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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

For the quarterly period ended September 30, 2004 or

for the transition period from              to             

Commission File Number: 000-32417

VERISITY LTD.

(Exact name of registrant as specified in its charter)

(650) 934-6800

(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 ¨

As of September 30, 2004, there were 23,811,202 of registrant’s ordinary shares, par value NIS 0.01 per share, outstanding.

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VERISITY LTD.

Quarterly Report on Form 10-Q

For the Quarter Ended September 30, 2004

Index

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PART I – FINANCIAL INFORMATION

VERISITY LTD.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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VERISITY LTD.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

The accompanying notes are integral part of these condensed consolidated financial statements.

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VERISITY LTD.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

The accompanying notes are integral part of these condensed consolidated financial statements.

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VERISITY LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The Company

These unaudited interim condensed consolidated financial statements reflect the Company’s financial position as of September 30, 2004. The statements also show the Company’s statements of operations for the three and nine month periods ended September 30, 2004 and 2003, and the statements of cash flow for the nine month periods ended September 30, 2004 and 2003. The December 31, 2003 condensed consolidated balance sheet data was derived from the Company’s audited financial statements and does not include all of the disclosures required by accounting principles generally accepted in the United States. These interim statements include all normal recurring adjustments, which the Company believes are necessary to fairly present the Company’s financial position. All material intercompany balances have been eliminated. Because all of the disclosures required by accounting principles generally accepted in the United States are not included, these interim statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2003, included in the Company’s annual report on Form 10-K filed with the Securities and Exchange Commission on March 12, 2004. The statements of operations for the periods presented are not necessarily indicative of results for any future period, or for the entire year.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires the Company to base its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

The Company accounts for employee share option grants in accordance with Accounting Principles Board Opinion No. 25, “Accounting For Stock Issued to Employees” (“APB 25”) and related interpretations. Under APB 25, when the exercise price of share options granted to employees equals or exceeds the market price of the underlying shares on the date of grant, no compensation expense is recognized. The Company has adopted the “disclosure only” alternative described in Statement of Financial Accounting Standards (“SFAS”) 123, “Accounting for Stock-Based Compensation”.

For purposes of disclosures pursuant to SFAS 123 as amended by SFAS 148, the estimated fair value of options is amortized to expense over the options’ vesting period.

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The following table illustrates the effect on reported net income and net income per share as if we had applied the fair value recognition provisions of SFAS 123 to share-based compensation:

The fair value of all options granted during the three months ended September 30, 2004 and 2003 was estimated as of the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:

The weighted average assumptions used in the first and second quarters of 2004 and 2003, were reported in the Company’s quarterly reports on Form 10-Q for the first and second quarters of 2004 and 2003.

Basic net income per share and diluted net loss per share are computed based on the weighted average number of ordinary shares outstanding during each period. Diluted net income per share is computed based on the weighted average number of ordinary shares outstanding during each period, plus dilutive potential ordinary shares considered outstanding during the period, in accordance with Financial Accounting Standards Board (“FASB”) Statement No. 128, “Earnings per Share.”

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The following is a reconciliation of the denominator used in basic and diluted net income (loss) per share computations for the three and nine months ended on September 30, 2004 and 2003 (in thousands, except per share data):

The Company operates in one industry segment which is focused on the development, marketing and support of software and hardware products that provide systems and semiconductor companies with the ability to automate the functional verification of system and integrated circuit designs. Operations in Israel and in the United States include research and development and sales and marketing. Operations in Europe, Taiwan and Japan include sales and marketing.

The following is a summary of operations within geographic areas based on the location of the entity making the sales and the location of the long-lived assets (in thousands):

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Inventory is stated at the lower of cost or market, with cost determined on a first-in, first-out basis. Inventory consisted of the following (in thousands):

On December 11, 2003, Verisity Ltd. and Axis Systems Inc. (“Axis”) entered into an Agreement and Plan of Merger (“Merger Agreement”) with the intended result of Axis becoming a wholly-owned subsidiary of Verisity. On February 9, 2004 Verisity and Axis closed this merger pursuant to the Merger Agreement in a transaction accounted for using the purchase method. Accordingly, the results of operation of Axis have been included in the Company’s financial statements since the date of acquisition.

Verisity’s primary objective in acquiring Axis was based on the Company’s belief that the combined Company would benefit from the following:

The purchase price exceeded the net assets acquired resulting in the recognition of goodwill. The Company attributed particular value to several of Axis’s underlying technologies, beyond its existing

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product lines, which the Company plans to integrate with several of its own technologies to create new products which will significantly enhance and broadened its VPA platform offerings and allow the Company to address a much larger target market, as mentioned above. Moreover, these underlying Axis technologies are mature, high performance and highly interoperable which will significantly reduce the Company’s integration time and time to market with new products versus having had to develop similar technologies and products over a much longer time period through its own internal development efforts.

The financial statements reflect an estimated purchase price of approximately $81.2 million, determined as follows (in thousands):

The total purchase price of $81.2 million includes cash of $40.6 million, Verisity ordinary shares valued at $35.3 million, assumed stock options with a fair value of $12.9 million (intrinsic value of $4.0 million), restricted incentive Verisity ordinary shares and restricted ordinary shares units valued at $1.8 million and estimated direct transaction costs of $3.5 million, reduced by amounts related to future employment that will be accounted for as deferred compensation costs of $11.1 million in respect of cash and share proceeds of certain key employees under retention agreements and $1.8 million in respect of restricted incentive Verisity ordinary shares and restricted ordinary shares units.

The fair value of Axis’ assumed options of $12.9 million was determined based on the fair value of Verisity ordinary shares as of the acquisition date using the Black-Scholes option pricing model applying the following assumptions: expected life of 4 years, risk-free interest rate of 2.8%, expected volatility of 62% and no expected dividend yield. The intrinsic value of the unvested options, totaling approximately $949,000, has been recorded as deferred stock compensation and will be amortized over the vesting period on a multiple option approach basis.

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Under the purchase method of accounting, the total estimated purchase price as shown in the table below is allocated to Axis’s net tangible and intangible assets based on their estimated fair values as of the date of the completion of the merger. Based on the final valuation and other factors, the purchase price is allocated as follows:

Based on the final valuation and other factors, the estimated purchase price, with respect to net tangible assets, is allocated as follows:

Intangible assets

Of the total estimated purchase price $20.0 million has been allocated to amortizable intangible assets acquired.

Developed technology, which is comprised of products that have reached technological feasibility, includes products in most of Axis’s product lines, principally the Axis Xcite, Xtreme, Xpert and Xchange products. Core technology and patents represent a combination of Axis processes, patents and trade secrets developed through the design and development of reconfigurable computing (RCC) technology and fielded products that can handle software simulation, acceleration, emulation, and hardware/software co-verification. Verisity expects to amortize the developed and core technology and patents on a straight-line basis over an average estimated life of five years.

Customer contracts represent existing contracts that relate primarily to underlying customer relationships pertaining to the products and services provided by Axis. Customer lists and distribution agreements represent Axis’s relationships with its installed base of products and service, and agreements with sales representatives and distributors. Verisity expects to amortize the fair value of these assets on a straight-line basis over an average estimated life of five years. Maintenance contracts represent agreements to deliver support services to certain customers and Verisity expects to amortize the fair value of these contracts on a straight line basis over an average estimated life of three years.

Of the total estimated purchase price, $53.0 million has been allocated to goodwill. Goodwill represents the excess of the purchase price of an acquired business over the fair value of the underlying net tangible and intangible assets. The Company attributed particular value to several of Axis’s underlying technologies which the Company plans to integrate with several of its own technologies to create new

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products which will significantly enhance and broadened its verification process automation platform offerings and allow the Company to address a much larger target market. Moreover, these underlying Axis technologies are mature, high performance and highly interoperable which will significantly reduce the Company’s integration time and time to market with new products versus having to develop similar technologies and products over a much longer time period through its own internal development efforts.

Of the total estimated purchase price no value is being allocated to in-process research and development. Axis is currently developing new products that have generally reached technological feasibility and do not qualify for treatment as in-process research and development. Technological feasibility is defined as being equivalent to completion of a beta-phase working prototype in which there is no remaining risk relating to the development.

The discount rates used for the valuation of the various intangible assets of Axis were based on a weighted average cost of capital of 17.0 percent. The weighted average cost of capital was calculated employing estimates of required equity rates of return and after-tax costs of debt based upon a group of peer companies. In order to estimate an appropriate equity rate of return, the Capital Asset Pricing Model was employed. Specifically, a discount rate of 15.0 percent was assigned to the developed technology on the basis that the risk associated with this asset class was estimated to be lower than the overall Axis business since the technology was proven and was being sold in the marketplace as of the valuation date. Alternatively, a discount rate of 17.0 percent was assigned to the customer and maintenance contracts on the basis that the risk associated with these assets was estimated to approximate the same risk as the overall Axis business.

The following unaudited pro forma financial information presents the combined results of operations of Verisity and Axis as if the acquisition had occurred as of the beginning of fiscal 2003 and 2004, after giving effect to certain adjustments (discussed below), including amortization of intangibles. The unaudited pro forma financial information does not necessarily reflect the results of operations that would have occurred had the combined companies constituted a single entity during such periods, and is not necessarily indicative of results which may be obtained in the future.

