SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-K/A(Amendment No. 2)

|(Mark One) |                                                                                         
|---------- | ----------------------------------------------------------------------------------------
|ý          | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|           | For the fiscal year ended December 31, 2003                                             
|OR        
|o          | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|           | For the transition period from  to                                                      

Commission file number 000-29335

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WITNESS SYSTEMS, INC.(Exact Name of Registrant as Specified in Its Charter)

|Delaware(State or Other Jurisdiction of
Incorporation or Organization)               |  | 23-2518693(I.R.S. Employer
Identification No.)
|------------------------------------------------------------------------------------ |  | ----------------------------------------------
|300 Colonial Center Parkway
Roswell, Georgia(Address of Principal Executive Offices) |  | 30076(Zip Code)                               

Registrant's
telephone number, including area code770-754-1900

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Securities
registered pursuant to Section 12(b) of the Act:None

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

|Title of each class                    |  | Name of each exchange on which registered
|-------------------------------------- |  | -----------------------------------------
|Common Stock, par value $.01 per share |  | NASDAQ                                   

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

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
the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form
10-K. o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule
12b-2). Yes ý    No o

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DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's definitive proxy statement for its annual meeting of stockholders, currently scheduled for May 26, 2004, are incorporated by
reference in Part III of this report.

EXPLANATORY NOTE

Witness Systems, Inc. is filing this Amendment No. 2 on Form 10-K/A to further amend its annual report on
Form 10-K for the year ended December 31, 2003 to revise (1) Part II, Item 7, and (2) Part II, Item 8, Note 1, Note 4 and
Note 9 of the Witness Systems, Inc. Consolidated Financial Statements in response to certain comments received from the staff of the Securities and Exchange Commission in connection with
its review of the Company's registration statement on Form S-3 filed March 15, 2004. This Form 10-K/A Amendment No. 2 makes no changes to the
Company's Form 10-K or Form 10-K/A Amendment No. 1, other than as noted above, except to include (1) an updated Consent of Independent Registered
Public Accounting Firm





and (2) updated officer certifications as Exhibits 31.1 and 31.2. This Amendment does not modify or update the disclosures contained in the Form 10-K in any other respect.



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WITNESS SYSTEMS, INC.
FORM 10-K/A
(Amendment No. 2)

TABLE OF CONTENTS

|                     |  |                                                                                       |  | Page
|-------------------- |  | ------------------------------------------------------------------------------------- |  | ----
|PART II              |  |                                                                                      
|Item 7.              |  | Management's Discussion and Analysis of Financial Condition and Results of Operations |  | 1   
|Item 8.              |  | Financial Statements and Supplementary Data                                           |  | 28  
|SIGNATURES           |  | 29                                                                                   
|EXHIBIT INDEX        |  | 30                                                                                   
|FINANCIAL STATEMENTS |  | F-1                                                                                  

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

This annual report on Form 10-K contains forward-looking statements that are not historical facts but rather are based on current expectations, estimates and
projections about our business and industry, our beliefs and assumptions. Words such as "anticipates", "expects", "intends", "plans", "believes", "seeks", "estimates" and variations of these words and
similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, some of
which are beyond our control, are difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. Forward-looking
statements that were true at the time made may ultimately prove to be incorrect or false. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our
management's view only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future
events or otherwise.

The
following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes
thereto included elsewhere in this report. Investors should carefully review the information contained in this report under the caption "Factors That May Affect Our Future Results and Market Price of
Our Stock" beginning on page 29.

Overview

We provide the contact center market an integrated performance optimization software suite that enables global enterprises to capture customer intelligence and
optimize workforce performance. Our solution is comprised of business-driven and/or full-time customer interaction recording, performance analysis and e-learning management applications that are
designed to enhance the quality of customer interactions across multiple communications media, including the telephone, e-mail and the Internet. Our software suite allows contact center management to
share information gathered in the contact center with departments that touch the customer, as well as executives throughout the organization. Using an integrated business consulting, installation and
training methodology, we provide services to support an effective and rapid deployment of our software that enables organizations to maximize their return on an investment in our products and
services. Our software is designed to integrate with a variety of third-party software applications, such as customer relationship management ("CRM") and enterprise resource planning applications, and
with existing telephony and computer network hardware
and software. The majority of our customers are companies with an international presence and one or more contact centers that handle voice and data customer interactions for outbound sales and
marketing operations, inbound service/support lines, or both.

Corporate
spending for information technology ("IT") and CRM applications contracted in 2002 and remained relatively flat in 2003. While the economic environment remains challenging,
there were indications of an improving economic outlook and IT spending showed signs of improvement during the second half of 2003. The International Data Corporation has predicted that IT spending
will increase by 6% to 8% in 2004, and based upon our own analysis of the demand for our products and services, we have forecasted revenue growth in 2004.

During
the second quarter of 2003, we completed the acquisition of Eyretel plc ("Eyretel"), a United Kingdom-based provider of compliance and recording solutions for customer contact
centers, for $55.3 million. We acquired Eyretel with the intent to extend our presence in international markets and to expand our product line by adding a full-time compliance recording software
solution. Prior to the acquisition, our principal focus had been software to improve the quality of contact center performance; in contrast substantially all of Eyretel's sales were attributable to
its full-time compliance recording solution. In addition to this opportunity to expand our product line and the absence of

1

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significant
product overlap, Eyretel was attractive to us because it derived nearly half of its revenues from Europe, the Middle East and Africa, and another 24% from the Asia-Pacific
region, and thus afforded us an opportunity to quickly gain access to those markets, and to quickly expand our indirect sales channel. During 2003, we successfully integrated the two companies in
terms of product offerings and business operations. We began consolidating Eyretel's results on March 22, 2003, the date we assumed majority ownership of Eyretel.

We
derive product revenue by licensing software and derive services revenue by providing related installation, training, consulting, and maintenance services. In 2003, we also derived
approximately $6 million of product revenue by selling hardware to customers. During 2002 and the first half of 2003, the reduction in overall IT spending limited our ability to grow product revenue.
However, in 2003 with the benefit of the Eyretel acquisition, we grew product revenue by 39%. To date, eQuality Balance and eQuality ContactStore, our business-driven and/or full-time
customer interaction recording solutions, have generated the majority of our product revenue and will continue to do so in 2004. However, we believe we have additional product revenue growth
opportunities in the following areas:



Factors
that may influence our ability to grow our product revenue include:



We
intend to maintain our competitive position from a technology perspective through the timely introduction of new products and platforms. We currently offer VoIP products to our
customers. Although sales of such products were not material to our total revenue in 2003, we believe our VoIP product offerings are a material growth opportunity as the market transitions to an IP
technology environment. In addition to growing our revenues by expanding our product lines, we also intend to grow our product revenue by expanding our global sales channels by continuing to enter
into reseller, distributor and similar arrangements with key vendors in the contact center workforce optimization market. During 2003, 31% of total product revenue was derived from the indirect sales
channel, compared to 23% in 2002.

Our
services revenue has continued to increase over the past several years. When our customers license our products, they generally purchase installation, training and one year of
support services. Therefore, as we generate product revenue, we also generate these related services revenue. In addition, our customers generally renew their maintenance contracts with us each year.
Therefore, our maintenance
revenue generally increases as our customer base increases. Factors that may influence our ability to grow our services revenue include the growth in product revenue and our ability to maintain a high
level of customer satisfaction.

We
are headquartered in Roswell, Georgia and have other offices throughout the United States. We deliver our products and services internationally through our offices in Australia,
Brazil, Canada, China, Germany, Hong Kong, Japan, Malaysia, Mexico, Singapore and the United Kingdom. During 2003, 2002 and 2001, 45%, 25% and 16%, respectively, of our revenue was derived from
customers

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outside
the United States. We had 497 full-time employees at December 31, 2003, compared to 309 at December 31, 2002 and 327 at December 31, 2001. As of December 31, 2003,
189 full-time employees were located outside the United States.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make certain estimates and judgments that affect
our reported assets, liabilities, revenues and expenses, and our related disclosure of contingent assets and liabilities. On an on-going basis, we re-evaluate our estimates, including those related to
revenue recognition, the collectibility of receivables, accounting for acquisitions, impairment of long-lived assets, income taxes and stock-based compensation. We base our estimates on historical
experience and on various assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

Factors
that could affect our future operating results and cause actual results to vary materially from expectations include, but are not limited to, lower than anticipated revenue
growth from existing customers, our ability to attract new customers, our ability to grow through acquisitions and to successfully integrate acquisitions, the availability and cost of debt and equity
financing, technology changes, or a decline in the financial stability of our customers. Negative developments in these or other risk factors could have a material adverse effect on our financial
position and results of operations. A summary of our critical accounting policies follows.

Revenue Recognition.We recognize revenue in accordance with Statement of Position ("SOP") 97-2, Software Revenue
Recognition,and SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain
Transactions. Revenue is primarily derived from licensing software and providing related services including maintenance. Product revenue, which includes software and hardware,
is recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or determinable, collection is probable and vendor specific objective evidence
("VSOE") exists to allocate revenue to the undelivered elements of the arrangement. We report hardware revenue gross in accordance with Emerging Issues Task Force No. 99-19 because
the factors indicating gross reporting outweigh the factors indicating net reporting. We recognize revenue using the residual method of accounting since our revenues are derived from customer orders
that contain multiple element arrangements, including the sale of licensed software, hardware, maintenance, and professional services. We generally have VSOE of fair value for maintenance and
professional services, but not for the software and hardware elements of the order. Under the residual method, services revenue, including maintenance and professional services, is deferred at an
amount equal to its fair value until those elements are delivered. Consequently, product revenue for the software and hardware may be recognized (i) upon delivery of those products when we have VSOE
on the related maintenance and professional services sold and (ii) at an amount representing the difference between the total order amount and the amount deferred. Services revenue includes
installation, training, consulting, maintenance and reimbursable travel expenses. Revenue from installation, training and consulting services is recognized upon performance of the related services and
is offered and billed as separate elements of contracts. Reimbursable travel expenses revenue is recognized upon incurrence of the related expenses. The functionality of the software and any hardware
sold is not dependent on installation and training services and customization is not required to enable our customers to use our products. Maintenance is offered as a separate element and the majority
of contracts include the right to unspecified upgrades on a when-and-if available basis. Maintenance revenue, which is generally billed in advance, is deferred and recognized ratably over the term of
the related contract. Specified upgrades are not typically offered to customers.

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Our
revenue recognition policy is significant because our revenues are a key component of our results of operations. We follow very specific and detailed guidelines, discussed above, in
measuring revenues; however, certain judgments affect the application of our revenue policy. Further, assessment of collectibility is particularly critical in determining whether or not revenues
should be recognized in the current market environment. We record provisions for estimated sales allowances on product and service related revenues at the time the related revenues are recorded. These
estimates are based on historical sales and services allowances, analysis of customer credits and other known factors. If future sales credits prove to be greater than the historical data and the
estimates we used to calculate these provisions, our revenues could be overstated.

Allowance for Doubtful Accounts.We perform ongoing evaluations of our customers and continuously monitor collections and
payments and estimate an allowance for doubtful accounts based on the aging of the underlying receivables, our historical experience and any specific customer collection issues that we have
identified. While such credit losses have historically been within our expectations and we believe appropriate reserves have been established, we cannot assure that we will continue to experience the
same credit loss rates that we have experienced in the past or adequately predict future credit losses. If the financial condition of our customers was to deteriorate and resulted in an
impairment of their ability to make payments, additional allowances may be required which would result in an additional selling, general and administrative expense in the period such determination is
made.

Accounting for Acquisitions.Accounting for acquisitions requires management to make judgments and estimates in determining
the purchase price, the fair value of the assets and liabilities acquired and merger-related and restructuring expenses. In recording the Eyretel acquisition in 2003, management estimates primarily
related to the following purchase price components or merger-related costs:



Changes
to purchase price estimates, prior to the completion of the final purchase price allocation, are reflected as an adjustment to intangible assets. Subsequent adjustments would be
reflected in our results of operations.

Impairment of Long-lived Assets.Long-lived assets, such as property and equipment and intangible assets, are reviewed for
impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. All of our intangible assets are amortized on a straight-line basis. Useful
lives of amortizable intangible assets are reviewed annually with any changes in estimated useful lives being accounted for prospectively over the revised remaining useful life. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount
of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. The determination
of estimated future cash flows, however, requires management to make estimates. Future events and changes in circumstances may require us to record a significant impairment charge in any given period.
Impairment testing requires considerable analysis and judgment in determining the results. If other assumptions and estimates were used in our evaluations, the results could differ significantly.

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Accounting for Income Taxes.We account for income taxes in accordance with Statement of Financial Accounting Standards
("SFAS") No. 109,Accounting for Income Taxes, which requires companies to recognize deferred tax assets and liabilities using enacted tax rates for the
effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more
likely than not that some portion or all of the deferred tax asset will not be realized. We evaluate the realizability of our deferred tax assets quarterly by assessing our valuation allowance and by
adjusting the amount of such allowance, if necessary. At December 31, 2003, we had net deferred tax liabilities primarily resulting from temporary differences between the book and tax bases of assets
and liabilities, and loss and credit carry forwards. We continue to provide a valuation allowance on our deferred tax assets based on an assessment of the likelihood of their realization. In reaching
our conclusion, we evaluated certain relevant criteria including deferred tax liabilities that can be used to offset deferred tax assets, estimates of future taxable income of appropriate character
within the carry forward period available under the tax law, and tax planning strategies. Our judgments regarding future taxable income may change due to market conditions, changes in U.S. or
international tax laws, and other factors. These changes, if any, may require material adjustments to these deferred tax assets, resulting in a tax benefit if it is estimated that future taxable
income is likely.

Once
the deferred tax asset is realized through the utilization of net operating loss carryforwards to future income, we would expect our provision for income taxes in future periods to
reflect an effective tax rate significantly higher than past periods.

In
addition, we have provided for potential tax liabilities due in foreign jurisdictions. Judgment is required in determining our worldwide income tax expense provision. In the ordinary
course of conducting a global business enterprise, there are many transactions and calculations undertaken whose ultimate tax outcome cannot be certain. Some of these uncertainties arise as a
consequence of transactions and arrangements made among related parties. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome of these matters will
not be different from what is reflected in our historical income tax provisions and accruals. Such differences could have
a material impact on our income tax provision and operating results in the period in which such a determination is made.

Stock-Based Compensation.With the exception of the deferred stock compensation that we recorded at our initial public
offering, we generally do not record compensation expense for options granted to our employees because all options granted under our stock option plans have an exercise price equal to the market value
of the underlying common stock on the date of grant. As permitted under SFAS No. 148,Accounting for Stock-Based CompensationTransition and
Disclosure, and SFAS No. 123,Accounting for Stock-Based Compensation, we have elected to continue to apply the provisions of
Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees,and have adopted the disclosure requirements of SFAS No. 123. The
pro forma disclosures of stock-based compensation include the use of certain input factors in calculating the fair value of stock option grants, some of which require management to make estimates and
use judgment. In addition, the Financial Accounting Standards Board is exploring the possibility of modifying generally accepted accounting principles to require us to record stock-based compensation
expense in the future.

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Results of Operations

The table below shows operating data as a percentage of total revenue for the periods indicated:

Year Ended December 31,2003

2002

2001Revenue:Product

43
%
49
%
64
%Services

57

51

36Total revenue

100

100

100Cost of revenue:Product

11

2

1Services

22

18

17Total cost of revenue

33

20

18Gross profit

67

80

82Operating expenses:Selling, general and administrative

56

60

65Research and development

17

22

22Merger-related costs

7

0

0Acquired in-process research and development and related charges

7

0

8Operating loss

(20
)
(2
)
(13
)Interest and other income, net

1

2

5(Loss) income before provision for income taxes

(19
)
0

(8
)Provision for income taxes

0

0

0Net (loss) income

(19
)%
0
%
(8
)%


Impact of Eyretel Acquisition

We largely completed the integration of Witness and Eyretel during the second quarter of 2003 by substantially combining all sales, services, development,
marketing, product and support functions. We estimate that the acquisition of Eyretel contributes approximately $50 million of additional annual revenue and that we have achieved approximately
$20 million of annual expense savings, primarily though reductions in overhead and personnel. We believe that revenue and expenses beginning in the second half of 2003 reflect the full impact
of the Eyretel acquisition and integration. Consequently, the acquisition of Eyretel significantly increased our reported revenues and expenses in 2003 as compared to 2002. Cost of revenue increased
in 2003 due primarily to the inclusion of hardware revenue (which has immaterial profit margins) and the amortization of intangible assets arising from the Eyretel acquisition. Operating expenses,
expressed as a percentage of total revenue, decreased in 2003, as compared to 2002, due to the aforementioned increase in revenue and expense savings following the acquisition of Eyretel.

Revenue

Total revenue increased 60% in 2003, as compared to 2002, to $108.0 million, due to increases in product and services revenue. The number of installed customer
sites grew to 2,341 sites at the end of 2003, an increase from 1,177 sites at the end of 2002. Total revenue increased 8% in 2002, as compared to 2001, to $67.7 million due to an increase in services
revenue from the increased sites. The number of installed customer sites grew to 1,177 sites at the end of 2002 from 885 sites at the end of 2001.

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Product
revenue, which included software as well as hardware revenue in 2003 only, increased 39% in 2003, as compared to 2002, to $46.2 million, due to increased sales to our
international markets and to the sales of hardware. International revenue increased as a result of our acquisition of Eyretel, which was based in the United Kingdom and had a broader international
presence than we previously had. Hardware revenue, which was derived exclusively from Eyretel, was $6.3 million in 2003 and none in
2002 and 2001. Because hardware sales negatively impact our gross profit, we intend to continue to transition our customers to third-party hardware suppliers and, as a result, expect hardware revenue
to decline over time. Product revenue decreased 16% in 2002, as compared to 2001, to $33.4 million, due to fewer contracts signed by customers during 2002, which we believe was attributable to a
reduction in the level of corporate IT spending, partially offset by our increase in the number of product offerings within our software product suite.

Product
revenue as a percentage of total revenue has been decreasing over the previous two years due to increased services revenue, as discussed below. Our product pricing has remained
consistent over the previous three years. Product revenue derived from our indirect sales channel increased to 31% in 2003 from 23% in 2002. Prior to 2002, less than 10% of our revenue was derived
from our indirect sales channel. This increase correlates to the increase in international revenue and to continually broadening our target market through the indirect channel. If a substantial number
of our indirect sales participants were to terminate their relationship with us, it could have a material adverse effect on our revenues.

During
2003, 2002 and 2001, 27%, 46% and 47%, respectively, of product revenue was attributable to new customers compared to follow-on revenue from our existing customer base. We receive
follow-on revenue from our customers when they purchase additional user licenses or license additional applications at existing sites and when they license our products at new sites. We expect the
proportion of new customer product revenue to increase in 2004 as we expect companies to increase their overall IT spending.

Services
revenue, consisting of installation, training, consulting, maintenance revenue and reimbursable travel expenses, increased 80% in 2003, as compared to 2002, to
$61.8 million. Our services revenue increased in 2003 primarily due to the services related to new product sales and to customer's renewing their maintenance contracts with us. In addition,
during 2003 we continued to experience growth in our business consulting offerings which help our customers better utilize the products they license. The deferred maintenance revenue balance acquired
in the Eyretel transaction was recorded at the fair value of the underlying maintenance contracts as required by generally accepted accounting principles as related to purchase accounting. We expect
that renewals of these contracts, which will not be affected by a fair value adjustment, should result in an increase in our maintenance revenue in 2004.

Services
revenue increased 52% in 2002, as compared to 2001, to $34.3 million due to growth in all areas of our services revenue. Installation, training and consulting revenue increased
in 2002 due to overall increased services revenue per customer site and the addition of new consulting services offerings. The growth in maintenance revenue in 2002 resulted from the growth in new
customer sites under maintenance contracts and the increasing recurring maintenance revenue stream. The percentage of Witness customers that have historically renewed their maintenance contracts with
us has exceeded 90%. We believe that maintenance contracts will be renewed at a similar rate during 2004.

Our
pricing for services has remained relatively constant over the past three years. Services revenue as a percentage of total revenue increased in 2003 and 2002 due to the compounding
effect of maintenance revenue from both new customer sites and renewals of maintenance contracts from existing customer sites and, to a lesser extent, from the increase in other services revenue. We
expect services revenue, in absolute dollars and as a percentage of total revenue, to continue to increase over

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time
due to the compounding effect of renewals of annual maintenance contracts from existing customer sites and increased business consulting services offered around our expanded product suite.

Cost of Revenue

Total cost of revenue increased 167% to $35.9 million in 2003, as compared to 2002, and 21% to $13.4 million in 2002, as compared to 2001. Expressed as a percent
of revenue, gross profit margins decreased to 67% in 2003 and 80% in 2002 from 82% in 2001. Excluding hardware cost of sales, which was a new cost in 2003 due to the acquisition of Eyretel, gross
profit margin was 70% in 2003. The decline in gross profit margin in 2003 was mainly attributable to the amortization of certain intangible assets resulting from the Eyretel acquisition. The decrease
in gross profit margin in 2002 was attributable to a greater percentage of revenue in 2002 generated from services, which have a lower profit margin than product revenue. Our profit margin for
services is lower than our product profit margin because the expenses related to producing services revenue are higher than those expenses related to generating product revenue. For example, the cost
to employ an installation technician is higher than the cost to produce a CD-ROM containing a copy of one of our software programs for delivery to a client site.

We
expect the decline in future hardware sales, the diminishing impact of the fair value adjustment to maintenance revenue, and the implementation of improved services methodologies will
improve our gross profit margin in the near term. However, we would also expect that these gross profit margin improvements would be offset as lower margin services revenue represents a greater
percentage of our total revenue in the future.

Cost
of product revenue primarily consists of amortization of acquired technology, hardware, royalties due to third parties for software components that are embedded in our software
applications and packaging costs. Cost of product revenue increased 923% to $11.6 million in 2003, as compared to 2002, due to the cost of hardware in the amount of $5.7 million and the
amortization of intangible assets in the amount of $4.1 million in 2003, none of which existed in 2002 or 2001. We will continue to incur this amortization expense but expect the cost of
hardware to decline as we reduce the amount of hardware sold. Cost of product revenue in 2002 increased 88%, as compared to 2001, to $1.1 million due to license fees associated with third-party
software components that are embedded in our software applications. As we develop upgrades of our existing products and add new offerings to our product
suite we often embed third-party technology into our software, which will increase the cost of product revenue in the future.

Cost
of services revenue for installation, training, consulting and maintenance services include personnel costs and related expenses and allocated overhead. Personnel costs include
salaries, bonuses and benefits. Cost of services revenue in 2003 increased 98%, as compared to 2002, to $24.3 million due to an increase in the number of employees engaged in installation, training,
consulting and customer maintenance services primarily due to the Eyretel acquisition. Cost of services revenue as a percentage of services revenue increased to 39% in 2003 from 36% in 2002. This
percentage increase was primarily due to the impact of the fair value adjustment to Eyretel's deferred services revenue on the purchase date. Cost of services revenue increased 18%, as compared to
2001, to $12.3 million in 2002 primarily due to an increase in the number of employees and contractors engaged in consulting and customer maintenance services. Cost of services revenue as a percentage
of services revenue decreased to 36% in 2002 from 46% in 2001. This improvement was due primarily to the increased services revenue per customer site as well as improved methodologies in the
consulting and maintenance services group, combined with an increase in consulting and maintenance revenue.

We
expect that the cost of services revenue, as a percentage of services revenue, will decrease as the impact of Eyretel's fair market adjustment decreases and as renewal maintenance
revenue is reflected in income at the actual invoice amount, rather than the lower amount recorded due to

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purchase
accounting requirements. In addition, we anticipate that our services margins will improve due to the services methodology being implemented throughout our entire international organization
during 2004. We expect our customer service organization to continue to grow over time and, therefore, we anticipate that our cost of services revenue, in absolute dollars, will increase as we grow
our customer base.

Operating Expenses

Selling, General and Administrative.Selling, general and administrative ("SG&A") expenses consist primarily of personnel
costs, sales commissions, marketing programs, provisions for bad debt expense, and the amortization of certain intangible assets. SG&A expense increased 48% in 2003 to $60.0 million due to the
increased size of our company after the Eyretel acquisition and due to $1.8 million of amortization of acquired intangible assets. Bad debt expense also increased by $2.2 million in 2003, as compared
to 2002, primarily due to an increase in exposure from international receivables. As the percentage of our international revenue increases, we expect our bad debt expense to also increase. SG&A
expense remained fairly constant in 2002, as compared to 2001, at $40.4 million, but decreased as a percentage of total revenue due to a reduction in certain discretionary marketing spending, certain
cost saving measures implemented during 2002 and a decrease in the provision for bad debt expense in 2002 resulting from collections in 2002 that were significantly reserved for during 2001. We expect
SG&A expense to remain relatively constant in the near future as some additional operating efficiencies will be offset by an increase in internal and third-party costs associated with compliance with
the rules and regulations of the Sarbanes-Oxley Act of 2002.

Research and Development.Research and development ("R&D") expenses consist primarily of personnel and consulting costs to
support product development, and allocated overhead. R&D costs are generally expensed as incurred. Costs incurred subsequent to establishing technological feasibility are capitalized and amortized
over their estimated useful lives. Historically, software development costs incurred after technological feasibility has been established have not been material and, therefore, have been charged to
expense. During 2003, we capitalized $0.6 million of third-party costs in connection with the adaptation of existing products and technologies for new applications. R&D expenses increased 20%,
as compared to 2002, to $18.0 million in 2003 and 11%, as compared to 2001, to $15.1 million in 2002 due primarily to an increased number of employees and consultants engaged in research and
development activities. We anticipate R&D expenses to remain constant in 2004 as compared to 2003.

Merger-related Costs.We incurred merger-related costs of $7.9 million during 2003. These merger-related costs
included $0.9 million for a sterling-based forward exchange contract to hedge the dollar cost of the acquisition, $3.8 million of expenses related to integrating Eyretel's software products,
training personnel on products acquired and consolidating the operations of Eyretel with the Company, $0.7 million of facilities costs to consolidate Witness' facilities, $1.5 million of
expenses related to employee severance and benefits, and $1.0 million relating to the partial accrual of a bonus payable to Eyretel's former Chief Executive Officer, now our Chief Operating
Officer ("COO"). Our Board of Directors agreed to pay a bonus of £1.0 million (or $1.8 million as of December 31, 2003) to our COO in connection with the Eyretel
acquisition and subsequent integration. This bonus is payable in two installments due March 2004 and March 2005 but may be payable in advance of these dates under certain circumstances, such as a
change of control. We expect merger-related activities to be substantially completed by the end of the first quarter of 2004. However, we will continue to accrue the COO bonus over the related service
period through the first quarter of 2005.

Acquired In-Process Research and Development and Related Charges.In 2003, we estimated that $7.8 million of the purchase
price of Eyretel represented acquired in-process research and development ("IPR&D") that had not yet reached technological feasibility as defined by SFAS No. 86,Accounting

9

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for the Cost of Computer Software to Be Sold, Leased or Otherwise Marketed,and had no alternative future use. Accordingly, these amounts were immediately charged to expense
upon consummation of the acquisition. The value of the IPR&D was calculated with the assistance of an independent third-party by utilizing a discounted cash flow methodology, focusing on the
income-producing capabilities of the in-process technologies and taking into consideration: stage of completion; complexity of work to date and to complete; anticipated product development and
introduction schedules; forecasted product sales cycles; internal and external risk factors; revenue and operating expense estimates; contributory asset charges, and costs already incurred and the
expected costs to complete.

During
2001, we recorded charges totaling $4.8 million for IPR&D acquired from various third parties. At the date of these transactions, the acquired IPR&D technologies had not
progressed to a stage where they met technological feasibility and had no alternative future uses. At the time of each transaction, we estimated the stage of completion of the project and the time and
resources required to complete the project by creating a product design plan and evaluating the progress of the acquired technology towards this plan. A significant amount of uncertainty existed as to
our ability to complete the development projects within a timeframe acceptable to the market, and failure to do so would have caused our competitive position in the market to erode. Additionally, the
amount of development required to enable the acquired technology to integrate with our primary product was estimated to be significant, which increased the uncertainty surrounding its successful
development. These projects were successfully completed by June 30, 2002.

Interest and Other Income, Net

Interest and other income, net consists primarily of interest earned on funds available for investment, net of foreign currency exchange gains and losses.
Interest and other income, net decreased 17%, as compared to 2002, to $1.3 million in 2003 due to lower yields and lower investment balances as a result of the acquisition of Eyretel which was paid
for in cash. Interest and other income, net decreased 45%, as compared to 2001, to $1.6 million in 2002 due to lower yields. We expect that interest and other income, net will increase slightly in
2004 in concert with interest rates.

Provision for Income Taxes

We recorded a provision for foreign income tax in 2003, a provision for federal alternative minimum tax and foreign income tax in 2002, and a provision for state
income tax, federal alternative minimum tax and foreign income tax in 2001. Deferred tax assets are normally recognized for deductible temporary differences and net operating loss and tax credit
carryforwards. We have recorded a full valuation allowance against deferred tax assets generated as a result of net operating loss carryforwards aggregating $18.2 million for U.S. tax purposes and
$37.9 million for foreign tax purposes at December 31, 2003, as the future realization of the tax benefits is not currently considered more likely than not.

10

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Quarterly Results of Operations

The following tables present unaudited quarterly statements of operations data for each of the last eight quarters in the period ended December 31, 2003, as well
as the percentage of total revenue represented by each item. The information has been derived from our unaudited consolidated financial statements, which have been prepared on substantially the same
basis as the audited consolidated financial statements contained in this report. The unaudited consolidated financial statements contain all adjustments, consisting only of normal recurring
adjustments that we consider to be necessary to present fairly this information when read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this
report. The results of operations for any quarter are not necessarily indicative of the results to be expected for any future period.

|                               |                                                                  | Three Months Ended                             
|------------------------------ | ---------------------------------------------------------------- | -----------------------------------------------
|
|
|Revenue:                       |                                                                  |                                                
|                               | Product                                                          |                                                
|                               | Services                                                         |                                                
|                               |                                                                  |                                                
|                               |                                                                  | Total revenue                                  
|                               |                                                                  |                                                
|Cost of revenue:               |                                                                  |                                                
|                               | Product                                                          |                                                
|                               | Services                                                         |                                                
|                               |                                                                  |                                                
|                               |                                                                  | Total cost of revenue                          
|                               |                                                                  |                                                
|                               |                                                                  | Gross profit                                   
|Operating expenses:            |                                                                  |                                                
|                               | Selling, general and administrative                              |                                                
|                               | Research and development                                         |                                                
|                               | Merger-related costs                                             |                                                
|                               | Acquired in-process research and development and related charges |                                                
|                               |                                                                  |                                                
|                               |                                                                  | Operating (loss) income                        
|Interest and other income, net |                                                                  |                                                
|                               |                                                                  |                                                
|                               |                                                                  | (Loss) income before provision for income taxes
|Provision for income taxes     |                                                                  |                                                
|                               |                                                                  |                                                
|                               |                                                                  | Net (loss) income                              
|                               |                                                                  |                                                

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|                                  |                                                                  | Three Months Ended                              |   
|--------------------------------- | ---------------------------------------------------------------- | ----------------------------------------------- | --
|
|
|As a Percentage of Total Revenue: |                                                                  |                                                 |   
|Revenue:                          |                                                                  |                                                 |   
|                                  | Product                                                          |                                                 | 42
|                                  | Services                                                         |                                                 | 58
|                                  |                                                                  |                                                 |   
|                                  |                                                                  | Total revenue                                   |   
|                                  |                                                                  |                                                 |   
|Cost of revenue:                  |                                                                  |                                                 |   
|                                  | Product                                                          |                                                 | 12
|                                  | Services                                                         |                                                 | 23
|                                  |                                                                  |                                                 |   
|                                  |                                                                  | Total cost of revenue                           |   
|                                  |                                                                  |                                                 |   
|                                  |                                                                  | Gross profit                                    |   
|Operating expenses:               |                                                                  |                                                 |   
|                                  | Selling, general and administrative                              |                                                 | 52
|                                  | Research and development                                         |                                                 | 14
|                                  | Merger-related costs                                             |                                                 | 5 
|                                  | Acquired in-process research and development and related charges |                                                 | 0 
|                                  |                                                                  |                                                 |   
|                                  |                                                                  | Operating (loss) income                         |   
|Interest and other income, net    |                                                                  | 0                                               |   
|                                  |                                                                  |                                                 |   
|                                  |                                                                  | (Loss) income before provision for income taxes |   
|Provision for income taxes        |                                                                  | 0                                               |   
|                                  |                                                                  |                                                 |   
|                                  |                                                                  | Net (loss) income                               |   
|                                  |                                                                  |                                                 |   

The increase in total revenue, beginning in the second quarter of 2003, reflects the consolidation of Eyretel, which was acquired in March 2003.
Our second and fourth quarters generally have higher product revenue than the first and third quarters due to our customers' budgeting and spending
patterns. Product revenue includes hardware sales of $2.0 million, $1.0 million and $3.3 million in the fourth, third and second quarters of 2003, respectively. During 2002 and much of 2003, we
believe product revenue was affected by a reduction in the level of corporate IT spending. Services revenue, in absolute dollars and as a percentage of total revenue, generally increased during 2002
and 2003 due to the compounding effect of maintenance renewals and the expansion of our service offerings. We expect that services revenue will continue to grow relative to license revenue throughout
2004. Gross profit margins decreased from quarter-to-quarter due to hardware costs and amortization of intangibles in 2003, as well as the increased percentage of total revenue derived from services
in 2003 and 2002.

Total
operating expenses in 2003, excluding merger-related costs and acquired IPR&D, decreased as a percentage of total revenue, as we were able to realize planned synergies from the
Eyretel acquisition in addition to implementing certain cost saving measures throughout the year.

Our
quarterly operating results, particularly product revenues, have experienced significant fluctuations in the past and we expect that this pattern will continue in the future. For
instance, quarterly results may fluctuate based on the timing of sales due to customer calendar-year budgeting cycles, slow summer purchasing patterns and compensation policies that tend to compensate
sales personnel, typically in the latter half of the year, for achieving annual quotas. As a result of the foregoing and other factors, we believe that quarter-to-quarter comparisons of results are
not necessarily meaningful, and such comparisons should not be relied upon as indications of future performance.

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Liquidity and Capital Resources

We used $4.1 million in cash from operating activities in 2003, which was largely due to costs associated with our acquisition of Eyretel. We paid
$6.4 million of the $7.9 million in merger-related costs during 2003. In 2004, we expect to pay approximately $5.7 million in additional accrued merger-related and restructuring
costs. Following the acquisition, our accounts receivable from international customers increased significantly. Our accounts receivable days sales outstanding ("DSO") increased from 70 days at
December 31, 2002 to 85 days at December 31, 2003. We expect our DSO to remain in the mid-80s range in the future as we derive a greater proportion of our revenue from international
operations, where payment is typically slower than in the United States. We generated $8.9 million in cash flows from operating activities in 2002 compared to cash used in operating activities
of $(0.5) million in 2001. This increase in cash flow from operations in 2002 was due primarily to the collection of accounts receivable and a reduction in operating expenses as a percentage of
total revenue.

Net
cash flows used in investing activities in 2003 was $(7.1) million which included the acquisition of Eyretel for $21.4 million (net of $38.8 million in cash held by Eyretel) and
certain other assets purchased for $2.4 million from a software and services company focused on the business intelligence
marketplace. In addition, in 2003 cash was provided by the sale of investments securities of $26.5 million to initially fund the Eyretel acquisition, while $12.9 million has since been reinvested. Net
cash flows provided by investing activities was $5.5 million in 2002 compared to cash used in investing activities of ($7.4) million in 2001. This increase was primarily due to the release of our
restricted cash in 2002 and the purchase of IPR&D in 2001. Capital expenditures of $2.2 million, $3.2 million and $3.3 million in 2003, 2002 and 2001, respectively, were primarily for computer
equipment and leasehold improvements.

Net
cash flows provided by (used in) financing activities was $1.3 million, $(1.1) million and $1.6 million in 2003, 2002 and 2001, respectively. Generally, since 2001, funds have been
provided by the exercise of stock options and the purchase of shares under the employee stock purchase plan. In 2002 and continuing into the first quarter of 2003, we repurchased $3.1 million of our
common stock. Up to $10 million of stock repurchases have been authorized, but we do not currently anticipate making any further repurchases at this time.

At
December 31, 2003, we had $40.9 million in total cash and cash equivalents and short-term investments and $29.3 million in working capital. In addition, we had $11.7 million available
under a line of credit, which was net of outstanding letters of credit of $3.3 million. The letters of credit secure the lease on the corporate headquarters facility and have decreasing schedules that
ultimately expire in 2007. At our election, borrowings under the line of credit bear interest at the bank's prime rate, or LIBOR plus 300 basis points and are limited to 85% of eligible accounts
receivable, as defined by the agreement. The revolving line of credit is secured by all of our assets and requires compliance with various covenants, including liquidity ratios and tangible net worth
requirements, among others. In May 2003, we amended the amount of our tangible net worth requirement due to the effect of the Eyretel acquisition.

We
currently expect to have total capital expenditures of approximately $1.8 million in 2004. We anticipate that our capital expenditures will increase over the next several years as we
expand our facilities and acquire equipment to support the expansion of our research and development activities and internal management information systems.

We
anticipate that operating expenses and capital expenditures will continue to be a material use of our cash resources. We believe that our existing cash and cash equivalents are
sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. Excess cash and investments, plus the availability under our line of credit,
may be used to fund future merger or acquisition transactions. If cash generated from operations is insufficient to satisfy our

13

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liquidity
requirements, we may seek to sell additional equity or debt securities or establish new financing arrangements. The sale of additional equity or convertible debt securities could result in
additional dilution to our stockholders. We cannot assure that any financing arrangements will be available in sufficient amounts or on acceptable terms.

Market
risk represents the risk of loss that may affect us due to adverse changes in financial market prices and rates. Our market risk exposure is primarily fluctuations in foreign
exchange rates and interest rates. Except for the hedge transaction entered into in connection with the Eyretel acquisition, we have not entered into derivative or hedging transactions to manage risk
in connection with such fluctuations. During 2003, due to the relative strength of foreign currencies compared to the U.S. dollar, foreign currency translations contributed $4.1 million to our
December 31, 2003 cash balance as a result of our subsidiaries' cash denominated in foreign currencies. As of December 31, 2002 and 2001, foreign currencies impacted cash by $(0.1) million in each
year.

The
majority of our operations have historically been in the United States and, accordingly, the majority of our transactions are denominated in U.S. dollars. However, with the
acquisition of Eyretel and along with our existing foreign-based operations, where transactions may be denominated in foreign currencies, we are subject to market risk with respect to fluctuations in
the relative value of currencies. Currently, we have offices in Australia, Brazil, Canada, China, Germany, Hong Kong, Japan, Malaysia, Mexico, Singapore and the United Kingdom and conduct transactions
in either the local currency of the location or U.S. dollars. We are exposed to adverse movements in foreign currency exchange rates because we translate foreign currencies into U.S. dollars for
reporting purposes. Historically, these risks have been minimal, but as our international operations continue to grow, adverse currency fluctuations could have a material adverse impact on our
financial results. Net foreign exchange gains and (losses) were $0.4 million, $0, and $(0.1) million in 2003, 2002 and 2001, respectively.

Exposure
to market rate risk for changes in interest rates relates to our investment portfolio. Our investments are made with capital preservation and liquidity as our primary
objectives. We generally hold only high-grade investments such as commercial paper, corporate bonds and U.S. government agency securities to maturity. To reduce our balance sheet exposure to
variations in asset values, our investment policy guidelines specify that we invest in the highest investment grade securities and maintain a weighted average maturity of nine months for our entire
portfolio. Our investment portfolio may contain securities with maturities of up to three years. While this minimizes our interest rate risk to asset values, our results are exposed to fluctuations in
interest income due to changes in market rates. In order to acquire the shares of Eyretel, we converted our investment portfolio to cash in February 2003, realizing a gain of $0.2 million.

Contractual Obligations and Off Balance Sheet Arrangements

As of December 31, 2003, our contractual cash obligations associated with lease obligations, operational restructuring and merger-related costs are as follows (in
thousands):

Payments Due by PeriodTotal

Less than
1 Year

2-3
Years

4-5
Years

After 5
YearsOperating lease obligations

$
30,321

$
6,248

$
10,344

$
5,432

$
8,297Acquisition-related commitments


5,085


4,014


1,071





Total

$
35,406

$
10,262

$
11,415

$
5,432

$
8,297


As
of December 31, 2003, we did not have any other contractual commitments or off-balance sheet arrangements.

14

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Transactions with Related Parties

Tom Crotty, a member of our Board of Directors, is a managing member of Battery Partners IV LLC, the general partner of Battery Ventures IV, and a managing member
of Battery Partners VI LLC, the general partner of Battery Ventures VI. Battery Ventures IV held more than 5% of our stock at
December 31, 2003 and holds less than 1% of our stock at the date of this report. Our Chief Executive Officer ("CEO") is a limited partner in Battery Ventures VI, L.P.

During
2002, notes receivable due from certain officers totaling $0.5 million were satisfied by delivering, at current fair market value, shares of our common stock, which such
employees had held for longer than six months. In February 2002, the notes receivable from our CEO totaling $1.8 million were refinanced in part with a full recourse note (the "2002 Note") for
approximately $1.5 million with floating monthly interest of 325 basis points over the Federal Funds Rate. The 2002 Note was payable in three equal payments of principal and interest due annually
through February 2005. The balance was satisfied in full during 2003 by the CEO delivering either cash or, at current fair market value, shares of our common stock, which he had held for more than six
months.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation ("FIN") No. 46,Consolidation
of Variable Interest Entities. FIN 46 requires companies to evaluate variable interest entities for specific characteristics to determine whether additional consolidation and
disclosure requirements apply. FIN 46 is immediately applicable for variable interest entities created after January 31, 2003, and applies to the first fiscal year or interim period beginning
after June 15, 2003 for variable interest entities acquired prior to February 1, 2003. The adoption of FIN 46 did not have any impact on our financial statements. In
December 2003, the FASB revised FIN 46 to exempt certain entities from its requirements and to clarify certain issues arising during the implementation of FIN 46. The adoption of this revised
interpretation in the first quarter of 2004 is not expected to have any impact on our consolidated financial statements.

In
May 2003, the FASB issued SFAS No. 150,Accounting for Certain Financial Instruments with Characteristics of both Liabilities and
Equity. SFAS No. 150 establishes standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity.
SFAS No. 150 also includes required disclosures for financial instruments within its scope. SFAS No. 150 was effective for instruments entered into or modified after May 31, 2003
and otherwise was effective as of the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have any impact on our financial
statements.

Effective
January 1, 2003, we adopted SFAS No. 143,Accounting for Asset Retirement Obligations, which addresses financial accounting and
reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The adoption of SFAS No. 143 did not have a material impact on our
financial statements.

Effective
January 1, 2003, we adopted FIN 45,Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others, which clarifies disclosure and
recognition/measurement requirements related to certain guarantees. The adoption of FIN 45 did not have a material impact on our financial statements.

Effective
January 1, 2003, we adopted SFAS No. 145,Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections. SFAS No. 145 amends existing guidance on reporting gains and losses on the extinguishment of debt to prohibit the classification of the gain or loss as
extraordinary, as the use of such extinguishments have become part of the risk management strategy of many companies. SFAS No. 145 also amends SFAS No. 13,Accounting for
Leases, to require sale-leaseback accounting for certain lease modifications that have economic effects

15

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similar
to sale-leaseback transactions. The adoption of SFAS No. 145 did not have a material impact on our financial statements.

Effective
January 1, 2003, we adopted SFAS No. 146,Accounting for Costs Associated with Exit or Disposal Activities.SFAS No. 146
addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3,Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity. In connection with the Eyretel acquisition in March 2003, we executed a restructuring plan, which is being accounted
for pursuant to SFAS No. 146 (see Note 5).

Effective
July 1, 2003, we prospectively adopted SFAS No. 149,Amendment of Statement 133 on Derivative Instruments and Hedging
Activities. SFAS No. 149 amends SFAS No. 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires
contracts with similar characteristics to be accounted for on a comparable basis. The adoption of SFAS No. 149 did not have a material impact on our financial statements.

Effective
July 1, 2003, we prospectively adopted EITF No. 00-21,Accounting for Revenue Arrangements with Multiple Deliverables, and EITF
No. 03-05,Applicability of AICPA SOP 97-2 to Non Software Deliverables in an Arrangement Containing More Than Incidental Software. The consensus
opinion in EITF No. 03-05 clarifies the guidance in EITF No. 00-21. The transition provisions allow either prospective application or a cumulative effect adjustment upon adoption. The adoption of EITF
Nos. 00-21 and 03-05 did not have a material impact on our financial statements.

Effective
January 1, 2003, we adopted Emerging Issues Task Force ("EITF") No. 03-1,The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments.EITF No. 03-1 provides guidance on other-than-temporary impairment and its application to debt and equity securities. The requirement applies to investments in
debt and marketable securities that are accounted for under SFAS No. 115. The adoption of EITF No. 03-1 did not have a material effect on our financial statements.

Factors That May Affect Our Future Results and Market Price of Our Stock

Our future operating results may vary substantially from period to period. The price of our common stock will fluctuate in the future, and an investment in our
common stock is subject to a variety of risks, including, but not limited to, the specific risks identified below. Inevitably, some investors in our securities will experience gains while others will
experience losses depending on the prices at which they purchase and sell our securities. Prospective and existing investors should consider the following factors in evaluating our business or an
investment in our securities. If any of the following or other risks actually occurs, our business, financial condition and results of operations could be adversely affected. In that case, the trading
price of our common stock could decline.

Because our products have a long sales cycle, it is difficult to plan our expenses and forecast our results; and our operating results may fail to meet investor expectations,
which may adversely affect our stock price.

It typically takes three to nine months from the time we qualify a sales lead until we sign a sales contract with the customer. As a result, it is difficult for
us to predict the quarter in which a particular sale will occur. If our sales cycle unexpectedly lengthens for one or more large orders or a significant number of small orders, it would delay the
timing of our revenue, but not the timing of our corresponding expenses. Lengthening our sales cycle could also increase the total cost of a sale due to additional employee time and costs allocable to
the sale. Material or long-term changes in our sales cycle could cause our quarterly revenue or operating results to be below the expectations of investors, and the price of our common
stock could fall substantially.

16

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Our customers' decision process regarding their purchase of our products and services is relatively long due to several factors, including:



If our products and services are not used and accepted by existing and prospective customers, our business and results of operations will be adversely affected.

The market for customer relationship management software, including software that records and analyzes customer interactions, is still developing. Our success
depends on the use and acceptance of our software and services by existing and prospective customers. In addition, demand for our software remains uncertain because our existing and potential
customers may:



If we continue to experience losses from operations in the future, the market price of our common stock may be materially and adversely affected.

With the exception of the first and second quarters of 2002, we have historically experienced quarterly losses from operations. We may continue to suffer losses
in the future. As a result of our operating losses, we had an accumulated deficit of $48.5 million as of December 31, 2003. In addition, we expect to continue to devote substantial
resources to research and development, professional services, and sales and marketing activities. As a result, we will need to generate significant revenue to achieve sustained profitability.

If
we do not achieve profitability from operations, we may need to obtain additional financing. We cannot assure you that additional financing would be available to us at an acceptable
cost, if at all.

Our operating results are difficult to predict and adverse fluctuations in operating results could cause our stock price to fall.

Our quarterly revenue and operating results are difficult to predict and could fluctuate significantly from period to period. In particular, we typically derive a
significant portion of our software product revenue in each quarter from a small number of relatively large orders. The delay or failure to close anticipated sales in a particular quarter could reduce
our revenue in that quarter and subsequent

17

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quarters
over which revenue for the sale could be recognized. In addition, because our revenue from installation, maintenance and training services largely correlates with our product revenue, a
decline in product revenue could also cause a decline in our services revenue in the same quarter or in subsequent quarters. Our quarterly revenue is difficult to forecast for several reasons,
including the following:



As
a result of these and other factors, we believe that quarter-to-quarter comparisons of our operating results may not be a good indicator of our future
performance, and you should not rely on them to predict our future performance or the performance of our stock price. If our revenue or operating results fall below the expectations of investors or
securities analysts, the price of our common stock would likely decline.

We may be unable to manage and expand our international operations, which may adversely affect our business and operating results.

We derived $48.2 million, $17.1 million and $9.9 million in 2003, 2002 and 2001, respectively, from customers outside the United States,
principally in the United Kingdom, Continental Europe, Hong Kong/Greater China, Canada, Singapore, Japan, Australia, Brazil, India and Mexico. During 2003, we completed the purchase of Eyretel plc.
Through this acquisition, we significantly expanded our operations outside of North America. Our operations outside of the United States at December 31, 2003 consisted of 189 dedicated
employees located in Australia, Brazil, Canada, China, Germany, Hong Kong, Japan, Malaysia, Mexico, Singapore and the United Kingdom. We have also established relationships with a number of
international resellers.

We
intend to continue to expand our international operations through additional acquisitions, internal business expansion and strategic business relationships. These efforts require
significant management attention and financial resources. We may not be able to successfully penetrate international markets or, if we do, we may not be able to grow or to maintain adequate profit
margins in these markets. Because of the complex nature of our international expansion, it may adversely affect our business and operating results. International expansion and sales are subject to
many risks, including the following:



18

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As
we further expand our operations outside the United States, we will also face new competitors and competitive environments. In addition to the risks associated with our domestic
competitors, foreign competitors may pose an even greater risk, because they may possess a better understanding of their local markets and have better working relationships with local infrastructure
providers and others. In particular, because telephone protocols and standards are unique to each country, local competitors will have more experience with these protocols, and may have a competitive
advantage in, these markets. We may not be able to obtain similar levels of knowledge, which could place us at a significant competitive disadvantage. In addition, we have limited experience in
developing local language versions of our products or in marketing our products to international customers. We may not be able to successfully translate, market, sell, and deliver our products
internationally.

If we are unable to maintain a productive direct sales force, our business and operating results could be materially adversely affected.

We believe that our future success will depend on maintaining a productive direct sales force. Historically, it has taken us up to six months to train new sales
personnel before they reach an acceptable level of productivity. We have also experienced difficulty in recruiting sales personnel with experience in computer and telephone integration technologies.
We cannot assure you that we will be able to continue to manage turnover and hire new sales personnel to meet our needs. If the personnel we hire are less qualified than we expect, it may take us more
time to train them before they reach an acceptable level of productivity, which could increase our costs and impact our revenue.

If we are unable to expand the distribution of our products through indirect sales channels, our business and operating results could be materially adversely affected.

Our strategy is to continue to increase the proportion of customers served through indirect sales channels, such as select resellers and a variety of strategic
marketing alliances. Product revenue from our indirect sales channel represented approximately 31% and 23% of total product revenue in 2003 and 2002, respectively. We expect revenue from our indirect
sales channel and, accordingly, our dependence on distribution partners, to continue to increase as we establish relationships with companies to resell our software worldwide. We cannot assure you
that we will be able to maintain productive relationships with our current partners, or that we will be able to establish similar relationships with additional resellers on a timely basis, if at all.

Our
reseller agreements are not exclusive and may generally be terminated by either party. Some resellers with which we do business have similar, and often more established,
relationships with our competitors, and may recommend the products and services of our competitors to customers instead of our software and services. We cannot provide assurance that these
distribution partners will devote adequate resources to selling our software and services or that our resellers may not learn about our

19

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products
and the market for our software and services and develop and sell competing products and services. As a result, our relationships with resellers could lead to increased competition for us.

Intense competition in our business could adversely affect our revenue, profitability and market share.

The market for products that record customer interactions, analyze performance and/or provide electronic learning is intensely competitive, evolving and is
subject to rapid changes in technology. We believe our principal competitors include, but are not limited to:



Many
of our current and potential competitors have longer operating histories, more established business relationships, larger customer bases, a broader range of products and services,
greater name recognition and substantially greater financial, technical, marketing, personnel, management, service, support and other resources than we do. As a result, our current and potential
competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, take better advantage of acquisitions and other opportunities, devote greater
resources to marketing and selling their products and services and adopt more aggressive pricing policies. We cannot assure you that our current or potential competitors will not develop products
comparable or superior in terms of price and performance features to those developed by us.

In
addition, many of our competitors market their products through resellers and companies that integrate their technology and products with those of the competitor. These resellers and
technology partners often have strong business relationships with our customers and potential customers. For example, some of our competitors have better and more long standing relationships than we
do with telephone switch vendors. Our competitors may use these business relationships to market and sell their products and compete for potential customers. It is also possible that resellers or
technology partners may acquire or be acquired by one or more of our competitors, which would further solidify their business relationships.

We
expect that competition will increase as other established and emerging companies enter our market and as new products, services and technologies are introduced. Increased competition
may result in price reductions, lower gross margins and loss of our market share, any of which could materially and adversely affect our business, financial condition and results of operations.

Our heavy reliance on sales of our eQuality Balance, eQuality Evaluation and eQuality ContactStore products exposes us to risks of obsolescence due to changes in competitive
product offerings.

We continue to derive a substantial portion of our product revenues from sales of our eQuality Balance and eQuality Evaluation software, and most of Eyretel's
product revenue was derived from sales of eQuality ContactStore. We expect revenue from these products to continue to account for most of our revenue for the foreseeable future. As a result, any
factors affecting the markets for these products, could materially and adversely affect our business, financial condition and results of operations. We cannot assure you that the market will continue
to demand our current products or that

20

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we
will be successful in marketing any new or enhanced products. If our competitors release new products that are superior to our products in performance or price, demand for our products may decline.
A decline in demand for our products as a result of competition, technological change or other factors would reduce our total revenues and harm our ability to maintain profitability. See also
"BusinessOur Products" above.

If we fail to develop new software or improve our existing software, we may not be able to remain competitive.

The markets for our products are characterized by rapidly changing technology, frequent new product introductions and enhancements, changes in customer demands
and evolving industry standards. Our existing products could be rendered obsolete if we fail to continue to advance our technology. We have also found that the technological life cycles of our
products are difficult to estimate, partially because of changing demands of our customers. We believe that our future success will depend on our ability to continue to enhance our current product
line while we concurrently develop and introduce new products that keep pace with competitive and technological developments. These developments require us to continue to make substantial product
development investments. Although we are presently developing a number of product enhancements to our product suites, we cannot assure you that these enhancements will be completed on a timely basis
or gain customer acceptance. See also "BusinessOur Products" above.

If our software development activities in the Asia-Pacific region are not successful, we may not be able to meet our development schedules.

In April 2004, we announced that we will significantly expand our software development capabilities in the Asia-Pacific region in order to
optimize available research and development
resources and better meet development timeframes. We have limited experience with remote software development activities. Accordingly, there are a number of risks associated with this activity,
including:



Our
inability to meet development schedules because of our reliance on developers in the Asia-Pacific region may affect our ability to enhance our current product line or
introduce new products, which would have a material adverse affect on our financial results and could harm our reputation. The loss of key development personnel could have a material adverse effect on
our product development process and adversely affect our future product revenues.

Our liability to customers may be substantial if our products fail to perform properly.

Our software is used in a complex operating environment that requires its integration with computer and telephone networks and other business software
applications. If our products fail to function as required, we may be subject to claims for substantial damages. Courts may not enforce provisions in our contracts that would limit our liability or
otherwise protect us from liability for damages. Although we maintain general liability insurance coverage, including coverage for errors or omissions, this coverage may not continue to be available
on reasonable terms or in sufficient amounts to cover claims against us. In addition, our insurer may disclaim coverage as to any future claim. If

21

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claims
exceeding the available insurance coverage are successfully asserted against us, or our insurer imposes premium increases, large deductibles or co-insurance requirements on us, our
business and results of operations could be adversely affected.

Our software may contain undetected errors or "bugs," resulting in harm to our reputation and operating results.

Software products as complex as those offered by us might contain undetected errors or failures when first introduced or when new versions are released. We cannot
assure you, despite testing by us and by current and prospective customers, that errors will not be found in new products or product enhancements after commercial release. Any errors found may cause
substantial harm to our reputation and result in additional unplanned expenses to remedy any defects as well as a loss in revenue.

If our advanced compliance recording applications fail to record 100% of our customers' interactions, we may be subject to liability and our reputation may be harmed.

Through our acquisition of Eyretel, we have extended our product line to include advanced compliance recording applications and related services. Many of our
Eyretel customers use these applications to record and store interactions with customers to provide back-up and verification of transactions and to guard against risks posed by lost or
misinterpreted voice communications. These customers rely on our applications to record, store and retrieve voice data in a timely, reliable and efficient manner. If our applications fail to record
100% of our customers' interactions or our customers are unable to retrieve the recordings when necessary, we may be subject to liability and our reputation may be harmed.

If we are unable to maintain the security of our systems, our business, financial condition and operating results could be harmed.

The occurrence or perception of security breaches in the operation of our business or by third parties using our products could harm our business, financial
condition and operating results. Our customers use our products to compile and analyze highly sensitive or confidential information. We may come into contact with such information or data when we
perform support or maintenance functions for our customers. While we have internal policies and procedures for employees performing these functions, the perception that we have improperly handled
sensitive, confidential information could have a negative effect on our business. If, in handling this information, we fail to comply with privacy or security laws, we could incur civil liability to
government agencies, customers and individuals whose privacy is compromised. If personal information is received or used from sources outside the U.S., we could be subject to civil, administrative or
criminal liability under the laws of other countries. In addition, while we implement sophisticated security measures, third parties may attempt to breach our security or inappropriately use our
products through computer viruses, electronic break-ins and other disruptions. If successful, confidential information may be improperly obtained and we may be subject to lawsuits and
other liability. Any internal or external security breaches could harm our reputation, and even the perception of security risks, whether or not valid, could inhibit market acceptance of our products.

Fluctuations in foreign currency exchange rates could affect our financial results.

We may experience gains and losses resulting from fluctuations in currency exchange rates for which hedging activities may not adequately protect us. Moreover, in
locations where we price our products in U.S. dollars, our sales could be affected adversely by declines in foreign currencies relative to the dollar, thereby making our products more expensive in
local currencies. In locations, where we sell our products in local currencies, we could be competitively unable to increase our prices to reflect

22

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fluctuations
in exchange rates. We cannot predict the impact that future exchange rate fluctuations may have on our results.

Certain provisions in agreements that we have entered into may expose us to liability for breach that is not limited in amount by the terms of the contract.

Certain contract provisions, principally confidentiality and indemnification obligations in certain of our license agreements, could expose us to risks of loss
that, in some cases, are not limited by contract to a specified maximum amount. If we fail to perform to the standards required by these contracts, we
could be subject to additional liability and our business, financial condition and results of operations could be materially and adversely affected. There have been no material losses to date as a
result of any such contractual provisions.

If we fail to protect our intellectual property, third parties may use our technology for their own benefit.

Our success and ability to compete depends to a significant degree upon our proprietary technology. We rely on a combination of patent, trade secret, copyright
and trademark laws and confidentiality agreements with employees and third parties to establish and protect our proprietary rights. These measures may not be sufficient to protect our proprietary
rights, and we cannot be certain that third parties will not misappropriate our technology and use it for their own benefit. Also, most of these protections do not preclude our competitors from
independently developing products with functionality or features substantially equivalent or superior to our software. Any infringement of our proprietary rights could negatively impact our future
operating results.

As
of December 31, 2003, we had six registered trademarks, three patents and 16 patent applications pending in the U.S. and six patent applications pending internationally. There
is no guarantee that our pending applications will result in issued patents or, if issued, that they will provide us with any competitive advantage. We cannot assure you that we will file further
patent or trademark applications, that any future applications will be approved, that any existing or future patents, trademarks or copyrights will adequately protect our intellectual property or that
any existing or future patents, trademarks or copyrights will not be challenged by third parties.

We
are aware of certain uses, U.S. trademark registrations, and U.S. trademark applications for our "eQuality" trademark and its variations that predate our use, and the
April 2002 issuance of the U.S. registration for our trademark eQuality®. It is possible that an owner of legal rights resulting from prior use, registrations, or applications will
bring legal action to challenge our registration of and/or our use of the trademark eQuality®, and may also seek compensation for damages resulting from our use this trademark. As a
result, we cannot assure you that our registration of this trademark will be undisturbed, or that this use will not result in liability for trademark infringement, trademark dilution, and/or unfair
competition.

Moreover,
the laws of certain foreign countries do not protect our intellectual property rights to the same extent, as do the laws of the United States. Furthermore, policing the
unauthorized use of our products is difficult, and litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and
scope of the proprietary rights of others. Litigation could result in substantial costs and diversion of resources and could negatively impact our future operating results.

Claims by other companies that our software infringes their intellectual property could require us to incur substantial expenses or prevent us from selling our software or
services.

It is possible that third parties will claim that we have infringed their current or future products. We expect that we and other participants in our industry
will be increasingly subject to infringement claims as the number of competitors and products grows. Any claims, with or without merit, could be

23

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time-consuming,
result in costly litigation, require us to reengineer or redevelop our software, cause product shipment delays or require us to enter into royalty or licensing agreements,
any of which could negatively impact our operating results. Any efforts to reengineer our software or obtain licenses from third parties may not be successful, could be extremely costly and would
likely divert valuable management and product development resources. For example, depending on the outcome of our lawsuit against Knowlagent (as described under the heading "Legal Proceedings"), we
may be required to enter into royalty and licensing agreements on unfavorable terms, to stop selling or redesign our eQuality® NOW application, or to pay damages or satisfy indemnification
commitments with our customers.

In
addition, we cannot assure you that legal action claiming patent infringement will not be commenced against us, or that we would prevail in litigation given the complex technical
issues and inherent uncertainties in patent litigation. In addition, users of our software may become subject to claims if our software is alleged to infringe the intellectual property of others.
These software users could attempt to hold us responsible for these claims and any resulting harm they suffer. If a patent claim against us was successful and we could not obtain a license on
acceptable terms or license a substitute technology or redesign to avoid infringement, we may be prevented from distributing our software or required to incur significant expense and delay in
developing non-infringing software. Such a result would have a material adverse effect on our business, financial condition and results of operations.

If we are unable to maintain the compatibility of our software with certain other products and technologies, our future business would be adversely affected.

Our software must integrate with software and hardware solutions provided by a number of our existing and potential competitors. For example, our products must
integrate with phone switches made by the telephone switch vendors and computer telephony software applications offered by other software providers. These competitors or their business partners could
alter their products so that our software no longer integrates well with them, or they could delay or deny our access to software releases that allow us to timely adapt our software to integrate with
their products. If we cannot adapt our software to changes in necessary technology, it may significantly impair our ability to compete effectively, particularly if our software must integrate with the
software and hardware solutions of our competitors.

If our professional services employees do not provide installation services effectively and efficiently, our customers may not use our installation services or may stop using
our software.

Our customers ordinarily purchase installation, training and maintenance services together with our products. We generate a material part of our revenues from
these services. Due to the complexity of most of our software implementations, including integration work with a number of computer and telephone network systems, our implementation cycle can be
lengthy. We believe that the speed and quality of installation services are competitive factors in our industry. If our installation services are not satisfactory to our customers, the customers may
choose not to use our installation services or they may not license our software in the future. As a result, we would lose licensing and services revenue, and it could harm our reputation.

We may make acquisitions or investments that are not successful and that adversely affect our ongoing operations.

We may acquire or make investments in companies, products, services and technologies that we believe complement our business and assist us in quickly bringing new
products to market. We have limited experience in making acquisitions and investments. As a result, our ability to identify and evaluate prospects, complete acquisitions and properly manage the
integration of businesses is relatively

24

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unproven.
If we fail to properly evaluate and execute acquisitions or investments, it may have a material adverse effect on our business and operating results. In making or attempting to make
acquisitions or investments, we face a number of risks, including:



If we need additional financing to maintain or expand our business, it may not be available on favorable terms, if at all.

Although we believe our current cash and borrowing capacity will be sufficient to meet our anticipated cash needs for at least the next 12 months and the
foreseeable future, we may need additional funds to
expand or meet all of our operating needs. If we need additional financing, we cannot be certain that it will be available to us on favorable terms, or at all. If we raise additional funds by issuing
equity securities or convertible debt, the ownership interest of our stockholders could be significantly diluted, and any additional equity securities we issue may have rights, preferences or
privileges senior to the rights of our stockholders. Also, the terms of any additional financing we obtain may significantly limit our future financing and operating activities. If we need funds and
cannot obtain them on acceptable terms, we may be unable to:



Any
of these events could significantly harm our business and financial condition and limit our growth.

The loss of third-party hardware suppliers could harm our business.

A number of customers expect us to source hardware to support the implementation of our software. We do not intend to continue selling hardware and have
transferred the fulfillment of all hardware orders to third-party distributors. Thus, we are largely dependent on third parties for the

25

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supply
of hardware components to our customers. If these hardware distributors experience financial, operational or quality assurance difficulties, or if there is any other disruption in our
relationship, we may be required to locate alternative hardware sources. We are subject to the following risks due to our hardware distribution system:



Even
if we and/or our distributors are successful in locating alternative sources of supply, alternative suppliers could increase prices significantly. In addition, alternative
components may malfunction or interact with existing components in unexpected ways. The use of new suppliers and the modification of our products to function with new systems would require testing and
may require further modifications, which may result in additional expense, diversion of management attention and other resources, inability to fulfill customer orders or delay in fulfillment,
reduction in quality and reliability, customer dissatisfaction, and other adverse effects on our reputation, business and operating results.

Our stock price has been volatile.

The market price of our common stock has been subject to significant fluctuations in response to variations in quarterly operating results and other factors. In
addition, the stock market has experienced significant volatility that has particularly affected the market prices of equity securities of many technology companies and that often has been unrelated
or disproportionate to the operating performance of these companies. Any announcement with respect to any adverse variance in revenue or earnings from levels generally expected by securities analysts
or investors could have a significant adverse effect on the trading price of our common stock. In addition, factors such as announcements of technological innovations or new products by us, our
competitors or third parties, changing conditions in the customer relationship management software market, changes in the market valuations of similar companies, loss of a major customer, additions or
departures of key personnel, changes in estimates by securities analysts, announcements of extraordinary events, such as acquisitions or litigation, or general economic conditions may have an adverse
effect on the market price of our common stock.

