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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2004

or

For the transition period from              to             

Commission File Number: 1-11859

PEGASYSTEMS INC.

(Exact name of Registrant as specified in its charter)

(617) 374-9600

(Registrant’s telephone number including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

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

There were 35,759,283 shares of the Registrant’s common stock, $.01 par value per share, outstanding on July 22, 2004.

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PEGASYSTEMS INC.

Index to Form 10-Q

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PEGASYSTEMS INC.

Condensed Consolidated Balance Sheets

(in thousands, except share-related amounts)

See notes to condensed consolidated financial statements.

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PEGASYSTEMS INC.

Condensed Consolidated Statements of Income

(in thousands, except per share amounts)

See notes to condensed consolidated financial statements.

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Condensed Consolidated Statements of Cash Flows

(in thousands)

See notes to condensed consolidated financial statements.

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PEGASYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The unaudited condensed consolidated financial statements of Pegasystems Inc. (“we” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six month period ended June 30, 2004 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2004. We suggest that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2003, included in our 2003 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”).

2. SIGNIFICANT ACCOUNTING POLICIES

(a) Business

We develop, market, license and support software that enables transaction intensive organizations to manage a broad array of business processes. We also offer consulting, training and maintenance support services to facilitate the installation and use of our products.

(b) Management estimates and reporting

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates. Significant assets and liabilities with reported amounts based on estimates include trade and installment accounts receivable, long-term license installments, deferred income taxes and deferred revenue.

(c) Principles of consolidation

The consolidated financial statements include the accounts of Pegasystems Inc. and its wholly owned subsidiaries, Pegasystems Limited (a United Kingdom company), Pegasystems Company (a Canadian company), Pegasystems Worldwide Inc. (a United States corporation), Pegasystems Pty Ltd. (an Australian company), Pegasystems Investment Inc. (a United States corporation) and Pegasystems Private Limited (a Singapore company). All intercompany accounts and transactions have been eliminated in consolidation.

(d) Revenue recognition

Our revenue is derived from two primary sources: software license fees and service fees. We offer both perpetual and term software licenses. Perpetual license fees are generally payable at the time the software is delivered, and are generally recognized as revenue when the software is delivered, any acceptance required by contract is obtained, and no significant obligations or contingencies exist related to the software, other than maintenance support. Payments subject to refund are recognized in revenue as refund provisions lapse.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Term software license fees are generally payable on a monthly basis under license agreements that generally have a five-year term and may be renewed for additional years at the customer’s option. The present value of future license payments is generally recognized as revenue upon customer acceptance, provided that no significant obligations or contingencies exist related to the software, other than maintenance support. A portion of the license fees payable under each term license agreement (equal to the difference between the total license payments and the discounted present value of those payments) is initially deferred and recognized as installment receivable interest income (and is not part of total revenue) over the license term. Many of our license agreements provide for license fee increases based on inflation. When such an increase occurs, as determined by the terms of the license agreement, we recognize the present value of such increases as revenue; the remainder of the increase is recognized as installment receivable interest income over the remaining license term. For purposes of the present value calculations, the discount rates used are estimates of customers’ borrowing rates at the time of recognition, typically below prime rate, and have varied between 3.25% and 8.0% for the past few years. As a result, revenue that we recognize relative to these types of license arrangements would be impacted by changes in market interest rates. For term license agreement renewals, license revenue is recognized with the same present value approach, when the customer becomes committed to the new license terms and no significant obligations or contingencies exist related to the software, other than maintenance support.

In certain circumstances, such as when license fees are not fixed or determinable, some term licenses are accounted for on a subscription basis, where revenue is recognized as payments become due over the term of the license.

Our services revenue is comprised of fees for software implementation, consulting, maintenance and training services. Our software implementation and consulting agreements typically require us to provide services for a fixed fee or at an hourly rate. Revenues for time and material projects are recognized as services are delivered and fees are billed. Until the fair value of the elements of a contract can be determined, the recognition of services revenue for fixed-price projects is limited to amounts equal to direct costs incurred, resulting in no gross profit. We do not have a reliable track record for accurately estimating the time and resources needed to complete fixed-price service projects. As a result, determination of the fair values of the elements of the contract has generally occurred late in the implementation process, typically when implementation is complete and remaining services are no longer significant to the project. If the fair values of the elements of a contract are then apparent, the remaining revenue and profit associated with the fixed-price services elements will be recognized when the project is completed. To the extent that a software license is included in the contract, any residual amounts remaining after revenue is allocated to the services elements are recorded as license revenues. All costs of services are expensed as incurred.

Software license customers are offered the option to enter into a maintenance contract, which usually requires the customer to pay a monthly maintenance fee over the term of the maintenance agreement, typically renewable annually. Prepaid maintenance fees are deferred and are recognized evenly over the term of the maintenance agreement. We generally recognize training fees revenue as the services are provided.

We reduce revenue for estimates of the fair values of potential concessions, such as disputed services, when revenue is initially recorded. These estimated amounts are deferred or reserved until the related elements of the agreement are completed and provided to the customer or the dispute is resolved.

Our agreements with customers generally require us to indemnify the customer against claims that our software infringes third party patent, copyright, trademark or other proprietary rights. Such indemnification obligations are generally limited in a variety of industry-standard respects, including our right to replace an infringing product. As of June 30, 2004, we had not experienced any material losses related to these indemnification obligations and no claims with respect thereto were outstanding. We do not expect significant claims related to these indemnification obligations, and consequently, we have not established any related reserves.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(e) Cash and equivalents and short-term investments

We consider debt securities with remaining maturities of three months or less, when purchased, to be cash equivalents. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. Purchases and sales of securities are recorded on a trade-date basis. Interest is recorded when earned. Investments classified as available-for-sale are carried at fair value with unrealized gains and losses recorded as a component of accumulated other comprehensive income. Management determines the appropriate classification of its investment in debt securities at the time of purchase and re-evaluates such determination at each balance sheet date. There have been no reclassifications between investment categories. As of June 30, 2004, remaining maturities of marketable debt securities ranged from zero to thirty months. As of December 31, 2003 remaining maturities of marketable debt securities ranged from two to twenty-four months. We hold $0.6 million of restricted cash, invested in money market funds, as collateral for a letter of credit in accordance with an office lease arrangement. As of June 30, 2004, this balance was classified as a cash equivalent.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(f) Earnings per share

Basic earnings per share is computed based on the weighted average number of common shares outstanding during the period. Diluted earnings per share includes, to the extent inclusion of such shares would be dilutive to earnings per share, the effect of outstanding options and warrants, computed using the treasury stock method.

(g) Segment reporting

We currently operate in one operating segment – rules based business process management, or BPM, software. We derive substantially all of our operating revenue from the sale and support of one group of similar products and services. Substantially all of our assets are located within the United States. We derived our operating revenue from the following geographic areas (sales outside the United States are principally through export from the United States):

During the three months ended June 30, 2004, one customer represented 20% of our total revenue. During the three months ended June 30, 2003, two customers represented 27% and 15% of our total revenue, respectively. During the six months ended June 30, 2004, one customer accounted for approximately 11% of our total revenue. During the six months ended June 30, 2003, two customers accounted for approximately 28% and 15% of our total revenue, respectively.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(h) Stock options

We periodically grant stock options for a fixed number of shares to employees, directors and non-employee contractors with an exercise price equal to the fair market value of the shares at the date of the grant. We account for stock option grants to employees and directors using the intrinsic value method. Under the intrinsic value method, compensation associated with stock awards to employees and directors is determined as the difference, if any, between the current fair value of the underlying common stock on the date compensation is measured and the price an employee or director must pay to exercise the award. The measurement date for employee and director awards is generally the date of grant.

Stock options granted to non-employee contractors are accounted for using the fair value method. Under the fair value method, compensation associated with stock awards to non-employee contractors is determined based on the estimated fair value of the award itself, measured using either current market data or an established option pricing model. The measurement date of non-employee contractor awards is generally the date performance of services is complete.

Stock options summary

The following table presents combined activity for stock options for the three months ended March 31, 2004 and June 30, 2004:

The following table presents weighted average price and life information about significant option groups outstanding and exercisable at June 30, 2004:

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following are the pro forma net income and income per share, as if compensation expense for the option plans had been determined based on the fair value at the date of grant:

The fair values of options at the date of grant were estimated using the Black-Scholes option pricing model with the following assumptions:

The effects on three and six months ended June 30, 2004 and 2003 pro forma net income and net income per share of the estimated fair value of stock options and shares are not necessarily representative of the effects on the results of operations in the future. In addition, the estimates utilize a pricing model developed for traded options with relatively short lives; our option grants typically have a life of up to ten years and are not transferable. Therefore, the actual fair value of a stock option grant may be different from our estimates. We believe that our estimates incorporate all relevant information and represent a reasonable approximation in light of the difficulties involved in valuing non-traded stock options.

3. VALUATION AND QUALIFYING ACCOUNTS

We maintain allowances for bad debts based on factors such as the composition of accounts receivable, historical bad debt experience, and current economic trends. These estimates are adjusted periodically to reflect changes in facts and circumstances. Our allowance for doubtful accounts was $0.4 million at June 30, 2004 and December 31, 2003. The following is a summary of the activity of the allowance for doubtful accounts:

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

Results of Operations

Overview

Total revenue decreased 5% to $48.7 million for the first half of 2004 from $51.1 million for the first half of 2003 due to a decrease in license revenue, which was partially offset by an increase in services revenue. A majority of our revenue in the first half of 2004 continued to be from existing customers who chose to add on to, renew or extend their use of our software. However, during the first half of 2004 we derived 35% of our total revenue from new customers. The decrease in license revenue in the first half was due to a decrease in term license renewals, extensions and additions, and to the anticipated decline in license revenue from First Data Resources (“FDR”). Like other companies in our industry, we have been experiencing delays in customer signings and lengthy negotiations. The increase in services revenue in the first half of 2004 was primarily due to implementation services associated with new licenses and to maintenance services associated with an expanded installed base of software.

We are facing several challenges to growth in 2004, including an anticipated reduction of license revenue from FDR of approximately $10.6 million and reduced scheduled renewals of term licenses. In response to these challenges, we have increased our sales force and the number of third party partners capable of supplementing our sales and implementation efforts. Consequently, we anticipate incurring significant additional sales and marketing expenses in advance of generating incremental sales. Additionally, our effective tax rate is approaching statutory rates in 2004, higher than in prior periods, contributing to an expected earnings per share decline on a year-over-year basis.

Income before provision for income taxes decreased to $6.0 million in the first half of 2004 from $13.6 million in the first half of 2003 primarily due to a $10.8 million reduction in license gross margin, a $4.2 million increase in operating expenses, partially offset by an $8.6 million improvement in service margins. Net income for the first half of 2004 decreased to $3.9 million from $10.7 million for the first half of 2003. We ended the first half of 2004 with $95.2 million in cash and short-term investments compared to $87.9 million at the end of 2003, and $77.9 million in combined short and long-term license installment receivables compared to $82.2 million at the end of 2003.

Three and Six Months Ended June 30, 2004 Compared to Three and Six Months Ended June 30, 2003

Revenue

Total revenue for the second quarter of 2004 decreased 6% to $24.0 million from $25.5 million for the second quarter of 2003. Total revenue for the first half of 2004 decreased 5% to $48.7 million from $51.1 million for the first half of 2003. The decreases were due to declines in license revenue, partially offset by increases in services revenue. The following table summarizes our revenue composition: