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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended MARCH 31, 2004

OR

For the transition period from                      to                     

Commission file number 0-24544

CYBERGUARD CORPORATION

(Exact name of Registrant as Specified in Its Charter)

Registrant’s Telephone Number, Including Area Code 954-958-3900

Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report

Indicate by check ü whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports),  Yes ü  No         

and (2) has been subject to such filing requirements for the past 90 days.  Yes ü  No         

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

As of May 7, 2004, 24,632,083 shares of the Registrant’s $0.01 par value Common Stock were outstanding.

TABLE OF CONTENTS

PART I: FINANCIAL INFORMATION

CYBERGUARD CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(Amounts in thousands)

1

CYBERGUARD CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(Amounts in thousands, except per share data)

2

CYBERGUARD CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Amounts in thousands)

3

Supplemental disclosure of non-cash information

During January 2001, approximately 310 options to purchase shares of the Company’s common stock were issued at a below market price, which required the Company to record approximately $11 and $16 in compensation expense during fiscal year 2003 and 2002.

The Company’s former CEO, Scott Hammack, participated in a special option program where he received no salary for twelve months which required the Company to record compensation expense of $59 for the nine months ended March 31, 2003.

In connection with the acquisition of NetOctave, 107 shares valued at $750 were issued, a contingent purchase consideration of $450 and costs associated with the closing of $68 were accrued for during the quarter ended March 31, 2003.

In connection with the acquisition of SnapGear, 1,651 shares valued at $14,222 were issued and a contingent purchase consideration of $800 was accrued for. The following assets and liabilities were acquired:

See accompanying notes to condensed consolidated financial statements

4

CYBERGUARD CORPORATION

Notes to Condensed Consolidated Financial Statements

March 31, 2004

Amounts in thousands, except per share data

(Unaudited)

CyberGuard Corporation (the “Company”) has prepared the condensed consolidated financial statements included herein, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission with respect to Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures made are adequate so as to make the information contained not misleading. These interim financial statements and the notes should be read in conjunction with the financial statements and the notes included in the Company’s 10-K for the year ended June 30, 2003 and the risk factors set forth in the Company’s annual report on Form 10-K, including, without limitation, risk related to the factors listed below. In the Company’s opinion, all adjustments (consisting only of normal recurring adjustments) necessary for fair presentation of the information shown, have been included. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an on-going basis, we evaluate significant estimates used in preparing our financial statements, including revenue recognition, bad debt, software development cost, inventory valuation, and reserve for deferred taxes. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The results of operations for the nine months ended March 31, 2004 are not necessarily indicative of the results of operations that may be expected for the year ending June 30, 2004.

Software Development Costs—The Company capitalizes costs related to the development of certain software products on a product by product basis in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86, “Accounting For the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed” which requires capitalization to begin when technological feasibility has been established and ends when the product is available for general release to customers. Software development costs incurred prior to technological feasibility, defined by implementation of a beta project, are considered research and development costs and are expensed as incurred. Capitalized costs are amortized on a straight-line method over two years. The amount amortized, is the greater of the two amounts calculated using the methods noted in SFAS 86. Amortization starts when the product is available for general release to customers. Unamortized capitalized software cost is evaluated at each balance sheet date and compared to the net realizable value. Any excess capitalized cost above net realizable value will be written off. No such impairment existed at March 31, 2004. The Company capitalized $632 in software development costs for the three months ended March 31, 2004 and $1,139 for the nine months ended March 31, 2004.

5

CYBERGUARD CORPORATION

Notes to Condensed Consolidated Financial Statements

March 31, 2004

Amounts in thousands, except per share data

(Unaudited)

Revenue Recognition—The Company recognizes revenue in accordance with Statement of Position (“SOP”) 97-2 “Software Revenue Recognition”, SOP 81-8, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts”, and Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition”. Revenue recognition in accordance with these pronouncements can be complex due to the nature and variability of the Company’s sales transactions. The Company’s revenue is primarily from the following sources:

Revenues from product sales are recognized only when a contract or agreement has been executed, delivery of the product has occurred, the fee is fixed and determinable and we believe collection is probable. Product revenue is generally recognized on product shipment; this includes the transfer of both title and risk of loss, provided that no significant obligations remain. There is no product right of return available to the customer. We defer revenues on product sales for new value added resellers where we are unable to determine the ability of the reseller to honor a commitment to make fixed or determinable payment. Revenue will be deferred until the resellers demonstrate consistency of payment within terms and there are no instances where we have to take back the product because of non-payment for a three-month period. For the quarter ended March 31, 2004, three resellers were reclassified from cash basis to accrual, based on a reasonable assurance of collectibility from evaluating their payment history and no product returns. Two resellers were reclassified for the quarter ended March 31, 2003. For the nine months ended March 31, 2004 and 2003, eight and fifteen resellers, respectively were reclassified from cash basis to accrual. The impact of the reclassifications did not have a material effect on revenue in any of the periods.

The Company recognizes contract engineering service revenue on a completed contract basis in accordance with SOP 81-1. Contract engineering contracts are relatively short term ranging from 1-3 months. Revenues from this source are insignificant as a percentage of total revenue and are generated from a limited number of customers served by the SnapGear subsidiary.

The Company recognizes revenue from product sales with customer-specific acceptance provisions when such specifications have been met and the title and risks and rewards of ownership transfer to the customer. This applies to revenue generated from customers of the SnapGear subsidiary.

The Company recognizes revenue from product sales to one customer on a bill and hold basis in accordance with the criteria established by SAB 104 for such transactions. Revenue is recognized after the risk of ownership has passed to the customer and when there are no remaining performance obligations on the part of the Company. This applies to revenue generated from a customer of the SnapGear subsidiary.

Service revenues consist primarily of the annual fee for maintenance (post-contract customer support) and maintenance renewals from our existing customers and are recognized ratably on a monthly

6

CYBERGUARD CORPORATION

Notes to Condensed Consolidated Financial Statements

March 31, 2004

Amounts in thousands, except per share data

(Unaudited)

basis over the service contract term. These services provide our customers access to our worldwide support organization for technical support, unspecified product updates/enhancements on a when and if available basis, and general security information. The updates are considered minor enhancements to the software that are not separately marketable or considered a competitive feature or major upgrade. All products and services are separately priced.

The Company also provides other professional support services, such as training and consulting, which are available under service agreements and charged for separately. These services are generally provided under time and materials contracts and revenue is recognized as the service is provided.

Goodwill—In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” the Company performs its test of goodwill on an annual basis at the end of each fiscal year to determine if impairment has occurred. No impairment has been identified or recorded during fiscal 2004 as goodwill was recorded for the first time in November 2003 in connection with the SnapGear acquisition and the first testing will be performed at the end of the current fiscal year.

Net Income (loss) Per Share—Basic income / (loss) per share is computed by dividing net income / (loss) available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings / (loss) per share data is computed on the basis of the weighted average number of common shares outstanding plus the effect of outstanding stock options and warrants using the treasury method. When the effects of the outstanding stock options, warrants and/or convertible securities are anti-dilutive, they are not included in the calculation of diluted earnings per share.

The table below illustrates the components of earnings per share:

7

CYBERGUARD CORPORATION

Notes to Condensed Consolidated Financial Statements

March 31, 2004

Amounts in thousands, except per share data

(Unaudited)

Stock-Based Compensation. The Company has adopted the disclosure provisions of SFAS No. 148, “Accounting for Stock Based Compensation – Transition and Disclosure,” which amends SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 148 allows for continued use of recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25 and related interpretations in accounting for stock based compensation. The Company applies the recognition and measurement principles of APB Opinion No. 25, and related interpretations in accounting for stock based compensation. For the three and nine months ended March 31, 2004 there was approximately $0 and $11 of stock based compensation included in net income / (loss). For the three and nine months ended March 31, 2003, there was approximately $5 and $16 of stock based compensation included in net income. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions to stock-based employee compensation. Such disclosure is not necessarily indicative of the fair value of stock options that could be granted by the Company in future periods or of the value of all options currently outstanding.

8

CYBERGUARD CORPORATION

Notes to Condensed Consolidated Financial Statements

March 31, 2004

Amounts in thousands, except per share data

(Unaudited)

The fair value method for these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for the three month and nine month period ended March 31, 2004 and 2003: the risk-free interest rate was 2.13%; the expected dividend yield was 0.0%, the volatility factor of the expected market price of the Company’s common stock was 89%, and a grant life of the option of 3 years.

The Company’s operating results and financial condition may be impacted by a number of factors including, but not limited to, the following, any of which could cause actual results to vary materially from current and historical results or the Company’s anticipated future results. A portion of the Company’s revenue is derived from its international operations and sources. As a result, the Company’s operations and financial results could be affected by international factors such as; changes in foreign currency exchange rates, weak economic conditions in the international markets in which the Company distributes its products, conflict in the Middle East, and recent health warnings in the Asia / Pacific region. The network security industry is highly competitive and competition is expected to intensify. There are numerous companies competing in segments of the market in which the Company does business. Competitors include organizations significantly larger and with more development, marketing and financial resources than the Company. In addition, the Company is subject to risks and uncertainties which include, but are not limited to, the timely development of and acceptance of new products, impact of competitive products, competition for and retention of key management and technology employees, possible attacks on our networks causing changes to the public’s perception of the Company, the ability to secure additional financing, government regulation, inventory obsolescence, the ultimate outcome of certain litigation matters, and cash balances in excess of federally insured limits.For a more complete discussion of these factors affecting the Company’s business and prospects and forward-looking statements, please refer to Part II, Item 7 of Form 10K for the fiscal year ended June 30, 2003.

On May 15, 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 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). SFAS No. 150 affects the issuer’s accounting for three types of freestanding financial instruments:

SFAS No. 150 does not apply to features embedded in a financial instrument that is not a derivative in its entirety. Most of the guidance in SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective for our first quarter of fiscal 2004. The

9

CYBERGUARD CORPORATION

Notes to Condensed Consolidated Financial Statements

March 31, 2004

Amounts in thousands, except per share data

(Unaudited)

adoption of SFAS No. 150 did not have an impact on our consolidated financial position or results of operations during the period.

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 Activities. In general, the SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of SFAS No. 149 did not have a material impact on our financial condition or results of operations.

In January 2003, the FASB issued FASB Interpretation 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 clarifies the application of Accounting Research Bulletin 51, Consolidated Financial Statements, for certain entities that do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties or in which equity investors do not have the characteristics of a controlling financial interest (“variable interest entities”). Variable interest entities within the scope of FIN 46 will be required to be consolidated by their primary beneficiary. The primary beneficiary of a variable interest entity is determined to be the party that absorbs a majority of the entity’s expected losses, receives a majority of its expected returns, or both. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. At March 31, 2004 we were not a party to transactions contemplated under FIN 46.

In November 2002, the Emerging Issues Task Force reached a consensus opinion on EITF 00-21, Revenue Arrangements with Multiple Deliverables. The consensus provides that revenue arrangements with multiple deliverables should be divided into separate units of accounting if certain criteria are met. The consideration for the arrangement should be allocated to the separate units of accounting based on their relative fair values, with different provisions if the fair value of all deliverables is not known or if the fair value is contingent on delivery of specified items or performance conditions. Applicable revenue recognition criteria should be considered separately for each separate unit of accounting. EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Entities may elect to report the change as a cumulative effect adjustment in accordance with APB Opinion 20, Accounting Changes. At March 31, 2004, we were not a party to transactions contemplated by EITF 02-21.

In November 2002 the Emerging Issues Task Force reached a consensus opinion on EITF 02-16, Accounting by a Customer (including a reseller) for Certain Consideration Received from a Vendor. EITF 02-16 requires that cash payments, credits, or equity instruments received, as consideration by a customer from a vendor should be presumed to be a reduction of cost of sales when recognized by the customer in the income statement. In certain situations, the presumption could be overcome and the consideration recognized either as revenue or a reduction of a specific cost incurred. The consensus should be applied prospectively to new or modified arrangements entered into after December 31, 2002. At March 31, 2004, we were not a party to transactions contemplated by EITF 02-16.

10

CYBERGUARD CORPORATION

Notes to Condensed Consolidated Financial Statements

March 31, 2004

Amounts in thousands, except per share data

(Unaudited)

Comprehensive income is defined as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources, and is comprised of net income and “other comprehensive income”. The Company’s other comprehensive income is comprised exclusively of changes in the Company’s Cumulative Translation Adjustment (“CTA”) account.

Comprehensive income, for the three and nine months ended March 31, 2004 and 2003, was as follows:

The Company views its operations and we manage our business as one segment, enterprise security solutions. Major foreign markets for our products and services include Europe, Japan, the Pacific Rim, and Latin America. In each market, we have independent channel partners who are responsible for marketing, selling and supporting our products and services to resellers and end-users within their defined territories. International sales accounted for 44% and 51% of total revenues for the three months ended March 31, 2004 and 2003 respectively, and 49% for each of the nine months ended March 31, 2004 and 2003.

