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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended February 25, 2005

OR

For the transition period from                      to                     

Commission File No. 000-50402

PalmSource, Inc.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (408) 400-3000

Former name, former address and former fiscal year, if changed since last report:

1240 Crossman Avenue, Sunnyvale, California 94089-1116.

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 Securities Exchange Act of 1934). Yes ¨     No x

As of February 25, 2005 16,734,378 shares of our Common Stock were outstanding.

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PalmSource, Inc.

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PalmSource’s 52-53 week fiscal year ends on the Friday nearest May 31, with each fiscal quarter ending on the Friday generally nearest August 31, November 30 and February 28. For presentation purposes, the periods are shown as ending on August 31, November 30, February 28 and May 31, as applicable.

The page numbers in this Table of Contents reflect actual page numbers, not EDGAR page tag numbers.

References to “PalmSource,” “Company,” “we”, “us,” and “our” in this Form 10-Q refer to PalmSource, Inc. and its subsidiaries unless the context requires otherwise.

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PART I. FINANCIAL INFORMATION

PalmSource, Inc.

Condensed Consolidated Statements of Operations

(In thousands, except per share amounts)

(Unaudited)

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

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PalmSource, Inc.

Condensed Consolidated Balance Sheets

(In thousands, except par value amounts)

(Unaudited)

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

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PalmSource, Inc.

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

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

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PalmSource, Inc.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 1. Background and Basis of Presentation

On August 27, 2001, Palm, Inc. (“Palm”) announced its plan to form a wholly-owned subsidiary to own and operate Palm’s operating system platform and licensing business, subsequently named PalmSource, Inc. (“PalmSource” or the “Company”). PalmSource develops and licenses operating system software, personal information management applications, and software development tools for mobile information devices. PalmSource targets device manufacturers, as well as developers, enterprises and consumers with its software, services and support.

In December 2001, PalmSource was incorporated in Delaware as a wholly-owned subsidiary of Palm, an event this document refers to as the separation, and as of December 3, 2001, authorized and issued 50,000 shares of Series A preferred stock to Palm in exchange for the assignment to PalmSource of certain of Palm’s assets and liabilities, including intellectual property. Effective May 9, 2002, PalmSource’s board of directors authorized a re-capitalization of the authorized and outstanding Series A preferred stock into common stock and a simultaneous 1,000-for-1 stock split, resulting in 50,000,000 shares of PalmSource common stock issued and outstanding and owned by Palm, which was later re-capitalized as 10,000,000 shares of common stock via a one-for-five reverse stock split. The one-for-five reverse stock split was approved by the Company’s Board of Directors on June 30, 2003 and became effective on September 22, 2003. Shares outstanding and net loss per share have been retroactively adjusted for periods presented prior to the effective date.

In December 2001, Palm and PalmSource entered into a Master Separation and Distribution Agreement, as amended June 3, 2003, (the “Separation Agreement”) under which Palm transferred to PalmSource at December 3, 2001, the date of legal separation, substantially all of the assets and liabilities of Palm’s operating system and software business except for the Palm brands, trademarks and certain other related intellectual property which were transferred at a later date. (See Note 9, Transactions with Palm.)

On October 7, 2002, Sony Corporation of America (“Sony”) invested $20.0 million in PalmSource, purchasing 3,333,333 shares of the Company’s Series A redeemable convertible preferred stock. The shares of preferred stock were automatically converted into 666,666 shares of the Company’s common stock immediately prior to the October 28, 2003 distribution of PalmSource’s common stock by Palm to Palm’s stockholders.

On October 28, 2003, Palm distributed on a pro-rata basis all of the outstanding shares of PalmSource common stock to Palm stockholders, an event referred to in this document as the distribution. At the same time as the distribution, Palm acquired Handspring, Inc., an event referred to in this document as the Handspring merger, and the combined entity changed its name to palmOne, Inc. This document refers to palmOne, Inc. as “palmOne” or “Palm” interchangeably, depending on the time and context of the event described.

The condensed consolidated financial statements include allocations of certain Palm expenses, including centralized legal, accounting, treasury, real estate, information technology and other Palm corporate services and infrastructure costs. The expense allocations through the distribution date have been determined on bases that Palm and PalmSource considered to be reasonable reflections of the utilization of services provided or the benefit received by PalmSource.

Prior to the distribution, related party revenues in the condensed consolidated financial statements included revenues from Palm and Sony, a PalmSource stockholder. Subsequent to the distribution, related party revenues, cost of revenues and accounts receivable in the condensed consolidated financial statements only included those from Sony.

The majority of the Company’s cost of revenues are of a fixed nature, either amortization of intangibles or term license fees paid to technology vendors recognized ratably, and are not directly related or allocable to either third-party or related party revenues.

The Company did not incur separately identifiable costs directly associated with related party professional services revenue for the three months ended February 28, 2005, and February 29, 2004, respectively and incurred zero costs and $23,000 for the nine months ended February 28, 2005, and February 29, 2004, respectively.

The results of operations for the interim periods presented are not necessarily indicative of the results that may be expected for any other period or for the entire fiscal year, which ends May 31, 2005 (see Note 2, Summary of Significant Accounting Policies). The condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission and are not audited. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. In the opinion of

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management, the condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments necessary for a fair presentation of the financial position, operating results and cash flows for those periods presented. These condensed consolidated financial statements should be read in conjunction with the audited combined and consolidated financial statements and notes thereto for the fiscal year ended May 31, 2004 included in the Company’s Annual Report on Form 10-K (File No. 000-50402), filed with the Securities and Exchange Commission.

Note 2. Summary of Significant Accounting Policies

Fiscal Year

PalmSource’s 52-53 week fiscal year ends on the Friday nearest to May 31. PalmSource’s fiscal quarters end on a Friday and are generally thirteen weeks in length. For presentation purposes, the periods have been presented as ending on February 28 and May 31. Unless otherwise stated, all years and dates refer to PalmSource’s fiscal year and fiscal quarters.

Use of Estimates and Reclassifications

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported in PalmSource’s condensed consolidated financial statements and the accompanying notes. The Company bases its estimates and judgments on historical experience and on various other assumptions that it believes are reasonable under the circumstances. However, future events are subject to change, and the best estimates and judgments routinely require adjustment. The amounts of assets and liabilities reported in the Company’s balance sheets and the amounts of revenues and expenses reported for each of its fiscal periods are affected by estimates and assumptions, which are used for, but not limited to, the accounting for revenue recognition, allocations from Palm, goodwill impairments, loss contingencies, restructuring and income taxes. Actual results could differ from these estimates.

In the third quarter of fiscal year 2005, the Company has determined that it was appropriate to classify its investment in auction-rate securities as short-term investments. These investments were included in cash and cash equivalents in previous periods ($18 million at May 31, 2004), and such amounts have been reclassified to conform to the current period classification. This change in classification had no effect on the amounts of previously reported total current assets, total assets, net income or cash flow from operations of the Company.

Revenue Recognition

The Company’s revenue recognition policy is in accordance with American Institute of Certified Public Accountants Statement of Position (SOP) 97-2, “Software Revenue Recognition,” as amended. When contracts contain multiple elements, wherein vendor specific objective evidence exists for all undelivered elements, the Company accounts for the delivered elements in accordance with the “Residual Method” prescribed by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Arrangements.” Vendor specific objective evidence of fair value is determined based on the price charged when the same element is sold separately or the contractually stated renewal rate. License and royalty revenues consist principally of revenue earned under software license agreements with manufacturers of hand-held devices. License and royalty revenues are recognized when a signed contract exists, the software has been shipped or electronically delivered, the license fee is fixed or determinable, and collection of the resulting receivable is probable. License and royalty revenues that are contingent upon licensees’ sales are generally recognized on a per-unit or net sales basis in the period information is reported by licensees, generally the month or quarter subsequent to the period of sale by the licensee. When arrangements include bundled professional services and the pattern of performance over the term of the agreement is not discernable or if an arrangement includes ongoing support for which vendor specific objective evidence of fair value does not exist, the entire fee is recognized ratably over the term of the arrangement. Arrangements generally do not allow for product returns and PalmSource has no history of product returns. Accordingly, no allowance for returns has been provided. Revenues from minimum commitment and other arrangements payable on extended payment terms are recognized in the period the payment becomes due. If an arrangement includes specified upgrade rights for which sufficient vendor specific objective evidence of fair value does not exist, revenue is deferred until the specified upgrade has been delivered. Amounts legally disputed are not recognized to revenue until such disputes are settled.

Support and service revenues consist primarily of fees for providing unspecified software updates when and if available and technical support for software products. Support revenues are deferred and recognized ratably over the term of the agreement. Service revenues consist primarily of fees received for providing product development, engineering services, consulting and training to licensees and, to a lesser extent, to third-party application developers. Service revenues are generally billed on a time-and-materials basis, and revenue is generally recognized as the services are performed.

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Stock-Based Compensation

PalmSource employees participate in PalmSource employee stock plans, which are described more fully in Note 7, Stockholders’ Equity, and, until the distribution, participated in Palm employee stock plans. The Company accounts for activity under its stock plans using the intrinsic value method prescribed by Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and Financial Accounting Standards Board Interpretation (FIN) No. 44, “Accounting for Certain Transactions Involving Stock Compensation (an Interpretation of APB No. 25)” and has adopted the disclosure-only provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” PalmSource accounts for stock-based compensation relating to equity instruments issued to non-employees based on the fair value of options or warrants estimated using the Black-Scholes option valuation model on the date of grant and re-measured until the measurement date in compliance with Emerging Issues Task Force (EITF) Issue No. 96-18, “Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” Compensation expense is amortized using the multiple option approach in compliance with FIN No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.”

The following table illustrates the effect on net income (loss) if PalmSource had elected to recognize stock-based compensation expense based on the fair value of the options granted at the date of grant and restricted stock at the grant date as prescribed by SFAS No. 123. For the purposes of this disclosure, the estimated fair value of the options and restricted stock is assumed to be amortized to expense over the vesting periods, using the multiple option approach.

SFAS No. 123 allows the use of option valuation models that were not developed for use in valuing employee stock options, including the expected stock price volatility. Because options held by PalmSource employees and directors have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the fair value of these options.

After the distribution on October 28, 2003, PalmSource employees did not participate in the Palm Employee Stock Purchase Plan and no stock options were issued under the Palm stock option plans.

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The weighted average estimated fair value of Palm stock options granted during the period from September 1, 2003 to October 28, 2003 and the period from June 1, 2003 to October 28, 2003 was $9.50 per share and $6.00 per share, respectively (as adjusted for Palm’s October 2002 one-for-twenty reverse stock split). The weighted average estimated fair value of shares granted under the Palm Employee Stock Purchase Plan during the period from September 1, 2003 to October 28, 2003 and the period from June 1, 2003 to October 28, 2003 was $7.93 per share for both periods.

The weighted average estimated fair value of PalmSource stock options granted during the three and nine months ended February 28, 2005 was $7.36 per share and $10.84 per share, respectively, and during the three and nine months ended February 29, 2004 was $12.51 per share and $20.81 per share, respectively, (as adjusted for PalmSource’s one-for-five reverse stock split). The weighted average estimated fair value of PalmSource Employee Stock Purchase Plan during the three and nine months ended February 28, 2005 was $11.38 per share and $10.57 per share, respectively, and during the three and nine months ended February 29, 2004 was $24.19 per share for both periods (as adjusted for PalmSource’s one-for-five reverse stock split).

Net Income (Loss) Per Share

Basic net income (loss) per share is calculated based on the weighted average shares of common stock outstanding during the period, excluding shares of restricted stock subject to repurchase. Diluted net income (loss) per share is calculated based on the weighted average shares of common stock outstanding and shares of common stock equivalents. Common stock equivalents consist of stock options and common stock subject to repurchase, calculated using the treasury stock method, and convertible preferred stock, calculated using the if-converted method. Diluted net income (loss) per share does not include outstanding Palm options held by PalmSource employees, as these are not options to purchase PalmSource stock. For the three months ended February 28, 2005, 0.3 million shares and for the nine months ended February 29, 2004, 0.9 million shares of potential common stock equivalents, stock options and outstanding shares of convertible preferred stock and restricted stock were excluded from the calculation of diluted net loss per share because the effect would have been anti-dilutive. For the three months ended February 29, 2004, and the nine months ended February 28, 2005, no potential common stock equivalents, stock options and outstanding shares of convertible preferred stock and restricted stock were excluded from the calculation of diluted net income per share.

Comprehensive Income (Loss)

Comprehensive income (loss) consists of net income (loss), net unrealized gain (loss) on investments and accumulated foreign currency translation adjustments. Comprehensive income (loss) for the three months ended February 28, 2005 and February 29, 2004 was $(745,000) and $709,000, respectively. Comprehensive income (loss) for the nine months ended February 28, 2005 and February 29, 2004 was $1.2 million and $(12.1) million, respectively. Other comprehensive income (loss) for the three months ended February 28, 2005 and February 29, 2004 was $(24,000) and $112,000, respectively. Other comprehensive income (loss) for the nine months ended February 28, 2005 and February 29, 2004 was $60,000 and $173,000 respectively. Other comprehensive income (loss) primarily consists of accumulated foreign currency translation adjustments for all periods presented.

Effects of Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment.” SFAS 123(R) requires companies to apply a fair-value based measurement method in accounting for share-based payment transactions with employees and to record compensation expense for all stock awards granted, and to awards modified, repurchased or cancelled after the required effective date. The fair value will be amortized to expense over the service periods. SFAS No. 123(R) will be effective for quarterly periods beginning after June 15, 2005, which is the Company’s first quarter of fiscal 2006. The adoption of SFAS 123(R) may have a material impact on the Company’s consolidated financial position, results of operations and cash flows.

In March 2004, EITF reached consensus on recognition and measurement guidance under Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The consensus clarified the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under SFAS No. 115 and to investments accounted for under the cost method or the equity method. In September 2004, the FASB delayed the recognition and measurement guidance to be applied to other-than-temporary impairment evaluations.

Note 3. Loan Receivable

On September 29, 2004, PalmSource made a $1.5 million unsecured loan to China MobileSoft, Ltd. (CMS), which conducts operations through its wholly-owned subsidiary, MobileSoft Technology (Nanjing) Co., Ltd. (MTN), organized under the laws of the

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People’s Republic of China. The CMS loan was originally due on May 25, 2005. The loan carried a stated interest rate of 6% per annum, compounded quarterly, payable at maturity. On December 8, 2004, the Company announced it had entered into an agreement for the acquisition of CMS. The acquisition was completed on January 28, 2005. The $1.5 million loan and accrued interest was included in the total purchase consideration as of that date (see Note 4, Acquisitions and Dispositions).

Note 4. Acquisitions and Dispositions

Acquisitions

On January 28, 2005, the Company completed the acquisition of all of the outstanding stock of CMS, a Chinese mobile phone software company with business operations headquartered, through its wholly-owned subsidiary MTN, in China. The acquisition of CMS is expected to further extend PalmSource’s leadership as a software provider for phones and mobile devices worldwide. In consideration of the acquisition, the Company issued 1,508,010 shares of the Company’s common stock valued at $21.4 million. Of the total shares issued, the Company restricted an aggregate of 347,859 shares valued at $3.6 million for certain executives. These shares were not included in the net purchase price and will be recorded as compensation expense in future periods. These shares will vest every six months over a twenty-four month period following the acquisition closing date. The Company also had an outstanding loan to CMS valued at $1.5 million and incurred $2.7 million in transaction fees, consisting of legal, valuation, and accounting fees. The common stock issued was valued in accordance with EITF No. 99-12, using the average of the closing prices of the Company’s common stock on The Nasdaq National Market for the two days prior to measurement date and two days after the measurement date of December 8, 2004. The total purchase price is summarized below (in thousands).

As part of the purchase agreement, twenty percent shares of the Company’s common stock issued for the purchase are held in escrow for unknown liabilities that may have existed as of the acquisition date. The escrow shares are included as part of the purchase price in the Consolidated Balance Sheet as of February 28, 2005. One-third of the shares, less the amount of any pending or settled indemnification claims, will be released from escrow on the date that is 20 business days after completion of the audit of the Company’s 2005 financial statements, and issuance of the opinion thereon by the Company’s independent registered public accounting firm but in no event later than January 28, 2006. The remaining shares will be released from escrow on the date that is 20 business days after completion of the audit of the Company’s 2006 financial statements, and issuance of the opinion thereon by the Company’s independent registered public accounting firm but in no event later than January 28, 2007, subject to extension for any pending claims for indemnification.

The preliminary allocation of the purchase price to the tangible and identifiable intangible assets acquired and liabilities assumed are summarized below (in thousands). Certain amounts of the purchase price were allocated to intangible assets which were determined through established valuation techniques in the high-technology computer industry. The allocation of purchase price may be subject to change based on the final estimates of fair value, however, such changes are not expected to be material.

The allocation of the purchase price to the tangible and intangible assets acquired and liabilities assumed is as follows: (in thousands)

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The other intangible assets will be amortized over periods which reflect the pattern in which the economic benefits of the assets are expected to be realized. The existing technology is being amortized straight-line over an estimated useful life of three years, customer relationships are being amortized straight-line over an estimated useful life of five years, non compete agreements are amortized straight line over a two year period, and tradenames are amortized straight-line over three years. No residual value is estimated for the other intangible assets. In accordance with SFAS No. 142, the Company will not amortize the goodwill, but will evaluate it at least annually for impairment. Goodwill is not expected to be deductible for tax purposes. Results of operations and balance sheets for periods prior to the acquisition were not material to us and accordingly, pro forma results of operations have not been presented. Results of operations from the acquisition date have been included in the consolidated results of operations.

Dispositions

On August 29, 2003, PalmSource and PalmGear consummated certain transactions related to a stock purchase agreement, strategic alliance and service provider agreement and a brand license agreement between the parties. There was no pre-existing related party interest between PalmSource and PalmGear. In connection with the closing of the transactions, PalmSource sold its wholly-owned subsidiary whose assets comprised the Palm Digital Media product line to PalmGear. In addition, as part of the strategic alliance, PalmGear agreed to support an online store at PalmSource’s U.S. website, for Palm OS applications, and PalmSource provided PalmGear certain rights to a customer database. The initial term of the strategic alliance is three years. The total transaction fee to PalmSource from the above described transactions equaled $4.0 million. However, this amount was subject to a maximum $0.3 million contingent holdback based upon Palm Digital Media meeting certain financial metrics for the five month period ending January 31, 2004, thereby resulting in current total proceeds of $3.7 million. The contingent holdback was settled for $0.2 million, resulting in total proceeds from the transaction of $3.9 million. In accordance with EITF No. 00-21, “Revenue Arrangements with Multiple Deliverables,” PalmSource concluded that the entire arrangement represents a single unit of accounting as there is an undelivered element for which objective and reliable evidence of fair value does not exist. Accordingly, $3.5 million, representing net proceeds of $3.9 million less the book value of net assets of $0.4 million transferred to PalmGear, is being recognized ratably over the term of the arrangement. In addition, PalmSource is guaranteed additional future minimum fees from the strategic alliance and service provider agreement of $1.4 million over the three-year term of the arrangement.

Note 5. Debt

In October 2003, the Company entered into an agreement with Silicon Valley Bank for a $15.0 million revolving line of credit, but never made any borrowings under the line of credit. In May 2004, the revolving line of credit agreement with Silicon Valley Bank was terminated.

In connection with distribution of PalmSource from Palm, PalmSource issued a $15.0 million convertible subordinated note to Texas Instruments, Inc. (“Texas Instruments”), bearing interest at 5% per annum and due December 6, 2006. In June 2004, PalmSource negotiated a prepayment of the $15.0 million convertible subordinated note in exchange for a 12.5% discount on the outstanding principal. Under the terms of the prepayment agreement, PalmSource paid approximately $13.1 million (plus accrued interest) of the original $15.0 million principal outstanding, resulting in a discount of approximately $1.9 million.

Note 6. Commitments

PalmSource, during fiscal year 2005, entered into a new lease agreement for its headquarters facility located in Sunnyvale, California, beginning in February 2005 and extending, without renewals, until February, 2010. The Company’s prior lease agreement for its former headquarters facility expired in February 2005. PalmSource’s facilities are leased under operating leases expiring at various dates through February 2010. Certain facility leases have renewal options with rentals based upon changes in the Consumer Price Index or the fair market rental value of the property. PalmSource’s equipment lease expires in March 2007. Total future minimums for all lease payments are $0.3 million, $1.1 million, $1.1 million, $1.0 million, $1.0 million and $0.7 million for the remaining three months ending May 31, 2005, and years ending May 31, 2006, 2007, 2008, 2009 and 2010, respectively.

In June 2002, PalmSource entered into two royalty agreements with third-party technology vendors, and in February 2004, PalmSource entered into another royalty agreement with a third-party technology vendor for certain licensed technology, which includes minimum commitments. In December 2003, one of these royalty agreements was renegotiated and the minimum commitment was eliminated. Future minimum commitments under these agreements are $0.2 million, $0.9 million, $0.7 million, $0.5 million, and $0.3 million for the remaining three months ending May 31, 2005, and for the years ending May 31, 2006, 2007, 2008, 2009 and thereafter, respectively.

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PalmSource has certain payments due to palmOne under business services and other agreements that were entered into with Palm in connection with the separation. The agreements with Palm also include certain indemnifications, including indemnifications of Palm under the tax sharing agreement, of any tax liability incurred by Palm on account of the sale of PalmSource’s common stock in connection with the distribution. The terms of such indemnification provide for no limitation for the maximum potential payments for such obligations and accordingly the maximum potential amount of future payments is undeterminable at this time. The Company has not been notified of any claims under these indemnifications and has no liabilities recorded for these indemnifications as of February 28, 2005 and May 31, 2004 (see Note 9, Transactions with Palm).

Under the indemnification and warranty provisions of the Company’s standard software license agreements, the Company agrees to defend the licensee against third-party claims asserting infringement by the Company’s products of certain intellectual property rights, which may include patents, copyrights, trademarks or trade secrets, and to pay any judgments entered on such claims against the licensee. The Company has never incurred significant expense under its product or services indemnification or warranty provisions. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of February 28, 2005 or May 31, 2004.

As permitted under Delaware law, the Company has agreements whereby it indemnifies its officers and directors for certain events or occurrences while the officer or director is, or was, serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has a director and officer insurance policy that limits its exposure and enables the Company to recover a portion of any future amounts paid. These indemnification agreements were grandfathered under the provisions of Financial Accounting Standards Board Interpretation No. 45 (“FIN No. 45”), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, as they were in effect prior to December 31, 2002, however, new directors added under these arrangements will not be grandfathered. As a result of its insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is minimal. Accordingly, the Company had no liabilities recorded for these agreements as of February 28, 2005.

The Company had made certain acquisitions prior to the adoption of FIN No. 45. As part of an acquisition, the Company acquires all of a company’s stock or all of its assets and liabilities including assuming certain indemnification obligations that took place prior to the date of acquisition. The maximum potential amount of future payments the Company could be required to make for such obligations is undeterminable at this time. All of these obligations were grandfathered under the provisions of FIN No. 45 as they were in effect prior to December 31, 2002. Accordingly, the Company had no liabilities recorded for these obligations as of February 28, 2005.

Note 7. Stockholders’ Equity

Amended and Restated Certificate of Incorporation

On the distribution date, the Company’s Board of Directors approved the Amended and Restated Certificate of Incorporation, which amended the number of shares of common stock authorized for issuance to 100,000,000 shares and the number of shares of preferred stock authorized for issuance to 5,000,000 shares.

Common stock

On June 30, 2003, the Company’s Board of Directors approved a one-for-five reverse stock split of the issued and outstanding shares of common stock of the Company. The one-for-five reverse stock split was effected on September 22, 2003. Shares outstanding have been retroactively adjusted for periods presented prior to September 22, 2003.

In October 2002, PalmSource received an investment of $20.0 million from Sony for 3,333,333 shares of PalmSource Series A preferred stock at a purchase price of $6.00 per share, which was automatically converted into 666,666 shares of common stock upon the distribution (taking into account PalmSource’s one-for-five reverse stock split).

Restricted Stock

On August 4, 2003, the Company, pursuant to the Board of Directors’ approval on June 30, 2003, issued restricted stock to certain key executives of the Company through a voluntary stock option exchange program, an option waiver program and a restricted stock bonus program.

Under the voluntary stock option exchange program, certain key executives were offered the opportunity to exchange outstanding stock option grants for restricted stock and replacement stock options. In connection with the program, 1,042,000 stock options, as adjusted for the one-for-five reverse stock split, were cancelled on August 4, 2003 and, on the same date, 689,490 shares of restricted stock with a purchase price equal to the par value of a share of PalmSource common stock were granted in exchange. In addition,

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713,914 replacement options were granted on February 2, 2004 with an exercise price of $18.42, which was the closing price of a share of PalmSource common stock on the date of grant.

Under the option waiver program, rights to 335,200 stock options that were to be granted to certain key executives were waived and 170,300 shares of restricted stock of the Company were issued with a purchase price equal to $0.001. In addition, the Company granted 419,415 new options with an exercise price equal to $36.50, the closing price of PalmSource common stock on the date of grant, November 7, 2003.

Additionally, on August 4, 2003, the Company granted to certain key executives, 73,175 shares of restricted stock with a purchase price equal to $0.001.

The issuance of the restricted stock grants to executives resulted in an aggregate of $14.0 million of unamortized stock-based compensation, which is being amortized as a non-cash compensation charge as the restrictions lapse (the vesting period). This restricted stock charge was calculated based on the intrinsic value of each share of restricted stock. The intrinsic value represents the difference between the imputed fair value of $14.98 per share of PalmSource stock on August 4, 2003 and the par value of each share of restricted stock of $0.001 per share. As there was no market for the PalmSource stock on August 4, 2003, the fair value of PalmSource common stock was determined based on the respective market price of Handspring and Palm common stock as of August 4, 2003 and the contractual exchange ratio defined by the Palm and Handspring merger agreement.

On November 7, 2003, the Company granted 30,572 shares of restricted stock to employees with a purchase price equal to $0.001. The issuance of the restricted stock grants to employees resulted in an aggregate of $1.1 million of unamortized stock-based compensation, which is being amortized as a non-cash compensation charge as the restrictions lapse (the vesting period). The restricted stock charge was calculated based on the closing price of PalmSource common stock on November 7, 2003.

On July 29, 2004, the Company granted 50,268 shares of restricted stock to key executives with a purchase price equal to $0.001. The issuance of the restricted stock grants to key executives resulted in an aggregate of $1.0 million of unamortized stock-based compensation, which is being amortized as a non-cash compensation charge as the restrictions lapse (the vesting period). The restricted stock charge was calculated based on the closing price of PalmSource common stock on July 29, 2004.

On August 19, 2004, the Company granted 10,000 shares of restricted stock to a consultant with a purchase price equal to $0.001. The issuance of the restricted stock grant to the consultant resulted in an aggregate of $0.2 million of unamortized stock-based compensation, which is being amortized as a non-cash compensation charge as the restrictions lapse (the vesting period). The restricted stock charge was calculated based on the closing price of PalmSource common stock on August 19, 2004.

On January 28, 2005, in connection with the acquisition of CMS, the Company issued 347,859 shares of restricted stock to certain key executives of CMS. The issuance of the restricted stock to these employees resulted in an aggregate of $3.6 million of unamortized stock-based compensation, which is being amortized as a non-cash compensation charge as the restrictions lapse (the vesting period). The restricted stock charge was calculated based on the closing price of PalmSource common stock on January 28, 2005.

On February 4, 2005, the Company granted 50,000 shares of restricted stock to employees with a purchase price equal to $0.001. The issuance of the restricted stock grants to employees resulted in an aggregate of $0.4 million of unamortized stock-based compensation, which is being amortized as a non-cash compensation charge as the restrictions lapse (the vesting period). The restricted stock charge was calculated based on the closing price of PalmSource common stock on February 4, 2005.

The Company amortizes non-cash stock compensation charges over the vesting period using the multiple option approach in accordance with FIN No. 28. The employee and executive restricted stock awards issued in 2003 and 2004 vest 50% on the first anniversary of the grant date and 50% on the second anniversary of the grant date. The consultant restricted stock awards vest 25% on the grant date and thereafter 25% upon 6-month anniversary of the grant date, one-year anniversary of the grant date, and 18-month anniversary of the grant date. The restricted stock awards issued in 2005 vest over a two year period. During the three and nine months ended February 28, 2005 the Company recognized stock-based compensation expense of $1.5 million and $4.9 million, respectively, related to the above restricted-stock grants. During the three and nine months ended February 29, 2004 the Company recognized stock-based compensation expense of $2.8 million and $6.4 million, respectively, related to the above restricted-stock grants.

On September 15, 2003, the Company paid approximately $1.9 million to PalmSource’s President and Chief Executive Officer, David Nagel, pursuant to the terms of two restricted stock grants of Palm common stock issued in September 2001, representing the difference between the guaranteed value of $2.0 million and the fair market value of 7,500 shares of Palm common stock on September 15, 2003.

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Employee Stock Purchase Plan

On June 30, 2003, the Company’s Board of Directors adopted the PalmSource 2003 Employee Stock Purchase Plan (“ESPP”). The ESPP provides eligible employees, including employees of participating subsidiaries, with the opportunity to purchase shares of the Company’s common stock through payroll deductions. The ESPP is intended to qualify as an employee stock purchase plan under Section 423 of the Internal Revenue Code. The Company has reserved a total of 580,000 shares of common stock, which includes 180,000 shares added in January, 2005 pursuant to the ESPP provision for annual increase, as adjusted for the one-for-five reverse stock split. There were no shares purchased under the plan in this quarter.

Stock Option Plans

On June 30, 2003, the Company’s Board of Directors approved the adoption of the PalmSource 2003 Equity Incentive Plan (“Equity Incentive Plan”) and the termination of the 2001 Stock Option Plan effective as of August 1, 2003. The Equity Incentive Plan provides for the grant of the following types of incentive awards: (a) stock options, (b) stock appreciation rights, (c) restricted stock, (d) performance units and (e) performance shares. The Company has reserved a total of 4,395,330 shares of its common stock, as adjusted for the one-for-five reverse stock split. This includes an increase of 760,036 shares pursuant to the annual increase provision and 9,000 shares from the Company’s 2001 Stock Option Plan which had been reserved but not granted pursuant to options under the PalmSource 2001 Stock Plan and returned to the PalmSource 2001 Stock Plan as a result of the termination of options or the repurchase of unvested shares issued under the 2001 Stock Plan. For the three months ended February 28, 2005, 458,000 options were granted and 109,000 options were cancelled. No options were exercised during this period. For the nine months ended February 28, 2005, 1,325,000 options were granted, 217,000 options were cancelled, and 5,000 options were exercised.

On March 17, 2004, PalmSource’s Board of Directors authorized a voluntary stock option exchange program for its employees. Commencing on April 1, 2004, the option exchange offer was made to all eligible employees for all vested and unvested options with exercise prices equal to or greater than $30.00 per share that were granted on or after November 7, 2003. On April 30, 2004, 956,040 options were cancelled under the option exchange program. On November 1, 2004 and January 7, 2005, 735,435 options and 72,093 options were granted under the option exchange program at an exercise price per share of $20.33 and $12.23, respectively, the closing price of the common stock of the Company on the Nasdaq on the date of grant. All new options vest as to one-third of the shares covered by such new options twenty-four weeks after the new option vest date and the remaining shares covered by such new options vest with respect to one-third of the shares covered by such new options forty-eight weeks after the new option vest date and with respect to one-third of the shares covered by such new options seventy-two weeks after the new option vest date.

On December 7, 2004, the Company’s Board of Directors authorized the 2004 Inducement Equity Incentive Plan (“Inducement Plan”). The Inducement Plan provides for the grant of the following types of incentive awards: (a) nonqualified stock options, (b) stock appreciation rights, (c) restricted stock, and (d) restricted stock units. The Company has reserved a total of 300,000 shares of its common stock for the Inducement Plan. For the three months ended February 28, 2005, 229,966 options were granted. No options were exercised during this period.

Public Offering

In April 2004, PalmSource sold 3,450,000 shares of common stock at a public offering price of $18.00 per share. After deducting underwriting discounts and commissions and estimated offering expenses, the net proceeds from the offering were approximately $57.4 million.

Note 8. Restructuring Charges

During the fiscal first quarter ended August 31, 2004, the Company recorded restructuring charges of $0.6 million related to restructuring action which consisted of workforce reductions of 16 regular employees, primarily in the U.S., for severance, benefits, and related costs, In accordance with SFAS 146, restructuring costs are recorded as incurred. Restructuring charges for employee workforce reductions are recorded upon employee notification for employees whose required continuing service period is 60 days or less. During the fiscal third quarter ended February 28, 2005, certain charges related to expected to COBRA coverage and employment assistance were reversed. The time period for election of these expired without these employees availing themselves for such benefits, thus necessitating the reversal.

Note 9. Transactions with Palm

For the periods subsequent to the separation date through the distribution date on October 28, 2003, intercompany transactions and balances between PalmSource and Palm consisted of the following (in thousands):

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For the periods presented, PalmSource’s costs and expenses included allocations from Palm for centralized legal, finance, treasury, real estate, information technology, customer support, sales, marketing, engineering, and other Palm corporate services and infrastructure costs. These allocations were determined on bases that Palm and PalmSource considered to be reasonable reflections of the utilization of services provided or the benefit received by PalmSource. The allocation methods include relative revenues or headcount.

Allocated costs included in the accompanying condensed consolidated statements of operations were as follows (in thousands):

From the beginning of fiscal year 2004 until the distribution date, Palm made capital contributions and net asset transfers to PalmSource of $26.2 million consisting of the re-capitalization of the $20.0 million note issued by Palm to the Company in accordance with the Amended and Restated Intercompany Loan Agreement, the $6.0 million cash contribution in accordance with the Letter Agreement Regarding Cash Contributions, and $0.2 million in net asset transfers.

For purposes of governing certain of the ongoing relationships between PalmSource and Palm at and after December 3, 2001 and to provide for an orderly transition, PalmSource and Palm entered into various agreements. For a description of all PalmSource and Palm agreements, refer to the notes to the combined and consolidated financial statements for the year ended May 28, 2004 included in the Company’s Annual Report on Form 10-K (File No. 0-50402) filed with the Securities and Exchange Commission. Following is a summary of some of those agreements:

Software License Agreement

Under the Amended and Restated Software License Agreement (the “Software License Agreement”), PalmSource agreed to grant to Palm certain licenses to develop, manufacture, test, maintain and support its products. In addition, PalmSource agreed to grant to Palm a source code license and certain rights to use, produce, grant end user sublicenses and distribute certain software. Palm will pay PalmSource license and royalty fees based upon the shipment of Palm’s products which incorporate PalmSource’s software and maintenance and support fees. The Software License Agreement expires December 3, 2006 and includes a minimum annual royalty and license commitment of $40.0 million, $37.5 million, $39.0 million, $41.0 million and $42.5 million during each of the contract years expiring December 3, 2002, 2003, 2004, 2005, and 2006, respectively. Under the terms of the Software License Agreement, PalmSource has recognized license and royalty revenues of $17.6 million, and $38.1 million for the years ended May 31, 2002 and 2003, respectively. For the year ended May 31, 2004, PalmSource recognized license and royalty revenues of $17.1 million prior to the distribution from Palm, and $21.0 million after the distribution from palmOne. During the three months ended February 29, 2004 PalmSource recognized license and royalty revenues of $0 million prior to the distribution from Palm and of $11.2 million after the distribution from palmOne, and during the three months ended February 28, 2005, PalmSource recognized license and royalty revenues of $12.1 million from palmOne. During the nine months ended February 29, 2004 PalmSource recognized license and royalty revenues of $17.1 million prior to the distribution from Palm and $11.4 million after the distribution from palmOne, and during the nine months ended February 28, 2005 PalmSource recognized license and royalty revenues of $34.5 million from palmOne. In addition, PalmSource has recognized support and service revenues of $0.8 million and $1.2 million for the years ended May 31,

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2002 and 2003, respectively. For the year ended May 31, 2004, PalmSource recognized support and service revenues of $0.2 million prior to the distribution from Palm, and $0.5 million after the distribution from palmOne. PalmSource recognized support and service revenues of $0 million prior to the distribution from Palm and $0.2 million after the distribution from palmOne during the three months ended February 29, 2004 and $0.3 million from palmOne during the three months ended February 28, 2005. PalmSource recognized support and service revenues of $0.2 million prior to the distribution from Palm and $0.3 million after the distribution from palmOne during the nine months ended February 29, 2004 and $0.7 million from palmOne during the nine months ended February 28, 2005.

