Incorporated by Reference

Portions of the Registrant’s definitive proxy statement, to be delivered to shareholders in connection with the Registrant’s 2004 Annual Meeting of Shareholders, are incorporated by reference into Part III of this Report.

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Forward-Looking Information

Discussions under the captions “Business,” “Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” include or may include forward-looking statements within the meaning of the federal securities laws. We have based these forward-looking statements on currently available information and our current beliefs, expectations and projections about future events. All forward-looking statements contained herein are subject to numerous risks and uncertainties. Our actual results and the timing of certain events could differ materially from those projected in the forward looking statements due to a number of factors discussed under the heading “Risk Factors” in this Report and in our other filings with the Securities and Exchange Commission. Should one or more of these risks or uncertainties materialize, or should the underlying estimates or assumptions prove incorrect, actual results or outcomes may vary significantly from those suggested by forward-looking information. Any forward-looking statements contained in this document are based on information available at the time of filing and we make no undertaking to update any of these forward-looking statements.

PART I

Item 1.    Business

Introduction

Quest Software develops, sells and supports software products that improve our customers’ ability to develop, deploy and manage their packaged and custom software applications and associated software infrastructure components such as databases, application servers and operating systems. Quest fits generally into a category of software companies referred to as “Independent Software Vendors,” or “ISVs,” which are companies whose products support other vendors’ software or hardware products. We focus on delivering products for widely adopted applications and infrastructure components such as:

We generate revenues by licensing our products, principally on a perpetual basis, and by providing support, maintenance and implementation services for these products. Our products improve the quality of service of our customers’ key software applications and component infrastructure. Examples of our products’ benefits include the improvement of application and database code quality, the detection, diagnosis and resolution of hardware and software performance problems, the provision of database replication and failover capabilities and the simplified administration of large, multi-user Microsoft deployments. Our products can significantly reduce customers’ capital and operating expenses by minimizing hardware, software and/or personnel costs.

Our traditional focus has been on the Oracle database management system, and we are currently recognized as a leading Oracle ISV. Enterprises must contend with the demands of ever increasing data, and much of this data is stored in database management systems such as Oracle, IBM’s DB2 and Microsoft’s SQL Server. These trends create demand for our database tools that can improve the utilization and reliability of large-scale databases and of the developers and database administrators and other personnel responsible for maintaining reliability and performance.

Over the last four years, we have emphasized acquisitions and internal development of products supporting platforms other than the Oracle database. In March 2000, we acquired Foglight Software, Inc., and its Foglight monitoring product has become our primary Application Performance Management product. In September 2000,

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we acquired FastLane Technologies Inc. and its products for migration and management of Microsoft Active Directory and Exchange environments. In November 2002, we acquired Sitraka and its development tools and Application Performance Management products for J2EE applications. Revenues from these and other acquired and internally developed products have reduced the percentage of total revenues generated by our Oracle-only products to approximately 50.0% in fiscal 2003 as compared to approximately 60.0% in fiscal 2001.

Over the last three years we have worked to integrate many of our point products into integrated product suites or workbenches aimed at particular IT functions, such as database administration, application administration or Exchange administration. The first of these integrated product suites were Quest Central for Oracle and Quest Central for UDB.

In addition to integrating point products into a management suite for a given domain, such as Oracle or Exchange, we have worked to deliver tools for cross-platform management. In the fourth quarter of 2003, for example, we introduced Quest Central for Databases, which we believe is the first database management solution to combine rich domain-specific functionality and full performance management into a single console (or User Interface) for heterogeneous database environments including Oracle, DB2 (distributed and mainframe) and Microsoft SQL Server. Most medium-to-large enterprises employ applications, databases and other systems components from multiple vendors, creating the need for a comprehensive heterogeneous database management environment. Employing a common console for database administrators responsible for managing these disparate systems helps to minimize database differences.

We are likewise pursuing a heterogeneous platform management strategy with our Application Performance Management products. Key enterprise applications are highly complex and require substantial investment, personnel and expertise in their development, deployment and management. Application Performance Management involves measuring service levels provided by an application, such as application response times and application outages, and providing the capabilities to diagnose the root causes of performance problems and the means to correct or eliminate them. Because the predominance of enterprise packaged and custom-developed applications run in multi-vendor environments, the need exists for heterogeneous management tools that have deep monitoring, reporting and diagnostic capabilities for all the components of the application stack. Our Application Performance Management strategy comprises three integrated product areas that detect, diagnose and resolve application performance issues in the major packaged applications, databases and application servers.

We invest a significant portion of revenues in our product engineering capabilities, and approximately one-third of our employees work in product development, quality assurance or technical documentation roles. In building our products, we stress technical innovation and depth, ease of deployment, ease of use and tangible, readily articulated customer benefits. We sell our products primarily via our direct sales channel, supplemented by indirect sales through systems integrators and value added resellers. We operate in North and South America, Europe, Australia and Japan.

We are a California corporation incorporated in 1987. Our principal offices are located at 8001 Irvine Center Drive, Irvine, California 92618.

Products

We currently market over 50 products, which we have grouped into three main categories: Database Management; Application Performance Management; and Microsoft Infrastructure Management. Major products in these categories are described as follows.

Database Management

TOAD^® and SQL Navigator^®.    These tools improve the productivity and capability of application developers working in the Oracle PL/SQL environment. We provide a complete and integrated development

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environment for coding stored procedures, schemas and SQL scripts from one intuitive graphical user interface. Debugging, SQL tuning, change analysis, and general administration features improve the quality and performance of database applications before they enter production.

Quest Central^™ for Databases.    Administrating large databases in production involves many tedious, error-prone and repetitive tasks. To simplify these tasks and increase the accuracy and effectiveness of database administrators (“DBAs”), we have developed Quest Central^™ for Databases. Quest Central for Databases is an integrated workbench for Oracle, DB2 (mainframe and distributed) and Microsoft SQL Server databases that combines four functional components into one suite: Database Administration, Performance Diagnostics, SQL Tuning, and “live” or traditional Space. Quest Central for Databases provides a consistent look and feel for the management of Oracle, DB2 and SQL Server databases, reducing cross training costs and enabling DBAs to manage more databases without adding resources.

SharePlex^®.    In many cases, an organization’s data can be its most valuable resource. Ensuring that data remains available during an unplanned outage, disaster, or even planned downtime for maintenance can be imperative to an organization’s success. SharePlex provides real-time replication of Oracle databases for customers who need to ensure a current, secondary copy of their transactional Oracle database is available if the primary database goes down. Many customers use SharePlex to offload management reporting, so the activity no longer compromises the performance of transaction processing. Finally, SharePlex is also frequently used to eliminate end user disruption by providing access to data during the migration of operating systems, hardware platforms and major application releases.

Application Performance Management

Our Application Performance Management products include our Foglight and Spotlight products, and for custom J2EE applications, our PerformaSure and JProbe products. We also combine these products into Application Performance Management Suites which pair business-centric views of applications with deep domain expertise to both measure and improve the performance of packaged and custom applications.

Foglight^® and Spotlight^®.    Foglight is a 24x7 application monitoring solution that provides a holistic view of an entire application and its related components, including application servers, web servers, databases and operating systems. Foglight offers an array of specialized cartridges focused on ERP and CRM applications to provide a complete monitoring solution for a distributed IT environment. Foglight will alert appropriate IT personnel of existing or threatened nonconforming operating conditions so that they can take preventative or corrective actions. Our series of complementary Spotlight diagnostic products allow IT personnel to drill down deeply into the many components of an application, database or other layer of the application stack to identify the root causes of a problem. With these Application Performance Management solutions, administrators can spend less time in reactive mode and more time focusing on improving and managing their IT infrastructures through notification of potential problems before end users are affected, monitoring transaction response time, resolving problems through real-time diagnostics and maintaining strict service level agreements.

PerformaSure^™ and JProbe^™.    Custom-developed J2EE applications require a unique set of performance management solutions to assure performance and reliability across the entire application lifecycle. We provide an integrated solution designed to help all the stakeholders in J2EE application performance management accelerate the detection, diagnosis and resolution of business-threatening performance issues. Our PerformaSure and JProbe solutions provide comprehensive coverage, from code optimization in development, through pre-production testing in quality assurance, to 24x7 performance monitoring once the application goes into production. PerformaSure gives J2EE performance investigators a transaction-centric view of performance so issues may be rapidly identified and repaired before they impact customer experience. A complete performance toolkit for Java code tuning, JProbe helps developers diagnose and resolve performance bottlenecks, memory leaks, excessive garbage collection, threading issues and coverage deficiencies in their J2EE and J2SE applications.

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Microsoft Infrastructure Management

Microsoft applications and platforms are the global standard for desktop productivity applications. Our products enable IT personnel to more effectively migrate to, manage and administer Microsoft Windows 2000, Exchange and Active Directory environments. Our Microsoft Infrastructure Management products fall into the following four solution sets:

Quest^® Management Suite for Windows^®.    An integrated Microsoft Management Console (MMC), the Quest Management Suite for Windows improves the security, simplifies the delegated administration, and enhances the performance of Windows and Active Directory environments. Designed as a solution that Windows and Active Directory administrators can open and use all day, the Quest Management Suite for Windows combines Quest ActiveRoles, Quest Reporter and Spotlight on Active Directory to provide a comprehensive delegation model, reporting/auditing system and expert resolution advice for teams managing complex Microsoft infrastructures.

Quest^® Management Suite for Exchange.    In today’s business world, email use is growing at a staggering rate, leading to increased traffic, storage and support issues. The Quest Management Suite for Exchange provides a comprehensive set of tools to intelligently manage this growth and the related spending for mission critical Exchange infrastructures. The Suite’s features enable mailbox and public folder management, distribution list management, usage analysis, and diagnostics to optimize investment and performance in Exchange environments. This allows administrators and managers to better target investments, enforce corporate policy, enhance customer service, reduce administrative costs and improve troubleshooting efficiency. Additional functionality and integration is available for customers who have chosen Microsoft Operations Manager (MOM) as their unattended monitoring solution.

Quest^® Migration Suite.    The Quest Migration Suite provides a complete solution to help organizations rapidly transition from one platform to another. Whether it is an Exchange migration, a migration from Windows NT4 to Active Directory or NDS to Active Directory, the Quest Migration Suite provides the tools to accomplish migration tasks quickly, accurately and most importantly, without disruption to end users.

Quest^® Consolidator.    Quest Consolidator helps organizations examine their Windows storage from any angle and take corrective action. This data migration solution contains agentless storage analytics, which help organizations determine how much data they have, where it is, who owns it and when it was last used. This allows companies to determine where the “junk” data is, and provides methods to offload unused files, balance data loads or consolidate servers to make the most of their storage resources.

In January 2004, we announced a definitive agreement to acquire Aelita Software, a privately held software company, a leading provider of systems management solutions that improve the productivity, system availability and security of Microsoft Active Directory and Microsoft Exchange environments. With the proposed acquisition of Aelita, we expect to add breadth and depth to our Microsoft expertise and product portfolio and deliver a comprehensive set of product solutions that enable customers to manage today’s complex Microsoft infrastructures throughout their entire lifecycle. The combined product offering will deliver the robust solutions customers require to better administer, migrate, consolidate, recover and audit their Microsoft Active Directory and Exchange environments.

Sales, Marketing and Distribution

We market and sell our products and services worldwide primarily through our direct sales organization. At December 31, 2003, we had approximately 300 direct sales representatives. We reduced the number of sales representatives by over 50 in mid-2003 to reduce our direct sales expenses. Approximately three-fourths of our sales representatives are field sales persons. We have over 130 pre-sales systems engineers who work with these field sales teams to provide technical assistance and demonstrations to sales prospects. The remaining one-fourth of our sales representatives are telesales representatives, who sell products such as our Oracle and J2EE development tools that are generally evaluated through internet downloads. We supplement our direct sales

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organization with indirect sales channels such as value added resellers and systems integrators. We also employ local resellers in certain international territories not covered by our local sales offices.

We have opened sales offices in the major cities of the United States, Europe and Australia to facilitate close contact between current and potential customers and our field sales organization, which includes sales teams as well as pre- and post-sales technical consultants. In 2003, we began to expand our direct sales efforts into Asia with the opening of a sales office in Japan.

Our marketing efforts are designed to create awareness and generate demand for our products. To achieve these goals, we participate in industry trade shows, technical conferences and seminars and publish technical and educational articles in industry journals. Advertising has to date not been a key major part of our marketing programs, other than targeted advertisements in technical magazines and journals.

Our professional services organization complements our direct sales organization by providing customers with a full range of support services, including implementations, consulting services and training. We believe that professional services are important to customer satisfaction and the development of long-term customer relationships.

Customer Service and Support

A high level of customer service and support is critical to the successful marketing and sale of our products and the development of long-term customer relationships. We have a reputation for providing a high level of customer support and believe this is a competitive differentiator. Enrollment in our support, maintenance and enhancement program is annual and entitles a customer to:

Annual maintenance, support and enhancement fees generally range from 20% to 25% of the initial purchase cost, depending on the product and the level of problem resolution support purchased. Customer support is provided domestically through our offices in Irvine and internationally through our offices in Europe and Canada.

Research and Development

We believe that strong research and product development capabilities are essential to enhancing our core technologies and developing additional products. Innovative capabilities, strong product engineering and rich user interfaces are typical Quest attributes. We target ease of implementation and ease of use in designing our products. Our commitment to ongoing product development is reflected in our investments in research and development, which were $63.3 million, $60.1 million and $67.4 million for the years ended December 31, 2001, 2002 and 2003, respectively. We have actively recruited key software engineers and developers with expertise in the areas of Oracle technologies, Java, Microsoft infrastructure technologies, ERP and CRM systems, IBM database technologies and document management. Complementing these individuals, our senior management has extensive background in applications, database management, monitoring, and enterprise and system software industries.

Competition

The market for application management solutions is emerging rapidly, and, as a result, is intensely competitive and characterized by rapidly changing technology and evolving standards. Pricing pressures have

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increased over the past year, reflecting both competition and IT spending contraction. We expect competition to continue to increase both from existing competitors and new market entrants. We believe that our ability to compete effectively depends on many factors, including:

We compete in some cases with the vendors of databases, applications and other systems that we manage; for example, Oracle provides various tools for managing its databases that are competitive with our offerings. Competition from Oracle with certain of our Database Management products including SharePlex and Quest Central for Oracle has increased over the last 24 months and continues to increase with Oracle’s introduction of the next version of its database, known as Oracle 10G. Oracle 10G is claimed to have enhanced capabilities in the functions competitive with Quest Central for Oracle and with certain Oracle monitoring capabilities of Foglight. For the reasons discussed below, if Oracle 10G does provide capabilities closely equivalent to those of Quest Central for Oracle, our revenues from that product line would likely be materially adversely affected.

In some cases these platform vendor-provided tools are bundled with the platform and in other cases they are separately chargeable products, albeit at significantly lower price points. The inclusion of the functionality of our software as standard features of the underlying database solution or application supported by our products or sale at much lower cost could erode our revenues, particularly if the competing products and features were of comparable capability to our products. Even if the functionality provided as standard features or lower costs by these system providers is more limited than that of our software, there can be no assurance that a significant number of customers would not elect to accept more limited functionality in lieu of purchasing our products. Moreover, there is substantial risk that the mere announcements of competing products or features by large competitors such as Oracle could result in the delay or cancellation of customer orders for our products in anticipation of the introduction of such new products or features.

We also compete with other vendors of database, application and systems management tools. Public companies with whom we compete include:

Some of our competitors and potential competitors have greater name recognition, a larger installed customer base company-wide and significantly greater financial, technical, marketing, and other resources than we do. Competitors may also be able to respond more quickly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products than we can.

Because there are relatively low barriers to entry in the software market, we may encounter additional competition as other established and emerging companies enter our field and introduce new products and technologies. Venture capitalists and others have funded numerous application, database and systems management companies over the last five years. Accordingly, it is likely that new competitors or alliances among current and new competitors will emerge and rapidly gain acceptance.

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There can be no assurance that we will be able to compete successfully against current and future competitors. Increased competition could result in price reductions, fewer customer orders, reduced gross margins and loss of market share, any of which could materially affect our business, operating results or financial condition.

Proprietary Rights

Our success and ability to compete depend on our capacity to develop and maintain the proprietary aspects of our technology. We rely on a combination of trademark, trade secret, copyright, patent law and contractual restrictions to protect the proprietary aspects of our technology. We seek to protect our source code for our software, documentation and other written materials under trade secret and copyright laws. We license our software pursuant to signed or shrink-wrap license agreements, which impose restrictions on the licensee’s ability to utilize the software. Finally, we seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements with us and by restricting access to our source code. We currently hold several trademark registrations and have numerous trademark applications in the United States and certain foreign countries.

Employees

As of December 31, 2003, we employed 1,735 full-time employees, including 692 in sales and marketing, 54 in professional services, 658 in research and development, 131 in customer service and support and 200 in general and administrative. We believe that our future success will depend in large part upon our continuing ability to attract and retain highly skilled managerial, sales, marketing, customer support and research and development personnel. Like other software companies, we face intense competition for such personnel, and we have at times experienced and continue to experience difficulty in recruiting qualified personnel. There can be no assurance that we will be successful in attracting, assimilating and retaining other qualified personnel in the future. None of our employees are represented by a labor union; we have never experienced any work stoppages and we believe that our relationships with our employees are good.

Website

Our website is located at www.quest.com. We make available, free of charge on or through our website, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. Information contained on our website is not part of this annual report on Form 10-K.

Item 2.    Properties

Our headquarters and our principal administrative, sales, marketing, support and research and development facilities are currently located in two leased buildings comprising approximately 135,100 square feet of space in Irvine, California. In addition, we lease facilities in Canada, Australia, Israel and Russia for research and development activities. We also operate in leased facilities throughout North America, including Toronto, Chicago, Atlanta, Ottawa and Houston. Our international subsidiaries and branches operate in leased facilities worldwide, including Australia, the United Kingdom and Germany.

