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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2005

OR

For the transition period from                      to                     

COMMISSION FILE NO. 000-26937

QUEST SOFTWARE, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (949) 754-8000

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  x    No  ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)

Yes  x    No  ¨

The number of shares outstanding of the Registrant’s Common Stock, no par value, as of April 27, 2005, was 96,676,724.

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QUEST SOFTWARE, INC.

FORM 10-Q

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PART I—FINANCIAL INFORMATION

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See Note 3 for details of assets acquired and liabilities assumed in purchase transactions.

See accompanying notes to condensed consolidated financial statements.

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QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS

(In thousands)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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QUEST SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Basis of Presentation

Our accompanying unaudited condensed consolidated financial statements as of March 31, 2005 and for the three months ended March 31, 2004 and 2005, reflect all adjustments (consisting of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These financial statements should be read in conjunction with the audited financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2004. The results for the interim periods presented are not necessarily indicative of the results that may be expected for any future period.

Recently Issued Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), that upon implementation, will impact our net income and net income per share and change the classification of certain elements in the statement of cash flows. SFAS 123R eliminates the alternative to use the intrinsic value method of accounting under SFAS No. 123 and supersedes Accounting Principles Board (“APB”) Opinion No. 25, and its related implementation guidance. Under APB Opinion No. 25, no compensation expense is recognized for options granted to employees where the exercise price equals the market price of the underlying stock on the date of grant. SFAS 123R will require us to measure all employee stock-based compensation awards using a fair value method and record such amounts as an expense in our statement of operations, on a prospective basis, as the underlying options vest. In April 2005, the Securities and Exchange Commission amended the compliance dates for SFAS 123R to require adoption at the beginning of fiscal years beginning after June 15, 2005. We are required to adopt SFAS 123R in our first quarter of 2006, with expensing to begin January 1, 2006. See “Stock Based Compensation” in Note 2 of these “Notes to Condensed Consolidated Financial Statements” for the pro forma net income and net income per share amounts, for the three months ended March 31, 2005 and 2004, as if we had used one of the fair-value-based methods, similar to the methods available under SFAS 123R, to measure compensation expense for employee stock incentive awards. While we are still evaluating the requirements under and effects of SFAS 123R we expect the adoption to have a significant adverse impact on our consolidated income from operations, net income and net income per share.

In December 2004, the FASB issued FASB Staff Position No. FAS 109-1 (“FAS 109-1”), “Application of FASB Statement No. 109, “Accounting for Income Taxes,” to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (“AJCA”).” The AJCA introduces a special 9% tax deduction on qualified production activities, which is phased in through 2010. FAS 109-1 clarifies that this tax deduction should be accounted for as a special tax deduction in accordance with Statement 109. This provision may provide a tax benefit to us from both a financial statement effective tax rate perspective and as a deduction on our tax return, which may effectively reduce the amount of taxes owed.

In December 2004, the FASB issued FASB Staff Position No. FAS 109-2 (“FAS 109-2”), “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creations Act of 2004.” The AJCA introduces a limited time 85% dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. FAS 109-2 provides accounting and disclosure guidance for the repatriation provision. We expect to complete our evaluation of the effects of the repatriation provision by the end of the third quarter of 2005.

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

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2. Stock Based Compensation

We account for stock-based awards to employees using the intrinsic value method, as prescribed by Accounting Principles Board (“APB”) Opinion No. 25 “Accounting for Stock Issued to Employees” and interpretations thereof. Under APB Opinion 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. Generally, the exercise price of options granted under our stock option plans is equal to the market value of the underlying stock on the date of grant, thereby giving rise to no compensation expense. We value stock options assumed in purchase business combinations at the date of acquisition at their fair value calculated using the Black-Scholes option-pricing model. The purchase price of these business combinations includes the fair value of assumed vested options while the intrinsic value attributable to unvested options is recorded as unearned compensation and amortized over the remaining vesting period of the stock options. We record compensation costs from additional payroll taxes incurred when employees exercise stock options based on the difference between the exercise price and the market price on the date of exercise.

Pro forma information regarding net income and earnings per share is required by SFAS No. 123 “Accounting for Stock Based Compensation.” This information is required to be determined as if we had accounted for our employee stock options and stock purchase plans under the fair value based method. Had compensation cost been determined using the fair value method our net income would have been adjusted to the pro forma net income (loss) amounts indicated below (in thousands, except per share data):

For purposes of estimating the compensation cost of our option grants the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. 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. We use projected volatility rates, which are based upon historical volatility rates trended into future years. Because our employee stock options 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 management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our options. These fair value calculations for options granted in the three months ended March 31, 2005 and 2004 are based on the following assumptions:

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3. Acquisitions

We acquired Wingra Technologies, LLC (“Wingra”), a provider of messaging integration and migration solutions, during the three months ended March 31, 2005. The purchase price for the transaction, consisting primarily of cash, totaled $13.1 million, and was preliminarily allocated as follows: $8.0 million to goodwill, $3.4 million to purchased technology, $1.1 million to in-process research and development, $0.6 million to other purchased intangibles, $1.0 million to total assets acquired and $(1.0) million to total liabilities assumed. Goodwill is expected to be deductible for tax purposes and was assigned to our business segments as follows: $6.4 million to the licenses segment and $1.6 million to the services segment. The purchase price allocation is preliminary and subject to change based upon additional information related to the valuation of certain intangible assets. Actual results of operations of Wingra are included in our condensed consolidated financial statements from January 18, 2005, the effective date of this acquisition. The pro forma impact of the Wingra acquisition was not significant to the periods presented.

On March 17, 2004, we acquired Aelita Software Corporation (“Aelita”), a leading provider of systems management solutions for Microsoft Active Directory and Microsoft Exchange products. The acquisition expands our product portfolio of solutions to simplify, automate and secure increasingly complex Microsoft infrastructures. The purchase price for Aelita was $117.3 million, consisting of $102.0 million in cash, the assumption of Aelita stock options valued at $13.4 million using the Black-Scholes option pricing model and direct acquisition costs of $1.9 million. The intrinsic value of unvested stock options of $4.0 million was allocated to unearned compensation and is being recognized as a non-cash compensation expense. Of the cash paid for this acquisition, $15.8 million was deposited in escrow to satisfy certain indemnification obligations of the selling shareholders. In-process research and development of $6.7 million was expensed immediately upon completion of the acquisition. Goodwill in the amount of $67.4 million and $19.0 million was assigned to the license and service segments, respectively, of our business and is not expected to be deductible for tax purposes. Goodwill allocation of 78% to licenses and 22% to services is based on both historical and projected relative contribution from licenses and services revenues.

In connection with our acquisition of Aelita, the merger agreement requires us to make certain payments to the former stockholders of Aelita in respect of assumed Aelita options that are prematurely forfeited within eighteen months of the acquisition date. We estimate the maximum possible exposure to be approximately $2.8 million as of March 31, 2005, and any such payments will be considered additional purchase price. As of March 31, 2005, we have accrued an obligation of $0.5 million representing the amount we estimate to become payable under this provision based on assumed Aelita options which have been prematurely forfeited through March 31, 2005, which amount is recorded on the balance sheet in other accrued expenses.

Actual results of operations of Aelita are included in our condensed consolidated financial statements from March 17, 2004, the effective date of this acquisition. The unaudited financial information in the table below summarizes the combined results of operations of Quest and Aelita, on a pro forma basis, as though the companies had been combined as of the beginning of the period presented, and combines the historical results for Quest for the three months ended March 31, 2004 and Aelita’s historical results for the period from January 1, 2004 to March 17, 2004. The pro forma financial information includes amortization of identified intangibles and unearned compensation charges of $1.6 million and $0.4 million, respectively, that we would have recognized had the Aelita acquisition closed on January 1, 2004. The pro forma data is presented for informational purposes only and is not necessarily indicative of the results of future operations nor of the actual results that would have been achieved had the acquisition taken place at the beginning of the period presented (in thousands, except per share data):

4. Goodwill and Amortizing Intangible Assets

Amortizing intangible assets are comprised of the following (in thousands):

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Amortization expense for amortizing intangible assets was $3.5 million and $2.2 million for the three months ended March 31, 2005 and 2004, respectively. Estimated annual amortization expense related to amortizing intangible assets by fiscal year is as follows:

All intangible assets currently recorded will be fully amortized by the end of 2010.

The changes in the carrying amount of goodwill by reportable operating segment for the three months ended March 31, 2005 are as follows (in thousands):

5. Obligation Under Repurchase Agreement

We entered into a repurchase agreement in March 2004, utilizing $67.6 million of our investment securities as collateral. The cash proceeds of this transaction were used to provide funding for our acquisition of Aelita and our purchase of a new office facility. Our remaining obligation under this agreement of $12.7 million was paid in full in February 2005.

6. Income Tax Provision

The effective income tax rate for the three months ended March 31, 2005 was 33% compared to 91% in the comparable period of 2004. The significant tax rate in the first quarter of 2004 was primarily due to a permanent difference between GAAP pre-tax income and taxable income as a result of a $6.7 million non-deductible write-off of Aelita’s in-process research and development in the three months ended March 31, 2004.

7. Other (Expense) Income, Net

Other (expense) income, net consists of the following (in thousands):

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8. Net Income Per Share

Basic earnings per share is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities by including other common stock equivalents, including stock options, in the weighted-average number of common shares outstanding for a period, if dilutive.

The table below sets forth the reconciliation of the denominator of the earnings per share calculation (in thousands):

9. Geographic and Segment Information

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by our chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. Our operating segments are managed separately because each segment represents a strategic business unit that offers different products or services.

Our reportable operating segments are Licenses and Services. The Licenses segment develops and markets licenses to use our software products. The Services segment provides after-sale support for software products and fee-based training and consulting services related to our software products.

We do not separately allocate operating expenses to these segments, nor do we allocate specific assets to these segments. Therefore, segment information reported includes only revenues, cost of revenues, and gross profit.

Reportable segment data is as follows (in thousands):

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Revenues are attributed to geographic areas based on the location of the entity to which the products or services were delivered. Revenues and long-lived assets concerning principal geographic areas in which we operate are as follows (in thousands):

10. Commitments and Contingencies

In December 2004, we entered into an agreement to purchase a building located in Aliso Viejo, California, adjacent to our existing Aliso Viejo building, comprising approximately 89,000 square feet for approximately $19 million. The completion of the purchase is expected to occur by May 31, 2005.

In March 2005, we settled our lawsuit with Computer Associates International, Inc. for $16.0 million plus royalties under a non-exclusive license agreement. The settlement was fully accrued for in fiscal 2004 and did not impact our operating results for the current quarter. We have resumed marketing and licensing of our Quest Central for DB2 products and providing full support for this solution to our customers.

We are a party to a variety of immaterial litigation proceedings and claims, either asserted or unasserted, which we consider to be routine and incidental to our business. While the outcome of any of these matters cannot be predicted with certainty, we do not believe the outcome of any of these proceedings or claims will have a material adverse effect on our consolidated financial position, results of operations or cash flows.

In the normal course of our business, we enter into certain types of agreements that require us to indemnify or guarantee the obligations of other parties. These commitments include (i) intellectual property indemnities to licensees of our software products, (ii) indemnities to certain lessors under office space leases for certain claims arising from our use or occupancy of the related premises, or for the obligations of our subsidiaries under leasing arrangements, (iii) indemnities to customers, vendors and service providers for claims based on negligence or willful misconduct of our employees and agents, (iv) indemnities to our directors and officers to the maximum extent permitted under applicable law, and (v) letters of credit and similar obligations as a form of credit support for our international subsidiaries and certain resellers. The terms and duration of these commitments varies and, in some cases, may be indefinite, and certain of these commitments do not limit the maximum amount of future payments we could become obligated to make thereunder; accordingly, our actual aggregate maximum exposure related to these types of commitments cannot be reasonably estimated. Historically, we have not been obligated to make significant payments for obligations of this nature, and no liabilities have been recorded for these obligations in our financial statements included in this report, as the estimated fair value of these obligations as of March 31, 2005 was considered nominal.

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11. Related Party Transactions; Subsequent Event

On March 17, 2004, we acquired Aelita Software Corporation. See Note 3 above. Certain venture capital funds associated with Insight Venture Partners (the “Insight Funds”) previously holding shares of Aelita’s preferred stock became entitled to receive (subject to claims against an indemnity escrow fund) approximately $47.6 million in cash in respect of those shares of preferred stock as a result of this acquisition.

On April 26, 2005, Quest Software entered into an Agreement and Plan of Merger with Imceda Software, Inc. (“Imceda”), a privately held company that provides systems, storage and database management solutions, contemplating the acquisition of Imceda by Quest in a transaction valued at approximately $60.6 million, of which 20% will be paid to Imceda’s stockholders in Quest Software Common Stock. Closing of the contemplated transaction is subject to customary closing conditions, including expiration of the applicable Hart-Scott-Rodino waiting period, and is expected to be completed by the end of the second quarter of 2005. We expect to fund the cash portion of the consideration to be paid in this acquisition from our available cash and marketable securities and cash generated from operations. The Insight Funds hold shares of Imceda’s preferred stock, and will be entitled upon the closing of the transaction to receive (in respect of those shares of preferred stock) cash and (subject to claims against an indemnity escrow fund) shares of Quest Software common stock representing an aggregate value (based on the manner in which Quest Software common stock is valued under the Agreement and Plan of Merger) of approximately $47.3 million.

Jerry Murdock, a director of Quest Software, is a Managing Director and the co-founder of Insight Venture Partners and an investor in the Insight Funds. Vincent Smith, Quest’s Chairman of the Board and CEO, and Ray Lane and Paul Sallaberry, directors of Quest Software, are passive limited partners in Insight Funds and, as a result, have interests in the Aelita transaction and the proposed Imceda transaction which are considered to be not material.

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

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

Overview and Business Model

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

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Our revenue consists primarily of software license fees and maintenance fees from customers. Our software-licensing model is primarily based on perpetual license fees, and our license fees are typically calculated either on a per-server basis or a per seat basis, depending on the product. Maintenance contracts entitle a customer to technical support via telephone and the internet and unspecified maintenance releases, updates and enhancements. First-year maintenance contracts are typically sold with the related software license and renewed on an annual basis thereafter. Annual maintenance renewal fees are priced as a percentage of the net initial purchase fee of a perpetual license and first year maintenance. Maintenance revenue is based on vendor-specific objective evidence of fair value and amortized over the term of the maintenance contract, typically 12 months. We also provide consulting and training services, which relate to installation of our products and do not include significant customization to or development of the underlying software code. Consulting and training service revenues are recognized as the services are performed and represent approximately 12% of total services revenues for the three months ended March 31, 2005.

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

Quarterly Update

As discussed in more detail throughout our MD&A:

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Results of Operations

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

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Comparison of Three Months Ended March 31, 2005 and 2004

Revenues

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

Licenses Revenues — Growth in license revenues is primarily a result of increased software license sales within our Microsoft Systems Management product line, of which our Aelita products contributed approximately one-half of the overall license revenues growth. The license revenues contribution from the acquired Aelita products have become less identifiable because we have created product suites comprising both Aelita and Quest Microsoft Systems Management products and because in some cases Aelita products have replaced comparable Quest products. North American license revenues from our Microsoft Systems Management product line was approximately 45% higher in the first quarter of 2005 over the comparable period in 2004, but was offset entirely by the fact that we had significantly reduced revenue contribution during the first quarter of 2005 from our Quest Central for DB2 products (affected by the preliminary injunction issued in our litigation with Computer Associates) and our former Vista Plus output management products (which were sold during the third quarter of 2004). We noted particular strength in license revenues growth from our Microsoft Systems Management products in EMEA, which increased by approximately 123% from the first quarter of 2004 to the comparable period in 2005. To a lesser extent, our Development and Deployment product line contributed to growth in license revenues, increasing by 15% over the prior year and also showing particular strength in EMEA. Our strong cash collection efforts on license transactions on which we recognize revenue upon receipt of payment also contributed to license revenues growth.

Services Revenues — The largest component of service revenues is maintenance revenue. Service revenues also include fees for consulting and training services. Three factors were the primary contributors to our 37.0% growth in service revenues. First, from a product perspective, our Microsoft Systems Management product line contributed approximately $6.4 million to growth in service revenues. Second, maintenance revenues from renewals of annual maintenance agreements have continued to grow. Third, revenues from post-sales consulting and training increased $1.6 million or 35.1%. Post-sales consulting and training as a percentage of total service revenues represented 12.3% and 12.5% in the three months ended March 31, 2005 and 2004, respectively. Our Vista Plus output management product line, sold in September 2004, generated approximately $2.5 million of our North American first quarter 2004 services revenues. Excluding Vista Plus, our North American service revenues increased by 42%.

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

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Cost of Revenues

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

Cost of Licenses — Cost of licenses primarily consists of third-party software royalties, product packaging, documentation, duplication, delivery and personnel costs. Cost of licenses as a percentage of license revenues was 1.8% and 2.3% for the three months ended March 31, 2005 and 2004, respectively. The percentage of revenue decrease is primarily the result of reduced license revenues from sales of licenses to royalty-bearing products.

Cost of Services — Cost of services primarily consists of personnel, outside consultants, facilities and systems costs used in providing support, consulting and training services. Personnel related costs, such as labor, bonuses, vacation and payroll taxes, increased by approximately $1.5 million. This rise in personnel related costs is primarily due to a significant increase in headcount, including the additional headcount from the acquisition of Aelita. Consulting fees paid to outside professional services consultants in support of product deployments increased by $0.2 million. Cost of services as a percentage of service revenues was 17.8% in the three months ended March 31, 2005, compared to 18.0% in the comparable period of 2004.

Amortization of Purchased Technology — Amortization of purchased technology includes amortization of the fair value of acquired technology associated with acquisitions made since 2001. We expect amortization of purchased technology to be at least $6 million for the remaining three quarters of 2005.

Operating Expenses

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

Sales and Marketing — Sales and marketing expenses consist primarily of the following types of costs related to our sales and marketing activities: compensation and benefits for personnel; sales commissions; facilities and Information Systems (“IS”); trade shows; travel and entertainment; and marketing communications programs. Personnel related costs, such as labor, bonuses, vacation and payroll taxes, increased approximately $5.5 million. This increase in personnel related expenses is primarily due to a significant increase in headcount, including the additional headcount from the acquisition of Aelita. Marketing communications and program expenses increased by approximately $1.0 million. A portion of the overall increase was offset by a reduction of approximately $0.8 million to depreciation expense related to our sales force automation system, implemented in 2001 and fully depreciated by the end of the third quarter in 2004. Sales and marketing expenses as a percentage of total revenues were 42.0% and 43.8% in 2005 and 2004, respectively. In the three months ended March 31, 2005, the decline of the U.S. Dollar from the first quarter of 2004 to the comparable period in 2005, primarily against the Euro and the British Pound, contributed approximately $0.4 million to the year-over-year increase in sales and marketing expenses.

Research and Development — Research and development expenses consist primarily of compensation and benefit costs for software developers, software product managers, quality assurance and technical documentation personnel, associated facilities and IS costs and payments made to outside software development consultants in connection with our ongoing efforts to enhance our core technologies and develop additional products. Compensation and benefit costs, such as labor, bonuses, severance, vacation and payroll taxes, increased approximately $2.0 million. This rise in personnel related expenses is primarily due to a significant increase in headcount, including the additional headcount from the acquisition of

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Aelita. Research and development expenses as a percentage of total revenues were 20.4% and 22.0% for the three months ended March 31, 2005 and 2004, respectively.

General and Administrative — General and administrative expenses consist primarily of compensation and benefit costs for our executive, finance, legal, administrative and IS personnel, professional fees for audit, tax and legal services, and associated facilities and IS costs. Compensation and benefit costs, such as labor, bonuses, temporary labor and payroll taxes, increased approximately $1.4 million. This rise in personnel related costs are primarily due to a significant increase in headcount. Higher accounting and tax fees related to our ongoing SOX 404 compliance efforts also contributed approximately $0.5 million to the 17.5% increase in general and administrative expenses as the first quarter of 2004 was a light spend quarter on SOX related efforts. Legal costs decreased by approximately $0.8 million as a result of the settlement or dismissal of litigation matters early in the first quarter of 2005. General and administrative expenses as a percentage of total revenues were 9.4% and 10.0% for the three months ended March 31, 2005 and 2004, respectively.

Amortization of Other Purchased Intangible Assets — Amortization of other purchased intangible assets includes the amortization of customer lists, trademarks, non-compete agreements and maintenance contracts associated with acquisitions. We expect amortization of other purchased intangible assets to be at least $4 million for the remaining three quarters of 2005.

In-Process Research and Development — In-process research and development expenses relate to in-process technology acquired from Wingra Technologies, LLC in January 2005 and our acquisition of Aelita in March 2004. These costs were charged to operations as the technologies had not reached technological feasibility and did not have alternative future uses at the date of acquisition.

Other (Expense) Income, Net

Other (expense) income, net includes interest income on our investment portfolio, and gains and losses from foreign exchange fluctuations, as well as gains or losses on other financial assets. Other (expense) income, net decreased from $0.7 million in the first quarter of 2004 to a loss of $(1.5) million in the comparable period of 2005. Our net interest income was $1.9 million in the three months ended March 31, 2005 and 2004. Foreign currency losses were $2.9 million and $1.0 million in 2005 and 2004, respectively. Foreign currency losses were predominantly attributable to translation losses on accounts receivable and cash denominated in primarily the Euro, and to a lesser extent, the British Pound and the Australian Dollar. The foreign currency translation adjustments to these balance sheet items are calculated by comparing the currency spot rates on March 31, 2005 to the spot rates on December 31, 2004. On this basis the U.S. Dollar strengthened against the Euro, the British Pound and the Australian Dollar during the periods presented.

Income Tax Provision

During the three months ended March 31, 2005, the provision for income taxes increased to $4.4 million from $3.9 million in the comparable period of 2004, representing an increase of $0.5 million. The effective income tax rate for the three months ended March 31, 2005 and 2004 was approximately 33% and 91%, respectively. The significant tax rate in the first quarter of 2004 was primarily due to a permanent difference between GAAP pre-tax income and taxable income as a result of a $6.7 million non-deductible write-off of Aelita’s in-process research and development in the three months ended March 31, 2004.

Liquidity and Capital Resources

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