**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K/A**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe fiscal year ended December 31, 2005**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition periodfrom                to               **

**Commissionfile number 000-29335**

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**WITNESSSYSTEMS, INC.**

(Exact Name of Registrantas Specified in Its Charter)

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

 

Registrant’s telephone number, including area code **770-754-1900**

Securities registered pursuant toSection 12(b) of the Act:**None**

Securitiesregistered 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                                         |

 

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o  No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act. Yes o  No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x  No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amend-ment to thisForm 10-K. o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non- accelerated filer (as defined in Exchange ActRule 12b-2).
| Large accelerated filer o |   | Accelerated filer x |   | Non-accelerated filer o |
|--------------------------------|--------|---------------------|--------|-------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o   No x

The aggregate marketvalue of the voting stock held by non-affiliates of the registrant as ofJune 30, 2005 was 488.7 million. The number of shares of theregistrant’s common stock outstanding on February 28, 2006was 33,102,494

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**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of theregistrant’s definitive proxy statement for its annual meeting of stockholders,currently scheduled for May 18, 2006, are incorporated by reference inPart III of this report

 

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**EXPLANATORY NOTE**

We are amending our Annual Report on Form 10-K for theyear ended December 31, 2005 as filed on March 16, 2006 (the “Original Filing”)to restate our Consolidated Financial Statements for the years endedDecember 31, 2005, 2004, and 2003 and the related disclosures. Thisamended Annual Report on Form 10-K/A also includes the restatement of theselected consolidated financial data as of and for the years ended December 31,2005, 2004, 2003, 2002 and 2001, which is included in Item 6, and theunaudited quarterly financial data for each of the quarters in the years endedDecember 31, 2005 and 2004, which is included in Item 7.  See Note 2, “Restatement of ConsolidatedFinancial Statements,” of the Notes to the Consolidated Financial Statements fora detailed discussion of the effect of the restatement.

Beginning in late May 2006, the Company’s managementinitiated a preliminary internal review of the Company’s historical stockoption practices and related accounting treatment in response to general mediaattention concerning stock option grants at various public companies andshareholder interest with respect to this particular issue. On August 8, 2006,in response to the results of management’s preliminary internal review, ourBoard of Directors voluntarily formed a Special Committee of independentdirectors to review our stock option practices and grants during the periodbetween the date of the Company’s initial public offering on February 10, 2000and August 31, 2002.  The SpecialCommittee undertook its investigation with the assistance of independentcounsel and accounting experts retained by its counsel. The Special Committeereviewed all 5.7 million stock options granted throughout the period covered byits investigation. In December 2006, the Special Committee completed its reviewand reported its findings and recommendations to our full Board of Directors.The Special Committee did not find fraud or intentional misrepresentation inthe financial reporting of the option grants that it analyzed but foundinaccuracies in the determination of measurement dates for certain stock optiongrants affecting the Company’s accounting and disclosures. For a number ofthese grants, the Special Committee found that it was likely that the statedgrant date was selected in hindsight based on price given the lack ofsupporting documentation and that the option price was the low price in a givenmonth or quarter. Such grants were found to be present during 2000 and throughapproximately mid-year 2001. 

In addition to the Special Committee investigation,the Company, with the assistance of outside legal counsel, reviewed theCompany’s stock option practices and grants for the periods subsequent toAugust 31, 2002. This review evaluated 90 percent of the 11.1 million optionsgranted after August 31, 2002. This review did not find fraud or intentionalmisrepresentation in the financial reporting relating to option grants but dididentify errors in the determination of measurement dates. However, such errorswere relatively immaterial and did not exhibit evidence of selection of afavorable grant date and price in hindsight. 

The restatement of our Original Filing (Annual Reportfiled on March 16, 2006) reflected in this amended Annual Report on Form 10-K/Aincludes adjustments arising from the review performed by the Special Committeeand our internal review.

In those instances during the two review periods wherethe fair market value of our common stock at the originally stated grant datewas lower than the fair market value on the re-determined measurement date, weconcluded that approximately $9.7 million of additional stock-basedcompensation expense related to 4.6 million options of the 15.8 millionoptions reviewed should be recorded in accordance with Accounting PrinciplesBoard No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) andrelated interpretations. 

In connection with the restatement of our historical ConsolidatedFinancial Statements, we identified additional adjustments that needed to berecorded to our historical Consolidated Financial Statements. These adjustmentsconsisted primarily of purchase accounting relating to Blue Pumpkin, Inc.,income taxes and miscellaneous other items. These adjustments resulted in anincrease of approximately $1.0 million in the previously reported net lossin 2005.

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In connection with the restatement of stock-basedcompensation expense, we are also restating the pro forma disclosures forstock-based compensation expense required under Statement of FinancialAccounting Standard No. 123, Accounting for Stock–Based Compensation includedin Note 1 of the Notes to the Consolidated Financial Statements.

For more information on these matters, please refer toItem 7, “Management’s Discussion and Analysis of Financial Condition andResults of Operations;” Item 9A, “Controls and Procedures;” and Note 2 of theNotes to the Consolidated Financial Statements.

We have not amended, and we do not intend to amend,any of our other previously filed Annual Reports on Form 10-K for the periodsaffected by the restatement other than this Annual Report on Form 10-K/A forthe year ended December 31, 2005. As part of our review, we also determinedthat we need to amend our Quarterly Report on Form 10-Q for the quarter endedMarch 31, 2006 originally filed on May 9, 2006, which we are filingconcurrently with this Form 10-K/A. We have not amended and we do not intend toamend any of our other Quarterly Reports on Form 10-Q as a result of ourrestatement. For this reason, the Consolidated Financial Statements and relatedfinancial information contained in any related previously filed financialreports should no longer be relied upon. All of the information in this Form10-K/A is as of December 31, 2005 and does not reflect events occurring afterthe Original Filing, other than the restatement and subsequent events asdescribed in Note 17 to the Consolidated Financial Statements, or modifyor update disclosures (including the Exhibits to the Original Filing, exceptfor the updated Exhibits 31.1, 31.2, 32.1, and 32.2 described below).

For the convenience of the reader, this Form 10-K/Asets forth the Original Filing in its entirety, as amended by, and to reflect,the restatement. The following sections of this Form 10-K/A have been amendedto reflect the restatement.
| Part I—Item 1A—Risk Factors;                                                                                             |
|------------------------------------------------------------------------------------------------------------------------------------|
| Part I—Item 3—Legal  Proceedings, as to legal proceedings related to the stock option  investigation;                    |
| Part II—Item  5—Market for Our Common Equity and Related Shareholder Matters and Issuer  Purchases of Equity Securities; |
| