<PAGE>

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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, 2000

[_]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)

                Delaware                               77-0224776
                                          (I.R.S. Employer Identification No.)
     (State or other jurisdictionof
     incorporation or organization)

                   1325 Borregas Avenue, Sunnyvale, CA 94089
                    (Address of principal executive offices)

                                 (408) 822-5200
              (Registrant's telephone number, including area code)

                               ----------------

          Securities registered pursuant to Section 12(g) of the Act:

                         Common Stock, $0.002 par value

                               ----------------

   Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such a shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES [X] NO [_]

   Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. [_]

   The aggregate market value of the voting stock held by non-affiliates of the
Registrant was approximately $4,469,532,189 as of February 28, 2001, 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
28, 2001 was 81,530,505.

                      DOCUMENTS INCORPORATED BY REFERENCE

   Portions of the Proxy Statement for Registrant's 2000 Annual Meeting of
Stockholders to be held May 15, 2001 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
                                                                          ----

                                     PART I

 <C>      <S>                                                             <C>
 Item 1.  Business......................................................    3
          General.......................................................    3
          Web Performance Testing and Monitoring Solutions..............    5
          Research and Development......................................    7
          Marketing, Sales and Support..................................    8
          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

 Item 5.  Market for the Registrant's Common Equity and Related
          Stockholder Matters...........................................   12
 Item 6.  Selected Consolidated Financial Data..........................   13
 Item 7.  Management's Discussion and Analysis of Financial Condition
          and Results of Operations.....................................   14
 Item 7a. Quantitative and Qualitative Disclosures about Market Risk....   25
 Item 8.  Financial Statements and Supplementary Data...................   26
 Item 9.  Changes in and Disagreements with Accountants on Accounting
          and Financial Disclosure......................................   26

                                    PART III

 Item 10. Directors and Executive Officers of the Registrant............   27
 Item 11. Executive Compensation........................................   27
 Item 12. Security Ownership of Certain Beneficial Owners and
          Management....................................................   27
 Item 13. Certain Relationships and Related Transactions................   27

                                    PART IV

 Item 14. Exhibits, Financial Statement Schedules and Reports on
          Form 8-K......................................................   28
</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
"Management's Discussion and Analysis of Financial Condition and Results of
Operations-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 Web-based applications. Our
software products and hosted services help Global 2000 companies enhance the
user experience by improving the performance, availability, reliability and
scalability of their Web-based applications. Our hosted services provide our
customers a cost-effective solution that quickly meets business needs without
dedicating significant time and internal resources. By using our solutions to
identify and assess performance problems, businesses can increase their ability
to attract and retain customers, improve their competitive advantage and
maximize overall performance with minimum investment.

   Our customers represent a wide range of industries including global
enterprises such as Anheuser-Busch, BMW, Charles Schwab, Citibank,
DaimlerChrysler, DHL Airways, Ericsson, Ford Motor Company Hewlett-Packard, MCI
WorldCom, Microsoft, Motorola, Nokia, Norwich Union, Qwest Communications,
Siemens, Sony (US), Verizon and Walmart; and Internet infrastructure providers
such as Akamai, BEA Systems, i2 Technologies and Oracle.

   Our integrated performance management solutions enable 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, alert our customers to performance problems
and quickly diagnose the root cause of these problems. Our hosted services
provide outsourced load testing and Web performance monitoring services that
complement our software products. Specifically, our performance management
solutions include:

  . 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 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.

                                       3
<PAGE>

   We collaborate with a number of enterprise software and Internet
infrastructure companies, including Art Technology Group, Akamai, Allaire,
Alteon Websystems, Ariba, BEA Systems, Bluestone Software (recently acquired by
Hewlett-Packard), BroadVision, Cacheflow, Checkpoint, Cisco, IBM, iPlanet, i2
Technologies, Merant, Oracle, Peoplesoft, SAP, Siebel Systems and Vignette, 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.

   In February 2000, we formed a wholly-owned subsidiary to offer our hosted
Web performance monitoring service, ActiveWatch, and our hosted Web load
testing service, ActiveTest. We believe our Managed Service Provider (MSP)
subsidiary complements our existing offerings by providing a cost-effective
solution that allows customers to quickly meet their needs without dedicating
significant time and internal resources. This subsidiary currently serves more
than 400 customers.

                                       4
<PAGE>

Web Performance Testing and Monitoring Solutions

   Our products and hosted solutions bring together two key aspects of
application performance management ("APM"): Web performance testing and
monitoring. Testing allows customers to check the scalability and reliability
of applications prior to release. Customers then have the information they need
to fix any problems and optimize performance before making an application
available to users. After the application is released, customers can ensure
continuous performance and availability through the use of Web performance
monitoring products and services. Monitoring enables customers to detect,
diagnose and isolate performance problems that can negatively impact the end-
user experience. In particular, monitoring solutions alert customers to
performance problems and provide the information needed to locate their exact
source. Our software products and hosted services provide a comprehensive,
integrated solution for Web performance testing and monitoring.

   Our current Web performance testing and monitoring solutions include:

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

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

Load Testing
ActiveTest.............. Hosted Web site stress testing      January 2000  $15,000 for 100 virtual
                                                                           users
Astra LoadTest.......... Stress testing for Web applications December 1996 $9,995 for 50 virtual
                                                                           users
LoadRunner.............. Automated multi-user load testing   November 1993 $40,000-$50,000 for
                         for Web, client server and                        package simulating 50
                         enterprise applications                           users

Functional Testing
Astra QuickTest......... Functional testing for Web          May 1998      $3,995 per copy
                         applications
WinRunner............... Automated functional application    June 1993     $4,995-$10,000 per user
                         testing for Web, client server and
                         enterprise applications
XRunner................. Automated functional application    1991          $10,000-$15,000 per
                         testing for UNIX, X-Window                        user

Test Management
Astra FastTrack......... Web-based defect tracking tool      January 2001  $595/concurrent user
                                                                           (limited to 10 users)
Astra SiteManager....... Visual Web site management tool     October 1996  No charge
TestDirector............ Automated test management system    November 1994 $12,000 for server and
                         for QA workgroups                                 5 users

Monitoring Solutions
ActiveWatch............. Hosted performance monitoring       October 1999  $9,375/month
Topaz................... Web application performance         October 1999  $5,000/month
                         monitoring
Topaz Prism............. Web site monitoring from inside the October 2000  $3,333/month
                         firewall
</TABLE>
--------
* List prices vary according to system configuration and country where
  purchased. In addition, actual prices may vary from list prices.

                                       5
<PAGE>

Testing Solutions

 ActiveTest

   ActiveTest(TM) is the hosted load testing service that can conduct full-
scale testing of Web sites in as little as 24 hours. Based on LoadRunner
technology, ActiveTest can emulate the behavior of millions of users
interacting with a Web application to identify bottlenecks and capacity
constraints before the site goes live. This hosted service enables customers
with minimal hardware, personnel or technical expertise to achieve rapid
results. ActiveTest was initially introduced in 2000.

 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 the 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, Windows 95, Windows NT, UNIX and Linux. LoadRunner was initially
released in 1993.

 Astra QuickTest

   Astra QuickTest(TM) is an icon-based tool that allows expert and novice
testers to test the functionality of dynamically changing Web applications. By
mirroring end user behavior, Astra QuickTest creates interactive customizable
tests that simplify and shorten the testing cycle for complex Web environments.
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 2000, Windows Me 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 FastTrack

   Astra FastTrack(TM) is a fast, simple Web-based defect-tracking tool. It
supports the process for end-to-end defect management, helping companies
deliver higher quality applications. Astra FastTrack was initially released in
2001.

 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.

                                       6
<PAGE>

 TestDirector

   TestDirector(R) is a Web-based test management solution that globally
coordinates testing across an organization. TestDirector integrates
requirements management with test planning, test scheduling, test execution and
defect tracking in a single application to accelerate the testing process.
TestDirector was initially released in 1994.

Monitoring Solutions

 ActiveWatch

   ActiveWatch(TM) is a hosted service that monitors Web site performance
around the clock to proactively identify and pinpoint problems within complex
Web sites. Based on Topaz, ActiveWatch accurately measures the Web site user
experience from various points across the globe to ensure peak performance
24x7. ActiveWatch was initially introduced in 1999.

 Topaz and Topaz Prism

   Topaz(TM) is a solution for monitoring, detecting and diagnosing Web
application performance problems. It measures the end-user experience and
correlates any performance issues with their root cause in the Web
infrastructure. The Topaz family of application performance management
solutions consists of Topaz ActiveAgent and Topaz Prism. These products alert
customers to performance problems and provide the information needed to isolate
their root cause and minimize the impact on users. By using Topaz, customers
can optimize their Web site performance to ensure a positive end-user
experience anytime, anywhere. Topaz was initially released 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 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
from the government of Israel. Geographic proximity to Europe, a strategic
market for Mercury, offers another key advantage.

   As of December 31, 2000, our research and development group consisted of 316
employees. Our research and development expenses were $32.0 million in 2000,
$23.5 million in 1999 and $16.9 million in 1998. We anticipate that we will
continue to commit substantial resources to research and development.

                                       7
<PAGE>

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 systems
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.
Our direct sales organization includes our cybersales group which is focused on
selling ActiveWatch and ActiveTest hosted services. As of December 31, 2000,
our direct sales organization consisted of 561 employees.

   We have 23 sales and support centers throughout the United States.
Internationally, our subsidiaries operate 20 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 32% of our total revenues in 2000, 34% in
1999 and 35% in 1998, respectively. We expect that in future periods,
international sales will continue to account for a significant portion of our
total revenue.

 Indirect Distribution Channels

   We derive a substantial portion of our revenue from sales of our products
through indirect distribution channels such as systems integrators and value-
added resellers, including Accenture, Computer Sciences Corporation, Ernst &
Young, IBM Global Services, IXL, Inventa, Primix Solutions, Viant and ZEFER.

   We also target alternative distribution channels to complement our
traditional direct and indirect channels. Our Astra family of products is now
offered over the Internet. We also have private-labelling arrangements with
application service providers (ASPs), Internet service providers (ISPs) and
independent software vendors (ISVs) who incorporate our hosted services into
their offerings.

 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,
2000, our Customer Support Organization consisted of 254 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 generally 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, our APM
products and some of our testing products are priced based on usage, such as
the number of transactions monitored, number of virtual users emulated per day,
or period of usage.

                                       8
<PAGE>

   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 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. Training
and consulting revenues are generated on a time and expense basis.

Competition

   The market for testing and performance monitoring products and services is
extremely competitive, dynamic, and subject to frequent technological change.
There are few substantial barriers of entry in our market. In addition, the use
of the Internet for a growing range of Web applications is a recent and
emerging phenomenon. The Internet has further reduced these barriers of entry,
allowing 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, Empirix, Radview, Rational Software and Segue
Software. In the new and rapidly changing market for application performance
management solutions, our competitors include providers of hosted services such
as BMC Software, Keynote Systems and Service Metrics (a division of Exodus
Communications), and emerging companies such as Freshwater Software. 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 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 rely on a combination of patents, copyrights, trademarks, service marks,
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 our 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.

                                       9
<PAGE>

   We rely on software that we license from third parties for certain
components of our products. For example, we use software that we license from
RealNetworks and Microsoft to support the ability of our products to test and
monitor the performance of streaming media Web applications. In the future, we
may license other third party technologies to enhance our products and meet
evolving customer needs. The failure to license any necessary technology, or to
maintain our existing licenses, could result in reduced demand for our
products.

   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.

   We hold seven 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, 2000, we had a total of 1,418 employees, of which 634
were based in the Americas and 784 were based internationally. Of the total,
941 were engaged in marketing, sales and related customer support services, 316
were in research and development, and 161 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, 2001 are as follows:

<TABLE>
<CAPTION>
    Name                 Age                                 Position
    ----                 ---                                 --------
<S>                      <C> <C>
Amnon Landan............  42 President, Chief Executive Officer and Chairman of the Board of Directors
Kenneth Klein...........  41 Chief Operating Officer and Director
Sharlene Abrams.........  43 Chief Financial Officer and Vice President of Finance and Administration
Moshe Egert.............  36 President of European Operations
Douglas Smith...........  49 Executive Vice President of Corporate Development
</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 and a member of the Board of Directors since July 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, he served as Regional Sales Manager for Interactive
Development Environments, a CASE tool company. He has served as a director of
Tumbleweed Communications Corporation since February 2000.

                                       10
<PAGE>

   Ms. Sharlene Abrams has served as our Chief Financial Officer and Vice
President of Finance and Administration since November 1993. From 1988 to
November 1993, she was employed at Price Waterhouse LLP, most recently as a
senior manager. Between 1978 and 1988, she 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 as our Director
of European Marketing. From October 1990 through January 1994, he served with
us in several management and technical positions.

   Mr. Douglas Smith has served as our Executive Vice President of Corporate
Development since May 2000. From September 1996 to May 2000, he served in
various positions with Chase H&Q, most recently as Managing Director and co-
head of the Internet Group. From September 1994 to September 1996, he was the
Chief Financial Officer and Executive Vice President of Strategy for
ComputerVision Corporation.

Item 2. Properties

   We are headquartered in Sunnyvale, California in two buildings that we own
with a total square footage of 105,500. At the end of 2000, we purchased 26,000
and 24,000 square foot buildings in Sunnyvale, which will serve as additional
headquarters, sales, and operations facilities.

   Our research and development activities are conducted by our subsidiary in
Israel in a 78,000 square foot building that we own. During 1999, we purchased
an additional parcel of land in Israel, and have since begun construction of a
second research and development facility.

   Our field sales and support operations occupy leased facilities in 21
locations in the United States, one location in Canada, one location in Brazil,
15 locations in Europe, one location in Israel, one location in South Africa
and five locations in the Pacific Rim.

   We believe that our existing 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

   No matters were submitted during the fourth quarter of 2000 to a vote of the
holders of our common stock through the solicitation of proxies or otherwise.

                                       11
<PAGE>

                                    PART II

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

Market for Common Stock

   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, 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
   Year Ended December 31, 2000
     First Quarter.............................................. $134.50 $40.13
     Second Quarter.............................................  110.38  45.00
     Third Quarter..............................................  159.75  81.63
     Fourth Quarter.............................................  162.50  57.88
</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 28, 2001, there were approximately 64,500 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

<TABLE>
<CAPTION>
                                              Year ended December 31,
                                     ------------------------------------------
                                       2000     1999     1998    1997    1996
                                     -------- -------- -------- ------- -------
                                      (in thousands, except per share amounts)
<S>                                  <C>      <C>      <C>      <C>     <C>
Consolidated Statements of
 Operations Data:
Revenues:
  License........................... $216,100 $130,900 $ 84,450 $56,683 $43,270
  Service...........................   90,900   56,800   36,550  20,017  11,280
                                     -------- -------- -------- ------- -------
    Total revenues..................  307,000  187,700  121,000  76,700  54,550
                                     -------- -------- -------- ------- -------
Cost of revenues:
  License...........................   17,138    7,736    6,291   4,351   3,419
  Service...........................   24,679   16,957   10,500   5,849   2,968
                                     -------- -------- -------- ------- -------
    Total cost of revenues..........   41,817   24,693   16,791  10,200   6,387
                                     -------- -------- -------- ------- -------
Gross profit........................  265,183  163,007  104,209  66,500  48,163
                                     -------- -------- -------- ------- -------
Operating expenses:
  Research and development, net.....   32,042   23,484   16,907  11,333   9,670
  Write off of in-process research
   and development and related
   expenses.........................      --       --       --    5,500     --
  Marketing and selling.............  151,897   89,874   58,186  37,355  29,630
  General and administrative........   17,831   11,662    8,780   6,736   4,246
  Settlement of litigation..........      --       --       --      --    2,600
  Merger related expenses...........      --     2,000      --      --      --
                                     -------- -------- -------- ------- -------
    Total operating expenses........  201,770  127,020   83,873  60,924  46,146
                                     -------- -------- -------- ------- -------
Income from operations..............   63,413   35,987   20,336   5,576   2,017
Other income, net...................   17,462    6,026    4,640   3,083   3,375
                                     -------- -------- -------- ------- -------
Income before provision for income
 taxes..............................   80,875   42,013   24,976   8,659   5,392
Provision for income taxes..........   16,175    8,869    5,451   2,927   1,157
                                     -------- -------- -------- ------- -------
Net income.......................... $ 64,700 $ 33,144 $ 19,525 $ 5,732 $ 4,235
                                     ======== ======== ======== ======= =======
Net income per share (basic)........ $   0.81 $   0.44 $   0.28 $  0.09 $  0.07
                                     ======== ======== ======== ======= =======
Net income per share (diluted)...... $   0.70 $   0.39 $   0.25 $  0.08 $  0.06
                                     ======== ======== ======== ======= =======
Weighted average common shares
 (basic)............................   79,927   76,112   70,654  65,494  63,634
                                     ======== ======== ======== ======= =======
Weighted average common shares and
 equivalents (diluted)..............   91,938   85,208   78,818  68,458  66,254
                                     ======== ======== ======== ======= =======
</TABLE>

<TABLE>
<CAPTION>
                                                   December 31,
                                   --------------------------------------------
                                     2000     1999     1998     1997     1996
                                   -------- -------- -------- -------- --------
<S>                                <C>      <C>      <C>      <C>      <C>
Consolidated Balance Sheet Data:
Working capital................... $552,938 $137,066 $ 97,288 $ 87,733 $ 78,046
Total assets...................... $976,375 $297,218 $204,686 $143,663 $117,625
Stockholders' equity.............. $303,032 $199,531 $146,408 $112,120 $ 99,048
</TABLE>

                                       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 "Management's Discussion and
Analysis of Financial Condition and Results of Operations--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 have introduced a number of new products, and
new versions of existing products, including products and versions designed for
Web applications. We believe that a majority of customers that licensed our
products in 2000 are using these products to test and monitor their Web
applications. We also offer hosted load testing and monitoring services for Web
applications.

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,
                                                               ----------------
                                                               2000  1999  1998
                                                               ----  ----  ----
   <S>                                                         <C>   <C>   <C>
   Revenues
     License..................................................  70%   70%   70%
     Service..................................................  30    30    30
                                                               ---   ---   ---
       Total revenues ........................................ 100   100   100
                                                               ---   ---   ---
   Cost of revenues
     License..................................................   6     4     5
     Service..................................................   8     9     9
                                                               ---   ---   ---
       Total cost of revenues ................................  14    13    14
                                                               ---   ---   ---
   Gross profit...............................................  86    87    86
                                                               ---   ---   ---
   Operating expenses:
     Research and development, net............................  10    13    14
     Marketing and selling....................................  49    48    48
     General and administrative...............................   6     6     7
     Merger related expenses.................................. --      1   --
                                                               ---   ---   ---
       Total operating expenses...............................  65    68    69
                                                               ---   ---   ---
   Income from operations.....................................  21    19    17
   Other income, net..........................................   5     3     4
                                                               ---   ---   ---
   Income before provision for income taxes...................  26    22    21
                                                               ---   ---   ---
   Provision for income taxes.................................   5     5     5
                                                               ---   ---   ---
   Net income.................................................  21%   17%   16%
                                                               ---   ---   ---
</TABLE>

                                       14
<PAGE>

 Revenue

   License revenue increased to $216.1 million in 2000 from $130.9 million in
1999 and $84.5 million in 1998. Our growth in license revenue is attributable
primarily to growth in license fees from our LoadRunner, WinRunner and
TestDirector products, as well as revenue from our new application performance
management and MSP offerings.

   Service revenue increased to $90.9 million in 2000 from $56.8 million in
1999 and $36.6 million in 1998. The increase in service revenue in 2000
compared to 1999 and 1998 is a result of new maintenance contracts accompanying
the growth in license revenue as well as renewals of existing 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 includes costs of materials, product packaging,
equipment depreciation, production personnel, and costs associated with our
MSP. License cost of revenue as a percentage of license revenue increased to 8%
in 2000 from 6% in 1999 and 7% in 1998. The increase was primarily due to the
investment in the headcount, capital equipment and Internet service fees for
our MSP.

   Service cost of revenue consists primarily of costs of providing customer
technical support, training and consulting. Service cost of revenue increased
to $24.7 million in 2000 from $17.0 million in 1999 and $10.5 million in 1998.
As a percentage of service revenue, it decreased to 27% in 2000 from 30% in
1999 and 29% in 1998. The absolute dollar increase in service cost of revenue
in 2000 as compared to 1999 was primarily due to an increase in personnel-
related costs of $5.0 million reflecting growth in customer support and
consulting headcount from 156 at December 31, 1999 to 254 at December 31, 2000
and a $2.1 million increase in training and consulting outsourcing expense.

 Research and development, net

   Research and development expense consists primarily of costs associated with
the development of new products, enhancements of existing products, and quality
assurance procedures, and comprised primarily of employee salaries and related
costs, consulting costs, equipment depreciation and facilities expenses. For
the year ended December 31, 2000, research and development, net was $32.0
million, or 10% of total revenue, an increase from $23.5 million, or 13% of
total revenue in 1999, and $16.9 million, or 14% of total revenue in 1998. The
increase in absolute dollars of research and development spending in 2000 as
compared to 1999 reflected primarily increased research and development
headcount from 226 at December 31, 1999 to 316 at December 31, 2000 and
increased salaries of research and development engineers.

   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 2000 and 1999. Research
grants received amounted to $1.6 million in 1998. 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. There
was no royalty expense under these agreements for the year ended December 31,
2000. Royalty expense amounted to approximately $2.7 million for each of the
years ended December 31, 1999 and 1998. As of December 31, 2000, 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.

 Marketing and selling

   Marketing and selling expense consists primarily of employee salaries and
related costs, commissions, facilities expenses and marketing programs.
Marketing and selling expenses were $151.9 million, or 49% of

                                       15
<PAGE>

total revenue, in 2000, compared to $89.9 million in 1999 and $58.2 million in
1998, both 48% of total revenue. The increase in expenses in 2000 as compared
to 1999 was primarily due to an increase in personnel-related costs of $26.7
million reflecting growth in headcount from 377 at December 31, 1999 to 632 at
December 31, 2000, including the increase in sales head count related to our
cybersales organization and APM business. The increase in expenses in 2000 as
compared to 1999 was also due to an increase in sales commissions of $17.9
million attributable to higher revenue, an increase in facilities and related
costs of $2.4 million and an increase in spending on marketing programs of $7.4
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 consists primarily of employee salaries
and related costs related to executive and finance personnel. General and
administrative expense increased to $17.8 million, or 6% of total revenue in
2000, from $11.7 million, or 6% of total revenue in 1999 and $8.8 million, or
7% of total revenue in 1998. The increase in the absolute dollars is primarily
due to increased staffing and associated costs necessary to manage and support
our growing operations.

 Other income, net

   Other income, net consists primarily of interest income and expense and
foreign exchange gains and losses. The increase in other income, net to $17.5
million in 2000 from $6.0 million in 1999 primarily reflected increased
interest income from the proceeds of the issuance in July 2000, of convertible
subordinated notes, net of interest expense on the notes.

 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
2010. 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."

 Merger-related expenses

   In connection with the acquisition of Conduct Ltd. in 1999, 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.

Liquidity and Capital Resources

   At December 31, 2000, our principal source of liquidity consisted of $782.4
million of cash and investments compared to $186.9 million at December 31, 1999
and $130.7 million at December 31, 1998. The December 31, 2000 balance included
$402.4 million of short-term and $153.6 million of long-term investments in
high quality financial, government, and corporate securities. In July 2000, we
raised $485.4 million from the issuance of convertible subordinated notes with
an aggregate principal amount of $500.0 million. The notes mature on July 1,
2007 and bear interest at a rate of 4.75% per annum, payable semiannually on
January 1 and July 1 of each year. The notes are subordinated in right of
payment to all of our future senior debt. The notes are convertible into shares
of our common stock at any time prior to maturity at a conversion price of
approximately $111.25 per share, subject to adjustment under certain
conditions. We may redeem our notes, in whole or in part, at any time on or
after July 1, 2003. Accrued interest to the redemption date will be paid in
each redemption.

                                       16
<PAGE>

   During 2000, we generated $130.1 million cash from operating activities,
compared to $61.1 million in 1999 and $39.5 million in 1998. The increase in
2000 compared to 1999 was due primarily to an increase in net income and
increases in deferred revenue and accrued liabilities.

   Our primary investing activities were net purchases of investments of $482.5
million in 2000 and $39.7 million in 1999 compared to net proceeds from
investments of $1.3 million in 1998. We also purchased property and equipment,
which totaled $45.6 million in 2000, $23.9 million in 1999 and $15.0 million in
1998. Purchases of property and equipment in 2000 included $19.2 million for
the purchase of two additional headquarters buildings in Sunnyvale, California,
as well as $5.7 million for the renovation of existing headquarters buildings.
In addition, we spent $8.2 million in 1999 and $1.5 million in 1998 for the
purchase and renovation of headquarters buildings in Sunnyvale, California. We
expect to spend an additional $7.0 million to complete the renovation of our
newly purchased buildings in Sunnyvale. We spent $3.5 million in 2000, $8.3
million in 1999, and $5.7 million in 1998, for the purchase and construction of
research and development facilities in Israel. We expect to spend approximately
$10.0 million to complete the construction in Israel.

   Our primary financing activity consisted of issuance of the convertible
subordinated notes and 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 $26.2
million in 2000, $20.4 million in 1999 and $14.4 million in 1998.

   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 we did in July 2000.

New Accounting Pronouncements

   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. In June
2000, the Financial Accounting Standards Board issued SFAS No. 138 "Accounting
for Derivative Instruments and Hedging Activities-An Amendment of FASB No. 133"
("SFAS 138"). SFAS 138 amends the accounting and reporting standards for
certain derivatives and hedging activities such as net settlement contracts,
foreign currency translations and intercompany derivatives. We will adopt SFAS
138 in our year ended December 31, 2001. The adoption as of January 1, 2001 of
SFAS 133, SFAS 137 and SFAS 138 did not have a material effect on our results
of operations, financial position or cash flows.

   In March 2000, the Financial Accounting Standards Board issued
Interpretation No. 44, "Accounting for Certain Transactions Involving Stock
Compensation--an interpretation of APB Opinion No. 25" ("FIN 44"). FIN 44
clarifies the application of Accounting Practice Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25"), regarding (a) the
definition of employee for purposes of applying APB 25, (b) the criteria for
determining whether a plan qualifies as a noncompensatory plan, (c) the
accounting consequence of various modifications to the terms of a previously
fixed stock option or award, and (d) the accounting for an exchange of stock
compensation awards in a business combination. FIN 44 was effective July 1,
2000, but certain conclusions in this Interpretation cover specific events that
occurred after either December 15, 1998, or January 12, 2000. The Company's
adoption of the provisions of FIN 44 has not had a material effect on our
results of operations, financial position or cash flows.

                                       17
<PAGE>

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 services and continually
improving the performance, features and reliability of our existing products
and services and responding 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 services and enhancements to
    existing products and services by our competitors;

  . increasing complexity and interdependence of Web-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
services 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, and it
is difficult to predict our future revenues and operating results. 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 services and
    the timing of new product and service introductions;

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

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

  . the discretionary nature of our customers' purchase and budget cycles and
    changes in their budgets for software and Web-related purchases;

  . changes in economic conditions affecting our customers or our industry;

  . 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
    services or product enhancements; and

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

                                       18
<PAGE>

   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. In
addition, our customers' decisions to purchase our products and services are
discretionary and subject to their internal budgets and purchasing processes. A
slowdown in the economy may cause customers to reassess their immediate
technology needs and to defer purchasing decisions, and accordingly could
reduce demand for our products and services.

   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 trading prices
of our securities 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 of entry
in our market. In addition, the use of the Internet for a growing range of Web
applications is a recent and emerging phenomenon. The Internet lowers the
barriers of entry, allowing 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, Empirix, Radview, Rational Software and Segue
Software. In the new and rapidly changing market for application performance
management solutions, our competitors include providers of hosted services such
as BMC Software, Keynote Systems and Service Metrics (a division of Exodus
Communications), and emerging companies such as Freshwater Software. 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 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 systems integrators, value-added resellers, ASPs,
ISPs or ISVs. 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 systems integrators, value-added resellers,
ASPs, ISPs or ISVs, 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 systems integrators, value-added resellers, ASPs, ISPs or
    ISVs can cease marketing our products and services with limited or no
    notice and with little or no penalty;

  . our existing systems integrators, value-added resellers, ASPs, ISPs or
    ISVs 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 systems
    integrators, value-added resellers, ASPs, ISPs or ISVs if we lose any of
    our existing ones;

  . our systems integrators, value-added resellers, ASPs, ISPs or ISVs may
    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 systems integrators, value-added resellers, ASPs, ISPs or ISVs 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 as long as Tivoli continued to pay minimum
royalties, we would 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 we would not enter into technology relationships to
create similar products with specified competitors of Tivoli as long as Tivoli
continued to agree to pay minimum royalties. In October 2000, Tivoli elected
not to continue paying their required minimum royalties and the exclusive
provisions of this agreement terminated. Tivoli continues to have the rights to
market and sell these elements of our technology on a non-exclusive basis.

   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
anticipate 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 32% in 2000, 34% in 1999 and 35% in 1998. 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 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.

   Acquisitions may be difficult to integrate, disrupt our business, dilute
stockholder value or divert the attention of our management. We may acquire or
make investments in other companies with similar products and technologies. 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 expenses for the impairment of the value of investments or acquired
    assets;

  . incur amortization expense related to 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 2, 2001, the closing prices of our common stock as reported
on the Nasdaq National Market ranged from a high of $156.75 to a low of $48.50.
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 the
trading prices of our securities 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

                                       23
<PAGE>

use information that we regard as proprietary to create products that compete
with ours. Some license provisions protecting against 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 and 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 product 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

                                       24
<PAGE>

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.

   Leverage and debt service obligations may adversely affect our cash flow. In
July 2000, we completed an offering of convertible subordinated notes with a
principal amount of $500.0 million. We now have a substantial amount of
outstanding indebtedness, primarily the convertible subordinated 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

   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. Information about our investment
portfolio is presented in the table below, which states notional amounts and
related weighted-average interest rates by year of maturity (in thousands):

<TABLE>
<CAPTION>
                                                                         Fair
                                2001      2002    Thereafter  Total     Value
                              --------  --------  ---------- --------  --------
<S>                           <C>       <C>       <C>        <C>       <C>
Cash Equivalents
  Fixed Rate................. $147,699       --      --      $147,699  $147,743
  Average Rate...............      6.3%      --      --           6.3%
  Variable Rate.............. $ 40,200       --      --      $ 40,200  $ 40,200
  Average Rate...............      5.6%      --      --           5.6%
Investments
  Fixed Rate................. $402,356  $153,623     --      $555,979  $557,573
  Average Rate...............      6.5%      6.3%    --           6.4%
                              --------  --------     ---     --------  --------
Total Investments............ $590,255  $153,623     --      $743,878  $745,516
                              --------  --------     ---     --------  --------
Average Rate.................      6.4%      6.3%    --           6.4%
</TABLE>

   Our long-term investments include $68.3 million of government agency
instruments which have callable provisions and accordingly may be redeemed by
the agencies should interest rates fall below the coupon rate of the
investments.

   The fair value of the our convertible subordinated debentures fluctuates
based upon changes in the price of our common stock, changes in interest rates
and changes in our creditworthiness. The fair market value of the convertible
subordinated debentures as of December 31, 2000 was $522.6 million.

   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.

                                       25
<PAGE>

   We have entered into forward foreign exchange contracts ("forward
contracts") to hedge foreign currency denominated receivables due from certain
European and Pacific Rim subsidiaries against fluctuations in exchange rates.
We have not entered into forward 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
forward contract as a hedge considers it's effectiveness in reducing risk by
matching hedging instruments to underlying transactions. Gains and losses on
forward contracts are recognized in other 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. We had outstanding forward contracts with notional
amounts totaling approximately $13.0 million, $10.6 million and $3.4 million at
December 31, 2000, 1999 and 1998, respectively. The open forward contracts at
December 31, 2000 mature at various dates through December 2001 and are hedges
of certain foreign currency transaction exposures in the Australian dollar,
British pound, Danish Krone, French Franc, Euro, German Mark, Norwegian Kroner,
Japanese Yen and Swedish Krona. The unrealized net gain on these forward
contracts at December 31, 2000 totaled approximately $282,000.

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, 2000 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.

                                       26
<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 15, 2001, 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."

                                       27
<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, 2000 and 1999.............  F-2
   Consolidated Statements of Operations for the years ended December 31,
    2000, 1999 and 1998..................................................  F-3
   Consolidated Statements of Stockholders' Equity for the years ended
    December 31, 2000, 1999 and 1998.....................................  F-4
   Consolidated Statements of Cash Flows for the years ended December 31,
    2000, 1999 and 1998..................................................  F-5
   Notes to Consolidated Financial Statements............................  F-6
</TABLE>

     2. Schedules

   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 Mercury Interactive, as amended
             and restated to date.

  3.2        Certificate of Amendment of the Restated Certificate of
             Incorporation.

  3.3(3)     By-laws of Mercury Interactive, as amended to date.

 10.1(4),(2) Amended and Restated 1989 Stock Option Plan and forms of Incentive
             Stock Option Agreement and NonstatutoryStock Option Agreement

 10.2(1)     Form of Directors' and Officers' Indemnification Agreement.

 10.3(4),(2) Form of 1998 Employee Stock Purchase Plan and form of Agreements.

 10.4(1)     401(k) Plan.

 10.5(5),(2) 1994 Directors' Stock Option Plan and form of Agreements.

 10.6(6),(2) Form of Change of Control Agreements entered into by Mercury
             Interactive with the Chairman, the Chief Executive Officer, the
             Executive Vice President of Corporate Development, the Chief
             Financial Officer, Chief Operating Officer and the President of
             European Operations.

 10.7(7),(2) Amended and Restated 2000 Supplemental Stock Option Plan.

 10.8(7),(2) Amended and Restated 1999 Stock Option Plan.

 10.9(9)     Preferred Share Purchase Rights Agreement.

 10.10(10)   Amendment to Rights Agreement dated March 31, 1999.

 10.11(11)   Amendment No. Two to Rights Agreement, dated May 19, 2000.
</TABLE>


                                       28
<PAGE>

<TABLE>
<CAPTION>
 Exhibit
  Number                               Description
 -------                               -----------
 <C>      <S>
 10.12    Purchase and Sale Agreement by and between WHSUM Real Estate Limited
          Partnership and Mercury Interactive.

 10.13(8) Form of Note for Mercury Interactive 4.75% Convertible Subordinated
          Notes due July 1, 2007.

 10.14(8) Indenture between Mercury Interactive, as Issuer and Chase Manhattan
          Bank and Trust Company, National Association, as Trustee dated July
          3, 2000 related to Mercury Interactive 4.75% Convertible Subordinated
          Notes due July 1, 2007.

 10.15(8) Registration Rights Agreement among Mercury Interactive and Goldman,
          Sachs & Chase Securities Inc. and Deutsche Banc Securities Inc. dated
          June 27, 2000 related to the Mercury Interactive 4.75% Convertible
          Subordinated Notes due July 1, 2007.

 10.16(2) Amended and Restated Employment Agreement by and between Mercury
          Interactive and Douglas P. Smith effective as of August 28, 2000.

 21.1     Subsidiaries of Mercury Interactive.

 23.1     Consent of Independent Accountants.

 24.1     Power of Attorney (see page 30).
</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 Mercury Interactive 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 3.3 is incorporated by reference to Exhibit 3.2 filed with the
     Form 10-Q for the three month period ended September June 30, 1999
 (4) Exhibits 10.1 and 10.3 are incorporated by reference to Exhibits 4.1 and
     4.3 filed with the Registration Statement on Form S- 8, No. 333-62125,
     filed with the Securities and Exchange Commission on August 24, 1998.
 (5) Exhibit 10.5 is incorporated by reference to Exhibit 10.1 filed with the
     Form 10-Q for the quarter ended September 30, 1994.
 (6) Exhibit 10.6 is incorporated by reference to Exhibit 10.26 filed with the
     Form 10-K for the year ended December 31, 1998.
 (7) Exhibits 10.7 and 10.8 are incorporated by reference to Exhibits 4.1 and
     4.2 filed with the Registration Statement on Form S-8, No. 333-56316,
     filed with the Securities and Exchange Commission on February 28, 2001.
 (8) Exhibits 10.13, 10.14 and 10.15 are incorporated by reference to Exhibits
     4.1, 4.2 and 4.3, respectively, filed with the Form 10-Q for the quarter
     ended June 30, 2000.
 (9) Exhibit 10.9 is incorporated by reference to Exhibit 1 to Form 8-A, filed
     with the Securities and Exchange Commission on July 9, 1996.
(10) Exhibit 10.10 is incorporated by reference to Exhibit 1 to Form 8-A,
     Amendment No. 1, filed with the Securities and Exchange Commission on
     April 2, 1999.
(11) Exhibit 10.11 is incorporated by reference to Exhibit 1 to Form 8-A,
     Amendment No. 2, filed with the Securities and Exchange Commission on May
     22, 2000.

   (b) Reports on Form 8-K

   No report on Form 8-K was filed during the fourth quarter of the year ended
December 31, 2000.

                                       29
<PAGE>

                                  SIGNATURES

   Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Mercury Interactive (s), 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.

Dated: March 15, 2001                     Mercury Interactive Corporation

                                                   /s/ Sharlene Abrams,
                                          By: _________________________________
                                                      Sharlene Abrams
                                               Chief Financial Officer, Vice
                                                 President of Finance and
                                               Administration and Secretary

   KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints jointly and severally, Amnon Landan,
Susan Skaer 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 15, 2001
______________________________________  Officer (Principal
             Amnon Landan               Executive Officer) and
                                        Chairman of the Board of
                                        Directors

       /s/ Sharlene Abrams             Chief Financial Officer      March 15, 2001
______________________________________  and Vice President,
           Sharlene Abrams              Finance and
                                        Administration (Principal
                                        Financial and Accounting
                                        Officer)

         /s/ Igal Kohavi               Director                     March 15, 2001
______________________________________
             Igal Kohavi

         /s/ Yair Shamir               Director                     March 15, 2001
______________________________________
             Yair Shamir

         /s/ Giora Yaron               Director                     March 15, 2001
______________________________________
             Giora Yaron

        /s/ Kenneth Klein              Director                     March 15, 2001
______________________________________
            Kenneth Klein
</TABLE>

                                      30
<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, 2000 and 1999, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2000, in conformity with accounting principles generally accepted in the
United States of America. These financial statements are the responsibility of
the Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with auditing standards generally accepted in the
United States of America, 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 our opinion.

PricewaterhouseCoopers LLP

San Jose, California
January 15, 2001

                                      F-1
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

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

<TABLE>
<CAPTION>
                                                              December 31,
                                                            ------------------
                                                              2000      1999
                                                            --------  --------
<S>                                                         <C>       <C>
                          ASSETS
Current assets:
  Cash and cash equivalents................................ $226,387  $113,346
  Short-term investments...................................  402,356    57,981
  Trade accounts receivable (net of allowance for doubtful
   accounts and sales returns of $8,229 and $5,533)........   62,989    40,399
  Other receivables........................................   13,233     6,325
  Prepaid expenses and other assets .......................   21,316    16,702
                                                            --------  --------
    Total current assets...................................  726,281   234,753
Long-term investments......................................  153,623    15,555
Property and equipment, net ...............................   82,895    46,910
Other assets, net..........................................   13,576       --
                                                            --------  --------
    Total assets........................................... $976,375  $297,218
                                                            ========  ========

           LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
  Accounts payable......................................... $ 12,931  $  8,469
  Accrued liabilities......................................   58,942    33,433
  Income taxes payable.....................................   23,797    19,945
  Deferred revenue.........................................   77,673    35,840
                                                            --------  --------
    Total current liabilities..............................  173,343    97,687
Convertible subordinated notes.............................  500,000       --
                                                            --------  --------
    Total liabilities......................................  673,343    97,687
                                                            --------  --------
Commitments and contingencies (Note 5)
Stockholders' equity:
  Common stock, par value $.002 per share, 240,000 shares
   authorized; 81,129 and 78,090 shares issued and
   outstanding.............................................      162       156
  Capital in excess of par value...........................  190,232   148,826
  Notes receivable from issuance of stock..................   (7,528)   (5,090)
  Accumulated other comprehensive loss.....................   (1,415)   (1,242)
  Retained earnings........................................  121,581    56,881
                                                            --------  --------
    Total stockholders' equity.............................  303,032   199,531
                                                            --------  --------
                                                            $976,375  $297,218
                                                            ========  ========
</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,
                                                    --------------------------
                                                      2000     1999     1998
                                                    -------- -------- --------
<S>                                                 <C>      <C>      <C>
Revenues:
  License ......................................... $216,100 $130,900 $ 84,450
  Service .........................................   90,900   56,800   36,550
                                                    -------- -------- --------
    Total revenues ................................  307,000  187,700  121,000
                                                    -------- -------- --------
Cost of revenues:
  License .........................................   17,138    7,736    6,291
  Service .........................................   24,679   16,957   10,500
                                                    -------- -------- --------
    Total cost of revenues ........................   41,817   24,693   16,791
                                                    -------- -------- --------
Gross profit ......................................  265,183  163,007  104,209
                                                    -------- -------- --------
Operating expenses:
  Research and development, net ...................   32,042   23,484   16,907
  Marketing and selling ...........................  151,897   89,874   58,186
  General and administrative ......................   17,831   11,662    8,780
  Merger related expenses .........................      --     2,000      --
                                                    -------- -------- --------
    Total operating expenses ......................  201,770  127,020   83,873
                                                    -------- -------- --------
Income from operations ............................   63,413   35,987   20,336
Other income, net .................................   17,462    6,026    4,640
                                                    -------- -------- --------
Income before provision for income taxes ..........   80,875   42,013   24,976
Provision for income taxes ........................   16,175    8,869    5,451
                                                    -------- -------- --------
Net income ........................................ $ 64,700 $ 33,144 $ 19,525
                                                    ======== ======== ========
Net income per share (basic) ...................... $   0.81 $   0.44 $   0.28
                                                    ======== ======== ========
Net income per share (diluted) .................... $   0.70 $   0.39 $   0.25
                                                    ======== ======== ========
Weighted average common shares (basic) ............   79,927   76,112   70,654
                                                    ======== ======== ========
Weighted average common shares and equivalents
 (diluted) ........................................   91,938   85,208   78,818
                                                    ======== ======== ========
</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>
                                                    Notes
                                         Capital  receivable           Accumulated
                          Common stock  in excess    from                 other
                          -------------  of par    issuance  Retained comprehensive Stockholders' Comprehensive
                          Shares Amount   value    of stock  earnings     loss         equity     income (loss)
                          ------ ------ --------- ---------- -------- ------------- ------------- -------------
<S>                       <C>    <C>    <C>       <C>        <C>      <C>           <C>           <C>
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        --         --            387
Stock issued under stock
 option and employee
 stock purchase plans...   4,100     8    20,398      (347)       --         --         20,059
                          ------  ----  --------   -------   --------    -------      --------
Balance at December 31,
 1999...................  78,090   156   148,826    (5,090)    56,881     (1,242)      199,531
Net income..............     --    --        --        --      64,700        --         64,700       $64,700
Currency translation
 adjustments............     --    --        --        --         --        (173)         (173)         (173)
                                                                                                     -------
Comprehensive income....                                                                             $64,527
                                                                                                     =======
Tax benefit from stock
 options................     --    --     12,805       --         --         --         12,805
Collection of notes
 receivable.............     --    --        --      2,314        --         --          2,314
Stock issued under stock
 option and employee
 stock purchase plans...   3,039     6    28,601    (4,752)       --         --         23,855
                          ------  ----  --------   -------   --------    -------      --------
Balance at December 31,
 2000...................  81,129  $162  $190,232   $(7,528)  $121,581    $(1,415)     $303,032
                          ======  ====  ========   =======   ========    =======      ========
</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,
                                                 -----------------------------
                                                   2000       1999      1998
                                                 ---------  --------  --------
<S>                                              <C>        <C>       <C>
Cash flows from operating activities:
  Net income ................................... $  64,700  $ 33,144  $ 19,525
  Adjustments to reconcile net income to net
   cash provided by operating activities:
  Depreciation and amortization ................     9,624     6,063     4,223
  Loss on retirement of property and equipment
   .............................................       337       121       --
  Deferred income taxes, net ...................    (2,340)   (2,802)   (1,840)
  Tax benefit from exercise of stock options ...    12,805       --        --
  Changes in assets and liabilities:
    Trade accounts receivable...................   (23,841)  (12,349)   (4,006)
    Other receivables...........................    (6,952)     (428)   (4,034)
    Prepaid expenses and other assets...........    (2,079)   (3,277)   (1,879)
    Accounts payable............................     4,702     4,076       803
    Accrued liabilities ........................    25,873    16,164     5,309
    Income taxes payable........................     4,654     8,688     8,373
    Deferred revenue ...........................    42,634    11,718    13,030
                                                 ---------  --------  --------
      Net cash provided by operating activities
       .........................................   130,117    61,118    39,504
                                                 ---------  --------  --------
Cash flows from investing activities:
  Maturity of investments ......................   275,860    28,616    35,128
  Purchases of investments .....................  (758,333)  (68,325)  (33,826)
  Acquisition of property and equipment ........   (45,568)  (23,897)  (15,040)
                                                 ---------  --------  --------
      Net cash used in investing activities ....  (528,041)  (63,606)  (13,738)
                                                 ---------  --------  --------
Cash flows from financing activities:
  Proceeds from issuance of convertible
   subordinated notes ..........................   500,000       --        --
  Proceeds from issuance of common stock, net ..    28,607    20,406    19,494
  Debt issuance costs ..........................   (14,620)      --        --
  Notes receivable from issuance of common
   stock........................................    (4,752)     (347)   (5,130)
  Notes receivable collected from issuance of
   common stock.................................     2,314       387       --
                                                 ---------  --------  --------
      Net cash provided by financing activities
       .........................................   511,549    20,446    14,364
                                                 ---------  --------  --------
Effect of exchange rate changes on cash.........      (584)   (1,448)     (585)
                                                 ---------  --------  --------
Net increase in cash ...........................   113,041    16,510    39,545
Cash and cash equivalents at beginning of year
 ...............................................   113,346    96,836    57,291
                                                 ---------  --------  --------
Cash and cash equivalents at end of year ....... $ 226,387  $113,346  $ 96,836
                                                 =========  ========  ========
Supplemental Disclosure:
Cash paid during the year for income taxes ..... $   2,008  $  1,354  $  1,365
</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 Web site and other applications.

   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 two years ended December 31, 1999 and 1998 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
and services. In February 2000, the Company formed a wholly-owned subsidiary to
offer its hosted Web site performance monitoring service, ActiveWatch, and its
hosted Web site load testing service, ActiveTest. The consolidated financial
statements include the accounts of the Company and its wholly-owned
subsidiaries. All significant intercompany accounts and transactions have been
eliminated.

 Use of 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 statements 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 as other accumulated comprehensive income and included as a separate
component of stockholders' equity. Net gains and losses resulting from foreign
exchange transactions were not significant during any of the periods presented.

 Derivative financial instruments

   The Company enters into forward foreign exchange contracts ("forward
contracts") to hedge foreign currency denominated intercompany receivables
against fluctuations in exchange rates. The Company does not enter into forward
contracts for speculative or trading purposes. The criteria used for
designating a forward contract as a hedge considers its effectiveness in
reducing risk by matching hedging instruments to underlying transactions. Gains
and losses on forward contracts are recognized in other income in the same
period as gains

                                      F-6
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

and losses on the underlying transactions. The Company had outstanding forward
contracts with notional amounts totaling approximately $13.0 million, $10.6
million and $3.4 million at December 31, 2000, 1999 and 1998, respectively. The
open forward contracts at December 31, 2000 mature at various dates through
December 2001 and are hedges of certain foreign currency transaction exposures
in the Australian Dollar, British Pound, Danish Krone, French Franc, Euro,
German Mark, Norwegian Kroner, Japanese Yen and Swedish Krona. The unrealized
net gain on the Company's forward contracts at December 31, 2000 was
approximately $282,000.

 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                                              2000     1999
   ---------------                                            -------- --------
   <S>                                                        <C>      <C>
   Cash and interest bearing demand deposits................. $ 50,126 $ 34,275
   Corporate debt securities.................................  462,108   86,593
   Municipal securities......................................  112,973   52,670
   U.S. treasury and agency securities.......................  157,159   13,344
                                                              -------- --------
     Total................................................... $782,366 $186,882
                                                              ======== ========
</TABLE>

 Revenue recognition

   Revenues are derived from product licensing fees, and from maintenance
support services, training and consulting. Effective January 1, 1998, the
Company adopted Statement of Position 97-2, "Software Revenue Recognition"
("SOP 97-2"), with the exception of the provisions deferred by Statement of
Position 98-4, "Deferral of the Effective Date of a Provision of SOP 97-2"
("SOP 98-4"). Effective January 1, 1999 the Company adopted SOP 98-9,
"Modification of SOP 97-2, Software Revenue Recognition" ("SOP 98-9"). In
accordance with the adopted provisions of SOP 97-2 and SOP 98-9, the Company
records revenues from software licenses when a license agreement is signed by
both parties, the fee is fixed and determinable, collection of the fee is
probable and delivery of the product has occurred. If an element of the
arrangement had not been delivered, revenues for the element are deferred based
on vendor-specific objective evidence of fair value. If vendor-specific
objective evidence of fair value does not exist, all revenues are deferred
until sufficient objective evidence exists or all elements have been delivered.
Payments received in advance of revenue

                                      F-7
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

recognition are recorded as deferred revenue. Revenues from hosted services and
the Company's application performance management products are recognized
ratably over the term of the related agreements. Service revenues from customer
maintenance fees for ongoing customer support and product updates are
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.

   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.
The Company applied the provisions of SAB 101 to all revenue transactions for
fiscal 2000. SAB 101 has not had a material impact on the results of
operations, financial position or cash flows of the Company.

   In accordance with the provisions of Accounting Principles Board Opinion No.
29, "Accounting for Nonmonetary Transactions" ("APB 29"), the Company records
barter transactions at the fair value of the goods or services provided or
received, whichever is more readily determinable in the circumstances. To date,
revenues from barter transactions have been insignificant and represent less
than 1% of net revenues.

 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, two
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.

 Internal use software

   The Company recognizes software development costs in accordance with
Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." As such, the Company
capitalizes substantially all external costs related to the purchase and
implementation of software projects used for business operations. Capitalized
software costs primarily include purchased software and external consulting
fees. The Company expenses all costs incurred that relate to the planning and
post-implementation phases of the software project. Capitalized costs are
amortized over the estimated useful life of the product.

 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

                                      F-8
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

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. During 2000, 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 significant. There were no amortization charges included in cost of license
revenues in 2000, $585,000 in 1999 and $600,000 in 1998.

   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
2000 and 1999. Research grants received amounted to $1.6 million in 1998. 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. There was no royalty expense under these
agreements for the year ended December 31, 2000. Royalty expense amounted to
approximately $2.7 million for each of the years ended December 31, 1999 and
1998. As of December 31, 2000, 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 No. 25, "Accounting for
Stock Issued to Employees" ("APB 25"), 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). The Company has not issued stock options to non-employees.

 Concentration of credit risks

   Financial instruments, which potentially subject the Company to
concentrations of credit risk, consist principally of cash, 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 United States,
Brazil, Canada, Europe, Pacific Rim and Israel. The Company performs ongoing
credit evaluations of its customers and to date has not experienced any
material losses. No customer accounted for more than 10% of accounts receivable
or revenue in 2000, 1999 or 1998.

 Fair value of financial instruments

   The carrying amount of the Company's financial instruments, including cash,
cash equivalents, investments, accounts receivable and accounts payable
approximates their respective fair values due to the short maturities of these
financial instruments. Changes in the fair value of the Company's foreign
currency forward contracts ("forward contracts") are generally offset by
changes in the value of the underlying exposures being hedged.

   The fair value of the Company's convertible subordinated debentures was
$522.6 million at December 31, 2000, based on quoted market price.

                                      F-9
<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 number of common shares outstanding
and all dilutive potential common shares outstanding, utilizing the treasury
stock method. For the years ended December 31, 2000, 1999 and 1998, 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, 2000, 1999 and 1998 (in thousands, except per share
amounts):

<TABLE>
<CAPTION>
                                                       Year ended December 31,
                                                       -----------------------
                                                        2000    1999    1998
                                                       ------- ------- -------
   <S>                                                 <C>     <C>     <C>
   Numerator:
     Net income....................................... $64,700 $33,144 $19,525
                                                       ======= ======= =======
   Denominator:
     Denominator for basic net income per share--
      weighted average shares.........................  79,927  76,112  70,654
     Incremental common shares attributable to shares
      issuable under employee stock plans.............  12,011   9,096   8,164
                                                       ------- ------- -------
     Denominator for diluted net income per share--
      weighted average shares.........................  91,938  85,208  78,818
                                                       ======= ======= =======
     Net income per share--basic...................... $  0.81 $  0.44 $  0.28
                                                       ======= ======= =======
     Net income per share--diluted.................... $  0.70 $  0.39 $  0.25
                                                       ======= ======= =======
</TABLE>

   At December 31, 2000, 1999 and 1998, options to purchase a total of 314,250
shares of common stock with an exercise price of $107.37, 504,000 shares of
common stock with an exercise price of $38.50, and 280,000 shares of common
stock with an exercise price of $9.91, respectively, were not included in
diluted earnings per share because the impact is considered anti-dilutive. The
4,494,000 shares of common stock reserved for issuance upon conversion of the
outstanding convertible subordinated notes issued in 2000 were not included in
diluted earnings per share because the assumed conversion would be
antidilutive.

 Reclassifications

   Information technology expenses of $1.7 million in 1999 and $1.3 million in
1998 were reclassified from cost of revenues into selling and marketing and
general and administrative expenses to reflect similar allocations made in the
current year presentation.

 Comprehensive income

   Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130").
SFAS 130 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
Statements of Stockholders' Equity for all periods.

                                      F-10
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


 Segment reporting

   Effective January 1998, the Company adopted Statement of Financial
Accounting Standard No. 131, "Disclosures about Segments of an Enterprise and
Related Information" ("SFAS 131"). SFAS 131 establishes standards for the
manner in which public companies report information about operating segments in
annual and interim financial statements. During each of the three years ended
December 31, 2000, 1999 and 1998, the Company's management considered its
business activities to be focused on the license of its products and related
services to end user customers. Since management's primary form of internal
reporting is aligned with the offering of products and services, the Company
believes it operates in one segment. Information related to geographic segments
is included in Note 7.

 New accounting pronouncements

   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. In June
2000, the Financial Accounting Standards Board issued SFAS No. 138 "Accounting
for Derivative Instruments and Hedging Activities-An Amendment of FASB No. 133"
("SFAS 138"). SFAS 138 amends the accounting and reporting standards for
certain derivatives and hedging activities such as net settlement contracts,
foreign currency translations and intercompany derivatives. The Company will
adopt SFAS 138 in its year ended December 31, 2001. The adoption as of January
1, 2001, of SFAS 133, SFAS 137 and SFAS 138 did not have a material effect on
the Company's results of operations, financial position or cash flows.

   In March 2000, the Financial Accounting Standards Board issued
Interpretation No. 44, "Accounting for Certain Transactions Involving Stock
Compensation--an Interpretation of APB Opinion No. 25" ("FIN 44"). FIN 44
clarifies the application of Accounting Practice Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25"), regarding (a) the
definition of employee for purposes of applying APB 25, (b) the criteria for
determining whether a plan qualifies as a noncompensatory plan, (c) the
accounting consequence of various modifications to the terms of a previously
fixed stock option or award, and (d) the accounting for an exchange of stock
compensation awards in a business combination. FIN 44 was effective July 1,
2000, but certain conclusions in this Interpretation cover specific events that
occured after either December 15, 1998, or January 12, 2000. The Company's
adoption of the provisions of FIN 44 has not had a material effect on the
Company's results of operations, financial position or cash flows.


                                      F-11
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 2--FINANCIAL STATEMENT COMPONENTS

<TABLE>
<CAPTION>
                                                             December 31,
                                                           ------------------
                                                             2000      1999
                                                           --------  --------
                                                            (in thousands)
   <S>                                                     <C>       <C>
   Other receivables:
     Employee ............................................ $  1,060  $  2,625
     Income taxes ........................................      838     2,178
     Interest ............................................    9,072     1,078
     Other ...............................................    2,263       444
                                                           --------  --------
                                                           $ 13,233  $  6,325
                                                           ========  ========
   Prepaid expenses and other assets
     Prepaid compensation ................................ $  8,958  $  6,579
     Deferred income taxes, net ..........................    6,982     4,642
     Other ...............................................    5,376     5,481
                                                           --------  --------
                                                           $ 21,316  $ 16,702
                                                           ========  ========
   Property and equipment, net:
     Land and buildings .................................. $ 63,403  $ 35,245
     Computers and equipment .............................   36,341    23,558
     Office furniture and equipment ......................    8,299     5,829
     Leasehold improvements ..............................    4,189     2,888
                                                           --------  --------
                                                            112,232    67,520
     Less: Accumulated depreciation and amortization .....  (29,337)  (20,610)
                                                           --------  --------
                                                           $ 82,895  $ 46,910
                                                           ========  ========
   Other assets, net:
     Debt-related costs .................................. $ 14,620       --
     Less: Accumulated amortization ......................   (1,044)      --
                                                           --------  --------
                                                           $ 13,576  $    --
                                                           ========  ========
   Accrued liabilities:
     Payroll and accrued commissions (including payroll
      taxes).............................................. $ 26,784  $ 16,751
     Interest on notes ...................................   11,743       --
     Vacation and severance ..............................    7,241     4,299
     Sales tax ...........................................    4,929     3,270
     Royalties ...........................................    1,050     1,596
     Other ...............................................    7,195     7,517
                                                           --------  --------
                                                           $ 58,942  $ 33,433
                                                           ========  ========
</TABLE>

<TABLE>
<CAPTION>
                                                   Year ended December 31,
                                                   --------------------------
                                                     2000     1999     1998
                                                   --------  -------  -------
                                                        (in thousands)
   <S>                                             <C>       <C>      <C>
   Other income, net:
     Interest income ............................. $ 30,526  $ 6,480  $ 4,741
     Interest expense ............................  (11,775)     --       --
     Debt-related cost amortization ..............   (1,044)     --       --
     Foreign exchange gain (losses) and other ....     (245)    (454)    (101)
                                                   --------  -------  -------
                                                   $ 17,462  $ 6,026  $ 4,640
                                                   ========  =======  =======
   Allowance for doubtful accounts and sales
    returns:
     Balance at beginning of period .............. $  5,533  $ 3,623  $ 1,878
     Additions charged to costs and expenses .....   12,959    4,485    2,943
     Deductions ..................................  (10,263)  (2,575)  (1,198)
                                                   --------  -------  -------
                                                   $  8,229  $ 5,533  $ 3,623
                                                   ========  =======  =======
</TABLE>


                                      F-12
<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. The term of the 1989 Plan expired in August 1999
and options are no longer granted under this plan.

   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 1989 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 July 2000, the Company adopted the 2000 Supplemental Stock Option Plan
(the "2000 Plan") which allows for options to be granted to any employee of the
Company who is not a United States citizen or resident and who is not an
executive officer or director of the Company. The Company reserved 2,000,000
shares of common stock for issuance upon exercise of stock options to be
granted under the 2000 Plan. In November 2000, the Board amended and restated
the 2000 Plan to better address tax issues of the Company and its employees in
countries other than the United States. In February 2001, the Board approved
the reservation of an additional 4,000,000 shares of common stock for issuance
upon exercise of stock options to be granted under the 2000 Plan. The
provisions of the 2000 Plan regarding option term, grant price and exercise
price are identical to those of the 1999 Plan except that all the term of
options granted in certain European countries may be different and the 2000
Plan provides for the grant of stock purchase rights.


                                      F-13
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The following table presents the combined activity of the 1989 Plan, the
1999 Plan, the 2000 Plan and the Supplemental Plan for the years ended December
31, 1998, 1999 and 2000 (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,
    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
   Additional shares authorized...........   5,637       --          --
   Options granted........................  (8,315)    8,315       55.40
   Options canceled.......................     256      (652)      25.61
   Options exercised......................     --     (2,714)       7.78
                                            ------    ------
   Balance outstanding at December 31,
    2000..................................   1,617    16,965       31.39
                                            ======    ======       =====
</TABLE>

   The following table presents weighted average price and remaining
contractual life information about significant option groups outstanding under
the above plans at December 31, 2000 (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 (yrs)  exercise price  at 12/31/00  exercise price
---------------          ----------- ---------------------- ---------------- ----------- ----------------
<S>                      <C>         <C>                    <C>              <C>         <C>
$   .075--  6.32........    4,804             6.46               $ 4.58         3,450         $ 4.15
$  8.10 --  0.72........    7,554             8.71                26.98         1,303          15.16
$ 41.34 -- 89.00........    4,293             9.45                63.57           125          55.57
$103.44 --125.44........      314             9.66               107.46             3         107.37
                           ------                                               -----
                           16,965             8.28                31.39         4,881           8.47
                           ======                                               =====
</TABLE>

   The Company holds notes receivable with balances totaling $7.5 million from
its officers and certain employees in connection with the purchase of common
stock. The notes bear interest at the market rate on the date of issuance and
are secured by the shares purchased and require quarterly interest payments.
The full amount of the notes and the final interest payment become due over the
next five years until November, 2004.

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

                                      F-14
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

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 Company, and to provide for a one-
time grant of 25,000 shares to the non-employee directors of the Company who
were serving as directors of the Company as of August 14, 1998. The option term
is ten years, and options are exercisable while such person remains a director.
The exercise price is no less than 100% of fair market value on the date of
grant. The initial option grants and the one-time 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.

   The following table presents the activity for the Directors' Plan for the
years ended December 31, 1998, 1999 and 2000 (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,
    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
   Options granted.........................     (30)      30        15.50
   Options canceled........................     --       --
   Options exercised.......................     --      (100)        6.27
                                              -----     ----
   Balance outstanding at December 31,
    2000...................................   1,010      430         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, 2000 (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(yrs)  exercise price  At 12/31/00  exercise price
---------------          ----------- --------------------- ---------------- ----------- ----------------
<S>                      <C>         <C>                   <C>              <C>         <C>
$ 3.07--$ 3.38..........     120             5.83               $3.22           --             --
$ 5.28--$ 8.66..........      80             6.62                7.81            20          $5.28
$ 9.91--$ 9.91..........     140             7.62                9.91            20           9.91
$15.50--$67.88..........      90             8.73               32.96           --             --
                             ---                                                ---
                             430             7.17               12.48            40           7.59
                             ===                                                ===
</TABLE>

                                      F-15
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


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. In
May 2000, the stockholders approved the reservation of an additional 500,000
shares of common stock for issuance under the 1998 ESPP. During 2000, 1999 and
1998, approximately 189,000, 345,000 and 84,000 shares, respectively, were
purchased under our Employee Stock Purchase Plans (the "ESPPs").

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 ESPPs.

   Pursuant to the requirements of SFAS 123, the following are pro forma net
income (loss) and net income (loss) per share for 2000, 1999, and 1998, as if
the compensation costs for the option plans and the ESPPs had been determined
based on the fair value at the grant date for grants in 2000, 1999, and 1998,
consistent with the provisions of SFAS 123:

<TABLE>
<CAPTION>
                                                           2000   1999    1998
                                                          ------ ------- ------
   <S>                                                    <C>    <C>     <C>
   Pro forma net income (loss) (in thousands)............ $1,097 $13,895 $7,882
   Pro forma net income (loss) per share (basic).........   0.01    0.18   0.11
   Pro forma net income (loss) per share (diluted).......   0.01    0.16   0.10
</TABLE>

   The fair value of options and shares issued pursuant to the option plans and
the ESPPs at the grant date were estimated using the Black-Scholes model with
the following weighted average assumptions:

<TABLE>
<CAPTION>
                                              Option plans          ESPP
                                             ----------------  ----------------
                                             2000  1999  1998  2000  1999  1998
                                             ----  ----  ----  ----  ----  ----
<S>                                          <C>   <C>   <C>   <C>   <C>   <C>
Expected life (years)....................... 4.00  4.00  4.00  0.50  0.50  0.50
Risk-free interest rate..................... 6.26% 5.01% 5.22% 6.49% 5.06% 4.90%
Volatility..................................   88%   83%   83%   88%   83%   83%
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, the 2000 Plan and Supplemental Plan during the years ended
December 31, 2000, 1999 and 1998 were $37.02, $10.12 and $4.13, respectively.
The weighted fair value per share of options granted under the Directors' Plan
during the years ended December 31, 2000, 1999 and 1998 were $45.51, $9.84, and
$6.13, respectively.

                                      F-16
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 4--INCOME TAXES

   Income before provision for income taxes consists of the following (in
thousands):

<TABLE>
<CAPTION>
                                                         Year ended December 31,
                                                         -----------------------
                                                          2000    1999    1998
                                                         ------- ------- -------
   <S>                                                   <C>     <C>     <C>
   Domestic............................................. $22,655 $ 9,357 $ 6,239
   Foreign..............................................  58,220  32,656  18,737
                                                         ------- ------- -------
                                                         $80,875 $42,013 $24,976
                                                         ======= ======= =======
</TABLE>

   The provision for income taxes consists of the following (in thousands):

<TABLE>
<CAPTION>
                                                      Year ended December 31,
                                                      -------------------------
                                                       2000     1999     1998
                                                      -------  -------  -------
   <S>                                                <C>      <C>      <C>
   Current:
     Federal......................................... $ 8,388  $ 5,375  $ 5,322
     State...........................................   2,362      931      350
     Foreign.........................................   7,765    5,365    1,619
                                                      -------  -------  -------
       Total current.................................  18,515   11,671    7,291
                                                      -------  -------  -------
   Deferred:
     Federal.........................................  (1,708)  (2,681)  (1,756)
     State...........................................    (452)    (121)     (84)
     Foreign.........................................    (180)     --       --
                                                      -------  -------  -------
       Total deferred................................  (2,340)  (2,802)  (1,840)
                                                      -------  -------  -------
   Total provision for income taxes.................. $16,175  $ 8,869  $ 5,451
                                                      =======  =======  =======
</TABLE>

   Deferred income taxes consists of the following (in thousands):

<TABLE>
<CAPTION>
                                                                December 31,
                                                               ----------------
                                                                2000     1999
                                                               -------  -------
   <S>                                                         <C>      <C>
   Accruals and reserves...................................... $ 5,406  $ 3,644
   Net operating loss carryforwards...........................   1,705    1,856
   Other......................................................   1,576      998
                                                               -------  -------
                                                                 8,687    6,498
   Valuation allowance........................................  (1,705)  (1,856)
                                                               -------  -------
     Deferred income taxes, net............................... $ 6,982  $ 4,642
                                                               =======  =======
</TABLE>

   The Company has provided a valuation allowance of $1.7 million and $1.9
million for the years ended December 31, 2000 and 1999, respectively. The
valuation allowance is for deferred income taxes due to foreign net operating
losses for which realization of future benefit is uncertain.

   As of December 31, 2000, the Company had net operating loss carryforwards
for federal and state purposes of approximately $119.2 million and $24.6
million, respectively. The federal and state carryforwards will expire in
various years through 2020 for the federal, and through 2005, for the state
carryforwards. The net operating losses are attributable to stock option
compensation deductions. Accordingly, the tax benefit realized upon utilization
of the net operating loss carryforwards will be credited directly to equity.

                                      F-17
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   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,
                                                   --------------------------
                                                     2000     1999     1998
                                                   --------  -------  -------
   <S>                                             <C>       <C>      <C>
   Provision at federal statutory rate ........... $ 28,306  $14,705  $ 8,492
   State tax, net of federal tax benefit .........    1,146      527      350
   Foreign rate differentials from U.S. statutory
    rate .........................................  (14,173)  (8,234)  (5,288)
   Non-utilized net operating losses and credits
    ..............................................      522    3,625    2,826
   Tax-exempt interest ...........................     (992)    (640)    (409)
   Other .........................................    1,366   (1,114)    (520)
                                                   --------  -------  -------
                                                   $ 16,175  $ 8,869  $ 5,451
                                                   ========  =======  =======
</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.

   The Company's Israeli operation has 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 benefits for 10 years
starting the first year in which the Company has Israeli taxable income (after
consideration of tax losses carried forward). The benefits include a corporate
tax rate of 10% on income from certain approved enterprises and a tax exemption
on income from approved enterprises in respect of which the Company has elected
the "alternative benefits". The exemption period is 2 years, after which the
income from these enterprises is taxable at the rate of 10% for 8 years, and
the regular rate thereafter. While the Company will continue to apply for
"Approved Enterprise" status in future years, there is no assurance that the
benefits available under the current law will remain unchanged.

   The Company's Israeli operation has six overlapping Approved Enterprises
plans. The Company expects to be able to realize the tax holidays and rate of
the current plans through the year 2010. The entitlement to the "Approved
Enterprise" benefits is conditional upon the Company fulfilling the conditions
stipulated by the law, regulations published thereunder and the instruments of
approval for the specific investments in approved enterprises or approved
assets. In the event of failure to comply with these conditions, the benefits
may be cancelled and the Company may be required to refund the amount of the
benefits, in whole or in part, with the addition of interest.

   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

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
2000 and 1999. Research grants received amounted to $1.6 million in 1998. 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. There was no

                                      F-18
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

royalty expense under these agreements for the year ended December 31, 2000.
Royalty expense amounted to approximately $2.7 million for each of the years
ended December 31, 1999 and 1998. As of December 31, 2000, 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 2001 through
2005. Certain of these leases contain renewal options. The Company leases
certain equipment 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, 2000 (in thousands):

<TABLE>
      <S>                                                                <C>
      2001.............................................................. $ 4,422
      2002..............................................................   3,421
      2003..............................................................   1,911
      2004..............................................................     522
      2005..............................................................     137
                                                                         -------
      Total............................................................. $10,413
                                                                         =======
</TABLE>

   Total rent expense under operating leases amounted to $4.1 million, $2.8
million and $2.0 million for the years ended December 31, 2000, 1999 and 1998,
respectively.

NOTE 6--RELATED PARTIES

   At December 31, 2000, the Company held notes receivable with balances
totaling $7.5 million from its officers and certain employees. These notes were
issued over the last 3 years to purchase shares of the Company's common stock
at the then fair market value. The remaining notes, which bear interest at the
market rate on the date of issuance, mature over the next five years until
November, 2004. 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 the respective notes maturity date, the unpaid portion of the note would
become payable in full. These notes are full recourse loans 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,
                                                     --------------------------
                                                       2000     1999     1998
                                                     -------- -------- --------
                                                           (in thousands)
   <S>                                               <C>      <C>      <C>
   Net revenue to third parties:
     North America.................................. $208,200 $123,900 $ 78,797
     Europe.........................................   73,000   49,700   33,140
     Rest of the World..............................   25,800   14,100    9,063
                                                     -------- -------- --------
       Consolidated................................. $307,000 $187,700 $121,000
                                                     ======== ======== ========
   Identifiable assets:
     North America.................................. $808,583 $200,854 $161,751
     Europe.........................................   21,538   25,389   14,388
     Rest of the World..............................  146,254   70,975   28,547
                                                     -------- -------- --------
       Consolidated................................. $976,375 $297,218 $204,686
                                                     ======== ======== ========
</TABLE>


                                      F-19
<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

   The subsidiary located in the United Kingdom accounted for 10%, 12% and 11%
of the consolidated net revenue to unaffiliated customers for the years ended
December 31, 2000, 1999 and 1998 respectively. Operations located in Israel
accounted for 13%, 23% and 19% of the consolidated identifiable assets at
December 31, 2000, 1999 and 1998 respectively.

NOTE 8--ACQUISITIONS

   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.

   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,
                                                        -----------------------
                                                         2000    1999    1998
                                                        ------- ------- -------
                                                            (in thousands)
   <S>                                                  <C>     <C>     <C>
   Net income (loss):
     Mercury Interactive Corporation................... $64,700 $33,144 $21,805
     Conduct Ltd.......................................     --      --   (2,280)
                                                        ------- ------- -------
                                                        $64,700 $33,144 $19,525
                                                        ======= ======= =======
</TABLE>

NOTE 9--LONG-TERM DEBT

   In July 2000, the Company issued $500.0 million in convertible subordinated
notes. The notes mature on July 1, 2007 and bear interest at a rate of 4.75%
per annum, payable semiannually on January 1 and July 1 of each year. The notes
are subordinated in right of payment to all of Mercury's future senior debt.
The notes are convertible into shares of the Company's common stock at any time
prior to maturity at a conversion price of approximately $111.25 per share,
subject to adjustment under certain conditions. The notes may be redeemed, in
whole or in part, by the Company at any time on or after July 1, 2003. Accrued
interest to the redemption date will be paid by the Company in each redemption.

   In connection with the issuance of convertible subordinated notes, the
Company incurred $14.6 million of issuance costs, which primarily consisted of
investment banker fees, legal, and other professional fees. The costs are being
amortized using a straight-line method over the seven-year term of the notes.
Amortization expense related to the issuance costs was $1.0 million in 2000.

NOTE 10--EMPLOYEE BENEFIT PLAN

   The Company has a qualified 401(k) plan available to eligible employees.
Participants may contribute up to 15% of their annual compensation to the plan,
limited to a maximum annual amount set by the Internal Revenue Service. The
Company matches employee contributions dollar for dollar up to a maximum of
$1,000 per year per person. Matching contributions vest according to the number
of years of employee service. The Company contributed approximately $415,000 to
the 401(k) plan during 2000.

                                      F-20
<PAGE>

                       UNAUDITED QUARTERLY FINANCIAL DATA

<TABLE>
<CAPTION>
                                                        Quarter ended
                          -------------------------------------------------------------------------
                           Dec.
                            31.   Sept. 30, June 30, March 31, Dec 31, Sept. 30, June 30, March 31,
                           2000,    2000      2000     2000     1999     1999      1999     1999
                          ------- --------- -------- --------- ------- --------- -------- ---------
                                          (in thousands, except per share amounts)
<S>                       <C>     <C>       <C>      <C>       <C>     <C>       <C>      <C>
Revenues:
  License...............  $71,400  $54,200  $48,500   $42,000  $43,500  $33,500  $29,300   $24,600
  Service...............   26,100   25,300   21,100    18,400   16,600   14,000   13,200    13,000
                          -------  -------  -------   -------  -------  -------  -------   -------
   Total revenues.......   97,500   79,500   69,600    60,400   60,100   47,500   42,500    37,600
                          -------  -------  -------   -------  -------  -------  -------   -------
Cost of revenues:
  License...............    5,350    5,152    3,730     2,906    2,190    2,040    1,870     1,636
  Service...............    7,199    6,942    5,710     4,828    4,536    4,548    4,121     3,752
                          -------  -------  -------   -------  -------  -------  -------   -------
   Total cost of
    revenues............   12,549   12,094    9,440     7,734    6,726    6,588    5,991     5,388
                          -------  -------  -------   -------  -------  -------  -------   -------
Gross profit............   84,951   67,406   60,160    52,666   53,374   40,912   36,509    32,212
                          -------  -------  -------   -------  -------  -------  -------   -------
Operating expenses:
Research and
 development, net.......    8,350    8,132    8,460     7,100    5,828    6,554    5,866     5,236
Marketing and selling...   45,030   38,995   35,334    32,538   27,608   22,275   20,620    19,371
General and
 administrative.........    5,608    4,766    4,060     3,397    3,193    3,182    2,877     2,410
Merger-related
 expenses...............      --       --       --        --     2,000      --       --        --
                          -------  -------  -------   -------  -------  -------  -------   -------
   Total operating
    Expenses............   58,988   51,893   47,854    43,035   38,629   32,011   29,363    27,017
                          -------  -------  -------   -------  -------  -------  -------   -------
Income from operations..   25,963   15,513   12,306     9,631   14,745    8,901    7,146     5,195
Other income, net.......    6,294    5,332    3,228     2,608    1,925    1,542    1,406     1,153
                          -------  -------  -------   -------  -------  -------  -------   -------
Income before provision
 for income taxes.......   32,257   20,845   15,534    12,239   16,670   10,443    8,552     6,348
Provision for income
 Taxes..................    6,451    4,169    3,107     2,448    3,334    2,297    1,840     1,398
                          -------  -------  -------   -------  -------  -------  -------   -------
Net income..............  $25,806  $16,676  $12,427   $ 9,791  $13,336  $ 8,146  $ 6,712   $ 4,950
                          =======  =======  =======   =======  =======  =======  =======   =======
Net income per share
 (basic)................  $  0.32  $  0.21  $  0.16   $  0.12  $  0.17  $  0.11  $  0.09   $  0.07
                          =======  =======  =======   =======  =======  =======  =======   =======
Net income per share
 (diluted)..............  $  0.28  $  0.18  $  0.14   $  0.11  $  0.15  $  0.09  $  0.08   $  0.06
                          =======  =======  =======   =======  =======  =======  =======   =======
Weighted average common
 shares (basic).........   80,996   80,263   79,507    78,943   77,824   76,796   75,394    74,434
                          =======  =======  =======   =======  =======  =======  =======   =======
Weighted average common
 shares (diluted).......   92,728   92,533   91,282    91,208   87,974   85,920   83,804    83,310
                          =======  =======  =======   =======  =======  =======  =======   =======
</TABLE>

                                      F-21