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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED March 31, 2005

FOR THE TRANSITION PERIOD FROM ____________ TO ____________

Commission File Number: 0-22350

MERCURY INTERACTIVE CORPORATION

(Exact name of registrant as specified in its charter)

379 North Whisman Road, Mountain View, California 94043-3969

(Address of principal executive offices)

Registrant’s telephone number, including area code: (650) 603-5200

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 a 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 x NO ¨

The number of shares of Registrant’s Common Stock outstanding as of April 29, 2005 was 86,602,772.

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MERCURY INTERACTIVE CORPORATION

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PART I — FINANCIAL INFORMATION

Item 1. Unaudited Financial Statements

MERCURY INTERACTIVE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)

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

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MERCURY INTERACTIVE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

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

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MERCURY INTERACTIVE CORPORATION

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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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1—OUR SIGNIFICANT ACCOUNTING POLICIES

Basis of presentation

We have wholly-owned sales subsidiaries in the Americas; Europe, the Middle East and Africa (EMEA); Asia Pacific (APAC); and Japan for marketing, distribution and support of products and services. The Americas includes Brazil, Canada, Mexico, and the United States of America (the U.S.). EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, Poland, South Africa, Spain, Sweden, Switzerland, and the United Kingdom (the U.K.). APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. Research and development activities are primarily conducted in our Israeli subsidiary. The condensed consolidated financial statements include our accounts and those of our wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

These interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information, and the rules and regulations of the Securities and Exchange Commission (SEC) for interim financial statements and accounting policies, consistent, in all material respects, with those applied in preparing our audited consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004. The unaudited financial information furnished herein reflects all adjustments, consisting only of normal recurring adjustments, that in our opinion are necessary to fairly state our consolidated financial position, the results of operations, and cash flows for the periods presented. This Quarterly Report on Form 10-Q should be read in conjunction with our audited financial statements for the year ended December 31, 2004, included in the 2004 Form 10-K. The condensed consolidated statement of operations for the three months ended March 31, 2005 are not necessarily indicative of results to be expected for any subsequent periods or for the entire fiscal year ending December 31, 2005.

Stock-based compensation

We account for stock-based compensation for our employees using the intrinsic value method presented in Accounting Principles Board (APB) Statement No. 25, Accounting for Stock Issued to Employees, and related interpretations and comply with the disclosure provisions of Statement of Financial Accounting Standards No. 123 (SFAS No. 123), Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure Amendment of SFAS No. 123. Under APB No. 25, compensation expense is based on the difference, as of the date of the grant, between the fair value of our stock and the exercise price. No stock-based compensation was recorded for stock options granted to our employees because we have granted stock options to our employees equal to the fair market value of the underlying stock on the date of grant. We account for stock issued to non-employees in accordance with the provisions of SFAS No. 123 and 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. We do not issue stock options to non-employees, except for our non-employee members of the Board of Directors. For options granted to our non-employee members of the Board of Directors, we account for the stock-based compensation using the intrinsic value method under APB No. 25. We value stock options assumed in a purchase business combination at the date of acquisition at their fair value calculated using the Black-Scholes option-pricing model, in accordance with Financial Accounting Standard Board Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation, an interpretation of APB No. 25. The fair value of assumed options is included as a component of the purchase price. The intrinsic value attributable to unvested options is recorded as unearned stock-based compensation and amortized over the remaining vesting period of the stock options.

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

The following table illustrates the effect on net income and net income per share if we had applied the fair value recognition provisions under SFAS No. 123 to stock-based employee compensation (in thousands, except per share amounts):

We calculate stock-based compensation expense under the fair value based method for shares issued pursuant to the 1998 Employee Stock Purchase Plan (ESPP) based upon actual shares issued, except for the period since the most recent purchase in February 2005. We estimate the number of shares issuable under the 1998 ESPP based upon actual contributions made by employees for the period from February 16, 2005 through March 31, 2005 and the lower of the fair market value of our common stock on February 16, 2005 or March 31, 2005.

We amortize unearned stock-based compensation expense using the straight-line method over the vesting periods of the related options, which is generally over a four-year period for non-qualified and incentive stock options. We have not provided a tax rate benefit on stock-based compensation expense for the three months ended March 31, 2005 because it is more likely than not that all of the deferred tax assets associated with this expense will not be realized. For the three months ended March 31, 2004, we applied a tax rate to the stock-based employee compensation expense for non-qualified options issued pursuant to the stock option plans to reflect tax benefits associated with the exercise of these options. In accordance with SFAS No. 123, we did not apply a tax rate to the stock-based employee compensation expense for incentive stock options issued pursuant to the stock option plans and shares issued pursuant to the 1998 ESPP. To the extent a future event, such as an employee’s disqualifying disposition, can give rise to a tax deduction, the tax effects of such an event will be recognized at that time.

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock price volatility and expected life of an option. Prior to the first quarter of 2005, the expected volatility assumptions we used were solely based on the historical volatility of our common stock. In the first quarter of 2005, we have modified our approach to estimate the expected volatility by also considering the implied volatility in market-traded options on our common stock. In the first quarter of 2005, we have also revised the expected life assumption by considering the historical stock option exercise behavior of our employees. We believe the modified expected stock price volatility and expected option life are more indicative of future trends. Because our employee stock options have characteristics significantly different from those of traded options and because

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

changes in the subjective input assumptions can materially affect the fair value estimate, in our opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our options.

The fair value of stock options and shares issued pursuant to the stock option plans and the 1998 ESPP at the grant date were estimated with the following weighted average assumptions for the three months ended March 31, 2005 and 2004:

Based upon the above assumptions, the weighted average fair valuation per share of options granted under the option plans during the three months ended March 31, 2005 and 2004 was $16.00 and $29.90, respectively. The weighted average fair valuation per share of options granted under the 1998 ESPP during the three months ended March 31, 2005 and 2004 was $9.77 and $15.70, respectively.

Revenue recognition

Revenue consists of fees for license and subscription licenses of our software products, maintenance fees, and professional service fees. We apply the provisions of SOP No. 97-2, Software Revenue Recognition, as amended by SOP No. 98-9, Modification of SOP No. 97-2, Software Revenue Recognition, With Respect to Certain Transactions, to all transactions involving the sale of software products and services. In addition, we apply the provisions of EITF No. 00-03, Application of AICPA SOP No. 97-2 to Arrangements that Include the Right to Use Software Stored on Another Entity’s Hardware, to our managed services software transactions. We also apply EITF No. 01-09, Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Products, to account for transaction related sales incentives.

In the second quarter of 2003, we adopted EITF No. 00-21, Revenue Arrangements with Multiple Deliverables. EITF No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue-generating activities. The adoption of this EITF did not have a material impact on our consolidated financial statements and we continue to account for our revenues in accordance with SOP 97-2, Software Revenue Recognition.

License revenue consists of license fees charged for the use of our products licensed under perpetual or multiple year arrangements in which the license fee is separately determinable from undelivered items such as maintenance and/or professional services based on the fair market value. We recognize revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the product has been delivered, the fee is fixed or determinable, and collection of the resulting receivable is probable. Delivery generally occurs when product is delivered to a common carrier or the software is made available for download. At the time of the transaction, we assess whether the fee associated with our revenue transaction is fixed or determinable based on the payment terms associated with the transaction and whether or not collection is probable. If a significant portion of a fee is due after our normal payment terms, which are generally within 30-60 days of the invoice date, we account for the fee as not being fixed or determinable. In these cases, we recognize revenue at the earlier of cash collection or as the fees become due. We assess the probability of collection based on a number of factors, including past transaction history with the customer. We do not request collateral from our customers. If we determine that collection of a fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon receipt of cash. For all sales, except those completed over the Internet, we use either a customer order document or signed license or service agreement as evidence of an arrangement. For sales over the Internet, we use a credit card authorization as evidence of an arrangement.

Subscription revenue, including managed service revenue, consists of fees to use one or more software products, and to receive maintenance support (such as customer support and product updates) for a limited period of time. Since subscription licenses include bundled products and services which are sold as a combined product offering and for which the fair value of the license fee is not separately determinable from maintenance, both product and service revenue, is generally recognized ratably over the term of the subscription. Customers do not pay a set up fee associated with a subscription arrangement. Furthermore, if a perpetual license is sold

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

at the same time as a subscription-based license to the same customer, then the two generally become bundled together and are recognized ratably over the term of the contract.

Maintenance revenue consists of fees charged for post-contract customer support, which are determinable based upon vendor specific evidence of fair value. Maintenance fee arrangements include ongoing customer support and rights to product updates if and when available. Payments for maintenance are generally made in advance and are nonrefundable. Revenue is recognized ratably over the period of the maintenance contract.

Professional service revenue consists of fees charged for product training and consulting services, which are determinable based upon vendor specific evidence of fair value. Professional service revenue is recognized when the professional services are delivered, provided that all other revenue recognition requirements are met.

For arrangements with multiple elements (for example, undelivered maintenance and support), we allocate revenue to each component of the arrangement using the residual value method based on the fair value of the undelivered elements, which is specific to us. This means that we defer revenue from the arrangement fee equivalent to the fair value of the undelivered elements. Fair values for the ongoing maintenance and support obligations within an arrangement are based upon substantive renewal rates quoted in the contracts, and in the absence of stated renewal rates, upon separate sales of renewals to other customers. Fair value of services, such as training or consulting, is based upon separate sales of these services to other customers without the bundling of other elements. Most of our arrangements involve multiple elements. Our arrangements do not generally include acceptance clauses. However, if an arrangement includes an acceptance provision, revenue is deferred until the earlier of receipt of a written customer acceptance or expiration of the acceptance period.

We derive a portion of our business from sales of our products and services through our alliance partners, which include value-added resellers, and major systems integration firms.

Sales commissions

Commissions are paid to employees in the month after we receive an order. We sell our products under non-cancelable perpetual, subscription, or term contracts. Commissions are calculated as a percentage of the sales value of a signed contract or a customer signed purchase order. Commission rates vary by position, title, and the extent that employees may achieve rate accelerators by exceeding their quotas. Once earned, there is no ongoing performance obligation by the employees. Our policy is that commissions paid to employees are only refundable when we have to write off a customer receivable because it is uncollectible. We have historically enforced this refund right and will continue to enforce this policy in the future.

Deferred commissions represent deferred cost directly related to revenues that are partially or entirely deferred in accordance with our revenue recognition policy. Current deferred commissions are included as “Prepaid expenses and other assets” and non-current deferred commissions are included as “Other assets” in our condensed consolidated balance sheet. We record deferred commissions because there is future economic benefit in the form of future revenue and we have the ability to recoup or seek restitution for commissions paid to employees in accordance with our stated policy.

Advertising expense

We expense the costs of producing advertisements at the time production occurs and expense the cost of communicating advertising in the period during which the advertising space or airtime is used. For the three months ended March 31, 2005 and 2004, advertising expenses totaled $2.0 million and $1.6 million, respectively.

Reclassifications

Certain reclassifications have been made to the December 31, 2004 balances to conform to the March 31, 2005 presentation, specifically the break out of current and non-current deferred commissions balances. Certain reclassifications have been made to the condensed consolidated statement of operations for the three months ended March 31, 2004 presentation, specifically the reclassification of certain amortization of intangible assets to cost of revenue. These reclassifications had an immaterial impact on the prior reported balances and no impact on total revenues, income from operations, or net income.

In connection with our conclusion at the end of 2004 to classify auction rate securities as short-term investments, we have made adjustments to our condensed consolidated statement of cash flows for the three months ended March 31, 2004 to reflect the gross purchases and sales of these securities as investing activities rather than as a component of cash and cash equivalents. This change in classification does not affect previously reported cash flows from operations nor from financing activities in our previously reported condensed consolidated statements of cash flows, nor our previously reported condensed consolidated statements of operations for any periods. For the three months ended March 31, 2004, prior to this classification adjustment, net cash used in investing activities related

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

to these investments of $0.4 million was included in cash and cash equivalents in our condensed consolidated statement of cash flows.

Recent accounting pronouncements

In April 2005, the SEC amended the compliance dates for SFAS No. 123R, Shared-Based Payment. The new rule allows public companies to implement SFAS No. 123R at the beginning of their next fiscal year that begins after June 15, 2005. We will be required to adopt SFAS No. 123R in the first quarter of 2006 and begin to recognize stock-based compensation related to employee equity awards in our condensed consolidated statements of operations using a fair value based method on a prospective basis. Since we currently account for equity awards granted to our employees using the intrinsic value method under APB No. 25, we expect the adoption of SFAS No. 123R will have a significant adverse impact on our financial position and results of operations.

In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (SAB No. 107). SAB No. 107 covers key topics related to the implementation of SFAS No. 123R which include the valuation models, expected volatility, expected option term, income tax effects of SFAS No. 123R, classification of stock-based compensation cost, capitalization of compensation costs, and disclosure requirements. We expect the adoption of SAB No. 107 will have a significant adverse impact on our financial position and results of operations upon our adoption of SFAS No. 123R in the first quarter of 2006.

In March 2005, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations (FIN No. 47). FIN No. 47 clarifies that a company should record a liability for a conditional asset retirement obligation when incurred if the fair value of the obligation can be reasonably estimated. This interpretation further clarified conditional asset retirement obligation, as used in SFAS No. 143, Accounting for Asset Retirement Obligations, as a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. FIN No. 47 is effective for companies no later than the end of their fiscal year ending after December 15, 2005. We do not expect the adoption of FIN No. 47 to have an impact on our financial position and results of operations.

NOTE 2—SALES RESERVE

Our license agreements and reseller agreements do not offer our customers or vendors the unilateral right to terminate or cancel the contract and receive a cash refund. In addition, the terms of our license agreements do not offer customers price protection.

We provide for sales returns based upon estimates of potential future credits, warranty cost of product and services, and write-offs of bad debts related to current period product revenues. We analyze historical credits, historical bad debts, current economic trends, average deal size, changes in customer demand, and acceptance of our products when evaluating the adequacy of the sales reserve. Revenues for the period are reduced to reflect the provision for sales returns.

The following table summarizes changes in our sales reserve during the three months ended March 31, 2005 and 2004 (in thousands):

NOTE 3—CONSOLIDATION OF FACILITIES

On January 7, 2005, we sold the remaining vacant building we owned for $4.9 million in cash, net of $0.3 million in transaction fees, and recognized a gain of $0.3 million. The vacant building had been previously written down to its fair value and was recorded as an asset held for sale. As of March 31, 2005, we had sold all vacant buildings we previously owned.

NOTE 4—INVESTMENTS IN NON-CONSOLIDATED COMPANIES

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

At March 31, 2005, our equity investments in non-consolidated companies consisted of investments in privately-held companies of $4.1 million, a private equity fund of $8.6 million, and a warrant to purchase common stock of Motive, Inc. of $0.8 million. At December 31, 2004, our equity investments in non-consolidated companies consisted of investments in privately-held companies of $4.1 million, a private equity fund of $8.0 million, and the Motive warrant of $0.9 million. Through March 31, 2005, we made capital contributions to a private equity fund totaling $9.8 million and we have committed to make additional capital contributions up to $5.2 million in the future.

As of March 31, 2005, there were no impairment losses that were considered to be temporary and as such, there were no unrealized losses associated with our investments in privately-held companies and the private equity fund as of such date. Based on our review of the investments in privately-held companies and the private equity fund for the three months ended March 31, 2005 and 2004, impairment losses were considered to be other-than temporary. For the three months ended March 31, 2005, we recorded a loss of $0.1 million on our investment in the private equity fund and an unrealized loss of $0.1 million related to a change in fair value of the Motive warrant. For the three months ended March 31, 2004, we recorded a loss of $0.5 million on our investment in the private equity fund. The loss was partially offset by an unrealized gain of $0.4 million related to a change in fair value of the Motive warrant. In calculating the loss on our investments, we took into account the latest valuation of each of the companies based on recent sales of equity securities to unrelated third party investors and whether the companies have sufficient funds and financing to continue as a going concern for at least twelve months. We believe that the carrying value of our investments in non-consolidated companies approximated their fair value at March 31, 2005 and December 31, 2004.

We had not exercised the Motive warrant as of March 31, 2005. The fair value of the Motive warrant as of the periods indicated below was calculated using the Black-Scholes option-pricing model with the following inputs:

In February 2004, one of the privately-held companies in which we had an equity investment was acquired by a public company. We received $1.5 million in cash and common stock of the public company. In May 2004, we sold this common stock and recognized a gain of approximately $0.3 million. In March 2005, we received additional cash of $0.4 million and common stock from the public company as a result of a distribution made from the escrow account in connection with the acquisition. We recorded a gain of $1.0 million upon the receipt of cash proceeds and the common stock. The common stock is treated as available-for-sale securities and is reported at fair value, based on the quoted market price. At March 31, 2005, the fair value of the common stock was $0.7 million. The unrealized gain, net of tax, was $14,000 as of March 31, 2005.

NOTE 5—GOODWILL AND INTANGIBLE ASSETS

There were no business acquisitions during the first quarter of 2005. The changes in the carrying amount of goodwill for the three months ended March 31, 2005 are as follows (in thousands):

The carrying amounts of intangible assets are as follows (in thousands):

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

The weighted average amortization period of existing technology is 42 months, patents and core technology is 57 months, employment agreements is 18 months, maintenance and support contracts is 70 months, customer contracts and other intangible assets is 38 months, and domain name is 60 months. The weighted average amortization period of all intangible assets is 47 months. The aggregate amortization expense of intangible assets was $3.9 million for both the three months ended March 31, 2005 and 2004. Amortization of intangible assets related to our current products are recorded as “Cost of revenue—amortization of intangible assets” in our condensed consolidated statements of operations. The following table shows the breakdown of amortization of intangible assets recorded in the condensed consolidated statements of operations for the periods indicated (in thousands):

Future amortization of intangible assets at March 31, 2005 is as follows (in thousands):

NOTE 6—LONG-TERM DEBT

In July 2000, we issued $500.0 million in 4.75% Convertible Subordinated Notes due July 1, 2007 (2000 Notes). The 2000 Notes mature on July 1, 2007 and bear interest at a rate of 4.75% per annum, payable semiannually on January 1 and July 1 of each year. The 2000 Notes are subordinated in right of payment to all of our future senior debt. The 2000 Notes are convertible into shares of our common stock at any time prior to maturity at a conversion price of approximately $111.25 per share, subject to adjustment under certain conditions. We may redeem the 2000 Notes, in whole or in part, at any time on or after July 1, 2003. If we redeem the 2000 Notes, we will pay accrued interest to the redemption date. We did not redeem any portion of the 2000 Notes since the original issuance through March 31, 2005. From December 2001 through March 31, 2005, we retired $200.0 million face value of the 2000 Notes.

In connection with the issuance of our 2000 Notes, we incurred $14.6 million of issuance costs, which primarily consisted of investment banker, legal, and other professional fees. In conjunction with the retirement of a portion of our 2000 Notes, we wrote-off

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

$3.8 million of debt issuance costs. The remaining costs are being amortized on a straight-line basis over the remaining term of the 2000 Notes. Amortization expense related to the issuance costs was $0.3 million for both the three months ended March 31, 2005 and 2004. At March 31, 2005 and December 31, 2004, net debt issuance costs associated with our 2000 Notes were $3.0 million and $3.3 million, respectively.

In April 2003, we issued $500.0 million of Zero Coupon Senior Notes due 2008 (2003 Notes) in a private offering. The 2003 Notes do not bear interest, have a zero yield to maturity and are convertible into shares of our common stock. Holders of the 2003 Notes may convert their 2003 Notes prior to maturity only if:

Upon conversion, we have the right to deliver cash instead of shares of our common stock. We may not redeem the 2003 Notes prior to their maturity.

In connection with the issuance of our 2003 Notes, we incurred $11.9 million of issuance costs, which primarily consisted of investment banker, legal, and other professional fees. These costs are being amortized on a straight-line basis over the term of the 2003 Notes. Amortization expense related to the issuance costs was $0.6 million and $0.7 million for the three months ended March 31, 2005 and 2004, respectively. At March 31, 2005 and December 31, 2004, net debt issuance costs associated with our 2003 Notes were $7.4 million and $8.0 million, respectively.

NOTE 7—COMMITMENTS AND CONTINGENCIES

Royalty agreement

On June 30, 2003, we entered into a non-exclusive agreement (amended in February 2004) to license technology from Motive. The agreement is non-transferable, except in the case of a merger, acquisition, spin-out or other transfer of all or substantially all of the business, stock or assets to which the agreement relates. The licensed technology will be combined with our other existing products, which should be generally available in early 2006. The agreement is in effect until December 31, 2006 with a right to renew and an option to purchase a fully paid up, perpetual license to the technology prior to July 1, 2008. In accordance with the agreement, we made royalty payments totaling $15.0 million for the licensed technology as well as maintenance and support services through December 31, 2005. We recorded such payments as prepaid royalties. We have also committed to pay $0.4 million for additional maintenance and support service from January 1 through December 31, 2006. The payment is due on December 31, 2005. Prepaid royalties are included in “Prepaid expenses and other assets” in our condensed consolidated balance sheet and will be amortized to

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

cost of license and subscription at the greater of the actual revenue over total forecasted revenue or straight line over the estimated useful life of the licensed technology.

Lease commitments

We lease facilities for our headquarters and sales offices in the U.S. and foreign locations primarily under non-cancelable operating leases that expire through 2015. Certain of these leases contain renewal options. We lease certain equipment under various lease agreements with lease terms ranging from month-to-month up to one year. In February 2005, we entered into a sublease agreement to sublease additional buildings at our headquarters in Mountain View, California. The sublease for additional buildings begins in May and July 2005 and expires in March 2013. Future minimum payments for all of our leased facilities, including the two vacant facilities from the Kintana acquisition are included in the following tables.

Future payments due under the lease, royalty, and license agreements at March 31, 2005 are as follows (in thousands):

Letters of credit

As of March 31, 2005, we had four outstanding irrevocable letter of credit agreements totaling $2.2 million with Wells Fargo & Company (Wells Fargo). These letter of credit agreements were drawn out of a $5.0 million letter of credit line issued on February 2005. Two of the letter of credit agreements are related to facility lease agreements assumed by us in conjunction with the acquisition of Kintana in 2003 and Freshwater in 2001. These agreements expire on March 1, 2006 and August 31, 2006, respectively. The third agreement is related to the facility lease agreement for our new headquarters in Mountain View, California. This agreement automatically renews annually unless we provide a termination notice to Wells Fargo. The fourth letter of credit agreement is issued in connection with the new sublease agreement we executed to lease additional buildings at our Mountain View headquarters. This agreement expires on March 26, 2013.

Contingencies

From time to time, we may have certain contingent liabilities that arise in the ordinary course of our business activities. We accrue for contingent liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. In the opinion of management, there are no pending claims of which the outcome is expected to result in a material adverse effect on our financial position, results of operations, or cash flows.

NOTE 8—GUARANTEES

We warrant that our software products will perform in all material respects in accordance with our standard published specifications in effect at the time of delivery of the licensed products to the customer for the life of the product. Additionally, we warrant that our maintenance services will be performed consistent with generally accepted industry standards through completion of the agreed upon services. If necessary, we would provide for the estimated cost of product and service warranties based on specific warranty claims and claim history. We have not incurred significant expense under our product or service warranties. As a result, we believe the estimated fair value on our product and service warranties is minimal. Accordingly, we have no liabilities recorded for our product or service warranties at March 31, 2005.

When, as part of an acquisition, we acquire all of the stock or all of the assets and liabilities of a company, we assume the liability for certain events or occurrences that took place prior to the date of acquisition. We are not aware of any potential obligations arising as a result of acquisitions completed prior to March 31, 2005 that were not included in the purchase price. Accordingly, we have no liabilities recorded for these types of agreements as of March 31, 2005.

As permitted under Delaware law, we have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

for the officer’s or director’s term in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have a director and officer insurance policy that limits our exposure and enables us to recover a portion of any future amounts to be paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal. Accordingly, we have no liabilities recorded for these agreements as of March 31, 2005.

We enter into standard indemnification agreements in the ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners, subsidiaries and/or customers, in connection with any U.S. patent, any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is insignificant. Accordingly, we have no liabilities recorded for these agreements at March 31, 2005.

We may, at our discretion and in the ordinary course of business, subcontract the performance of any of our services. Accordingly, we enter into standard indemnification agreements with our customers, whereby they are indemnified for other acts, such as personal property damage, of our subcontractors. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have general and excess insurance policies that enable us to recover a portion of any amounts paid. We have not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is insignificant. Accordingly, we have no liabilities recorded for these agreements at March 31, 2005.

We have arrangements with certain vendors whereby we guarantee the expenses incurred by certain of our employees. The term is from execution of the arrangement until cancellation and payment of any outstanding amounts. We would be required to pay any unsettled employee expenses upon notification from the vendor. The maximum potential amount of future payments we could be required to make under these indemnification agreements is insignificant. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements at March 31, 2005.

NOTE 9—EMPLOYEE BENEFIT PLAN

In the first quarter of 2005, certain employees, including our named executive officers, participated in the Mercury Long-Term Incentive Plan (Incentive Plan). The Incentive Plan was previously adopted by the Compensation Committee of our Board of Directors in December 2004 and amended in February 2005. The amounts and payments of cash awards under the Incentive Plan will be based on the attainment of financial goals set for 2005, the performance period, and the completion of a two-year vesting period subsequent to the performance period. We recognize expense related to these cash awards over a three-year period.

NOTE 10—NET INCOME PER SHARE

Net income per share is calculated in accordance with the provisions of SFAS No. 128, Earnings Per Share and EITF No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earning Per Share. Under these accounting standards, public companies are required to report both basic and diluted net income. Basic net income per share consists of the weighted-average number of common shares outstanding for the period, excluding unvested restricted common stock. Diluted net income per share includes the weighted-average number of common shares outstanding, incremental common stock from assumed exercise of dilutive stock options and unvested restricted common stock, and dilutive common stock issuable upon the conversion of our 2003 Notes as required by EITF No. 04-8.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

The following table summarizes our net income per share computations for the periods indicated (in thousands, except per share amounts):

For the three months ended March 31, 2005, options to purchase 7,664,000 shares of common stock with a weighted average exercise price of $56.95 were considered anti-dilutive because the options’ exercise price was greater than the average fair market value of our common stock for the period then ended. For the three months ended March 31, 2004, options to purchase 5,131,000 shares of common stock with a weighted average exercise price of $63.88 were considered anti-dilutive. For each of the three months ended March 31, 2005 and 2004, common stock reserved for issuance upon conversion of the outstanding 2000 Notes for 2,697,000 shares were not included in diluted earnings per share because the conversion would be anti-dilutive. Upon our adoption of EITF No. 04-8 in the fourth quarter of 2004, 9,673,050 shares issuable from the conversion of the 2003 Notes are included in the diluted net income per share computation, unless these shares are deemed to be anti-dilutive. Diluted share and per share amounts for the three months ended March 31, 2004 have been retroactively adjusted to reflect the inclusion of the 9,673,050 shares related to the conversion of our 2003 Notes. The inclusion of these shares resulted in a decrease of $0.01 to previously reported diluted net income per share for the three months ended March 31, 2004.