In February 2004, we entered into an agreement to purchase a building in Aliso Viejo, California comprising approximately 78,000 square feet and an agreement to lease approximately 57,000 square feet of space in an adjacent building for a ten-year term commencing in December 2005. The lease agreement includes an option, exercisable until November 15, 2004, to purchase this building. We intend to move all of our Irvine

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operations into these two buildings in stages over the next six quarters. See “Liquidity and Capital Resources” in Item 7 “Managements Discussion and Analysis of Financial Condition and Results of Operations” for additional discussion about costs associated with this move.

Item 3.    Legal Proceedings

On July 2, 2002, Computer Associates International, Inc. (“CA”) filed a complaint against us and four of our employees in the U.S. District Court for the Northern District of Illinois alleging copyright infringement and trade secret misappropriation in connection with the development of the database administration component of our Quest Central for DB2 product and seeking injunctive relief and unspecified money damages. The complaint was amended in May 2003 to add another Quest employee as a defendant and to assert breach of contract claims against three of the individual defendants. In October 2003, CA filed a motion for preliminary injunction. We responded to this motion in January 2004, arguing that CA cannot meet the requirements for injunctive relief. In connection with our response, we sought leave to assert a counterclaim for a declaratory judgment of invalidity of CA’s copyright registrations. Rulings on these motions are not expected until late in the second quarter of 2004. If CA’s motion is granted, we would be preliminarily enjoined from licensing Quest Central for DB2. We are vigorously defending CA’s claims and do not believe that this matter will have a material adverse effect on our results of operations or financial condition.

After we announced on July 23, 2003 that we would restate certain financial results as a result of our discovery of a computational error relating to an error in the method used to translate foreign currency denominated accounts into U.S. Dollars at historical rates, numerous separate complaints purporting to be class actions were filed in the United States District Court for the Central District of California alleging that we and some of our officers and directors violated provisions of the Securities Exchange Act of 1934. Orders designating a lead plaintiff and consolidating the federal class action complaints were issued by the U. S. District Court in late October 2003, and an amended consolidated class action complaint was filed in January 2004. The consolidated amended complaint contains varying allegations, including allegations that we made materially false and misleading statements with respect to our financial results for 2002 and the quarter ended March 31, 2003 included in our filings with the SEC and press releases. In addition, one complaint purporting to be a derivative action has been filed in California state court against some of our directors and officers. This complaint is based on the same facts and circumstances described in the consolidated amended class action complaints and generally alleges that the named directors and officers breached their fiduciary duties by failing to oversee adequately our financial reporting. Each of the complaints generally seek an unspecified amount of damages. The cases are in the very preliminary stages and we will vigorously defend these claims; however, it is not possible for us to quantify the extent of our potential liability, if any. Accordingly, no amounts have been accrued in the accompanying financial statements. Our motions to dismiss the federal class action complaint and the derivative action are expected to be filed during the second quarter of 2004. An unfavorable outcome in any of these cases could have a material adverse effect on our business, financial condition, results of operations and cash flow. In addition, defending any litigation may be costly and divert management’s attention from the day-to-day operations of our business.

We are a party to other litigation, which we consider to be routine and incidental to our business. Management does not expect the results of any of these actions to have a material adverse effect on our results of operations or financial condition.

In the normal course of our business, we enter into certain types of agreements that require us to indemnify or guarantee the obligations of other parties. These commitments include (i) intellectual property indemnities to licensees of our software products, (ii) indemnities to certain lessors under office space leases for certain claims arising from our use or occupancy of the related premises, or for the obligations of our subsidiaries under leasing arrangements, (iii) indemnities to customers, vendors and service providers for claims based on negligence or willful misconduct of our employees and agents, and (iv) indemnities to our directors and officers to the maximum extent permitted under applicable law. The terms and duration of these commitments varies and, in

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some cases, may be indefinite, and certain of these commitments do not limit the maximum amount of future payments we could become obligated to make thereunder; accordingly, our actual aggregate maximum exposure related to these types of commitments cannot be reasonably estimated. Historically, we have not been obligated to make significant payments for obligations of this nature, and no liabilities have been recorded for these obligations in the accompanying consolidated balance sheets as the fair value of these obligations issued during the twelve months ended December 31, 2003 was not significant to our financial position, results of operations, or cash flows.

Item 4.    Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the fourth quarter of 2003.

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PART II

Item 5.    Market for the Registrant’s Common Equity and Related Shareholder Matters

Our common stock is listed on the NASDAQ National Market under the symbol “QSFT.” The following table sets forth the high and low sale prices on the NASDAQ National Market for our common stock for the periods indicated.

On March 1, 2004, the closing price of our common stock on the NASDAQ National Market was $16.18 per share. As of March 2, 2004, there were 234 holders of record of our common stock (not including beneficial holders of shares held in “street name”).

We have never declared or paid any cash dividends on our common stock and do not expect to do so in the foreseeable future. We currently intend to retain all available funds for use in the operation and expansion of our business. Any future determination to pay dividends will be at the discretion of our board of directors and will depend on our results of operations, financial conditions, contractual and legal restrictions and other factors the board deems relevant.

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Item 6.    Selected Financial Data

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations also should be read in conjunction with the consolidated financial statements and notes to those statements included elsewhere in this Report. Certain statements in this Report, including statements regarding our business strategies, operations, financial conditions and prospects, are forward-looking statements. Use of the words “believe,” “expect,” “anticipate,” “will,” “contemplate,” “would” and similar expressions that contemplate future events may identify forward-looking statements.

Numerous important factors, risks and uncertainties affect our operations and could cause actual results to differ materially from those expressed or implied by these or any other forward-looking statements made by us or on our behalf. Readers are urged to carefully review and consider the various disclosures made in this Report, including those described under “Risk Factors,” and in other filings with the SEC, that attempt to advise interested parties of certain risks and factors that may affect our business. Readers are cautioned not to place undue reliance on these forward-looking statements, which are based on current expectations and reflect management’s opinions only as of the date thereof. We do not assume any obligation to revise or update forward-looking statements. Finally, our historic results should not be viewed as indicative of future performance.

Overview and Business Model

We are an independent software vendor of a broad portfolio of products that improve information technology operations. We focus our efforts on products for widely adopted software platforms such as the Oracle, IBM DB2 and Microsoft SQL Server database management systems, the packaged applications provided by companies such as SAP, Oracle, PeopleSoft and Siebel and the Microsoft Active Directory and Exchange systems. Products for the Oracle databases have traditionally been our core product set. Over the last three years, the revenue contribution from Oracle database-only products has declined as a percentage of total revenues because of reduced revenues from our High Availability products for Oracle and because of our efforts to build and acquire products outside of the Oracle database market, especially in the areas of Application Performance Management and Microsoft Infrastructure Management. Additional information about our products can be found under the discussion above under the heading “Business.”

Our revenue consists primarily of software license fees and maintenance fees from customers. Our software-licensing model is primarily based on perpetual license fees, and our license fees are calculated either on a per-server basis or, for our SQL and J2EE development, report management and Microsoft administration tools, a per user basis. First-year maintenance contracts are typically sold with the related software license and renewed on an annual basis thereafter. Maintenance services entitle a customer to technical support via telephone and the internet and unspecified maintenance releases, updates and enhancements. Maintenance revenue is based on vendor-specific objective evidence of fair value and amortized over the term of the maintenance contract, typically 12 months. We also provide consulting and training services, which relate to installation of our products and do not include significant customization to or development of the underlying software code. Consulting and training service revenues are recognized as the services are performed and represent approximately 10.0% of total services revenues.

Our total revenues increased 19.1% from 2002 to 2003 and increased 3.7% from 2001 to 2002. As discussed below, license revenues increased 11.8% from 2002 to 2003 after decreasing 7.8% from 2001 to 2002. Services revenues increased 31.4% from 2002 to 2003 and increased 31.2% from 2001 to 2002. Total revenues benefited in both 2003 and 2002 from the depreciation of the U.S. Dollar against the Euro and British Pound. Total revenues also benefited in 2003 and, to a lesser extent, in 2002, from the revenue contribution by Sitraka, Inc., which we acquired in November 2002. Revenue contributions from foreign currency translation benefits and Sitraka are quantified in the discussions headed “Revenues” below.

Our primary expenses are our personnel costs, which include compensation and benefits and costs of office facilities and travel and entertainment, which are a function of our world-wide headcount. This is reflected in our gross margins that ranged between 88.0% and 91.0% in 2002 and 2003 and in our estimate that these personnel

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related costs represented approximately 75.0% of total expenses in 2003. We have held our headcount fairly constant throughout 2002 and 2003, with the exceptions that the Sitraka acquisition in November 2002 added approximately 200 personnel and that we reduced headcount by 6.0% to 7.0% in the June and September quarters of 2003. This reduction in headcount and higher revenues have resulted in improved operating margins in the second half of 2003. We did not record any restructuring charges in connection with this headcount reduction.

Acquisitions

In January 2004, we signed a definitive agreement to acquire Aelita Software, a privately held software vendor, in a $115 million cash transaction. Aelita develops, markets and supports products that improve the productivity, system availability and security of Microsoft Active Directory and Microsoft Exchange environments. With the proposed acquisition of Aelita, we expect to add breadth and depth to our Microsoft expertise and product portfolio and deliver a comprehensive set of product solutions that enable customers to manage today’s complex Microsoft infrastructures throughout their entire lifecycle. We expect to complete the acquisition of Aelita in the first quarter of 2004.

In November of 2002, we acquired Sitraka, a leading developer of application server performance management products, and broadened our Application Performance Management portfolio of products to enable customers to detect, diagnose and resolve application bottlenecks within multi-tiered Java application environments. Results of operations from Sitraka and other acquisitions are included in our consolidated statements of operations from the respective dates of acquisition. For more information concerning our acquisitions during the periods presented herein, see Note 5 of “Notes to Consolidated Financial Statements.”

Results of Operations

Except as otherwise indicated, the following percentages are percentage of total revenues:

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Comparison of Fiscal Years Ended December 31, 2002 and 2003

Revenues

Total revenues and year-over-year changes are as follows (in thousands, except for percentages):

License Revenues—Total license revenues growth of 11.8% in 2003 derived from license revenues growth of 11.5% in North America, which increased to $126.2 million in 2003 and license revenues growth of 12.4% outside of North America to $53.4 million in 2003. The $18.9 million growth in license revenues in 2003 benefited from an $8.0 million contribution by Sitraka, Inc. acquired in November 2002 and an approximately $7.0 million contribution from the impact of the devaluation of the U.S. Dollar in 2003 relative to certain foreign currencies, primarily the Euro and the British Pound. We saw growth year-over-year primarily in our Application Performance Management products, with Foglight being the main contributor to the growth. License revenues were reduced by declines in sales of our high availability products for Oracle and our Vista output management products.

Service Revenues—Total service revenues growth of 31.4% derived from service revenues growth of 22.5% in North America, which increased to $94.4 million and service revenues growth of 69.5% outside of North America to $30.3 million in 2003. Higher revenues from support renewals primarily contributed to the growth, with an increasing base of products and customers we are supporting and, we believe, higher support renewal rates. Service revenues also benefited from a contribution of approximately $2.0 million from the impact of the devaluation of the U.S. Dollar in 2003 relative to certain foreign currencies, primarily the Euro and the British Pound and, to a much lesser extent, support revenues from the acquired base of Sitraka customers. Professional services as a percentage of total service revenues represented 10.0% in 2003 and 9.9% in 2002.

Cost of Revenues

Total cost of revenues and year-over-year changes are as follows (in thousands, except for percentages):

Cost of Licenses—Cost of licenses primarily consists of third-party software royalties, product packaging, documentation, duplication, delivery and personnel. Cost of licenses as a percentage of license revenues was 2.4% for 2003, compared with 2.2% in 2002. We expect that cost of licenses as a percentage of license revenues will remain relatively constant in 2004.

Cost of Services—Cost of services primarily consists of personnel, outside consultants, facilities and systems costs used in providing support, consulting and training services. Cost of services as a percentage of service revenues declined to 17.1% for 2003, compared to 18.9% for 2002. The increase in the absolute amounts of cost of services is primarily due to an increase in fees paid to outside professional services consultants in

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support of product deployments, an increase in the number of technical support personnel and consultants, mainly from the acquisition of Sitraka, as well as the impact from the devaluation of the U.S. Dollar relative to certain foreign currencies, primarily the Euro and the British Pound. The margin improvement is primarily due to our continued increase in customer maintenance and support revenues with a lower associated increase in headcount.

Amortization of Purchased Intangible Assets—Amortization of purchased intangible assets includes amortization of the fair value of acquired technology associated with the acquisitions made from 2000 through 2003. The increase is primarily due to amortization of purchased intangible assets related to the acquisitions of eCritical and Discus in the second quarter of 2003 and Sitraka in 2002, offset slightly by purchased intangible assets from acquisitions made in 2000 that were fully amortized by the beginning and middle of the year ended December 31, 2003. See Note 4 of the “Notes to Consolidated Financial Statements” for discussion of estimated future amortization expense. The useful lives of the acquired technologies range from two to seven years. See “Critical Accounting Policies and Estimates” for additional discussion regarding accounting for intangible assets.

Operating Expenses

Year-over-year changes in the principal components of our operating expenses are as follows (in thousands, except for percentages):

Sales and Marketing—Sales and marketing expenses consist primarily of the following types of costs related to our sales and marketing activities: compensation and benefits; sales commissions; facilities and systems; recruiting; trade shows; travel and entertainment; and marketing communications. Sales and marketing expenses as a percentage of total revenues were 47.5% in 2003 compared to 50.3% in 2002. The absolute increase in sales and marketing expenses resulted from increased labor expenses, primarily due to additional headcount from our acquisition of Sitraka, higher salary and commission rate in 2003 and to the U.S. Dollar devaluation. In addition, employee severance costs contributed approximately $1.4 million to sales and marketing expenses in 2003. These increases were offset somewhat by lower marketing program costs in 2003, primarily related to advertising and tradeshows. Sales and marketing expenses declined year-over-year on a percentage of revenues basis because of lower marketing costs in 2003 and reduced sales headcount in the third and fourth quarters of 2003.

Research and Development—Research and development expenses consist primarily of compensation and benefit costs for software developers, software product managers, quality assurance and technical documentation personnel, associated facilities and systems costs and payments made to outside software development consultants in connection with our ongoing efforts to enhance our core technologies and develop additional products. Research and development expenses as a percentage of total revenues were 22.2% in 2003 compared to 23.5% in 2002. Additional headcount from our acquisition of Sitraka was the primary reason for the absolute increase in research and development expenses. The devaluation of the U.S. Dollar to the Australian and Canadian Dollars also contributed to the expense increase, because we have significant development facilities in Australia and Canada.

General and Administrative—General and administrative expenses consist primarily of compensation and benefit costs for our executive, finance, legal, administrative and information services personnel, professional fees, and associated facilities and systems costs. General and administrative expenses as a percentage of total

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revenues were 9.7% in 2003 and 9.8% in 2002. The absolute increase in general and administrative expenses is primarily attributable to the inclusion of Sitraka’s general and administrative expenses, the currency effect of the U.S. Dollar devaluation, and higher accounting and legal fees. External accounting and legal fees alone increased by approximately $1.0 million in 2003 compared to 2002, with litigation defense costs and Sarbanes-Oxley compliance costs being the primary components.

Amortization of Purchased Intangible Assets—Intangible asset amortization includes the amortization of customer lists, trademarks and non-compete agreements associated with acquisitions. The increase in amortization is a result of the recent acquisitions, including Sitraka.

Other Income, Net

Other income, net includes interest income on our investment portfolio and gains and losses from foreign exchange fluctuations, as well as gains or losses on other financial or physical assets. Interest income decreased 33.7% from $8.9 million in 2002 to $5.9 million in 2003 as a result of lower reinvestment rates and a reduced investment portfolio on average. Foreign currency gains of $6.6 million were included in other income, net in 2003 as compared to $2.1 million of such gains included in 2002. The 2003 gains were primarily attributable to foreign currency fluctuations on certain non-U.S. Dollar denominated assets, primarily accounts receivable held in British Pounds and Euros, which appreciated 10.9% and 19.8%, respectively, against the U.S. Dollar in 2003. Other income, net in 2003 also includes an impairment charge of $3.5 million incurred in the fourth quarter of 2003 relating to our aircraft. The impairment charge is equal to the amount by which the carrying amount exceeded the estimated fair value of the aircraft.

Income Tax Provision

Provision for income taxes increased to $12.1 million in 2003 from $8.1 million in 2002, representing an increase of $4.0 million or 49.0%. The effective income tax rate in 2003 was 36.0% compared to 43.9% in 2002. The decline in the effective tax rate is largely the result of higher profitability of certain of our non-U.S. subsidiaries, which are subject to a lower effective tax rate primarily as a result of the utilization of historical net operating losses incurred in such jurisdictions.

Comparison of Fiscal Years Ended December 31, 2001 and 2002

Revenues

Total revenues and year-over-year changes are as follows (in thousands, except for percentages):

License Revenues—We believe customer efforts to reduce IT spending in response to general economic conditions contributed to the decrease in license revenues in 2002. In addition, we experienced increased competition related to our high availability and production support products for Oracle and our Vista output management products, which also contributed to the decline in license revenues. The decline in license revenues for these products was offset by growth in other product areas, primarily our Microsoft administration products and our monitoring products. License revenues in North America decreased to $113.1 million in 2002 from $136.1 million in 2001, a decline of 16.9%. License revenues outside of North America increased 24.8% to $47.5 million in 2002 from $38.1 million in 2001, and accounted for 29.6% of total license revenues, compared to

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21.9% in 2001. The increase in license revenues outside of North America is primarily due to strengthening operations in Europe as a result of continued investment in our foreign operations. License revenues attributable to our European operations represented $42.7 million in 2002, compared to $33.1 million in 2001, representing growth of 29.0%.

Service Revenues—The increase in service revenues was derived primarily from higher renewal maintenance fees. Higher renewal maintenance fees derived from growth in the base of installed products and, we believe, from improved support renewal billing processes and improved maintenance renewal rates. To a much lesser extent, support revenues from the acquired base of Sitraka customers also contributed to year-over-year increase in service revenues. Professional services as a percentage of total service revenues represented 9.9% in 2002 and 15.4% in 2001.

Cost of Revenues

Total cost of revenues and year-over-year changes are as follows (in thousands, except for percentages):

Cost of Licenses—Cost of licenses as a percentage of license revenues was 2.2% for 2002, compared with 2.6% in 2001. The decrease in cost of licenses for 2002 was primarily due to a decrease in third-party royalty obligations associated with our acquisition of RevealNet in the third quarter of 2001, whose products we distributed, and a decrease in amortization expense related to rights in purchased software rights.

Cost of Services—Cost of services as a percentage of service revenues declined to 18.9% for 2002, compared to 26.2% for 2001. The decrease in cost of services for 2002 is primarily attributable to a reduction in the amount of fees paid to outside consultants who provided specialized professional services.

Amortization of Purchased Intangible Assets—The decrease in amortization of purchased intangible assets is primarily due to the completion of amortization of purchased intangible assets related to certain acquisitions made in 2000, offset slightly by amortization related to acquisitions made in 2002. Intangible assets purchased as part of acquisitions were $3.2 million and $30.6 million in 2001 and 2002, respectively.

Operating Expenses

Year-over-year changes in the principal components of our operating expenses are as follows (in thousands, except for percentages):

Sales and Marketing—As a percentage of total revenues, sales and marketing remained flat at 50.3% from 2001 to 2002. The increase in sales and marketing expenses in 2002 resulted from increased labor expenses,

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primarily due to additional headcount from our acquisition of Sitraka, higher sales commission expenses and increased depreciation of sales and marketing information technology assets.

Research and Development—Research and development expenses declined as a percentage of total revenues to 23.5% in 2002 from 25.7% in 2001. In 2002, we implemented cost-control measures that resulted in decreases in travel expenses and fees paid to outside software development consultants. These savings were offset by increased labor costs primarily attributable to the additional headcount resulting from the Sitraka acquisition.

General and Administrative—The increase in general and administrative expenses in 2002 was primarily attributable to increased legal expenses and premiums for directors’ and officers’ liability insurance coverage. General and administrative expenses as a percentage of total revenues remained relatively flat from 2001 to 2002.

Intangible Asset and Goodwill Amortization—The decrease in intangible asset and goodwill amortization was principally due to our adoption of SFAS No. 142 Previously recognized workforce-in-place intangible assets were reclassified to goodwill effective January 1, 2002. See Note 1 of “Notes to Consolidated Financial Statements.”

Other Income, Net

Interest income decreased 13.5% from $10.3 million in 2002 to $8.9 million in 2003 as a result of lower reinvestment rates and a reduced investment portfolio on average. Foreign currency gains of $2.1 million were included in other income, net in 2002 as compared to a nominal amount in 2002. The 2002 gains were primarily attributable to foreign currency fluctuations on certain non-U.S. Dollar denominated assets, primarily accounts receivable held in British Pounds and Euros, which appreciated 10.5% and 18.3%, respectively, against the U.S. Dollar in 2002. Other income, net in 2002 also included a net gain on equity investments of $1.9 million arising from the sale of an equity investment and a loss of $1.6 million from an adjustment for other than temporary impairment of another equity investment. The gain is also attributable to a $4.4 million loss on equity investments recorded in 2001.

Income Tax Provision

Provision for income taxes increased to $8.1 million in 2002 from $5.9 million in 2001, representing an increase of $2.2 million or 38.6%. The effective income tax rate in 2002 was 43.9% compared to (11.7)% in 2001. The change in the effective tax rate from 2001 to 2002 results primarily from the elimination of goodwill amortization associated with the implementation of SFAS No. 142. See Note 9 of “Notes to Consolidated Financial Statements.”

Inflation

Inflation has not had a significant effect on our results of operations or financial position for the years ended December 31, 2001, 2002 and 2003.

Liquidity and Capital Resources

As of December 31, 2003, cash and cash equivalents and short-term marketable securities were $94.2 million and we held $184.2 million of long-term investment grade corporate and government securities.

Operating Activities

Net cash provided by operating activities increased to $76.7 million in 2003, compared with $53.2 million in 2002. The increase in cash from operating activities in 2003 was driven primarily by higher net income and

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deferred revenue with a reduction to deferred taxes. These increases were partially offset by an increase to accounts receivable and a reduction to income taxes payable.

Investing Activities

We used $80.2 million in investing activities in 2003, consisting primarily of $68.7 million net cash paid for purchases of marketable securities, $4.8 million net cash paid for acquisitions and $6.7 million in capital expenditures. We used $21.9 million in investing activities in 2002, consisting primarily of $56.8 million net cash paid for acquisitions and $3.0 million in capital expenditures, offset by net sales and maturities of marketable securities of $35.2 million and $2.8 million from the sale of an aircraft and equity investments. Capital expenditures primarily consisted of information technology hardware and software purchases.

In February 2004, we entered into an agreement to purchase a building in Aliso Viejo, California comprising approximately 78,000 square feet for approximately $14.0 million, and an agreement to lease approximately 57,000 square feet of space in an adjacent building for a ten-year term commencing in December 2005. The purchase of this building is expected to close at the end of the first quarter of 2004. The lease agreement includes an option, exercisable until November 15, 2004, to purchase this building. If we exercise this option, the purchase price would be approximately $18.6 million. We intend to move all of our Irvine operations into these two buildings in stages over the next six quarters. The cost of improvements and moving to a new location is expected to be approximately $9.0 million for each building.

On January 28, 2004, we signed a definitive agreement to acquire Aelita Software Corporation in a transaction valued at approximately $115.0 million, of which approximately $101.0 million is expected to be paid to Aelita’s stockholders in cash upon closing of this transaction (assuming no unanticipated exercise of existing Aelita stock options prior to closing). This transaction is expected to close by the end of the first quarter of 2004.

In the future, we expect cash will continue to be generated from our operations. We plan to reinvest our cash generated from operations in new short and long-term marketable securities consistent with past investment practices and continue to evaluate a variety of other strategic investment and acquisition opportunities.

Financing Activities

Financing activities generated $9.6 million in 2003, primarily from net proceeds of $14.1 million from issuances of our common stock under employee stock option and stock purchase plans, offset by the use of $4.6 million to repay debt. Financing activities generated $4.0 million in 2002, of which $6.2 million was generated from issuances of our common stock under employee stock option and stock purchase plans, offset by the use of $2.3 million to repay debt.

In December 2000, our Board of Directors authorized a stock repurchase program under which we may purchase up to two million shares of our common stock. Under the repurchase program, we may purchase shares from time to time at varying prices in open market or private transactions. In October 2001, our Board of Directors increased the total number of shares authorized for repurchase under the stock repurchase program from two million shares to five million. As of December 31, 2003, we had repurchased approximately 1.7 million shares of our common stock under this program for an aggregate cost of approximately $58.0 million. Repurchases help offset dilution from stock issued under our employee stock option and employee stock purchase plans. No shares of common stock were repurchased under this plan during 2002 or 2003.

Contractual Obligations

As of December 31, 2003, our contractual obligations or commercial commitments include our facility lease commitments and operating leases for office facilities and certain items of equipment as well as the remaining

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balance of $0.9 million for certain indebtedness assumed in connection with our acquisition of FastLane in September 2000, which is due in July of 2004. In addition, we are committed to pay additional capital contributions to a private equity fund totaling $1.7 million as capital calls are made. We do not have any off-balance sheet arrangements that could reduce our liquidity.

The following table summarizes our obligations as of December 31, 2003 and the effect we expect such obligations to have on our liquidity and cash flows in future periods (in thousands):

Based on our current operating plan, we believe that our existing cash, cash equivalents and investment balances and cash flows from operations will be sufficient to finance our working capital and capital expenditure requirements through at least the next 12 months. If we are not able to generate or sustain positive cash flow from operations, we would be required to use existing cash, cash equivalents and investment balances to support our working capital. Our ability to generate cash from operations is subject to substantial risks described below under the caption “Risk Factors.”

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, accounts receivable, intangible assets, income taxes and stock based compensation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. This forms the basis of judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies and the related judgments and estimates affect the preparation of our consolidated financial statements.

Revenue Recognition

We derive revenues from two primary sources: (1) software licenses and (2) services, which include post-contract customer support, consulting and education. We utilize written contracts as the means to establish the terms and conditions by which our products and services are sold to our customers. We license our products primarily through our direct sales force and indirectly through resellers.

We recognize revenue in accordance with the American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” and related interpretations, SOP 98-9 “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions,” Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 101 (“SAB 101”), “Revenue

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Recognition in Financial Statements,” and other related pronouncements. Based on our reading and interpretation of SOP 97-2, SOP 98-9, SAB 101 and other related pronouncements, we believe that our current sales contract terms and business arrangements have been properly reported. The AICPA and its Software Revenue Recognition Task Force continue to issue interpretations and guidance for applying the relevant standards to a wide range of sales contract terms and business arrangements that are prevalent in the software industry. Future interpretations of existing accounting standards or changes in our business practices could result in future changes in our revenue accounting policies that could have a material adverse effect on our business, financial condition and results of operations.

Our software products are “off-the-shelf” products that do not require modification or customization. Revenues from sales to of software licenses to customers are recognized when:

Our software license sales include an implicit first year annual customer support fee, which is recognized ratably over the one-year term of the arrangement. A customer’s renewal of annual customer support is priced as a percentage of the net software license fees, generally 20% to 25% of the initial purchase price.

We also offer product implementation and training services, which are sold separately under consulting engagement contracts. Revenues from these arrangements are accounted for separately from new software license revenues because the arrangements qualify as service transactions as defined in SOP 97-2 and are recognized as the services are performed.

For arrangements with multiple elements, we allocate revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor-specific objective evidence,” or “VSOE.” VSOE of fair value for all elements of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately. When multiple elements are sold to a customer in a single contract, the revenues from such multiple-element arrangements are allocated to each element based upon the residual method. Under the residual method, revenue is recognized for all delivered elements when (1) there is VSOE of the fair values of all undelivered elements and (2) all revenue recognition criteria of SOP 97-2, as amended, are satisfied. Under the residual method of accounting, any discount in the arrangement is allocated to the delivered elements. If we cannot objectively determine the fair value of any undelivered element included in bundled software and service arrangements, we defer revenue until all elements are delivered, services have been performed or until fair value can objectively be determined.

We sell our products primarily through direct sales. For indirect sales transactions sold through distributors or resellers, we recognize revenue using the sell-through method, meaning revenues are associated with specific customer orders. In addition, we defer recognition on indirect sales until receipt of payment unless we have a payment history with the reseller or distributor with no late payment experiences.

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Accounts Receivable

We maintain allowances for sales returns and doubtful accounts for estimated losses resulting from the unwillingness or inability of our customers to make required payments. This requires us to make estimates of future product returns, annual support cancellations and write-offs of bad debt accounts related to current period revenues. The amount of our reserves is based on historical experience and our analysis of the accounts receivable. As a percentage of current period revenues, charges against sales allowances for bad debt, sales returns and annual support cancellations were insignificant in both of the years ended December 31, 2003 and 2002.

If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required which would result in an additional general and administrative expense in the period such determination was made. Additionally, if significant product performance issues were to arise resulting in our accepting sales returns, additional allowances may be required which would result in a reduction of revenue in the period such determination was made. Our standard licensing agreement does not permit customers to return products unless we have breached the product warranty and are unable to cure the breach. Our product warranties are typical industry warranties that a product will perform in accordance with established product requirements. While such amounts have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past.

Intangible Assets

In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting. SFAS No. 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. We adopted SFAS No. 141 at the beginning of the third quarter of 2001 and adopted SFAS No. 142 at the beginning of the first quarter of 2002. As required by SFAS No. 142, we discontinued amortizing the remaining balances of goodwill as of the beginning of fiscal 2002. As a result, our annual amortization expense decreased approximately $56.0 million. All remaining and future acquired goodwill will be subject to impairment tests annually, or earlier if indicators of potential impairment exist, using a fair-value-based approach. All other intangible assets will continue to be amortized over their estimated useful lives and assessed for impairment under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

Under SFAS No. 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. We performed our annual impairment review and as a result determined that the carrying value of goodwill was less than the estimated fair value. In calculating the fair value of the reporting units (licenses and services), the Market Approach (Guideline Company Method) was the methodology deemed the most reliable and used for impairment analysis. We will perform subsequent annual impairment reviews during the fourth quarter of each year, or earlier if indicators of potential impairment exist. Future impairment reviews may result in charges against earnings to write down the value of goodwill.

Purchased intangible assets are recorded at the appraised value and amortized using the straight-line method over estimated useful lives of two years to seven years. The net carrying amount of purchased intangible assets was considered recoverable at December 31, 2003. In accordance with SFAS No. 144, purchased intangible assets are reviewed for events or changes in circumstances, which indicate that their carrying value may not be recoverable. We periodically review the carrying value of these assets to determine whether or not impairment to such value has occurred. In the event that in the future it is determined that the purchased intangible assets value has been impaired, an adjustment will be made resulting in a charge for the write-down in the period in which the determination is made.

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Income Taxes

We are required to estimate income taxes in each of the jurisdictions in which we operate as part of the process of preparing the consolidated financial statements. We recognize deferred income tax assets and liabilities based upon the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. Such deferred income taxes primarily relate to the timing of the recognition of certain revenue items and the timing of the deductibility of certain reserves and accruals for income tax purposes. We regularly review the deferred tax assets for recoverability and establish a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. If we are unable to generate sufficient future taxable income, or if there is a material change in the actual effective tax rates or time periods within which the underlying timing differences become taxable or deductible, we could be required to establish an additional valuation allowance against the deferred tax assets, which could result in a substantial increase in our effective tax rate and have a materially adverse impact on our operating results. U.S. income taxes were not provided for on undistributed earnings from certain non-U.S. subsidiaries. Those earnings are considered to be permanently reinvested.

Accounting for Stock-Based Compensation

Our stock-based employee compensation plans are described more fully in Note 11 of “Notes to Consolidated Financial Statements.” We account for those plans under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25 and related interpretations. Certain options granted under those plans had an exercise price less than the fair value of the underlying common stock on the date of grant, which is described more fully in Note 11. Unearned stock-based employee compensation costs associated with these options are reflected in net income. The expense equals the difference between the fair market value of our common stock on the grant date and the exercise price of the stock options and is recognized ratably over the vesting period of the stock options, currently four to five years.

We amortize stock-based compensation using the straight-line method over the remaining vesting periods of the related options, which is generally four to five years. Pro forma information regarding net income and earnings per share is required by SFAS No. 123. This information is required to be determined as if we had accounted for employee stock options and stock purchase plans under the fair value method of SFAS No. 123, as amended by SFAS No. 148.

Had employee stock based compensation cost been determined using the fair value method our net income (loss) would have been adjusted to the pro forma amounts indicated below (in thousands, except per share data):

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The fair value of options and shares issued pursuant to the Employee Stock Purchase Plan at the grant date was estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. We use projected volatility rates, which are based upon historical volatility rates trended into future years. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our options.

The effects of applying pro forma disclosures of net income and earnings per share are not likely to be representative of the pro forma effects on net income and earnings per share in the future years, because the number of future shares to be issued under these plans is not known and the assumptions used to determine the fair value can vary significantly.

Recently Issued Accounting Pronouncements

In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. We adopted the disclosure provisions of FIN 45 during the fourth quarter of fiscal 2002 and we provided the required disclosures in Note 13 “Commitments and Contingencies.” We adopted the recognition provisions of FIN 45 effective January 1, 2003 and such adoption did not have an impact on our consolidated results of operations or financial position.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation–Transition and Disclosure” effective for fiscal years ending after December 15, 2002. SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition to the fair value method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure provisions of SFAS No. 123 to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. SFAS No. 148 does not amend SFAS No. 123 to require companies to account for their employee stock-based awards using the fair value method. The disclosure provisions are required, however, for all companies with stock-based employee compensation, regardless of whether they utilize the fair value method of accounting described in SFAS No. 123 or the intrinsic value method described in APB Opinion No. 25, “Accounting for Stock Issued to Employees.” We adopted the disclosure requirements of SFAS No. 148 effective January 1, 2003. The adoption of this standard did not have a significant impact on our financial condition or operating results.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. We adopted the provisions of FIN 46 effective January 1, 2003. We do not have any variable interest entities; thus adoption of FIN 46 did not have an impact on our consolidated results of operations or financial position.

In January 2003, the Emerging Issues Task Force (“EITF”) issued EITF 00-21, “Revenue Arrangements with Multiple Deliverables,” which requires companies to allocate the consideration received on arrangements

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involving multiple arrangements based on their relative fair values. Further, this EITF requires that the companies consider the revenue recognition criteria separately for each of the deliverables. This EITF is applicable for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Early adoption is permitted. We adopted EITF 00-21 on January 1, 2003 and it did not have a material impact on our consolidated results of operations or financial position.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging.” The statement requires that contracts with comparable characteristics be accounted for similarly and clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, except in certain circumstances, and for hedging relationships designated after June 30, 2003. We adopted SFAS No. 149 effective July 1, 2003 and such adoption did not have an impact on our consolidated results of operations or financial position.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. We adopted SFAS No. 150 effective July 1, 2003 and such adoption did not have an impact on our consolidated results of operations or financial position because we have not issued any of these types of financial instruments.

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RISK FACTORS

An investment in our shares involves risks and uncertainties. You should carefully consider the factors described below before making an investment decision in our securities. The risks described below are the risks that we currently believe are material risks of business and the industry in which we compete.

Our business, financial condition and results of operations could be adversely affected by any of the following risks. If we are adversely affected by such risks, then the trading price of our common stock could decline, and you could lose all or part of your investment.

Our quarterly operating results may fluctuate in future periods and, as a result, we may fail to meet expectations of investors and analysts, causing our stock price to fluctuate or decline

Our revenues and operating results may vary significantly from quarter to quarter due to a number of factors. These factors include the following:

Fluctuations in our results of operations are likely to affect the market price of our common stock and may not be related to or indicative of our long-term performance.

The size and timing of our customer orders may vary significantly from quarter to quarter which could cause fluctuations in our revenues and operating results

Our license revenues in any quarter are substantially dependent on orders booked and delivered in that quarter. Our revenues in a given quarter could be adversely affected if we are unable to complete one or more large license agreements, or if the contract terms were to prevent us from recognizing revenue during that quarter. The sales cycles for certain of our software products, such as Vista Plus and SharePlex, can last from three to nine months and often require pre-purchase evaluation periods and customer education. Also, we have often booked a large amount of our sales in the last month, weeks or days of each quarter and delays in the closing of sales near the end of a quarter could cause quarterly revenue to fall short of anticipated levels. Finally, while a portion of our revenues each quarter is recognized from previously deferred revenue, our quarterly

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performance will depend primarily upon entering into new contracts to generate revenues for that quarter. These factors may cause significant periodic variation in our license revenues. In addition, we incur or commit to operating expenses based on anticipated revenue levels, and generally do not know whether revenues in any quarter will meet expectations until the end of that quarter. Accordingly, if our revenue growth rates slow or our revenues decline, our operating results could be seriously impaired because many of our expenses are relatively fixed in nature and cannot be easily or quickly changed.

General economic conditions and reduced levels of corporate IT spending may continue to affect revenue growth rates and impact our business

Our business and operating results are subject to the effects of changes in general economic conditions. Recent unfavorable economic conditions have resulted in continued reduced corporate IT spending in the industries that we serve and a softening of demand for computer software, not only in the database and application market segments we support but also in the product segment in which we compete. If these economic conditions do not improve, or we experience continued deterioration in general economic conditions or further reduced corporate IT spending, our business and operating results could continue to be adversely impacted.

Many of our products are vulnerable to direct competition from Oracle

We compete with Oracle in the market for database management solutions and the competitive pressure continues to increase. We expect that Oracle’s commitment to and presence in the database management product market will increase in the future and therefore substantially increase competitive pressures. We believe that Oracle will continue to incorporate database management technology into its server software offerings, possibly at no additional cost to its users. Competition from Oracle with certain of our Database Management products including SharePlex and Quest Central for Oracle has increased over the last two years and continues to increase with Oracle’s introduction of the next version of its database, known as Oracle 10G. Oracle 10G is claimed to have enhanced capabilities in the functions competitive with Quest Central for Oracle and with the Oracle monitoring capabilities of Foglight. If Oracle 10G does provide capabilities closely equivalent to those of Quest Central for Oracle, our revenues from that product line would likely be materially adversely affected.

In some cases these platform vendor-provided tools are bundled with the platform and in other cases they are separately chargeable products, albeit at significantly lower price points. The inclusion of the functionality of our software as standard features of the underlying database solution or application supported by our products or sale at much lower cost could erode our revenues, particularly if the competing products and features were of comparable capability to our products. Even if the functionality provided as standard features or lower costs by these system providers is more limited than that of our software, there can be no assurance that a significant number of customers would not elect to accept more limited functionality in lieu of purchasing our products. Moreover, there is substantial risk that the mere announcements of competing products or features by large competitors such as Oracle could result in the delay or cancellation of customer orders for our products in anticipation of the introduction of such new products or features.

Many of our products are dependent on database or application technologies of others; if these technologies lose market share or become incompatible with our products, or if these vendors acquire or form strategic relationships with our competitors, the demand for our products could suffer

We believe that our success has depended in part, and will continue to depend in part for the foreseeable future, upon our relationships with providers of major database and enterprise software programs, including Oracle, IBM, Microsoft, SAP, Siebel and PeopleSoft. Our competitive advantage consists in substantial part on the integration between our products and products provided by these major software providers, and our extensive knowledge of their products and technologies. If these companies for any reason decide to promote technologies and standards that are not compatible with our technologies, or if they lose market share for their database or application products, our business, operating results and financial condition would be materially adversely

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affected. Furthermore, these major software vendors could attempt to increase their presence in the markets we serve by acquiring or forming strategic alliances with our competitors, and may be in better position to withstand and respond to the current factors impacting this industry. These companies have longer operating histories, larger installed bases of customers and substantially greater financial, distribution, marketing and technical resources than we do, as well as well-established relationships with many of our present and potential customers. As a result, we may not be able to compete effectively with these companies in the future, which could materially adversely affect our business, operating results and financial condition.

Our success depends on our ability to develop new and enhanced products that achieve widespread market acceptance

Our future success depends on our ability to address the rapidly changing needs of our customers by developing and introducing new products, product updates and services on a timely basis, by extending the operation of our products on new platforms and by keeping pace with technological developments and emerging industry standards. In order to grow our business, we are committing substantial resources to developing software products and services for the applications management market. If this market does not continue to develop as anticipated, or demand for our products in this market does not materialize or occurs more slowly than we expect, or if our development efforts are delayed or unsuccessful, we will have expended substantial resources and capital without realizing sufficient revenues, and our business and operating results could be adversely affected.

Our operating results may be negatively impacted by fluctuations in foreign currency exchange rates

Our international operations are generally conducted through our international subsidiaries, with the associated revenues and related expenses, and balance sheets, denominated in the currency of the country in which the international subsidiaries operate. As a result, our operating results may be harmed by fluctuations in exchange rates between the U.S. Dollar and other foreign currencies. The foreign currencies to which we currently have the most significant exposure are the Canadian Dollar, the British Pound, the Euro and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our exposure to fluctuations in foreign currency exchange rates.

Our international operations and our planned expansion of our international operations expose us to certain risks

We maintain research and development operations in Canada, Australia, Israel and Russia, and continue to expand our international sales activities as part of our business strategy. As a result, we face increasing risks from our international operations, including, among others:

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Operating in international markets also requires significant management attention and financial resources and will place additional burdens on our management, administrative, operational and financial infrastructure. We cannot be certain that our investments in establishing facilities in other countries will produce desired levels of revenue or profitability. In addition, we have limited experience in developing localized versions of our products and marketing and distributing them internationally.

Acquisitions of companies or technologies may result in disruptions to our business and diversion of management attention

We have in the past made and we expect to continue to make acquisitions of complementary companies, products or technologies, including Sitraka and our recently announced acquisition of Aelita. Any additional acquisitions will require us to assimilate the operations, products and personnel of the acquired businesses and train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may subject us to liabilities and risks that are not known or identifiable at the time of the acquisition or may cause disruptions in our operations and divert management’s attention from day-to-day operations, which could impair our relationships with our current employees, customers and strategic partners. We may have to use cash, incur debt or issue equity securities to pay for any future acquisitions. Use of cash or debt may affect our liquidity and use of cash would reduce our cash reserves. The issuance of equity securities for any acquisition could be substantially dilutive to our shareholders. In addition, our profitability may suffer because of acquisition-related costs or amortization costs for intangible assets with indefinite useful lives. In consummating acquisitions, we are also subject to risks of entering geographic and business markets in which we have no or limited prior experience. If we are unable to fully integrate acquired businesses, products or technologies with our existing operations, we may not receive the intended benefits of an acquisition.

We Face Risks Associated With Governmental Contracting

We derive a portion of our revenues from contracts with the United States government and its agencies and from contracts with state and local governments or agencies. Demand and payment for our products and services are impacted by public sector budgetary cycles and funding availability, with funding reductions or delays adversely impacting public sector demand for our products and services. Public sector customers may also change the way they procure new contracts and may adopt new rules or regulations governing contract procurement, including required competitive bidding or use of “open source” products, where available. These factors may limit the growth of or reduce the amount of revenues we derive from the public sector, which could negatively affect our results of operations.

Our efforts to constrain costs may strain our management, administrative, operational and financial infrastructure

We are experiencing slower growth and are focused on increasing our operating margins. These efforts place a strain on our management, administrative, operational and financial infrastructure. Our ability to manage our operations while reducing operating costs requires us to continue to improve our operational, financial and management controls and reporting systems and procedures. Although we achieved a year over year increase in our margins from fiscal 2002 to 2003, there can be no guarantees that we will be successful in achieving our profitability targets in any future quarterly or annual period.