Verisity has not given effect in the pro forma statement of operations for the 2003 period to the deferred revenue adjustment on revenue as the adjustments are directly related to the merger and the effect is non-recurring. Such adjustments will be reflected in the post-merger statements of operations of the combined company.

The deferred revenue adjustment will have the effect of reducing the amount of revenue the combined company will recognize in periods subsequent to the merger compared to the amount of revenue Axis would have recognized in the same period absent the merger.

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In accordance with SFAS 142 goodwill and intangible assets with indefinite lives will be tested for impairment at least annually (or more frequently if certain indicators are present). In the event that the management of the combined company determines that the goodwill has become impaired, the combined company will incur an accounting charge for the amount of impairment during the fiscal quarter in which the determination is made.

Intangible assets are comprised of the following (in thousands):

Estimated future intangible amortization expense, based on current balances, as of September 30, 2004 is as follows (in thousands):

The Company accounts for income taxes in accordance with SFAS 109, “Accounting for Income Taxes”. This Statement prescribes the use of the liability method whereby deferred taxes assets and liability account balances are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.

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Under the terms of our standard contract with each of our customers, we agree to indemnify each customer against certain liabilities and damages to the extent such liabilities and damages arise from claims that such customer’s use of our software or services infringes intellectual property rights of a third party. These terms are common in the high technology industry. We do not record a liability for potential litigation claims related to indemnification obligations with our customers. We do not believe the likelihood of a material obligation is probable.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and the related notes included elsewhere in this quarterly report on Form 10-Q. Some of the statements contained in this Form 10-Q are forward looking statements, including but not limited to those specifically identified as such, that involve risks and uncertainties. The statements contained in this Form 10-Q that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Exchange Act of 1934, as amended (the “Exchange Act”), including, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Form 10-Q are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results to differ materially from those implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue,” or the negative of these terms or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Important factors that may cause actual results to differ from expectations include those discussed in “Risk Factors” in our annual report on Form 10-K for the year ended December 31, 2003, filed with the Securities and Exchange Commission, and elsewhere in this quarterly report on Form 10-Q.

Description of Business

We provide software and, with the acquisition in the first quarter of Axis Systems, Inc. discussed below, hardware products that automate the process of detecting flaws in the designs of electronic systems and ICs and enable our customers to deliver higher quality electronic products, accelerate time-to-market, reduce overall product development costs, and better manage the predictability of their design verification process. We were founded in September 1995 and commenced operations in January 1996.

In 1996, we released our original Specman functional verification software product. In the fourth quarter of 1998, we released Specman Elite, an enhanced version of our original Specman product. In 2003, we introduced further enhancements to our Specman Elite products as well as several new products and methodologies targeted at chip and system level verification and overall verification project level management. We have also introduced several other products and support programs, which enhance the use of our products in the functional verification process. In the most recent quarter ended September 30, 2004,

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we delivered our first new product, SpeXsim, resulting from the integration of technologies from Verisity and Axis. Since these new products and services were introduced primarily in the latter part of 2003 and year-to-date 2004, we expect customers to sample them in low volume initially, before adopting them more broadly, therefore we expect their contribution to total revenue to be modest in 2004.

We currently derive substantially all of our revenue from the sale of licenses for a small number of software and hardware products and related maintenance and other services. Sales of our Specman Elite and other functional verification class of products have accounted for 100% of our license revenue in the past. We expect that substantially all of our revenue in 2004 will continue to be generated from sales of licenses of our functional verification products and related maintenance and other services, including products and services from our acquisition of Axis Systems in February 2004.

Throughout all of 2002 and the first half of 2003, our customers continued to face a particularly difficult and unpredictable economic environment with respect to the end markets for their products and their overall financial health. The year 2002 marked the third consecutive year of such a protracted downturn in the economic environment for the electronics industry in which our customers compete. These uncertainties continued into 2003 and began to abate to some extent as the year progressed. The result of this prolonged uncertainty caused most customers to scrutinize carefully their R&D investments with spending decisions being delayed as long as possible and, in some cases, additional development programs being further rationalized or discontinued and many smaller companies going out of business. While the economic environment appeared to improve during the second half of 2003 and into 2004, our customers continued to demonstrate cautiousness in respect to their R&D spending decisions.

Orders for our functional verification products, maintenance and other services increased in 2002 over order levels recorded in 2000 and 2001, however the rate at which new orders were received slowed in the latter half of the year and did not keep pace with the growth in reported revenue causing backlog to drop, due primarily to the economic environment. As a result, we reported a sequential revenue decline in the first quarter of 2003 and flat revenue of just over $12 million per quarter for the remaining three quarters of 2003. New orders for our products and services declined in 2003 as compared to 2002, however, after hitting a low point in our seasonably weak first quarter we did experience resurgence in the rate of new orders as the year progressed. In particular, new orders in the second half of 2003 grew compared to the same period in 2002.

In the first quarter of 2004, traditionally our seasonally weakest quarter, orders declined sequentially from a strong fourth quarter 2003, but were up from the first quarter of 2003 and were at parity with revenue reported in the quarter. In the second and third quarter of 2004 orders increased sequentially from the same respective quarters of 2003 and were greater than the revenue reported in the periods, providing growth to our backlog. Orders for time-based licenses in the first nine months of 2004 continued to grow as a proportion of overall orders, which generates a more ratable and somewhat slower growing revenue stream over time. We cannot predict with any certainty if forward-looking orders will continue to grow, or when and if forward-looking revenue may increase. Please see the risk factors for the effect on our revenue if our products are not adopted as discussed in “Risk Factors” in our annual report on Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission and elsewhere in this quarterly report on Form 10-Q.

We sell our products and related maintenance and other services directly through our sales force and through indirect channels that include international distributors and sales representatives. Revenue from sales outside North America accounted for approximately 33.7% of our total revenue in the third quarter of 2004 and 33.6% of our total revenue in the third quarter of 2003. We believe that international markets represent a significant growth opportunity for our business and we anticipate that international revenue will increase as a percent of total revenue in the future.

In order to increase market share in international locations and better serve our global customers, we plan to further expand our international operations. We expect that this expansion will require a substantial investment in personnel, facilities and operations, which tend to be more costly than similar investments in domestic operations. As a result of these investments in our international operations, we

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may experience an increase in cost of sales and other operating expenses disproportionate to revenue from those operations.

We license our software products to customers under either perpetual or time-based licenses. Further, with respect to these time-based license arrangements for our software products, we allocate the revenue based on our standard price list, which has resulted in approximately 66% being allocated to license revenue and 34% being allocated to maintenance revenue. The term for our time-based software licenses is typically one year. Our software products do not require customization or modification for our customers to install and use them. Customers purchasing maintenance receive Internet-based technical support, telephone support and unspecified product updates when we choose to make updates available. Our perpetual and time-based licenses are always sold with maintenance. Maintenance for perpetual licenses may then be separately renewed. We believe these product updates, which our customers have the right to use for the remaining term of their license, are the primary reason that a majority of our customers renew maintenance every year. Our services include training in the use of our products and consulting services.

We sell our hardware system products in conjuncton with high value software elements and we recognize revenue in accordance with American Institute of Certified Public Accountants’ Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-9. Our hardware related contracts with customers generally include multi-year lease arrangements or perpetual license arrangements for software and hardware products and postcontract maintenance. Maintenance can be renewed annually at the customer’s discretion in the case of perpetual license. However, VSOE does not exist for the Company’s postcontract maintenance; therefore, product and maintenance revenue is recognized ratably in a time-based manner over the lease term or initial maintenance term in the case of perpetual license, once there are no other undelivered elements except postcontract maintenance. Revenue recognition begins when delivery has occurred and all other revenue recognition criteria have been met.

Recent Developments

On February 9, 2004, we completed our acquisition of Axis Systems, Inc. (“Axis”), a company that provides certification and simulation software/hardware system solutions that enable System-on-Chip designers to verify the accuracy, optimization and functionality of integrated circuits. Axis offers a unique, third-generation simulation technology that combines all languages and required engines for hardware, embedded software and system-level verification. The acquisition will enable Verisity to create a comprehensive and highly differentiated VPA platform to exploit multiple discontinuities in the rapidly changing functional verification market. For more information regarding the terms of the acquisition, please see the Company’s public disclosures made in connection with the acquisition, including, but not limited to, our filings with the SEC. The acquisition was accounted for under the purchase method of accounting. Under the purchase method of accounting, the total estimated purchase price is allocated to Axis’s net tangible and intangible assets based on their estimated fair values as of the date of the completion of the merger. The purchase price exceeded the net assets acquired resulting in the recognition of goodwill. Certain intangible assets and deferred compensation related to the merger will result in non-cash amortization expenses being reported over the useful life of the intangible assets and vesting period of the underlying compensation, respectively. On the merger date future revenue related to firm contracts amounted to approximately $21.4 million. Of this amount, in accordance with Emerging Issues Task Force (“EITF”) No. 01-3 “Accounting in a Business Combination for Deferred Revenue of an Acquiree,” approximately $15.3 million or 72% was permanently eliminated because the underlying obligations, primarily the delivery of software and hardware elements, had largely been met prior to the merger date. Although this purchase accounting requirement will have no impact on our business or cash flow, it will adversely impact our reported GAAP revenue and make certain measurements stated as a percentage of revenue less meaningful, particularly over the next twelve months during which approximately $11.5 million of the eliminated amount was scheduled to be reported as revenue for Axis.

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Following the completion of the acquisition, the results of operations of Axis have been included in our consolidated financial statements. Accordingly, our results of operations for the nine month period ended September 30, 2004 reflect Axis’s operations since February 10, 2004, while our results of operations for the comparable 2003 period reflect only Verisity’s historical operations.

Three and Nine Months Ended September 30, 2004 Compared to Three and Nine Months Ended September 30, 2003

Total Revenue

Our revenue consists of license revenue, maintenance revenue and other services revenue. License revenue consists of fees paid by our customers to license our software and hardware systems products. Maintenance revenue consists of fees for annual support and product updates. Other services revenue consists of training and consulting fees. Our total revenue was $15.5 million for the three months ended September 30, 2004, and $12.0 million for the comparable quarter of 2003, representing an increase of $3.5 million, or 28.9%, and was $40.3 million for the nine months ended September 30, 2004, and $36.2 million for the comparable period of 2003, representing an increase of $4.0 million, or 11.1%. Approximately 98% of revenue in both the three months and nine months periods ending September 30, 2004, was derived from existing customers, including Axis customers prior to the merger, with the balance coming from new customers.

License revenue. Our license revenue was $8.6 million for the three months ended September 30, 2004, and $7.4 million for the comparable quarter of 2003, representing an increase of $1.2 million, or 15.6%, and was $22.3 million for the nine months ended September 30, 2004, and $22.0 million for the comparable period of 2003, representing an increase of $0.3 million, or 1.3%. These increases resulted from decreases in revenue from perpetual licenses of $1.5 million and $3.1 million in the three and nine months ending September 30, 2004, respectively, and favorably offset by increases in revenue from time-based license revenue of $2.7 millions and $3.4 million for the three and nine months periods ending September 30, 2004. This reflects the continued shift in customers’ demand towards time-based license arrangements from perpetual licenses.with such time-base revenue contributing approximately 96% of total license revenue in these respective periods in 2004. License revenue from products acquired from Axis, Platform products began to contribute to total license revenue in the most recent quarterly period and are primarily recognized ratably in a time-based manner.

Maintenance revenue. Our maintenance revenue was $6.7 million for the three months ended September 30, 2004, and $4.3 million for the comparable quarter of 2003, representing an increase of $2.4 million, or 55.5%, and was $17.4 million for the nine months ended September 30, 2004, and $13.4 million for the comparable period of 2003, representing an increase of $3.9 million, or 29.3%. These increases were primarily attributable to the recognition of revenue from maintenance services that we sold in connection with the sale of new licenses, particularly in respect to time-based licenses, and ongoing maintenance contract obligations acquired from Axis.

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Other services revenue. Our other services revenue was $223,000 for the three months ended September 30, 2004, and $297,000 for the comparable quarter of 2003, representing a decrease of $74,000, or 24.9%, and was $0.6 million for the nine months ended September 30, 2004, and $0.8 million for the comparable period of 2003, representing a decrease of $0.2 million, or 24.0%. These decreases were primarily attributable to somewhat less training and consulting services.

Cost of Revenue

Cost of revenue consists of costs of software licenses, components and assembly of hardware systems, and the cost of providing maintenance and other services. Cost of revenue was $1.7 million for the three months ended September 30, 2004, and $650,000 for the comparable quarter of 2003, representing an increase of $1.0 million, or 161.5%, and was $4.0 million for the nine months ended September 30, 2004, and $2.1 million for the comparable period of 2003, representing an increase of $1.9 million, or 88.3%. These increases are primarily attributable to costs related to increased hardware product content in the 2004 period resulting from the Axis acquisition, as well as costs associated with increased revenue levels. Cost of revenue as a percentage of total revenue was 11.0% for the three months ended September 30, 2004, and 5.4% for the comparable quarter of 2003, and was 9.9% for the nine months ended September 30, 2004, and 5.8% for the comparable period of 2003.

Cost of license revenue. Cost of license revenue consists of costs of software licenses, components and assembly of hardware systems and is recognized in the same manner as the underlying product revenue. Cost of license revenue was $935,000 for the three months ended September 30, 2004, and $24,000 for the comparable quarter of 2003, representing an increase of $911,000, and was $1.8 million for the nine months ended September 30, 2004, and $97,000 for the comparable period of 2003, representing an increase of $1.7 million. These increases are primarily attributable to components and assembly costs related to the sales of hardware products in the 2004 period. As a percent of license revenue, the cost of license revenue was 10.9% for the three months ended September 30, 2004, and 0.3% for the comparable quarter of 2003, and was 8.2% for the nine months ended September 30, 2004, and 0.4% for the comparable period of 2003.

Cost of maintenance revenue. Cost of maintenance revenue was $630,000 for the three months ended September 30, 2004, and $510,000 for the comparable quarter of 2003, representing an increase of $120,000, or 23.5%, and was $1.8 million for the nine months ended September 30, 2004, and $1.6 million for the comparable period of 2003, representing an increase of $0.2 million, or 10.1%. As a percent of maintenance revenue, the cost of maintenance was 9.4% for the three months ended September 30, 2004, and 11.8% for the comparable quarter of 2003, and was 10.2% for the nine months ended September 30, 2004, and 12.0% for the comparable period of 2003.

Cost of other services revenue. Cost of other services revenue consists primarily of internal and contracted personnel and other expenses related to providing training and consulting services to our customers. Cost of other services revenue was $135,000 for the three months ended September 30, 2004, and $116,000 for the comparable quarter of 2003, representing an increase of $19,000, or 16.4%, and was $381,000 for the nine months ended September 30, 2004, and $401,000 for the comparable period of 2003, representing a decrease of $20,000, or 5.0%. As a percent of other services revenue, the cost of other services revenue increased from 39.1% for the three months ended September 30, 2003, to 60.5% for the comparable quarter of 2004, and increased from 48.6% for the nine months ended September 30, 2003, to 60.8% for the comparable period of 2004.

Operating Expenses

Research and development. Research and development expenses consist primarily of costs related to research and development personnel, including salaries and other personnel-related expenses, sub-contracting fees, facilities and depreciation from computer equipment used in our product and technology development. Research and development expenses were $4.2 million for the three months ended September 30, 2004, and $2.5 million for the comparable quarter of 2003, representing an increase of $1.7 million, or

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69.6%, and were $11.9 million for the nine months ended September 30, 2004, and $7.7 million for the comparable period of 2003, representing an increase of $4.2 million, or 54.5%. These increases were primarily related to the inclusion of engineering personnel acquired from Axis for the period beginning on February 10, 2004, and to a lesser extent attributable to the number of developers employed in the continuing enhancement and integration of our software products. Research and development expenses as a percentage of total revenues were 27.1% for the three months ended September 30, 2004, and 20.6% for the comparable quarter of 2003 and were 29.6% for the nine months ended September 30, 2004, and 21.3% for the comparable period of 2003. These increases as a percent of revenues are attributable to proportionately lower revenue for platform products in the three and nine months ended September 30, 2004 due to the purchase accounting effects on revenue and to a lesser extent the addition of personnel acquired from Axis and newly hired developers working on the enhancement and integration of products. We believe that significant investment in research and development has been and will continue to be required to develop new products and enhance existing products to allow us to further penetrate our target markets. Furthermore, we expect to increase research and development expenses directly related to the integration of certain of our technologies with technologies recently acquired with Axis to create new products that will significantly broaden our VPA platform and allow us to address much larger target markets. We therefore anticipate that the absolute dollar amount of research and development expenses will increase in the future.

Sales and marketing. Sales and marketing expenses consist primarily of salaries, commissions, travel for sales and marketing personnel and promotional and advertising costs. Sales and marketing expenses were $7.3 million for the three months ended September 30, 2004, and $5.1 million for the comparable quarter of 2003, representing an increase of $2.2 million, or 43.5%, and were $20.9 million for the nine months ended September 30, 2004, and $15.6 million for the comparable period of 2003, representing an increase of $5.3 million, or 34.0%. These increases are primarily attributable to the integration of Axis’s sales and marketing resources with Verisity beginning February 10, 2004. Sales and marketing expenses as a percentage of total revenues were 46.8% for the three months ended September 30, 2004, and 42.0% for the comparable period of 2003, and were 52.0% for the nine months ended September 30, 2004, and 43.1% for the comparable period of 2003. These increases as a percent of revenues are primarily attributable to proportionately lower revenue for platform products in the three and nine months ended September 30, 2004 due to the purchase accounting effects on reportable revenue. We expect sales and marketing expenses to increase as we expand our geographic reach, hire additional personnel and increase technical sales personnel in support of new products that we will introduce as a result of integrating Verisity and Axis technologies.

General and administrative. General and administrative expenses consist primarily of salaries and other personnel-related expenses for our administrative, legal, human resources, investor relations and finance personnel, facilities, insurance and professional services fees. General and administrative expenses were $2.4 million for the three months ended September 30, 2004, and $1.4 million for the comparable quarter of 2003, representing an increase of $932,000, or 64.4%, and were $6.3 million for the nine months ended September 30, 2004, and $4.3 million for the comparable period of 2003, representing an increase of $2.0 million, or 47.4%. These increase are primarily attributable to the inclusion of Axis’s expenses for the period beginning on February 10, 2004, and to a lesser extent increased expenses associated with preparing to meet new public reporting requirements, primarily as a result of the Sarbanes-Oxley Act. General and administrative expenses as a percentage of total revenue were 15.3% for the three months ended September 30, 2004, and 12.0% for the comparable quarter in 2003, and were 15.7% for the nine months ended September 30, 2004, and 11.9% for the comparable period of 2003. These increases as a percent of revenues are attributable to proportionately lower revenue for platform products in the three and nine months ended September 30, 2004 due to the purchase accounting effects on revenue and to a lesser extent the addition of personnel acquired from Axis and incremental costs of meeting new public reporting requirements. We expect general and administrative expenses to increase for the foreseeable future as we expand our administrative staff and incur expenses associated with being a public company, including the costs of annual and periodic reporting, and reporting in accordance with Section 404 of the Sarbanes-Oxley Act, investor relations programs and insurance.

Non-cash charges related to equity issuance, amortization of deferred compensation and amortization of intangible assets. Non-cash charges related to equity issuances reflect the amortization of

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the deferred share-based compensation, representing the difference between the fair value of the ordinary shares for financial reporting purposes and the exercise price of the underlying options. Non-cash charges related to equity issuances also include the amortization of deferred compensation associated with the Axis merger that is applicable to restricted ordinary shares and restricted share units granted to certain Axis employees as part of the merger, the intrinsic value of the unvested Axis’ options, and in respect to ordinary share proceeds retained by the Company from certain key Axis employees which are subject to vesting in connection with retention agreements. Non-cash charges related to equity issuances were $2.3 million for the three months ended September 30, 2004, and $128,000 for the comparable quarter of 2003, and were $4.3 million for the nine months ended September 30, 2004, and $160,000 for the comparable period of 2003. Amortization of deferred compensation associated with the retention of cash proceeds in respect to the merger were $2.1 million for the three months ended September 30, 2004, and $3.5 million for the nine months ended September 30, 2004. Amortization of intangible assets associated with the merger was $1.0 million for the three months ended September 30, 2004, and $2.8 million for the nine months ended September 30, 2004. Non-cash charges related to equity issuances and the amortization of deferred compensation for the quarter ended September 30, 2004, include acceleration of amortization due to Axis Systems former CEO departure on July 31, 2004.

Interest Income, Interest Expenses and Other Income, Net

Interest income, interest expenses and other income, net consists of interest income on our cash and cash equivalents, net of interest expense on our obligations under capital lease and other miscellaneous expenses. Our interest income, interest expenses and other income, net was $93,000 as an expense for the three months ended September 30, 2003, and income of $185,000 for the comparable quarter of 2003, and was an income of $125,000 for the nine months ended September 30, 2004, and $535,000 for the comparable period of 2003. These decreases were primarily due to foreign exchange differences and to a lesser extent lower balances of cash and cash equivalent due to the cash payment to Axis’ stockholders in connection with the merger.

Income Taxes

We recorded an income tax benefit of $2.3 million in the three months ended September 30, 2004, and an income tax provision of $196,000 for the comparable quarter of 2003, and income tax benefit of $5.4 million in the nine months ended September 30, 2004, and an income tax provision of $548,000 for the comparable period of 2003. The income tax benefit for the three and nine months ended September 30, 2004 is primarily due to a tax benefit from current operating losses in the U.S. offset by income and withholding taxes in other jurisdictions. The provision for income taxes for the three and nine months ended September 30, 2003 is primarily due to income taxes in jurisdictions other than Israel and various withholding taxes.

We have not recognized any benefit from the future use of loss carryforwards outside of the U.S. for these periods or for any other period since inception because of uncertainty surrounding their realization, in accordance with FAS 109. The amount of net operating losses that we can utilize may be limited under tax regulations in some circumstances, including acquisition activities.

Liquidity and Capital Resources

Since our inception, we have financed our operations primarily through the private sale of convertible preferred shares and the public offering of ordinary shares. We have also financed our operations through the sale of ordinary shares pursuant to our equity incentive plans, equipment financing and cash generated from the sale of our products and services. As of September 30, 2004, we had cash and cash equivalents of $56.0 million, an accumulated deficit of $3.2 million and working capital of $26.1 million.

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We used $40.6 million of our cash balances to complete our acquisition of Axis on February 9, 2004. However, we believe that cash flow from operations together with our current cash and investment balances will be sufficient to meet our operating requirements for at least the next 12 months, including increased operating expenses and purchases of property and equipment as described elsewhere in this Form 10-Q.

Net cash provided by operating activities was $2.3 million for the nine months ended September 30, 2004, and $1.1 million for the comparable period of 2003. Net cash provided by operating activities for the nine months ended September 30, 2004, resulted primarily from the net loss offset by adding back the favorable tax impact, non-cash charges associated with the merger and, in addition, net changes in balance sheet accounts, primarily deferred revenues and accounts receivable. Net cash provided by operating activities for the nine months ended September 30, 2003, resulted primarily from the net income and net changes in balance sheet accounts, which were primarily deferred revenues.

Net cash used in investing activities was $38.9 million for the nine months ended September 30, 2004, primarily attributable to the cash used in the acquisition of Axis, net of the cash acquired. Net cash used in investing activities was $1.2 million for the nine months ended September 30, 2003, consisting mostly of capital expenditures.

Net cash provided by financing activities was $1.7 million for the nine months ended September 30, 2004, and $1.7 million for the comparable period of 2003. Net cash provided by financing activities for both periods resulted primarily from the exercise of share options by employees and the purchase of shares under our equity incentives plans.

We believe that the cash flow from operations together with our current cash and cash equivalents balances and current credit facilities will be sufficient to meet our operating requirements for at least the next 12 months, including increased operating expenses and purchases of capital equipment.

Although we are not currently in discussions and have no commitments or agreements with respect to any new acquisitions or investments, it is possible that we may decide to undertake such strategic activities during the next 12 months to an extent that could require additional financial resources. In that case, we may be required to raise additional financing through public or private financings, strategic relationships or other arrangements. However, we cannot be certain that this funding, if needed, will be available on terms attractive to us, or at all. Furthermore, any additional equity financing may be dilutive to shareholders, and debt financing, if available, may involve restrictive covenants.

We develop products primarily in Israel, and also in North America, and sell those products primarily in North America, Israel, Europe and Asia. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. As substantially all of our sales are currently made in United States dollars, a strengthening of the United States dollar could make our products less competitive in foreign markets.

We incur expenses denominated in local currencies in Israel, Japan and Europe. As exchange rates vary, these expenses, when translated into United States dollars, may vary from expectations and adversely affect overall profitability.

Our exposure to market risk for changes in interest rates relates primarily to our cash and cash equivalents. We maintain a conservative investment policy, which intends to ensure the safety and preservation of our invested funds by limiting default risk, market risk and reinvestment risk. Our cash and cash equivalents as of September 30, 2004, consist primarily of short-term U.S. government securities, demand deposits and money market funds held by institutions in the United States.

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Management’s intent and current practice is to invest funds in excess of current operating requirements in:

According to our investment policy the obligor must be rated in the rating category as indicated below by at least two of the Nationally Recognized Statistical Rating Organizations (NRSRO’s).

These investments, included in our cash and cash equivalents, are exposed to short-term fluctuations in interest rates. Should interest rates fall, our cash equivalents may produce less income than expected. Our long-term liabilities, largely composed of deferred revenues, are not subject to interest rate risk. Given the liquid nature of our cash and cash equivalents and the non-exposed nature of our long-term liabilities, we have concluded that we do not have material market risk exposure due to changes in interest rates.

Under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Exchange Act, as of the end of the period covered by this report, and, based on their evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. During the third quarter of 2004, there were no changes in the Company’s internal control over financial reporting that has materially affected, or reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

None.

On February 9, 2004, we exchanged 2,901,191 ordinary shares of Verisity in consideration for Axis shares and granted 123,200 restricted shares to certain Axis key employees in connection with Axis acquisition. The Verisity shares which were part of the merger consideration were issued pursuant to Section 3(a)(10) of the Securities Act. We also issued additional 67,020 ordinary shares as a result of the exercise of share options and the purchase of ordinary shares pursuant to our equity incentives plans. The aggregate net consideration received by the Company for the issuance of the ordinary shares was $176,000. Certain of the ordinary shares were issued pursuant to compensatory plans registered by registration

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statements on Form S-8. Other ordinary shares were issued pursuant to compensatory plans of the Company that are compliant with Rule 701 promulgated under the Securities Act and in reliance on the exemption from the registration requirements of the Securities Act provided by such rule.

None.

None.

None.

See Exhibit Index on Page 23.

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SIGNATURES

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

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EXHIBIT INDEX