On November 26, 2003, the Company completed the acquisition of SnapGear, Inc., a Delaware corporation (“SnapGear”), pursuant to an Agreement and Plan of Merger dated November 12, 2003 (“Agreement”).

The consideration to SnapGear was approximately $16,000 in cash and stock. The $16,000 consideration consisted of: (a) approximately 1,651 shares of the Company’s common stock valued at $14,222; and (b) cash of approximately $1,600. In addition, the stockholders of SnapGear are entitled to receive up to approximately 367 additional shares of the Company’s common stock valued at $3,200 if certain revenue targets are attained post-closing.

SnapGear stockholders were granted certain registration rights pertaining to the common stock they received in the transaction. The purchase price was determined through arms-length negotiations between representatives of the Company and SnapGear. The Company’s general corporate funds were the source of the funds used to fund the cash portion of the purchase price.

11

CYBERGUARD CORPORATION

Notes to Condensed Consolidated Financial Statements

March 31, 2004

Amounts in thousands, except per share data

(Unaudited)

SnapGear, a privately-held company founded in Australia, is a leading developer of embedded Linux security and offers a popular line of edge firewall/VPN security appliances for the small to medium enterprise markets. SnapGear offers a range of products that will allow the Company to broaden its product offering and compete in new market segments.

The following table summarizes the estimated fair values of the assets acquired. The acquisition was accounted for using the purchase method of accounting, as required by Statement of Financial Accounting Standard No. 141, “Business Combinations.” Under this method of accounting, the Company allocated the purchase price to the fair value of the assets acquired, including identified intangible assets. The allocation was based on management’s estimates, which included an independent third party valuation. The Company is in the process of finalizing the purchase price allocation and these are subject to change. The purchase price allocated includes $800 of the $3,200 contingent earnout based on the Company’s estimate of SnapGear achieving a revenue target per the Agreement, during the twelve months ended November 30, 2004. The purchase price included closing costs of $219.

12

CYBERGUARD CORPORATION

Notes to Condensed Consolidated Financial Statements

March 31, 2004

Amounts in thousands, except per share data

(Unaudited)

The following values were assigned to intangible assets; (a) developed technology—$1,000 and (b) customer relationships—$2,000. A useful life of 30 months was assigned to developed technology and 60 months to customer relationships. Amortization expense included in the results of operations for these intangible assets acquired, for the quarter and nine-months ended March 31, 2004, was $200 and $267, respectively. Compensation expense of $4,113 and $4,387, related to unearned restricted stock compensation, was included in the results of operations for the quarter and nine-month period ended March 31, 2004. The results of operations of SnapGear have been included in the consolidated statement of operations from November 27, 2003 to March 31, 2004.

Unaudited pro forma results of operations after giving effect to certain adjustments resulting from the acquisition of SnapGear were as follows for the period ended March 31, 2004. The amounts are shown as if the acquisition had occurred at the beginning of the period presented:

This information is not necessarily indicative of the operational results that would have occurred if the acquisition had been consummated on the dates indicated nor is it necessarily indicative of future operating results or financial position of the combined enterprise. The unaudited proforma combined condensed financial information does not reflect any adjustments to conform accounting practices or to reflect any cost savings or other synergies anticipated as a result of the acquisition.

The components of intangible assets subject to amortization are:

13

CYBERGUARD CORPORATION

Notes to Condensed Consolidated Financial Statements

March 31, 2004

Amounts in thousands, except per share data

(Unaudited)

Amortization expense for the three and nine-month period ended March 31, 2004 amounted to $451 and $820 respectively. Estimated amortization expense for current and succeeding fiscal years is as follows:

On August 24, 1998, the Company announced, among other things, that due to a review of its revenue recognition practices relating to distributors and resellers, it would restate prior financial results. After the August 24, 1998 announcement, twenty-five purported class action lawsuits were filed by alleged shareholders against the Company and certain former officers and directors. Pursuant to an order issued by the Court, these actions have been consolidated into one action, styled Stephen Cheney, et al. v. CyberGuard Corporation, et al., Case No. 98-6879-CIV-Gold, in the United States District Court, Southern District of Florida. On August 23, 1999, the plaintiffs filed a Consolidated and Amended Class Action Complaint. This action seeks damages purportedly on behalf of all persons who purchased or otherwise acquired the Company’s common stock during various periods from November 7, 1996 through August 24, 1998. The complaint alleges, among other things, that as a result of accounting irregularities relating to the Company’s revenue recognition policies, the Company’s previously issued financial statements were materially false and misleading and that the defendants knowingly or recklessly published these financial statements which caused the Company’s common stock prices to rise artificially. The action alleges violations of Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and SEC Rule 10b-5 promulgated thereunder and Section 20(a) of the Exchange Act. Subsequently, the defendants, including the Company, filed their respective motions to dismiss the Consolidated and Amended Class Action Complaint. On July 31, 2000, the Court issued a ruling denying the Company’s and Robert L. Carberry’s (the Company’s CEO from June 1996 through August 1998) motions to dismiss. The court granted the motions to dismiss with prejudice for defendants William D. Murray (the Company’s CFO from November 1997 through August 1998), Patrick O. Wheeler (the Company’s CFO from April 1996 through October 1997), C. Shelton James (the Company’s former Audit Committee Chairman), and KPMG Peat Marwick LLP (“KPMG”). On August 14, 2000, the plaintiffs filed a motion for reconsideration of that order. The Company filed an answer to the plaintiffs’ Consolidated and Amended Class Action Complaint on August 24, 2000. On March 20, 2001, the Court ruled on the plaintiffs’ motion for reconsideration that the previously dismissed defendants William D. Murray, Patrick O. Wheeler and C. Shelton James should not have been dismissed from the action and shall be defendants in this action under the control person liability claims under Section 20(a) of the Exchange Act, and that the plaintiffs may amend the Consolidated and Amended Class Action Complaint to bring claims against C. Shelton James under Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder. On April 5, 2001, the plaintiffs filed their Second Consolidated and Amended Class Action Complaint to include amended claims against C. Shelton James. On May 10, 2001, the Company filed an answer and affirmative defenses to plaintiffs’ Second Consolidated and Amended Class Action Complaint. On August 14, 2002, the Court granted the plaintiffs’ Motion for Class Certification and certified the class to include all investors who acquired the Company’s common stock between November 7, 1996 and August 24, 1998 and were damaged by the purchase of such stock.

14

CYBERGUARD CORPORATION

Notes to Condensed Consolidated Financial Statements

March 31, 2004

Amounts in thousands, except per share data

(Unaudited)

In July 2003, the Company entered into a Memorandum of Understanding to settle this lawsuit. The settlement amount of $10 million required the Company to incur a one-time charge of $3.9 million in the fourth quarter of its fiscal year ending June 30, 2003 for the amount in excess of the insurance coverage and related costs. The Company paid its portion of the settlement amount in cash. On October 9, 2003, the Company and all other parties signed a Stipulation and Agreement of Settlement and filed a Joint Motion for Preliminary Approval of Settlement of the lawsuit. On November 6, 2003, a hearing was held on the joint motion. The court entered a preliminary order approving the settlement and scheduled a final fairness hearing for April 16, 2004.

On April 16, 2004 a fairness hearing was held before the magistrate judge. There were no objections raised to the proposed settlement. On April 19, 2004, the magistrate judge issued a Report and Recommendation to the district judge recommending that the settlement be approved. The terms of the proposed settlement are subject to final approval by the district court and there can be no assurance that the court will issue its approval.

Certain shareholders owning approximately 40,000 shares have elected to be excluded from the proposed settlement. These shareholders may assert claims against the Company. The Company cannot, at this time, estimate the amount of damages these shareholders might seek nor can it provide assurances that it will be successful in defending against such claims. If such claims are asserted, the Company would have no insurance coverage available to defray the cost of defending or paying the claims.

If the court does not approve the settlement, there can be no assurance that the Company will ultimately be successful in defending the lawsuit, or that if the Company is unsuccessful, that there will be sufficient insurance coverage to cover any expense of the lawsuit and/or any judgment rendered against the Company. The Company’s obligation to indemnify its officers and directors under the aforementioned lawsuit is insured to the extent of the limits of the applicable insurance policies. The Company has initially notified its insurance carrier of the existence of the lawsuit, and the carrier has sent the Company a reservation of rights letter. If the settlement is not approved by the court, the Company intends to vigorously defend this action, and believes that in the event that it is unsuccessful, insurance coverage will be available to defray a portion, or substantially all, of the expense of defending and settling the lawsuit or paying a judgment. However, the Company is unable to predict the ultimate outcome of the litigation. There can be no assurance that the Company will be successful in defending the lawsuit or, if unsuccessful, that insurance will be available to pay all or any portion of the expense of the lawsuit. If the Company is unsuccessful in defending the lawsuit and the insurance coverage is unavailable or insufficient, the resolution of the lawsuit could have a material adverse effect on the Company’s consolidated financial position, results of operations, and cash flows.

On November 14, 2002, the Company filed a lawsuit against Data Return Corporation in the United States District Court of the Northern District of Texas, alleging breach of contract, and seeking, among other remedies, damages of approximately $4 million. On December 9, 2002, Data Return Corporation filed an answer and affirmative defenses, and also counterclaims against the Company, alleging breach of contract, breach of warranty, fraud negligent misrepresentation and deceptive trade practices, and seeking unspecified damages. On December 30, 2002, the Company filed its answer and affirmative defenses to the counterclaim and a motion to dismiss the fraud, negligent misrepresentation and deceptive trade practices counterclaims.

In February 2003, the Data Return Corporation filed for bankruptcy protection under Chapter 11 in the United States Bankruptcy Court, District of Massachusetts. In Re Divine, et seq., (Nos. 11472-JNF, et seq.). More specifically, the Data Return bankruptcy proceeding was consolidated with a number

15

CYBERGUARD CORPORATION

Notes to Condensed Consolidated Financial Statements

March 31, 2004

Amounts in thousands, except per share data

(Unaudited)

of other Chapter 11 proceedings that had been filed for a series of other related entities, including but not limited to Divine, Inc. On December 16, 2003, Data Return filed a Motion in the bankruptcy proceeding requesting an order authorizing a settlement between Data Return Corporation and the Company pursuant to which the parties would engage in a mutual release of claims thereby resolving all disputes between them. On January 13, 2004, with no objections having been received, the Motion was granted authorizing this settlement agreement and the Order was entered on the bankruptcy court’s docket effective January 22, 2004. This resolves all disputes that existed between the Company and Data Return Corporation. All documents have been filed necessary to dismiss the proceeding in the United States District Court for the Northern District of Texas given the parties resolution of the disputes.

The Company is involved from time to time, in the ordinary course of its business, in various litigation relating to the conduct of its business. The Company believes that these other litigation matters will not have a material adverse effect on its consolidated financial position, results of operations or cash flows.

The Company recorded an income tax benefit of $481 for the three months ended March 31, 2004, and $1,348 for the nine months ended March 31, 2004, as a result of the reversal of a portion of the deferred tax asset valuation allowance. The reversal of the allowance was made because the Company believes it is more likely than not that the deferred tax assets relating to the U.S. net operating loss carryforward, will be realized to the extent of the tax benefit recorded. The computation of our deferred tax asset and valuation allowance is based on taxable income we expect to earn over the next two years which will include the utilization of previously accumulated net operating tax losses. We will continue to evaluate each quarter the amount, if any, of additional reduction of the valuation allowance that should be made. This will be based on management’s estimate and conclusions regarding the ultimate realization of the deferred tax asset, including but not limited to, the company’s recent positive financial results as well as projected earnings over a two-year period. The impact of further reductions of the valuation allowance will be to record a tax benefit which will increase net income in the period the determination is made.

The factors which we will consider in evaluating when, and if, it would be appropriate to reverse the entire valuation allowance would include: the sufficient passage of time in which we have achieved our projections and utilized the tax net operating loss carryforward as planned, changes in the industry, our product life-cycle, profitability trends, and tax law changes.

On April 29, 2004, the Company completed the acquisition of German high-end content security vendor Webwasher AG for $40 million, of which $8 million is in cash and the remainder in the Company’s common stock. There is additional earnout potential of $10 million in stock subject to Webwasher AG achieving certain revenue and profit targets through June 30, 2005. Webwasher AG develops and markets standalone and integrated solutions for Internet content security and filtering, including URL filtering, e-mail and spam filtering, virus protection, SSL filtering, Instant Message/Peer-to-Peer blocking and Internet usage reporting.

16

CYBERGUARD CORPORATION

March 31, 2004

(Dollars in thousands, except per share data)

This Form 10-Q contains forward-looking statements about future results, which are subject to risks, and uncertainties, including those discussed below. These statements relate to future events or our future financial performance. In many cases you can identify forward-looking statements by terminology such as “may”, “will”, “should”, “expects”, “plans”, “anticipates”, “believes”, “estimates”, “predicts”, “potential”, “intend”, or “continue”, or the negative of such terms and other comparable terminology. However, the absence of these words does not mean that the statements are not forward-looking. Forward-looking statements include statements about our plans, objectives, expectations, intentions and other statements that are not historical facts. They are subject to known and unknown risks and uncertainties and assumptions that could cause our actual results to differ materially from those expected or implied by the forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including, but not limited to, the risks described in Part II, Item 7, of the Company’s 10-K for the year ended June 30, 2003. You should not unduly rely on these forward-looking statements, which apply only as of the date of this quarterly report. We undertake no obligation to update any forward-looking statements to reflect new information, circumstances or events after the date of this report. These forward-looking statements are only predictions.

Overview

The Company provides a full suite of products and services for the network security industry. The products offered by the Company include the CyberGuard^® and SnapGear^® firewall appliances and VPN, proprietary and third party technology and consulting and support services.

We develop, market and support a broad family of integrated network security solutions. Our security appliance solutions include key security technology such as firewalls and Virtual Private Networking (VPN). Our appliances are built upon a highly secure operating system and proprietary software designed to identify network and application attacks and prevent them from reaching mission-critical resources. Our firewall combines stateful packet inspection and application proxy technologies to deliver the highest level of security and performance for an enterprise’s network. We believe that our ability to inspect each packet of network traffic at the application layer provides our customers some of the highest levels of protection. Our target customers are large enterprises, including Global 2000 companies, major financial institutions and government entities worldwide. Our appliances are sold to end-users directly and indirectly by a direct sales force and resellers in the United States and in over 30 foreign countries.

Results of Operations

The quarter ended March 31, 2004 compared to the quarter ended March 31, 2003

Total Revenues

Total revenues, consist of product sales and maintenance and professional services, related to the sale of products. For the quarter ended March 31, 2004, total revenues increased by $4,393 to $13,036 compared to $8,643 for the quarter ended March 31, 2003. The increase was comprised of an increase in product sales of $3,935 and an increase in services of $458. International revenue represented approximately 44% of total revenues for the three months ended March 31, 2004 and 51% of total revenues for the three months ended March 31, 2003. The increase in product revenue is primarily the result of inclusion of revenue from the SnapGear acquisition for a full quarter. The increase in product and service revenue is the result of an increase in the number of units shipped and not from an increase in product prices.

Network security product revenue accounted for 78% of revenue during the quarter ended March 31, 2004 compared to 71% of revenues during the quarter ended March 31, 2003. The increase in the contribution of product revenue as a percentage of total revenue is as a result of the inclusion of the results of SnapGear, which derives its revenues primarily from the sale of product.

Service revenue includes maintenance contracts related to new product sales, renewal maintenance contracts for products previously deployed, training and consulting services. Support services for network security products accounted for 22% of revenues during the quarter ended March 31, 2004, as compared to 29% of revenues during the quarter ended March 31, 2003. The decrease in service revenue as a percentage of total revenue corresponds to the growth in product revenue related to SnapGear which creates no significant service revenue related to product sales. The increase in services revenue when

17

CYBERGUARD CORPORATION

March 31, 2004

(Dollars in thousands, except per share data)

compared to the prior year is the result of the increase in the Company’s customer base and its timing of renewal maintenance.

Gross Profit

Gross profit as a percentage of revenues was 65% for the quarter ended March 31, 2004 and 76% for the quarter ended March 31,2003.

The lower gross margin is the direct result of the inclusion of the SnapGear product range, which tend to have lower gross margins than the existing CyberGuard product range due to the significant OEM component.

The Company’s gross margin has been, and will continue to be, affected by a variety of factors including, competition, the product mix and average selling prices of products, new product introductions and enhancements, and the fluctuations in manufacturing volumes. We must continue to manage each of these factors effectively for our gross margins to move back toward prior levels.

Operating Expenses, Other Income and Expense and Net Income / (Loss)

Research and development expense includes salaries, non-capitalized equipment, software, software tools, and depreciation from capital equipment. Research and development expense increased by $28 to $1,714 for the quarter ended March 31, 2004, compared to $1,686 for the quarter ended March 31, 2003. The increase is net of research and development costs capitalized during the quarter ended March 31, 2004 of $632 compared to $0 of research and development costs capitalized during the quarter ended March 31, 2003. Excluding the effect of costs capitalized, 49% of the increase in cost is the result of the acquisition of SnapGear and the balance of the increase is the result of higher payroll costs due to additional headcount in the current quarter, when compared to the prior year. As a percentage of total revenue, research and development expense decreased to 13% for the quarter ended March 31, 2004, from 19% for the quarter ended March 31, 2003. The lower percentage is the result of the increase in research and development costs capitalized in the current quarter when compared to the prior year as well as the increase in Company revenues.

We expect to increase our research and development costs in total dollars to enhance and expand our current product offerings and develop new products. We plan to continue to make the necessary investment in research and development to keep our products at a competitive advantage.

Selling, general and administrative expense includes salaries, commissions, costs associated with the executive, human resource, finance and administrative support functions, legal and accounting professional services, and depreciation and amortization expense. Selling, general and administrative expense increased by $1,515 to $5,432 for the quarter ended March 31, 2004, from $3,917 for the quarter ended March 31, 2003.

The increase in selling, general and administrative expenses for the quarter ended March 31, 2004, is attributable to increases in headcount in the following areas: sales, marketing, training, inside sales staff, US Government division, EMEA, APAC as well as SnapGear employees across all functional areas. The additional payroll related costs as a result of the additional headcount described above, accounted for 31% of the increase in selling, general and administrative expense of $1,515. An increase in the allowance for doubtful accounts accounted for 23% of the increase. Professional fees related to various services accounted for 7% of the increase and training expenditures accounted for 7% of the increase. Additionally, amortization and depreciation expense accounted for 9% of the increase in selling, general and administrative expense for the quarter when compared to the prior year, primarily as a result of the NetOctave and SnapGear acquisitions.

18

CYBERGUARD CORPORATION

March 31, 2004

(Dollars in thousands, except per share data)

The unamortized unearned restricted stock compensation balance of $4,113 at December 31, 2003, recorded in connection with the acquisition of SnapGear, was written off as a one-time non-cash charge during the current quarter. As discussed in Part I, Item 1, Footnote 7 of the Form 10-Q filed with the SEC for the quarter ended December 31, 2003, this is as a result of the Company’s election to remove the employment requirement from the restricted stock agreement. The restricted stock agreement still requires release of stock to these employees from escrow over the next two years.

Total other income increased $245 for the quarter ended March 31, 2004, to $251 compared to $6 for the quarter ended March 31, 2003. The increase was the result of an increase in interest income and an increase in foreign currency translation gains.

The Company recorded an income tax benefit of $481 as of March 31, 2004, and $4,169 as of March 31, 2003, as a result of the reversal of a portion of the deferred tax asset valuation allowance. The reversal of the allowance was made because the Company believes it is more likely than not that this portion of the deferred tax asset will be realized. The computation of our deferred tax asset and valuation allowance is based on taxable income we expect to earn over the next two years which will include the utilization of previously accumulated net operating tax losses. A valuation allowance is provided for that portion of our deferred tax asset, which we cannot determine, is more likely than not to be recognized, due to our cumulative losses and the uncertainty as to future recoverability. The risk factors discussed in Part II, Item 7 of Form 10-K for the fiscal year ended June 30, 2003, could adversely affect our ability to generate future taxable income, thereby also adversely impacting our ability to realize the deferred tax asset. We will continue to evaluate each quarter the amount, if any, of additional reduction of the valuation allowance that should be made. This will be based on management’s estimate and conclusions regarding the ultimate realization of the deferred tax asset, including but not limited to, the company’s recent positive financial results as well as projected earnings over a two-year period. These projections are based upon products currently being sold and markets that currently produce sales. The impact of further reductions of the valuation allowance will be to record a tax benefit which will increase net income in the period the determination is made.

Net loss for the quarter ended March 31, 2004 was $2,109 compared to net income of $5,148 for the quarter ended March 31, 2003.

The nine-month period ended March 31, 2004 compared to the nine-month period ended March 31, 2003

Total Revenues

Total revenues, consist of product sales and maintenance and professional services, related to the sale of products. For the nine-month period ended March 31, 2004, total revenues increased by $9,316 to $33,292 compared to $23,976 for the nine-month period ended March 31, 2003. The increase was comprised of an increase in product sales of $7,651 and an increase in services of $1,665. International revenue represented approximately 49% of total revenues for each of the nine-month periods ended March 31, 2004 and 2003. The growth in revenues was driven by increased demand for our product in all geographic markets and in both governmental and commercial sectors as well as the inclusion of the results of SnapGear in the nine-month period ended March 31, 2004. The increase in product and service revenue is the result of an increase in the number of units shipped and not from an increase in product prices.

Network security product revenue accounted for 74% of revenue during the nine-month period ended March 31, 2004, compared to 70% of revenues during the quarter ended March 31, 2003.

19

CYBERGUARD CORPORATION

March 31, 2004

(Dollars in thousands, except per share data)

Service revenue includes maintenance contracts related to new product sales, renewal maintenance contracts for products previously deployed, training and consulting services. Support services for network security products accounted for 26% of revenues during the nine-month period ended March 31, 2004 compared to 30% of revenues during the nine-month period ended March 31, 2003. The decrease in service revenue as a percentage of total revenue corresponds to the growth in product revenue related to SnapGear which creates no significant service revenue related to product sales. The increase in service revenue corresponds to the growth in the Company’s customer base and its timing of renewal maintenance.

Gross Profit

Gross profit as a percentage of revenues was 69% for the nine-month period ended March 31, 2004, and 75% for the nine-month period ended March 31, 2003.

The lower gross margin is the direct result of the inclusion of the SnapGear product range, which tend to have lower gross margins than the existing CyberGuard product range due to the significant OEM component.

The Company’s gross margin has been, and will continue to be, affected by a variety of factors including, competition, the product mix and average selling prices of products, new product introductions and enhancements, and the fluctuations in manufacturing volumes. We must continue to manage each of these factors effectively for our gross margins to move back toward their prior levels.

Operating Expenses, Other Income and Expense and Net Income

Research and development expense includes salaries, non-capitalized equipment, software, software tools, and depreciation from capital equipment. Research and development expense increased by $1,168 to $5,109 for the nine-month period ended March 31, 2004, compared to $3,941 for the nine-month period ended March 31, 2003. The increase is net of research and development costs capitalized during the nine-month period ended March 31, 2004 of $1,139 compared to $179 of research and development costs capitalized during the nine-month period ended March 31, 2003. Excluding the effect of costs capitalized, 55% of the cost increase is a combination of the return to full salary following the completion of the special option program discussed in Part I, Item 1, Footnote 7 of the Form 10-Q filed with the SEC for the quarter ended December 31, 2001, as well as higher payroll costs due to additional headcount in the current period, when compared to the prior year. Of the remaining increase, 27% is the result of the acquisition of NetOctave and 18% is the result of the acquisition of SnapGear. As a percentage of total revenue, research and development expense decreased to 15% for the nine-month period ended March 31, 2004, from 16% for the nine-month period ended March 31, 2003, primarily as a result of an increase in revenues.

We expect to increase our research and development costs in total dollars to enhance and expand our current product offerings and develop new products. We plan to continue to make the necessary investment in research and development to keep our products at a competitive advantage.

Selling, general and administrative expense includes salaries, commissions, costs associated with the executive, human resource, finance and administrative support functions, legal and accounting professional services, and depreciation and amortization expense. Selling, general and administrative expense increased by $3,071 to $13,853 for the nine-month period ended March 31, 2004, from $10,782 for the nine-month period ended March 31, 2003.

The increase in selling, general and administrative expenses for the nine-month period ended March 31, 2004, is attributable to increases in headcount in the following areas: sales, marketing, training, inside

20

CYBERGUARD CORPORATION

March 31, 2004

(Dollars in thousands, except per share data)

sales staff, US Government division, EMEA, APAC as well as SnapGear employees across all functional areas. The additional payroll related costs as a result of the additional headcount described above, accounted for 50% of the overall selling, general and administrative expense increase of $3,071. Other cost increases included higher expenditures related to marketing, which accounted for 9% of the increase, professional services, which accounted for 6% of the increase, and depreciation and amortization expense, which accounted for 13% of the increase.

The unearned restricted stock compensation balance of $4,387 recorded in connection with the acquisition of SnapGear in November 2003, has been fully amortized as of March 31, 2004. As discussed in Part I, Item 1, Footnote 7 of the Form 10-Q filed with the SEC for the quarter ended December 31, 2003, this is as a result of the Company’s election to remove the employment requirement from the restricted stock agreement. The restricted stock agreement still requires release of stock to these employees from escrow over the next two years.

Total other income increased $344 for the nine-month period ended March 31, 2004, to $471 compared to $127 for the nine-month period ended March 31, 2003. The increase was the result of an increase in interest income and foreign currency translation gains and a decrease in the loss on sale of fixed assets.

The Company recorded an income tax benefit of $1,348 and $4,169 for the nine-month periods ended March 31, 2004 and 2003, as a result of the reversal of a portion of the deferred tax asset valuation allowance. The reversal of the allowance was made because the Company believes it is more likely than not that this portion of the deferred tax asset will be realized. The computation of our deferred tax asset and valuation allowance is based on taxable income we expect to earn over the next two years which will include the utilization of previously accumulated net operating tax losses. A valuation allowance is provided for that portion of our deferred tax asset, which we cannot determine, is more likely than not to be recognized, due to our cumulative losses and the uncertainty as to future recoverability. The risk factors discussed in Part II, Item 7 of Form 10-K for the fiscal year ended June 30, 2003 could adversely affect our ability to generate future taxable income, thereby also adversely impacting our ability to realize the deferred tax asset. We will continue to evaluate each quarter the amount, if any, of additional reduction of the valuation allowance that should be made. This will be based on management’s estimate and conclusions regarding the ultimate realization of the deferred tax asset, including but not limited to, the company’s recent positive financial results as well as projected earnings over a two-year period. These projections are based upon products currently being sold and markets that currently produce sales. The impact of further reductions of the valuation allowance will be to record a tax benefit which will increase net income in the period the determination is made.

Net income for the nine-month period ended March 31, 2004, was $1,395 compared to net income of $7,588 for the nine-month period ended March 31, 2003.

CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of financial conditions and results of operations is based on our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an on-going basis, we evaluate significant estimates used in preparing our financial statements, including

21

CYBERGUARD CORPORATION

March 31, 2004

(Dollars in thousands, except per share data)

revenue recognition, bad debt, software development cost, inventory valuation, and reserve for deferred taxes. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value 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 affect the more significant judgments and estimates used in preparing our consolidated financial statements:

Revenue Recognition— The Company recognizes revenue in accordance with Statement of Position (“SOP”) 97-2 “Software Revenue Recognition”, SOP 81-8, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts”, and Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition”. Revenue recognition in accordance with these pronouncements can be complex due to the nature and variability of the Company’s sales transactions. The Company’s revenue is primarily from the following sources:

Revenues from product sales are recognized only when a contract or agreement has been executed, delivery of the product has occurred, the fee is fixed and determinable and we believe collection is probable. Product revenue is generally recognized on product shipment; this includes the transfer of both title and risk of loss, provided that no significant obligations remain. There is no product right of return available to the customer. We defer revenues on product sales for new value added resellers where we are unable to determine the ability of the reseller to honor a commitment to make fixed or determinable payment. Revenue will be deferred until the resellers demonstrate consistency of payment within terms and there are no instances where we have to take back the product because of non-payment for a three-month period. For the quarter ended March 31, 2004, three resellers were reclassified from cash basis to accrual, based on a reasonable assurance of collectibility from evaluating their payment history and no product returns. Two resellers were reclassified for the quarter ended March 31, 2003. For the nine months ended March 31, 2004 and 2003, eight and fifteen resellers respectively, were reclassified from cash basis to accrual. The impact of the reclassifications did not have a material effect on revenue in any of the periods.

The Company recognizes contract engineering service revenue on a completed contract basis in accordance with SOP 81-1. Contract engineering contracts are relatively short term ranging from 1-3 months. Revenues from this source are insignificant as a percentage of total revenue and are generated from a limited number of customers served by the SnapGear subsidiary.

The Company recognizes revenue from product sales with customer-specific acceptance provisions when such specifications have been met and the title and risks and rewards of ownership transfer to the customer. This applies to revenue generated from customers of the SnapGear subsidiary.

The Company recognizes revenue from product sales to one customer on a bill and hold basis in accordance with the criteria established by SAB 104 for such transactions. Revenue is recognized after the risk of ownership has passed to the customer and when there are no remaining performance

22

CYBERGUARD CORPORATION

March 31, 2004

(Dollars in thousands, except per share data)

obligations on the part of the Company. This applies to revenue generated from a customer of the SnapGear subsidiary.

Service revenues consist primarily of the annual fee for maintenance (post-contract customer support) and maintenance renewals from our existing customers and are recognized ratably on a monthly basis over the service contract term. These services provide our customers access to our worldwide support organization for technical support, unspecified product updates/enhancements on a when and if available basis, and general security information. The updates are considered minor enhancements to the software that are not separately marketable or considered a competitive feature or major upgrade. All products and services are separately priced.

The Company also provides other professional support services, such as training and consulting, which are available under service agreements and charged for separately. These services are generally provided under time and materials contracts and revenue is recognized as the service is provided.

Goodwill—In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” the Company performs its test of goodwill on an annual basis at the end of each fiscal year to determine if impairment has occurred. No impairment has been identified or recorded during fiscal 2004 as goodwill was recorded for the first time in November 2003 in connection with the SnapGear acquisition. The first testing will be performed at the end of the current fiscal year.

Bad Debts. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Significant judgment is required when we assess the ultimate realization of receivables, including the probability of collection and the credit-worthiness of each customer. In estimating the allowance for doubtful accounts, we analyze our accounts receivable aging, historical bad debts, customer credit-worthiness, current economic trends and other factors. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowance might be required.

Software Development Costs— The Company capitalizes costs related to the development of certain software products on a product by product basis in accordance with Statement of Financial Accounting Standards No. 86, “Accounting For the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed” (“SFAS No. 86”) which requires capitalization to begin when technological feasibility has been established and ends when the product is available for general release to customers. Software development costs incurred prior to technological feasibility, defined by implementation of a beta project, are considered research and development costs and are expensed as incurred. Capitalized costs are amortized on a straight-line method over two years. The amount amortized, is the greater of the two amounts calculated using the methods noted in SFAS 86. Amortization starts when the product is available for general release to customers. Unamortized capitalized software cost is evaluated at each balance sheet date and compared to the net realizable value. Any excess capitalized cost above net realizable value will be written off. No such impairment existed at March 31, 2004. The Company capitalized $632 in software development costs for the three months ended March 31, 2004 and $1,139 for the nine months ended March 31, 2004.

Inventory Valuation. Inventories consist primarily of component parts and computer hardware and are carried at the lower of cost, determined by the First-In-First-Out method, or market. We write our inventories down to estimated market value based on assumptions of our future demand, based on projected product releases and market conditions. Variation in market trends, customer preferences, introduction of new products (replacing existing products) or technological advances could, however, significantly affect these estimates and result in additional inventory write-downs.

23

CYBERGUARD CORPORATION

March 31, 2004

(Dollars in thousands, except per share data)

Deferred Taxes. We provide a valuation allowance for that portion of deferred tax assets, which it cannot determine is more likely than not to be recognized due to the Company’s cumulative losses and the uncertainty as to future recoverability. Any reversal of the allowance is made when we believe that it is more likely than not that this portion of the deferred tax asset will be realized. The computation of our deferred tax asset and valuation allowance is based on taxable income we expect to earn over the next two years which will include the utilization of previously accumulated net operating tax losses. We will continue to evaluate each quarter the amount, if any, of additional reduction of the valuation allowance that should be made. This will be based on management’s estimate and conclusions regarding the ultimate realization of the deferred tax asset, including but not limited to, the company’s recent positive financial results as well as projected earnings over a two-year period. The impact of further reductions of the valuation allowance will be to record a tax benefit, which will increase net income in the period the determination is made. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize the deferred tax asset, in the future, an adjustment to the deferred tax asset would increase income in the period the determination was made.

Liquidity and Capital Resources

At March 31, 2004, the Company had cash and cash equivalents on hand of $19,360 representing an increase of $7,265 from $12,095 as of June 30, 2003. Net cash provided by operating activities during the nine-month period ended March 31, 2004 of $3,912 was primarily attributable to net income from operations of $1,395 combined with an increase in accrued expenses and deferred revenue, compensation expense related to unearned restricted stock in the SnapGear acquisition and a decrease in litigation receivable and inventory, offset by a deferred tax benefit, and a decrease in litigation payable and accounts payable and an increase in accounts receivable and other current assets. Net cash used in investing activities during the nine-month period ended March 31, 2004 of $1,570 related to the purchase of property and equipment and the capitalization of software costs. Cash provided by financing activities of $4,911 during the nine-month period ended March 31, 2004 reflects the proceeds from stock options exercised, proceeds from stock purchase warrants exercised and purchases made through the Company’s Employee Stock Purchase Plan.

The Company’s principal sources of liquidity at March 31, 2004, consisted of cash, accounts receivable, and vendor trade credit.

We believe our existing cash, cash equivalents and short-term investments will be sufficient to meet our cash requirements at least through the next twelve months. However, we may be required or could elect to seek additional funding prior to that time. Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending on support, product development efforts, expansion of sales and marketing, the timing of introductions of new products and enhancement to existing products, and market acceptance of our products. Other recent and possible future events that could also materially impact the Company’s ability to successfully execute on its business plans are described in Information Relating to Forward Looking Statements of this Item on Form 10-Q. We are not aware of any known demands, commitments, events or uncertainties that will result or that are reasonably likely to result in our liquidity increasing or decreasing in a material way.

We have no other agreements or arrangements for third parties to provide us with sources of liquidity and capital resources, including off balance sheet arrangements.

Information Relating to Forward Looking Statements

Statements regarding future products, prospects, profitability, business plans and strategies, future revenues and revenue sources, future liquidity and capital resources, future computer network security

24

CYBERGUARD CORPORATION

March 31, 2004

(Dollars in thousands, except per share data)

market directions, future acceptance of the Company’s products and possible growth in markets, as well as all other statements contained in this Report on Form 10-Q that are not purely historical are forward-looking statements.

Forward-looking statements are based upon assumptions and analyses made by the Company in light of current conditions, future developments and other factors the Company believes are appropriate in the circumstances, or information obtained from third parties and are subject to a number of assumptions, risks and uncertainties. Readers are cautioned that forward-looking statements are not guarantees of future performance and that the actual results might differ materially from those suggested or projected in the forward-looking statements. Accordingly, there can be no assurance that the forward-looking statements will occur or that results will not vary significantly from those described in the forward-looking statements. Some of the factors that might cause future actual events to differ from those predicted or assumed include: future advances in technologies and computer security; the Company’s history of annual net operating losses and the financing of these losses through the sale of assets and newly issued Company securities; the Company’s ability to execute on its business plans; the Company’s ability to effectively integrate newly acquired operations; the Company’s dependence on outside parties such as its key customers and alliance partners; competition from major computer hardware, software, and networking companies; risk and expense of government regulation and effects on changes in regulation; the limited experience of the Company in marketing its products; uncertainties associated with product performance liability; risks associated with growth and expansion; global economic conditions, overall network security spending, risks associated with obtaining and maintaining patent and intellectual property right protection, uncertainties in availability of expansion capital in the future and other risks associated with capital markets, including the events of September 11, 2001 and its repercussions. In addition, certain events that have occurred also are factors that might cause future actual events to differ from those predicted or assumed, including: the impact of the restatement of financial results for the Company’s fiscal year ended June 30, 1997 and quarters ended September 30, 1997, December 31, 1997 and March 31, 1998; the completion of the numerous organizational changes and the assembly of a new management team for the Company; and the outcome of a class action lawsuit against the Company relating to the restatement of financial results for the fiscal periods noted above. In addition, the forward-looking statements herein involve assumptions, risks and uncertainties, including, but not limited to economic, competitive, operational, management, governmental, regulatory, litigation and technological factors affecting the Company’s operations, liquidity, capital resources, markets, strategies, products, prices and other factors discussed elsewhere herein and in the other documents filed by the Company with the Securities and Exchange Commission. Copies of these filings can be obtained at the Investor Relations section of our website at www.cyberguard.com. We provide our annual and quarterly reports free of charge on www.cyberguard.com, as soon as reasonably practicable after they are electronically filed, or furnished to the SEC. Many of the foregoing factors are beyond the Company’s control.

The Company’s future success is based largely on its ability to develop and sell increasingly technologically advanced network security solutions in sufficient volume and at sufficient prices to become profitable on a consistent basis. In addition, the network security market is characterized by extremely rapid technological change, requiring rapid product development. The velocity of technological change has accelerated, and the Company believes that it is important to its future that it keeps pace with these changes. The Company believes that competition will continue to intensify in the rapidly evolving markets in which the Company is involved, and that the continued development of technologically advanced products will be necessary to keep our products current. The Company believes that its ability to generate adequate cash flow from operations will be critical to its future.

25

Non-GAAP Financial Information

The following reconciliation details the difference between results calculated using Generally Accepted Accounting Principles (“GAAP”) and the same results reported excluding certain charges (“non-GAAP information”). The non-GAAP information is included with the intention of providing investors a more complete understanding of our underlying operational results and trends, but should only be used in conjunction with results reported in accordance with GAAP. The Company believes that the non-GAAP disclosures set forth below provide useful information to show the effect on net income when all acquisition-related costs and non-cash tax benefits are excluded.