Our performance may be negatively affected by macro-economic or other external influences.

Beginning in 2000, a declining United States economy began to adversely affect the performance of many businesses, especially within the technology sector. We are
a technology company selling technology-based solutions with total pricing, including software and services that in some cases exceeds $1.0 million. Reductions in the capital budgets of our
customers and prospective customers had an adverse impact on our ability to sell our solutions. Until late in 2003, we continued to experience effects from a weak spending environment for information
technology in both the United States and Europe, in the form of delayed and cancelled buying decisions by customers for our software, services and hardware, deferrals by customers of service
engagements previously scheduled and pressure by our customers and competitors to discount our offerings. If the current improvements now being seen in the general business climate do not continue,
this would likely have a material adverse effect on our business.

26

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Government regulation of telephone and Internet monitoring could cause a decline in the use of our software, result in increased expenses for us or subject our customers and us
to liability.

As the telecommunications industry continues to evolve, state, federal and foreign governments (including supranational governmental organizations such as the
European Union) may increasingly regulate the monitoring of telecommunications and telephone and Internet monitoring and recording products, such as our software. We believe that increases in
regulation could come in the form of a number of different kinds of regulations, including regulations regarding privacy, protection of personal information and employment. For example, the State of
California recently enacted the Database Security Breach Act, which requires any business that suffers a computer security breach to immediately notify customers in California if personal information
has been compromised. The adoption of any new regulations or changes to existing regulations could cause a decline in the use of our software and could result in increased expense for us, particularly
if we are required to modify our software to accommodate these regulations. Moreover, these regulations could subject our customers or us to liability. Whether or not these regulations are adopted, if
we do not adequately address the privacy concerns of consumers, companies may be hesitant to use our software. If any of these events occur, it could materially and adversely affect our business.

If we are unable to attract and retain key personnel, our ability to effectively manage and grow our business would suffer.

Our success greatly depends on our ability to hire, train, retain and motivate qualified personnel, particularly in sales, marketing, research and development,
service and support. We face significant competition for individuals with the skills required to perform the services we offer. If we are unable to attract and retain qualified personnel or if we
experience high personnel turnover, it could prevent us from effectively managing and expanding our business.

Our
success also depends upon the continued service of our executive officers, particularly our Chairman and Chief Executive Officer, David Gould, and our President and Chief Operating
Officer, Nick Discombe. We have employment agreements with Mr. Gould and Mr. Discombe and limited non-compete agreements with most of our other executive officers. However,
any of our executive officers and other employees could terminate his or her relationship with us at any time. The loss of the services of our executive officers or other key personnel, particularly
if lost to competitors, could materially and adversely affect our business.

Our certificate of incorporation and bylaws, as well as Delaware law, may inhibit a takeover of our company, which could limit the price investors might be willing to pay for
our securities.

Our amended and restated certificate of incorporation and bylaws, as well as Delaware law, contain provisions that might enable our management to resist a
takeover of our company. For example, our stockholders cannot take action by written consent or call a special meeting to remove our board of directors. In addition, our directors serve for staggered
terms, which makes it difficult to remove all our directors at once. Further, in October 2002, our board of directors approved, and we have implemented, a stockholder rights plan which has the
effect of causing substantial dilution to a person or group that attempts to acquire us on terms not approved by the board of directors.

These
anti-takeover provisions might discourage, delay or prevent a change in the control of our company or a change in our management. These provisions could also discourage
proxy contests and make it more difficult for you and other shareholders to elect directors and take other corporate actions. The existence of these provisions could also limit the price that
investors might be willing to pay in the future for our securities.

27

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Item 8. Financial Statements and Supplementary Data

Our consolidated financial statements, together with the related notes and report of KPMG LLP, an Independent Registered Public Accounting Firm, are set forth
beginning on page F-1 hereof.

28

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SIGNATURES

Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

Dated: July 30, 2004

| |  | WITNESS SYSTEMS, INC.
| |  | ---------------------
| |  | BY:                  

| |  |     |                                                                                                                                                        
| |  | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------
| |  |     |                                                                                                                                                        
| |  | BY: | /s/WILLIAM F. EVANSWilliam F. Evans Executive
Vice President and
Chief Financial Officer
(Principal Financial Officer and
Principal Accounting Officer)

29

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EXHIBIT INDEX

|Exhibit
Number |  | Description                                                                 
|-------------- |  | ----------------------------------------------------------------------------
|23.1           |  | Consent of Independent Registered Public Accounting Firm                    
|31.1           |  | Chief Executive Officer Certificate pursuant to Exchange Act Rule 13a-14(a).
|31.2           |  | Chief Financial Officer Certificate pursuant to Exchange Act Rule 13a-14(a).

30

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WITNESS SYSTEMS, INC.        Index to Consolidated Financial Statements

|                                                                                                      |  | Page
|----------------------------------------------------------------------------------------------------- |  | ----
|Report of Independent Registered Public Accounting Firm                                               |  | F-2 
|Consolidated Balance Sheets as of December 31, 2003 and 2002                                          |  | F-3 
|Consolidated Statements of Operations for the years ended December 31, 2003, 2002, and 2001           |  | F-4 
|Consolidated Statements of Stockholders' Equity for the years ended December 31, 2003, 2002, and 2001 |  | F-5 
|Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002, and 2001           |  | F-6 
|Notes to Consolidated Financial Statements                                                            |  | F-7 
|Schedule IIValuation and Qualifying Accounts                                                         |  | F-27
|Report of Independent Registered Public Accounting Firm on Schedule                                   |  | F-28

F-1

---





Report of Independent Registered Public Accounting Firm

The
Board of Directors
Witness Systems, Inc.:

We
have audited the accompanying consolidated balance sheets of Witness Systems, Inc. and subsidiaries (the "Company") as of December 31, 2003 and 2002, and the related
consolidated statements of operations, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2003. These consolidated financial
statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards 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. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.

In
our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Witness Systems, Inc. and subsidiaries
at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity
with accounting principles generally accepted in the United States of America.

| |  | /s/ KPMG LLP
| |  | ------------

Atlanta,
Georgia
January 23, 2004

F-2

---





WITNESS SYSTEMS, INC. AND SUBSIDIARIES        CONSOLIDATED BALANCE SHEETS        (In thousands, except share data)

|                                     |                                                                                                                                                                                                | December 31,               |        
|------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | -------
|
|ASSETS                               |                                                                                                                                                                                                |                            |        
|Current assets:                      |                                                                                                                                                                                                |                            |        
|                                     | Cash and cash equivalents                                                                                                                                                                      |                            | $      
|                                     | Investments                                                                                                                                                                                    |                            |        
|                                     | Accounts receivable, net of allowance for doubtful accounts of $2,584 in 2003 and $1,339 in 2002                                                                                               |                            |        
|                                     | Prepaid and other current assets                                                                                                                                                               |                            |        
|                                     |                                                                                                                                                                                                |                            |        
|                                     |                                                                                                                                                                                                | Total current assets       |        
|Intangible assets, net               |                                                                                                                                                                                                |                            | 20,083 
|Property and equipment, net          |                                                                                                                                                                                                |                            | 6,141  
|Other assets                         |                                                                                                                                                                                                |                            | 1,606  
|                                     |                                                                                                                                                                                                |                            |        
|                                     |                                                                                                                                                                                                | $                          | 104,291
|                                     |                                                                                                                                                                                                |                            |        
|LIABILITIES AND STOCKHOLDERS' EQUITY |                                                                                                                                                                                                |                            |        
|Current liabilities:                 |                                                                                                                                                                                                |                            |        
|                                     | Accounts payable                                                                                                                                                                               |                            | $      
|                                     | Accrued expenses                                                                                                                                                                               |                            |        
|                                     | Deferred revenue                                                                                                                                                                               |                            |        
|                                     |                                                                                                                                                                                                |                            |        
|                                     |                                                                                                                                                                                                | Total current liabilities  |        
|Other long-term liabilities          |                                                                                                                                                                                                |                            | 3,906  
|Deferred tax liability               |                                                                                                                                                                                                |                            | 3,197  
|                                     |                                                                                                                                                                                                |                            |        
|                                     |                                                                                                                                                                                                | Total liabilities          |        
|                                     |                                                                                                                                                                                                |                            |        
|Commitments and contingencies        |                                                                                                                                                                                                |                            |        
|Stockholders' equity:                |                                                                                                                                                                                                |                            |        
|                                     | Preferred stock, $.01 par value; 10,000,000 shares authorized; (50,000 shares of which have been designated as Series A Junior Participating Preferred Stock), no shares issued or outstanding |                            |        
|                                     | Common stock, $.01 par value; 50,000,000 shares authorized; 22,169,672 and 22,035,756 shares issued and outstanding at December 31, 2003 and 2002, respectively                                |                            |        
|                                     | Additional paid-in capital                                                                                                                                                                     |                            |        
|                                     | Accumulated deficit                                                                                                                                                                            |                            |        
|                                     | Notes receivable for stock                                                                                                                                                                     |                            |        
|                                     | Accumulated other comprehensive income                                                                                                                                                         |                            |        
|                                     |                                                                                                                                                                                                |                            |        
|                                     |                                                                                                                                                                                                | Total stockholders' equity |        
|                                     |                                                                                                                                                                                                |                            |        
|                                     |                                                                                                                                                                                                | $                          | 104,291
|                                     |                                                                                                                                                                                                |                            |        

See
accompanying notes to consolidated financial statements.

F-3

---



WITNESS SYSTEMS, INC. AND SUBSIDIARIES        CONSOLIDATED STATEMENTS OF OPERATIONS        (In thousands, except per share data)

|                                            |                                                                  | Years Ended December 31,                        |      
|------------------------------------------- | ---------------------------------------------------------------- | ----------------------------------------------- | -----
|
|Revenue:                                    |                                                                  |                                                 |      
|                                            | Product                                                          |                                                 | $    
|                                            | Services                                                         |                                                 |      
|                                            |                                                                  |                                                 |      
|                                            |                                                                  | Total revenue                                   |      
|                                            |                                                                  |                                                 |      
|Cost of revenue:                            |                                                                  |                                                 |      
|                                            | Product                                                          |                                                 |      
|                                            | Services                                                         |                                                 |      
|                                            |                                                                  |                                                 |      
|                                            |                                                                  | Total cost of revenue                           |      
|                                            |                                                                  |                                                 |      
|                                            |                                                                  | Gross profit                                    |      
|Operating expenses:                         |                                                                  |                                                 |      
|                                            | Selling, general and administrative                              |                                                 |      
|                                            | Research and development                                         |                                                 |      
|                                            | Merger-related costs                                             |                                                 |      
|                                            | Acquired in-process research and development and related charges |                                                 |      
|                                            |                                                                  |                                                 |      
|                                            |                                                                  | Operating loss                                  |      
|Interest and other income, net              |                                                                  |                                                 | 1,303
|                                            |                                                                  |                                                 |      
|                                            |                                                                  | (Loss) income before provision for income taxes |      
|Provision for income taxes                  |                                                                  |                                                 | 307  
|                                            |                                                                  |                                                 |      
|                                            |                                                                  | Net (loss) income                               |      
|                                            |                                                                  |                                                 |      
|Net income (loss) per share:                |                                                                  |                                                 |      
|                                            |                                                                  | Basic                                           |      
|                                            |                                                                  |                                                 |      
|                                            |                                                                  | Diluted                                         |      
|                                            |                                                                  |                                                 |      
|Weighted-average common shares outstanding: |                                                                  |                                                 |      
|                                            |                                                                  | Basic                                           |      
|                                            |                                                                  |                                                 |      
|                                            |                                                                  | Diluted                                         |      
|                                            |                                                                  |                                                 |      

See
accompanying notes to consolidated financial statements.

F-4

---





WITNESS SYSTEMS, INC. AND SUBSIDIARIES        CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY        (In thousands)        Years Ended December 31, 2003, 2002 and 2001

|                                                                        |                                                   | Common Stock               |   |   |     |   |   |        |   |   |         |         |  
|----------------------------------------------------------------------- | ------------------------------------------------- | -------------------------- | - | - | --- | - | - | ------ | - | - | ------- | ------- | -
|
|
|Balance at December 31, 2000                                            |                                                   | 21,908                     |   | $ | 219 |   | $ | 94,565 |   | $ | (22,805 | )       | $
|Exercise of stock options and warrants                                  |                                                   | 518                        |   |   | 5   |   |   | 1,174  |   |   |        |         |  
|Shares issued under employee stock purchase plan                        |                                                   | 53                         |   |   | 1   |   |   | 485    |   |   |        |         |  
|Repayment of notes receivable for stock                                 |                                                   |                           |   |   |    |   |   |       |   |   |        |         |  
|Comprehensive loss:                                                     |                                                   |                            |   |   |     |   |   |        |   |   |         |         |  
|                                                                        | Change in foreign currency translation adjustment |                            |  |   |     |  |   |        |  |   |         |        |  
|                                                                        | Change in unrealized loss on investments, net     |                            |  |   |     |  |   |        |  |   |         |        |  
|                                                                        | Net loss                                          |                            |  |   |     |  |   |        |  |   |         | (5,180  | )
|                                                                        |                                                   |                            |   |   |     |   |   |        |   |   |         |         |  
|                                                                        |                                                   | Total comprehensive loss   |   |   |     |   |   |        |   |   |         |         |  
|                                                                        |                                                   |                            |   |   |     |   |   |        |   |   |         |         |  
|Balance at December 31, 2001                                            |                                                   | 22,479                     |   |   | 225 |   |   | 96,224 |   |   | (27,985 | )       |  
|Exercise of stock options                                               |                                                   | 378                        |   |   | 4   |   |   | 985    |   |   |        |         |  
|Shares issued under employee stock purchase plan                        |                                                   | 85                         |   |   | 1   |   |   | 369    |   |   |        |         |  
|Repayment of notes receivable for stock and related interest receivable |                                                   | (66                        | ) |   | (1  | ) |   | (871   | ) |   |        |         |  
|Stock repurchases                                                       |                                                   | (840                       | ) |   | (9  | ) |   | (2,447 | ) |   |        |         |  
|Comprehensive income:                                                   |                                                   |                            |   |   |     |   |   |        |   |   |         |         |  
|                                                                        | Change in foreign currency translation adjustment |                            |  |   |     |  |   |        |  |   |         |        |  
|                                                                        | Change in unrealized loss on investments, net     |                            |  |   |     |  |   |        |  |   |         |        |  
|                                                                        | Net income                                        |                            |  |   |     |  |   |        |  |   |         | 48      |  
|                                                                        |                                                   |                            |   |   |     |   |   |        |   |   |         |         |  
|                                                                        |                                                   | Total comprehensive income |   |   |     |   |   |        |   |   |         |         |  
|                                                                        |                                                   |                            |   |   |     |   |   |        |   |   |         |         |  
|Balance at December 31, 2002                                            |                                                   | 22,036                     |   |   | 220 |   |   | 94,260 |   |   | (27,937 | )       |  
|Exercise of stock options                                               |                                                   | 285                        |   |   | 3   |   |   | 1,102  |   |   |        |         |  
|Shares issued under employee stock purchase plan                        |                                                   | 162                        |   |   | 2   |   |   | 557    |   |   |        |         |  
|Repayment of notes receivable for stock                                 |                                                   | (108                       | ) |   | (1  | ) |   | (985   | ) |   |        |         |  
|Stock repurchases                                                       |                                                   | (205                       | ) |   | (2  | ) |   | (641   | ) |   |        |         |  
|Comprehensive income:                                                   |                                                   |                            |   |   |     |   |   |        |   |   |         |         |  
|                                                                        | Change in foreign currency translation adjustment |                            |  |   |     |  |   |        |  |   |         |        |  
|                                                                        | Change in unrealized gain on investments, net     |                            |  |   |     |  |   |        |  |   |         |        |  
|                                                                        | Net loss                                          |                            |  |   |     |  |   |        |  |   |         | (20,569 | )
|                                                                        |                                                   |                            |   |   |     |   |   |        |   |   |         |         |  
|                                                                        |                                                   | Total comprehensive loss   |   |   |     |   |   |        |   |   |         |         |  
|                                                                        |                                                   |                            |   |   |     |   |   |        |   |   |         |         |  
|Balance at December 31, 2003                                            |                                                   | 22,170                     |   | $ | 222 |   | $ | 94,293 |   | $ | (48,506 | )       | $
|                                                                        |                                                   |                            |   |   |     |   |   |        |   |   |         |         |  

See accompanying notes to consolidated financial statements.

F-5

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WITNESS SYSTEMS, INC. AND SUBSIDIARIES        CONSOLIDATED STATEMENTS OF CASH FLOWS        (In thousands)

|                                               |                                                                                                    | Years Ended December 31,                                |                         
|---------------------------------------------- | -------------------------------------------------------------------------------------------------- | ------------------------------------------------------- | ------------------------
|
|Cash flows from operating activities:          |                                                                                                    |                                                         |                         
|                                               | Net (loss) income                                                                                  |                                                         | $                       
|                                               | Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities: |                                                         |                         
|                                               |                                                                                                    | In-process research and development                     |                         
|                                               |                                                                                                    | Amortization of intangible assets                       |                         
|                                               |                                                                                                    | Depreciation and amortization of property and equipment |                         
|                                               |                                                                                                    | Provision for doubtful accounts                         |                         
|                                               |                                                                                                    | Other non-cash items, net                               |                         
|                                               |                                                                                                    | Changes in operating assets and liabilities:            |                         
|                                               |                                                                                                    |                                                         | Accounts receivable     
|                                               |                                                                                                    |                                                         | Prepaid and other assets
|                                               |                                                                                                    |                                                         | Accounts payable        
|                                               |                                                                                                    |                                                         | Accrued expenses        
|                                               |                                                                                                    |                                                         | Deferred revenue        
|                                               |                                                                                                    |                                                         |                         
|                                               |                                                                                                    |                                                         |                         
|                                               |                                                                                                    |                                                         |                         
|Cash flows from investing activities:          |                                                                                                    |                                                         |                         
|                                               | Capital expenditures                                                                               |                                                         |                         
|                                               | Purchases of investments                                                                           |                                                         |                         
|                                               | Proceeds from maturities of investments                                                            |                                                         |                         
|                                               | Proceeds from sales of investments                                                                 |                                                         |                         
|                                               | Acquisition of Eyretel plc, net of cash acquired of $38,814                                        |                                                         |                         
|                                               | Purchase of other business assets                                                                  |                                                         |                         
|                                               | Allocation from (to) restricted cash                                                               |                                                         |                         
|                                               |                                                                                                    |                                                         |                         
|                                               |                                                                                                    |                                                         |                         
|                                               |                                                                                                    |                                                         |                         
|Cash flows from financing activities:          |                                                                                                    |                                                         |                         
|                                               | Proceeds from exercise of stock options                                                            |                                                         |                         
|                                               | Proceeds from employee stock purchase plan                                                         |                                                         |                         
|                                               | Repayments of notes receivable from stockholders                                                   |                                                         |                         
|                                               | Stock repurchases                                                                                  |                                                         |                         
|                                               |                                                                                                    |                                                         |                         
|                                               |                                                                                                    |                                                         |                         
|                                               |                                                                                                    |                                                         |                         
|                                               | Effect of exchange rate changes on cash                                                            |                                                         |                         
|                                               |                                                                                                    |                                                         |                         
|Cash and cash equivalents at beginning of year |                                                                                                    |                                                         | 36,391                  
|                                               |                                                                                                    |                                                         |                         
|Cash and cash equivalents at end of year       |                                                                                                    | $                                                       | 30,717                  
|                                               |                                                                                                    |                                                         |                         
|Supplemental cash flow information:            |                                                                                                    |                                                         |                        
|                                               |                                                                                                    |                                                         |                         
|                                               | Cash paid for interest                                                                             |                                                         | $                       
|                                               |                                                                                                    |                                                         |                         
|                                               | Cash paid for income taxes                                                                         |                                                         | $                       
|                                               |                                                                                                    |                                                         |                         
|Non-cash financing activities:                 |                                                                                                    |                                                         |                         
|                                               | Repayments of notes receivable and interest from stockholders                                      |                                                         | $                       
|                                               |                                                                                                    |                                                         |                         

See
accompanying notes to consolidated financial statements.

F-6

---





WITNESS SYSTEMS, INC. AND SUBSIDIARIES        NOTES TO CONSOLIDATED FINANCIAL STATEMENTS        December 31, 2003

1.     Summary of Significant Accounting Policies

BusinessWitness Systems, Inc. ("Witness") provides an integrated
contact center performance optimization software suite that enables global enterprises to capture customer intelligence and optimize workforce performance. Our solution is comprised of business-driven
and/or full-time customer interaction recording, performance analysis and e-learning management applications that are designed to enhance the quality of customer interactions
across multiple communications media, including the telephone, e-mail and the Internet. Our software suite allows contact center management to share information gathered in the contact
center with departments that touch the customer, as well as executives throughout the organization. Using an integrated business consulting, installation and training methodology, we provide services
to support an effective and rapid deployment of our software that enables organizations to maximize their return on an investment in our products and services. Our software is designed to integrate
with a variety of third-party software applications, such as customer relationship management ("CRM") and enterprise resource planning applications, and with existing telephony and computer network
hardware and software. The majority of our customers are companies with an international presence and one or more contact centers that handle voice and data customer interactions for outbound sales
and marketing operations, inbound service/support lines, or both.

We
are headquartered in Roswell, Georgia with other offices in the United States, Australia, Brazil, Canada, China, Germany, Hong Kong, Japan, Malaysia, Mexico, Singapore and the United
Kingdom. We were originally incorporated in 1988 in Georgia and were reincorporated in Delaware in 1997. We have been a publicly traded company since February 2000.

Principles of Consolidation and ReclassificationsThe consolidated financial statements include the financial statements of
Witness Systems, Inc. and its wholly-owned subsidiaries. During the first quarter of 2003, we acquired Eyretel plc ("Eyretel"), a U.K.-based provider of compliance and recording solutions for
customer contact centers. We commenced the consolidation of their results of operations on March 22, 2003, the date we assumed majority ownership of Eyretel. All significant intercompany
balances and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation.

Use of EstimatesThe consolidated financial statements have been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these financial statements requires us to make certain estimates and judgments that affect our reported assets, liabilities, revenues and expenses,
and our related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances.
Actual results may differ from these estimates under different assumptions or conditions.

Cash and Cash Equivalents and InvestmentsCash and cash equivalents consist of cash on deposit, money market accounts, auction
rate securities and commercial paper. We consider all highly liquid debt instruments with original maturities of three months or less to be cash equivalents.

Investments
are classified as available for sale and are carried at fair market value. Unrealized holding gains and losses on such investments are reported as a separate component of
accumulated other comprehensive income until realized. Realized gains and losses from sales are based on the specific identification method. Our investments are presented as current assets as
management expects to use them within one year even though some have scheduled maturities of greater than one year.

F-7

---



Accounts ReceivableAccounts receivable include amounts due from customers for which revenue has been recognized. We perform
ongoing evaluations of our customers and continuously monitor collections and payments and estimate an allowance for doubtful accounts based on the aging of the underlying receivables, our historical
experience and any specific customer collection issues that we have identified. Account balances are charged off against the allowance for doubtful accounts after reasonable means of collection have
been exhausted and the potential for recovery is considered remote.

Software Development CostsIn accordance with Statement of Financial Accounting Standards No. 86, software development
costs are expensed until technological feasibility of the product has been established and are capitalized commencing upon the establishment of technological feasibility through general release to
customers. Amortization of software development costs begins when the product is available for general release and is amortized using the greater of (1) the straight line



method over the expected life of the product or (2) the ratio of current product revenue to the total of current and future product revenue. At each balance sheet date, the unamortized software
development costs are compared to the net realizable value of the underlying product and to the extent any unamortized capitalized costs exceed the net realizable value of the asset, those costs are
written off.

Property and EquipmentProperty and equipment are stated at cost, less accumulated depreciation and amortization. Property and
equipment are depreciated on a straight-line basis over the estimated useful lives of the assets, which range from two to five years. Leasehold improvements are amortized using the
straight-line method over the shorter of the estimated life of the asset or the remaining term of the lease. Property and equipment are comprised of the following (in thousands):

December 31,2003

2002Computer equipment

$
5,091

$
3,287Software


2,571


1,792Other equipment


2,880


2,008Furniture and fixtures


593


276Leasehold improvements


2,562


1,57513,697


8,938Less accumulated depreciation and amortization


7,556


3,881$
6,141

$
5,057


Depreciation
and amortization of property and equipment was $3.8 million, $3.2 million and $3.0 million in 2003, 2002 and 2001, respectively.

Long-Lived AssetsLong-lived assets, such as property and equipment and intangible assets, are
reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. All of our intangible assets are amortized on a
straight-line basis. Useful lives of amortizable intangible assets are reviewed annually with any changes in estimated useful lives being accounted for prospectively over the revised
remaining useful life. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future cash flows expected to be
generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount

F-8

---



by
which the carrying amount of the asset exceeds the fair value of the asset. To date no impairments have been identified.

Revenue Recognition and Deferred RevenueWe recognize revenue in accordance with Statement of Position ("SOP")
97-2,Software Revenue Recognition,and SOP 98-9, Modification of SOP 97-2, Software Revenue
Recognition, With Respect to Certain Transactions. Revenue is primarily derived from licensing software and providing related services including maintenance. Product revenue,
which includes software and hardware, is recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or determinable, collection is probable and
vendor specific objective evidence ("VSOE") exists to allocate revenue to the undelivered elements of the arrangement. The Company reports hardware revenue gross in accordance with Emerging Issues
Task Force No. 99-19 because the factors indicating gross reporting outweigh the factors indicating net reporting. We recognize revenue using the residual method of accounting since
our revenues are derived from customer orders that contain multiple element arrangements, including the sale of licensed software, hardware, maintenance, and professional services. We generally have
VSOE of fair value for maintenance and professional services, but not for the software and hardware elements of the order. Under the residual method, services revenue, including maintenance and
professional services, is deferred at an amount equal to its fair value until those elements are delivered. Consequently, product revenue for the software and hardware may be recognized
(i) upon delivery of those products when we have VSOE on the related maintenance and professional services sold and (ii) at an amount representing the difference between the total order
amount and the amount deferred.

Services
revenue includes installation, training, consulting, maintenance and reimbursable travel expenses. Revenue from installation, training and consulting services is recognized upon
performance of the related services and is offered and billed as separate elements of contracts. Reimbursable travel expenses revenue is recognized upon incurrence of the related expenses. The
functionality of the software and any hardware sold is not dependent on installation and training services and customization is not required to enable our customers to use our products. Maintenance is
offered as a separate element and the majority of contracts include the right to unspecified upgrades on a when-and-if available basis. Maintenance revenue, which is generally
billed in advance, is deferred and recognized ratably over the term of the related contract. Specified upgrades are not typically offered to customers.

Deferred
revenue consists of amounts collected from customers for products and services that have not met the criteria for revenue recognition.

Advertising CostsAdvertising costs are expensed as incurred. Advertising expenses were $0.3 million,
$0.3 million and $0.7 million in 2003, 2002 and 2001, respectively.

Research and Development CostsResearch and development costs consist primarily of personnel and consulting costs to support
product development, and allocated overhead. These costs are expensed as incurred and include software development costs incurred prior to the establishment of technological feasibility.

Merger-Related Costs and Purchase Price ContingenciesMerger-related costs include expenses related to integrating the
software products of the acquired company, training personnel on products acquired, establishing the infrastructure and consolidating the operations of the acquired company. In addition, other
merger-related charges are comprised of costs related to Witness lease terminations and severance associated with Witness employee terminations resulting from closures and terminations during the
merger integration process. We account for other merger-related charges in accordance with

F-9

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SFAS
No. 146,Accounting for Costs Associated with Exit or Disposal Activities,which requires that a liability for a cost associated with an
exit or disposal activity must only be recognized when the liability is incurred.

In
connection with the acquisition of Eyretel, we accrued for certain Eyretel contingencies that existed at the date of acquisition and which we believed would result in future cash
expenditures. We will reduce such liabilities as those contingencies are resolved, or if we determine that the contingency no longer represents a probable loss. Any adjustments to these liabilities
prior to the finalization of the purchase price will impact purchase consideration. Any subsequent adjustments will impact our results of operations.

Stock-Based CompensationWith the exception of the deferred stock compensation that we recorded at our initial public offering
("IPO"), we generally do not record compensation expense for options granted to our employees because all options granted under our stock option plans have an exercise price equal to the market value
of the underlying common stock on the date of grant. As permitted under SFAS No. 148,Accounting for Stock-Based CompensationTransition and
Disclosure, and SFAS No. 123,Accounting for Stock-Based Compensation, we have elected to continue to apply the
provisions of Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees,and have adopted the disclosure requirements
of SFAS No. 123. The following table illustrates the effect on net (loss) income and net (loss) income per share if we had applied the fair value method as prescribed by SFAS No. 123 (in
thousands, except per share data):

|                                                                                                       |                             | Year ended December 31, |        
|------------------------------------------------------------------------------------------------------ | --------------------------- | ----------------------- | -------
|
|Reported net (loss) income                                                                             |                             | $                       | (20,569
|Add back: Stock-based employee compensation expense included in reported net (loss) income             |                             |                         | 129    
|Deduct: Total stock-based compensation expense determined under fair value based method for all awards |                             |                         | (7,893 
|                                                                                                       |                             |                         |        
|Pro forma net loss                                                                                     |                             | $                       | (28,333
|                                                                                                       |                             |                         |        
|Net (loss) income per share:                                                                           |                             |                         |        
|                                                                                                       | Reported basic and diluted  |                         | $      
|                                                                                                       |                             |                         |        
|                                                                                                       | Pro forma basic and diluted |                         | $      
|                                                                                                       |                             |                         |        

See
Note 12 for a description of the option pricing assumptions used to estimate the fair value of equity instruments granted to employees.

Income TaxesWe account for income taxes in accordance with SFAS No. 109,Accounting for Income
Taxes, which requires companies to recognize deferred tax assets and liabilities using enacted tax rates for the effect of temporary differences between the book and tax bases
of recorded assets and liabilities. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. SFAS
No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. We
evaluate the realizability of our deferred tax assets quarterly by assessing our valuation allowance and by adjusting the amount of such allowance, if necessary. We

F-10

---



continue
to provide a valuation allowance on our deferred tax assets based on an assessment of the likelihood of their realization.

Net Income (Loss) Per ShareWe calculate net income (loss) per share pursuant to SFAS No. 128, Earnings Per Share.
Basic net income (loss) per share is calculated by dividing our net income (loss) by the weighted average number of shares outstanding during the period. When the effects are not
anti-dilutive, diluted net income (loss) per share is computed by dividing our net income (loss) by the weighted average number of shares outstanding and the impact of all dilutive stock
options. The dilutive impact of stock options is determined by applying the treasury stock method. See Note 10 for further information.

Fair Value of Financial InstrumentsAt December 31, 2003 and 2002, our financial instruments included cash and cash
equivalents, accounts receivable and accounts payable. We believe all of the financial instruments' carrying values approximate fair values because of the short maturities of these instruments. Our
investment securities are carried at fair value.

Foreign CurrencyThe functional currency has been determined to be the local currency for our foreign subsidiaries. As a
result, those subsidiaries' assets and liabilities are translated at year-end exchange rates and income statement items are translated at average exchange rates prevailing during the year.
Such translation adjustments are recorded as a component of stockholders' equity and other comprehensive income (loss).

Net
gains and (losses) from foreign currency denominated transactions are included in other income (expense) and were $0.4 million, $0 and ($0.1) million in 2003, 2002 and 2001,
respectively.

Recent Accounting PronouncementsIn January 2003, the Financial Accounting Standards Board ("FASB") issued FASB
Interpretation ("FIN") No. 46,Consolidation of Variable Interest Entities. FIN 46 requires companies to evaluate variable interest entities for
specific characteristics to determine whether additional consolidation and disclosure requirements apply. FIN 46 is immediately applicable for variable interest entities created after
January 31, 2003, and applies to the first fiscal year or interim
period beginning after June 15, 2003 for variable interest entities acquired prior to February 1, 2003. The adoption of FIN 46 did not have any impact on our financial statements. In
December 2003, the FASB revised FIN 46 to exempt certain entities from its requirements and to clarify certain issues arising during the implementation of FIN 46. The adoption of this revised
interpretation in the first quarter of 2004 is not expected to have any impact on our consolidated financial statements.

In
May 2003, the FASB issued SFAS No. 150,Accounting for Certain Financial Instruments with Characteristics of both Liabilities and
Equity. SFAS No. 150 establishes standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity.
SFAS No. 150 also includes required disclosures for financial instruments within its scope. SFAS No. 150 was effective for instruments entered into or modified after May 31, 2003
and otherwise was effective as of the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have any impact on our financial
statements.

Effective
January 1, 2003, we adopted SFAS No. 143,Accounting for Asset Retirement Obligations, which addresses financial
accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The adoption of SFAS No. 143 did not
have a material impact on our financial statements.

F-11

---



Effective
January 1, 2003, we adopted FIN 45,Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others, which clarifies disclosure and recognition/measurement requirements related to certain guarantees. The adoption of FIN 45 did not have a material impact
on our financial statements.

Effective
January 1, 2003, we adopted SFAS No. 145,Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement
No. 13, and Technical Corrections. SFAS No. 145 amends existing guidance on reporting gains and losses on the extinguishment of debt to prohibit the
classification of the gain or loss as extraordinary, as the use of such extinguishments have become part of the risk management strategy of many companies. SFAS No. 145 also amends SFAS
No. 13,Accounting for Leases, to require sale-leaseback accounting for certain lease modifications that have economic effects
similar to sale-leaseback transactions. The adoption of SFAS No. 145 did not have a material impact on our financial statements.

Effective
January 1, 2003, we adopted SFAS No. 146,Accounting for Costs Associated with Exit or Disposal Activities.SFAS
No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity. In connection with the Eyretel acquisition in
March 2003, we executed a restructuring plan, which is being accounted for pursuant to SFAS No. 146 (see Note 4).

Effective
July 1, 2003, we prospectively adopted SFAS No. 149,Amendment of Statement 133 on Derivative Instruments and Hedging
Activities. SFAS No. 149 amends SFAS No. 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities
and requires contracts with similar characteristics to be accounted for on a comparable basis. The adoption of SFAS No. 149 did not have a material impact on our financial statements.

Effective
July 1, 2003, we prospectively adopted Emerging Issues Task Force ("EITF") No. 00-21,Accounting for Revenue Arrangements with
Multiple Deliverables, and EITF No. 03-05,Applicability of AICPA SOP 97-2 to Non Software Deliverables in an Arrangement
Containing More Than Incidental Software. The consensus opinion in EITF No. 03-05 clarifies the guidance in EITF No. 00-21. The transition
provisions allow either prospective application or a cumulative effect adjustment upon adoption. The adoption of EITF Nos. 00-21 and 03-05 did not have a material impact on our
financial statements.

Effective
January 1, 2003, we adopted EITF No. 03-1,The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments.EITF No. 03-1 provides guidance on other-than-temporary impairment and its application to debt
and equity securities. The requirement applies to investments in debt and marketable securities that are accounted for under SFAS No. 115. The adoption of EITF No. 03-1 did
not have a material effect on our financial statements.

2.     Eyretel Acquisition

During the first quarter of 2003, we acquired a controlling interest in Eyretel and completed the acquisition during the second quarter of 2003. We paid 25 pence
per share for a total purchase price of approximately £35.3 million, or $55.3 million, excluding shares owned by Eyretel's employee stock option trust at the time of
acquisition. The acquisition was intended to extend our presence in international markets and to expand our product line by adding a full-time compliance recording software solution. We
commenced the consolidation of Eyretel's results on March 22, 2003, the date we

F-12

---



assumed
majority ownership of Eyretel. The acquisition was accounted for using the purchase method of accounting.

The
following summarizes the total purchase price for Eyretel as of December 31, 2003 (in thousands):

Purchase price (paid in cash)

$
55,269Estimated direct transaction costs


4,958$
60,227


Under
the purchase method of accounting, the total purchase price is allocated to Eyretel's net tangible and intangible assets based upon their estimated fair values as of the date of
the acquisition. The purchase price allocation for this acquisition may be revised at a later date when additional information concerning pre-acquisition contingencies, cost of the
acquisition and asset and liability valuations becomes evident. The purchase price allocation is as follows (in thousands):

Cash and investments

$
38,814Other current assets


21,985Property and equipment, net


2,597Identifiable intangible assets acquired:Acquired technology


12,691Distribution arrangements


4,928Customer lists


2,389Trademarks


1,194In-process research and development


7,840Total assets acquired


92,438Current liabilities


(16,264
)Restructuring accruals


(4,958
)Deferred revenue


(5,512
)Other long-term liabilities


(2,280
)Deferred tax liability


(3,197
)Total liabilities assumed


(32,211
)$
60,227


The
fair value of identifiable intangible assets was determined with the assistance of Taylor Consulting Group, Inc., an independent third-party appraiser, using either an income or cost
approach taking into consideration the nature, risks, historical patterns, economic characteristics, and future considerations of the assets. We estimated that $7.8 million of the purchase
price of Eyretel represented acquired in-process research and development ("IPR&D") related to developing enhancements and new products for the voice and data recording, quality monitoring
and analysis industry that had not yet reached technological feasibility and had no alternative future use. Accordingly, these amounts were immediately charged to expense upon consummation of the
acquisition. We calculated the value of the IPR&D by utilizing a discounted cash flow methodology, focusing on the income-producing capabilities of the in-process technologies and taking
into consideration: stage of completion; complexity of work to date and to complete; anticipated product development and introduction schedules; forecasted product sales cycles; internal and external
risk

F-13

---



factors;
revenue and operating expense estimates; contributory asset charges; and costs already incurred and the expected costs to complete.

Supplemental
unaudited pro forma information reflecting the acquisition of Eyretel as if it occurred on January 1, 2002 is as follows (in thousands, except per share amounts):

December 31,2003

2002Total revenues

$
121,958

$
124,168Net loss


(25,219
)

(26,853
)Net loss per share

$
(1.15
)
$
(1.19
)


The
above pro forma results include adjustments for the amortization expense of intangible assets arising from the acquisition and the reversal of interest income. In addition, the pro
forma results exclude the IPR&D charge and certain merger-related and other costs directly attributable to the acquisition.

3.     Intangible Assets

The following tables present the components of intangible assets (in thousands):

December 31, 2003Gross Amount

Accumulated
Amortization

Net AmountAcquired technology

$
17,120

$
4,696

$
12,424Distribution arrangements


5,081


849


4,232Customer list


2,746


455


2,291Trademarks


1,373


379


994Patents


190


48


142$
26,510

$
6,427

$
20,083


December 31, 2002Gross Amount

Accumulated
Amortization

Net AmountAcquired technology

$
150

$
100

$
50Patents


148


13


135$
298

$
113

$
185


The
acquired technology and trademarks are being amortized on a straight-line basis over three or four years and the distribution arrangements, customer list and patents are
being amortized on a straight-line basis over five years. The intangible assets and amortization expenses are subject to foreign

F-14

---



currency
translation adjustments. Amortization of intangible assets included in the accompanying condensed consolidated statements of operations is as follows (in thousands):

Year Ended December 31,2003

2002

2001Included in:Cost of product revenue

$
4,139

$
50

$
50Selling, general and administrative


1,774


13


Research and development





338


488$
5,913

$
401

$
538


The
estimated future amortization expense of the intangible assets as of December 31, 2003 is as follows (in thousands):

2004

$
7,3832005


7,3832006


3,243Thereafter


2,074$
20,083


4.     Acquisition-Related Restructuring Accruals and Merger-Related Costs

As a result of the Eyretel acquisition in March 2003, we recorded $5.0 million in certain acquisition-related restructuring accruals comprised of
Eyretel personnel reductions, the closing of certain Eyretel facilities and the accrual of abandoned leased premises. All such costs met the criteria for accrual as outlined in Emerging Issues Task
Force No. 95-3,Recognition of Liabilities in Connection with a Purchase Business Combinationand were included among the assets acquired and
liabilities assumed in the purchase of Eyretel. The following table summarizes the restructuring accrual activity (in thousands):

Severance
and Benefits

Facilities

TotalAccrual at December 31, 2002








Acquisition-related restructuring accrual

$
2,522

$
2,436

$
4,958Cash payments


(2,138
)

(662
)

(2,800
)Foreign exchange translation





162


162Total accrual at December 31, 2003


384


1,936


2,320Less: Long-term portion





1,626


1,626Current portion at December 31, 2003

$
384

$
310

$
694


We also accrued $2.2 million in other merger-related restructuring costs for Witness personnel reductions and the consolidation of certain Witness facilities that are classified
as merger-related costs in the accompanying statement of operations. All such costs met the criteria for accrual as outlined in Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with
Exit or Disposal Activitiesand were recorded as merger-related costs in the accompanying statement of

F-15

---



operations for 2003. The following table summarizes the other merger-related restructuring accrual activity (in thousands):

Severance
and Benefits

Facilities

TotalAccrued at December 31, 2002








Merger-related restructuring provision

$
1,470

$
722

$
2,192Cash payments


(1,046
)

(722
)

(1,768
)Accrual at December 31, 2003

$
424




$
424


The following table summarizes the components of merger-related costs (in millions) that were charged to expense during the year ended December 31, 2003:

Merger-related restructuring provision (as shown in table above)

$
2.2Integration costs


3.8Bonus expense


1.0Cost of sterling-based forward exchange contract


0.9$
7.9


We reported the merger-related costs of $7.9 million in the accompanying consolidated statement of operations for 2003. Integration costs included expenses related to integrating
the software products of Eyretel, training personnel on the Eyretel products, establishing the infrastructure and consolidating the operations of Eyretel. The bonus expense of $1.0 million
related to the partial accrual of a bonus payable to Eyretel's former Chief Executive Officer, now our Chief Operating Officer ("COO"). Our Board of Directors agreed to pay this bonus totaling
£1.0 million (or $1.8 million at December 31, 2003) to our COO in association with the Eyretel acquisition and subsequent integration. This bonus is payable in two
installments due March 2004 and March 2005 but may be payable in advance of these dates under certain circumstances, such as a change of control. The forward exchange contract was
executed in order to fix the price of the Eyretel acquisition in US dollars. The merger-related restructuring activities were substantially completed as of December 31, 2003. Certain activity
may continue to occur through March 2004.

5.     Purchase of Other Business' Assets

In February 2003, we purchased the assets of a software and services company in order to acquire certain business intelligence technology for
$2.4 million in cash, including direct costs of $0.3 million. As a result of the purchase, we recorded an intangible asset of $2.5 million for acquired technology.

F-16

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6.     Investments

The amortized cost and fair market value of cash and cash equivalents and investments available for sale as of December 31, 2003 and 2002 were as follows:

UnrealizedCost

Gain

Loss

Market(in thousands)December 31, 2003Cash and cash equivalents:Cash

$
12,836







$
12,836Money market funds


7,682








7,682Auction rate securities


9,200








9,200Commercial paper


999








999Total cash and cash equivalents

$
30,717







$
30,717Investments:Certificates of deposit

$
542







$
542Corporate debt securities


6,621

$
1

$
(9
)

6,613U.S. Government Agency securities


3,000


2


(2
)

3,000Total investments

$
10,163

$
3

$
(11
)
$
10,155December 31, 2002Cash and cash equivalents:Cash

$
4,991







$
4,991Money market fund


25,098








25,098Auction rate securities


6,302








6,302Total cash and cash equivalents

$
36,391







$
36,391Investments:Auction rate securities

$
1,501







$
1,501Corporate debt securities


13,383

$
164





13,547U.S. Government Agency securities


13,888


11

$
(10
)

13,889Total investments

$
28,772

$
175

$
(10
)
$
28,937


At
December 31, 2003, all investments had maturity dates ranging from one to three years. The unrealized holding losses of $11,000 at December 31, 2003 were comprised of
seven corporate debt and one U.S. Government Agency security with a fair market value of $9.6 million. All of the corporate securities are of the highest triple A rating. The impairment is due
to the slight rise in interest rates. As of December 31, 2003, none of the individual securities have been in a loss position for more than 12 months, and we believe this impairment to
be temporary. Interest and other income, net includes $0.8 million of interest income and $0.2 million of realized gains during 2003, which were incurred primarily as a result of the
liquidation of our investment portfolio for the Eyretel acquisition.

F-17

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At December 31, 2002, the estimated fair market value of investments with maturity dates ranging from 91 days to one year totaled
$8.3 million and investments with maturity dates ranging from one to three years totaled $20.6 million. There were no realized gains or losses from sales during 2002 and 2001.

7.     Line of Credit

We maintain various borrowing and credit arrangements, primarily consisting of a line of credit of $15.0 million maturing in March 2004. At our
election, borrowings under the line of credit bear interest at the bank's prime rate, which was 4.0% at December 31, 2003 or LIBOR plus 300 basis points. Borrowings under the revolving line of
credit are limited to 85% of eligible accounts receivable, as defined by the agreement. The revolving line of credit is secured by all of our assets and requires compliance with various covenants,
including liquidity ratios and tangible net worth requirements, among others. During 2003, we amended the amount of our tangible net worth requirement due to the effect of the Eyretel acquisition. As
of December 31, 2003, we were in compliance with our bank covenants.

As
of December 31, 2003, we had no amounts outstanding under the line of credit and the amount available for borrowing was $11.7 million, which was net of outstanding
letters of credit of $3.3 million. The letters of credit secure the leases on the corporate headquarters facility and have decreasing schedules that ultimately expire in 2007. In addition, we
have a letter of credit securing our premises in the United Kingdom in the amount of £0.3 million.

8.     Acquired In-Process Research and Development and Related Charges

In connection with the Eyretel acquisition, we recorded $7.8 million in IPR&D charges during 2003. See Note 2 for further information.

During
2001, we recorded charges totaling $4.8 million for IPR&D acquired from various third parties. At the date of these transactions, the acquired IPR&D technologies had not
progressed to a stage where they met technological feasibility and had no alternative future uses. At the time of each transaction, we estimated the stage of completion of the project and the time and
resources required to complete the project by creating a product design plan and evaluating the progress of the acquired technology towards this plan. A significant amount of uncertainty existed as to
our ability to complete the development projects within a timeframe acceptable to the market, and failure to do so would have caused our competitive position in the market to erode. Additionally, the
amount of development required to enable the acquired technology to integrate with our primary product was estimated to be significant, which increased the uncertainty surrounding its successful
development. These projects were successfully completed by June 30, 2002.

F-18

---



9.     Accrued Expenses

Accrued expenses consisted of the following (in thousands):

December 31,2003

2002Accrued commissions, compensation and benefits

$
7,495

$
3,167Restructuring and merger-related expenses (Note 4)


1,118


Other accrued transaction costs


6,422


Other accrued expenses


8,544


3,322$
23,579

$
6,489


10.   Net (Loss) Income Per Share

The following is a reconciliation of the numerator and denominator used in the calculation of basic and diluted net (loss) income per share (in thousands, except
per share data):

Year Ended December 31,2003

2002

2001Net (loss) income

$
(20,569
)
$
48

$
(5,180
)Average shares of common stock outstanding:Basic


21,991


22,626


22,258Effect of stock options





898


Diluted common shares outstanding


21,991


23,524


22,258Net (loss) income per share:Basic

$
(0.94
)
$
0.00

$
(0.23
)Diluted

$
(0.94
)
$
0.00

$
(0.23
)


We
have excluded all outstanding stock options from the calculation of historical diluted net loss per common share for 2003 and 2001 because we reported a loss in these periods and all
such securities are anti-dilutive. The total number of shares excluded from the calculations of historical diluted net loss per common share for 2003 and 2001 was 1,301,994 and 1,573,445,
respectively, calculated using the treasury stock. See Note 12 for further information. In 2003, 2002 and 2001, 4,392,990, 3,587,378 and 638,528 stock options, respectively, were excluded from the
computation of diluted earnings per share because they had exercise prices that exceeded the fair market value of our common stock, and therefore had an anti-dilutive effect.

F-19

---



11.   Stockholders' Equity

Comprehensive IncomeAccumulated other comprehensive income consisted of the following (in thousands):

December 31,2003

2002Cumulative foreign currency translation adjustments

$
3,994

$
(164
)Unrealized (loss) gain on investments


(8
)

165$
3,986

$
1


Stock RepurchasesIn 2002, our Board of Directors authorized a stock repurchase program to spend up to $10.0 million to
repurchase our common stock. As of December 31, 2003, we had repurchased 1,045,500 shares of our common stock for $3.1 million, which were constructively retired.

Notes Receivable from Stock SalesIn 1999, we received notes totaling $1.8 million from our Chief Executive Officer
("CEO") in exchange for 991,993 shares of our common stock. In February 2002, the notes receivable were refinanced in part with a full recourse note (the "2002 Note") for approximately
$1.5 million with floating monthly interest of 325 basis points over the Federal Funds Rate. The 2002 Note was payable in three equal payments of principal and interest due annually through
February 2005. During the first quarter of 2003, the CEO made the first principal payment of approximately $0.5 million and the related interest. In December 2003, the CEO
transferred 107,866 shares of our common stock, which he had held for more than six months, to an investment brokerage account in full satisfaction of the note.

12.   Employee Benefit Plans

Stock Incentive PlansWe have three stock incentive plans: (i) the 1999 Stock Incentive Plan
(the "1999 Plan"); (ii) the 2003 Broad Based Option Plan (the "2003 Plan"); and (iii) the 2003 Non-employee Director Stock Option Global Plan (the "Director Plan").

Under
the 1999 Plan, we may grant shares of common stock in the form of stock options, restricted stock awards, or stock appreciation rights to employees and key persons affiliated with
Witness, as defined. In 2001, our stockholders modified a provision to increase, without further approval required, the number of shares authorized each year beginning on January 1, 2002 by a
number equal to the lesser of 10% of the total number of shares of common stock then outstanding or 3,000,000 shares. During 2003, 2,884,106 stock options were granted under the 1999 Plan. At
December 31, 2003, there were 10,873,128 shares authorized for issuance, of which 195,979 shares remain available for future grant.

In
connection with the Eyretel acquisition, we established the 2003 Plan for former Eyretel employees. The 2003 Plan became effective in June 2003, and we may grant shares of
common stock in the form of stock options. During 2003, 1,454,044 stock options were granted to former Eyretel employees under the 2003 Plan. At December 31, 2003, there were 1,600,000 shares
authorized for issuance, of which 148,956 shares remain available for future grant. We do not anticipate increasing the number of shares available for issuance.

The
Director Plan became effective in May 2003 and grants continuing non-employee members of the Board of Directors non-qualified options to purchase
shares of our common stock, pursuant to a formula award. During 2003, 24,000 stock options were granted under the Director Plan. At

F-20

---



December 31,
2003, there were 500,000 shares authorized for issuance, of which 476,000 shares remain available for future grant.

Each
plan remains in effect until the earlier of the tenth anniversary of its effective date or the date on which all reserved shares have been issued or are no longer available for use.
Options granted under these plans during 2003, 2002 and 2001 were non-qualified stock options that were granted at a price greater than or equal to the fair value of the stock on the grant
date. Option vesting terms typically range from two to four years and expire no more than ten years from the date of the grant. These plans provide for accelerated option vesting terms in connection
with a change in control of Witness. To the extent that this occurs, we may have a future charge.

For
the years ended December 31, 2003, 2002 and 2001, we incurred $0.1 million, $0.1 million and $0.2 million, respectively, in deferred stock compensation
charges for certain 1999 stock grants, with such charges being classified into their respective department functional areas. There was no unamortized deferred stock compensation balance at
December 31, 2003.

The
following summarizes stock option activity under all stock option plans:

Number
of shares

Weighted-
average
exercise
priceBalance at December 31, 2000

3,798,483

$
6.43Granted

2,637,630


9.02Exercised

(422,455
)

2.52Cancelled

(643,511
)

7.94Balance at December 31, 2001

5,370,147


7.82Granted

1,383,607


8.65Exercised

(378,017
)

2.37Cancelled

(769,620
)

9.82Balance at December 31, 2002

5,606,117


8.12Granted

4,362,150


4.27Exercised

(284,843
)

3.58Cancelled

(1,061,194
)

7.60Balance at December 31, 2003

8,622,230


6.39


F-21

---



The
following table summarizes information about stock options outstanding at December 31, 2003:

ExercisableWeighted-
Average
Remaining
Life

Weighted-
Average
Exercise
PriceRange of
Exercise Prices

Number
Outstanding

Number
of shares

Weighted-
Average
Exercise Price$0.20 - $  3.15

2,266,640

7.9 years

$
2.70

704,020

$
1.75$3.19 - $  5.69

2,368,516

9.3 years


4.65

159,815


5.27$5.82 - $  8.05

2,055,924

6.5 years


7.02

1,108,612


7.21$8.10 - $38.25

1,931,150

7.9 years


12.17

1,056,367


12.858,622,230

8.0 years


6.39

3,028,814


7.81


The
following are the fair values and assumptions used in calculating the pro forma option expense amounts under SFAS No. 123 which are disclosed in Note 1. The
weighted-average fair value of stock options granted during 2003, 2002, and 2001 was $2.31, $5.58 and $7.23 per share, respectively, on the date of grant using the Black-Scholes option-pricing model
with the following weighted-average assumptions: 2003volatility of 100%, expected dividend yield of 0%, risk-free interest rate of 2.37%, and an expected life of
2.8 years; 2002volatility of 120%, expected dividend yield of 0%, risk-free interest rate of 3.25%, and an expected life of 2.5 years;
2001volatility of 90%, expected dividend yield of 0%, risk-free interest rate of 4.5%, and an expected life of 7.5 years.

Director and Key Executive Stock Ownership Incentive PolicyIn December 2003, we adopted the Director and Key Executive
Stock Ownership Incentive Policy (the "Policy"). The Policy is intended to promote the interests of Witness and its stockholders by encouraging members of the Board of Directors and key executives to
purchase shares of our common stock. Under the Policy, an eligible person who purchases at least 500 shares and up to 3,000 shares of our common stock in the open market will be automatically and
immediately granted five options from our 1999 Plan for each share purchased, with an exercise price equal to the closing price of our common stock on the date of purchase. One half of the shares
purchased in the open market must be held for one year, and the balance must be held for two years. One-half of the options will vest on the first anniversary of the grant date, and the
remaining options will vest in 12 equal monthly installments thereafter. The Policy will remain in effect until March 15, 2004, unless extended by the Board of Directors. During 2003, 62,500
options were granted under this Policy.

Employee Stock Purchase PlanOur employee stock purchase plan ("ESPP") allows our employees to purchase shares of common stock
at a price per share that is 85% of the lesser of the fair market value as of the beginning or end of the semi-annual option period. The ESPP includes a provision to increase, without
further approval required, the number of shares authorized each year on January 1 by a number equal to the lesser of 2% of the total number of shares of common stock then outstanding or 900,000
shares. As of December 31, 2003, 339,217 shares of common stock have been issued under the ESPP.

The
following are the fair values and assumptions used in calculating the pro forma ESPP expense amounts under SFAS No. 123 which are disclosed in Note 1. The
weighted-average fair value of the employee's purchase rights under the ESPP granted during 2003, 2002 and 2001 was $1.74, $5.10 and $5.09 per share, respectively, using the Black-Scholes
option-pricing model with the same weighted-

F-22

---



average
assumptions as for the stock incentive plans except for the expected life assumption which was six months.

Retirement PlansWe have a U.S. tax-qualified defined contribution plan under Section 401(k) of the
Internal Revenue Code (the "401(k) Plan"). Employees are eligible to
participate the first of the month following their date of hire. The 401(k) Plan allows participants to contribute by salary reduction up to 20% of eligible compensation, subject to U.S. Internal
Revenue Service limitations. The 401(k) Plan also provides for discretionary employer matching contributions. We also have a personal savings plan ("Savings Plan") for our United Kingdom employees. In
accordance with the Inland Revenue limitations, employees are eligible to invest of up to 20% of base salary in the Savings Plan, which includes employer contributions ranging from 5% to 7%. We
contributed $0.6 million, $0.3 million and $0.3 million to the 401(k) Plan and Savings Plan in 2003, 2002 and 2001, respectively.

Stockholder's Rights PlanWe have a stockholder rights plan (the "Rights Plan") which has the effect of causing substantial
dilution to a person or group that attempts to acquire Witness on terms not approved by the Board of Directors. Under the Rights Plan, we issued a dividend of one right for each share of our common
stock, par value of $0.01 per share, held by stockholders of record as of the close of business on November 4, 2002. Each right will entitle stockholders to purchase one unit of a share of our
Series A Junior Participating Preferred Stock for $25.00. The rights generally will be exercisable only upon the occurrence of certain events, and will expire on November 4, 2012.

The
Rights Plan has no present dilutive effect on our capital structure, nor will it affect reported earnings per share or change the way our shares of common stock are traded. Neither
the adoption of the Rights Plan, nor the dividend distribution of the rights, was taxable to our shareholders or us.

13.   Income Taxes

The components of the provision for income taxes (all current) for 2003, 2002 and 2001 are as follows (in thousands):

2003

2002

2001Federal

$
(40
)
$
(32
)
$
52State








32Foreign


347


293


32Total

$
307

$
261

$
116


F-23

---



Income
tax expense (benefit) differed from the amounts computed by applying the statutory U.S. federal income tax rate of 34% to income (loss) before provision for income taxes as a
result of the following (in thousands):

|                                                    |                                                                         | Year ended December 31, |       
|--------------------------------------------------- | ----------------------------------------------------------------------- | ----------------------- | ------
|
|Computed "expected" tax expense (benefit)           |                                                                         | $                       | (6,889
|Increase (decrease) in income taxes resulting from: |                                                                         |                         |       
|                                                    | State income taxes, net of federal income taxes                         |                         |       
|                                                    | Nondeductible meals & entertainment                                     |                         |       
|                                                    | Other permanent differences                                             |                         |       
|                                                    | Income tax effect attributable to foreign operations at different rates |                         |       
|                                                    | Generation of research and experimentation credit carryforward          |                         |       
|                                                    | Increase in valuation allowance                                         |                         |       
|                                                    | Other, net                                                              |                         |       
|                                                    |                                                                         |                         |       
|                                                    |                                                                         | $                       | 307   
|                                                    |                                                                         |                         |       

The
income tax effects of temporary differences that give rise to significant portions our deferred income tax assets and liabilities are presented below (in thousands):

December 31,2003

2002Deferred income tax assets:Allowance for bad debts

$
538

$
449Accruals not deducted for tax


2,482


145Property and equipment, principally due to differences in depreciation


4,570


1,906Net operating loss and research and experimentation credit carryforwards


23,573


6,441Gross deferred income tax assets


31,163


8,941Less valuation allowance


(28,553
)

(8,941
)Net deferred income tax assets


2,610


Deferred income tax liabilities:Intangible assets


(5,807
)

$
3,197





The
net change in the valuation allowance for deferred income tax assets for 2003, 2002 and 2001 was an increase of $19.6 million, $0.4 million and $2.6 million,
respectively. We provide a valuation allowance on our deferred tax assets based on an assessment of the likelihood of their realization. In reaching our conclusion, we evaluated certain relevant
criteria including deferred tax liabilities that can be used to offset deferred tax assets, estimates of future taxable income of appropriate character within the carry forward period available under
the tax law, and tax planning strategies.

At
December 31, 2003, we had net operating loss and research and experimentation credit carryforwards for U.S. federal income tax purposes of $18.2 million and
$2.0 million, respectively, which

F-24

---



expire
in varying amounts beginning in the year 2014. We also have incurred foreign losses in the amount of $37.9 million as of December 31, 2003, which are available to offset future
taxable income in their respective foreign jurisdictions. These foreign losses expire in varying amounts beginning in 2005.

Included
in our U.S. net operating loss carryforward are tax deductions of approximately $4.0 million resulting from the exercise of stock options. We have established a valuation
allowance with respect to the tax benefit created by these tax deductions. In accordance with APB Opinion No. 25, any income tax benefit derived from these tax deductions will be reflected as
additional paid-in capital at the time we recognize any such income tax benefit.

Losses
before income taxes from foreign operations were $(4.0) million, $(0.8) million and $(2.6) million in 2003, 2002 and 2001, respectively. Income (losses) before income taxes from
U.S. operations were $(16.3) million, $1.1 million and ($2.5) million in 2003, 2002 and 2001, respectively.

14.   Segment and Geographic Information

We consider ourselves to be in a single industry segment, specifically licensing and servicing of software applications to the customer interaction recording and
analysis market. Our chief operating decision maker receives financial information by geographic region; however, our operating segments are aggregated into one reportable segment based upon similar
economic characteristics, products, services and delivery methods.

World-wide
annual revenue based on customer location is as follows (in thousands):

Year Ended December 31,2003

2002

2001United States

$
59,830

$
50,600

$
52,573United Kingdom


24,009


2,199


3,605Rest of world


24,198


14,887


6,344Total

$
108,037

$
67,686

$
62,522


The
rest of world revenue was derived primarily from customers located in Canada, Continental Europe, Mexico, Australia, China, India, Brazil and Japan. No individual customer accounted
for more than 10% of consolidated revenue during 2003, 2002 or 2001.

Long-lived
assets, including intangible assets, by geography are as follows (in thousands):

December 31,2003

2002United States

$
5,893

$
4,934United Kingdom


16,351


85Rest of World


3,980


223Total

$
26,224

$
5,242


15.   Related Party Transactions

Tom Crotty, a member of our Board of Directors, is a managing member of Battery Partners IV LLC, the general partner of Battery Ventures IV, and a managing member
of Battery Partners VI LLC, the general partner of Battery Ventures VI. Battery Ventures IV held more than 5% of our stock at

F-25

---



December 31,
2003 and holds less than 1% of our stock at the date of this report. Our CEO is a limited partner in Battery Ventures VI, L.P.

16.   Commitments and Contingencies

Operating CommitmentsWe lease office facilities, including our corporate headquarters, and certain
office furniture and equipment under various noncancelable operating lease agreements. Future minimum payments under these leases at December 31, 2003, are as follows (in thousands):

December 31,2004

$
6,2482005


5,6702006


4,6742007


4,0262008


1,406Thereafter


8,297$
30,321


Lease
expense for the years ended December 31, 2003, 2002, and 2001 was $5.6 million, $4.2 million and $4.4 million, respectively.

Legal ProceedingsFrom time to time we may be involved in legal proceedings and/or litigation arising in the ordinary course
of our business.

On
December 11, 2002, we filed in the United States District Court for the Northern District of Georgia, Atlanta Division, a lawsuit against Knowlagent, Inc.
("Knowlagent"), which is the assignee of the United States Patent Nos. 6,324,282 B1 and 6,459,787 B2. Knowlagent has accused our eQuality Now software suite of infringing the above patents. We filed
suit seeking a declaration that we did not and do not infringe either of the two patents listed above, as well as a declaration that the above patents are invalid and unenforceable. We also filed a
claim requesting that if the patents are found to be valid, that one of our own employees be named the rightful inventor of the patents. We also requested that monetary damages in an amount equal to
the amount that Knowlagent has received
from its use of the above patents. On December 31, 2002, Knowlagent filed its answer to our complaint as well as two counterclaims, alleging that we infringe and contribute to the infringement
by others of the above patents; Knowlagent seeks both monetary damages and an injunction in connection with its counterclaim. We are currently in the discovery phase of the lawsuit and, consequently,
an estimate of the potential outcome cannot be made. However, we do not believe the ultimate resolution will have a material adverse effect on our financial statements.

We
are not party to any other litigation or other legal proceedings that we believe could have a material adverse effect on our business, operating results or financial condition.

Indemnifications and WarrantiesWe more often than not indemnify our customers against damages and costs resulting from claims
of patent, copyright, or trademark infringement associated with use of our software in its software licensing agreements. We have historically not made any payments under such indemnifications.
However, we continue to monitor the conditions that are subject to the indemnifications to identify whether it is probable that a loss has occurred, and would recognize any such losses under the
indemnifications when those losses are estimable. In addition, we warrant to customers that our software products operate substantially in accordance with the software product's specifications.
Historically, no costs have been incurred related to software product warranties and none are expected in the future, and as such no accruals for warranty costs have been made.

F-26

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Schedule II

Valuation and Qualifying Accounts

|                                 |                              | Balance at
Beginning
of Year |   | Increases |  | Deductions |       | Balance at
End of Year
|-------------------------------- | ---------------------------- | ---------------------------- | - | --------- |  | ---------- | ----- | ----------------------
|Allowance for Doubtful Accounts: |                              |                              |   |           |  |            |       |                       
|                                 | Year ended December 31, 2003 |                              | $ | 1,339     |  | $          | 2,779 |                       
|                                 | Year ended December 31, 2002 |                              |   | 1,454     |  |            | 600   |                       
|                                 | Year ended December 31, 2001 |                              |   | 775       |  |            | 1,624 |                       
|Sales Allowances:                |                              |                              |   |           |  |            |       |                       
|                                 | Year ended December 31, 2003 |                              | $ | 235       |  | $          | 268   |                       
|                                 | Year ended December 31, 2002 |                              |   | 169       |  |            | 308   |                       
|                                 | Year ended December 31, 2001 |                              |   | 353       |  |            | 160   |                       

F-27

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Report of Independent Registered Public Accounting Firm on Schedule

The Board of Directors
Witness Systems, Inc.:

Under date of January 23, 2004, we reported on the consolidated balance sheets of Witness Systems, Inc. and subsidiaries as of December 31, 2003 and 2002, and the related consolidated
statements of operations, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2003, as contained in this Amendment No. 2 to the Annual
Report on Form 10-K/A for the year ended December 31, 2003. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related
consolidated financial statement schedule included in this Amendment No. 2 to the Annual Report on Form 10-K/A. This financial statement schedule is the responsibility of the Company's
management. Our responsibility is to express an opinion on this financial statement schedule based on our audits.

In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the
information set forth therein.

/s/KPMG LLP

Atlanta, Georgia

January 23, 2004

F-28

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