<PAGE>
 
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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, DC 20549
 
                               ----------------
 
                                   FORM 10-K
 
  [X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
       EXCHANGE ACT OF 1934.
 
                  for the fiscal year ended December 31, 1998
 
  [_]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
       SECURITIES EXCHANGE ACT OF 1934.
 
                        Commission File Number: 0-22350
 
                               ----------------
 
                        MERCURY INTERACTIVE CORPORATION
            (Exact name of registrant as specified in its charter)
 
<TABLE>
 <S>                              <C>
            Delaware                                77-0337705
 (State or other jurisdiction of                 (I.R.S. Employer
 incorporation or organization)                Identification No.)
</TABLE>
 
                   1325 Borregas Avenue, Sunnyvale, CA 94089
                   (Address of principal executive offices)
 
                                (408) 822-5200
             (Registrant's telephone number, including area code)
 
                               ----------------
 
          Securities registered pursuant to Section 12(g) of the Act:
                        Common Stock, $0.002 par value
 
   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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. [_]
 
   The aggregate market value of the voting stock held by non-affiliates of
the Registrant was approximately $923,955,141 as of February 26, 1999, based
upon the closing sale price reported for that date on the NASDAQ National
Market. Shares of Common Stock held by each officer and director and by each
person who owns 5% or more of the outstanding Common Stock have been excluded
because such persons may be deemed to be affiliates. This determination of
affiliate status is not necessarily conclusive for other purposes.
 
   The number of shares of Registrant's Common Stock outstanding as of
February 26, 1999 was 36,865,650.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
   Portions of the Proxy Statement for Registrant's 1999 Annual Meeting of
Stockholders to be held May 26, 1999 are incorporated by reference in Part III
of this Form 10-K Report.
 
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<PAGE>
 
                               TABLE OF CONTENTS
 
<TABLE>
<CAPTION>
                                                                           Page
                                                                           ----
 
                                     PART I
 
 <C>      <S>                                                              <C>
 Item 1.  Business......................................................     3
          General.......................................................     3
          Products......................................................     4
          Research and Development......................................     6
          Marketing, Sales and Support..................................     6
          Competition...................................................     8
          Manufacturing.................................................     8
          Patents, Trademarks and Licenses..............................     8
          Personnel.....................................................     9
          Operations in Israel..........................................    10
 
 Item 2.  Properties....................................................    10
 
 Item 3.  Legal Proceedings.............................................    11
 
 Item 4.  Submission of Matters to a Vote of Security Holders...........    11
 
                                    PART II
 
 Item 5.  Market for the Registrant's Common Equity and Related
           Stockholder Matters..........................................    12
 
 Item 6.  Selected Consolidated Financial Data..........................    13
 
 Item 7.  Management's Discussion and Analysis of Financial Condition
           and Results of Operations....................................    13
 
 Item 7a. Quantitative and Qualitative Disclosures about Market Risk....    23
 
 Item 8.  Financial Statements and Supplementary Data...................    23
 
 Item 9.  Changes in and Disagreements with Accountants on Accounting
           and Financial Disclosure.....................................    23
 
                                    PART III
 
 Item 10. Directors and Executive Officers of the Registrant............    24
 
 Item 11. Executive Compensation........................................    24
 
 Item 12. Security Ownership of Certain Beneficial Owners and
           Management...................................................    24
 
 Item 13. Certain Relationships and Related Transactions................    24
 
                                    PART IV
 
 Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-
           K ...........................................................    25
</TABLE>
 
                                       2
<PAGE>
 
                                    PART I
 
Item 1. Business
 
General
 
   Mercury Interactive Corporation and its subsidiaries (hereafter,
collectively, "Mercury Interactive" or the "Company") develops, markets and
supports a comprehensive suite of automated software testing solutions. The
Company's products automate testing of complex software applications
throughout the enterprise by helping to ensure that software works as required
by anticipating problems and identifying issues. This helps companies build
better applications, from e-business/Internet transaction systems to
enterprise resource planning and other client/server applications. The
Company's products also help companies test and refine software to meet two of
today's most pressing information system issues: the Year 2000 problem and the
adoption of a single European currency.
 
   Mercury Interactive's automated tools address the full range of enterprise
software testing challenges facing corporate IS departments, systems
integrators and consultants. The Company's products provide:
 
  (1) Functional testing: solutions that help ensure enterprise applications
      and their interfaces work as planned.
 
  (2) Load testing: software tools that test and stress enterprise
      applications under real world conditions to predict systems behavior
      and performance and to identify and isolate problems.
 
  (3) Test process management: integrated tools that organize and manage the
      testing process to determine application readiness.
 
   Mercury Interactive's solutions enhance and accelerate the application
deployment process because they are designed to support business and
functional needs as well as IS needs. The Company's products can be applied by
non-technical users who are helping determine IS priorities and requirements.
The products are also highly integrated, so they work together in combination
to test applications across the enterprise. Most of the Company's automated
testing products are available in specialized versions: for example,
customized products for SAP R/3 applications, or Year 2000-specific solutions
designed for legacy mainframe applications. The Company has established
relationships with several major software industry leaders to ensure that its
testing solutions reflect both their unique products and the unique needs of
their customers.
 
   Mercury Interactive is committed to continuing research and development in
order to achieve its strategy of offering advanced and innovative testing
solutions for evolving business needs. Mercury Interactive is also committed
to strong strategic alliances, both technology alliances with other industry-
leading companies and with channel partners, such as the major systems
integrators.
 
   The Company's products have been selected for the testing needs of many of
the world's largest and most innovative business organizations. Alcatel,
Allstate Insurance, American Airlines, America Online, Citibank, E*Trade, Eli
Lilly, Federal Express, Hewlett Packard, Internet Shopping Network, Nabisco,
Siemens, The Gap, and many others rely on Mercury Interactive's solutions to
ensure the performance and reliability of their critical business systems.
 
                                       3
<PAGE>
 
Products
 
   The Company's current testing products are presented in the table below,
and described immediately following.
 
<TABLE>
<CAPTION>
   Product Name       Product Description                Status          Typical List Price Range*
 ----------------- --------------------------   ------------------------ -------------------------
 <C>               <S>                          <C>                      <C>
 XRunner           Automated application        Release 1.0-1991         $60,000 for five
                                                                         users
                   testing for UNIX, X-         Release 4.0-July 1996
                   Window
 
 WinRunner         Automated application        Release 1.0-June 1993    $2,850-$5,000 per
                                                                         user
                   testing for Windows,         Release 4.0-March 1996
                   Windows NT, Windows 95       Release 5.0-July 1998
 
 LoadRunner        Automated multi-user         Release 1.0-November     $40,000-$50,000 for
                                                1993
                   testing for UNIX, RTE,       Release 4.5-May 1997     package simulating 50
                   Windows, Windows NT and      Release 5.0-July 1998    users
                   Windows 95
 
 TestDirector      Automated test               Release 1.0-November     $8,995 for server
                   management                   1994                     plus 5
                   system for QA workgroups     Release 4.0-June 1997    users, additional
                                                                         users
                                                Release 5.0-July 1998    for $495 each
 
 WebTest           World Wide Web application   Product family released  $195-$995 per copy
                   testing                      March 1996
 
 Astra SiteManager Visual Web site              Release 1.0-October 1996 $495 per copy
                   management tool
 
 Astra SiteTest    Web site stress testing      Release 1.0-December     $9,500 per copy
                                                1996
                                                Release 2.0-December
                                                1997
 
 Astra QuickTest   World Wide Web               Release 1.0-May 1998     $4,000 per copy
                   functional testing
</TABLE>
--------
*Prices vary within the ranges shown according to system configuration and
   country where purchased.
 
 XRunner
 
   The Company's XRunner(R) is an automated GUI regression tool which tests X-
Window applications running under UNIX. XRunner makes test development easier
by incorporating simplified test script management, point-and-click selection
and interactive debugging. These features boost new testers' productivity
while providing a complete testing solution for evolving business needs.
XRunner features the RapidTest Script Wizard which automatically learns an
application and generates tests for unattended regresssion testing. XRunner
was released in 1991.
 
 WinRunner
 
   The Company's WinRunner(R) tests enterprise applications on Windows 3.1,
Windows 95, and Windows NT platforms. WinRunner simplifies test automation by
providing powerful, productive and cost effective test solutions. WinRunner
utilizes Mercury Interactive's point-and-click Visual Testing to help users
quickly create test and verification scenarios. WinRunner provides support for
leading development environments such as SAP, PeopleSoft, Baan, Oracle NCA,
Microsoft Visual Basic and PowerBuilder. WinRunner 2000 is specifically
designed to test applications for compliance with Year 2000 requirements.
WinRunner was made generally available in 1993.
 
 
                                       4
<PAGE>
 
 LoadRunner
 
   The Company's LoadRunner(R) is an integrated client/server and Web load
testing tool. It provides a scalable load testing solution for managing the
risk of enterprise systems. LoadRunner uses a minimum of hardware resources to
provide consistent, repeatable and measurable load to exercise the system just
like real users would. LoadRunner automates both client and server load
testing from a single point of control while helping developers get an
accurate view of system behavior and performance throughout the application
development lifecycle. LoadRunner is available for Windows, Window 95, Windows
NT, UNIX and Remote Terminal Emulation (RTE). LoadRunner was made generally
available in 1993.
 
 TestDirector
 
   The Company's TestDirector(R) is a workgroup test management software which
directs the quality assurance process for software development. TestDirector
helps developers and testers to be more productive by walking them through a
full regression test cycle from planning and design, automated test creation,
manual and automatic test execution, defect tracking and application quality
analysis. TestDirector was released in 1994.
 
 WebTest
 
   The Company's WebTest(R) is designed specifically for testing World Wide
Web applications. The technology helps information systems' organizations
improve the quality and reliability of Web-based systems by allowing
developers to measure response time to a browser request, to determine the
maximum number of hits the server can support, and to validate the systems'
ability to function correctly under varying conditions. WebTest extends
Mercury Interactive's GUI testing tools, WinRunner and XRunner, allowing them
to interact with Web pages, browsers, HTML links and images. WebTest, together
with LoadRunner, tests Web site performance and capacity by emulating Web user
HTTP or secure sockets layer (SSL) encrypted traffic between the browser and
server. WebTest was released in 1996.
 
 Astra SiteManager
 
   The Company's Astra SiteManager(TM) is a comprehensive visual Web site
management tool that is designed to meet the challenges faced by Webmasters
and business managers of rapidly growing Web sites with changing content and
shape. Astra SiteManager scans an entire Web site highlighting functional
areas with color-coded links and URLs--to create a complete visual map of a
Web site. It pinpoints broken links or access problems, compares maps as a
site changes, identifies key usage patterns for improving Web site
effectiveness and validates dynamically generated pages. Astra SiteManager was
released in 1996.
 
 Astra SiteTest
 
   The Company's Astra SiteTest(TM) is a stress testing tool for Web-based
systems-Internet and intranet-that provides consistent, repeatable and
measurable load to exercise the systems as real users would. Astra SiteTest
helps Webmasters get an accurate view of system behavior and performance
throughout the application development lifecycle. Astra SiteTest was released
in 1996.
 
 Astra QuickTest
 
   The Company's Astra QuickTest(TM) is an icon-based functional testing tool
for e-business. By replacing traditional scripts with icons, it records and
represents user actions visually to simplify and accelerate testing. Astra
QuickTest is designed specifically for deploying reliable e-business
applications. Astra QuickTest(TM) was released in 1998.
 
 
                                       5
<PAGE>
 
Research and Development
 
   Since its inception, the Company has made substantial investments in
research and product development. The Company believes that its success will
depend in large part on its ability to maintain and enhance its current
product line, develop new products, maintain technological competitiveness and
meet an expanding range of customer requirements, each of which is essential
to maintaining the Company's current leadership position in its market.
 
   The technologies that drive the Company's products are aimed at providing a
consistent and comprehensive solution to software quality issues throughout
the software development organization. By enabling reliable automation of
testing, these technologies enable the Company's products to provide
substantial productivity improvement.
 
   The Company believes that it was the first to comprehensively address
client/server software quality by combining key enabling technologies such as
output synchronization, GUI-based application testing, multi-platform
portability, text recognition and multi-user testing. Mercury Interactive's
products are designed to be used throughout the development, maintenance and
porting processes and are available on a variety of computing platforms and
operating environments.
 
   In addition to the teams developing software testing products, the Company
maintains an advanced research group that is responsible for exploring new
directions and applications of core technologies, migrating new technologies
into the existing product lines and maintaining research relationships outside
the Company both within industry and academia. The research and development
group also maintains relationships with third party software vendors and with
all major hardware vendors on whose platforms the Company's products operate.
Key development engineers are rotated to assignments in customer support
positions in the Company's major markets for periods ranging from three months
to two years. This improves feedback from current customers and strengthens
ties between the Customer Support Organization and the research and
development group.
 
   The Company's primary research and development group is located near Tel
Aviv, Israel. Performing research and development in Israel offers a number of
strategic advantages. Israeli engineers typically hold advanced degrees in
computer-related disciplines. Operation in Israel has allowed the Company to
enjoy tax incentives and research subsidies from the government of Israel.
Geographic proximity to Europe, a strategic market for the Company, offers
another key advantage.
 
   As of December 31, 1998 the Company's research and development group
consisted of 166 employees. During 1998, 1997 and 1996 net research and
development costs were $15.7 million, $10.9 million and $9.4 million,
respectively. The Company anticipates that it will continue to commit
substantial resources to research and development in the future. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
 
Marketing, Sales and Support
 
 Direct Sales
 
   The Company markets its products primarily through its direct sales and
service organization, which focuses on major accounts. The Company employs
technically proficient salespeople and highly skilled field application
engineers capable of serving the sophisticated needs of prospective customers'
engineering and management staffs. As of December 31, 1998, the Company's
sales force consisted of 238 employees.
 
   The Company has 18 sales and support centers throughout the United States.
Internationally, the Company's subsidiaries operate eleven sales and support
offices located in Canada, Brazil, the United Kingdom, France, Germany,
Belgium, Sweden, Japan, Australia, Singapore and Israel. The Company also
markets its products through distributors in Europe and Pacific Rim countries.
 
 
                                       6
<PAGE>
 
   International sales represented 35%, 36%, and 33% of the Company's total
revenues in 1998, 1997, and 1996, respectively. The Company expects that in
future periods, international sales will continue to account for a significant
portion of the Company's total revenue. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
 
 Alternate Channels
 
   The Company has established an indirect sales channel of value added
resellers and major system integrators, including Andersen Consulting,
Deloitte & Touche, EDS, Ernst & Young, Keane and KPMG. For the year ended
December 31, 1998, the indirect sales channel accounted for approximately 50%
of total revenue compared to 47% and 43% for the years ended December 31, 1997
and 1996, respectively. The Company has derived a substantial portion of its
revenue from sales of its products through alternate distribution channels
such as referral partners, system integrators, and value-added resellers. The
Company expects that sales of its products through its alternate distribution
channels will continue to account for a substantial portion of its revenues
for the foreseeable future. Each of the Company's system integrators and value
added resellers can cease marketing the Company's products with limited notice
and with little or no penalty. There can be no assurance that the Company's
system integrators and value added resellers will continue to offer the
Company's products or that the Company will be able to recruit additional or
replacement system integrators and value added resellers. The loss of one or
more of the Company's major system integrators and value added resellers could
have a material adverse effect on the Company's business, financial condition
and results of operations. The Company's system integrators and value added
resellers also offer competitive products manufactured by third parties. There
can be no assurance that the Company's system integrators and value added
resellers will give priority to the marketing of the Company's products as
compared to its competitors' products. Any reduction or delay in sales of the
Company's products by its system integrators and value added resellers could
have a material adverse effect on the Company's business, financial condition
and results of operations.
 
 Customer Support
 
   The Company believes that strong customer support is crucial to both the
initial marketing of its products and maintenance of customer satisfaction,
which in turn enhances the Company's reputation and generates repeat orders.
In addition, the Company believes that the customer interaction and feedback
involved in its ongoing support functions provide the Company with information
on market trends and customer requirements that is critical to future product
development efforts.
 
   Pre-sales support is provided by sales personnel and post-sales support is
provided by the Company's Customer Support Organization ("CSO") pursuant to
training and consulting engagements and renewable annual maintenance
contracts. As of December 31, 1998, the Company's CSO consisted of 104
employees. The maintenance contracts provide for technical and emergency
support as well as software upgrades, on an if and when available basis. When
the Company's local sales and support offices are unable to solve a problem,
the Company's engineers and product developers in Israel work with the support
personnel. By taking advantage of time differences, the Company can provide
support around the clock, ensuring prompt resolution of problems.
 
 Pricing
 
   The Company licenses its software to customers under non-exclusive license
agreements that restrict use of the products to internal purposes at a
specified site. The Company typically licenses software products to either
allow up to a set number of users to access the software on a network at any
one time, using any workstation attached to that network, or to allow use of
the software on designated computers or workstations.
 
   The Company's products are priced to encourage customers to purchase
multiple products and licenses because the cost to the Company of supporting a
one-user configuration is almost as high as a multiple-user configuration.
License fees are dependent on the product licensed, the number of users of the
product licensed and the country in which such licenses are sold, as
international prices tend to be higher than United States prices.
 
                                       7
<PAGE>
 
Sales to the Company's indirect sales channel partners which are intended for
resale to end users are made at varying discounts off of the Company's list
prices, generally based on the sales volume of the indirect sales channel
partner. In addition, the Company sells annual maintenance contracts which
include on-site customer support and upgrades for approximately 15% of the
license purchase price. Training and consulting revenues are generated on a
time and expense basis at industry-competitive rates.
 
 Backlog
 
   The time between order and delivery of the Company's products is generally
quite short. The number of orders, as well as the size of individual orders,
can vary substantially from month to month. Because of the short period
between order receipt and shipment of products, the Company typically does not
have a significant backlog of unfilled orders and believes that backlog is not
significant to an understanding of its business nor representative of
potential revenue for any future period.
 
Competition
 
   While the Company believes it is the leading provider of automated
client/server, E-business and Enterprise Resource Planning ("ERP", such as
packaged applications offered by SAP and Oracle) testing tools, several other
companies compete in the automated client/server testing market and several
potential customers develop testing utilities internally. The market for
automated client/server, E-business and ERP testing tools is relatively young
and competing solutions for the problem of software testing productivity are
evolving rapidly.
 
   The market for software products, in general, is highly competitive. The
Company continues to face direct competition from well established, publicly-
held companies. There could be a material adverse effect on the Company's
results of operations or financial position if any of the major software
manufacturers, which have significantly greater financial and technical
resources than the Company, decided to devote substantial resources to
entering the software testing market or if there is an increase in developing
testing utilities internally by the Company's customers or potential
customers. A variety of external and internal factors could materially
adversely affect the Company's ability to compete. These include the relative
functionality, price, performance and reliability of the products offered by
the Company and its competitors, the timing and success of new product
development or enhancement efforts of the Company and its competitors, and the
effectiveness of the marketing and sales efforts of the Company and its
competitors. There can be no assurance that the Company will be able to
compete successfully in the future or that competitive pressure will not
materially adversely affect the Company's business.
 
Manufacturing
 
   The Company's products are principally composed of user manuals and storage
media, such as diskettes tapes, and/or CD-ROM, which are produced by the
Company in its facility in Israel. Often, the Company's products require
multiple user manuals and magnetic media. The Company believes that there is
an adequate supply of and source for the raw materials for its products and
that there are multiple sources available for storage media duplication and
manual printing. The Company performs final quality control tests on its
products. Although the Company believes that its quality control activities
effectively accomplish the Company's product quality goals, there can be no
assurance that the Company's quality control efforts will always be completely
successful. Undetected material programming errors, product tampering, and
exposure to a computer virus in the product development, duplication, assembly
or distribution process, whether performed by the Company, its contractors,
distributors, or resellers, could have a material adverse effect on shipments
of new and existing products. Assembly and packaging of final products are
performed both by the Company and by domestic and overseas subcontractors of
the Company.
 
Patents, Trademarks and Licenses
 
   The Company currently relies upon a combination of trademark, copyright,
and trade secret laws and contractual provisions to protect proprietary rights
in its products. The source code for the Company's products is protected both
as a trade secret and as an unpublished copyrighted work. Despite these
precautions, it may be
 
                                       8
<PAGE>
 
possible for a third party to copy or otherwise obtain and use the Company's
products or technology without authorization. In addition, the laws of various
countries in which the Company's products may be sold may not protect the
Company's products and intellectual property rights to the same extent as the
laws of the United States.
 
   Because the software industry is characterized by rapid technological
change, the Company believes that factors such as the technological and
creative skills of its personnel, new product developments, frequent product
enhancements, name recognition and reliable product maintenance are more
important to establishing and maintaining a technology leadership position
than the various legal protections of its technology.
 
   The Company presently has one registered copyright. The Company holds four
patents for elements contained in certain of its products, and it has filed
several other U.S. and foreign patent applications on various elements of its
products. There can be no assurance that any of the Company's patent
applications will result in an issued patent or that, if issued, such patent
would be upheld if challenged. There can be no assurance that the Company's
competitors will not independently develop technologies that are substantially
equivalent or superior to the Company's technology. There can also be no
assurance that the measures taken by the Company to protect its proprietary
rights will be adequate to prevent misappropriation of the technology or
independent development by others of similar technology.
 
   Although the Company believes that its products and other proprietary
rights do not infringe upon the proprietary rights of third parties there can
be no assurance that third parties will not assert intellectual property
infringement claims against the Company in the future or that any such claims
will not require the Company to enter into royalty or cross-license
arrangements or result in costly litigation.
 
Personnel
 
   As of December 31, 1998, the Company had a total of 621 employees, of which
263 were based in the United States and 358 were based internationally. Of the
total, 391 were engaged in marketing, sales and related customer support
services, 166 were in research and development, and 64 were in general and
administrative functions. The Company's success depends in significant part
upon the performance of its senior management and certain key employees.
Competition for highly skilled employees, including sales, technical and
management personnel, is intense in the computer industry. There can be no
assurance that the Company will retain its key managerial and technical
employees. The Company's failure to attract, assimilate or retain highly
qualified sales, technical and managerial personnel could materially adversely
affect the Company's business. None of the Company's employees are represented
by a labor union. The Company has never experienced any work stoppages.
 
   The executive officers of the Company as of March 1, 1999 are as follows:
 
<TABLE>
<CAPTION>
          Name           Age                       Position
          ----           ---                       --------
<S>                      <C> <C>
Aryeh Finegold..........  52 Chairman of the Board of Directors
Amnon Landan............  40 President, Chief Executive Officer and Director
Kenneth R. Klein........  39 President, North American Operations
Sharlene Abrams.........  41 Vice President of Finance and Administration, Chief
                             Financial Officer and Secretary
Moshe Egert.............  34 Vice President of European Operations
</TABLE>
 
   Mr. Aryeh Finegold, a founder of the Company, has served as Chairman of the
Board of Directors since the Company's incorporation in July 1989, served as
Chief Executive Officer from July 1989 until January 1997 and served as
President from July 1989 until October 1995. Previously, Mr. Finegold was
President, Chief Executive Officer and Chairman of the Board of Directors of
Ready Systems, Inc. He also co-founded Daisy Systems, Inc., serving as its
President and Chief Executive Officer. Previously, Mr. Finegold was a product
line architect in the microprocessor division at Intel Corporation.
 
                                       9
<PAGE>
 
   Mr. Amnon Landan has served as President and Chief Executive Officer of the
Company since February 1997, and has been a director of the Company since
February 1996. From October 1995 to January 1997 he served as President, and
from March 1995 to September 1995 he served as President of North American
Operations. He served as Chief Operating Officer from August 1993 until March
1995. From December 1992 to August 1993, he served as the Company's Vice
President of Operations and from June 1991 to December 1992, he served as Vice
President of Research and Development. From November 1989 to June 1991, he
served in several technical positions with the Company.
 
   Mr. Kenneth R. Klein has served as President, North American Operations
since July 1998. From April 1995 to July 1998 he served as Vice President of
North American Sales. From May 1992 to March 1995, he served as the Company's
Western Area Sales Manager. From March 1990 to May 1992, Mr. Klein served as
Regional Sales Manager for Interactive Development Environments, a CASE tool
company.
 
   Ms. Sharlene Abrams has served as Vice President of Finance and
Administration and Chief Financial Officer of the Company since November 1993.
She has served as Secretary of the Company since February 1996. From 1988
until joining the Company, Ms. Abrams was employed at Price Waterhouse LLP
most recently as a senior manager. Prior to 1988, Ms. Abrams held various
finance and accounting positions in other public companies and in public
accounting. She is a Certified Public Accountant.
 
   Mr. Moshe Egert has served as Vice President of European Operations since
July 1996. From February 1994 to June 1996, he served as Director of European
Marketing. From October 1990 through January 1994, he served in several
management and technical positions with the Company.
 
Operations in Israel
 
   The Company's research and development operations are primarily located in
Israel and may be affected by economic, political and military conditions in
that country. The Company's business is also dependent on trading
relationships between Israel and other countries. Accordingly, the Company's
operations could be adversely affected if major hostilities involving Israel
should occur or if trade between Israel and its current trading partners were
interrupted or curtailed. The Company benefits from various policies of the
government of Israel, including reduced taxation and special subsidy programs,
designed to stimulate economic activity, particularly the high technology
industry in that country. The Company's operations also benefit from the
availability of highly skilled and relatively low cost scientific and
technical personnel in Israel. As a condition of its receipt of funds for
various research and development projects conducted under programs sponsored
by the government of Israel, the Company has agreed that products resulting
from these projects may not be manufactured, nor may the technology developed
in the projects be transferred, outside of Israel without government consent.
 
Item 2. Properties
 
   The Company is headquartered in Sunnyvale, California in a 55,000 square
foot building which the Company owns.
 
   The Company's research and development activities are conducted by the
Company's subsidiary in Israel, where that subsidiary leases approximately
24,000 square feet under a lease that expires in December 2000. In addition,
in 1995, the Company purchased land in Israel where construction of a new
research and development facility is currently underway. Relocation of the
Israel subsidiary to this new facility is expected to occur in the third
quarter of 1999.
 
   The Company's field sales and support operations occupy leased facilities
in 17 locations in the United States, one location in Canada, one location in
Brazil, five locations in Europe, one location in Israel, and three locations
in the Pacific Rim. The Company believes that its existing facilities are
adequate for its current needs and that additional space will be available as
needed.
 
 
                                      10
<PAGE>
 
Item 3. Legal Proceedings
 
   There are presently pending no legal proceedings, other than routine
litigation incidental to the Company's business, to which the Company is a
party or to which any of its properties is subject.
 
Item 4. Submission of Matters to a Vote of Security Holders
 
   No matters were submitted during the fourth quarter of 1998 to a vote of
the holders of Mercury Interactive Corporation's Common Stock through the
solicitation of proxies or otherwise.
 
                                      11
<PAGE>
 
                                    PART II
 
Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters
 
Market for Common Stock
 
   Mercury Interactive Corporation Common Stock is traded on the NASDAQ
National Market tier of The NASDAQ Stock Market under the symbol MERQ. The
following table lists the high and low sales price since January 1, 1997:
 
<TABLE>
<CAPTION>
                                                                   High   Low
                                                                  ------ ------
   <S>                                                            <C>    <C>
   1998:
   First quarter ended March 31.................................. $19.13 $12.19
   Second quarter ended June 30.................................. $22.32 $15.63
   Third quarter ended September 30.............................. $22.88 $15.75
   Fourth quarter ended December 31.............................. $31.63 $10.57
 
   1997:
   First quarter ended March 31.................................. $ 7.38 $ 4.88
   Second quarter ended June 30.................................. $ 8.88 $ 5.16
   Third quarter ended September 30.............................. $11.94 $ 7.13
   Fourth quarter ended December 31.............................. $13.38 $ 9.75
</TABLE>
 
   The above prices per share, as well as those set forth elsewhere in this
Form 10-K, are adjusted to reflect the 2:1 stock split (effected as a stock
dividend) distributed to stockholders in late February 1999.
 
   The Company's stock price, has been and will continue to be, subject to
significant volatility. Past financial performance should not be considered a
reliable indicator of future performance, and investors should not use
historical trends to anticipate results or trends in future periods. If
revenues or earnings in any quarter fail to meet expectations of the
investment community, there could be an immediate and significant impact on
the Company's stock price. In addition, the Company's stock price may be
impacted by broader market trends that are unrelated to the Company's
operating results.
 
Holders of Record
 
   On February 26, 1999, there were approximately 7,700 holders of record of
Mercury Interactive Corporation Common Stock.
 
Dividends
 
   The Company paid no cash dividends during fiscal 1998. The Company intends
to retain earnings for use in its business and does not anticipate paying any
cash dividends in the foreseeable future.
 
                                      12
<PAGE>
 
Item 6. Selected Consolidated Financial Data
<TABLE>
<CAPTION>
                                              Year ended December 31,
                                    --------------------------------------------
                                      1998     1997     1996     1995     1994
                                    -------- -------- -------- --------  -------
                                     (in thousands, except per share amounts)
<S>                                 <C>      <C>      <C>      <C>       <C>
Statements of Operations Data:
Revenue:
  License.........................  $ 84,450 $ 56,683 $ 43,270 $ 32,765  $20,270
  Service.........................    36,550   20,017   11,280    6,685    3,180
                                    -------- -------- -------- --------  -------
    Total revenue.................   121,000   76,700   54,550   39,450   23,450
                                    -------- -------- -------- --------  -------
Cost of revenue:
  License.........................     6,291    4,351    3,419    2,626    1,594
  Service.........................    11,757    6,225    3,240    1,887      872
                                    -------- -------- -------- --------  -------
    Total cost of revenue.........    18,048   10,576    6,659    4,513    2,466
                                    -------- -------- -------- --------  -------
Gross profit......................   102,952   66,124   47,891   34,937   20,984
                                    -------- -------- -------- --------  -------
Operating expenses:
  Research and development, net...    15,747   10,933    9,396    6,523    4,285
  Write off of in-process research
   and development and related
   expenses.......................       --     5,500      --     7,700      --
  Marketing and selling...........    56,476   36,804   29,360   21,361    9,576
  General and administrative......     8,052    6,362    4,113    3,911    2,531
  Settlement of litigation........       --       --     2,600    2,000      --
                                    -------- -------- -------- --------  -------
    Total operating expenses......    80,275   59,599   45,469   41,495   16,392
                                    -------- -------- -------- --------  -------
Income (loss) from operations.....    22,677    6,525    2,422   (6,558)   4,592
Other income, net.................     4,579    3,109    3,361    2,277    1,348
                                    -------- -------- -------- --------  -------
Income (loss) before provision for
 income taxes.....................    27,256    9,634    5,783   (4,281)   5,940
Provision for income taxes........     5,451    2,927    1,157      970      891
Net income (loss).................  $ 21,805 $  6,707 $  4,626 $ (5,251) $ 5,049
                                    ======== ======== ======== ========  =======
Net income (loss) per share
 (basic)..........................  $   0.62 $   0.20 $   0.15 $  (0.19) $  0.20
                                    ======== ======== ======== ========  =======
Net income (loss) per share
 (diluted)........................  $   0.56 $   0.20 $   0.14 $  (0.19) $  0.19
                                    ======== ======== ======== ========  =======
Weighted average common shares
 (basic)..........................    34,958   32,746   31,816   27,894   25,220
                                    ======== ======== ======== ========  =======
Weighted average common shares
 (diluted)........................    39,030   34,208   33,126   27,894   26,674
                                    ======== ======== ======== ========  =======
<CAPTION>
                                                   December 31,
                                    --------------------------------------------
                                      1998     1997     1996     1995     1994
                                    -------- -------- -------- --------  -------
<S>                                 <C>      <C>      <C>      <C>       <C>
Balance Sheet Data:
  Working capital.................  $ 95,657 $ 88,739 $ 78,082 $ 75,475  $33,722
  Total assets....................   203,576  143,410  117,489  112,820   49,594
  Stockholders' equity............   145,589  112,987   99,039   92,616   39,167
</TABLE>
 
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
 
Results of Operations
 
   This Management's Discussion and Analysis of Financial Condition and
Results of Operations contains descriptions of the Company's expectations
regarding future trends affecting its business. These forward looking
statements and other forward looking statements made elsewhere in this
document are made in reliance upon the safe harbor provision of the Private
Securities Litigation Reform Act of 1995. Please read the section below titled
"Factors that may affect future results" to review conditions which the
Company believes could cause actual
 
                                      13
<PAGE>
 
results to differ materially from those contemplated by the forward looking
statements. Forward looking statements include, but are not limited to, those
items identified with a footnote symbol /1/. The Company undertakes no
obligation to update the information contained herein.
 
   The following table sets forth, as a percentage of revenue, certain
consolidated statements of operations data for the periods indicated (after
giving effect to rounding). These operating results are not necessarily
indicative of the results for any future period.
 
<TABLE>
<CAPTION>
                                                     Year ended December 31,
                                                     ---------------------------
                                                      1998      1997      1996
                                                     -------   -------   -------
<S>                                                  <C>       <C>       <C>
Revenue:
  License...........................................      70%       74%       79%
  Service...........................................      30        26        21
                                                     -------   -------   -------
    Total Revenue...................................     100       100       100
                                                     -------   -------   -------
Cost of revenue:
  License...........................................       5         6         6
  Service...........................................      10         8         6
                                                     -------   -------   -------
Total cost of revenue...............................      15        14        12
                                                     -------   -------   -------
Gross profit........................................      85        86        88
                                                     -------   -------   -------
Operating expenses:
  Research and development, net.....................      13        14        17
  Write off of in-process research and development
   and related expenses.............................     --          7       --
  Marketing and selling.............................      47        48        54
  General and administrative........................       6         8         7
  Settlement of litigation..........................     --        --          5
                                                     -------   -------   -------
    Total operating expenses........................      66        77        83
                                                     -------   -------   -------
Income from operations..............................      19         9         5
Other income, net...................................       4         4         6
                                                     -------   -------   -------
Income before provision for income taxes............      23        13        11
                                                     -------   -------   -------
Provision for income taxes..........................       5         4         2
                                                     -------   -------   -------
Net income .........................................      18%        9%        9%
                                                     -------   -------   -------
</TABLE>
 
 Revenue
 
   License revenue increased to $84.5 million in 1998 from $56.7 million in
1997 and $43.3 million in 1996. The Company's growth in license revenue is
attributable primarily to growth in license fees from the WinRunner,
LoadRunner and TestDirector products, particularly for use by customers to
test electronic business, enterprise resource planning, and Year 2000
remediation applications. License revenue also benefited from increased
productivity from the Company's alternate distribution channels, such as
referral partners, systems integrators and value added resellers. For the year
ended December 31, 1998, the indirect sales channel accounted for
approximately 50% of total revenue compared to 47% and 43% for the years ended
December 31, 1997 and 1996, respectively.
 
   Service revenue increased to $36.6 million or 30% of total revenue in 1998
from $20.0 million or 26% of total revenue in 1997 and $11.3 million or 21% of
total revenue in 1996. The increase in service revenue in 1998 compared to
1997 and 1996 was primarily due to the renewal of maintenance contracts and an
increase in training and consulting revenue. The Company expects that service
revenue will continue to increase in absolute dollars as long as the Company's
customer base continues to grow./1/
 
--------
/1/ Forward looking statement
 
                                      14
<PAGE>
 
   International revenue represented 35%, 36% and 33% of total revenue in
1998, 1997 and 1996, respectively. The absolute dollar growth in international
revenue reflected the Company's continued investment in international
operations. The decrease in international revenue as a percentage of revenue
from 1997 to 1998 was due primarily to higher relative growth in domestic
revenues during 1998. The Company expects international revenue to continue to
increase in absolute dollars; however, achievement of these results cannot be
assured./1/
 
 Cost of revenue
 
   License cost of revenue, as a percentage of license revenue, was 7% in 1998
and 8% in 1997 and 1996. License cost of revenue includes cost of production
personnel, product packaging and amortization of capitalized software
development costs. The decreased license cost of revenue as a percentage of
revenue in 1998 reflected primarily flat absolute dollar amortization of
capitalized software development costs over the three years.
 
   Service cost of revenue, as a percentage of service revenue, increased to
32% in 1998 from 31% in 1997 and 29% in 1996. Service cost of revenue consists
primarily of costs of providing customer technical support, training and
consulting. The increased service cost of revenue in 1998 reflected increased
outsourcing of training and consulting.
 
 Research and development
 
   For the year ended December 31, 1998, research and development, net was
$15.7 million, or 13% of total revenue, an increase from $10.9 million, or 14%
of total revenue in 1997, and $9.4 million, or 17% of total revenue in 1996.
The increase in absolute dollars in 1998 as compared to 1997 reflected an
increase in spending of $2.8 million due to growth in research and development
headcount from 130 to 166, and increased royalty payments to the Office of the
Chief Scientist in Israel, net of grants received, of $712,000. Also, in 1997,
the Company capitalized software development costs of $500,000 compared to
zero in 1998.
 
   In September of 1997, the Company acquired certain technologies from Dixon
Software Technology, which was integrated into its next generation of load-
testing products. As a result of this purchase in the third quarter of 1997,
the Company recorded a one-time charge for write off of in-process research
and development and related expenses of $5.5 million.
 
   Research and development expense for each of the three years ended December
31, 1998, 1997 and 1996 was net of research grants received by the Company
from the government of Israel, and included royalty expense for obligations to
the government of Israel for sales of products developed under government-
funded research. The Company obtained grants from the Office of the Chief
Scientist in the Israeli Ministry of Industry and Trade ("the Chief
Scientist") in the amounts of $1.6 million, $2.0 million and $1.8 million in
1998, 1997 and 1996, respectively. In 1996, the Company also received a grant
in the amount of $391,000 from the Israel-U.S. Binational Industrial Research
and Development Foundation ("BIRD-F"). The Company is not obligated to repay
these grants; however, it has agreed to pay royalties at rates ranging from 2%
to 5% of product sales resulting from the research, up to the amount of the
grants obtained and for certain grants up to 150% of the grants obtained.
Royalty expense under these agreements amounted to approximately $2.7 million,
$1.6 million and $1.1 million for the years ended December 31, 1998, 1997 and
1996, respectively. As of December 31, 1998, the Company was committed to pay,
if and when earned, $2.7 million in additional royalties for Chief Scientist
grants and $700,000 for the BIRD-F grants. The Company has not applied for,
nor does it anticipate applying for, any future Chief Scientist or BIRD-F
grants.
 
   During 1998, the Company did not capitalize any software development costs.
The Company capitalized $500,000 and $1.3 million during the years ended
December 31, 1997 and 1996, respectively, in accordance with Statement of
Financial Accounting Standards No. 86, "Accounting for the Costs of Computer
Software to be Sold, Leased, or Otherwise Marketed." Amortization charges
included in cost of license revenues were $600,000 in both 1998 and 1997 and
$300,000 in 1996. In conjunction with the technology acquisition in 1997, the
--------
/1/ Forward looking statement
 
                                      15
<PAGE>
 
Company wrote-off approximately $250,000 of capitalized development costs as
obsolete. At December 31, 1998 and 1997 the Company had a net balance of
capitalized software development costs of $585,000 and $1.2 million,
respectively.
 
   The Company intends to continue making significant expenditures on research
and development to develop new products and expand the platforms and operating
systems on which its products are offered./1/ While the Company believes that
these current research and development expenditures will be beneficial in the
long term development of its business, there can be no assurance that the
development of products will be successful or will not be rendered obsolete by
future technology acquisitions or developments./1/ Research and development
expenditures are incurred substantially in advance of related revenue and in
some cases do not result in the generation of revenue.
 
 Marketing and selling
 
   Marketing and selling expenses were $56.5 million in 1998, compared to
$36.8 million in 1997 and $29.4 million in 1996. The increase in expenses in
1998 as compared to 1997 was primarily due to an increase in personnel related
costs of $8.7 million reflecting growth in sales headcount from 159 to 238, an
increase in sales commissions of $5.6 million attributable to higher revenue,
an increase in facilities and related costs of $2.0 million and an increase in
spending on marketing programs of $1.7 million. The increase in expenses in
1997 as compared to 1996 was primarily due to an increase in personnel related
costs of $3.7 million, and an increase in sales commissions of $3.4 million.
The Company expects marketing and selling expenses to increase in absolute
dollars as total revenue increases, but such expenses may vary as a percentage
of revenue./1/
 
 General and administrative
 
   General and administrative expense increased to $8.1 million, or 6% of
total revenue in 1998, from $6.4 million, or 8% of total revenue in 1997 and
$4.1 million, or 7% of total revenue in 1996. The increase in absolute dollars
in 1998 reflected primarily increased personnel and information systems costs.
 
 Other income, net
 
   Other income, net consists primarily of interest income and foreign
exchange gains and losses. The increase in other income, net to $4.6 million
in 1998 from $3.1 million in 1997 reflected increased interest income on
higher average cash and investment balances. The decrease in other income, net
in 1997 from $3.4 million in 1996 was due primarily to foreign exchange
losses. (See Note 2 to Notes to Consolidated Financial Statements)
 
 Provision for income taxes
 
   The Company participates in special programs sponsored by the government of
Israel relating to taxation, contributing to significantly lower income tax
expense than expected based on the U.S. federal income tax rate. Future
provisions for taxes will depend upon the mix of worldwide income and the tax
rates in effect for various tax jurisdictions.
 
   In the 1997 and 1998 tax provisions, the Company has not fully recognized
the tax benefit associated with the write off of in-process technology and
related expenses because realization of the future tax benefit is uncertain.
 
 Net income
 
   The Company reported net income of $21.8 million in 1998, compared to net
income of $6.7 million in 1997 and $4.6 million in 1996. In 1997, the results
of operations were impacted by the acquisition of certain technologies which
resulted in a one-time charge for write off of in-process research and
development and related costs of $5.5 million. The Company's operating
expenses are based, in part, on its expectations of future revenues, and
expenses are generally incurred in advance of revenues. The Company plans to
continue to expand and increase its operating expenses to support anticipated
revenue growth /1/ If revenues do not materialize in a
--------
/1/ Forward looking statement
 
                                      16
<PAGE>
 
quarter as expected, the Company's results from operations for that quarter
are likely to be materially adversely affected. Net income may be
disproportionately affected by a reduction in revenue because only a small
portion of the Company's expenses varies with its revenue.
 
 Inflation
 
   Inflation has not had a significant impact on the Company's operating
results to date.
 
Year 2000
 
   The approach of Year 2000 presents significant issues for many computer
systems, since much of the software in use today may not accurately process
data beyond 1999. The Company is in the process of conducting an internal
review of most of its internal corporate headquarters computer systems and
software ("IT Systems") including finance, human resources, intranet
applications, payroll systems and customer support organization systems to
determine their Year 2000 compliance. As part of this process, the Company is
contacting vendors of its relevant corporate IT Systems to determine potential
exposure to Year 2000 issues and will be obtaining written assurance from such
vendors regarding Year 2000 compliance. Although the Company believes that
most of its principal corporate IT Systems are Year 2000 compliant, the
Company has not yet completed its assessment and testing of these systems.
 
   At this time, the Company has not determined the state of compliance of
certain third-party suppliers of services such as phone companies, long
distance carriers, financial institutions and electric companies. The failure
of any one of these third-party suppliers could severely disrupt the Company's
ability to carry on its business as well as disrupt the business of the
Company's customers. The Company is in the process of polling these companies
in order to determine their state of compliance and their contingency plans.
 
   Failure of the Company to provide Year 2000 compliant business solutions to
its customers or to receive such business solutions from its suppliers could
result in liability to the Company or otherwise have a material adverse effect
on the Company's business, results of operations, financial condition and
prospects. Furthermore, the Company believes that the purchasing patterns of
customers and potential customers may be affected by Year 2000 issues as
companies expend significant resources to correct or patch their current
software systems for Year 2000 compliance. These expenditures may result in
reduced funds available to purchase products and services such as those
offered by the Company, which could result in a material adverse effect on the
Company's business, results of operations and financial condition. The Company
could be affected through disruptions in the operation of the enterprises with
which the Company interacts or from general widespread problems or an economic
crisis resulting from noncompliant Year 2000 systems. Despite the Company's
efforts to address the Year 2000 effect on its internal systems and business
operations, such effect could result in a material disruption of its business
or have a material adverse effect on the Company's business, financial
condition or results of operations. The Company has just begun the process of
developing a contingency plan to respond to any of the foregoing consequences
of internal and external failures to be Year 2000 compliant.
 
   In selling its products, the Company frequently relies on "shrink wrap"
licenses that are not signed by licensees. The provisions in such licenses
limiting the Company's exposure to potential product liability claims may
therefore be unenforceable under the laws of certain jurisdictions. Further,
the Company's license agreements typically contain a representation that the
software is Year 2000 compliant through its description of specifically how
the Company's products process the Year 2000 calendar dates. While the Company
believes its products are Year 2000 compliant, the risk of Year 2000
noncompliance claims may increase as December 31, 1999 approaches and passes.
The Company currently carries errors and omissions insurance against such
claims, however, there can be no assurance that such insurance will continue
to be available on acceptable terms, if at all, or that such insurance will
provide the Company with adequate protection against any such claims. Although
the Company has not experienced any product liability or other Year 2000
claims to date, the sale and support of products by the Company may entail the
risk of such claims. A significant product liability claim against the Company
would have a material adverse effect upon the Company's business, financial
condition and results of operations.
 
                                      17
<PAGE>
 
Factors that May Affect Future Results
 
   The Company operates in a dynamic and rapidly changing environment that
involves numerous risks and uncertainties. The following section lists some,
but not all, of those risks and uncertainties which may have a material
adverse effect on the Company's business, financial condition or results of
operations. This section should be read in conjunction with the audited
Consolidated Financial Statements and Notes thereto and Management's
Discussion and Analysis of Financial Condition and Results of Operations
included in this Annual Report on Form 10-K. The Company has identified
certain forward looking statements in the Management's Discussion and Analysis
of Financial Condition and Results of Operations with a footnote symbol/1/.
The Company may also make oral forward looking statements from time to time.
Actual results may differ materially from those projected in any such forward
looking statements due to a number of factors, including those set forth below
and elsewhere in this Form 10-K.
 
   The market for software products is generally characterized by rapidly
changing technology, frequent new product introductions and changes in
customer requirements which can render existing products obsolete or
unmarketable. To maintain its competitive position, the Company must continue
to develop and introduce in a timely and cost-effective manner enhancements to
its existing and new products that keep pace with technological developments
and achieve market acceptance. There can be no assurance that the Company will
be able to identify, develop, manufacture, market or support new products or
enhancements successfully, that any such new products or enhancements will
gain market acceptance, or that the Company will be able to respond
effectively to technological changes. There can be no assurance that the
Company will not encounter technical or other difficulties that could delay
introduction of new products in the future. If the Company is unable to
introduce new products or enhancements and respond to industry changes on a
timely basis, its business could be materially adversely affected.
 
   The Company's current products and products under development are limited
in number and concentrated exclusively in the automated software testing
market. This market has experienced rapid worldwide growth, and it remains
relatively new and not well penetrated. Although the Company believes that the
current trend toward increased use of automated software testing will
continue, there can be no assurance that the automated software testing market
will continue to expand or that the Company's products will be accepted in any
expanded market./1/ Price reductions or declines in demand for the Company's
software testing products, whether as a result of competition, technological
change or other factors, would have a material adverse effect on the Company's
results of operations or financial position.
 
   The Company may from time to time experience significant fluctuation in
quarterly operating results due to a variety of factors, some of which are
outside of the Company's control. A significant portion of the Company's
operating expenses are relatively fixed, and planned expenditures are based on
sales forecasts. Products are generally shipped as orders are received, and,
consequently, quarterly sales and operating results depend primarily on the
volume and timing of orders received during the quarter, which are difficult
to forecast. In particular, the Company has historically received a
substantial portion of its orders at the end of a quarter, up to the last few
days of a quarter. If an unanticipated order shortfall occurs at the end of a
quarter, the Company's operating results for the quarter could be materially
adversely affected. In addition, product orders are affected by the buying
patterns of customers. The buying trends of customers are further impacted by
internal budgetary considerations relating to Year 2000 remediation or Euro
conversion efforts. All of the foregoing may result in unanticipated quarterly
earning shortfalls or losses. Accordingly, the Company believes that period-
to-period comparisons of its results of operations are not necessarily
meaningful and should not be relied upon as indications of future performance.
 
   The computer software market is intensely competitive. The Company
continues to face direct competition mainly from well established, publicly-
held companies. There could be a material adverse effect on the Company's
results of operations or financial position if any of the major software
manufacturers, which have
--------
/1/ Forward looking statement
 
                                      18
<PAGE>
 
significantly greater financial and technical resources than the Company,
decided to devote substantial resources to entering the software testing
market or if there is an increase in developing testing utilities internally
by the Company's customers or potential customers. A variety of external and
internal factors could materially adversely affect the Company's ability to
compete. These include the relative functionality, price, performance and
reliability of the products offered by the Company and its competitors, the
timing and success of new product development or enhancement efforts of the
Company and its competitors, and the effectiveness of the marketing and sales
efforts of the Company and its competitors. The Company expects to face
increasing competition in the automated software testing market./1/ There can
be no assurance that the Company will be able to compete successfully in the
future or that competitive pressures will not materially adversely affect the
Company's business.
 
   The Company has derived a substantial portion of its revenues from sales of
its products through alternate distribution channels such as referral
partners, system integrators, and value-added resellers. The Company expects
that sales of its products through its alternate distribution channels will
continue to account for a substantial portion of its revenues for the
foreseeable future. Each of the Company's system integrators and value added
resellers can cease marketing the Company's products with limited notice and
with little or no penalty. There can be no assurance that the Company's system
integrators and value added resellers will continue to offer the Company's
products or that the Company will be able to recruit additional or replacement
system integrators and value added resellers. The loss of one or more of the
Company's major system integrators and value added resellers could have a
material adverse effect on the Company's business, financial condition and
results of operations. The Company's system integrators and value added
resellers also offer competitive products manufactured by third parties. There
can be no assurance that the Company's system integrators and value added
resellers will give priority to the marketing of the Company's products as
compared to its competitors' products. Any reduction or delay in sales of the
Company's products by its system integrators and value added resellers could
have a material adverse effect on the Company's business, financial condition
and results of operations.
 
   Sales to customers located outside the United States have historically
accounted for a significant percentage of revenue and the Company anticipates
that such sales will continue to be a significant percentage of the Company's
total revenue./1/ Accordingly, such factors as currency fluctuations,
political and economic instability and trade restrictions could have a
negative impact on the Company's financial performance.
 
   As a global concern, the Company faces exposure to adverse movements in
foreign currency exchange rates. Historically, the Company's primary exposure
related to non-dollar denominated sales and operating expenses in Europe and
Australia. As the Company expands its operations in Europe and the Pacific
Rim, the Company expects to see an increase in exposures related to non-dollar
denominated sales./1/ The Company attempts to limit foreign exchange exposure
by operational strategies and, on a limited basis, by using forward contracts
to offset the effects of exchange rate changes on intercompany trade balances.
These efforts depend upon estimates of transaction activities in various
currencies. There can be no assurance that the company will be successful in
making these estimates. To the extent these estimates are overstated or
understated during periods of currency volatility, the Company could
experience unanticipated material currency gains or losses.
 
   The Company's stock price, has been and will continue to be, subject to
significant volatility. Past financial performance should not be considered a
reliable indicator of future performance, and investors should not use
historical trends to anticipate results or trends in future periods. If
revenues or earnings in any quarter fail to meet expectations of the
investment community, there could be an immediate and significant impact on
the Company's stock price. In addition, the Company's stock price may be
impacted by events or broader market trends that are unrelated to the
Company's operating results.
 
   As part of its growth strategy, the Company may, from time to time, acquire
or invest in complimentary businesses, products or technologies. While there
are currently no commitments with respect to any particular
--------
/1/ Forward looking statement
 
                                      19
<PAGE>
 
acquisition or investment, the Company's management frequently evaluates the
strategic opportunity available related to complimentary businesses, products
or technologies. The process of integrating an acquired company's business
into the Company's operations may result in unforeseen operating difficulties
and expenditures and may absorb significant management attention that would
otherwise be available for the ongoing development of the Company's business.
Moreover, there can be no assurance that the anticipated benefits of any
acquisition or investment will be realized. Future acquisitions or investments
by the Company could result in potentially dilutive issuances of equity
securities, the incurrence of debt and contingent liabilities, amortization
expenses related to goodwill and other intangible assets, any of which could
materially adversely affect the Company's operating results and financial
condition.
 
   Since its inception, the Company has obtained royalty-bearing grants from
various Israeli government agencies. The Company received and recognized $1.6
million in such grants during 1998; however, it has not applied nor does it
currently anticipate applying for future grants./1/ The Company believes these
grants are no longer needed to subsidize the Company's research and
development projects./1/ The terms of certain grants prohibit the manufacture
of products developed under these grants outside of Israel and the transfer of
technology developed pursuant to the terms of these grants to any person,
without the prior written consent of the government of Israel. As a result, if
the Company is unable to obtain the consent of the government of Israel, the
Company may not be able to take advantage of strategic manufacturing and other
opportunities outside of Israel.
 
   Since 1991, the Company has experienced significant annual increases in
revenue. This growth has placed and, if it continues, will place a significant
strain on the Company's management, resources and operations. To accommodate
its recent growth, the Company has been implementing a variety of new or
expanded business and financial systems, procedures and controls, including
the improvement of its accounting and other internal management systems. There
can be no assurance that the implementation of such systems, procedures and
controls can be completed successfully, or without disruption of the Company's
operations. If the Company's growth continues, the Company will be required to
hire and integrate substantial numbers of new employees. The market has become
increasingly competitive both in the United States and internationally and may
require the Company to pay higher salaries. The Company's failure to manage
growth effectively could have a material adverse effect on the Company's
business, operating results and financial condition.
 
   The Company's success depends to a significant extent on the performance of
its senior management and certain key employees. Competition for highly
skilled employees, including sales, technical and management personnel, is
intense in the computer industry. The Company's continued success depends in
significant part on its ability to attract additional qualified employees and
to retain the services of current key employees. In particular, the loss of
the services of one or more of the Company's executive officers could have a
material adverse effect on the Company's business and results of operations.
 
   The Company currently relies on a combination of trademark, copyright and
trade secret laws and contractual provisions to protect its proprietary rights
in its products. The Company presently has one registered copyright. The
Company holds four patents for elements contained in certain of its products,
and it has filed several other U.S. and foreign patent applications on various
elements of its products. There can be no assurance that any of the Company's
patent applications will result in an issued patent or that, if issued, such
patent would be upheld if challenged. There can be no assurance that the
Company's competitors will not independently develop technologies that are
substantially equivalent or superior to the Company's technology. There can
also be no assurance that the measures taken by the Company to protect its
propriety rights will be adequate to prevent misappropriation of the
technology or independent development by others of similar technology. In
addition, the laws of various countries in which the Company's products may be
sold may not protect the Company's products and intellectual property rights
to the same extent as the laws of the United States. There can be no assurance
that third parties will not assert intellectual property infringement claims
against the Company or that any such claims will not require the Company to
enter into royalty or cross-license arrangements or result in costly
litigation.
--------
/1/ Forward looking statement
 
                                      20
<PAGE>
 
   In selling its products, the Company frequently relies on "shrink wrap"
licenses that are not signed by licensees. The provisions in such licenses
limiting the Company's exposure to potential product liability claims may
therefore be unenforceable under the laws of certain jurisdictions. Further,
the Company's license agreements typically contain a representation that the
software is Year 2000 compliant through its description of specifically how
the Company's products process the Year 2000 calendar dates. While the Company
believes its products are Year 2000 compliant, the risk of Year 2000
noncompliance claims may increase as December 31, 1999 approaches and passes.
The Company currently carries errors and omissions insurance against such
claims, however, there can be no assurance that such insurance will continue
to be available on acceptable terms, if at all, or that such insurance will
provide the Company with adequate protection against any such claims. Although
the Company has not experienced any product liability or other Year 2000
claims to date, the sale and support of products by the Company may entail the
risk of such claims. A significant product liability claim against the Company
could have a material adverse effect upon the Company's business, financial
condition and results of operations.
 
   The approach of Year 2000 presents significant issues for many computer
systems, since much of the software in use today may not accurately process
data beyond 1999. The Company is in the process of conducting an internal
review of most of its internal corporate headquarters computer systems and
software ("IT Systems") including finance, human resources, Intranet
applications, payroll systems and customer support organization systems to
determine their Year 2000 compliance. As part of this process, the Company is
contacting vendors of its relevant corporate IT Systems to determine potential
exposure to Year 2000 issues and will be obtaining written assurance from such
vendors regarding Year 2000 compliance. Although the Company believes that
most of its principal corporate IT Systems are Year 2000 compliant, the
Company has not yet completed its assessment and testing of these systems.
 
   At this time, the Company has not determined the state of compliance of
certain third-party suppliers of services such as phone companies, long
distance carriers, financial institutions and electric companies. The failure
of any one of these third-party suppliers could severely disrupt the Company's
ability to carry on its business as well as disrupt the business of the
Company's customers. The Company is in the process of polling these companies
in order to determine their state of compliance and their contingency plans.
 
   Failure of the Company to provide Year 2000 compliant business solutions to
its customers or to receive such business solutions from its suppliers could
result in liability to the Company or otherwise have a material adverse effect
on the Company's business, results of operations, financial condition and
prospects. Furthermore, the Company believes that the purchasing patterns of
customers and potential customers may be affected by Year 2000 issues as
companies expend significant resources to correct or patch their current
software systems for Year 2000 compliance. These expenditures may result in
reduced funds available to purchase products and services such as those
offered by the Company, which could result in a material adverse effect on the
Company's business, results of operations and financial condition. The Company
could be affected through disruptions in the operation of the enterprises with
which the Company interacts or from general widespread problems or an economic
crisis resulting from noncompliant Year 2000 systems. Despite the Company's
efforts to address the Year 2000 effect on its internal systems and business
operations, such effect could result in a material disruption of its business
or have a material adverse effect on the Company's business, financial
condition or results of operations. The Company has begun the process of
developing a contingency plan to respond to any of the foregoing consequences
of internal and external failures to be Year 2000 compliant.
 
   The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the recorded amounts of assets and liabilities,
disclosure of those assets and liabilities at the date of the financial
statements and the recorded amounts of expenses during the reporting period. A
change in the facts and circumstances surrounding these estimates could result
in a change to the estimates and impact future operating results.
 
Liquidity and Capital Resources
 
   At December 31, 1998, the Company's principle source of liquidity consisted
of $129.9 million of cash and investments as compared to $92.3 million and
$80.0 million at December 31, 1997 and 1996, respectively.
 
                                      21
<PAGE>
 
The December 31, 1998 balance included $88.3 million of short-term and $20.7
million of long-term investments in high quality government and corporate
securities.
 
   During 1998, the Company generated $41.9 million cash from operating
activities, compared to cash generated from operating activities of $17.1
million in 1997 and cash used for operating activities of $1.6 million in
1996. The increase in 1998 compared to 1997 was due primarily to an increase
in net income, an increase in deferred revenue, and increases in accrued
liabilities and income taxes payable. The increase in 1997 compared to 1996
was primarily due to an increase in net income, excluding the write off of in-
process research and development and an increase in deferred revenue,
partially offset by an increase in accounts receivable.
 
   The Company's primary investing activities were net purchases of
investments in 1998 of $1.3 million compared to net proceeds from investments
in 1997 and 1996 of $512,000 and $4.1 million, respectively. The Company also
purchased property and equipment, which totaled $14.9 million, $11.8 million
and $4.6 million in 1998, 1997 and 1996, respectively. The Company spent $1.5
million and $7.3 million in 1998 and 1997, respectively, for purchase and
renovation of its headquarters building in Sunnyvale, California. The Company
spent $5.7 million and $1.8 million in 1998 and 1997, respectively, on
construction of a new research and development facility in Israel. The Company
expects to spend an additional $4.0 million to complete this construction and
will relocate its Israel subsidiary to the new facility in the third quarter
of 1999.
 
   The Company's primary financing activity consisted of issuances of common
stock under the Employee Stock Option and Stock Purchase Plans. Proceeds from
issuance of stock under the Employee Stock Option and Purchase Plans amounted
to $11.1 million, $7.6 million and $1.9 million in 1998, 1997 and 1996,
respectively.
 
   Assuming there is no significant change in the Company's business, the
Company believes that its current cash and investment balances and cash flow
from operations, will be sufficient to fund the Company's cash needs for at
least the next twelve months./1/
 
New Accounting Pronouncements
 
   In March 1998, the American Institute of Certified Public Accountants
("AICPA") issued a Statement of Position 98-1, "Accounting for the Cost of
Computer Software Developed or Obtained for Internal Use" (SOP 98-1). SOP 98-1
is effective for the financial statements for years beginning after December
15, 1998. SOP 98-1 provides guidance over accounting for computer software
developed or obtained for internal use including the requirement to capitalize
specified costs and amortization of such costs. The company will adopt the
provisions of SOP 98-1 in its fiscal year ending December 31, 1999, and does
not expect such adoption to have a material effect on the Company's financial
statements.
 
   In March 1998, the AICPA issued Statement of Position 98-4, "Deferral of
Effective Date of a provision of SOP 97-2" ("SOP 98-4"). SOP 98-4 defers for
one year the application of certain provisions of Statement of Position 97-2
"Software Revenue Recognition" ("SOP 97-2"). Different informal and non-
authoritative interpretations of certain provisions of SOP 97-2 have arisen
and, as a result, the AICPA issued SOP 98-9 in December 1998 which is
effective for periods beginning after March 15, 1999. SOP 98-9 extends the
effective date of SOP 98-4 and provides additional interpretive guidance. The
adoption of SOP 97-2, SOP 98-4 and SOP 98-9 have not had and are not expected
to have a material impact on the Company's results of operations, financial
position or cash flows.
 
   In June 1998, the Financial Accounting Standards Board issued SFAS 133,
"Accounting for Derivative Instruments and Hedging Activities." SFAS 133
establishes accounting and reporting standards for derivative instruments and
for hedging activities and is effective for all fiscal quarters of fiscal
years beginning after June 15, 1999. The Company does not expect the adoption
of SFAS 133 to have a material impact on the Company's results of operations.
--------
/1/ Forward looking statement
 
                                      22
<PAGE>
 
Item 7a. Quantitative and Qualitative Disclosures about Market Risk
 
   Interest rate risk. The Company's exposure to market rate risk for changes
in interest rates relates primarily to the Company's investment portfolio. The
Company has not used derivative financial instruments in its investment
portfolio. The Company places its investments with high quality issuers and,
by policy, limits the amount of credit exposure to any one issue or issuer. At
December 31, 1998, $96.1 million (74%) of the Company's cash, cash equivalents
and investment portfolio carried a maturity of less than 90 days, and $109.2
million (84%) carried a maturity of less than one year. All investments
mature, by policy, in less than two years. The Company has the ability and
intent to hold the portfolio to maturity. The effect of a 10% rate decline
would not have a material effect on the portfolio. Information about the
Company's investment portfolio is set forth in Footnote 1 of Item 14(a)(1) of
this Form 10-K and is incorporated herein by reference.
 
   Foreign currency risk. The Company transacts business in various foreign
currencies, primarily in Europe and the Pacific Rim. Accordingly, the Company
is subject to exposure from movements in foreign currency exchange rates. The
Company's operating expenses in each of these countries are in the local
currencies, which mitigates a significant portion of the exposure related to
local currency revenues.
 
   In addition, the Company uses forward contracts to offset the effects of
exchange rate changes on intercompany trade payables. The Company has not
entered into forward foreign exchange contracts for speculative or trading
purposes. The Company's accounting policies for these contracts are based on
the Company's designation of the contracts as hedging transactions. The
criteria the Company uses for designating a contract as a hedge include the
contract's effectiveness in risk reduction and one-to-one matching of hedging
instruments to underlying transactions. Gains and losses on forward foreign
exchange contracts are recognized in income in the same period as gains and
losses on the underlying transactions. The effect of an immediate 10% change
in exchange rates would not have a material impact on the Company's future
operating results or cash flows. At December 31, 1998, the Company had no
outstanding forward foreign exchange contracts.
 
Item 8. Financial Statements and Supplementary Data
 
   Financial statements required pursuant to this Item are presented beginning
on page F-1 of this report.
 
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
 
   During the twenty-four month period preceding December 31, 1998, the
Company neither changed accountants nor had disagreements with its accountants
on any matter of accounting principles or practices, financial statement
disclosure or auditing scope and procedures.
 
                                      23
<PAGE>
 
                                   PART III
 
   Certain information required by Part III is omitted from this Annual Report
on Form 10-K because the Company will file a definitive proxy statement within
120 days after the end of its fiscal year pursuant to Regulation 14A (the
"Proxy Statement") for its Annual Meeting of Stockholders, currently scheduled
for May 26, 1999, and the information included in the Proxy Statement is
incorporated herein by reference.
 
Item 10. Directors and Executive Officers of the Registrant
 
   The information concerning the Company's officers required by this Item is
incorporated by reference to the section of Part I of this Annual Report on
Form 10-K entitled "Item 1. Business--Personnel." The information concerning
the Company's directors required by this Item is incorporated by reference to
the information under the heading "Election of Directors--Nominees" in the
Company's Proxy Statement.
 
Item 11. Executive Compensation
 
   The information required by this Item is incorporated by reference to the
Company's Proxy Statement under the heading "Executive Compensation."
 
Item 12. Security Ownership of Certain Beneficial Owners and Management
 
   The information required by this Item is incorporated by reference to the
Company's Proxy Statement under the heading "Security Ownership of Certain
Beneficial Owners and Management."
 
Item 13. Certain Relationships and Related Transactions
 
   The information required by this Item is incorporated by reference to the
Company's Proxy Statement under the heading "Certain Transactions."
 
                                      24
<PAGE>
 
                                    PART IV
 
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
 
   (a) The following documents are filed as a part of this report:
 
     1. Financial Statements. The following financial statements of Mercury
  Interactive Corporation are filed as a part of this report:
 
<TABLE>
<CAPTION>
                                                                           Page
                                                                           ----
   <S>                                                                     <C>
   Report of Independent Accountants.....................................  F- 1
   Consolidated Balance Sheets at December 31, 1998 and 1997.............  F- 2
   Consolidated Statements of Operations for the years ended December 31
    1998, 1997 and 1996..................................................  F- 3
   Consolidated Statements of Stockholders' Equity for the years ended
    December 31, 1998, 1997 and 1996.....................................  F- 4
   Consolidated Statements of Cash Flows for the years ended December 31,
    1998, 1997 and 1996..................................................  F- 5
   Notes to Consolidated Financial Statements............................  F- 6
</TABLE>
 
     2. Schedules
 
   The following financial statement schedule is filed as part of this Form 10-
K:
 
   Schedule II--Valuation and Qualifying Accounts for the Three Years Ended
December 31, 1998
 
     Financial statement schedules not listed above have been omitted because
  they are not applicable or the required information is shown in the
  financial statements or notes thereto.
 
     3. Exhibits
 
<TABLE>
<CAPTION>
                                   Description
                                   -----------
 <C>          <S>
  3.1(1)      Certificate of Incorporation of Registrant, as amended and
              restated to date.
  3.2(10)     Certificate of Amendment of the Restated Certificate of
              Incorporation
  3.3(1)      By-laws of Registrant, as amended to date.
 10.1(11),(2) 1989 Stock Option Plan and forms of Incentive Stock Option
              Agreement and Nonstatutory Stock Option Agreement.
 10.2(1)      Form of Directors' and Officers' Indemnification Agreement.
 10.3(1)      Registration and Information Rights Agreement made as of March
              13, 1992.
 10.4(1)      Lease Agreement dated August 30, 1990 between the Registrant and
              Reuven Down covering the property at 4 Hayotzrim Street, Or
              Yehudah, a suburb of Tel Aviv, Israel (translated from original
              Hebrew).
 10.5(1)      Consulting Agreement by and between the Registrant and Aryeh
              Finegold, dated March 1, 1992.
 10.6(1)      Agreement by and between Mercury Interactive (Israel) Limited, a
              wholly-owned subsidiary of the Registrant ("Mercury Israel"), and
              the Office of the Chief Scientist in the Ministry of Industry and
              Trade dated February 11, 1991 (translation from original Hebrew).
 10.7(1)      Agreement by and between Mercury Israel and the Office of the
              Chief Scientist in the Ministry of Industry and Trade dated
              February 10, 1992 (translation from original Hebrew).
 10.8(1)      Agreement by and between Mercury Israel and the Office of the
              Chief Scientist in the
              Ministry of Industry and Trade dated December 13, 1992
              (translation from original
              Hebrew).
</TABLE>
 
                                       25
<PAGE>
 
<TABLE>
<CAPTION>
                                   Description
                                   -----------
 <C>           <S>
 10.9(11),(2)  Form of 1998 Employee Stock Purchase Plan and form of
               Agreements.
 10.10(1)      401(k) Plan.
 10.11(1)      Microsoft Solutions Channel Alliance Agreement dated March 5,
               1993 between Registrant and Microsoft Corporation.
 10.12(2),(4)  1994 Directors' Stock Option Plan and form of Agreements.
 10.13(3)      Agreement by and between Mercury Israel and the Office of the
               Chief Scientist in the Ministry of Industry and Trade dated May
               5, 1993 (translation from original Hebrew).
 10.14(3)      Agreement by and between Mercury Israel and the Office of the
               Chief Scientist in the Ministry of Industry and Trade dated June
               21, 1993 (translation from original Hebrew).
 10.15(3)      Agreement by and between Mercury Israel and the Fund for the
               Encouragement of Marketing Abroad in the Ministry of Industry
               and Trade dated February 15, 1993 (translation from original
               Hebrew).
 10.16(5)      Agreement by and between Mercury Israel and the Office of the
               Chief Scientist in the Ministry of Industry and Trade dated
               November 13, 1994 (translation from original Hebrew).
 10.17(5)      Agreement by and between Mercury Israel and the Office of the
               Chief Scientist in the Ministry of Industry and Trade dated
               November 13, 1994 (translation from original Hebrew).
 10.18(6)      Agreement by and between Mercury Israel and the Fund for the
               Encouragement of Marketing Abroad in the Ministry of Industry
               and Trade dated January 1, 1996 (translation from original
               Hebrew).
 10.19(6)      Agreement by and between Mercury Israel and the Office of the
               Chief Scientist in the Ministry of Industry and Trade dated
               September 30, 1995 (translation from original Hebrew).
 10.20(6)      Agreement by and between Mercury Israel and the Office of the
               Chief Scientist in the Ministry of Industry and Trade dated
               September 30, 1995 (translation from original Hebrew).
 10.21(7)      Preferred Share Purchase Rights Agreement.
 10.22(8)      1996 Supplemental Stock Plan.
 10.23(9)      Purchase Agreement between Mercury Interactive Corporation and
               Dixon Software Technology dated September 30, 1997.
 10.24(9)      Purchase and Sale Agreement and Joint Escrow Instructions by and
               between Mercury Interactive Corporation and M. C. Securities,
               LLC dated July 1, 1997.
 10.25(11),(2) 1999 Stock Option Plan
 10.26         Form of Change of Control Agreements entered into by the Company
               with the Chairman, the Chief Executive Officer, the Chief
               Financial Officer and the President of North American
               Operations.
 21.1          Subsidiaries of Registrant.
 23.1          Consent of Independent Accountants.
 24.1          Power of Attorney (see page 26).
 27.1          Financial Data Schedule
</TABLE>
--------
 (1) Exhibits 3.1, 3.3, 10.2, 10.3, 10.4, 10.5, 10.6, 10.7, 10.8, 10.10, and
     10.11 are incorporated by reference to Exhibits 3.3, 3.4, 10.2, 10.3,
     10.5, 10.7, 10.8, 10.9, 10.10, 10.12, and 10.14 respectively, filed in
     response to Item 16(a), "Exhibits," of the Registrant's Registration
     Statement on Form S-1, as amended (File No. 33-68554), which was declared
     effective on October 29, 1993.
 
                                      26
<PAGE>
 
 (2) Designates management contract or compensatory plan arrangements required
     to be filed as an exhibit of this Annual Report on Form 10-K.
 (3) Exhibits 10.13, 10.14, and 10.15 are incorporated by reference to
     Exhibits 10.1, 10.2 and 10.3, respectively, filed with the Form 10-Q for
     the three month period ended March 31, 1994.
 (4) Exhibit 10.12 is incorporated by reference to Exhibit 10.1 filed with the
     Form 10-Q for the three month period ended September 30, 1994.
 (5) Exhibits 10.16 and 10.17 are incorporated by reference to Exhibits 10.19
     and 10.20, respectively, filed with the Form 10-K for the year ended
     December 31, 1994.
 (6) Exhibits 10.18, 10.19, and 10.20 are incorporated by reference to
     Exhibits 10.21, 10.22, and 10.23, respectively, filed with the Form 10-K
     for the year ended December 31, 1995.
 (7) Exhibit 10.21 is incorporated by reference to the Exhibit 1 to the
     Company's Form 8-A, filed with the Securities and Exchange Commission on
     July 9, 1996.
 (8) Exhibit 10.22 is incorporated by reference to Exhibit 4.2 to the
     Company's Registration Statement on Form S-8, No. 333-09913, filed with
     the Securities and Exchange Commission on August 9, 1996.
 (9) Exhibits 10.23 and 10.24 are incorporated by reference to Exhibits 10.1
     and 10.2, respectively, filed with the Form 10-Q for the three month
     period ended September 30, 1997.
(10) Exhibit 3.2 is incorporated by reference to Exhibit 3.1 filed with the
     Form 10-Q for the three month period ended September 30, 1998.
(11) Exhibits 10.1, 10.9, and 10.25 are incorporated by reference to Exhibits
     4.1, 4.3, and 4.2, respectively, filed with the Company's Registration
     Statement on Form S-8, No. 333-62125, filed with the Securities and
     Exchange Commission on August 24, 1998.
 
    (b)Reports on Form 8-K
 
       No report on Form 8-K was filed during the fourth quarter of the year
    ended December 31, 1998.
 
                                      27
<PAGE>
 
                                  SIGNATURES
 
   Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant, Mercury Interactive Corporation, a
corporation organized and existing under the laws of the State of Delaware,
has duly caused this Report to be signed on its behalf by the undersigned,
thereunto duly authorized.
 
                                          Mercury Interactive Corporation
 
                                          By     /s/ Sharlene Abrams
                                             __________________________________
                                                     Sharlene Abrams,
                                               Vice President of Finance and
                                                      Administration,
                                                Chief Financial Officer and
                                                         Secretary
 
Dated: March 30, 1999
 
   KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints jointly and severally, Amnon Landan
and/or Sharlene Abrams and each one of them, his or her attorneys-in-fact,
each with the power of substitution, for him or her in any and all capacities,
to sign any and all amendments to this Annual Report on Form 10-K and to file
the same, with exhibits thereto and other documents in connection therewith,
with the Securities and Exchange Commission, hereby ratifying and confirming
all that each of said attorneys-in-fact, or his or her substitute or
substitutes, may do or cause to be done by virtue hereof.
 
<TABLE>
<CAPTION>
                 Signature                             Title                    Date
                 ---------                             -----                    ----
 
 <S>                                       <C>                           <C>
 /s/   Aryeh Finegold                      Chairman of the Board of        March 30, 1999
 ________________________________________   Directors
    Aryeh Finegold
 
 /s/   Amnon Landan                        President, Chief Executive      March 30, 1999
 ________________________________________   Officer and Director
    Amnon Landan                            (Principal Executive
                                            Officer)
 
 /s/   Sharlene Abrams                     Vice President of Finance       March 30, 1999
 ________________________________________   and Administration, Chief
    Sharlene Abrams                         Financial Officer
                                            (Principal Financial and
                                            Accounting Officer) and
                                            Secretary
 
 /s/   Igal Kohavi                         Director                        March 30, 1999
 ________________________________________
    Igal Kohavi
 
 /s/   Yair Shamir                         Director                        March 30, 1999
 ________________________________________
    Yair Shamir
 
 /s/   Giora Yaron                         Director                        March 30, 1999
 ________________________________________
    Giora Yaron
</TABLE>
 
                                      28
<PAGE>
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
 
To the Board of Directors and Stockholders of
Mercury Interactive Corporation
 
   In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a) (1) and (2) present fairly, in all material
respects, the financial position of Mercury Interactive Corporation and its
subsidiaries (the "Company") at December 31, 1998 and 1997, and the results of
their operations and their cash flows for each of the three years in the
period ended December 31, 1998, in conformity with generally accepted
accounting principles. These financial statements are the responsibility of
the Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
 
PRICEWATERHOUSECOOPERS LLP
 
San Jose, California
January 28, 1999
 
                                      F-1
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
                          CONSOLIDATED BALANCE SHEETS
                    (in thousands, except per share amounts)
 
<TABLE>
<CAPTION>
                                                              December 31,
                                                            ------------------
                                                              1998      1997
                                                            --------  --------
<S>                                                         <C>       <C>
ASSETS
Current assets:
  Cash and cash equivalents................................ $ 96,073  $ 57,211
  Short-term investments...................................   13,130    31,357
  Trade accounts receivable (net of allowance for doubtful
   accounts and sales returns of $3,623 and $1,878)........   27,903    23,782
  Government grants and other receivables..................    6,012     3,606
  Inventories..............................................      271       252
  Prepaid expenses and other current assets................   10,255     2,954
                                                            --------  --------
    Total current assets...................................  153,644   119,162
Long-term investments......................................   20,697     3,771
Property and equipment, net................................   28,250    19,292
Other assets...............................................      985     1,185
                                                            --------  --------
                                                            $203,576  $143,410
                                                            ========  ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable......................................... $  4,575  $  4,045
  Accrued liabilities......................................   17,792    12,290
  Income taxes payable.....................................   11,498     3,121
  Deferred revenue.........................................   24,122    10,967
                                                            --------  --------
    Total current liabilities..............................   57,987    30,423
                                                            --------  --------
Commitments and contingencies (Note 5)
Stockholders' equity:
  Common Stock, par value $.002 per share, 120,000 shares
   authorized; 36,626 and 33,476 shares issued and
   outstanding.............................................       73        67
  Capital in excess of par value...........................  124,038   107,766
  Notes receivable from sale of stock......................   (5,130)      --
  Accumulated comprehensive income.........................     (775)     (424)
  Retained earnings........................................   27,383     5,578
                                                            --------  --------
    Total stockholders' equity.............................  145,589   112,987
                                                            --------  --------
                                                            $203,576  $143,410
                                                            ========  ========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                      F-2
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (in thousands, except per share amounts)
 
<TABLE>
<CAPTION>
                                                       Year ended December 31,
                                                       ------------------------
                                                         1998    1997    1996
                                                       -------- ------- -------
<S>                                                    <C>      <C>     <C>
Revenue:
  License............................................. $ 84,450 $56,683 $43,270
  Service.............................................   36,550  20,017  11,280
                                                       -------- ------- -------
    Total revenue.....................................  121,000  76,700  54,550
                                                       -------- ------- -------
Cost of revenue:
  License.............................................    6,291   4,351   3,419
  Service.............................................   11,757   6,225   3,240
                                                       -------- ------- -------
    Total cost of revenue.............................   18,048  10,576   6,659
                                                       -------- ------- -------
Gross profit..........................................  102,952  66,124  47,891
                                                       -------- ------- -------
Operating expenses:
  Research and development, net.......................   15,747  10,933   9,396
  Write off of in-process research and development and
   related expenses...................................      --    5,500     --
  Marketing and selling...............................   56,476  36,804  29,360
  General and administrative..........................    8,052   6,362   4,113
  Settlement of litigation............................      --      --    2,600
                                                       -------- ------- -------
    Total operating expenses..........................   80,275  59,599  45,469
                                                       -------- ------- -------
Income from operations................................   22,677   6,525   2,422
Other income, net.....................................    4,579   3,109   3,361
                                                       -------- ------- -------
Income before provision for income taxes..............   27,256   9,634   5,783
Provision for income taxes............................    5,451   2,927   1,157
                                                       -------- ------- -------
Net income............................................ $ 21,805 $ 6,707 $ 4,626
                                                       ======== ======= =======
Net income per share (basic).......................... $   0.62 $  0.20 $  0.15
                                                       ======== ======= =======
Net income per share (diluted)........................ $   0.56 $  0.20 $  0.14
                                                       ======== ======= =======
Weighted average common shares (basic)................   34,958  32,746  31,816
                                                       ======== ======= =======
Weighted average common shares (diluted)..............   39,030  34,208  33,126
                                                       ======== ======= =======
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                      F-3
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                 (in thousands)
 
<TABLE>
<CAPTION>
                          Common stock                                   Accumulated other
                          -------------                       ---------------------------------------
                                                     Notes     Retained
                                        Capital in receivable  earnings/  Comprehensive               Comprehensive
                                        excess of  from sale  Accumulated    income     Stockholders'    income
                          Shares Amount par value   of stock    deficit      (loss)        equity        (loss)
                          ------ ------ ---------- ---------- ----------- ------------- ------------- -------------
<S>                       <C>    <C>    <C>        <C>        <C>         <C>           <C>           <C>
Balance at December 31,
 1995...................  31,456  $ 63   $ 98,277   $   --      $(5,755)      $  31       $ 92,616
Net income..............     --    --         --        --        4,626         --           4,626       $ 4,626
Currency translation
 adjustment.............     --    --         --        --          --         (130)          (130)         (130)
                          ------  ----   --------   -------     -------       -----       --------       -------
Other comprehensive
 income.................                                                                                   4,496
                                                                                                         -------
Stock issued under stock
 option and employee
 stock purchase plans...     656     1      1,926       --          --          --           1,927
                          ------  ----   --------   -------     -------       -----       --------
Balance at December 31,
 1996...................  32,112    64    100,203       --       (1,129)        (99)        99,039
Net income..............     --    --         --        --        6,707         --           6,707         6,707
Currency translation
 adjustment.............     --    --         --        --          --         (325)          (325)         (325)
                          ------  ----   --------   -------     -------       -----       --------       -------
Other comprehensive
 income.................                                                                                   6,382
                                                                                                         -------
Stock issued under stock
 option and employee
 stock purchase plans...   1,364     3      7,563       --          --          --           7,566
                          ------  ----   --------   -------     -------       -----       --------       -------
Balance at December 31,
 1997...................  33,476    67    107,766       --        5,578        (424)       112,897
Net income..............     --    --         --        --       21,805         --          21,805        21,805
Currency translation
 adjustment.............     --    --         --        --          --         (351)          (351)        (351)
                          ------  ----   --------   -------     -------       -----       --------       -------
Other comprehensive
 income.................                                                                                 $21,454
                                                                                                         -------
Stock issued under stock
 option and employee
 stock purchase plans...   3,150     6     16,272   $(5,130)        --          --          11,148
                          ------  ----   --------   -------     -------       -----       --------
Balance at December 31,
 1998...................  36,626  $ 73   $124,038   $(5,130)    $27,803       $(775)      $145,589
                          ======  ====   ========   =======     =======       =====       ========
</TABLE>
 
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                      F-4
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)
 
<TABLE>
<CAPTION>
                                                     Year ended December 31,
                                                    ---------------------------
                                                      1998      1997     1996
                                                    --------  --------  -------
<S>                                                 <C>       <C>       <C>
Cash flows from operating activities:
  Net income......................................  $ 21,805  $  6,707  $ 4,626
  Adjustments to reconcile net income to net cash
   provided by (used in) operating activities:
    Depreciation and amortization.................     4,141     3,741    3,263
    Deferred income taxes.........................    (1,840)      270      674
    Changes in assets and liabilities:
      Trade accounts receivable...................    (3,902)   (7,214)  (6,527)
      Government grant and other receivables......    (4,034)     (730)    (564)
      Inventories.................................         8       345      (44)
      Prepaid expenses and other current assets...    (1,451)      513   (1,084)
      Other assets................................      (400)      --       --
      Accounts payable............................       899     1,800      591
      Accrued liabilities.........................     5,303     4,271   (5,324)
      Income taxes payable........................     8,373     2,485      237
      Deferred revenue............................    13,030     4,936    2,594
                                                    --------  --------  -------
        Net cash provided by (used in) operating
         activities...............................    41,932    17,124   (1,558)
                                                    --------  --------  -------
Cash flows from investing activities:
  Maturity of investments.........................    35,128    35,640   39,789
  Purchases of investments........................   (33,826)  (35,128) (35,640)
  Acquisition of property and equipment...........   (14,924)  (11,799)  (4,596)
  Capitalization of software development costs....       --       (500)  (1,340)
                                                    --------  --------  -------
        Net cash used in investing activities.....   (13,622)  (11,787)  (1,787)
                                                    --------  --------  -------
Cash flows from financing activities:
  Proceeds from issuance of Common Stock, net.....    16,267     7,565    1,927
  Notes receivable from issuance of stock.........    (5,130)      --       --
                                                    --------  --------  -------
        Net cash provided by financing
         activities...............................    11,137     7,565    1,927
                                                    --------  --------  -------
Effect of exchange rate changes on cash...........      (585)      (28)     (95)
                                                    --------  --------  -------
Net increase (decrease) in cash...................    38,862    12,874   (1,513)
Cash and cash equivalents at beginning of period..    57,211    44,337   45,850
                                                    --------  --------  -------
Cash and cash equivalents at end of period........  $ 96,073  $ 57,211  $44,337
                                                    ========  ========  =======
Supplemental Disclosure:
Cash paid during the period for income taxes......  $  1,365  $  2,083  $ 1,182
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                      F-5
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 1--THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES
 
   Mercury Interactive Corporation (the "Company"), incorporated in Delaware
in July 1989, develops, markets and supports a family of automated
client/server and Web-based system tools for testing business-critical
enterprise applications. The Company operates in one industry segment. See
Note 7 for geographic reporting. No customer accounted for more than 10% of
the Company's revenue in 1998, 1997 or 1996.
 
 Basis of presentation
 
   The Company has a wholly owned research and development subsidiary
incorporated in Israel and sales subsidiaries in Canada, Europe and the
Pacific Rim for marketing, distribution and support of products. The
consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated.
 
 Foreign currency translation
 
   The functional currency of the Company's subsidiary in Israel is the U.S.
dollar. Assets and liabilities in Israel are translated at year-end exchange
rates, except for property and equipment, which is translated at historical
rates. Revenues and expenses are translated at average exchange rates in
effect during the year, except for costs related to those balance sheet items,
which are translated at historical rates. Foreign currency translation gains
and losses, which have not been material to date for this subsidiary, are
included in the statement of operations.
 
   The functional currencies of all other subsidiaries are the local
currencies. Accordingly, all assets and liabilities of these subsidiaries are
translated at the current exchange rate at the end of the period and revenues
and costs at average exchange rates in effect during the period. The gains and
losses from translation of these subsidiaries' financial statements are
recorded directly into a separate component of stockholders' equity. Net gains
and losses resulting from foreign exchange transactions were not significant
during any of the periods presented.
 
 Cash and cash equivalents
 
   The Company considers all highly liquid debt instruments purchased with a
maturity of three months or less at the date of purchase to be cash
equivalents.
 
 Short-term and long-term investments
 
   The Company considers all investments with maturities of less than one year
as of December 31, 1998 to be short-term investments and all investments with
maturities greater than one year to be long-term investments. In accordance
with Statement of Financial Accounting Standards No. 115, "Accounting for
Certain Investments in Debt and Equity Securities," the Company has
categorized its marketable securities as "held to maturity" securities. The
investments, which all have contractual maturities of less than two years, are
carried at cost plus accrued interest. Realized gains or losses are determined
based on the specific identification method and are reflected in other income.
 
                                      F-6
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
   The portfolio of short and long-term investments (including cash and cash
equivalents) consisted of the following:
 
<TABLE>
<CAPTION>
                                                                 December 31,
                                                               ----------------
                          Investment Type                        1998    1997
                          ---------------                      -------- -------
     <S>                                                       <C>      <C>
     Cash and interest bearing demand deposits................ $ 20,892 $13,087
     Municipal securities.....................................   50,936  63,449
     Corporate debt securities................................   38,022   7,856
     Money market preferred stock.............................   18,450   7,947
     U.S. treasury and agency securities......................    1,600     --
                                                               -------- -------
       Total.................................................. $129,900 $92,339
                                                               ======== =======
</TABLE>
 
 Revenue recognition
 
   The Company's product revenues are derived from product licensing fees, and
the Company's service revenues are derived from maintenance support services,
training and consulting. Revenue from product licensing fees is recognized
upon shipment and resolution of any material vendor obligations. Products
shipped, for which material vendor obligations exist, are recorded as deferred
revenue. Service revenue from customer maintenance fees for ongoing customer
support and product updates is recognized ratably over the period of the
contract. Payments for maintenance fees are generally made in advance, are
nonrefundable and are classified as deferred revenue. Revenues for training
and consulting services are recognized as the services are provided.
 
 Inventories
 
   Inventories are stated at the lower of standard cost, which approximates
actual cost, using the first-in, first-out method, or market.
 
 Property and equipment
 
   Property and equipment are stated at cost. Depreciation and amortization
are provided using the straight-line method over the estimated economic lives
of assets, which are three to ten years for office furniture and equipment,
three to five years for computers and related equipment, four to ten years for
leasehold improvements, or the term of the lease, whichever is shorter, and
thirty years for the building.
 
 Research and development
 
   In accordance with Statement of Financial Accounting Standards No. 86,
"Accounting for Costs of Computer Software to be Sold, Leased or Otherwise
Marketed," all costs incurred to establish the technological feasibility of a
computer product to be sold, leased or otherwise marketed are expensed as
research and development costs. Costs incurred subsequent to the establishment
of technological feasibility, and prior to the general release of the product
to the public are capitalized. Amortization of capitalized software
development costs is provided on a product-by-product basis using the
straight-line method over the estimated economic life of the products of two
years.
 
   In 1998, the Company did not capitalize any software development costs. The
Company capitalized $500,000 and $1.3 million of software development costs
during the years ended December 31, 1997 and 1996, respectively. Amortization
charges included in cost of license revenues were $600,000 in 1998 and 1997,
and $300,000 in 1996. In conjunction with the technology acquisition in 1997
the Company wrote-off approximately $250,000 of capitalized development costs
as obsolete in the year ended December 31, 1997. At December 31,
 
                                      F-7
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
1998 and 1997 the Company had a net balance of capitalized software
development costs of $585,000 and $1.2 million, respectively.
 
   Research and development expense for each of the three years ended December
31, 1998, 1997 and 1996 is net of research grants received by the Company from
the government of Israel, and includes royalty expense for obligations to the
government of Israel for sales of products developed under government-funded
research. The Company obtained grants from the Office of the Chief Scientist
in the Israeli Ministry of Industry and Trade ("the Chief Scientist") in the
amounts of $1.6 million, $2.0 million and $1.8 million in 1998, 1997 and 1996,
respectively. In 1996, the Company also received a grant in the amount of
$391,000 from the Israel-U.S. Binational Industrial Research and Development
Foundation ("BIRD-F"). The Company is not obligated to repay these grants;
however, it has agreed to pay royalties at rates ranging from 2% to 5% of
product sales resulting from the research, up to the amount of the grants
obtained and for certain grants up to 150% of the grants obtained. Royalty
expense under these agreements amounted to approximately $2.7 million, $1.6
million and $1.1 million for the years ended December 31, 1998, 1997 and 1996,
respectively. As of December 31, 1998, the Company is committed to pay, if and
when earned, $2.7 million in additional royalties for Chief Scientist grants
and $700,000 for the BIRD-F grants. The Company has not applied for, nor does
it expect to apply for, any future Chief Scientist or BIRD-F grants.
 
 Stock-based compensation
 
   The Company accounts for stock-based compensation using the intrinsic value
method presented in Accounting Principles Board Opinion (APB) No. 25,
"Accounting for Stock Issued to Employees" and related interpretations. The
Company's policy is to grant options with an exercise price equal to the
quoted market price of the Company' stock on the grant date. Accordingly, no
compensation cost has been recognized in the Company's statements of
operations. The Company provides additional pro forma disclosure as required
under Statement of Financial Accounting Standard No. 123 (SFAS 123),
"Accounting for Stock-based Compensation." See Note 3.
 
 Concentration of risks
 
   Financial instruments, which potentially subject the Company to
concentrations of credit risk, consist principally of cash equivalents,
investments and accounts receivable. The Company invests primarily in money
market accounts and marketable securities and places its investments with high
quality financial, government or corporate institutions. The Company's
accounts receivables are derived from sales to customers located primarily in
the U.S., Canada, Europe, Pacific Rim and Israel. The Company performs ongoing
credit evaluations of its customers and to date has not experienced any
material losses.
 
                                      F-8
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
 Net income per share
 
   Earnings per share are calculated in accordance with the provisions of
Statement of Accounting Standards No. 128, "Earnings per Share," (SFAS 128).
SFAS 128 requires the Company to report both basic earnings per share, which
is the weighted-average number of common shares outstanding, and diluted
earnings per share, which includes the weighted-average common shares
outstanding and all dilutive potential common shares outstanding. All periods
presented herein have been restated to reflect the adoption of SFAS 128. For
the years ended December 31, 1998, 1997 and 1996, dilutive potential common
shares outstanding reflects shares issuable under the Company's stock option
plans. The following table summarizes the Company's earnings per share
computations for the years ended December 31, 1996, 1997 and 1998:
 
<TABLE>
<CAPTION>
                                                               Average Earnings
                                                    Net income shares  per share
                                                    ---------- ------- ---------
   <S>                                              <C>        <C>     <C>
   December 31, 1996:
     Basic earnings per share......................  $ 4,626   31,816    $0.15
     Dilutive adjustments..........................      --     1,310
                                                     -------   ------
     Diluted earnings per share....................  $ 4,626   33,126     0.14
                                                     -------   ------
   December 31, 1997:
     Basic earnings per share......................  $ 6,707   32,746    $0.20
     Dilutive adjustments..........................      --     1,462
                                                     -------   ------
     Diluted earnings per share....................  $ 6,707   34,208     0.20
                                                     -------   ------
   December 31, 1998:
     Basic earnings per share......................  $21,805   34,958    $0.62
     Dilutive adjustments..........................      --     4,072
                                                     -------   ------
     Diluted earnings per share....................  $21,805   39,030     0.56
                                                     =======   ======
</TABLE>
 
   At December 31, 1998, 1997,and 1996, options to purchase a total of 140,000
shares of common stock with an average exercise price of $19.24, 470,546
shares of common stock with an average exercise price of $9.65, and 502,942
shares of common stock with an average exercise price of $9.03, respectively,
are considered anti-dilutive because the options' exercise price was greater
than the average fair market value of the Company's common stock for the years
then ended.
 
 Management Estimates
 
   The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
 
 Reclassifications
 
   Certain previously reported amounts have been reclassified to conform to
the 1998 consolidated financial statement presentation.
 
 Comprehensive Income
 
   Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income." This Statement
requires that all items recognized under accounting standards as components of
comprehensive earnings be reported in an annual financial statement that is
displayed with the same prominence as other annual financial statements. The
Company's comprehensive income has been included in the consolidated statement
of Stockholders' Equity for all periods.
 
                                      F-9
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
 Segment Reporting
 
   Effective January 1998, the Company adopted Statement of Financial
Accounting Standard No. 131, "Disclosures about Segments of an Enterprise and
Related Information." This statement establishes standards for the manner in
which public companies report information about operating segments in annual
and interim financial statements. The Company has included information related
to geographical segments. See Note 7.
 
 New Accounting Pronouncements
 
   In March 1998, the American Institute of Certified Public Accountants
("AICPA") issued a Statement of Position 98-1, "Accounting for the Cost of
Computer Software Developed or Obtained for Internal Use" (SOP 98-1). SOP 98-1
is effective for the financial statements for years beginning after December
15, 1998. SOP 98-1 provides guidance over accounting for computer software
developed or obtained for internal use including the requirement to capitalize
specified costs and amortization of such costs. The company will adopt the
provisions of SOP 98-1 in its fiscal year ending December 31, 1999, and does
not expect such adoption to have a material effect on the Company's financial
statements.
 
   In March 1998, the AICPA issued Statement of Position 98-4, "Deferral of
Effective Date of a provision of SOP 97-2" ("SOP 98-4"). SOP 98-4 defers for
one year the application of certain provisions of Statement of Position 97-2
"Software Revenue Recognition" ("SOP 97-2"). Different informal and non-
authoritative interpretations of certain provisions of SOP 97-2 have arisen
and, as a result, the AICPA issued SOP 98-9 in December 1998 which is
effective for periods beginning after March 15,1999. SOP 98-9 extends the
effective date of SOP 98-4 and provides additional interpretive guidance. The
adoption of SOP 97-2, SOP 98-4 and SOP 98-9 have not had and are not expected
to have a material impact on the Company's results of operations, financial
position or cash flows.
 
   In June 1998, the Financial Accounting Standards Board issued SFAS 133,
"Accounting for Derivative Instruments and Hedging Activities." SFAS 133
establishes accounting and reporting standards for derivative instruments and
for hedging activities and is effective for all fiscal quarters of fiscal
years beginning after June 15, 1999. The Company does not expect the adoption
of SFAS 133 to have a material impact on the Company's results of operations.
 
                                     F-10
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
NOTE 2--FINANCIAL STATEMENT COMPONENTS
 
<TABLE>
<CAPTION>
                                                             December 31,
                                                           ------------------
                                                             1998      1997
                                                           --------  --------
                                                            (in thousands)
   <S>                                                     <C>       <C>
   Government grant and other receivables:
     Government grant receivables......................... $    400  $    977
     Employee receivables.................................    1,014       277
     Income tax receivable................................    2,618     1,484
     Other receivables....................................    1,980       868
                                                           --------  --------
                                                           $  6,012  $  3,606
                                                           ========  ========
   Prepaid expenses and other current assets:
     Prepaid compensation................................. $  5,717  $  1,427
     Deferred income tax..................................    1,840       --
     Other................................................    2,698     1,527
                                                           --------  --------
                                                           $ 10,255  $  2,954
                                                           ========  ========
   Property and equipment:
     Land................................................. $  4,807  $  5,128
     Buildings............................................   13,504     6,712
     Computers and equipment..............................   17,819    13,722
     Office furniture and equipment.......................    4,433     2,186
     Leasehold improvements...............................    2,902     2,154
                                                           --------  --------
                                                             43,465    29,902
     Less: accumulated depreciation and amortization......  (15,215)  (10,610)
                                                           --------  --------
                                                           $ 28,250  $ 19,292
                                                           ========  ========
   Accrued liabilities:
     Payroll and accrued commissions (including payroll
      taxes).............................................. $  8,759  $  4,822
     Vacation and severance...............................    3,422     2,517
     Acquisition of technologies and related costs........      --      2,316
     Royalties............................................    2,177     1,357
     Other................................................    3,434     1,278
                                                           --------  --------
                                                           $ 17,792  $ 12,290
                                                           ========  ========
</TABLE>
 
<TABLE>
<CAPTION>
                                                         Year ended December
                                                                 31,
                                                         ----------------------
                                                          1998    1997    1996
                                                         ------  ------  ------
                                                            (in thousands)
   <S>                                                   <C>     <C>     <C>
   Other income, net:
     Interest income.................................... $4,680  $3,547  $3,148
     Foreign exchange gains (losses) and other..........   (101)   (438)    213
                                                         ------  ------  ------
                                                         $4,579  $3,109  $3,361
                                                         ======  ======  ======
</TABLE>
 
NOTE 3--COMMON STOCK
 
   In August 1989, the Company adopted a stock option plan (the "Plan").
Options granted under the Plan are for periods not to exceed ten years. For
holders of 10% or more of the total combined voting power of all
 
                                     F-11
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
classes of the Company's stock, options may not be granted at less than 110%
of the fair value of the Common Stock at the date of grant and the option term
may not exceed 5 years. Incentive stock option grants under the Plan must be
at exercise prices no less than 100% of the fair market value and non-
statutory stock option grants under the Plan must be at exercise prices no
less than 85% of the fair market value of the stock on the date of grant.
Options are immediately exercisable but all shares purchased upon exercise of
options are subject to repurchase by the Company until vested. Options
generally vest over a period of four years. In August 1998, the stockholders
reserved additional 600,000 shares of Common Stock for issuance upon exercise
of stock options to be granted under this plan.
 
   In August 1998, the stockholders adopted the 1999 Stock Option Plan (the
"1999 Plan") to replace the Amended and Restated 1989 Stock Option plan,
effective on the expiration of the term of such plan in August 1999. The
Company reserved 450,000 shares of Common Stock for issuance upon exercise of
stock options to be granted under this plan. The provisions of the
supplemental plan regarding option term, grant price, exercise price, and
resting period are identical to those of the Plan except that all options
granted under the 1999 Plan must be at exercise prices no less than 100% of
the fair market value.
 
   In May 1996, the Company adopted a stock option plan solely for grants to
employees of the Company and its subsidiaries located outside the United
States (the "Supplemental Plan"). The Company reserved 1,000,000 shares of
Common Stock for issuance upon exercise of stock options to be granted under
this plan. The provisions of the Supplemental Plan regarding option term,
grant price, exercise price, and vesting period is identical to those of the
Plan.
 
   The following table presents the combined activity of the Plan and the
Supplemental Plan for the years ended December 31, 1996, 1997 and 1998 (shares
in thousands):
 
<TABLE>
<CAPTION>
                                                                    Options
                                                                  outstanding
                                                                ----------------
                                                                        Weighted
                                                       Options  Number  average
                                                      available   of    exercise
                                                      for grant shares   price
                                                      --------- ------  --------
   <S>                                                <C>       <C>     <C>
   Balance outstanding at December 31, 1995..........     320    4,008   $5.35
     Additional shares authorized....................   2,418      --      --
     Options granted.................................  (3,756)   3,756    6.04
     Options canceled................................   1,046   (1,046)   7.23
     Options exercised...............................     --      (468)   3.67
                                                       ------   ------
   Balance outstanding at December 31, 1996..........      28    6,250    5.64
     Additional shares authorized....................   1,496      --      --
     Options granted.................................  (2,134)   2,134    5.93
     Options canceled................................     626     (626)   5.99
     Options exercised...............................     --    (1,062)   4.81
                                                       ------   ------
   Balance outstanding at December 31, 1997..........      16    6,696    5.84
     Additional shares authorized....................   2,214      --      --
     Options granted.................................  (2,632)   2,632   13.04
     Options canceled................................     456     (456)   8.86
     Options exercised...............................     --    (3,040)   5.44
                                                       ------   ------
   Balance outstanding at December 31, 1998..........      54    5,832   $8.99
                                                       ======   ======
</TABLE>
 
   In May of 1996, the Board of Directors authorized the Company to offer all
employees with outstanding options at exercise price in excess of $8.00 per
share the opportunity to exchange such options for new options.
 
                                     F-12
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
Each new option was issued under the same terms as the surrendered options. As
a result, options covering 542,166 shares ranging in price from $8.38 to $9.50
were canceled and options for an equal number of shares were granted at the
exercise price of $6.38.
 
   The following table presents weighted average price and remaining
contractual life information about significant option groups outstanding under
the Plan and the Supplemental Plan at December 31, 1998 (shares in thousands):
 
<TABLE>
<CAPTION>
                                  Options outstanding        Options exercisable
                            -------------------------------- --------------------
                                         Weighted
                                          average   Weighted             Weighted
     Range of                            remaining  average    Number    average
     exercise                 Number    contractual exercise exercisable exercise
      prices                outstanding life (yr.)   price   at 12/31/98  price
     --------               ----------- ----------- -------- ----------- --------
   <S>                      <C>         <C>         <C>      <C>         <C>
   $ 0.15-- 6.13...........    1,440       5.86      $ 4.89       528     $ 4.95
   $ 6.19-- 7.63...........    1,654       7.23        6.62       718       6.49
   $ 7.88--12.63...........    2,404       9.09       12.06       156       9.67
   $16.19--19.82...........      334       9.29       16.67        10      16.97
                               -----                            -----
                               5,832       7.77      $ 8.99     1,412     $ 6.34
                               =====                            =====
</TABLE>
 
   In October 1998, the Company issued notes receivable of $5.1 million to
officers and key employees of the Company in connection with the purchase of
common stock. The notes bear interest at 5%, are secured by the shares
purchased, and require quarterly interest payments. The full amount of the
notes and the final interest payment are due no later than December 31, 2000.
 
 Directors' Stock Option Plan
 
   On August 3, 1994, the Board of Directors of the Company adopted the 1994
Directors' Stock Option Plan (the "Directors' Plan"). The Company reserved
1,000,000 shares of Common Stock for issuance upon exercise of stock options
to be granted during the ten year term of the Directors' Plan. Only outside
directors may be granted options under the Directors' Plan. The Plan provided
for an initial option grant of 25,000 shares to outside directors of the
Company as of August 3, 1994 or upon initial election to the Board of
Directors after August 3, 1994. In addition, the plan provided for automatic
annual grants of 5,000 shares upon re-election of the individual to the Board
of Directors. In August 1998, the stockholders agreed to amend the Directors'
plan to increase the number of shares granted to 50,000 shares as an initial
grant to new non-employee directors, 10,000 shares as the annual grant to
continuing non-employee directors of the Corporation, and to provide for a
one-time grant of 25,000 shares to the non-employee directors of the
Corporation who were serving as directors of the Corporation as of August 14,
1998. The option term shall be ten years, and options shall be exercisable
while such person remains a director. The exercise price shall be 100% of fair
market value on the date of grant. The initial option grants vest 20% annually
for each director on the date of each Annual Meeting of Stockholders of the
Company after the date of grant of such option. The annual option grants shall
vest in full on the fifth anniversary following each individual's re-election
to the Board of Directors.
 
                                     F-13
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
   The following table presents the activity for the Directors' Plan for the
years ended December 31, 1996, 1997 and 1998 (shares in thousands):
 
<TABLE>
<CAPTION>
                                                                     Options
                                                                   outstanding
                                                                 ---------------
                                                        Options  Number Weighted
                                                       available   of   average
                                                       for grant shares  price
                                                       --------- ------ --------
   <S>                                                 <C>       <C>    <C>
   Balance outstanding at December 31, 1995...........    760     220    $ 5.66
     Options granted..................................    (90)     90      7.38
     Options canceled.................................     90     (90)     6.14
     Options exercised................................    --      (40)     4.57
                                                         ----     ---
   Balance outstanding at December 31, 1996...........    760     180      6.52
     Options granted..................................    (30)     30      6.13
     Options canceled.................................    --      --        --
     Options exercised................................    --      (20)     4.57
                                                         ----     ---
   Balance outstanding at December 31, 1997...........    730     190      6.66
     Options granted..................................   (180)    180     19.40
     Options canceled.................................    --      --        --
     Options exercised................................    --      (80)     7.62
                                                         ----     ---
   Balance outstanding at December 31, 1998...........    550     290    $14.28
                                                         ====     ===
</TABLE>
 
   The following table presents weighted average price and remaining
contractual life information about significant option groups outstanding under
the Director's Plan at December 31, 1998 (shares in thousands):
 
<TABLE>
<CAPTION>
                                  Options outstanding        Options exercisable
                            -------------------------------- --------------------
                                         Weighted
                                          average   Weighted             Weighted
     Range of                            remaining  average    Number    average
     exercise                 Number    contractual exercise exercisable exercise
      prices                outstanding life (yr.)   price   at 12/31/98  price
     --------               ----------- ----------- -------- ----------- --------
   <S>                      <C>         <C>         <C>      <C>         <C>
   $ 4.57--$ 6.75..........      80        7.20      $ 5.97      --          --
   $ 7.88--$10.57..........      40        6.83        9.22      --          --
   $17.32--$19.82..........     170        9.50       18.57       20      $19.82
                                ---                              ---
                                290        8.54      $14.28       20      $19.82
                                ===                              ===
</TABLE>
 
 Employee Stock Purchase Plans
 
   In October 1993, the Board of Directors and stockholders adopted the
Employee Stock Purchase Plan (the "1993 ESPP") and reserved 1,000,000 shares
for issuance. Under the plan, employees were granted the right to purchase
shares of Common Stock at a price per share that was the lesser of: (i) 85% of
the fair market value of the shares at the participant's entry date into the
two-year offering period, or (ii) the fair market value at the end of each
six-month segment within such offering period. The 1993 ESPP was terminated in
February 1998. In August 1998, the stockholders adopted the 1998 Employee
Stock Purchase Plan (the "1998 ESPP") to replace the 1993 ESPP and the
reservation of 650,000 shares for issuance thereunder. Under the 1998 ESPP,
employees are granted the right to purchase shares of common stock at a price
per share that is the lesser of 85% of the fair market value of the shares at
the participant's entry date into the six month offering period, or 85% of the
fair market value of the shares at the end of the six month offering period.
During 1998, 1997 and 1996, approximately 42,000, 280,000 and 188,000 shares,
respectively, were purchased under the Company's Employee Stock Purchase
Plans.
 
                                     F-14
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
 Pro Forma Disclosure
 
   The Company has adopted the disclosure provisions only of SFAS No. 123 and
will continue to account for its stock option plans in accordance with the
provisions of APB 25. Accordingly, no compensation cost has been recognized
for the stock option plans of the ESPP.
 
   Pursuant to the requirements of SFAS 123, the following are pro forma net
income (loss) and net income (loss) per share for 1998, 1997 and 1996, as if
the compensation costs for the option plans and the ESPP had been determined
based on the fair value at the grant date for grants in 1998, 1997 and 1996,
consistent with the provisions of SFAS 123:
<TABLE>
<CAPTION>
                                                             1998   1997 1996
                                                            ------- ---- -----
   <S>                                                      <C>     <C>  <C>
   Pro forma net income (loss) (in thousands).............. $10,162 $596 $(437)
   Pro forma net income (loss) per share (basic)...........    0.29 0.02 (0.02)
   Pro forma net income (loss) per share (diluted).........    0.26 0.02 (0.02)
</TABLE>
 
   The fair value of options and shares issued pursuant to the option plans
and the ESPP at the grant date were estimated using the Black-Scholes model
with the following weighted average assumptions:
 
<TABLE>
<CAPTION>
                                              Option plans          ESPP
                                             ----------------  ----------------
                                             1998  1997  1996  1998  1997  1996
                                             ----  ----  ----  ----  ----  ----
   <S>                                       <C>   <C>   <C>   <C>   <C>   <C>
   Expected life (years).................... 4.00  5.00  4.45  0.50  0.50  0.50
   Risk-free interest rate.................. 5.22% 6.10% 6.20% 4.90% 5.36% 5.13%
   Volatility...............................   83%   86%   94%   83%   86%   94%
   Dividend yield........................... None  None  None  None  None  None
</TABLE>
 
   The weighted fair value per share of options granted under the Plan and
Supplemental Plan during the years ended December 31, 1998, 1997 and 1996 were
$8.26, $4.24 and $4.09, respectively. The weighted fair value per share of
options granted under the Directors' Plan during the years ended December 31,
1998, 1997 and 1996 were $12.25, $4.36, and $5.68, respectively.
 
NOTE 4--INCOME TAXES
 
   Income (loss) before income taxes consists of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                           Year ended December
                                                                   31,
                                                          ---------------------
                                                           1998    1997   1996
                                                          ------- ------ ------
   <S>                                                    <C>     <C>    <C>
   Domestic.............................................. $ 6,939 $   16 $ (933)
   Foreign...............................................  20,317  9,618  6,716
                                                          ------- ------ ------
                                                          $27,256 $9,634 $5,783
                                                          ======= ====== ======
</TABLE>
 
                                     F-15
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
   The provision for income taxes is comprised of the following (in
thousands):
 
<TABLE>
<CAPTION>
                                                          Year ended December
                                                                  31,
                                                         ----------------------
                                                          1998     1997   1996
                                                         -------  ------ ------
   <S>                                                   <C>      <C>    <C>
   Current:
     Federal............................................ $ 5,322  $1,222 $ (110)
     State..............................................     350     355     65
     Foreign............................................   1,619   1,080    528
                                                         -------  ------ ------
       Total Current....................................   7,291   2,657    483
                                                         -------  ------ ------
   Deferred:
     Federal............................................  (1,756)    193    597
     State..............................................     (84)     77     77
                                                         -------  ------ ------
       Total Deferred...................................  (1,840)    270    674
                                                         -------  ------ ------
   Total tax expense.................................... $ 5,451  $2,927 $1,157
                                                         =======  ====== ======
</TABLE>
 
   Deferred tax assets consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                                 December 31,
                                                                ---------------
                                                                 1998    1997
                                                                ------  -------
   <S>                                                          <C>     <C>
   Tax credits................................................. $  253  $   860
   Accruals and reserves.......................................  1,821      972
   Other.......................................................   (234)     357
                                                                ------  -------
                                                                 1,840    2,189
   Valuation allowance.........................................    --    (2,189)
                                                                ------  -------
                                                                $1,840  $   --
                                                                ======  =======
</TABLE>
 
   Management believes it is more likely than not that future operations will
generate sufficient taxable income to realize the December 31, 1998 deferred
tax assets.
 
   The provision for income taxes differs from the amount obtained by applying
the statutory federal income tax rate to income before taxes as follows (in
thousands):
 
<TABLE>
<CAPTION>
                                                         December 31,
                                                    -------------------------
                                                     1998     1997     1996
                                                    -------  -------  -------
   <S>                                              <C>      <C>      <C>
   Statutory federal tax........................... $ 9,267  $ 3,276  $ 2,024
   State tax, net of federal benefit...............     350      549       58
   Foreign rate differentials from U.S. statutory
    rate...........................................  (5,208)  (2,739)  (2,194)
   Non-deductible expenses.........................     --        51       68
   Non-utilized net operating losses...............   2,051    2,390    1,746
   Tax-exempt interest.............................    (409)    (756)    (779)
   Other...........................................    (520)     156      234
                                                    -------  -------  -------
                                                    $ 5,451  $ 2,927  $ 1,157
                                                    =======  =======  =======
</TABLE>
 
   Income taxes are not provided for the undistributed earnings of the
Company's foreign subsidiaries because it is management's intention to
reinvest such earnings in its foreign operations.
 
                                     F-16
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
   The Company's Israeli facilities have been granted the status of an
"Approved Enterprise" under the Israeli law for the Encouragement of Capital
Investments, 1959, as amended. An Approved Enterprise is eligible for
significant tax rate reductions for several years following the first year in
which the Company has Israeli taxable income (after consideration of tax
losses carried forward). The Company realized tax savings of approximately
$5.2 million, $4.2 million, and $2.2 million in 1998, 1997 and 1996,
respectively, as a result of this tax holiday. Because the Israeli Company
currently has four overlapping Approved Enterprise plans, the tax holidays and
rate reductions which the Company will be able to realize in future years are
expected to extend until 2007.
 
NOTE 5--COMMITMENTS AND CONTINGENCIES
 
 Royalty Commitments
 
   Research and development expense for each of the three years ended December
31, 1998, 1997 and 1996 is net of research grants received by the Company from
the government of Israel, and includes royalty expense for obligations to the
government of Israel for sales of products developed under government-funded
research. The Company obtained grants from the Office of the Chief Scientist
in the Israeli Ministry of Industry and Trade ("the Chief Scientist") in the
amounts of $1.6 million, $2.0 million and $1.8 million in 1998, 1997 and 1996,
respectively. In 1996, the Company also received a grant in the amount of
$391,000 from the Israel-U.S. Binational Industrial Research and Development
Foundation ("BIRD-F"). The Company is not obligated to repay these grants;
however, it has agreed to pay royalties at rates ranging from 2% to 5% of
product sales resulting from the research, up to the amount of the grants
obtained and for certain grants up to 150% of the grants obtained. Royalty
expense under these agreements amounted to approximately $2.7 million, $1.6
million and $1.1 million for the years ended December 31, 1998, 1997 and 1996,
respectively. As of December 31, 1998, the Company is committed to pay, if and
when earned, $2.7 million in additional royalties for Chief Scientist grants
and $700,000 for the BIRD-F grants.
 
 Lease commitments
 
   The Company leases facilities for sales offices in the U.S. and foreign
locations under non-cancelable operating leases that expire from 1999 through
2003. Certain of these leases contain renewal options. The Company also leases
certain equipment and vehicles under various leases with lease terms ranging
from month-to-month up to one year. Future minimum payments under the
facilities and equipment leases with non-cancelable terms in excess of one
year are as follows as of December 31, 1998 (in thousands):
 
<TABLE>
            <S>                                    <C>
            1999.................................. $1,519
            2000..................................  1,114
            2001..................................    379
            2002..................................    191
            2003..................................     83
                                                   ------
              Total............................... $3,286
                                                   ======
</TABLE>
 
   Total rent expense under operating leases amounted to $1.9 million, $1.5
million, and $1.0 million for the years ended December 31, 1998, 1997 and
1996, respectively.
 
                                     F-17
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
NOTE 6--RELATED PARTIES
 
   At December 31, 1998, the Company held seven notes receivable with balances
totaling $5.1 million from officers and key employees of the Company. These
notes arose from transactions occurring on October 5, 1998 whereby the Company
loaned the key employees money to purchase an aggregate of 443,214 shares of
the Company's common stock at the then fair market value. These notes, which
bear interest at the rate of 5% per annum, mature on December 31, 2000.
Interest on the notes is due quarterly, with the principal amount and final
interest payment being payable in full no later than the maturity date. If the
officer or key employee's employment is terminated prior to January 1, 2001,
the unpaid portion of the note would become payable in full. These notes are
collateralized by the shares purchased. The receivable is shown on the balance
sheets as a reduction in equity.
 
NOTE 7--GEOGRAPHIC REPORTING
 
<TABLE>
<CAPTION>
                                                      Year ended December 31,
                                                     --------------------------
                                                       1998     1997     1996
                                                     -------- -------- --------
                                                           (in thousands)
   <S>                                               <C>      <C>      <C>
   Net revenue to third parties:
     North America.................................. $ 78,797 $ 49,354 $ 36,364
     Europe.........................................   33,140   21,223   12,003
     Israel and Rest of the World...................    9,063    6,123    6,183
                                                     -------- -------- --------
       Consolidated................................. $121,000 $ 76,700 $ 54,550
                                                     ======== ======== ========
   Identifiable assets:
     North America.................................. $161,751 $111,561 $ 94,748
     Europe.........................................   14,388   11,656    6,960
     Israel and Rest of the World...................   27,437   20,193   15,781
                                                     -------- -------- --------
       Consolidated................................. $203,576 $143,410 $117,489
                                                     ======== ======== ========
</TABLE>
 
   The subsidiary located in the United Kingdom accounted for 11% of the 1998
consolidated revenue to unaffiliated customers. Operations located in Israel
accounted 19% of the December 31, 1998 consolidated identifiable assets. In
1997 and 1996, no subsidiary represented 10 percent or more of the related
consolidated amounts.
 
                                     F-18
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
NOTE 8--ACQUISITIONS
 
   On September 30, 1997, the Company acquired certain in-process technologies
from Dixon Software Technology, an unrelated company, for $4.5 million and
related acquisition costs of $1.0 million. As a result of this purchase, the
Company recorded a one-time charge of $5.5 million during the year ended
December 31, 1997.
 
NOTE 9--LEGAL MATTERS
 
   During 1995, the Company was engaged in the defense of a lawsuit, which
alleged that an employee of the Company attempted to copy a software program
without authorization. The matter was settled on March 7, 1996 and, as a
result, the Company recorded a charge of $2.6 million during the quarter
ending March 31, 1996 reflecting settlement costs and related legal fees.
 
NOTE 10--SUBSEQUENT EVENTS
 
   In January 1999, the Company declared a two-for-one stock split in the form
of a stock dividend. One additional share of the Company's common stock has
been issued for each share of common stock held by shareholders of record as
of February 12, 1999. New shares were distributed on March 1, 1999. All per
share data contained herein has been restated to reflect the increased number
of shares outstanding.
 
                                     F-19
<PAGE>
 
                        MERCURY INTERACTIVE CORPORATION
 
                       UNAUDITED QUARTERLY FINANCIAL DATA
 
<TABLE>
<CAPTION>
                                                         Quarter ended
                          ---------------------------------------------------------------------------
                          Dec. 31, Sept. 30, June 30, March 31, Dec. 31, Sept. 30, June 30, March 31,
                            1998     1998      1998     1998      1997     1997      1997     1997
                          -------- --------- -------- --------- -------- --------- -------- ---------
                                           (in thousands, except per share amounts)
<S>                       <C>      <C>       <C>      <C>       <C>      <C>       <C>      <C>
Revenue:
 License................  $28,200   $21,550  $19,100   $15,600  $18,800   $14,300  $12,300   $11,283
 Service................   12,800     9,050    8,100     6.600    5,400     5,300    5,200     4,117
                          -------   -------  -------   -------  -------   -------  -------   -------
 Total revenue..........   41,000    30,600   27,200    22,200   24,200    19,600   17,500    15,400
                          -------   -------  -------   -------  -------   -------  -------   -------
Cost of revenue:
 License................    1,867     1,545    1,550     1,329    1,382     1,073      992       904
 Service................    3,864     2,959    2,600     2,334    1,879     1,520    1,612     1,214
                          -------   -------  -------   -------  -------   -------  -------   -------
 Total cost of revenue..    5,731     4,504    4,150     3,663    3,261     2,593    2,604     2,118
                          -------   -------  -------   -------  -------   -------  -------   -------
Gross profit............   35,269    26,096   23,050    18,537   20,939    17,007   14,896    13,282
                          -------   -------  -------   -------  -------   -------  -------   -------
Operating expenses:
 Research and
  development, net......    4,970     4,098    3,656     3,023    2,479     2,970    2,928     2,556
 Write off of in-process
  research and
  development and
  related expenses......      --        --       --        --       --      5,500      --        --
 Marketing and selling..   17,968    14,146   13,379    10,983   11,302     9,154    8,574     7,774
 General and
  administrative........    2,262     2,042    1,899     1,849    1,583     1,786    1,563     1,430
                          -------   -------  -------   -------  -------   -------  -------   -------
 Total operating
  expenses..............   25,200    20,286   18,934    15,855   15,364    19,410   13,065    11,760
                          -------   -------  -------   -------  -------   -------  -------   -------
Income (loss) from
 operations.............   10,069     5,810    4,116     2,682    5,575    (2,403)   1,831     1,522
Other income, net.......    1,590     1,214      925       850      738       816      846       709
                          -------   -------  -------   -------  -------   -------  -------   -------
Income (loss) before
 provision for income
 taxes..................   11,659     7,024    5,041     3,532    6,313    (1,587)   2,677     2,231
Provision for income
 taxes..................    2,332     1,405    1,008       706    1,263       683      535       446
                          -------   -------  -------   -------  -------   -------  -------   -------
Net income (loss).......  $ 9,327   $ 5,619  $ 4,033   $ 2,826  $ 5,050   $(2,270) $ 2,142   $ 1,785
                          =======   =======  =======   =======  =======   =======  =======   =======
Net income (loss) per
 share (basic)..........  $  0.26   $  0.16  $  0.12   $  0.08  $  0.15   $ (0.07) $  0.07   $  0.06
                          =======   =======  =======   =======  =======   =======  =======   =======
Net income (loss) per
 share (diluted)........  $  0.23   $  0.14  $  0.10   $  0.07  $  0.14   $ (0.07) $  0.06   $  0.05
                          =======   =======  =======   =======  =======   =======  =======   =======
Weighted average common
 shares (basic).........   36,306    34,976   34,570    33,984   33,306    32,866   32,534    32,274
                          =======   =======  =======   =======  =======   =======  =======   =======
Weighted average common
 shares (diluted).......   39,902    39,114   38,820    38,282   36,678    32,866   34,002    33,288
                          =======   =======  =======   =======  =======   =======  =======   =======
</TABLE>
 
                                      F-20
<PAGE>
 
                                                                     SCHEDULE II
 
                        MERCURY INTERACTIVE CORPORATION
 
                       VALUATION AND QUALIFYING ACCOUNTS
                  For the Three Years Ended December 31, 1998
                                 (In thousands)
 
<TABLE>
<CAPTION>
                                             Additions
                                  Balance at charged to Deductions  Balance at
                                  beginning  costs and   bad debts    end of
           Description            of period   expenses  charged off   period
           -----------            ---------- ---------- ----------- ----------
<S>                               <C>        <C>        <C>         <C>
Reserve for sales returns and
 doubtful accounts receivable:
  December 31, 1998..............   $1,878     $2,943     $1,198      $3,623
  December 31, 1997..............   $1,136     $1,927     $1,185      $1,878
  December 31, 1996..............   $  705     $2,831     $2,400      $1,136
</TABLE>