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                                 UNITED STATES

                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 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, 1999

[_]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                                       77-0224776
        (State or other jurisdiction                          (I.R.S. Employer
      of 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. [X]

  The aggregate market value of the voting stock held by non-affiliates of the
Registrant was approximately $7,625,566,441 as of February 29, 2000, 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
29, 2000 was 79,123,906.

                      DOCUMENTS INCORPORATED BY REFERENCE

  Portions of the Proxy Statement for Registrant's 2000 Annual Meeting of
Stockholders to be held May 24, 2000 are incorporated by reference in Part III
of this Annual Report on Form 10-K.

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<PAGE>

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                           Page
                                                                           ----
 <C>      <S>                                                              <C>
                                      PART I

 Item 1.  Business......................................................     3
          General.......................................................     3
          Products and Hosted Solutions.................................     4
          Research and Development......................................     7
          Marketing, Sales and Support..................................     7
          Competition...................................................     9
          Patents, Trademarks and Licenses..............................     9
          Personnel.....................................................    10

 Item 2.  Properties....................................................    11

 Item 3.  Legal Proceedings.............................................    11

 Item 4.  Submission of Matters to a Vote of Security Holders...........    11

                                      PART II

          Market for the Registrant's Common Equity and Related
 Item 5.  Stockholder Matters...........................................    12

 Item 6.  Selected Consolidated Financial Data..........................    13

          Management's Discussion and Analysis of Financial Condition
 Item 7.  and Results of Operations.....................................    14

 Item 7a. Quantitative and Qualitative Disclosures about Market Risk....    25

 Item 8.  Financial Statements and Supplementary Data...................    25

          Changes in and Disagreements with Accountants on Accounting
 Item 9.  and Financial Disclosure......................................    25

                                     PART III

 Item 10. Directors and Executive Officers of the Registrant............    26

 Item 11. Executive Compensation........................................    26

          Security Ownership of Certain Beneficial Owners and
 Item 12. Management....................................................    26

 Item 13. Certain Relationships and Related Transactions................    26

                                      PART IV

          Exhibits, Financial Statement Schedules and Reports on Form 8-
 Item 14. K.............................................................    27
</TABLE>

                                       2
<PAGE>

  This Annual Report on Form 10-K contains forward-looking statements within
the meaning of Section 21E of the Securities Exchange Act of 1934 and Section
27A of the Securities Act of 1933. In some cases, forward-looking statements
are identified by words such as "believes," "anticipates," "expects,"
"intends," "plans," "will," "may" and similar expressions. In addition, any
statements that refer to our plans, expectations, strategies or other
characterizations of future events or circumstances are forward-looking
statements. Our actual results could differ materially from those discussed
in, or implied by, these forward-looking statements. Factors that could cause
actual results or conditions to differ from those anticipated by these and
other forward-looking statements include those more fully described in "Risk
Factors." Our business may have changed since the date hereof, and we
undertake no obligation to update the forward-looking statements in this
Annual Report on Form 10-K.

                                    PART I

Item 1. Business

General

  We are the leading provider of integrated performance management solutions
that enable businesses to test and monitor their Internet applications. Our
software products and hosted services help e-businesses enhance the user
experience by improving the performance, availability, reliability and
scalability of their Web sites. By using our solutions to identify and assess
performance problems, e-businesses can increase their ability to attract and
retain customers, and improve their competitive advantage.

  Our customers represent a wide range of industries including Internet
companies such as Amazon.com, America Online, Ameritrade, E*Trade,
Healtheon/WebMD, HomeGrocer.com, Jobs.com, ShopLink.com and WingspanBank.com;
Internet infrastructure providers such as Ariba, Broadbase, Broadvision, i2
Technologies and Oracle; and Fortune 1000 enterprises such as Apple Computer,
Caterpillar, Cisco Systems, Ford Motor Co. and Walmart.

  Our integrated performance management solutions address these requirements,
enabling customers to more quickly identify and correct problems before users
experience them. Our products include load testing, functional testing and
test management products that automate the testing of Internet and other
applications, as well as Web performance monitoring products that monitor and
measure Web site performance from the end-user's perspective and alert our
customers to performance problems. Our hosted Web performance monitoring and
load testing services provide out-sourced testing and monitoring services.
Specifically, our products consist of:

  .  Load testing products that stress applications under real-world
     conditions to predict systems' behavior, scalability and performance and
     to identify and isolate problems;

  .  Functional testing products that help ensure that e-commerce and other
     applications operate as expected;

  .  Test process management products that organize and manage the testing
     process to determine application readiness;


  .  Web performance monitoring products that monitor sites in real time and
     alert operations groups to performance problems before users experience
     them;

  .  Hosted Web performance monitoring services that proactively monitor Web
     sites in real time; and

  .  Hosted load testing services that identify bottlenecks and capacity
     constraints before a Web site goes live.

  We collaborate with a number of e-business software companies such as
Allaire, Ariba, BEA, Bluestone, Broadvision, Calico Commerce, CommerceQuest,
DoubleClick, IBM, Selectica, Silverstream, Sun-Netscape

                                       3
<PAGE>

Alliance and Vignette. These collaborations allow us to ensure that our
performance management solutions are optimized for use with their product
offerings. In addition, many of these collaborations allow us to conduct joint
marketing programs and joint seminars and participate in their user
conferences.

  On November 30, 1999, we acquired Conduct Ltd., an Israeli-based provider of
software for monitoring network performance. We plan to integrate Conduct's
technology into our products to provide root cause analysis and to enable our
customers to more readily pinpoint performance bottlenecks. We issued
approximately 408,000 shares of common stock in exchange for all of Conduct's
outstanding capital stock (including outstanding Conduct stock options and
warrants that we assumed).

  In February 2000, we formed a wholly-owned subsidiary to offer our hosted
Web site performance monitoring service, Topaz ActiveWatch, and our hosted Web
site load testing service, Load Runner Active Test. We believe our ASP
subsidiary will complement our existing offerings by providing a cost-
effective solution that allows customers to quickly meet their needs without
dedicating significant time and internal resources.

Products and Hosted Solutions

  We offer a comprehensive, integrated solution for application testing and
Web performance monitoring. Our software products and hosted e-services enable
our customers to test and monitor their Web sites and other applications.
These solutions include functional testing, load testing and test management
products that automate the testing of e-commerce applications as well as Web
performance monitoring offerings that measure end-user experience of Web sites
in production. Our hosted e-services provide outsourced testing and
monitoring, complementing our product offerings by providing a cost-effective
solution that allows customers to quickly meet their needs without dedicating
significant time and internal resources.

                                       4
<PAGE>

Our current products and hosted solutions consist of the following:

<TABLE>
<CAPTION>
                                                       Date of      Typical List Price
 Solution Name             Solution Description     Introduction          Range*
 -------------             --------------------     ------------    ------------------

 <C>                     <S>                        <C>           <C>
 Testing Solutions

 Load Testing
 Astra LoadTest......... Stress testing for Web     December 1996 $9,995 for 50 virtual
                         applications                             users
 LoadRunner............. Automated multi-user       November 1993 $40,000-$50,000 for
                         load testing for Web,                    package simulating
                         client server and                        50 users
                         enterprise applications
 LoadRunner ActiveTest.. Hosted Web site stress     January 2000  $15,000 for 100
                         testing                                  virtual users (3
                                                                  iterations)
 Functional Testing
 Astra QuickTest........ Functional testing for     May 1998      $2,995 per copy
                         Web applications
 WinRunner.............. Automated functional       June 1993     $4,995-$10,000 per
                         application testing for                  user
                         Web, client server and
                         enterprise applications
 XRunner................ Automated functional       1991          $10,000-$15,000 per
                         application testing for                  user
                         UNIX, X-Window
 Test Management
 Astra SiteManager...... Visual Web site            October 1996  No charge
                         management tool
 TestDirector........... Automated test             November 1994 $12,000 for server
                         management system for QA                 plus 5 users,
                         workgroups                               additional users for
                                                                  $495 each
 Monitoring Solutions
 Topaz.................. Web application            October 1999  $2,495/month for
                         performance monitoring                   5 monitoring
                                                                  transactions
 Topaz ActiveWatch...... Hosted performance         October 1999  $3,750/month for
                         monitoring                               5 monitoring
                                                                  transactions
</TABLE>
--------
* List prices vary within the ranges shown according to system configuration
  and country where purchased. In addition, actual license prices may vary
  from list prices.

 Testing Solutions

 Astra LoadTest

  Astra(R) LoadTest is an easy-to-use load testing tool that tests the
scalability and performance of Web applications. With Astra LoadTest, users
can emulate the traffic of thousands of real users to identify and isolate
bottlenecks and optimize user experience. Astra LoadTest was initially
released in 1996.

 LoadRunner

  LoadRunner(R) is a load testing tool that predicts system behavior and
performance. It exercises an entire enterprise infrastructure by emulating
thousands of users to identify and isolate problems. LoadRunner's integrated
real-time monitors enable organizations to minimize test cycles, optimize
performance and accelerate application deployment. LoadRunner is available for
Windows, Window 95, Windows NT, UNIX and Remote Terminal Emulation (RTE).
LoadRunner was initially released in 1993.

                                       5
<PAGE>

 LoadRunner ActiveTest

  LoadRunner ActiveTest(TM) is the hosted load testing service that can
conduct full-scale testing of Web sites in as little as 24 hours. By emulating
the behavior of thousands of users against a staging server, it identifies
bottlenecks and capacity constraints before going live. Using this hosted
offering allows customers with minimal hardware, personnel or technical
expertise to achieve rapid results. LoadRunner ActiveTest was initially
introduced in 2000.

 Astra QuickTest

  Astra QuickTest(TM) is an icon-based tool for testing the functionality of
dynamically changing Web applications. By replacing traditional scripts with
icons, it records and represents user actions visually to simplify and
accelerate testing. By mirroring end user behavior, Astra QuickTest creates
interactive customizable tests that simplify and shorten the testing cycle.
Astra QuickTest is designed specifically for deploying reliable e-business
applications. Astra QuickTest was initially released in 1998.

 WinRunner

  WinRunner(R) is an enterprise functional testing tool that verifies that
applications work as expected. By capturing, verifying and replaying user
interactions automatically, WinRunner identifies defects and ensures that
business processes work flawlessly and remain reliable throughout the
lifecycle. WinRunner is available for Windows 3.1, Windows 95 and Windows NT
platforms. WinRunner was initially released in 1993.

 XRunner

  XRunner(R) automates functional testing to ensure X-Window-based
applications work as expected. It records business processes into test
scripts, supports script enhancements as the application is developed or
updated, executes scripts, reports results and enables script reusability
throughout an application's lifecycle. XRunner was initially released in 1991.

 Astra SiteManager

  Astra SiteManager(TM) is a comprehensive visual Web site management tool
that is designed to meet the challenges faced by Webmasters, Internet
professionals and business managers of rapidly growing Web sites. Astra
SiteManager automatically schedules and performs scans of an entire Web site--
highlighting functional areas with color-coded links and URLs--to create a
complete visual map of a Web site. Astra SiteManager was initially released in
1996.

 TestDirector

  TestDirector(R) is an integrated enterprise application for organizing and
managing the entire testing process. It enables all members of the IT
organization to coordinate their testing efforts and control testing projects
at every step of the quality cycle, from test planning through execution to
defect management. TestDirector was initially released in 1994.

 Monitoring Solutions

 Topaz

  Topaz(TM) is a Web application performance management solution that allows
customers to monitor the performance of their Web sites on a 24x7 basis to
ensure a positive end-user experience. By proactively monitoring sites in real
time, Topaz alerts operations groups of performance problems before users
experience them. Topaz was initially released in 1999.

                                       6
<PAGE>

 Topaz ActiveWatch

  Topaz ActiveWatch(TM) is a hosted service that monitors Web site
performance. Using this hosted offering allows customers with minimal
hardware, personnel or technical expertise to achieve rapid results. Topaz
ActiveWatch was initially introduced in 1999.

Research and Development

  Since our inception in 1989, we have made substantial investments in
research and product development. We believe that our success will depend in
large part on our ability to maintain and enhance our current product line,
develop new products, maintain technological competitiveness and meet changing
customer requirements.

  In addition to the teams developing Web testing and performance monitoring
products and services, we maintain 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 Mercury 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 our products operate. Key development engineers are rotated to
assignments in customer support positions in our 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.

  Our primary research and development group is located near Tel Aviv, Israel.
Performing research and development in Israel offers a number of strategic
advantages. Our Israeli engineers typically hold advanced degrees in computer-
related disciplines. Operation in Israel has allowed us to enjoy tax
incentives and research subsidies from the government of Israel. Geographic
proximity to Europe, a strategic market for Mercury, offers another key
advantage.

  As of December 31, 1999, our research and development group consisted of 226
employees. Our net research and development expenses were $23.5 million in
1999, $16.9 million in 1998 and $11.3 million in 1997. We anticipate that we
will continue to commit substantial resources to research and development. If
we are not able to continue to introduce new products and product enhancements
that address the changing needs of our customers, our business would be
seriously harmed. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Risk Factors."

Marketing, Sales and Support

  We distribute our products and offer our services both directly, through our
growing sales force, and indirectly, through our relationships with system
integrators and value-added resellers.

 Direct Sales

  We sell our products primarily through our direct sales organization. We
employ technically proficient salespeople and highly skilled field application
engineers capable of serving the sophisticated needs of prospective customers.
As of December 31, 1999, our direct sales organization consisted of 328
employees.

  We have 19 sales and support centers throughout the United States.
Internationally, our subsidiaries operate 21 sales and support offices located
in Canada, Brazil, Europe, Israel, South Africa and the Pacific Rim. We also
market our products through international distributors in some markets.

  International sales represented 34% of our total revenues in 1999, 35% in
1998 and 36% in 1997, respectively. We expect that in future periods,
international sales will continue to account for a significant portion of our
total revenue. Our international operations and sales present a number of
risks. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Risk Factors."

                                       7
<PAGE>

 Indirect Distribution Channels

  We derive a substantial portion of our revenue from sales of our products
through indirect distribution channels such as system integrators and value-
added resellers, including Andersen Consulting, Computer Sciences Corporation,
Ernst & Young, IBM Global Services, IXL, Inventa, Oracle, Primix Solutions,
Technology Builders Inc, Viant and ZEFER. A significant portion of our
international sales are derived from sales through distributors.

  We have recently begun targeting new distribution channels to complement our
traditional direct and indirect channel. Our Astra family of products is now
offered through our cyber sales program over the Internet. We have also
entered into private-labelling arrangements with ASPs that incorporate our
products and services into theirs. In March 1999, we entered into an agreement
with Tivoli Systems, a subsidiary of IBM, for the joint development and
marketing of a family of products for enterprise application performance
management, incorporating elements of our technology, which would be marketed
and sold only by Tivoli. In addition, we recently entered into agreements with
two ASPs, Breakaway and Conxion, under which they offer our hosted Web
performance monitoring services under their own names.

  We expect that sales of our products through indirect distribution channels
will continue to account for a substantial portion of our revenues for the
foreseeable future. Our dependence on these channels presents a number of
risks. Each of our system integrators, value-added resellers and ASPs can
cease marketing our products and services with limited or no notice and with
little or no penalty. Our current system integrators, value-added resellers
and ASPs may not continue to offer our products and services, and we may not
be able to recruit additional or replacement system integrators, value-added
resellers and ASPs. The loss of one or more of our system integrators, value-
added resellers and ASPs could reduce our revenues. Our system integrators,
value-added resellers and ASPs also offer competitive products manufactured by
third parties. Our system integrators, value-added resellers and ASPs may not
give priority to the marketing of our products over competitors' products.
Finally, we may face conflicts between our indirect channels and our directs
sales and marketing activities.

 Customer Support

  We believe that strong customer support is crucial to both the initial
marketing of our products and maintenance of customer satisfaction, which in
turn enhances our reputation and generates repeat orders. In addition, we
believe that the customer interaction and feedback involved in our ongoing
support functions provide us 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 our Customer Support Organization through training and consulting
engagements and renewable annual maintenance contracts. As of December 31,
1999, our Customer Support Organization consisted of 171 employees. The
maintenance contracts provide for technical and emergency support as well as
software upgrades, on an if and when available basis. When our local sales and
support offices are unable to solve a problem, our engineers and product
developers in Israel work with the support personnel. By taking advantage of
time differences, we can provide support around the clock, ensuring prompt
resolution of problems.

 Pricing

  We license our software to customers under non-exclusive license agreements
that restrict use of the products to internal purposes at a specified site. We
typically license 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. In addition, our hosted services and
some of our products are priced based on usage, such as the number of
transactions monitored or number of virtual users emulated per day.

  Our products are priced to encourage customers to purchase multiple products
and licenses because our cost to support a one-user configuration is almost
the same as a multiple-user configuration. License fees depend on

                                       8
<PAGE>

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. Sales to our indirect sales channels, which
are intended for resale to end users, are made at varying discounts off of our
list prices, generally based on the sales volume of the indirect sales
channels. In addition, we sell annual maintenance contracts that include on-
site customer support and upgrades, generally for 18% of the license purchase
price. Training and consulting revenues are generated on a time and expense
basis.

Competition

  The market for testing and performance monitoring products and services is
highly competitive. There are few substantial barriers to entry in our market,
and the Internet has further lowered these barriers to entry for other
companies to compete with us in the testing and application performance
management markets. As a result of the increased competition, our success will
depend, in large part, on our ability to identify and respond to the needs of
potential customers, and to new technological and market opportunities, before
our competitors identify and respond to these needs and opportunities. We may
fail to respond quickly enough to these needs and opportunities.

  In the market for solutions for testing of applications, our competitors
include Compuware, Radview, Rational Software, RSW (a division of Teradyne)
and Segue Software. In the new and rapidly changing market for application
performance management, our competitors include providers of hosted services
such as Keynote Systems and Service Metrics (a division of Exodus
Communications), and emerging application providers such as Freshwater. In
addition, we face potential competition in this market from existing providers
of testing solutions such as Segue. Finally, in both the market for testing
solutions and the market for application performance management solutions, we
face potential competition from established providers of systems and network
management software such as BMC Software and Computer Associates.

  We believe that the principal competitive factors affecting our market are:

  .  product functionality;

  .  product performance, including scalability and reliability;

  .  price and cost-effectiveness;

  .  quality of support and service; and

  .  company reputation.

  Although we believe that our products currently compete favorably with
respect to these factors, the market for Web performance management
applications is new and rapidly evolving. We may not be able to maintain our
competitive position, and competitive pressure could seriously harm our
business.

Patents, Trademarks and Licenses

  We currently rely upon a combination of trademark, patent, copyright,
service mark, and trade secret laws and contractual restrictions to establish
and protect proprietary rights in our products and services. The source code
for our products is protected both as a trade secret and as an unpublished
copyrighted work. Despite these precautions, it may be possible for a third
party to copy or otherwise obtain and use our products or technology without
authorization. In addition, the laws of various countries in which our
products may be sold may not protect our products and intellectual property
rights to the same extent as the laws of the United States. Our competitors
may independently develop technologies that are substantially equivalent or
superior to our technology.

  Because the software industry is characterized by rapid technological
change, we believe that factors such as the technological and creative skills
of our 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 our technology.

                                       9
<PAGE>

  We hold six patents for elements contained in some of our products, and we
have filed several other U.S. and foreign patent applications on various
elements of our products. Our patent applications may not result in issued
patents and, if issued, such patents may not be upheld if challenged.

  Although we believe that our products and other proprietary rights do not
infringe upon the proprietary rights of third parties, third parties may
assert intellectual property infringement claims against us in the future. Any
such claims may result in costly, time-consuming litigation and may require us
to enter into royalty or cross-license arrangements.

Personnel

  As of December 31, 1999, we had a total of 857 employees, of which 362 were
based in the Americas and 495 were based internationally. Of the total, 548
were engaged in marketing, sales and related customer support services, 226
were in research and development, and 83 were in general and administrative
and operations support functions. Our success depends in significant part upon
the performance of our senior management and certain key employees.
Competition for highly skilled employees, including sales, technical and
management personnel, is intense in the software and technology industry. We
may not be able to recruit and retain key sales, technical and managerial
employees. Our failure to attract, assimilate or retain highly qualified
sales, technical and managerial personnel could seriously harm our business.
None of our employees is represented by a labor union, and we have never
experienced any work stoppages.

  Our executive officers as of March 1, 2000 are as follows:

<TABLE>
<CAPTION>
   Name              Age                        Position
   ----              ---                        --------
   <C>               <C> <S>
   Amnon Landan.....  41 President, Chief Executive Officer and Chairman of the
                          Board of Directors
   Kenneth Klein....  40 Chief Operating Officer
   Sharlene Abrams..  42 Chief Financial Officer and Vice President of Finance
                          and Administration
   Moshe Egert......  35 President of European Operations
</TABLE>

  Mr. Amnon Landan has served as our President and Chief Executive Officer
since February 1997, has served as Chairman of the Board of Directors since
July 1999, and has been a director 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 our 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 with us in various technical positions.

  Mr. Kenneth Klein has served as our Chief Operating Officer since January
2000. He served as President of North American Operations from July 1998 until
December 1999. From April 1995 to July 1998 he served as Vice President of
North American Sales. From May 1992 to March 1995, he served as our 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.
Mr. Klein has served as a director of Tumbleweed Communications Corp. since
February 2000.

  Ms. Sharlene Abrams has served as our Chief Financial Officer and President
of Finance and Administration since November 1993. From 1988 to November 1993,
Ms. Abrams was employed at Price Waterhouse LLP, most recently as a senior
manager. Between 1978 and 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 our President of European Operations since
July 1999. From July 1996 to June 1999, he served as our Vice President of
European Operations. From February 1994 to June 1996, he served

                                      10
<PAGE>

as our Director of European Marketing. From October 1990 through January 1994,
he served with us in several management and technical positions.

Item 2. Properties

  We are headquartered in Sunnyvale, California in a 55,000 square foot
building that we own. In 1999, we purchased a 50,500 square foot building in
Sunnyvale, which will become a second headquarters facility.

  Our research and development activities are conducted by our subsidiary in
Israel in a 120,000 square foot building that we own. During 1999, we
purchased an additional parcel of land in Israel.

  Our field sales and support operations occupy leased facilities in 20
locations in the United States, one location in Canada, one location in
Brazil, 12 locations in Europe, one location in Israel, one location in
South Africa and five locations in the Pacific Rim. We believe that our
existing sales and support facilities are adequate for our current needs.

Item 3. Legal Proceedings

  There are presently no legal proceedings pending, other than routine
litigation incidental to our business, to which we are a party or to which any
of our properties is subject.

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

  (a) A special meeting of our stockholders was held at our offices at 1325
Borregas Avenue, Sunnyvale, California 94089 on December 16, 1999 at 10:00
a.m.

  (b) At that meeting, the following matter was voted upon and approved with
the number of votes cast for, against or withheld as set forth in the columns
set forth below the matter.

  PROPOSAL 1--Ratification and approval of the amendment of the Amended and
Restated 1999 Stock Option Plan to automatically increase each year the
aggregate number of shares reserved for issuance under our Amended and
Restated 1999 Stock Option Plan by 4% of the common stock and equivalents
outstanding as of January 1 of each year starting in 2000 and ending in 2003.

<TABLE>
<CAPTION>
                                                                                  Broker
        For               Against                   Abstentions                  Non-Votes
        ---               -------                   -----------                  ---------
     <S>                 <C>                        <C>                         <C>
     14,523,285          13,463,324                  120,552                     10,286,424
</TABLE>

                                      11
<PAGE>

                                    PART II

Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters

Market for Common Stock

  Our common stock is traded publicly on the Nasdaq National Market under the
trading symbol "MERQ." The following table presents, for the periods
indicated, the high and low sales prices of our common stock as reported on
the Nasdaq National Market.

<TABLE>
<CAPTION>
                                                                   High   Low
                                                                  ------ ------
   <S>                                                            <C>    <C>
   Year Ended December 31, 1998
     First Quarter............................................... $ 9.57 $ 6.10
     Second Quarter..............................................  11.16   7.82
     Third Quarter...............................................  11.44   7.88
     Fourth Quarter..............................................  15.82   5.29
   Year Ended December 31, 1999
     First Quarter............................................... $19.97 $10.75
     Second Quarter..............................................  19.94  10.50
     Third Quarter...............................................  34.41  17.31
     Fourth Quarter..............................................  55.13  30.94
</TABLE>

  The prices shown in the table above reflect the two-for-one splits of our
common stock, each of which were distributed as stock dividends to our
stockholders, on February 26, 1999 and February 11, 2000.

Holders of Record

  On February 29, 2000, there were approximately 30,600 holders of record of
our common stock. Because many of these shares are held by brokers and other
institutions on behalf of stockholders, we are unable to estimate the total
number of stockholders represented by these record holders.

Dividends

  We have never declared or paid any cash dividends on our common stock. We
currently intend to retain earnings for use in our business and do not
anticipate paying any cash dividends in the foreseeable future.

                                      12
<PAGE>

Item 6. Selected Consolidated Financial Data(1)

<TABLE>
<CAPTION>
                                              Year ended December 31,
                                     -----------------------------------------
                                       1999     1998    1997    1996    1995
                                     -------- -------- ------- ------- -------
                                     (in thousands, except per share amounts)
<S>                                  <C>      <C>      <C>     <C>     <C>
Statements of Operations Data:
Revenue:
  License........................... $130,900 $ 84,450 $56,683 $43,270 $32,765
  Service...........................   56,800   36,550  20,017  11,280   6,685
                                     -------- -------- ------- ------- -------
    Total revenue...................  187,700  121,000  76,700  54,550  39,450
                                     -------- -------- ------- ------- -------
Cost of revenue:
  License...........................    7,736    6,291   4,351   3,419   2,626
  Service...........................   18,642   11,757   6,225   3,240   1,887
                                     -------- -------- ------- ------- -------
    Total cost of revenue...........   26,378   18,048  10,576   6,659   4,513
                                     -------- -------- ------- ------- -------
Gross profit........................  161,322  102,952  66,124  47,891  34,937
                                     -------- -------- ------- ------- -------
Operating expenses:
  Research and development, net.....   23,484   16,907  11,333   9,670   6,523
  Write off of in-process research
   and development and related
   expenses.........................      --       --    5,500     --    7,700
  Marketing and selling.............   88,609   57,243  37,073  29,426  21,361
  General and administrative........   11,242    8,466   6,642   4,178   3,911
  Settlement of litigation..........      --       --      --    2,600   2,000
  Merger related expenses...........    2,000      --      --      --      --
                                     -------- -------- ------- ------- -------
    Total operating expenses........  125,335   82,616  60,548  45,874  41,495
                                     -------- -------- ------- ------- -------
Income (loss) from operations.......   35,987   20,336   5,576   2,017  (6,558)
Other income, net...................    6,026    4,640   3,083   3,375   2,277
                                     -------- -------- ------- ------- -------
Income (loss) before provision for
 income taxes.......................   42,013   24,976   8,659   5,392  (4,281)
Provision for income taxes..........    8,869    5,451   2,927   1,157     970
                                     -------- -------- ------- ------- -------
Net income (loss)................... $ 33,144 $ 19,525 $ 5,732 $ 4,235 $(5,251)
                                     ======== ======== ======= ======= =======
Net income (loss) per share
 (basic)(2)......................... $   0.44 $   0.28 $  0.09 $  0.07 $ (0.09)
                                     ======== ======== ======= ======= =======
Net income (loss) per share
 (diluted)(2)....................... $   0.39 $   0.25 $  0.08 $  0.06 $ (0.09)
                                     ======== ======== ======= ======= =======
Weighted average common shares
 (basic)(2).........................   76,112   70,654  65,494  63,634  55,788
                                     ======== ======== ======= ======= =======
Weighted average common shares and
 equivalents (diluted)(2)...........   85,208   78,818  68,458  66,254  55,788
                                     ======== ======== ======= ======= =======
</TABLE>

<TABLE>
<CAPTION>
                                                    December 31,
                                    --------------------------------------------
                                      1999     1998     1997     1996     1995
                                    -------- -------- -------- -------- --------
<S>                                 <C>      <C>      <C>      <C>      <C>
Balance Sheet Data:
Working capital.................... $137,066 $ 97,288 $ 87,733 $ 78,046 $ 75,475
Total assets....................... $297,218 $204,686 $143,663 $117,625 $112,820
Stockholders' equity............... $199,531 $146,408 $112,120 $ 99,048 $ 92,616
</TABLE>
--------
(1) All historical information has been restated to reflect the acquisition of
    Conduct Ltd. on November 30, 1999, which was accounted for as a pooling of
    interests.

(2) All share and per share information gives effect to our two-for-one stock
    split distributed to our stockholders as a stock dividend on February 11,
    2000.

                                      13
<PAGE>

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

  The following discussion contains forward-looking statements within the
meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A
of the Securities Act of 1933. In some cases, forward-looking statements are
identified by words such as "believes," "anticipates," "expects," "intends,"
"plans," "will," "may" and similar expressions. In addition, any statements
that refer to our plans, expectations, strategies or other characterizations
of future events or circumstances are forward-looking statements. Our actual
results could differ materially from those discussed in, or implied by, these
forward-looking statements. Factors that could cause actual results or
conditions to differ from those anticipated by these and other forward-looking
statements include those more fully described in "Risk Factors." Our business
may have changed since the date hereof, and we undertake no obligation to
update these forward-looking statements.

Overview

  We were incorporated in 1989, and began shipping automated software testing
products in 1991. Since 1991, we introduced a number of new products, and new
versions of existing products, including products and versions designed for e-
business applications. We believe that a majority of customers that licensed
our products in 1999 are using these products to test and monitor their Web
applications. Recently, we began offering hosted load testing and monitoring
services for Web applications.

  On November 30, 1999 we acquired Conduct Ltd., an Israeli-based provider of
software for monitoring network performance. We issued approximately 408,000
shares of common stock in exchange for all of Conduct's outstanding capital
stock (including outstanding Conduct stock options and warrants that we
assumed). We accounted for the transaction as a pooling of interests, and all
prior periods presented in our financial statements have been restated to
reflect this transaction.

Results of Operations

  The following table sets forth, as a percentage of total revenue, certain
consolidated statements of operations data for the periods indicated. These
operating results are not necessarily indicative of the results for any future
period.

<TABLE>
<CAPTION>
                                                                Year ended
                                                               December 31,
                                                              ----------------
                                                              1999  1998  1997
                                                              ----  ----  ----
   <S>                                                        <C>   <C>   <C>
   Revenue:..................................................
     License.................................................  70%   70%   74%
     Service.................................................  30    30    26
                                                              ---   ---   ---
       Total revenue......................................... 100   100   100
                                                              ---   ---   ---
   Cost of revenue:
     License.................................................   4     5     6
     Service.................................................  10    10     8
                                                              ---   ---   ---
       Total cost of revenue.................................  14    15    14
                                                              ---   ---   ---
   Gross profit..............................................  86    85    86
                                                              ---   ---   ---
   Operating expenses:
     Research and development, net...........................  13    14    15
     Write off of in-process research and development and
      related expenses.......................................  --    --     7
     Marketing and selling...................................  47    47    48
     General and administrative..............................   6     7     9
     Merger related expenses.................................   1    --    --
                                                              ---   ---   ---
       Total operating expenses..............................  67    68    79
                                                              ---   ---   ---
   Income from operations....................................  19    17     7
   Other income, net.........................................   3     4     4
                                                              ---   ---   ---
   Income before provision for income taxes..................  22    21    11
                                                              ---   ---   ---
   Provision for income taxes................................   5     5     4
                                                              ---   ---   ---
   Net income ...............................................  17%   16%    7%
                                                              ---   ---   ---
</TABLE>

                                      14
<PAGE>

Revenue

  License revenue increased to $130.9 million in 1999 from $84.5 million in
1998 and $56.7 million in 1997. Our growth in license revenue is attributable
primarily to growth in license fees from the LoadRunner, WinRunner and
TestDirector products, particularly for use by customers to test e-business
applications.

  Service revenue increased to $56.8 million or 30% of total revenue in 1999
from $36.6 million or 30% of total revenue in 1998 and $20.0 million or 26% of
total revenue in 1997. The absolute dollar increase in service revenue in 1999
compared to 1998 and 1997 was primarily due to the renewal of maintenance
contracts. We expect that service revenue will continue to increase in
absolute dollars as long as our customer base continues to grow.

 Cost of revenue

  License cost of revenue as a percentage of license revenue decreased to 6%
in 1999 from 7% in 1998 and 8% in 1997. License cost of revenue includes cost
of production personnel, product packaging and amortization of capitalized
software development costs. The decrease in license cost of revenue as a
percentage of license revenue in 1999 primarily reflected flat absolute dollar
amortization of capitalized software development costs during each of the
three years.

  Service cost of revenue increased to $18.6 million in 1999 from $11.8
million in 1998 and $6.2 million in 1997. As a percentage of service revenue,
it increased to 33% in 1999 from 32% in 1998 and 31% in 1997. Service cost of
revenue consists primarily of costs of providing customer technical support,
training and consulting. The increased service cost of revenue in 1999 as
compared to 1998 was primarily due to an increase in personnel-related costs
of $4.2 million reflecting growth in customer support headcount from 126 at
December 31, 1998 to 171 at December 31, 1999 and a $2.2 million increase in
training and consulting out-sourcing expense.

 Research and development, net

  For the year ended December 31, 1999, research and development, net was
$23.5 million, or 13% of total revenue, an increase from $16.9 million, or 14%
of total revenue in 1998, and $11.3 million, or 15% of total revenue in 1997.
The increase in absolute dollars in 1999 as compared to 1998 reflected an
increase in spending of $4.1 million due to growth in research and development
headcount from 166 at December 31, 1998 to 226 at December 31, 1999, as well
as $1.6 million of research grants received in 1998 from the Israeli Office of
the Chief Scientist, as compared to no grants received in 1999.

  In September of 1997, we acquired technologies from Dixon Software
Technology that we integrated into our load-testing products. As a result of
this purchase, in the third quarter of 1997, we 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 is reported net of research grants received
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. No grants were obtained from the Office of the Chief
Scientist in the Israeli Ministry of Industry and Trade during 1999. Research
grants received amounted to $1.6 million in 1998 and $2.1 million in 1997. We
were not obligated to repay these grants; however, we 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 for each of the years ended December 31, 1999 and
1998, and $1.6 million for the year ended December 31, 1997. As of December
31, 1999, we had no outstanding royalty obligations. We have not applied for,
nor do we anticipate applying for, any future grants from the Office of the
Chief Scientist.

  During 1999 and 1998, no software development costs were capitalized because
the costs incurred subsequent to achieving technological feasibility and
before the general release of our products were not

                                      15
<PAGE>

significant. We capitalized $500,000 of software development costs during the
year ended December 31, 1997. Amortization charges included in cost of license
revenues were $585,000 in 1999 and $600,000 in each of 1998 and 1997. In
conjunction with the technology acquisition in 1997, we wrote off
approximately $250,000 of capitalized development costs as obsolete. At
December 31, 1999, we did not have any capitalized software development costs.
At December 31, 1998 we had a net balance of capitalized software development
costs of $585,000.

 Marketing and selling

  Marketing and selling expenses were $88.6 million, or 47% of total revenue,
in 1999, compared to $57.2 million, or 47% of total revenue, in 1998 and
$37.1 million, or 48% of total revenue, in 1997. The increase in expenses in
1999 as compared to 1998 was primarily due to an increase in personnel-related
costs of $14.6 million reflecting growth in headcount from 265 at December 31,
1998 to 377 at December 31, 1999, an increase in sales commissions of $4.8
million attributable to higher revenue, an increase in facilities and related
costs of $1.8 million and an increase in spending on marketing programs of
$7.5 million. We expect marketing and selling expenses to increase in absolute
dollars as total revenue increases, but these expenses may vary as a
percentage of revenue.

 General and administrative

  General and administrative expense increased to $11.2 million, or 6% of
total revenue in 1999, from $8.5 million, or 7% of total revenue in 1998 and
$6.6 million, or 9% of total revenue in 1997. The increase in expenses in 1999
as compared to 1998 was primarily due to an increase in personnel-related
costs of $1.6 million reflecting growth in headcount from 53 at December 31,
1998 to 70 at December 31, 1999.

 Other income, net

  Other income, net consists primarily of interest income and foreign exchange
gains and losses. The increase in other income, net to $6.0 million in 1999
from $4.6 million in 1998 reflected increased interest income on higher
average cash and investment balances.

 Provision for income taxes

  We have structured our operations in a manner designed to maximize income in
Israel where tax rate incentives have been extended to encourage foreign
investments. The tax holidays and rate reductions which we will be able to
realize under programs currently in effect expire at various dates through
2007. Future provisions for taxes will depend upon the mix of worldwide income
and the tax rates in effect for various tax jurisdictions. See Note 4 of Notes
to Consolidated Financial Statements and "--Risk Factors--We are subject to
the risk of increased taxes."

  We calculated the 1999 tax provision without the benefit of Conduct's pre-
acquisition net operating losses because we may not be able to offset these
losses against our future income.

 Merger related expenses

  In connection with the acquisition of Conduct, we incurred merger-related
expenses of approximately $2.0 million, primarily relating to legal and
accounting expenses, severance and the write-off of redundant facilities and
equipment.

 Net income

  We reported net income of $33.1 million in 1999, compared to net income of
$19.5 million in 1998 and $5.7 million in 1997.

                                      16
<PAGE>

Liquidity and Capital Resources

  At December 31, 1999, our principal source of liquidity consisted of $186.9
million of cash and investments compared to $130.7 million at December 31,
1998 and $92.4 million at December 31, 1997. The December 31, 1999 balance
included $137.1 million of short-term and $15.6 million of long-term
investments in high quality government and corporate securities.

  During 1999, we generated $61.1 million cash from operating activities,
compared to $39.5 million in 1998 and $17.1 million in 1997. The increase in
1999 compared to 1998 was due primarily to an increase in net income and
increases in accounts payable and accrued liabilities.

  Our primary investing activities were net purchases of investments in 1999
of $39.7 million compared to net proceeds from investments of $1.3 million in
1998 and $512,000 in 1997. We also purchased property and equipment, which
totaled $23.9 million in 1999, $15.0 million in 1998 and $11.9 million in
1997. Of these amounts, we spent $8.2 million in 1999, and $1.5 million 1998,
for purchase and renovation of our headquarters buildings in Sunnyvale,
California. We expect to spend an additional $3.5 million to complete the
construction in California. We spent $5.6 million in 1999, and $5.7 million in
1998, on construction of a new research and development facility in Israel.
Also in 1999, we spent $2.7 million to purchase additional land in Israel for
anticipated future expansion.

  Our primary financing activity consisted of issuances of common stock under
our stock option and stock purchase plans. Proceeds from issuance of stock
under these plans, net of notes receivable issued and collected from issuance
of stock, amounted to $20.4 million in 1999, $14.4 million in 1998 and $7.7
million in 1997.

  Assuming there is no significant change in our business, we believe that our
current cash and investment balances and cash flow from operations will be
sufficient to fund our cash needs for at least the next twelve months. We also
expect to satisfy our financing requirements through the incurrence of debt
from time to time. As of December 31, 1999, we did not have any debt
outstanding. We currently plan to issue up to $500,000,000 in principal amount
of convertible subordinated notes. If we complete this transaction, our
leverage will increase significantly. We may not succeed in completing this
transaction.

New Accounting Pronouncements

  In March 1998, the American Institute of Certified Public Accountants
("AICPA") issued 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 of 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. We adopted the
provisions of SOP 98-1 in our fiscal year ended December 31, 1999. Adoption
did not have a material effect on our 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 Statement of Position 98-9, "Modification
of SOP 97-2, Software Revenue Recognition, with Respect to Certain
Transactions" ("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 did not have a material effect on our results of operations,
financial position or cash flows.

  In June 1999, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 137, "Accounting for Derivative Instruments
and Hedging Activities--Deferral of the Effective Date of FASB Statement No.
133--an amendment of FASB Statement No. 133" ("SFAS 137"). SFAS 137

                                      17
<PAGE>

defers for one year the application of Statement of Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities ("SFAS
133") to all fiscal quarters of fiscal years beginning after June 15, 2000.
SFAS 133 establishes accounting and reporting standards for derivative
instruments and hedging activities. The adoption of SFAS 133 and SFAS 137 have
not had and are not expected to have a material effect on our results of
operations, financial position or cash flows.

  In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements,"
("SAB 101") which provides guidance on the recognition, presentation, and
disclosure of revenue in financial statements filed with the SEC. SAB 101
outlines the basic criteria that must be met to recognize revenue and provides
guidance for disclosures related to revenue recognition policies. We believe
that the impact of SAB 101 will not have a material effect on our results of
operations, financial position or cash flows.

Risk Factors

  In addition to the other information included in this Annual Report on Form
10-K, the following risk factors should be considered carefully in evaluating
us and our business.

  Our future success depends on our ability to respond to rapid market and
technological changes by introducing new products and to continually improve
the performance, features and reliability of our existing products and respond
to competitive offerings. Our business will suffer if we do not successfully
respond to rapid technological changes. The market for our software products
is characterized by:

  .  rapidly changing technology;

  .  frequent introduction of new products and enhancements to existing
     products by our competitors;

  .  increasing complexity and interdependence of Internet related
     applications;

  .  changes in industry standards and practices; and

  .  changes in customer requirements and demands.

  To maintain our competitive position, we must continue to enhance our
existing software testing and application performance management products and
to develop new products and services, functionality and technology that
address the increasingly sophisticated and varied needs of our prospective
customers. The development of new products and services, and enhancement of
existing products and services, entail significant technical and business
risks and require substantial lead-time and significant investments in product
development. If we fail to anticipate new technology developments, customer
requirements or industry standards, or if we are unable to develop new
products and services that adequately address these new developments,
requirements and standards in a timely manner, our products may become
obsolete, our ability to compete may be impaired and our revenues could
decline.

  We expect our quarterly revenues and operating results to fluctuate, which
may cause the price of our stock and the notes to decline. Our revenues and
operating results have varied in the past and are likely to vary significantly
from quarter to quarter in the future. These fluctuations are due to a number
of factors, many of which are outside of our control, including:

  .  fluctuations in demand for and sales of our products and services;

  .  our success in developing and introducing new products and the timing of
     new product introductions;

  .  our ability to introduce enhancements to our existing products in a
     timely manner;

  .  the introduction of new or enhanced products by our competitors and
     changes in the pricing policies of these competitors;

  .  the discretionary nature of our customers' purchase and budget cycles;

                                      18
<PAGE>

  .  the amount and timing of operating costs and capital expenditures
     relating to the expansion of our business;

  .  deferrals by our customers of orders in anticipation of new products or
     product enhancements; and

  .  the mix of our domestic and international sales, together with
     fluctuations in foreign currency exchange rates.

  In addition, the timing of our license revenues is difficult to predict
because our sales cycles are typically short and can vary substantially from
product to product and customer to customer. We base our operating expenses on
our expectations regarding future revenue levels. As a result, if total
revenues for a particular quarter are below our expectations, we could not
proportionately reduce operating expenses for that quarter.

  We have experienced seasonality in our revenues and earnings, with the
fourth quarter of the year typically having the highest revenue and earnings
for the year and higher revenue and earnings than the first quarter of the
following year. We believe that this seasonality results primarily from the
budgeting cycles of our customers and from the structure of our sales
commission program. We expect this seasonality to continue in the future.

  Due to these and other factors, we believe that period-to-period comparisons
of our results of operations are not necessarily meaningful and should not be
relied upon as indications of future performance. If our operating results are
below the expectations of investors or securities analysts, the price of our
common stock, and therefore the notes, could decline.

  We expect to face increasing competition in the future, which could cause
reduced sales levels and result in price reductions, reduced gross margins or
loss of market share. The market for our testing and application performance
management products and services is extremely competitive, dynamic and subject
to frequent technological changes. There are few substantial barriers to entry
in our market. In addition, the rapid growth and use of Internet for e-
business is a recent and emerging phenomenon. The Internet lowers the barriers
to entry for other companies to compete with us in the testing and application
performance management markets. As a result of the increased competition, our
success will depend, in large part, on our ability to identify and respond to
the needs of potential customers, and to new technological and market
opportunities, before our competitors identify and respond to these needs and
opportunities. We may fail to respond quickly enough to these needs and
opportunities.

  In the market for solutions for testing of applications, our principal
competitors include Compuware, Radview, Rational Software, RSW (a division of
Teradyne) and Segue Software. In the new and rapidly changing market for
application performance management solutions, our competitors include
providers of hosted services such as Keynote Systems and Service Metrics (a
division of Exodus Communications), and emerging application providers such as
Freshwater. In addition, we face potential competition in this market from
existing providers of testing solutions such as Segue. Finally, in both the
market for testing solutions and the market for application performance
management solutions, we face potential competition from established providers
of systems and network management software such as BMC Software and Computer
Associates.

  The software industry is increasingly experiencing consolidation, and this
could increase the resources available to our competitors and the scope of
their product offerings. Our competitors and potential competitors may
undertake more extensive marketing campaigns, adopt more aggressive pricing
policies or make more attractive offers to distribution partners and to
employees.

  If we fail to maintain our existing distribution channels and develop
additional channels in the future, our revenues will decline. We derive a
substantial portion of our revenues from sales of our products through
distribution channels such as system integrators, value-added resellers. We
expect that sales of our products through these channels will continue to
account for a substantial portion of our revenues for the foreseeable future.
We have also entered into private labelling arrangements with ASPs and an
enterprise software company who incorporate our products and services into
theirs. We may not experience increased revenues from these new channels,
which could harm our business.

                                      19
<PAGE>

  The loss of one or more of our system integrators, value-added resellers or
ASPs, or any reduction or delay in their sales of our products and services
could result in reductions in our revenue in future periods. In addition, our
ability to increase our revenue in the future depends on our ability to expand
our indirect distribution channels.

Our dependence on indirect distribution channels presents a number of risks,
including:

  .  each of our system integrators, value-added resellers and ASPs can cease
     marketing our products and services with limited or no notice and with
     little or no penalty;

  .  our existing system integrators, value-added resellers and ASPs may not
     be able to effectively sell any new products and services that we may
     introduce;

  .  we may not be able to replace existing or recruit additional system
     integrators, value-added resellers and ASPs if we lose any of our
     existing ones;

  .  our system integrators, value-added resellers and ASPs also offer
     competitive products and services from third parties;

  .  we may face conflicts between the activities of our indirect channels
     and our direct sales and marketing activities; and

  .  our system integrators, value-added resellers and ASPs may not give
     priority to the marketing of our products and services as compared to
     our competitors' products.

  In March 1999, we entered into an agreement with Tivoli Systems, a
subsidiary of IBM, for the joint development and marketing of a family of
products for enterprise application performance management, incorporating
elements of our technology, which would be marketed and sold only by Tivoli.
Under this agreement, we agreed that until October 2002, we will not license
this technology to any other party for purposes of developing a product
similar to any developed under this agreement. In addition, we agreed that
until October 2002, we will not enter into technology relationships to create
similar products with specified competitors of Tivoli as long as Tivoli
continues to agree to pay minimum royalties. These restrictions may limit our
ability to enter into new private labelling relationships. In addition, Tivoli
may not succeed in developing and selling these new products.

  We depend on strategic relationships and business alliances for continued
growth of our business. Our development, marketing and distribution strategies
rely increasingly on our ability to form strategic relationships with software
and other technology companies. These business relationships often consist of
cooperative marketing programs, joint customer seminars, lead referrals and
cooperation in product development. Many of these relationships are not
contractual and depend on the continued voluntary cooperation of each party
with us. Divergence in strategy or change in focus by, or competitive product
offerings by, any of these companies may interfere with our ability to
develop, market, sell or support our products, which in turn could harm our
business. Further, if these companies enter into strategic alliances with
other companies or are acquired, they could reduce their support of our
products. Our existing relationships may be jeopardized if we enter into
alliances with competitors of our strategic partners. In addition, one or more
of these companies may use the information they gain from their relationship
with us to develop or market competing products.

  If we are unable to manage our growth, our business may be harmed. Since
1991, we have experienced significant annual increases in revenue, employees
and number of product and service offerings. This growth has placed and, if it
continues, will place a significant strain on our management and our
financial, operational, marketing and sales systems. If we cannot manage our
growth effectively, our business, competitive position, operating results and
financial condition could suffer. Although we are implementing a variety of
new or expanded business and financial systems, procedures and controls,
including the improvement of our sales and

                                      20
<PAGE>

customer support systems, the implementation of these systems, procedures and
controls may not be completed successfully, or may disrupt our operations. Any
failure by us to properly manage these transitions could impair our ability to
attract and service customers and could cause us to incur higher operating
costs and experience delays in the execution of our business plan.

  The success of our business depends on the efforts and abilities of our
senior key personnel. We depend on the continued services and performance of
our senior management and other key personnel. We do not have long term
employment agreements with any of our key personnel. The loss of any of our
executive officers or other key employees could hurt our business.

  If we cannot hire qualified personnel, our ability to manage our business,
develop new products and increase our revenues will suffer. We believe that
our ability to attract and retain qualified personnel at all levels in our
organization is essential to the successful management of our growth. In
particular, our ability to achieve revenue growth in the future will depend in
large part on our success in expanding our direct sales force and in
maintaining a high level of technical consulting, training and customer
support. There is substantial competition for experienced personnel in the
software and technology industry. If we are unable to retain our existing key
personnel or attract and retain additional qualified individuals, we may from
time to time experience inadequate levels of staffing to perform services for
our customers. As a result, our growth could be limited due to our lack of
capacity to develop and market our products to our customers.

  We depend on our international operations for a substantial portion of our
revenues. Sales to customers located outside the United States have
historically accounted for a significant percentage of our revenue and we
anticipates that such sales will continue to be a significant percentage of
our revenue. As a percentage of our total revenues, sales to customers outside
the United States were approximately 34% in 1999, 35% in 1998 and 36% in 1997.
In addition, we have substantial research and development operations in
Israel. We face risks associated with our international operations, including:

  .  changes in taxes and regulatory requirements;

  .  difficulties in staffing and managing foreign operations;

  .  reduced protection for intellectual property rights in some countries;

  .  the need to localize products for sale in international markets;

  .  longer payment cycles to collect accounts receivable in some countries;

  .  seasonal reductions in business activity in other parts of the world in
     which we operate;

  .  political and economic instability; and

  .  economic downturns in international markets.

  Any of these risks could harm our international operations and cause lower
international sales. For example, some European countries already have laws
and regulations related to technologies used on the Internet that are more
strict than those currently in force in the United States. Any or all of these
factors could cause our business to be harmed.

  Because our research and development operations are primarily located in
Israel, we may be affected by volatile economic, political and military
conditions in that country and by restrictions imposed by that country on the
transfer of technology. Our operations depend on the availability of highly-
skilled and relatively low-cost scientific and technical personnel in Israel.
Our business also depends on trading relationships between Israel and other
countries. In addition to the risks associated with international sales and
operations generally, our 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.


                                      21
<PAGE>

  These risks are compounded due to the restrictions on our ability to
manufacture or transfer outside of Israel any technology developed under
research and development grants from the government of Israel, without the
prior written consent of the government of Israel. If we are unable to obtain
the consent of the government of Israel, we may not be able to take advantage
of strategic manufacturing and other opportunities outside of Israel. We have,
in the past, obtained royalty-bearing grants from various Israeli government
agencies. In addition, we participate in special Israeli government programs
that provide significant tax advantages. The loss of or any material decrease
in these tax benefits could negatively affect our financial results.

  We are subject to the risk of increased taxes. We have structured our
operations in a manner designed to maximize income in Israel where tax rate
incentives have been extended to encourage foreign investment. Our taxes could
increase if these tax rate incentives are not renewed upon expiration or tax
rates applicable to us are increased. Tax authorities could challenge the
manner in which profits are allocated among us and our subsidiaries, and we
may not prevail in any such challenge. If the profits recognized by our
subsidiaries in jurisdictions where taxes are lower became subject to income
taxes in other jurisdictions, our worldwide effective tax rate would increase.

  Our financial results may be negatively impacted by foreign currency
fluctuations. Our foreign operations are generally transacted through our
international sales subsidiaries. As a result, these sales and related
expenses are denominated in currencies other than the U.S. Dollar. Because our
financial results are reported in U.S. Dollars, our results of operations may
be harmed by fluctuations in the rates of exchange between the U.S. Dollar and
other currencies, including:

  .  a decrease in the value of Pacific Rim or European currencies relative
     to the U.S. Dollar, which would decrease our reported U.S. Dollar
     revenue, as we generate revenues in these local currencies and report
     the related revenues in U.S. Dollars; and

  .  an increase in the value of Pacific Rim, European or Israeli currencies
     relative to the U.S. Dollar, which would increase our sales and
     marketing costs in these countries and would increase research and
     development costs in Israel.

  We attempt to limit foreign exchange exposure through operational strategies
and by using forward contracts to offset the effects of exchange rate changes
on intercompany trade balances. This requires us to estimate the volume of
transactions in various currencies. We may not be successful in making these
estimates. If these estimates are overstated or understated during periods of
currency volatility, we could experience material currency gains or losses.

  Our ability to successfully implement our business strategy depends on the
continued growth of the Internet. In order for our business to be successful,
the Internet must continue to grow as a medium for conducting business.
However, as the Internet continues to experience significant growth in the
number of users and the complexity of Web-based applications, the Internet
infrastructure may not be able to support the demands placed on it or the
performance or reliability of the Internet might be adversely affected.
Security and privacy concerns may also slow the growth of the Internet.
Because our revenues ultimately depend upon the Internet generally, our
business may suffer as a result of limited or reduced growth.

  Our recent acquisition and any future acquisitions may be difficult to
integrate, disrupt our business, dilute stockholder value or divert the
attention of our management. We have acquired, and in the future we may
acquire or make investments in other companies with similar products and
technologies. For example, in November 1999, we completed our acquisition of
Conduct Ltd. In the event of any future acquisitions or investments, we could:

  .  issue stock that would dilute the ownership of our then-existing
     stockholders;

  .  incur debt;

  .  assume liabilities;

                                      22
<PAGE>

  .  incur amortization expense related to goodwill and other intangible
     assets; or

  .  incur large write-offs.

  If we fail to achieve the financial and strategic benefits of past and
future acquisitions, our operating results will suffer. Acquisitions and
investments involve numerous other risks, including:

  .  difficulties integrating the acquired operations, technologies or
     products with ours;

  .  failure to achieve targeted synergies;

  .  unanticipated costs and liabilities;

  .  diversion of management's attention from our core business;

  .  adverse effects on our existing business relationships with suppliers
     and customers or those of the acquired organization;

  .  difficulties entering markets in which we have no or limited prior
     experience; and

  .  potential loss of key employees, particularly those of the acquired
     organizations.

  The price of our common stock may fluctuate significantly, which may result
in losses for investors and possible lawsuits. The market price for our common
stock has been and may continue to be volatile. For example, during the 52-
week period ended March 17, 2000, the closing prices of our common stock as
reported on the Nasdaq National Market ranged from a high of $132.13 to a low
of $10.94. We expect our stock price to be subject to fluctuations as a result
of a variety of factors, including factors beyond our control. These factors
include:

  .  actual or anticipated variations in our quarterly operating results;

  .  announcements of technological innovations or new products or services
     by us or our competitors;

  .  announcements relating to strategic relationships or acquisitions;

  .  changes in financial estimates or other statements by securities
     analysts;

  .  changes in general economic conditions;

  .  conditions or trends affecting the software industry and the Internet;
     and

  .  changes in the economic performance and/or market valuations of other
     software and high-technology companies.

  Because of this volatility, we may fail to meet the expectations of our
stockholders or of securities analysts at some time in the future, and our
stock price could decline as a result.

  In addition, the stock market has experienced significant price and volume
fluctuations that have particularly affected the trading prices of equity
securities of many high technology companies. These fluctuations have often
been unrelated or disproportionate to the operating performance of these
companies. Any negative change in the public's perception of software or
Internet software companies could depress our stock price regardless of our
operating results.

  If we fail to adequately protect our proprietary rights and intellectual
property, we may lose a valuable asset, experience reduced revenues and incur
costly litigation to protect our rights. We rely on a combination of patents,
copyrights, trademark, service mark and trade secret laws and contractual
restrictions to establish and protect our proprietary rights in our products
and services. We will not be able to protect our intellectual property if we
are unable to enforce our rights or if we do not detect unauthorized use of
our intellectual property. Despite our precautions, it may be possible for
unauthorized third parties to copy our products and use information that we
regard as proprietary to create products that compete with ours. Some license
provisions protecting against

                                      23
<PAGE>

unauthorized use, copying, transfer and disclosure of our licensed programs
may be unenforceable under the laws of certain jurisdictions and foreign
countries. Further, the laws of some countries do not protect proprietary
rights to the same extent as the laws of the United States. To the extent that
we increase our international activities, our exposure to unauthorized copying
and use of our products and proprietary information will increase.

  In many cases, we enter into confidentiality or license agreements with our
employees and consultants and with the customers and corporations with whom we
have strategic relationships and business alliances. No assurance can be given
that these agreements will be effective in controlling access to and
distribution of our products and proprietary information. Further, these
agreements do not prevent our competitors from independently developing
technologies that are substantially equivalent or superior to our products.

  Litigation may be necessary in the future to enforce our intellectual
property rights and to protect our trade secrets. Litigation like this,
whether successful or unsuccessful, could result in substantial costs and
diversions of our management resources, either of which could seriously harm
our business.

  Third parties could assert that our products and services infringe their
intellectual property rights, which could expose us to litigation that, with
or without merit, could be costly to defend. We may from time to time be
subject to claims of infringement of other parties' proprietary rights. We
could incur substantial costs in defending ourselves sand our customers
against these claims. Parties making these claims may be able to obtain
injunctive or other equitable relief that could effectively block our ability
to sell our products in the United States and abroad and could result in an
award of substantial damages against us. In the event of a claim of
infringement, we may be required to obtain licenses from third parties,
develop alternative technology or to alter our products or processes or cease
activities that infringe the intellectual property rights of third parties. If
we are required to obtain licenses, we cannot be sure that we will be able to
do so at a commercially reasonable cost, or at all. Defense of any lawsuit or
failure to obtain required licenses could delay shipment of our products and
increase our costs. In addition, any such lawsuit could result in our
incurring significant costs or the diversion of the attention of our
management.

  Defects in our products may subject us to product liability claims and make
it more difficult for us to achieve market acceptance for these products,
which could harm our operating results. Our products may contain errors or
"bugs" that may be detected at any point in the life of the product. Any
future product defects discovered after shipment of our products could result
in loss of revenues and a delay in the market acceptance of these products
that could adversely impact our future operating results.

  In selling our products, we frequently rely on "shrink wrap" or "click wrap"
licenses that are not signed by licensees. Under the laws of various
jurisdictions, the provisions in these licenses limiting our exposure to
potential product liability claims may be unenforceable. We currently carry
errors and omissions insurance against such claims, however, we cannot assure
you that this insurance will continue to be available on commercially
reasonable terms, or at all, or that this insurance will provide us with
adequate protection against product liability and other claims. In the event
of a products liability claim, we may be found liable and required to pay
damages which would seriously harm our business.

  We have adopted anti-takeover defenses that could delay or prevent an
acquisition of our company, including an acquisition that would be beneficial
to our stockholders. Our Board of Directors has the authority to issue up to
5,000,000 shares of preferred stock and to determine the price, rights,
preferences and privileges of those shares without any further vote or action
by the stockholders. The rights of the holders of common stock will be subject
to, and may be adversely affected by, the rights of the holders of any
preferred stock that may be issued in the future. The issuance of preferred
stock, while providing desirable flexibility in connection with possible
acquisitions and other corporate purposes, could have the effect of making it
more difficult for a third party to acquire a majority of our outstanding
voting stock. We have no present plans to issue shares of preferred stock.
Furthermore, certain provisions of our Certificate of Incorporation and of
Delaware law may have the effect of delaying or preventing changes in our
control or management, which could adversely affect the market price of our
common stock.


                                      24
<PAGE>

  Leverage and debt service obligations may adversely affect our cash
flow. Upon completion of the currently proposed offering of up to $500,000,000
principal amount of convertible subordinated notes, we will have a substantial
amount of outstanding indebtedness, primarily the notes. There is the
possibility that we may be unable to generate cash sufficient to pay the
principal of, interest on and other amounts due in respect of our indebtedness
when due. Our leverage could have significant negative consequences,
including:

  .  increasing our vulnerability to general adverse economic and industry
     conditions;

  .  requiring the dedication of a substantial portion of our expected cash
     flow from operations to service our indebtedness, thereby reducing the
     amount of our expected cash flow available for other purposes, including
     capital expenditures; and

  .  limiting our flexibility in planning for, or reacting to, changes in our
     business and the industry in which we compete.

Item 7a. Quantitative and Qualitative Disclosures about Market Risk

  Interest rate risk. Our exposure to market rate risk for changes in interest
is limited to our investment portfolio. Derivative financial instruments are
not a part of our investment policy. We place our investments with high
quality issuers and, by policy, limit the amount of credit exposure to any one
issuer or issue. In addition, we have classified all of our investments as
"held to maturity." This classification does not expose the consolidated
statement of income or balance sheet to fluctuation in interest rates. At
December 31, 1999, $113.3 million, or 61%, of our cash, cash equivalents and
investment portfolio carried at a maturity of less than 90 days, and
$171.3 million, or 92% carried a maturity of less than one year. All
investments mature, by policy, in less than two years. The effect of a 10%
rate decline would not be material on the portfolio. Information about our
investment portfolio is presented in Note 1 to the Consolidated Financial
Statements included in this Annual Report on Form 10-K and is incorporated
herein by reference.

  Foreign currency risk. A portion of our business is conducted in currencies
other than the U.S. Dollar. Our 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.

  We have entered into forward foreign exchange contracts to hedge amounts due
from select subsidiaries denominated in foreign currencies, mainly Europe and
the Pacific Rim, against fluctuations in exchange rates. We have not entered
into forward foreign exchange contracts for speculative or trading purposes.
Our accounting policies for these contracts are based on our designation of
the contracts as hedging transactions. The criteria we use for designating a
contract as a hedge considers the contract's effectiveness in reducing risk by
matching 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 our operating
results or cash flows. At December 31, 1999, we had outstanding forward
foreign exchange contracts to sell $10.7 million in currencies with a fair
value of $10.6 million.

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 24 month period preceding December 31, 1999 we neither changed
accountants nor had disagreements with our accountants on any matter of
accounting principles or practices, financial statement disclosure or auditing
scope and procedures.

                                      25
<PAGE>

                                   PART III

  Certain information required by Part III is omitted from this Annual Report
on Form 10-K because we will file a definitive proxy statement within 120 days
after the end of our fiscal year pursuant to Regulation 14A for our annual
meeting of stockholders, currently scheduled for May 24, 2000, 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 our 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
our directors required by this Item is incorporated by reference to the
information under the heading "Election of Directors--Nominees" in our proxy
statement.

Item 11. Executive Compensation

  The information required by this Item is incorporated by reference to our
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 our
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 our
proxy statement under the heading "Certain Transactions."

                                      26
<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, 1999 and 1998.............  F-2
   Consolidated Statements of Operations for the years ended December 31,
    1999, 1998 and 1997..................................................  F-3
   Consolidated Statements of Stockholders' Equity for the years ended
    December 31, 1999, 1998 and 1997.....................................  F-4
   Consolidated Statements of Cash Flows for the years ended December 31,
    1999, 1998 and 1997..................................................  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, 1999

  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>
 Exhibit
 Number                                  Description
 -------                                 -----------
 <C>          <S>
 3.1(1)       Certificate of Incorporation of Registrant, as amended and
              restated to date.
 3.2(7)       Certificate of Amendment of the Restated Certificate of
              Incorporation.
 3.3(1)       By-laws of Registrant, as amended to date.
 10.1(6),(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(6),(2)  Form of 1998 Employee Stock Purchase Plan and form of Agreements.
 10.4(1)      401(k) Plan.
 10.5(2),(3)  1994 Directors' Stock Option Plan and form of Agreements.
 10.6(4)      Preferred Share Purchase Rights Agreement.
 10.7(5)      1996 Supplemental Stock Plan.
 10.10(6),(2) 1999 Stock Option Plan
 10.11(8)     Form of Change of Control Agreements entered into by the Company
              with the Chairman, the Chief Executive Officer, the Chief
              Financial Officer, Chief Operating Officer and the President of
              European Operations.
 10.12(4)     Amendment to Rights Agreement dated March 31, 1999.
 10.13        Share Exchange Agreement among the Company, Conduct, Ltd.,
              Conduct Software Technologies, Inc. and the shareholders of
              Conduct, Ltd. dated November 23, 1999.
 21.1         Subsidiaries of Registrant.
 23.1         Consent of Independent Accountants.
</TABLE>

                                       27
<PAGE>

<TABLE>
<CAPTION>
 Exhibit
 Number             Description
 -------            -----------
 <C>     <S>
 24.1    Power of Attorney (see page 29).
 27.1    Financial Data Schedule.
</TABLE>
--------
(1) Exhibits 3.1, 3.3, 10.2, and 10.4 are incorporated by reference to
    Exhibits 3.3, 3.4, 10.2, and 10.12, 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.

(2) Designates management contract or compensatory plan arrangements required
    to be filed as an exhibit of this Annual Report on Form 10-K.

(3) Exhibit 10.5 is incorporated by reference to Exhibit 10.1 filed with the
    Form 10-Q for the three month period ended September 30, 1994.

(4) Exhibit 10.6 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, as amended by Amendment No. 1 to Form 8-A filed with the SEC
    on April 2, 1999.

(5) Exhibit 10.7 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.

(6) Exhibits 10.1, 10.3, and 10.10 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.

(7) Exhibit 3.3 is incorporated by reference to Exhibit 4.1 filed with the
    Company's Registration Statement on Form S-3, No. 333-95097, filed with
    the Securities and Exchange Commission on January 20, 2000.

(8) Exhibit 10.10 is incorporated by reference to Exhibit 10.26 filed with the
    Form 10-K for the year ended December 31, 1999.

(b) Reports on Form 8-K

  No report on Form 8-K was filed during the fourth quarter of the year ended
December 31, 1999.

                                      28
<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

Dated: March 20, 2000                     By:     /s/ Sharlene Abrams
                                             __________________________________
                                                    Sharlene Abrams,
                                              Chief Financial Officer, Vice
                                                       President of
                                               Finance and Administration

  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/ Amnon Landan             President, Chief Executive        March 20, 2000
____________________________________  Officer
            Amnon Landan              (Principal Executive Officer) and
                                      Chairman of the Board of
                                      Directors

      /s/ Sharlene Abrams            Chief Financial Officer, Vice     March 20, 2000
____________________________________  President, Finance and
          Sharlene Abrams             Administration (Principal
                                      Financial and Accounting
                                      Officer)

        /s/ Igal Kohavi              Director                          March 20, 2000
____________________________________
            Igal Kohavi

        /s/ Yair Shamir              Director                          March 20, 2000
____________________________________
            Yair Shamir

        /s/ Giora Yaron              Director                          March 20, 2000
____________________________________
            Giora Yaron
</TABLE>


                                      29
<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) present fairly, in all material respects, the
financial position of Mercury Interactive Corporation and its subsidiaries
(the "Company") at December 31, 1999 and 1998, and the results of their
operations and their cash flows for each of the three years in the period
ended December 31, 1999, in conformity with accounting principles generally
accepted in the United States. In addition, in our opinion, the financial
statement schedule listed in the index appearing under Item 14(a)(2) presents
fairly, in all material respects, the information set forth therein when read
in conjunction with related consolidated financial statements. These financial
statements and financial statement schedule are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements and financial statement schedule based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States 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 20, 2000, except as to Note 9, which is as of February 11, 2000.

                                      F-1
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

                          CONSOLIDATED BALANCE SHEETS
                    (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                              December 31,
                                                            ------------------
                                                              1999      1998
                                                            --------  --------
<S>                                                         <C>       <C>
                          ASSETS
Current assets:
  Cash and cash equivalents................................ $113,346  $ 96,836
  Short-term investments...................................   57,981    13,130
  Trade accounts receivable (net of allowance for doubtful
   accounts and sales returns of $5,533 and $3,623)........   40,399    27,903
  Other receivables........................................    6,325     6,012
  Prepaid expenses and other current assets................   16,702    11,685
                                                            --------  --------
    Total current assets...................................  234,753   155,566
Long-term investments......................................   15,555    20,697
Property and equipment, net................................   46,910    28,423
                                                            --------  --------
                                                            $297,218  $204,686
                                                            ========  ========
           LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable......................................... $  8,469  $  4,422
  Accrued liabilities......................................   33,433    18,236
  Income taxes payable.....................................   19,945    11,498
  Deferred revenue.........................................   35,840    24,122
                                                            --------  --------
    Total current liabilities..............................   97,687    58,278
                                                            --------  --------
Commitments and contingencies (Note 5)
Stockholders' equity:
  Common stock, par value $.002 per share, 120,000 shares
   authorized; 78,090 and 73,990 shares issued and
   outstanding.............................................      156       148
  Capital in excess of par value...........................  148,826   128,428
  Notes receivable from issuance of stock..................   (5,090)   (5,130)
  Accumulated other comprehensive loss.....................   (1,242)     (775)
  Retained earnings........................................   56,881    23,737
                                                            --------  --------
    Total stockholders' equity.............................  199,531   146,408
                                                            --------  --------
                                                            $297,218  $204,686
                                                            ========  ========
</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,
                                                      -------------------------
                                                        1999     1998    1997
                                                      -------- -------- -------
<S>                                                   <C>      <C>      <C>
Revenue:
  License............................................ $130,900 $ 84,450 $56,683
  Service............................................   56,800   36,550  20,017
                                                      -------- -------- -------
    Total revenue....................................  187,700  121,000  76,700
                                                      -------- -------- -------
Cost of revenue:
  License............................................    7,736    6,291   4,351
  Service............................................   18,642   11,757   6,225
                                                      -------- -------- -------
    Total cost of revenue............................   26,378   18,048  10,576
                                                      -------- -------- -------
Gross profit ........................................  161,322  102,952  66,124
                                                      -------- -------- -------
Operating expenses:
  Research and development, net......................   23,484   16,907  11,333
  Write off of in-process research and development
   and related expenses..............................      --       --    5,500
  Marketing and selling..............................   88,609   57,243  37,073
  General and administrative.........................   11,242    8,466   6,642
  Merger related expenses............................    2,000      --      --
                                                      -------- -------- -------
    Total operating expenses.........................  125,335   82,616  60,548
                                                      -------- -------- -------
Income from operations...............................   35,987   20,336   5,576
Other income, net....................................    6,026    4,640   3,083
                                                      -------- -------- -------
Income before provision for income taxes.............   42,013   24,976   8,659
Provision for income taxes...........................    8,869    5,451   2,927
                                                      -------- -------- -------
Net income........................................... $ 33,144 $ 19,525 $ 5,732
                                                      ======== ======== =======
Net income per share (basic)......................... $   0.44 $   0.28 $  0.09
                                                      ======== ======== =======
Net income per share (diluted)....................... $   0.39 $   0.25 $  0.08
                                                      ======== ======== =======
Weighted average common shares (basic)...............   76,112   70,654  65,494
                                                      ======== ======== =======
Weighted average common shares and equivalents
 (diluted)...........................................   85,208   78,818  68,458
                                                      ======== ======== =======
</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>
                                        Capital    Notes
                                           in    receivable  Retained    Accumulated
                          Common stock   excess     from     earnings/      other
                          -------------  of par   issuance  accumulated comprehensive Stockholders' Comprehensive
                          Shares Amount  value    of stock    deficit       loss         equity     income (loss)
                          ------ ------ -------- ---------- ----------- ------------- ------------- -------------
<S>                       <C>    <C>    <C>      <C>        <C>         <C>           <C>           <C>
Balance at December 31,
 1996...................  64,226  $128  $100,539      --      $(1,520)     $   (99)     $ 99,048
Net income..............     --    --        --       --        5,732          --          5,732       $ 5,732
Currency translation
 adjustments............     --    --        --       --          --          (325)         (325)         (325)
                                                                                                       -------
Comprehensive income....                                                                               $ 5,407
                                                                                                       =======
Stock issued under stock
 option and employee
 stock purchase plans...   2,728     6     7,560      --          --           --          7,566
Pooling of interests
 acquisition............     --    --         99      --          --           --             99
                          ------  ----  --------  -------     -------      -------      --------
Balance at December 31,
 1997...................  66,954   134   108,198      --        4,212         (424)      112,120
Net income..............     --    --        --       --       19,525          --         19,525        19,525
Currency translation
 adjustments............     --    --        --       --          --          (351)         (351)         (351)
                                                                                                       -------
Comprehensive income....                                                                               $19,174
                                                                                                       =======
Stock issued under stock
 option and employee
 stock purchase plans...   6,300    12    16,266   (5,130)        --           --         11,148
Pooling of interests
 acquisition............     736     2     3,964      --          --           --          3,966
                          ------  ----  --------  -------     -------      -------      --------
Balance at December 31,
 1998...................  73,990   148   128,428   (5,130)     23,737         (775)      146,408
Net income..............     --    --        --       --       33,144          --         33,144        33,144
Currency translation
 adjustments............     --    --        --       --          --          (467)         (467)         (467)
                                                                                                       -------
Comprehensive income....                                                                               $32,677
                                                                                                       =======
Collection of notes
 receivable.............     --    --        --       387         --           --            --
Stock issued under stock
 option and employee
 stock purchase plans...   4,100     8    20,398     (347)        --           --         20,446
                          ------  ----  --------  -------     -------      -------      --------
Balance at December 31,
 1999...................  78,090  $156  $148,826  $(5,090)    $56,881      $(1,242)     $199,531
                          ======  ====  ========  =======     =======      =======      ========
</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,
                                                  ----------------------------
                                                    1999      1998      1997
                                                  --------  --------  --------
<S>                                               <C>       <C>       <C>
Cash flows from operating activities:
  Net income..................................... $ 33,144  $ 19,525  $  5,732
  Adjustments to reconcile net income to net cash
   provided by (used in) operating activities:
  Depreciation and amortization..................    6,063     4,223     3,775
  Loss on retirement of property and equipment...      121       --        --
  Deferred income taxes..........................   (2,802)   (1,840)      270
  Changes in assets and liabilities:
    Trade accounts receivable....................  (12,349)   (4,006)   (7,240)
    Other receivables............................     (428)   (4,034)     (730)
    Prepaid expenses and other current assets....   (3,277)   (1,879)      857
    Accounts payable.............................    4,076       803     1,923
    Accrued liabilities..........................   16,164     5,309     5,141
    Income taxes payable.........................    8,688     8,373     2,485
    Deferred revenue.............................   11,718    13,030     4,936
                                                  --------  --------  --------
      Net cash provided by operating activities..   61,118    39,504    17,149
                                                  --------  --------  --------
Cash flows from investing activities:
  Maturity of investments........................   28,616    35,128    35,640
  Purchases of investments.......................  (68,325)  (33,826)  (35,128)
  Acquisition of property and equipment, net.....  (23,897)  (15,040)  (11,927)
  Capitalization of software development costs ..      --        --       (500)
                                                  --------  --------  --------
      Net cash used in investing activities......  (63,606)  (13,738)  (11,915)
                                                  --------  --------  --------
Cash flows from financing activities:
  Proceeds from issuance of common stock, net....   20,406    19,494     7,665
  Notes receivable from issuance of stock........     (347)   (5,130)      --
  Notes receivable collected from issuance of
   stock.........................................      387       --        --
                                                  --------  --------  --------
      Net cash provided by financing activities
       ..........................................   20,446    14,364     7,665
                                                  --------  --------  --------
Effect of exchange rate changes on cash..........   (1,448)     (585)      (28)
                                                  --------  --------  --------
Net increase in cash.............................   16,510    39,545    12,871
Cash and cash equivalents at beginning of year...   96,836    57,291    44,420
                                                  --------  --------  --------
Cash and cash equivalents at end of year......... $113,346  $ 96,836  $ 57,291
                                                  ========  ========  ========
Supplemental Disclosure:
Cash paid during the year for income taxes....... $  1,354  $  1,365  $  2,083
</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") develops, markets and
supports performance management solutions that enable businesses to test and
monitor their Internet and other applications. The Company operates in one
industry segment. (See Note 7 for geographic reporting.) No customer accounted
for more than 10% of revenue in 1999, 1998 or 1997.

  The Company acquired Conduct Ltd. on November 30, 1999, which was accounted
for as a pooling of interests. The consolidated financial statements for each
of the three years ended December 31, 1999, 1998 and 1997 and the accompanying
notes reflect the results of operations as if the acquired entity was a wholly
owned subsidiary since its inception (see Note 8).

 Basis of presentation

  The Company has a wholly owned research and development and sales subsidiary
incorporated in Israel and sales subsidiaries in Brazil, Canada, Europe, South
Africa 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.

  In January 2000, the Company's Board of Directors approved a two-for-one
split of the Company's common stock, which was distributed as a stock dividend
to the Company's stockholders, on February 11, 2000. All share and per share
amounts reflect the effect of the split.

 Management Estimates

  The preparation of financial statements in conformity with accounting
principles generally accepted in the United States 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.

 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 consolidated 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.

  The Company enters into forward foreign exchange contracts to hedge foreign
currency denominated intercompany payables against fluctuations in exchange
rates. The Company does not enter into forward foreign exchange contracts for
speculative or trading purposes. The criteria used for designating a contract as
a hedge considers the contract's effectiveness in reducing risk by matching
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. At December 31, 1999, the Company had
outstanding forward foreign exchange contracts to sell $10.7 million in
currencies with a fair value of $10.6 million.

                                      F-6
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Cash and cash equivalents

  The Company considers all highly liquid debt instruments purchased with an
original maturity of three months or less to be cash equivalents.

 Short-term and long-term investments

  The Company considers all investments with remaining maturities of less than
one year to be short-term investments and all investments with remaining
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.

  The portfolio of short-term and long-term investments (including cash and
cash equivalents) consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                                December 31,
                                                              -----------------
                        Investment Type                         1999     1998
                        ---------------                       -------- --------
   <S>                                                        <C>      <C>
   Cash and interest bearing demand deposits................. $ 34,275 $ 21,655
   Corporate debt securities.................................   86,593   56,472
   Municipal securities......................................   52,670   50,936
   U.S. treasury and agency securities.......................   13,344    1,600
                                                              -------- --------
       Total................................................. $186,882 $130,663
                                                              ======== ========
</TABLE>

 Revenue recognition

  Revenues are derived from product licensing fees, and 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.

 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 five to seven 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 buildings.

 Long-lived assets

  The Company evaluates the recoverability of its long-lived assets in
accordance with Statement of Financial Accounting Standards No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to be Disposed Of" ("SFAS 121"). SFAS 121 requires recognition of impairment
of long-lived assets in the event the net book value of such assets exceeds
the future undiscounted cash flows attributable to such assets. No such
impairments have been identified to date. The Company assesses the impairment
of long-lived assets when events or changes in circumstances indicate that the
carrying value of an asset may not be recoverable.

                                      F-7
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 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 1999 and 1998, no software development costs were capitalized because the
costs incurred subsequent to achieving techological feasibility and prior to
the general release of the products were not significant. The Company
capitalized $500,000 of software development costs during the year ended
December 31, 1997. Amortization charges included in cost of license revenues
were $585,000 in 1999 and $600,000 in each of 1998 and 1997. In conjunction
with the technology acquisition in 1997 approximately $250,000 of capitalized
development costs were written off as obsolete in the year ended December 31,
1997. At December 31, 1999, the Company did not have any capitalized software
development costs. At December 31, 1998, the net balance of capitalized
software development costs was $585,000.

  Research and development expense is reported net of research grants received
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. No grants were obtained from the Office of the Chief
Scientist in the Israeli Ministry of Industry and Trade ("the Chief
Scientist") during 1999. Research grants received amounted to $1.6 million in
1998 and $2.1 million in 1997. The Company was not obligated to repay these
grants; however, the Company 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
for each of the years ended December 31, 1999 and 1998, and $1.6 million for
the year ended December 31, 1997. As of December 31, 1999, the Company had no
outstanding royalty obligations. The Company has not applied for, nor does it
anticipate applying for, any future Chief Scientist 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 its stock on the grant date. Accordingly, no
compensation cost has been recognized in the statements of operations.
Additional pro forma disclosure is provided 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. 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 reporting of 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. For the years ended December 31,
1999, 1998 and 1997, dilutive potential common shares outstanding reflects
shares issuable under our stock option plans. Share and per share amounts
reflect the effect of the two-for-one stock split distributed to stockholders
on February 11, 2000. The following table summarizes the Company's earnings
per share computations for the years ended December 31, 1997, 1998 and 1999
(in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                                                        Earnings
                                                          Net   Average   per
                                                        income  shares   share
                                                        ------- ------- --------
   <S>                                                  <C>     <C>     <C>
   December 31, 1997:
     Basic earnings per share.......................... $ 5,732 65,494   $0.09
     Dilutive adjustments..............................     --   2,964
                                                        ------- ------
     Diluted earnings per share........................ $ 5,732 68,458   $0.08
                                                        ------- ------
    December 31, 1998:
     Basic earnings per share.......................... $19,525 70,654   $0.28
     Dilutive adjustments..............................     --   8,164
                                                        ------- ------
     Diluted earnings per share........................ $19,525 78,818   $0.25
                                                        ------- ------
    December 31, 1999:
     Basic earnings per share.......................... $33,144 76,112   $0.44
     Dilutive adjustments..............................     --   9,096
                                                        ------- ------
     Diluted earnings per share........................ $33,144 85,208   $0.39
                                                        ======= ======
</TABLE>

  At December 31, 1999, 1998, and 1997, options to purchase a total of 504,000
shares of common stock with an average exercise price of $38.50, 280,000
shares of common stock with an average exercise price of $9.62, and 941,092
shares of common stock with an average exercise price of $4.83, respectively,
are considered anti-dilutive because the options' exercise price was greater
than the average fair market value of our common stock for the years then
ended.

 Reclassifications

  Certain previously reported amounts have been reclassified to conform to the
1999 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.
Comprehensive income has been included in the Consolidated Statement of
Stockholders' Equity for all periods.

 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

                                      F-9
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

for the manner in which public companies report information about operating
segments in annual and interim financial statements. Information related to
geographic segments is included in Note 7.

 New Accounting Pronouncements

  In March 1998, the American Institute of Certified Public Accountants
("AICPA") issued 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 adopted the
provisions of SOP 98-1 in its fiscal year ending December 31, 1999. Adoption
did not have a material effect on the 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 Statement of Position 98-9, "Modification
of SOP 97-2, Software Revenue Recognition, with Respect to Certain
Transactions" ("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 a material effect on the results of operations,
financial position or cash flows.

  In June 1999, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 137, "Accounting for Derivative Instruments
and Hedging Activities--Deferral of the Effective Date of FASB Statement No.
133--an amendment of FASB Statement No. 133" ("SFAS 137"). SFAS 137 defers for
one year the application of Statement of Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities ("SFAS 133") to
all fiscal quarters of fiscal years beginning after June 15, 2000. SFAS 133
establishes accounting and reporting standards for derivative instruments and
hedging activities. The adoption of SFAS 133 and SFAS 137 have not had and are
not expected to have a material effect on the results of operations, financial
position or cash flows.

  In December 1999, the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial
Statements," ("SAB 101") which provides guidance on the recognition,
presentation, and disclosure of revenue in financial statements filed with the
SEC. SAB 101 outlines the basic criteria that must be met to recognize revenue
and provides guidance for disclosures related to revenue recognition policies.
Management believes the impact of SAB 101 will not have a material effect on
the results of operations, financial position or cash flows.

                                     F-10
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 2--FINANCIAL STATEMENT COMPONENTS

<TABLE>
<CAPTION>
                                                              December 31,
                                                            ------------------
                                                              1999      1998
                                                            --------  --------
                                                             (in thousands)
<S>                                                         <C>       <C>
Other receivables:
  Government grants receivables............................ $    --   $    400
  Employee receivables.....................................    2,625     1,014
  Income taxes receivable..................................    2,178     2,618
  Other receivables........................................    1,522     1,980
                                                            --------  --------
                                                            $  6,325  $  6,012
                                                            ========  ========
Prepaid expenses and other current assets:
  Prepaid compensation..................................... $  6,579  $  5,717
  Deferred income taxes, net...............................    4,642     1,840
  Other....................................................    5,481     4,128
                                                            --------  --------
                                                            $ 16,702  $ 11,685
                                                            ========  ========
Property and equipment, net:
  Land and buildings....................................... $ 35,245  $ 18,311
  Computers and equipment..................................   23,558    18,039
  Office furniture and equipment...........................    5,829     4,481
  Leasehold improvements...................................    2,888     2,934
                                                            --------  --------
                                                              67,520    43,765
  Less: Accumulated depreciation and amortization..........  (20,610)  (15,342)
                                                            --------  --------
                                                            $ 46,910  $ 28,423
                                                            ========  ========
Accrued liabilities:
  Payroll and accrued commissions (including payroll
   taxes).................................................. $ 16,751  $  5,939
  Vacation and severance...................................    4,299     3,457
  Sales tax................................................    3,270     2,820
  Royalties................................................    1,596     2,177
  Merger related expenses..................................      937       --
  Other....................................................    6,580     3,843
                                                            --------  --------
                                                            $ 33,433  $ 18,236
                                                            ========  ========
</TABLE>

<TABLE>
<CAPTION>
                                                         Year ended December
                                                                 31,
                                                         ----------------------
                                                          1999    1998    1997
                                                         ------  ------  ------
                                                            (in thousands)
<S>                                                      <C>     <C>     <C>
Other income, net:
  Interest income....................................... $6,480  $4,741  $3,521
  Foreign exchange losses and other.....................   (454)   (101)   (438)
                                                         ------  ------  ------
                                                         $6,026  $4,640  $3,083
                                                         ======  ======  ======
</TABLE>

                                      F-11
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 3--COMMON STOCK

  In August 1989, the Company adopted a stock option plan (the "1989 Plan").
Options granted under the 1989 Plan are for periods not to exceed ten years.
For holders of 10% or more of the total combined voting power of all 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 1989 Plan must be
at exercise prices no less than 100% of the fair market value and non-
statutory stock option grants under the 1989 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 an additional 1,200,000 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 1989 Plan, effective on the expiration of the term
of such plan in August 1999. The Company reserved 900,000 shares of common
stock for issuance upon exercise of stock options to be granted under this
plan. The provisions of the 1999 Plan regarding option term, grant price,
exercise price, and vesting period are identical to those of the 1989 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 December 1999, the stockholders
approved an automatic increase in the aggregate number of shares reserved for
issuance under the 1999 Plan by 4% of the common stock and equivalents
outstanding as of January 1 of each year starting in 2000 and ending in 2003.

  In May 1996, the Company adopted a stock option plan solely for grants to
employees of its subsidiaries located outside the United States (the
"Supplemental Plan"). The Company reserved 2,000,000 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 1989 Plan, the
1999 Plan and the Supplemental Plan for the years ended December 31, 1997,
1998 and 1999 (shares in thousands):

<TABLE>
<CAPTION>
                                                       Options outstanding
                                                     ------------------------
                                            Options               Weighted
                                           available Number of    average
                                           for grant  shares   exercise price
                                           --------- --------- --------------
   <S>                                     <C>       <C>       <C>
   Balance outstanding at December 31,
    1996..................................      56    12,500       $ 2.82
   Additional shares authorized...........   2,992       --           --
   Options granted........................  (4,268)    4,268         2.97
   Options canceled.......................   1,252    (1,252)        3.00
   Options exercised......................     --     (2,124)        2.41
                                            ------    ------
   Balance outstanding at December 31,
    1997..................................      32    13,392         2.92
   Additional shares authorized...........   4,466       --           --
   Options granted........................  (5,320)    5,320         6.49
   Options canceled.......................     930      (930)        4.41
   Options exercised......................     --     (6,080)        2.72
                                            ------    ------
   Balance outstanding at December 31,
    1998..................................     108    11,702         4.49
   Additional shares authorized...........   7,857       --           --
   Options granted........................  (4,871)    4,871        16.02
   Options canceled.......................     945      (945)        6.38
   Options exercised......................     --     (3,612)        4.42
                                            ------    ------
   Balance outstanding at December 31,
   1999...................................   4,039    12,016       $ 9.07
                                            ======    ======
</TABLE>

                                     F-12
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  The following table presents weighted average price and remaining
contractual life information about significant option groups outstanding under
the above plans at December 31, 1999 (shares in thousands):

<TABLE>
<CAPTION>
                                      Options outstanding                    Options exercisable
                         --------------------------------------------- --------------------------------
                                     Weighted average
                                        remaining                        Number
        Range of           Number    contractual life Weighted average exercisable Weighted average
    Exercise Prices      outstanding      (yr.)        exercise price  at 12/31/99  exercise price
    ---------------      ----------- ---------------- ---------------- ----------- ----------------
<S>                      <C>         <C>              <C>              <C>         <C>              <C>
$ 0.08- 3.19............    3,061          5.46            $ 2.78         2,044         $ 2.85
$ 3.38- 6.32............    4,015          8.07              5.73         1,359           5.65
$ 8.10-12.03............    3,691          9.01             11.55           192           8.89
$15.50-45.47............    1,249          9.81             28.09             4          19.57
                           ------                                         -----
                           12,016          7.87            $ 9.07         3,599         $ 4.24
                           ======                                         =====
</TABLE>

  In October 1998, the Company issued notes receivable of $5.1 million to its
officers and key employees 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 adopted the 1994 Directors' Stock
Option Plan (the "Directors' Plan"). The Company reserved 2,000,000 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 the Company's outside directors 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, 1997, 1998 and 1999 (shares in thousands):

<TABLE>
<CAPTION>
                                                        Options outstanding
                                             Options  -----------------------
                                            available Number of   Weighted
                                            for grant  shares   average price
                                            --------- --------- -------------
   <S>                                      <C>       <C>       <C>
   Balance outstanding at December 31,
    1996...................................   1,520      360       $ 3.26
   Options granted.........................     (60)      60         3.07
   Options canceled........................     --       --           --
   Options exercised.......................     --       (40)        2.29
                                              -----     ----
   Balance outstanding at December 31,
    1997...................................   1,460      380         3.33
   Options granted.........................    (360)     360         9.70
   Options canceled........................     --       --           --
   Options exercised.......................     --      (160)        3.81
                                              -----     ----
   Balance outstanding at December 31,
    1998...................................   1,100      580         7.14
   Options granted.........................     (60)      60        15.50
   Options canceled........................     --       --           --
   Options exercised.......................     --      (140)        7.96
                                              -----     ----
   Balance outstanding at December 31,
    1999...................................   1,040      500       $ 7.91
                                              =====     ====
</TABLE>

  The following table presents weighted average price and remaining
contractual life information about significant option groups outstanding under
the Directors' Plan at December 31, 1999 (shares in thousands):

<TABLE>
<CAPTION>
                                        Options outstanding                     Options exercisable
                         -------------------------------------------------- ----------------------------
                                       Weighted average                       Number
        Range of           Number          remaining       Weighted average exercisable Weighted average
    Exercise prices      outstanding contractual life(yr.)  exercise price  at 12/31/99  exercise price
    ---------------      ----------- --------------------- ---------------- ----------- ----------------
<S>                      <C>         <C>                   <C>              <C>         <C>
$ 2.28-$ 3.38...........     140             6.47               $ 3.06           20          $2.28
$ 5.28-$ 8.66...........     120             6.99                 6.75          --             --
$ 9.91-$ 9.91...........     180             8.62                 9.91          --             --
$15.50-$15.50...........      60             9.40                15.50          --             --
                             ---                                                ---
                             500             7.72               $ 7.91           20          $2.28
                             ===                                                ===
</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 2,000,000 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 1,300,000 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 (i) 85% of the fair market value of the shares
at the participant's entry date into the six month offering period, or (ii)
85% of the fair market value of the shares at the end of the six month
offering period. During 1999, 1998 and 1997, approximately 345,000, 84,000 and
560,000 shares, respectively, were purchased under our 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 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 option plans or the ESPP.

  Pursuant to the requirements of SFAS 123, the following are pro forma net
income (loss) and net income (loss) per share for 1999, 1998 and 1997, 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 1999, 1998 and 1997,
consistent with the provisions of SFAS 123:
<TABLE>
<CAPTION>
                                                           1999    1998  1997
                                                          ------- ------ -----
   <S>                                                    <C>     <C>    <C>
   Pro forma net income (loss) (in thousands)............ $13,895 $7,882 $(379)
   Pro forma net income (loss) per share (basic).........    0.18   0.11 (0.01)
   Pro forma net income (loss) per share (diluted).......    0.16   0.10 (0.01)
</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
                                             ----------------  ----------------
                                             1999  1998  1997  1999  1998  1997
                                             ----  ----  ----  ----  ----  ----
<S>                                          <C>   <C>   <C>   <C>   <C>   <C>
Expected life (years)....................... 4.00  4.00  5.00  0.50  0.50  0.50
Risk-free interest rate..................... 5.01% 5.22% 6.10% 5.06% 4.90% 5.36%
Volatility..................................   83%   83%   86%   83%   83%   86%
Dividend yield.............................. None  None  None  None  None  None
</TABLE>

  The weighted fair value per share of options granted under the 1989 Plan,
the 1999 Plan and Supplemental Plan during the years ended December 31, 1999,
1998 and 1997 were $10.12, $4.13 and $2.12, respectively. The weighted fair
value per share of options granted under the Directors' Plan during the years
ended December 31, 1999, 1998 and 1997 were $9.84, $6.13, and $2.18,
respectively.

NOTE 4--INCOME TAXES

  Income (loss) before income taxes consists of the following (in thousands):
<TABLE>
<CAPTION>
                                                          Year ended December
                                                                  31,
                                                         ----------------------
                                                          1999    1998    1997
                                                         ------- ------- ------
<S>                                                      <C>     <C>     <C>
Domestic................................................ $ 9,357 $ 6,239 $ (284)
Foreign.................................................  32,656  18,737  8,943
                                                         ------- ------- ------
                                                         $42,013 $24,976 $8,659
                                                         ======= ======= ======
</TABLE>

                                     F-15
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

  The provision for income taxes comprises the following (in thousands):
<TABLE>
<CAPTION>
                                                         Year ended December
                                                                 31,
                                                        ------------------------
                                                         1999     1998     1997
                                                        -------  -------  ------
   <S>                                                  <C>      <C>      <C>
   Current:............................................
     Federal........................................... $ 5,375  $ 5,322  $1,222
     State.............................................     931      350     355
     Foreign...........................................   5,365    1,619   1,080
                                                        -------  -------  ------
       Total Current...................................  11,671    7,291   2,657
                                                        -------  -------  ------
   Deferred:
     Federal...........................................  (2,681)  (1,756)    193
     State.............................................    (121)     (84)     77
     Foreign...........................................     --       --      --
                                                        -------  -------  ------
       Total Deferred..................................  (2,802)  (1,840)    270
                                                        -------  -------  ------
   Total tax expense................................... $ 8,869  $ 5,451  $2,927
                                                        =======  =======  ======
</TABLE>

  Deferred tax assets consist of the following (in thousands):
<TABLE>
<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                1999     1998
                                                               -------  -------
   <S>                                                         <C>      <C>
   Accruals and reserves...................................... $ 3,644  $ 1,821
   Net operating loss carryforwards...........................   1,856    1,336
   Other......................................................     998       19
                                                               -------  -------
                                                                 6,498    3,176
   Valuation allowance........................................  (1,856)  (1,336)
                                                               -------  -------
     Deferred tax assets, net................................. $ 4,642   $1,840
                                                               =======  =======
</TABLE>

  The Company has provided a valuation allowance for the years ended December
31, 1999 and 1998 for net operating loss carryforwards in foreign
jurisdictions, for which realization of future benefit is uncertain.

  Management believes it is more likely than not that future operations will
generate sufficient taxable income to realize the December 31, 1999 deferred
tax assets, net.

  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,
                                                    -------------------------
                                                     1999     1998     1997
                                                    -------  -------  -------
   <S>                                              <C>      <C>      <C>
   Provision at federal statutory rate............. $14,705  $ 8,492  $ 2,944
   State tax, net of federal tax benefit...........     527      350      549
   Foreign rate differentials from U.S. statutory
    rate...........................................  (8,234)  (5,288)  (2,739)
   Non-utilized net operating losses and credits...   3,625    2,826    2,722
   Tax-exempt interest.............................    (640)    (409)    (756)
   Other...........................................  (1,114)    (520)     207
                                                    -------  -------  -------
                                                    $ 8,869  $ 5,451  $ 2,927
                                                    =======  =======  =======
</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 there is Israeli taxable income (after consideration of tax losses
carried forward). The Company realized tax savings of approximately
$6.3 million, $5.2 million, and $4.2 million in 1999, 1998 and 1997,
respectively, as a result of this tax holiday. Because the Israeli subsidiary
currently has five 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.

  The Company had US federal net operating loss carryforwards of approximately
$23.1 million as of December 31, 1999, expiring through the year 2019. The net
operating losses are attributable to stock option compensation deductions.
Accordingly, any tax benefit realized upon utilization of these net operating
loss carryforwards will be accounted for as additions to Capital in Excess of
Par Value. For the year ended December 31, 1999 the Company had California net
operating loss carryforwards of approximately $4.4 million available to reduce
future income subject to income taxes. If not utilized, the California net
operating losses will expire through the year 2004.

  The 1999 tax provision was calculated without the benefit of Conduct's pre-
acquisition losses because the realization of any future tax benefit is
uncertain.

NOTE 5--COMMITMENTS AND CONTINGENCIES

Royalty Commitments

  Research and development expense is reported net of research grants received
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. No grants were obtained from the Office of the Chief
Scientist in the Israeli Ministry of Industry and Trade ("the Chief
Scientist") during 1999. Research grants received amounted to $1.6 million in
1998 and $2.1 million in 1997. The Company was not obligated to repay these
grants; however, the Company 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
for each of the years ended December 31, 1999 and 1998, and $1.6 million for
the year ended December 31, 1997. As of December 31, 1999, the Company had no
outstanding royalty obligations. The Company has not applied for, nor does it
anticipate applying for, any future Chief Scientist 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 2000 through
2004. Certain of these leases contain renewal options. The Company 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, 1999 (in thousands):

<TABLE>
             <S>                                <C>
             2000.............................. $3,101
             2001..............................  2,397
             2002..............................  1,555
             2003..............................    569
             2004..............................    229
                                                ------
             Total............................. $7,851
                                                ======
</TABLE>

                                     F-17
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Total rent expense under operating leases amounted to $2.8 million, $2.0
million, and $1.6 million for the years ended December 31, 1999, 1998 and
1997, respectively.

NOTE 6--RELATED PARTIES

  At December 31, 1999, the Company held seven notes receivable with balances
totaling $5.1 million from its officers and key employees. These notes arose
from transactions occurring on October 5, 1998 whereby the Company loaned its
key employees money to purchase an aggregate of 886,428 shares of our 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,
                                                     --------------------------
                                                       1999     1998     1997
                                                     -------- -------- --------
                                                           (in thousands)
   <S>                                               <C>      <C>      <C>
   Net revenue to third parties:
     North America.................................. $123,900 $ 78,797 $ 49,354
     Europe.........................................   49,700   33,140   21,223
     Rest of the World..............................   14,100    9,063    6,123
                                                     -------- -------- --------
       Consolidated................................. $187,700 $121,000 $ 76,700
                                                     ======== ======== ========
   Identifiable assets:
     North America.................................. $200,854 $161,751 $111,561
     Europe.........................................   25,389   14,388   11,656
     Rest of the World..............................   70,975   28,547   20,446
                                                     -------- -------- --------
       Consolidated................................. $297,218 $204,686 $143,663
                                                     ======== ======== ========
</TABLE>

  The subsidiary located in the United Kingdom accounted for 12% and 11% of
the consolidated net revenue to unaffiliated customers for the years ended
December 31, 1999 and 1998, respectively. Operations located in Israel
accounted 23% and 19% of the consolidated identifiable assets at December 31,
1999 and 1998, respectively. In 1997, no subsidiary represented 10 percent or
more of the related consolidated amounts.

NOTE 8--ACQUISITIONS

  On September 30, 1997, the Company acquired 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, 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.

  On November 30, 1999, the Company acquired Conduct Ltd. Under terms of the
agreement, approximately 408,000 shares of the Company's common stock were
issued in exchange for all issued and outstanding convertible preferred and
common shares of Conduct, and assumption of all outstanding Conduct stock
options, warrants and other securities. The transaction was accounted for as a
pooling of interests in the year ended December 31, 1999; therefore, all prior
periods presented have been restated to include Conduct in operations since
its inception.

                                     F-18
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Since its inception, Conduct Ltd. has not recorded any revenues. The net
income for the separate companies and the combined amounts presented in the
consolidated financial statements follow (in thousands).

<TABLE>
<CAPTION>
                                                         Year ended December
                                                                 31,
                                                        -----------------------
                                                         1999    1998     1997
                                                        ------- -------  ------
                                                            (in thousands)
<S>                                                     <C>     <C>      <C>
Net Income (loss):
  Mercury Interactive Corporation...................... $33,144 $21,805  $6,707
  Conduct Ltd..........................................     --   (2,280)   (975)
                                                        ------- -------  ------
                                                        $33,144 $19,525  $5,732
                                                        ======= =======  ======
</TABLE>

NOTE 9--SUBSEQUENT EVENTS

  In January 2000, the Company declared a two-for-one stock split in the form
of a stock dividend. One additional share of common stock has been issued for
each share of common stock held by shareholders of record as of January 28,
2000. New shares were distributed on February 11, 2000. All per share data
contained herein have been restated to reflect the increased number of shares
outstanding.

                                     F-19
<PAGE>

                       UNAUDITED QUARTERLY FINANCIAL DATA

<TABLE>
<CAPTION>
                                                     Quarter ended
                          -------------------------------------------------------------------
                           Dec.    Sept.   June              Dec.    Sept.   June
                            31,     30,     30,   March 31,   31,     30,     30,   March 31,
                           1999    1999    1999     1999     1998    1998    1998     1998
                          ------- ------- ------- --------- ------- ------- ------- ---------
                                       (in thousands, except per share amounts)
<S>                       <C>     <C>     <C>     <C>       <C>     <C>     <C>     <C>
Revenue:
  License...............  $43,500 $33,500 $29,300  $24,600  $28,200 $21,550 $19,100  $15,600
  Service...............   16,600  14,000  13,200   13,000   12,800   9,050   8,100    6,600
                          ------- ------- -------  -------  ------- ------- -------  -------
    Total revenue.......   60,100  47,500  42,500   37,600   41,000  30,600  27,200   22,200
                          ------- ------- -------  -------  ------- ------- -------  -------
Cost of revenue:
  License...............    2,190   2,040   1,870    1,636    1,867   1,545   1,550    1,329
  Service...............    5,181   4,948   4,441    4,072    3,864   2,959   2,600    2,334
                          ------- ------- -------  -------  ------- ------- -------  -------
    Total cost of
     revenue............    7,371   6,988   6,311    5,708    5,731   4,504   4,150    3,663
                          ------- ------- -------  -------  ------- ------- -------  -------
Gross profit............   52,729  40,512  36,189   31,892   35,269  26,096  23,050   18,537
                          ------- ------- -------  -------  ------- ------- -------  -------
Operating expenses:
Research and
 development, net.......    5,828   6,554   5,866    5,236    5,274   4,463   3,907    3,263
Marketing and selling...   27,123  21,975  20,380   19,131   18,085  14,338  13,753   11,067
General and
 administrative.........    3,033   3,082   2,797    2,330    2,440   2,116   1,963    1,947
Merger related
 expenses...............    2,000     --      --       --       --      --      --       --
                          ------- ------- -------  -------  ------- ------- -------  -------
    Total operating
     expenses...........   37,984  31,611  29,043   26,697   25,799  20,917  19,623   16,277
                          ------- ------- -------  -------  ------- ------- -------  -------
Income from operations..   14,745   8,901   7,146    5,195    9,470   5,179   3,427    2,260
Other income, net.......    1,925   1,542   1,406    1,153    1,610   1,227     947      856
                          ------- ------- -------  -------  ------- ------- -------  -------
Income before provision
 for income taxes.......   16,670  10,443   8,552    6,348   11,080   6,406   4,374    3,116
Provision for income
 taxes..................    3,334   2,297   1,840    1,398    2,332   1,405   1,008      706
                          ------- ------- -------  -------  ------- ------- -------  -------
Net income..............  $13,336 $ 8,146 $ 6,712  $ 4,950  $ 8,748 $ 5,001 $ 3,366  $ 2,410
                          ======= ======= =======  =======  ======= ======= =======  =======
Net income per share
 (basic)................  $  0.17 $  0.11 $  0.09  $  0.07  $  0.12 $  0.07 $  0.05  $  0.04
                          ======= ======= =======  =======  ======= ======= =======  =======
Net income per share
 (diluted)..............  $  0.15 $  0.09 $  0.08  $  0.06  $  0.11 $  0.06 $  0.04  $  0.03
                          ======= ======= =======  =======  ======= ======= =======  =======
Weighted average common
 shares (basic).........   77,824  76,796  75,394   74,434   73,352  70,692  69,880   68,708
                          ======= ======= =======  =======  ======= ======= =======  =======
Weighted average common
 shares (diluted).......   87,974  85,920  83,804   83,310   80,584  79,008  78,380   77,604
                          ======= ======= =======  =======  ======= ======= =======  =======
</TABLE>

                                      F-20
<PAGE>

                                                                     SCHEDULE II

                        MERCURY INTERACTIVE CORPORATION

                       VALUATION AND QUALIFYING ACCOUNTS

                  For the Three Years Ended December 31, 1999
                                 (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, 1999..............   $3,623     $4,485     $2,575      $5,533
  December 31, 1998..............   $1,878     $2,943     $1,198      $3,623
  December 31, 1997..............   $1,136     $1,927     $1,185      $1,878
</TABLE>