NOTE 11—INCOME TAXES

The effective tax rates for the three months ended March 31, 2005 and 2004 differ from statutory tax rates principally because of our participation in taxation programs in Israel. This tax structure is dependent upon continued reinvestment in our Israeli operations. Other factors that cause the effective tax rate and statutory tax rates to differ include the treatment of charges for amortization of intangible assets, stock-based compensation, and in-process research and development.

NOTE 12—SUPPLEMENTAL CASH FLOW DISCLOSURES

Supplemental cash flow disclosures are as follows (in thousands):

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(unaudited)

NOTE 13—COMPREHENSIVE INCOME

We report components of comprehensive income in our annual consolidated statements of shareholders’ equity. Comprehensive income consists of net income, foreign currency translation adjustments, and unrealized gain from available-for-sale marketable equity securities. Total comprehensive income for the three months ended March 31, 2005 and 2004 is as follows (in thousands):

NOTE 14—DERIVATIVE FINANCIAL INSTRUMENTS

We comply with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The standard requires us to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through the statements of operations. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings, or recognized in other comprehensive income (loss) until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. The accounting for gains or losses from changes in fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship, as well as on the type of hedging relationship.

We enter into forward contracts to manage foreign currency exposures related to certain foreign currency denominated intercompany balances attributable to subsidiaries and foreign offices in the Americas, EMEA, APAC, and Japan. Additionally, we may adjust our foreign currency hedging position by taking out additional contracts, terminating, or offsetting existing forward contracts. These adjustments may result from changes in the underlying foreign currency exposures. We do not enter into forward contracts for speculative or trading purposes. The criteria used for designating a forward contract as a hedge includes its effectiveness in reducing risk by matching the hedging instruments to underlying intercompany balances. Gains or losses on forward contracts are recognized in other income or expense in the same period as gains or losses on the underlying revaluation of intercompany balances. We had outstanding forward contracts with notional amounts totaling $33.1 million and $31.2 million at March 31, 2005 and December 31, 2004, respectively. The forward contracts in effect at March 31, 2005 were hedges of certain foreign currency transaction exposures in the Australian Dollar, British Pound, Danish Kroner, Euro, Indian Rupee, Japanese Yen, Korean Won, Norwegian Kroner, South African Rand, Swedish Kroner, and Swiss Franc.

We also utilize forward exchange contracts of one fiscal-month duration to offset translation gains and losses of various non-functional currency exposures that occur with foreign currency market fluctuations. Currencies hedged under this program include the Canadian Dollar, Hong Kong Dollar, Israeli Shekel, and Singapore Dollar. Increases or decreases in the value of these non-functional currency assets are offset by gains or losses on the forward exchange contracts. We had outstanding forward contracts with notional amounts totaling $18.8 million and $23.7 million at March 31, 2005 and December 31, 2004, respectively.

The forward contracts in effect at March 31, 2005 had only one fiscal-month duration and they matured on April 29, 2005.

These forward exchange contracts contain credit risk in that the counterparties may be unable to meet the terms of the agreements. However, we minimize such risk of loss by limiting these agreements to major financial institutions. We also monitor closely the potential risk of loss with any one financial institution. We do not expect any material losses as a result of default by counterparties.

In January and February, 2002, we entered into two interest rate swaps with respect to $300.0 million of our 2000 Notes. In November 2002, we merged the two interest rate swaps with Goldman Sachs Capital Markets, L.P. (GSCM) into a single interest rate swap with GSCM to improve the overall effectiveness of our interest rate swap arrangement. The November interest rate swap of $300.0 million, with a maturity date of July 2007, is designated as an effective hedge of the change in the fair value attributable to the London Interbank Offering Rate (LIBOR) of our 2000 Notes. The objective of the swap is to convert the 4.75% fixed interest rate on the 2000 Notes to a variable interest rate based on the 3-month LIBOR plus 48.5 basis points. The gain or loss from changes in the fair value of the interest rate swap is expected to be highly effective at offsetting the gain or loss from changes in the fair value attributable to changes in LIBOR throughout the life of the 2000 Notes. The interest rate swap creates a market exposure to changes in LIBOR. Under the terms of the swap, we provided initial collateral in the form of cash or cash equivalents to GSCM in the amount of $6.0

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

million as continuing security for our obligations under the swap (irrespective of movements in the value of the swap) and from time to time additional collateral can change hands between us and GSCM as swap rates and equity prices fluctuate. We classified the initial collateral and will classify any additional collateral as restricted cash in our condensed consolidated balance sheet. If the price of our common stock exceeds the original conversion or redemption price of the 2000 Notes, we will be required to pay the fixed rate of 4.75% and receive a variable rate on the $300.0 million principal amount of the 2000 Notes. If we call the 2000 Notes at a premium (in whole or in part), or if any of the holders of the 2000 Notes elected to convert the 2000 Notes (in whole or in part), we will be required to pay a variable rate and receive the fixed rate of 4.75% on the principal amount of such called or converted 2000 Notes.

Our interest rate swap qualifies under SFAS No. 133 as a fair-value hedge. We record the fair value of our interest rate swap and the change in the fair value of the underlying 2000 Notes attributable to changes in the LIBOR in our condensed consolidated balance sheet, and we record the ineffectiveness arising from the difference between the two fair values in our condensed consolidated statement of operations as “Other expense, net.” At March 31, 2005 and December 31, 2004, the fair value of the swap was approximately $24,000 and $4.8 million, respectively, and the change in the fair value of our 2000 Notes attributable to changes in the LIBOR during the period resulted in a decrease to the carrying value of our 2000 Notes of $346,000 and $4.5 million, respectively. The unrealized gains on the interest rate swap were less than $0.1 million for each of the three months ended March 31, 2005 and 2004, respectively. At March 31, 2004 and December 31, 2004, our total restricted cash associated with the swap was $6.0 million.

We have credit exposure with respect to GSCM as counterparty under the swap. However, we believe that the risk of such credit exposure is limited because GSCM is an affiliate of a major U.S. investment bank and because its obligations under the swap are guaranteed by the Goldman Sachs Group L.P.

For the three months ended March 31, 2005 and 2004, we recorded interest expense of $2.3 million and $1.2 million, respectively, and interest income of $3.6 million and $3.6 million, respectively, as a result of our interest rate swap. Our net interest expense, including the interest paid on our 2000 Notes, was $2.3 million and $1.2 million for the three months ended March 31, 2005 and 2004, respectively.

NOTE 15—SEGMENT AND GEOGRAPHIC REPORTING

We organize, manage, and analyze our business geographically. The reportable operating segments are: the Americas, EMEA, APAC, and Japan. We operate in one industry segment: the development, marketing, and selling of integrated application delivery, application management, and IT governance solutions. Our chief decision makers rely on internal management reports, which provide contribution margin analysis by geographic locations, to make financial decisions and allocate resources. Contribution margin consists of revenues from third parties less costs and expenses over which management of the geographic regions can directly control. These costs and expenses are primarily personnel-related costs for supporting our customer service, professional service, managed service, and sales organizations. Other operating segment costs and expenses are excluded from the internal management reporting as our chief decision makers do not use the information to evaluate the operating segment performance. Other operating segment costs and expenses include research and development costs, general and administrative expenses, marketing costs, information technology infrastructure expenses, and other costs not allocated to the geographic locations. Revenues from third parties are attributed to a country primarily based on the location where the invoice is issued. The following table summarizes the financial performance of our operating segments for periods indicated (in thousands):

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

The following table highlights the percentages of third party revenues from countries that exceeded 10% of the total revenues and international revenues as a percentage of total revenues from third parties for periods indicated (in thousands):

Long-lived assets, which mainly consist of property and equipment, are attributed to a country primarily based on the physical locations of the assets. Property and equipment, net of accumulated depreciation, summarized by for our operating segments is as follows (in thousands):

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(unaudited)

Property and equipment, net:

Operations located in the U.S. accounted for 63% and 67% of the consolidated identifiable assets at March 31, 2005 and December 31, 2004, respectively. Operations located in Israel accounted for 30% and 25% of the consolidated identifiable assets at March 31, 2005 and December 31, 2004, respectively.

Although we operate in one industry segment, our chief decision makers evaluate net revenues based on the components of application delivery, application management, and IT governance. The following tables present revenues for application delivery, application management, and IT governance for the three months ended March 31, 2005 and 2004 (in thousands):