Trademark Agreements

Since the distribution, the use of trade names, trademarks, service marks and domain names that contain the word or letter string “palm” (including “palmOne”) are controlled by Palm Trademark Holding Company, LLC (the “Holding Company”), a holding company established and owned 45% by palmOne and 55% by PalmSource for the purpose of receiving, holding, maintaining, registering, enforcing and defending such intellectual property. The Holding Company’s administration of the intellectual property is governed by its operating agreement and by trademark license agreements between the Holding Company and each of PalmSource and palmOne. Based on its operating structure, the Holding Company arrangement is essentially a cost sharing mechanism between palmOne and PalmSource to administer the intellectual property rights attributed to the “Palm” trademark.

Intercompany Loan Agreement

The terms of the note payable to Palm for $20.0 million were set forth in the Amended and Restated Intercompany Loan Agreement. The note payable to Palm bore interest at 2.48% per annum. At the time of the distribution, the $20.0 million was contributed by Palm to the Company as additional paid-in capital. The related accrued interest was paid within seven days after the distribution date.

In connection with the distribution, Palm and Texas Instruments agreed that the $50.0 million 5% convertible subordinated note issued in December 2001 would be divided into and replaced by two notes: one issued by Palm, or the new Palm note, and one issued by PalmSource, the PalmSource note. Following the distribution, the new Palm note was issued in the principal amount of $35.0 million and the PalmSource note was issued in the principal amount of $15.0 million. PalmSource’s assumption of the PalmSource note was recorded as a capital distribution to Palm as a reduction to additional paid-in capital. The Texas Instruments note was repaid in June 2004 (see Note 5, Debt, for further discussion).

Note 10. Other Related Party Transactions

Under the terms of the license agreement between PalmSource and Sony, PalmSource has recognized license and royalty revenues of $0.7 million and $3.0 million for the three months ended February 28, 2005 and 2004, respectively, and $2.0 million and $6.5 million for the nine months ended February 28, 2005 and 2004, respectively. In addition, PalmSource has recognized support and service revenues of $0.1 million and $0.1 million for the three months ended February 28, 2005 and 2004, respectively, and $0.3 million and $0.3 million for the nine months ended February 28, 2005 and 2004, respectively. These amounts have been included in related party revenues in the condensed consolidated financial statements. As of February 28, 2005 and May 31, 2004, there were no outstanding receivables from Sony in the condensed consolidated financial statements.

Effective October 7, 2002, PalmSource entered into a business collaboration agreement, which expires in October 2012, with Sony under which PalmSource and Sony agreed to share certain information regarding ongoing product and development plans and, for a period of at least three years, to establish mutually agreed written co-development plans for potential areas of joint development. Under the business collaboration agreement, prior to October 7, 2003, PalmSource agreed not to engage another licensee of Palm OS as a development partner under a joint development agreement to participate in a co-development program for new versions of Palm OS and from October 7, 2003 until October 7, 2005, PalmSource will not engage more than two development partners meeting the above requirements in addition to Sony, and PalmSource will first offer to discuss new projects with Sony prior to engaging such additional development partners.

Prior to July 2000, Palm was a wholly-owned subsidiary of 3Com Corporation. PalmSource’s former chairman of the board of directors, Eric Benhamou, is also the chairman of the board of directors of 3Com Corporation and the chairman of the board of directors of palmOne. Mr. Benhamou retired after the Company’s annual meeting in October 2004.

PalmSource’s president and chief executive officer, David Nagel, was a director of palmOne until the distribution.

The Company entered into a consulting agreement with one of its former directors effective as of August 1, 2003 through July 31, 2005, to provide services to PalmSource for four days per month. Under the terms of the consulting agreement, this former director will be paid $11,200 per month for consulting services outlined by PalmSource’s chief executive officer. This formed director retired from the PalmSource board of directors after the Company’s annual meeting in October 2004.

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Note 11. Litigation

On February 9, 2004, a suit was filed in the United States District Court for the Northern District of California naming the Company, palmOne, and Handspring as defendants. The case is captioned E-Pass Technologies, Inc. v. palmOne, Inc., PalmSource, Inc. and Handspring, Inc., Case No. C04-0528. The case alleges that the three defendants have engaged in willful infringement, both direct and contributory and inducement of infringement, of U.S. Patent No. 5,276,311, titled, “Method and Device for Simplifying the Use of a Plurality of Credit Cards, or the Like,” with respect to certain hardware products allegedly offered for sale by palmOne, PalmSource and Handspring. The complaint seeks injunctive relief, unspecified damages and attorneys’ fees. E-Pass filed claims against 3Com and Palm in 2000 alleging infringement of the same patent; however, the suit naming the Company identifies additional products as infringing and seeks unspecified compensatory damages, treble damages and a permanent injunction against future infringement. On February 25, 2005, the court issued its claim construction order and the parties anticipate initiating discovery following an as yet unscheduled status conference. The Company intends to defend vigorously against the claim.

On July 16, 2003, a suit was filed in the Los Angeles County Superior Court naming PalmSource as a defendant. The case is captioned Chet Taylor, et al. v. Palm, Inc., PalmSource, Inc., and Solutions Group, et al., No. BC299134. The complaint alleges that persons who purchased Palm PDAs with customer-accessible batteries after June 1999 lost data upon battery replacement. The complaint alleges unfair and deceptive business practices in alleged violation of California’s unfair competition statute and Consumer Legal Remedies Act, breach of express and implied warranties and fraud. The complaint seeks unspecified compensatory and punitive damages, restitution and an injunction prohibiting the defendants from similar conduct in the future. palmOne is managing this litigation, and believes it has good defenses for all parties. On March 28, 2005 palmOne, on behalf of itself and its unincorporated department Solutions Group and PalmSource, Inc. (for the purpose of this paragraph, “Palm”) entered into a Settlement Agreement and General Release (the “Settlement”). A hearing seeking preliminary court approval of the proposed Settlement is scheduled for May 4, 2005. palmOne is responsible for the Palm obligations agreed to in the Settlement and will not look to PalmSource for contribution or reimbursement related to this matter.

On April 28, 1997, Xerox Corporation filed suit in the United States District Court for the Western District of New York. The case came to be captioned Xerox Corporation v. 3Com Corporation, U.S. Robotics Corporation, U.S. Robotics Access Corp., and Palm Computing, Inc., Civil Action No. 97-CV-6182T. The complaint alleged willful infringement of U.S. Patent No. 5,596,656, or ‘656 patent, titled “Unistrokes for Computerized Interpretation of Handwriting.” The complaint sought unspecified damages and to permanently enjoin the defendants from infringing the ‘656 patent in the future. In 2000, the District Court granted summary judgment to the defendants, ruling that the ‘656 patent is not infringed by the Graffiti handwriting recognition software then used in handheld computers using Palm OS. Xerox appealed the dismissal to the United States Court of Appeals for the Federal Circuit, or CAFC. On October 5, 2001, the CAFC affirmed-in-part and reversed-in-part the District Court’s ruling, and the CAFC remanded the case to the District Court for further proceedings. On December 20, 2001, the District Court granted Xerox’s motion for summary judgment that the ‘656 patent is valid, enforceable, and infringed. The defendants appealed. The CAFC remanded the case to the District Court for a determination of the issues of invalidity and enforceability of the ‘656 patent. Following the CAFC’s remand to the District Court, both parties filed motions for summary judgment with the District Court on the issue of invalidity, and the District Court heard those motions on December 10, 2003. On February 21, 2003, CAFC affirmed the finding that the defendants infringed the ‘656 patent, but reversed the district court’s finding that the ‘656 patent was valid, and enforceable, and remanded for further proceedings. The CAFC denied Xerox’s petition for a rehearing, and the case was remanded to the district court for a determination of whether the patent is valid and enforceable. On March 29, 2004, the District Court granted Xerox’s unopposed motion to amend its complaint naming PalmSource as a defendant. On May 21, 2004, the District Court granted the defendants’ motion for summary judgment due to invalidity and denied Xerox’s motion for summary judgment that the patent is not invalid. On May 26, 2004, the District Court entered final judgment in favor of the defendants. On June 1, 2004, the defendants filed a motion for clarification of the ruling regarding the District Court’s summary judgment decision and on June 10, 2004, Xerox filed a motion to alter or amend that decision. On June 18, 2004, Xerox filed a Notice of Appeal to the District Court’s summary judgment decision. On July 15, 2004, the CFAC issued an order decertifying Xerox’s appeal pending resolution of Xerox’s motion to alter or amend the District Court’s summary judgment decision. On February 16, 2005, the court issued its order: (i) granting defendant’s motion for consideration and held that the asserted claims for the ‘656 patent are invalid as anticipated or obvious in light of prior art; and (ii) denying plaintiff’s motion for reconsideration and/or relief for judgment. The CAFC’s February 20, 2003 decision indicates that the District Court should grant Xerox’s request for injunctive relief if the patent is valid and enforceable. If an injunction is obtained by Xerox, it could have a significant adverse impact on PalmSource’s operations and financial condition if licensees have not transitioned to a handwriting recognition system outside the scope of Xerox’s asserted claims. In addition, if palmOne is not successful in establishing that the ‘656 patent is invalid or unenforceable, Xerox has stated in its court pleadings that it will seek at trial a significant compensatory and punitive damage award or license fees from palmOne. Furthermore, if palmOne is not successful in establishing that the ‘656 patent is invalid or unenforceable, palmOne might be liable to palmOne’s licensees and other third parties under contractual obligations or otherwise sustain adverse financial impact if Xerox seeks to enforce its patent claims against palmOne’s licensees and other third parties. In connection with Palm’s separation from 3Com, pursuant to the terms of the Indemnification and Insurance Matters Agreement between 3Com and Palm, palmOne may be required to indemnify and hold 3Com harmless for any damages or losses that may arise out of the Xerox litigation. As part of PalmSource’s separation agreements with palmOne, palmOne is required to

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indemnify PalmSource for certain damages that PalmSource may incur due to the Xerox litigation. If palmOne is not successful in the Xerox litigation and is unable to or does not indemnify PalmSource, PalmSource might be required to pay Xerox significant damages or license fees or pay PalmSource’s licensees significant amounts to indemnify them for their losses. In particular, pursuant to the separation agreements between PalmSource and palmOne and, if palmOne is required to pay Xerox, as a result of a judgment or in connection with a settlement, and fails to do so within 60 days after the entry of such judgment or the due date under such settlement, PalmSource will be required to pay any shortfall amounts. Any such payment by PalmSource does not, however, relieve palmOne of its obligation either to make the payment or to reimburse PalmSource. Damages in patent litigation of this nature can be calculated in a variety of ways, and are subject to factual determinations. PalmSource cannot easily predict the amount of these damages, but if palmOne is not successful in the litigation, damages could be substantial. Although palmOne has prevailed at the current stage of the litigation on the claims made by Xerox, there can be no assurance that palmOne will be ultimately successful or that an adverse outcome will not significantly harm PalmSource’s business. PalmSource further believes that it is remote that PalmSource will incur a loss resulting from any fees or damages in excess of amounts recoverable from Palm under Palm’s indemnification of PalmSource.

In the course of palmOne’s business, it occasionally receives claims related to consumer protection, general commercial claims related to the conduct of its business and the performance of its products and services and other litigation claims, such as stockholder derivative class action lawsuits. In the course of palmOne’s business, it also receives claims of infringement or otherwise becomes aware of potentially relevant patents or other intellectual property rights held by other parties. palmOne is currently subject to a number of these claims. Although the majority of the claims currently do not name PalmSource as a defendant, the substance of their claims may implicate PalmSource and result in claims against PalmSource in the future or require that PalmSource indemnify palmOne pursuant to the separation agreements. PalmSource currently is not able to estimate, with reasonable certainty, the possible loss, or range of loss, if any, from these cases, but an unfavorable resolution of these lawsuits could materially adversely affect PalmSource’s business, results of operations or financial condition.

From time to time, PalmSource also may be subject to other legal proceedings, as well as demands, claims and threatened litigation, that arise in the normal course of its business. The ultimate outcome of any litigation is uncertain, and either unfavorable or favorable outcomes could have a material negative impact. Regardless of outcome, litigation can have an adverse impact on PalmSource because of defense costs, diversion of management resources and other factors.

Note 12. Business Segment Information

PalmSource operates in one reportable segment.

Geographic Information

PalmSource is headquartered in the United States. In addition to most of its operations in the United States, the Company has a development center in France. With the acquisition of CMS, the Company has established operations in China, principally Nanjing. PalmSource conducts its sales, marketing and customer service activities throughout the world and also has a research and development facility in France. Geographic revenue information is based on the location of the customer. Geographic long-lived tangible asset information is based on the physical location of the assets. All restricted investments are located in the United States. For the three and nine months ended February 28, 2005 and 2004, no country outside the United States or Japan accounted for 10% or more of total revenues. Revenues and net property and equipment by geographic region are as follows (in thousands):

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The following individual customers accounted for 10% or more of total revenues for the fiscal periods ended:

Note 13. Subsequent Events

Effective on February 28, 2005, the Company announced the employment of Jeanne Seeley, the Company’s newly appointed Chief Financial Officer. In conjunction with this appointment, also, effective as of February 28, 2005, Ira Cook ceased serving as the Company’s principal financial officer and resumed his position as the Company’s Vice President of Finance.

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The following discussion of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and the related notes included in this quarterly report. This document contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Such forward-looking statements include: any projections of earnings, revenues, expenses, or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning proposed new products, services, developments, acquisitions or investments, anticipated performance of products or services; the outcome or initiation of patent or other intellectual property litigation; any statements regarding future economic conditions or performance; statements of belief and any statement of assumptions underlying any of the foregoing. You can identify these statements by the fact that they do not relate strictly to historical or current facts. These statements use words such as “anticipate,” “estimate,” “project,” “intend,” “plan,” “believe,” and other words and terms of similar meaning.

The risks, uncertainties and assumptions referred to above include, but are not limited to, those risks discussed here and the risks discussed from time to time in our other public filings. All forward-looking statements included in this document are based on information available to us as of the date hereof, and we assume no obligation to update these forward-looking statements. Please see the section titled “Cautionary factors that may affect future results” for a discussion of risks and uncertainties relevant to our business. These items are factors that we believe could cause our actual results to differ materially from expected and historical results. We also advise you to consult any future disclosure we make on related subjects in our reports we file with the SEC. Other factors also could adversely affect us.

Overview

We are a leading developer and licensor of platform software that enables mobile information devices. We have begun to license Palm OS to smartphone and wireless device manufacturers and intend to continue to build on our leadership position and experience in PDAs to become a leading licensor of platform software for smartphones, wireless devices, and other next generation smart mobile products. We intend to expand our product portfolio with the long-term goal of becoming a leading provider of software for phones and mobile devices at all price points. Our software platform consists of operating system software, or Palm OS, and software development tools. From time to time, we evaluate other operating systems for which we may develop Palm OS products in the future. We have also extended our platform with applications such as personal information management software, web browsers and e-mail. We license Palm OS to leading smart mobile information device manufacturers, including palmOne, Garmin, GSPDA, Kyocera, and Samsung. A wide range of smart mobile devices incorporate our solutions, including PDAs, smartphones, location-aware devices, entertainment devices, and industry-specific devices used in industries such as education, hospitality and healthcare.

Our 52-53 week fiscal year ends on the Friday nearest to May 31. Our fiscal quarters end on a Friday and are generally 13 weeks in length. For presentation purposes, our periods have been presented as ending on February 28 and May 31. Unless otherwise stated, all years and dates refer to our fiscal year and fiscal quarters.

Our Separation from Palm

We were incorporated in December 2001 as a wholly-owned subsidiary of Palm to conduct substantially all of the business of its operating system software group. In connection with the separation of the two businesses, Palm contributed to us substantially all of the assets and liabilities comprising the Palm operating system software group, and issued to us an intercompany loan of $20.0 million, which was contributed as additional paid-in-capital immediately prior to the distribution. Since our incorporation, Palm also made additional net capital contributions and transfers to us totaling $47.9 million, consisting of capital contributions and transfers of $38.1 million in fiscal year 2002 reduced by a capital distribution and transfers of $1.4 million during fiscal year 2003 and net capital contributions and transfers of $11.2 million from the beginning of fiscal year 2004 through the distribution date. In connection with Palm’s capital contributions and distributions, we issued a $15.0 million 5% convertible subordinated note payable to Texas Instruments, due December 6, 2006. For a description of the 5% convertible subordinated note see the section titled “Liquidity and Capital Resources—The Convertible Note.” The 5% convertible subordinated note was prepaid in June 2004 (see Note 5 of Notes to Condensed Consolidated Financial Statements for further discussion).

We have entered into a number of agreements that govern the separation of our business operations from Palm. In general, these agreements provide for the transfer from Palm to us of assets comprising our business and the assumption by us of liabilities relating to our business. The separation agreements, in some cases, allocated various costs between the parties and require us to indemnify Palm for certain liabilities Palm may incur. We also entered into an agreement with Palm for the licensing to Palm of Palm OS for use in the manufacturing of Palm’s mobile information devices. All of the agreements we entered into with Palm were entered into in the context of a parent-subsidiary relationship and were negotiated in the overall context of our separation from Palm. As a result, the terms of these agreements may be more or less favorable to us than if they had been negotiated with unaffiliated third parties.

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Our operating results historically have been included in Palm’s consolidated U.S. income tax return and consolidated, combined or unitary state income returns and in tax returns of certain foreign subsidiaries. The income tax provision in our financial statements has been determined on a separate-return basis. Pursuant to our tax sharing agreement with Palm, as of the fiscal year ended 2003, $65.4 million of deferred tax assets are deemed attributes of Palm. Accordingly, we will not be able to use these deferred tax assets to offset our corresponding tax liabilities.

Business

Our revenues consist of license and royalty, and support and service revenues. We primarily generate revenues by licensing our software to mobile information device manufacturers. We also generate revenues from providing support and services to our licensees, from the Palm OS Ready program participants and from our online software store. Prior to the distribution, we presented revenues from Palm and Sony, a PalmSource stockholder, separately as related party revenues. Subsequent to the distribution, we present only revenues from Sony as related party revenues.

License and royalty revenues consist principally of revenues earned under software license agreements with manufacturers of mobile information devices. Historically, our license agreements with these manufacturers generally provided for an upfront license fee and additional royalties based on the number of units sold by the licensee incorporating Palm OS. However, we do not expect this trend of upfront payments to continue. We recognize license and royalty revenues when a signed contract exists, the software has been shipped or electronically delivered, the license fee is fixed or determinable, and collection of the resulting receivable is probable. License and royalty revenues from royalty fees are generally recognized on a per-unit or net sales royalty basis based on contractually reported information from licensees. Currently, the majority of our royalty revenue stream is derived from licensees with a royalty fee that is calculated on a net sales basis. The royalty rate generally ranges from 3% to 6% of net sales based on the average selling price of the licensee’s Palm Powered product. Payments received in advance of royalties being earned are recorded as deferred revenues. Our total deferred revenue balance at February 28, 2005 was $12.2 million, of which $7.9 million or 65% represents deferred balance for one single licensee.

Our license agreements with licensees may contain minimum commitments. For example, under the Palm software license agreement, minimum annual license and royalty commitments consist of $40.0 million, $37.5 million, $39.0 million, $41.0 million and $42.5 million during each of the contract years expiring on December 3, 2002, 2003, 2004, 2005, and 2006, respectively. Prior to the Handspring merger, Handspring had minimum license and royalty commitments of $1.5 million for each of Handspring’s fiscal quarters through the term of its license agreement with us. As a result of the Handspring merger, the Handspring license agreement terminated, we are no longer entitled to the $1.5 million quarterly minimum commitments and revenues from the sale of Handspring products may be used by palmOne to satisfy its minimum commitments. Accordingly, we lost $6.0 million in Handspring’s annual contractual minimum commitments through April 2009 and our combined revenues from palmOne and Handspring will decline if the merger does not result in significant increased sales. We calculate minimum commitment shortfalls on a quarterly or annual basis based on the terms of the respective license agreement. Shortfalls or otherwise known as top-up payments, if any, are recorded in the period that the minimum commitment becomes due to us.

Support revenues consist primarily of fees for providing software updates and technical support for software products to our licensees and service revenues represent product development, engineering services, consulting and training for our licensees and, to a lesser extent, to third-party application developers. Support revenues are deferred and recognized ratably over the term of the agreement. Service revenues are generally billed on a time-and-materials basis, and the revenues are generally recognized as the services are performed.

Historically, our licensees have experienced higher seasonal demand for their products, particularly PDA’s, during our second and third fiscal quarters. We believe that this seasonality is primarily the result of the winter holiday season. In addition, certain licensees, including palmOne, satisfy the remaining amount of their yearly minimum commitments, if necessary, in our third fiscal quarter. Historically, these factors have resulted in a substantial increase in revenues for our third fiscal quarter as compared to other quarters in the fiscal year. Recently, we have seen the mix of the products our licensees are shipping shift towards smartphones and other products that do not have the high seasonal demand that we have experienced historically. As a consequence, we are uncertain if, in the future, the trend of higher seasonal revenue during our third quarter will be as pronounced as it has been in the past, or whether it will be evident at all.

An important part of our strategy is to increase our international sales, particularly in the European and Asian markets. Certain countries in which we currently license or may in the future license our technology require significant withholding taxes on payments for intellectual property that we may not be able to offset against our U.S. tax obligations. In addition, international tax authorities may re-characterize some of our engineering fees as license fees, which could result in increased tax withholdings and penalties.

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Current Trends Affecting Our Operating Results

Concentration of Our Customers. We currently depend on palmOne for a large percentage of our revenues. Revenues and percentage of total revenues from palmOne, including Handspring, and Sony for the three and nine months ended February 28, 2005 and February 29, 2004 were as follows (in thousands):