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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

For the Fiscal Year Ended December 31, 2004

OR

For the Transition Period from             to             .

Commission File No. 000-26937

QUEST SOFTWARE, INC.

(Exact Name of Registrant as Specified in its Charter)

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

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

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

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

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

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

The aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $690.8 million as of June 30, 2004, based upon the closing sale price reported for that date on the NASDAQ National Market. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded because such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily conclusive for other purposes.

As of February 22, 2005, 96,549,026 shares of the Registrant’s common stock were outstanding.

Documents Incorporated by Reference

Portions of the Registrant’s definitive proxy statement, to be delivered to shareholders in connection with the Registrant’s 2005 Annual Meeting of Shareholders, are incorporated by reference into Part III of this Report.

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Forward-Looking Information

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

PART I

Item 1.    Business

Introduction

Quest Software designs, develops, sells and supports software products that improve the performance and productivity of our customers’ packaged and custom software applications and associated software infrastructure components such as databases, application servers and operating systems. Quest fits generally into a category of software companies referred to as “Independent Software Vendors,” or “ISVs,” which are companies whose products support other vendors’ software or hardware products. We both internally develop and acquire our products.

We generate revenues by licensing our products, principally on a perpetual basis, and by providing support, maintenance and implementation services for these products. Our products improve the quality of service of our customers’ key software applications and component infrastructure and can significantly reduce customers’ capital and operating expenses by minimizing hardware, software and/or personnel costs. Our major product areas are Database Management, Windows Management, and Application Management. Examples of our products’ benefits include:

One of our core strengths is in the area of database management. We are currently recognized as a leading Oracle ISV. Oracle’s database management system (“DBMS”) has the largest market share for large production distributed systems. Oracle’s installed base is large and growing—it is estimated to grow to over $30 billion by 2008. Databases continue to grow in size, complexity and mission criticality every year. These trends create demand for our database tools, which are designed to: 1) improve the utilization and reliability of large-scale databases; and 2) improve the effectiveness and productivity of the developers, database administrators and other personnel responsible for maintaining reliability and performance. In addition to Oracle DBMS systems, we also offer solutions for other popular database management products including IBM DB2, Microsoft SQL Server, Sybase ASE and MySQL.

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We also have built up significant technical competencies and product portfolios for the widely adopted Microsoft Windows Server, Active Directory and Exchange platform. We call this our Windows Management product area. Active Directory is an essential part of Microsoft’s Windows architecture that acts as the central authority to define and maintain the network infrastructure, perform system administration and control the user experience of a customer’s Microsoft infrastructure, including Microsoft Exchange, Microsoft’s widely used email system. When an individual logs onto his or her employer’s e-mail system, for example, he or she is logging on through Active Directory, which stores and verifies the person’s passwords, access rights and system profiles. Active Directory is a powerful system that is gaining wider acceptance as a primary system for controlling and validating user access rights, with Microsoft’s desktop predominance driving this trend. According to market analysts, Microsoft Windows Server is going to remain the dominating operating system for deployment outside of the data center, in companies over $1 billion in revenue. Industry analyst’s research data projects that 92% of these large companies will be using Active Directory and Microsoft Windows Server by 2006. As a result, our products for Windows Server, Active Directory and Exchange have been our fastest growing product lines over the last four years.

Our third major product area is Application Management, which includes the monitoring and performance management of customers’ primary enterprise software applications, whether packaged or custom-developed. These applications are highly complex and require substantial investment, personnel and expertise in their development, deployment and management. Application Management involves measuring the service levels provided by an application, such as application response times and application outages, and providing the capabilities to diagnose the root causes of performance problems and the means to correct or eliminate them. Because most enterprise packaged and custom-developed applications run in multi-vendor environments, the need exists for heterogeneous management tools that have deep monitoring, diagnostic capabilities and reporting for all the components of the application stack. Quest offers application management products for the following application platforms: Custom Web applications (based on Java 2 Enterprise Edition “J2EE”), PeopleSoft, Oracle E-Business Suite, Siebel and SAP.

We are continuing to increase our focus on the three key product areas outlined above and to improve and simplify our marketing messages. To this end, we divested our Vista output management products in September 2004, which, while profitable, were not core to our primary product lines. The Vista products were sold to a company that could combine them with other offerings to create a more complete content and output management product set.

We invest a significant portion of revenues in our product engineering capabilities, and approximately one-third of our employees work in product development, quality assurance or technical documentation roles. In building our products, we stress technical innovation and depth, ease of deployment, ease of use and tangible, readily articulated customer benefits. We sell our products primarily via our direct sales channel, supplemented by indirect sales through systems integrators and value added resellers. We operate in 22 countries worldwide.

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

Products

We currently market over 100 products, which we have grouped into three main categories: Database Management; Windows Management; and Application Management. Major products in these categories are described as follows.

Database Management

The Development and Deployment Product Family.    These tools improve the productivity and capability of application developers working in the Oracle Procedural Language (PL)/SQL environment.

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The primary products in this product family are TOAD^® and SQL Navigator.^® We provide a complete and integrated development environment for coding stored procedures, schemas and SQL scripts from one intuitive graphical user interface. Debugging, SQL tuning, change analysis, and general administration features improve the quality and performance of database applications before they enter production.

The Quest Central^® product family for Oracle, SQL Server and Sybase.    Administering large databases in production involves many tedious, error-prone and repetitive tasks. To simplify these tasks and increase the accuracy and effectiveness of database administrators (“DBAs”), we have developed the Quest Central product family. Quest Central is an integrated DBA workbench that combines multiple functional components into one suite including: Database Administration, Performance Diagnostics, Performance Monitoring and SQL Tuning. The Quest Central family of products provides a consistent look and feel for the performance management of multiple databases enabling DBAs to manage more databases without adding resources. We are currently marketing Quest Central DBA product families for Oracle, Microsoft SQL Server and Sybase ASE databases.

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

Microsoft Windows Management

Microsoft applications and platforms are the global standard for desktop productivity applications. Our products enable IT personnel to more effectively administer, migrate, report, recover and audit Microsoft Windows Server, Exchange and Active Directory environments, using secure processes. The Aelita organization added breadth and depth to our Microsoft expertise and product portfolio. Our Microsoft Windows Management products include:

Quest Management Suite for Active Directory.    Microsoft Active Directory can be technically complex and requires meticulous management to ensure the security of its content across the entire enterprise. The Quest Management Suite for Active Directory is a set of products that provide diagnostics, recovery, detailed auditing, Group Policy management, reporting, self-service, role-based delegation, and user provisioning. It offers a practical approach to automated user provisioning and provides a comprehensive delegation model, consolidated reporting and auditing, and expert advice on problem resolution for teams managing complex Microsoft infrastructures.

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

Quest Management Suite for Windows.    An integrated Microsoft Management Console (MMC), the Quest Management Suite for Windows helps IT administrators discover, recover and protect their Windows infrastructure from a single console. The Management Suite for Windows enhances security, streamlines management, and increases system uptime and availability for an entire enterprise. As a result, it increases administrator knowledge and worker productivity. The Quest Management Suite for Windows combines Spotlight on Windows, ERDisk, Quest Patch Management and Quest Central for Microsoft.

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Quest Migration Suite for Active Directory.    The Quest Migration Suite for Active Directory is a ZeroIMPACT^™ solution for planning and executing migration projects to Active Directory from Windows NT, Novell NDS, or Active Directory. It supports thorough migration planning and Active Directory pruning and grafting—with no interruption to business workflow. Its distributed processing and robust project management features simplify migration processes.

Quest Migration Suite for Exchange.    The Quest Migration Suite for Exchange is also a ZeroIMPACT solution that helps plan and execute migration projects to Exchange 2000/2003 from Exchange 5.5, 2000 or 2003. It helps to ensure seamless migration processes and provides a centralized place for project management as well as analysis tools and reporting mechanisms.

Quest InTrust.    Quest InTrust offers auditing and policy compliance to help systems administrators securely collect, store and report on event data to meet the needs of external regulations, internal policies, and best practices.

Application Management

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

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

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

Stat^® ACM.    Stat ACM (Application Change Management) helps IT managers lower their PeopleSoft and Oracle E-Business Suite total cost of ownership by providing end-to-end change management and version control. It helps keep up with change configurations and customizations so that they are updated, approved and deployed to instances throughout the application implementation lifecycle. By tracking version control and versioning capabilities as well as process management, change request tracking, requirements management and distributed development support, Stat ACM adds visibility, hides complexity and automates workflow through an easy-to-use GUI environment.

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Sales, Marketing and Distribution

We market and sell our products and services worldwide primarily through our direct sales organization. At December 31, 2004, we had approximately 345 direct sales representatives. Approximately three-fourths of our sales representatives are field sales personnel, who sell all of our products other than those sold by our telesales representatives. The remaining one-fourth of our sales representatives are telesales representatives, who sell products such as our Oracle and J2EE development tools that are generally evaluated through Internet downloads rather than on-site technical demonstrations. We have over 187 pre-sales systems engineers who work with these field sales teams to provide technical assistance and demonstrations to sales prospects. We supplement our direct sales organization with indirect sales channels such as value added resellers and systems integrators. We also employ local resellers in certain international territories not covered by our local sales offices.

We have opened sales offices in many major cities of the United States, Europe, Asia and Australia to facilitate close contact between current and potential customers and our field sales organization. Our European operation, which has received considerable focus and investment, has been our fastest growing geographic region over the last several years. In 2003, we began to expand our direct sales efforts into Asia with the opening of a sales office in Japan. In 2004, we continued our expansion into Asia by adding offices in five countries: China, Korea, Hong Kong, Singapore and Malaysia. We continue to invest in our Asia operations by hiring additional industry experienced sales personnel. We are also investing in developing localized versions of certain of our products.

Our marketing efforts are designed to create awareness, generate leads, and assist the worldwide sales organization with converting leads into closed sales. We use a full complement of marketing vehicles including industry trade shows and seminars, user groups and discussion forums, educational white papers and knowledge briefs, electronic and print advertising, webcasts, and direct marketing via electronic and postal mailings. Strategic and channel partners often assist us with the development, funding and execution of our marketing programs. Targeted campaigns and sales programs are developed based on objective, audience and product mix and are executed in our regions around the world to maximize revenue opportunities as quickly as possible.

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

Customer Service and Support

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

Customer support is provided domestically through our offices in Irvine and internationally through our offices in Europe and Canada.

Research and Development

We believe that strong research and product development capabilities are essential to enhancing our core technologies and developing additional products. Innovative capabilities, strong product engineering and rich user interfaces are typical Quest attributes. We target ease of implementation and ease of use in designing our

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products. Our commitment to ongoing product development is reflected in our investments in research and development, which were $60.1 million, $67.4 million and $78.3 million for the years ended December 31, 2002, 2003 and 2004, respectively. We have actively recruited key software engineers and developers with expertise in the areas of Oracle technologies, Java, Microsoft infrastructure technologies, ERP and CRM systems, IBM database technologies and document management. We have also built-up these competencies through small and medium-sized acquisitions. In addition to the U.S., we have major product development operations in Russia, Canada, Australia and Israel.

Competition

The market for application management solutions is emerging rapidly, and, as a result, is intensely competitive and characterized by rapidly changing technology and evolving standards. We expect competition to continue to increase both from existing competitors and new market entrants. We believe that our ability to compete effectively depends on many factors, including:

We compete in some cases with the vendors of databases, applications and other systems that our products help to improve and manage. To the extent these vendors are able to include similar or equivalent functionality of our software as standard features of their underlying database solution or application our revenues could be eroded. Competition with Oracle has increased over the last 36 months, for example, with certain of our Database Management products including SharePlex and Quest Central for Oracle. This competition continues to increase with Oracle’s introduction of the current version of its database, known as Oracle 10G. Oracle 10G’s component called Oracle Enterprise Manager has enhanced capabilities in its functions that competed with Quest Central for Oracle and with certain Oracle monitoring capabilities of Foglight. We believe increased competition from Oracle has materially depressed our SharePlex and Quest Central for Oracle revenues over the last several years.

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

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

Some of our competitors and potential competitors have greater name recognition, a larger installed customer base company-wide and significantly greater financial, technical, marketing, and other resources than

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we do. Competitors may also be able to respond more quickly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products than we can.

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

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

Proprietary Rights

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

Employees

As of December 31, 2004, we employed 2,257 full-time employees, including 865 in sales and marketing, 79 in professional services, 925 in research and development, 157 in customer service and support and 231 in general and administrative, including information services personnel. We believe that our future success will depend in large part upon our continuing ability to attract and retain highly skilled managerial, sales, marketing, customer support and research and development personnel. Like other software companies, we face intense competition for such personnel, and we have at times experienced and continue to experience difficulty in recruiting qualified personnel. There can be no assurance that we will be successful in attracting, assimilating and retaining other qualified personnel in the future. None of our employees are represented by a labor union; we have never experienced any work stoppages and we believe that our relationships with our employees are good.

Website

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

Item 2.    Properties

Our headquarters and our principal administrative, sales, marketing, support and research and development facilities are currently located in one owned building in Aliso Viejo, California and one leased building in Irvine, California comprising approximately 78,000 and 68,000 square feet of space, respectively. In addition, we lease facilities in Canada, Australia, Israel and Russia for research and development activities. We also operate in approximately twenty field sales offices in North and South America, Europe and Asia Pacific.

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In March 2004, we purchased the building in Aliso Viejo, California and have moved approximately one half of our headquarters personnel into this building. We have also exercised an option to purchase the adjacent building consisting of approximately 92,000 square feet and expect to move the remainder of our headquarters personnel into that building by November 2005. See “Liquidity and Capital Resources” in Item 7 “Managements Discussion and Analysis of Financial Condition and Results of Operations” for additional discussion about costs associated with this purchase and related move.

Item 3.    Legal Proceedings

On July 2, 2002, Computer Associates International, Inc. (“CA”) filed a complaint against us and four of our employees in the U.S. District Court for the Northern District of Illinois alleging copyright infringement and trade secret misappropriation in connection with the development of our Quest Central for DB2 product and seeking injunctive relief and unspecified money damages. The complaint was amended in May 2003 to add another Quest employee as a defendant and to assert breach of contract claims against three of the individual defendants. In July 2004, the Court entered an order preliminarily enjoining our use, marketing, licensing or distribution of Quest Central for DB2, pending trial, based upon its determination that CA is likely to prove its claims of copyright infringement or trade secret misappropriation. We are permitted by the terms of the order to continue providing technical support and product maintenance to existing users of Quest Central for DB2. Our appeal of the preliminary injunction order is pending. The related products accounted for approximately 3% of total revenues in the six months ended June 30, 2004 and the year ended December 31, 2003. We have established a loss contingency reserve in the amount of $ 16.0 million, which reflects our current estimate of the value to Quest of settling this litigation and removing the injunction so that we could promptly resume selling our Quest Central for DB2 products. We are engaged in settlement discussions with Computer Associates in connection with a mediation process initiated by the Seventh Circuit Court of Appeals. There can be no assurance that we will be able to reach a settlement on terms and conditions acceptable to Quest or at all. If settlement discussions do not result in a settlement, we will continue to incur substantial legal expenses in the appeal of the preliminary injunction order and defense of these claims, which may also divert management’s attention from the day-to-day operations of our business.

The securities class action litigation filed in July 2003 and described in our filings since then was dismissed with prejudice at no cost to the company other than our litigation defense costs. The related state derivative action was also dismissed in February 2005.

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

In the normal course of our business, we enter into certain types of agreements that require us to indemnify or guarantee the obligations of other parties. These commitments include (i) intellectual property indemnities to licensees of our software products, (ii) indemnities to certain lessors under office space leases for certain claims arising from our use or occupancy of the related premises, or for the obligations of our subsidiaries under leasing arrangements, (iii) indemnities to customers, vendors and service providers for claims based on negligence or willful misconduct of our employees and agents, and (iv) indemnities to our directors and officers to the maximum extent permitted under applicable law. The terms and duration of these commitments varies and, in some cases, may be indefinite, and certain of these commitments do not limit the maximum amount of future payments we could become obligated to make thereunder; accordingly, our actual aggregate maximum exposure related to these types of commitments cannot be reasonably estimated. Historically, we have not been obligated to make significant payments for obligations of this nature, and no liabilities have been recorded for these obligations in our financial statements included in this report as the estimated fair value of these obligations as of December 31, 2004 was considered nominal.

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

No matters were submitted to a vote of security holders during the fourth quarter of 2004.

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PART II

Item 5.    Market for the Registrant’s Common Equity and Related Shareholder Matters and Issuer Purchases of Equity Securities

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

On February 22, 2005, the closing price of our common stock on the NASDAQ National Market was $14.04 per share. As of February 22, 2005, there were 197 holders of record of our common stock (not including beneficial holders of shares held in “street name”).

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

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Item 6.    Selected Financial Data

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

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

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

Overview and Business Model

We are an independent software vendor of a broad portfolio of products that improve information technology operations. We focus our efforts on products for widely adopted software platforms such as the Oracle, IBM DB2 and Microsoft SQL Server database management systems, the Microsoft Windows Server, Active Directory and Exchange systems, the packaged enterprise software applications provided by companies such as SAP, Oracle, PeopleSoft, Siebel and the J2EE platform for custom application development. Products for the Oracle databases were traditionally our core product set. Over the last three years, the revenue contribution from Oracle database-only products has declined as a percentage of total revenues because of reduced revenues from our High Availability and Quest Central for Oracle products and because of our efforts to build and acquire products outside of the Oracle database market, especially in the areas of Application Performance Management and Microsoft Windows Management. Additional information about our products can be found under the discussion above under the heading “Business.”

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

We invest heavily in R&D in order to design and develop a wide variety of products and technologies that will be attractive to customers. In addition, we are a direct-sales driven organization that expends significant selling costs in order to secure new customer license sales and the follow-on maintenance revenue stream that can continue forward beyond the initial license sale year.

Trends in Our Business

As discussed in more detail throughout our MD&A:

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Results of Operations

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

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Comparison of Fiscal Years Ended December 31, 2003 and 2004

Revenues

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

Licenses Revenues—Growth in license revenues for the twelve months ended December 31, 2004, is primarily a result of robust sales within our Microsoft Systems Management and Development and Deployment product lines. The license revenue contribution from the acquired Aelita products has become less identifiable because we have created product suites comprising both Aelita and Quest Microsoft systems management products and because in some cases Aelita products have replaced comparable Quest products. We nonetheless estimate that acquired Aelita products contributed approximately 50% to license revenues growth from 2003 to 2004. We also noted particular strength of the sales of Aelita products in EMEA. The Microsoft Windows management products now represent approximately 33% of total software license sales for the year ended December 31, 2004. Software license sales of our Development and Deployment products increased approximately 24% from 2003 to 2004, and these products also showed particular strength in Europe. A major new release of our TOAD Oracle database development product was a primary driver of license revenues growth in this product line. In the twelve months ended December 31, 2004, the decline of the U.S. Dollar against the Euro and British Pound contributed approximately $6.3 million to the year over year increase in license revenues. Our currency-adjusted license revenue growth rate would have been 21.8%, compared to the 25.3% mentioned above.

Services Revenues—The largest component of service revenues is maintenance revenue. Services revenues also include fees for consulting and training services. Three factors were the primary contributors to our 31.8% growth in services revenues. First, Aelita contributed approximately $15.0 million in maintenance revenue for the year ended December 31, 2004. Second, maintenance revenues from renewals of annual maintenance agreements have continued to grow. Third, revenues from post-sales consulting and training increased from $12.4 million in 2003 to $19.6 million in 2004, representing a 57.6% increase. Post-sales consulting and training as a percentage of total service revenues represented 10.0% and 11.9% in the twelve months ended December 31, 2003 and 2004, respectively. In the twelve months ended December 31, 2004, devaluation of the U.S. Dollar against the Euro and British Pound contributed approximately $2.4 million to the year over year increase in services revenues. Our currency-adjusted services revenue growth rate would have been 29.9%, compared to 31.8% mentioned above.

As our software maintenance customer base grows, the renewal rate has a larger influence on the software maintenance revenue growth rate and the amount of new software license revenues has a diminishing effect. Therefore, the growth rate of software maintenance revenues does not necessarily correlate directly to the growth rate of new software license revenues in a given period. The primary determinant of changes in our software maintenance revenue profile is the rate at which our customers renew their annual maintenance and support agreements. If our maintenance renewal rates were to decline materially, our maintenance revenues and total revenues would likely decline materially as well. Although we do not currently expect our maintenance renewal rates to deteriorate, there can be no assurance they will not.

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Cost of Revenues

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

Cost of Licenses—Cost of licenses primarily consists of third-party software royalties, product packaging, documentation, duplication, delivery and personnel costs. Cost of licenses as a percentage of license revenues was 2.4% and 1.8% for the twelve months ended December 31, 2003 and 2004, respectively. The percentage of revenue decrease is primarily the result of reduced license sales of royalty-bearing products.

Cost of Services—Cost of services primarily consists of personnel, outside consultants, facilities and systems costs used in providing support, consulting and training services. The increase in cost of services is primarily due to an increase of $2.2 million in fees paid to outside professional services consultants in support of product deployments and to a 15% increase in headcount, including the additional headcount from the acquisition of Aelita. Cost of services as a percentage of service revenues increased to 18.0% in the twelve months ended December 31, 2004, compared to 17.1% in the comparable period of 2003.

Amortization of Purchased Technology—Amortization of purchased technology includes amortization of the fair value of acquired technology associated with acquisitions made from 2001 through the end of 2004. We expect amortization of purchased technology to be at least $8.0 million in the year ending 2005.

Operating Expenses

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

Sales and Marketing—Sales and marketing expenses consist primarily of the following types of costs related to our sales and marketing activities: compensation and benefits for personnel; sales commissions; facilities and Information Systems (“IS”); trade shows; travel and entertainment; and marketing communications programs. The increase in sales and marketing expense is primarily attributable to additional headcount from the Aelita acquisition, which contributed approximately $15.4 million in the twelve months ended December 31, 2004, and sales commission expense, which increased $7.8 million year-over-year, as a result of higher license revenues. Sales and marketing expenses as a percentage of total revenues were 47.5% and 43.8% in 2003 and

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2004, respectively. The decline in expenses as a percentage of total revenues is primarily attributable to increasing productivity in our sales organization. In the twelve months ended December 31, 2004, the decline of the U.S. Dollar against the Euro and British Pound contributed approximately $5.4 million to the year-over-year increase in sales and marketing expenses.

Research and Development—Research and development expenses consist primarily of compensation and benefit costs for software developers, software product managers, quality assurance and technical documentation personnel, associated facilities and IS costs and payments made to outside software development consultants in connection with our ongoing efforts to enhance our core technologies and develop additional products. Research and development expenses as a percentage of total revenues were 22.2% and 20.1% in 2003 and 2004, respectively. The absolute dollar increase in research and development expenses is primarily due to increased headcount associated with the Aelita acquisition. Aelita contributed $6.7 million to research and development costs in 2004. In the twelve months ended December 31, 2004, the decline of the U.S. Dollar against the Euro and British Pound contributed approximately $0.9 million to the year-over-year increase in research and development expenses.

General and Administrative—General and administrative expenses consist primarily of compensation and benefit costs for our executive, finance, legal, administrative and IS personnel, professional fees for audit, tax and legal services, and associated facilities and IS costs. General and administrative expenses as a percentage of total revenues were 9.7% and 9.4% in 2003 and 2004, respectively. The increase in general and administrative costs in both periods is primarily due to higher compensation costs ($4.0 million), increased accounting fees associated with Sarbanes-Oxley compliance efforts ($1.4 million) and increased litigation defense costs associated with ongoing litigation ($0.4 million). In the twelve months ended December 31, 2004, the decline of the U.S. Dollar against the Euro and British Pound contributed approximately $0.5 million to the year-over-year increase in general and administrative expenses.

Amortization of Other Purchased Intangible Assets—Amortization of other purchased intangible assets includes the amortization of customer lists, trademarks, non-compete agreements and maintenance contracts associated with acquisitions. The increase in amortization expense is due to the purchase of intangible assets in conjunction with acquisitions during the first two quarters of 2004. We expect amortization of other purchased intangible assets to be at least $4.9 million in the year ending 2005.

Other Income, Net

Other income, net includes interest income on our investment portfolio, and gains and losses from foreign exchange fluctuations, as well as gains or losses on other financial assets. Other income, net increased by $1.4 million to $9.0 million in the twelve months ended December 31, 2004 compared to $7.6 million in the comparable period of 2003. This increase is due to an impairment charge included in other income in 2003 of $3.5 million relating to our investment in an aircraft. The increase is partially offset by lower foreign currency gains in 2004. Foreign currency gains were $6.2 million and $3.2 million in 2003 and 2004, respectively. These gains are primarily attributable to foreign currency fluctuations on certain non-U.S. Dollar denominated assets, primarily accounts receivable and cash held in British Pounds and Euros, which appreciated 7.4% and 7.6%, respectively, against the U.S. Dollar in 2004. Our net interest income was $6.7 million in 2004 versus $5.9 million in 2003.

Income Tax Provision

During the twelve months ended December 31, 2004, the provision for income taxes increased to $25.4 million from $12.1 million in the comparable period of 2003, representing an increase of $13.3 million. The effective income tax rate for 2003 and 2004 was approximately 36.0% and 35.0%, respectively.

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Comparison of Fiscal Years Ended December 31, 2002 and 2003

Revenues

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

Licenses Revenues—Total licenses revenues growth of $18.9 million in 2003 benefited from an $8.0 million contribution by Sitraka, Inc. acquired in November 2002 and an approximately $7.0 million contribution from the impact of the devaluation of the U.S. Dollar in 2003 relative to certain foreign currencies, primarily the Euro and the British Pound. We saw growth year-over-year primarily in our Application Performance Management products, with Foglight being the main contributor to the growth. Licenses revenues growth was partly offset by lower sales of our high availability products for Oracle and our Vista output management products.

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

Cost of Revenues

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

Cost of Licenses—Cost of licenses as a percentage of license revenues was 2.4% for 2003, compared with 2.2% in 2002.

Cost of Services—Cost of services as a percentage of service revenues declined to 17.1% for 2003, compared to 18.9% for 2002. The increase in the absolute amounts of cost of services is primarily due to an

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increase in fees paid to outside professional services consultants in support of product deployments ($1.2 million), an increase in the number of technical support personnel and consultants, mainly from the acquisition of Sitraka, as well as the impact from the devaluation of the U.S. Dollar relative to certain foreign currencies, primarily the Euro and the British Pound ($0.5 million). The margin improvement is primarily due to our continued increase in customer maintenance and support revenues with a lower associated increase in headcount.

Amortization of Purchased Technology—The increase in amortization of purchased technology is primarily due to amortization of purchased intangible assets related to the acquisitions of eCritical and Discus in the second quarter of 2003 and Sitraka in 2002, offset slightly by purchased intangible assets from acquisitions made in 2000 that were fully amortized by the beginning and middle of the year ended December 31, 2003. See Note 5 of the “Notes to Consolidated Financial Statements” for discussion of estimated future amortization expense. The useful lives of the acquired technologies range from two to seven years. See “Critical Accounting Policies and Estimates” for additional discussion regarding accounting for intangible assets.

Operating Expenses

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

Sales and Marketing—Sales and marketing expenses as a percentage of total revenues were 47.5% in 2003 compared to 50.3% in 2002. The absolute increase in sales and marketing expenses resulted from increased labor expenses ($8.8 million), primarily due to additional headcount from our acquisition of Sitraka, higher salary and commission rate in 2003 and to the U.S. Dollar devaluation ($5.4 million). In addition, employee severance costs contributed approximately $1.4 million to sales and marketing expenses in 2003. These increases were offset somewhat by lower marketing program costs in 2003 ($1.8 million), primarily related to advertising and tradeshows. Sales and marketing expenses declined year-over-year on a percentage of revenues basis because of lower marketing costs in 2003 and reduced sales headcount in the third and fourth quarters of 2003.

Research and Development—Research and development expenses as a percentage of total revenues were 22.2% in 2003 compared to 23.5% in 2002. Additional headcount from our acquisition of Sitraka was the primary reason for the absolute increase in research and development expenses. The devaluation of the U.S. Dollar to the Australian and Canadian Dollars also contributed approximately $2.7 million to the expense increase, because we have significant development facilities in Australia and Canada.

General and Administrative—General and administrative expenses as a percentage of total revenues were 9.7% in 2003 and 9.8% in 2002. The absolute increase in general and administrative expenses is primarily attributable to the inclusion of Sitraka’s general and administrative expenses ($1.2 million), the currency effect of the U.S. Dollar devaluation ($0.9 million), and higher accounting and legal fees. External accounting and legal fees alone increased by approximately $1.0 million in 2003 compared to 2002, with litigation defense costs and Sarbanes-Oxley compliance costs being the primary components.

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

Other Income, Net

Other income, net includes interest income on our investment portfolio and gains and losses from foreign exchange fluctuations, as well as gains or losses on other financial assets or investments. Interest income, net decreased 33.7% from $8.9 million in 2002 to $5.9 million in 2003 as a result of lower reinvestment rates and, on average, a reduced investment portfolio. Foreign currency gains of $6.2 million were included in other income, net in 2003 as compared to $2.1 million of such gains included in 2002. The 2003 gains were primarily attributable to foreign currency fluctuations on certain non-U.S. Dollar denominated assets, primarily accounts receivable held in British Pounds and Euros, which appreciated 10.9% and 19.8%, respectively, against the U.S. Dollar in 2003. Other income, net in 2003 also includes an impairment charge of $3.5 million incurred in the fourth quarter of 2003 relating to our investment in an aircraft.

Income Tax Provision

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

Inflation

Inflation has not had a significant effect on our results of operations or financial position for the years ended December 31, 2002, 2003 and 2004.

Liquidity and Capital Resources

Year-over-year changes in the principal components of our liquidity and capital resources are as follows (in thousands, except for percentages):

Operating Activities

Our primary source of operating cash flows is cash collections from our customers following the purchase of new software licenses, maintenance and support and post-sale consulting and training. Our primary use of cash from operating activities is for compensation and personnel-related expenditures.

The increase in net cash provided by operating activities from 2003 to 2004 is primarily due to the increase in our earnings from net income of $21.5 million in 2003 to $47.2 million in 2004. During 2002, 2003 and 2004

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our cash flows from operations were primarily derived from (i) our earnings from operations prior to non-cash expenses, which were then adjusted for gains or losses resulting from sale or impairment of assets; (ii) the addback of depreciation and amortization costs, which represent a non-cash expense, which contributed between $23.4 million and $26.6 million per year to cash flow over the 2002 to 2004 period; (iii) the tax benefit related to stock options exercised, which reduces our cash outlay for income tax expense; and (iv) changes in our working capital. Working capital changes are mostly driven by deferred revenue (representing net cash inflows of $9.4 million, $19.6 million and $41.4 million in the 2002, 2003 and 2004 periods, respectively), which primarily represent the receipt of cash payments for maintenance support, which will be delivered over the coming twelve month period. This substantial cash inflow is partially offset by growth in accounts receivable of $14.6 million and $34.3 million over the last two years. The increase in receivables is the result of both our overall revenue growth as well as growth in our European geography, which generally has longer payment terms with customers.

In the future, we expect cash will continue to be generated from our operations. We plan to use cash generated from operations to invest in short and long-term marketable securities consistent with past investment practices. We also plan to use cash generated from operations to fund other strategic investment and acquisition opportunities that we continue to evaluate.

Investing Activities

Our primary source of investing cash flows is from sales and maturities of marketable securities. Our primary uses of cash from investing activities are from purchases of property, equipment and marketable securities and payments for acquisitions.

Cash used in investing activities in the twelve months ended December 31, 2004, consists of $96.7 million net cash paid for acquisitions and $31.9 million in capital expenditures, including the purchase of our building, partially offset by $30.4 million net cash received from sales and maturities of marketable securities and cash proceeds of $22.5 million received from the sale of our Vista Plus output management product line as described in Note 4 to the “Notes to Consolidated Financial Statements.” Cash used in investing activities in the 2003 period consists of $4.8 million net cash paid for acquisitions, $6.7 million in capital expenditures and $68.7 million net cash paid for marketable securities. Cash used in investing activities in the 2002 period consists of $56.8 million net cash paid for acquisitions, $3.0 million in capital expenditures, partially offset by $35.2 million net cash received from sales and maturities of marketable securities, $1.9 million from the sale of an aircraft and $0.9 million in proceeds from a sale of equity investments.

Capital expenditures in the twelve months ended December 31, 2004 included $14.9 million to purchase a building and the remainder for furniture and fixtures for the new building as well as information technology hardware and software purchases. The building, located in Aliso Viejo, California, comprises approximately 78,000 square feet. Cash paid for costs of improvements related to this building were approximately $8.4 million through the twelve months ended December 31, 2004.

On December 9, 2004, we entered into an agreement to purchase a second building located in Aliso Viejo, California, adjacent to our existing Aliso Viejo building, comprising approximately 89,000 square feet for approximately $18.6 million. The purchase price is subject to increase by one-half percent (0.5%) for each thirty (30) day period after November 15, 2004 until the completion of the purchase, which is expected to occur in May 2005. We exercised our option to lease back approximately 8,000 square feet of this building back to the seller. We intend to move our remaining Irvine operations into this new building in stages over the next three quarters. We expect costs of improvements for this new building to be approximately $10.0 million to $11.0 million.

Financing Activities

Our primary sources of financing cash flows are from a repurchase agreement and issuances of our common stock under employee stock option and stock purchase plans. Our primary use of cash from financing activities is for repayment of our repurchase agreement, as described below, and repayment of notes payable.

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The increase in net cash provided by financing activities from 2003 to 2004 is primarily due to net proceeds of $12.1 million from a repurchase agreement, as described below, and an increase of $7.2 million in proceeds from stock options exercised. Proceeds received from our stock option plans were $1.8 million, $9.5 million and $16.7 million in 2002, 2003 and 2004, respectively. Annual proceeds received from our employee stock purchase plan were approximately $4.5 to $4.8 million in the 2002 to 2004 periods. In April 2004, our Board of Directors elected to terminate the employee stock purchase plan effective July 31, 2004.

We entered into a repurchase agreement in March 2004, utilizing $67.6 million of our investment securities as collateral. The cash proceeds of this transaction were used to provide funding for our acquisition of Aelita and our purchase of a new office facility. Our remaining obligation under this agreement was paid in full in February 2005.

Our Board of Directors authorized a stock repurchase program for up to five million shares of our common stock. As of December 31, 2004, we had repurchased approximately 1.7 million shares of our common stock under this program for an aggregate cost of approximately $58.0 million. No shares of common stock were repurchased under this plan during 2003 or 2004.

Based on our current operating plan, we believe that our existing cash, cash equivalents, investment balances and cash flows from operations will be sufficient to finance our working capital, building and capital expenditure requirements through at least the next 12 to 24 months. If we are not able to generate or sustain positive cash flow from operations, we would be required to use existing cash, cash equivalents and investment balances to support our working capital. Our ability to generate cash from operations is subject to substantial risks described below under the caption “Risk Factors.”

Contractual Obligations

As of December 31, 2004, our contractual obligations or commercial commitments include our facility lease commitments and operating leases for office facilities and certain items of equipment. In addition, we are committed to pay additional capital contributions to a private equity fund totaling $1.2 million as capital calls are made. We do not have any off-balance sheet arrangements that could reduce our liquidity.

The following table summarizes our obligations as of December 31, 2004 and the effect we expect such obligations to have on our liquidity and cash flows in future periods (in thousands):

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Critical Accounting Policies and Estimates

Our consolidated financial statements are based on the selection and application of generally accepted accounting principles, which require us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and the accompanying notes. Future events and their effects cannot be determined with certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates, and any such differences may be material to our financial statements. We believe that the policies set forth below may involve a higher degree of judgment and complexity in their application than our other accounting policies and represent the critical accounting policies and estimates used in the preparation of our financial statements. If different assumptions or conditions were to prevail, the results could be materially different from our reported results. Historically, our assumptions, judgments and estimates relative to our critical accounting policies and estimates have not differed materially from actual results. Our significant accounting policies are presented within Note 1 of our Notes to Consolidated Financial Statements.

Management has discussed the development and selection of these critical accounting policies and estimates with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the foregoing disclosure.

Revenue Recognition

We recognize revenue in accordance with current generally accepted accounting principles that have been prescribed for the software industry. Our revenue recognition policy is one of our critical accounting policies because revenue is a key component of our results of operations and is based on complex rules, which require us to make judgments and estimates. In applying our revenue recognition policy we must determine which portions of our revenue are recognized currently and which portions, if any, must be deferred. We analyze various factors, including our pricing policies, the credit-worthiness of our customers, contractual terms and conditions, our historical experience and market and economic conditions. Changes in judgments on these factors could materially impact the timing and amount of revenue and costs recognized.

Our revenues consist of software license revenues, maintenance revenues and professional services revenues. Our revenue recognition policies for these revenue categories are as follows.

Almost all of our software license revenues are from sales of perpetual licenses. The fee for one year of maintenance and support services is included in the initial purchase fee for a perpetual license of a Quest product, so that the purchase of a perpetual license with first year maintenance and support services is a “multi-element arrangement” for revenue recognition purposes. We offer customers the right to purchase maintenance and support services on a standalone basis for annual periods beyond the first year.

We account for the perpetual license component of these multiple-element arrangements using the residual method. The residual method generally requires recognition of software license revenue in a multiple-element arrangement once all software products have been delivered and accepted by the customer and the only undelivered element is PCS (post contract support, or maintenance) and/or certain services. The value of the undelivered maintenance services is determined based on VSOE (vendor-specific, objective evidence) and is deferred and recorded to revenue ratably over the maintenance term. The residual revenue is allocated to the license fees associated with the software product or products being licensed in the transaction. Our maintenance and support services’ VSOE of fair value is determined by reference to the price our customers are required to pay for the services when sold separately; that is, the maintenance and support renewal fees paid by our customers. Annual maintenance and support renewal fees are generally priced as a percentage of the initial discounted purchase price and are recognized ratably over the maintenance periods, generally one year.

In addition to perpetual licenses, we sell a small amount of subscription software licenses each year. Less than 2% of 2004 total revenue was generated by subscription software licenses. Software subscriptions are term based and the customer pays a single fee for the right to use the software and receive maintenance and support

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services for the term. A subscription sale’s license and maintenance and support fee components are both deferred and recognized ratably over the license term.

Our professional services fees are generally derived from time- and-materials based contracts that typically range on average from five to fifteen days in duration. These services are generally implementation and training services. Revenue is recognized on such contracts as work is performed. We sell our professional services both standalone and as part of multi-element arrangements. When professional services are sold as part of a multi-element arrangement, VSOE of fair value is based on established pricing and discounting practices for those services when sold separately.

Historically, we have been able to establish VSOE for customer support and professional services, but we may modify our pricing practices in the future, which could result in changes in, or the inability to support, VSOE of fair value for these undelivered elements. If this occurs, our future revenue recognition for multi-element arrangements could differ significantly from our historical results. If in the future we were unable to support VSOE of fair value for an undelivered element, the entire amount of revenue from the arrangement would be deferred and recognized ratably over the life of the contract.

Asset Valuation

Asset valuation includes assessing the recorded value of certain assets, including accounts receivable, goodwill and other intangible assets. We use a variety of factors to assess valuation, depending upon the asset.

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Accounting for Income Taxes

As part of the process of preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. U.S. and foreign tax returns are subject to routine compliance reviews by the various tax authorities. We accrue for tax contingencies based upon our best estimate of the taxes we expect to pay. These estimates are updated over time as more definitive information becomes available from taxing authorities, completion of tax audits or upon occurrence of other events. The tax contingency accrual is recorded as a component of our net income taxes payable/receivable balance.

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

Recently Issued Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), that upon implementation, will impact our net income and net income per share and change the classification of certain elements in the statement of cash flows. SFAS 123R eliminates the alternative to use the intrinsic value method of accounting under SFAS No. 123 and supersedes Accounting Principles Board (“APB”) Opinion No. 25, and its related implementation guidance. Under APB Opinion No. 25, no compensation expense is recognized for options granted to employees where the exercise price equals the market price of the underlying stock on the date of grant. SFAS 123R will require us to measure all employee stock-based compensation awards using a fair value method and record such amounts as an expense in our statement of operations as the underlying options vest. We are required to adopt SFAS 123R in our third quarter of 2005, with expensing to begin July 1, 2005. See “Stock-Based Compensation” in Note 1 to the “Notes to Consolidated Financial Statements” for the pro forma net income and net income per share amounts, for fiscal 2002 through fiscal 2004, as if we had used a fair-value-based method similar to the methods required under SFAS 123R to measure compensation expense for employee stock incentive awards. While we are still evaluating the requirements under and effects of SFAS 123R we expect the adoption to have a significant adverse impact on our consolidated income from operations, net income and net income per share.

In December 2004, the FASB issued FASB Staff Position No. FAS 109-1 (“FAS 109-1”), “Application of FASB Statement No. 109, “Accounting for Income Taxes,” to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (“AJCA”).” The AJCA introduces a special 9% tax deduction on qualified production activities, which is phased in through 2010. FAS 109-1, clarifies that this tax deduction should be accounted for as a special tax deduction in accordance with Statement 109. This provision may provide a tax benefit to us from both a financial statement effective tax rate perspective and as a deduction on our tax return, which may effectively reduce the amount of taxes owed. The amount of the additional deduction and overall benefit has not yet been determined. Additionally, the Internal Revenue Service is continuing to issue additional guidance regarding the benefits provided by the Qualified Production Activities deduction.

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In December 2004, the FASB issued FASB Staff Position No. FAS 109-2 (“FAS 109-2”), “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creations Act of 2004.” The AJCA introduces a limited time 85% dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. FAS 109-2 provides accounting and disclosure guidance for the repatriation provision. Although FAS 109-2 is effective immediately, we are awaiting the issuance of further regulatory guidance and passage of statutory technical corrections with respect to certain provisions of the Act prior to determining the amount, if any, that we will repatriate. We expect to complete our evaluation of the effects of the repatriation provision by the end of the third quarter of 2005.

In November 2004, the Emerging Issues Task Force (“EITF”) ratified EITF Issue No. 03-13 (“EITF 03-13”), “Applying the Conditions in Paragraph 42 of FASB Statement No. 144, ‘Accounting for the Impairment or Disposal of Long-Lived Assets’, in Determining Whether to Report Discontinued Operations.” EITF 03-13 provides additional guidance for purposes of classifying the results of operations of a component of an entity that either has been disposed of or is classified as held for sale as discontinued operations. This guidance is effective for components disposed of or classified as held for sale in fiscal periods beginning after December 15, 2004. We will adopt EITF 03-13 beginning in 2005 for components disposed of or classified as held for sale in 2005 and thereafter.

In March 2004, the FASB issued EITF Issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which provided new guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004 (see Note 2 of our Notes to Consolidated Financial Statements). We will evaluate the impact of EITF 03-1 once final guidance is issued.

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RISK FACTORS

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

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

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

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

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

The recent accounting pronouncement requiring employee stock options to be accounted for using a fair-value method will materially reduce our reported operating margins, operating income, net income and net income per share

We currently account for the issuance of stock options under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under APB No. 25, no compensation expense is recognized for options granted to employees where the exercise price equals the market price of the underlying stock on the date of grant. In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which eliminates the alternative to use the intrinsic value method of accounting under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and supersedes APB No. 25, and its related implementation guidance. SFAS 123R will require us to measure all employee stock-based compensation

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awards using a fair value method and record such amounts as an expense in our statement of operations. We are required to adopt SFAS 123R in our third quarter of 2005, beginning July 1, 2005. The additional expense associated with stock options will be substantial and will materially reduce our operating margins, operating income, net income and net income per share. These reductions in our operating results may result in a reduction to our stock price and market value, the magnitude of which cannot be determined. Note 1 of the “Notes to Consolidated Financial Statements” contain a detailed presentation of our current methods of accounting for stock-based compensation plans and includes pro forma fair value disclosures currently required under SFAS No. 123.

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

Our license revenues in any quarter are substantially dependent on orders booked and delivered in that quarter. Our revenues in a given quarter could be adversely affected if we are unable to complete one or more large license agreements, or if the contract terms were to prevent us from recognizing revenue during that quarter. The sales cycles for certain of our software products, such as SharePlex, can last from three to nine months and often require pre-purchase evaluation periods and customer education, which can affect timing of orders. Further, we have often booked a large amount of our sales in the last month, weeks or days of each quarter and delays in the closing of sales near the end of a quarter could cause quarterly revenue to fall short of anticipated levels. Finally, while a portion of our revenues each quarter is recognized from previously deferred revenue, our quarterly performance will depend primarily upon entering into new contracts to generate revenues for that quarter. These factors may cause significant periodic variation in our license revenues. In addition, we incur or commit to operating expenses based on anticipated revenue levels, and generally do not know whether revenues in any quarter will meet expectations until the end of that quarter. Accordingly, if our revenue growth rates slow or our revenues decline, our operating results could be seriously impaired because many of our expenses are relatively fixed in nature and cannot be easily or quickly changed.

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

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

Many of our products are vulnerable to direct competition from Oracle

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