We may not generate increased business from our current customers, which could slow our revenue growth in the future

Most of our customers initially make a purchase of our products for a single department or location. Many of these customers may choose not to expand their use of our products. If we fail to generate expanded business from our current customers, our business, operating results and financial condition could be materially adversely

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affected. In addition, as we deploy new modules and features for our existing products or introduce new products, our current customers may choose not to purchase this new functionality or these new products. Moreover, if customers elect not to renew their maintenance agreements, our service revenues would be materially adversely affected.

Our operating results may be affected if we are required to change our accounting for employee stock options

We currently account for the issuance of stock options under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under APB No. 25, no compensation expense is recognized for options granted to employees where the exercise price equals the market price of the underlying stock on the date of grant. Certain proposals related to treating the grant of an employee stock option as an expense are currently under consideration by accounting standards organizations and governmental authorities. If such proposals are adopted and we are required to change the way we account for stock options, our operating results could be negatively impacted as a result of the additional expenses associated with stock options. See Note 1 of the “Notes to Consolidated Financial Statements” for a more detailed presentation of our accounting for stock-based compensation plans.

Failure to develop strategic relationships could harm our business by denying us selling opportunities and other benefits

Our current collaborative relationships may not prove to be beneficial to us, and they may not be sustained. We also may not be able to enter into successful new strategic relationships in the future, which could have a material adverse effect on our business, operating results and financial condition. We could lose sales opportunities if we fail to work effectively with these parties. Moreover, we expect that maintaining and enhancing these and other relationships will become a more meaningful part of our business strategy in the future. However, many of our current partners are either actual or potential competitors with us. In addition, many of these third parties also work with competing software companies and we may not be able to maintain these existing relationships, due to the fact that these relationships are informal or, if written, are terminable with little or no notice.

Failure to adequately protect our intellectual property rights could harm our competitive position

Our success and ability to compete are dependent on our ability to develop and maintain the proprietary aspects of our technology. We generally rely on a combination of trademark, trade secret, patent, copyright law and contractual restrictions to protect the proprietary aspects of our technology.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, and to determine the validity and scope of the proprietary rights of others. Any such resulting litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management and financial resources, which could harm our business.

Our means of protecting our proprietary rights may prove to be inadequate and competitors may independently develop similar or superior technology. Policing unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. We also believe that, because of the rapid rate of technological change in the software industry, trade secret and copyright protection are less significant than factors such as the knowledge, ability and experience of our employees, frequent product enhancements and the timeliness and quality of customer support services.

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Third parties may claim that our software products or services infringe on their intellectual property rights, exposing us to litigation that, regardless of merit, may be costly to defend

Our success and ability to compete are also dependent on our ability to operate without infringing upon the proprietary rights of others. Third parties may claim that our current or future products infringe their intellectual property rights. Any such claim, with or without merit, could have a significant effect on our business and financial results. See “Legal Proceedings” in Part I, Item 3, of this report, for information concerning copyright infringement and trade secret misappropriation claims initiated against Quest by Computer Associates International, Inc. This and any future third party claim could be time consuming, divert management’s attention from our business operations and result in substantial litigation costs, including any monetary damages and customer indemnification obligations, which may result from such claims. In addition, parties making these claims may be able to obtain injunctive or other equitable relief affecting our ability to license the products that incorporate the challenged intellectual property. As a result of such claims, we may be required to obtain licenses from third parties, develop alternative technology or redesign our products. We cannot be sure that such licenses would be available on terms acceptable to us, if at all. If a successful claim is made against us and we are unable to develop or license alternative technology, our business and financial results and position could be materially adversely affected.

Our business will suffer if our software contains errors

The software products we offer are inherently complex. Despite testing and quality control, we cannot be certain that errors will not be found in current versions, new versions or enhancements of our products after commencement of commercial shipments. Significant technical challenges also arise with our products because our customers purchase and deploy our products across a variety of computer platforms and integrate it with a number of third-party software applications and databases. If new or existing customers have difficulty deploying our products or require significant amounts of customer support, our operating margins could be harmed. Moreover, we could face possible claims and higher development costs if our software contains undetected errors or if we fail to meet our customers’ expectations. As a result of the foregoing, we could experience:

In addition, a product liability claim, whether or not successful, could harm our business by increasing our costs and distracting our management.

We incorporate software licensed from third parties into some of our products and any significant interruption in the availability of these third-party software products or defects in these products could reduce the demand for, or prevent the shipping of, our products

Certain of our software products contain components developed and maintained by third-party software vendors. We expect that we may have to incorporate software from third-party vendors in our future products. We may not be able to replace the functionality provided by the third-party software currently offered with our

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products if that software becomes obsolete, defective or incompatible with future versions of our products or is not adequately maintained or updated. Any significant interruption in the availability of these third-party software products or defects in these products could harm our sales unless and until we can secure an alternative source. Although we believe there are adequate alternate sources for the technology licensed to us, such alternate sources may not provide us with the same functionality as that currently provided to us.

Natural disasters or power outages could disrupt our business

A substantial portion of our operations is located in California, and we are subject to risks of damage and business disruptions resulting from earthquakes, floods, fires and similar events, as well as from power outages. We have in the past experienced limited and temporary power losses in our California facilities due to power shortages, and we expect in the future to experience additional power losses. While the impact to our business and operating results has not been material, we cannot assure you that power losses will not adversely affect our business in the future, or that the cost of acquiring sufficient power to run our business will not increase significantly. Since we do not have sufficient redundancy in our networking infrastructure, a natural disaster or other unanticipated problem could have an adverse effect on our business, including both our internal operations and our ability to communicate with our customers or sell and deliver our products.

The demand for our products will depend on our ability to adapt to rapid technological change

Our future success will depend on our ability to continue to enhance our current products and to develop and introduce new products on a timely basis that keep pace with technological developments and satisfy increasingly sophisticated customer requirements. Rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles, changes in customer demands and evolving industry standards characterize the market for our products and services. The introduction of products embodying new technologies and the emergence of new industry standards can render our existing products obsolete and unmarketable. As a result of the complexities inherent in today’s computing environments and the performance demanded by customers for embedded databases and Web-based products, new products and product enhancements can require long development and testing periods. As a result, significant delays in the general availability of such new releases or significant problems in the installation or implementation of such new releases could have a material adverse effect on our business, operating results and financial condition. We may not be successful in:

We may not be able to attract and retain personnel

Our future success depends on the continued service of our executive officers and other key administrative, sales and marketing and support personnel, many of whom have recently joined our company. In addition, the success of our business is substantially dependent on the services of our Chief Executive Officer and other executive officers. There has in the past been and there may in the future be a shortage of personnel that possess the technical background necessary to sell, support and develop our products effectively. Competition for skilled personnel is intense, and we may not be able to attract, assimilate or retain highly qualified personnel in the future. Our business may not be able to grow if we cannot attract qualified personnel. Hiring qualified sales, marketing, administrative, research and development and customer support personnel is very competitive in our industry, particularly in Southern California where Quest is headquartered.

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Item 7a.    Quantitative and Qualitative Disclosures About Market Risks

We transact business in a number of different foreign countries around the world. In most instances, revenues are collected and operating expenses are paid in the local currency of the country in which we are transacting. Accordingly, we are exposed to incremental volatility in sales and earnings within these countries due to fluctuations in foreign exchange rates.

Our exposure to foreign exchange risk is directly proportional to the magnitude of foreign net profits and losses denominated in currencies other than the U.S. Dollar, as well as our net foreign investment in non-U.S. Dollar assets. These exposures have the potential to produce either gains or losses. Our cumulative currency gains or losses in any given period are typically lessened by the economic benefits of diversification and low correlation between different currencies, but there can be no assurance that this pattern will continue to be true in future periods.

The foreign currencies to which we currently have the most significant exposure are the Canadian Dollar, the British Pound, the Euro and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our foreign exchange exposures, nor do we use such instruments for speculative trading purposes. We regularly monitor the potential cost and benefits of hedging foreign exchange exposures with derivatives and there remains the possibility that our foreign exchange hedging practices could change accordingly in time.

Interest Rate Risk

Our exposure to market interest-rate risk relates primarily to our investment portfolio. We have not used derivative financial instruments to hedge the market risks of our investments. We place our investments with high-quality issuers and, by policy, limit the amount of credit exposure to any one issuer other than the United States government and its agencies. Our investments in marketable securities consist primarily of investment-grade bonds and United States government and agency securities. Investments purchased with an original maturity of three months or less are considered to be cash equivalents. We classify all of our investments as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of shareholders’ equity.

Information about our investment portfolio is presented in the table below, which states the amortized book value and related weighted-average interest rates by year of maturity (in thousands):

We maintain a level of cash and cash equivalents such that we have generally been able to hold our investments to maturity. Accordingly, changes in the market interest rate would not have a material effect on the fair value of such investments.

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Item 8.    Financial Statements and Supplementary Data

The financial statements required by this item are included in Part IV, Item 15 (a) of this Form 10-K and are presented beginning on page F-1.

The following table sets forth selected unaudited consolidated quarterly financial data for the eight quarters ended December 31, 2003: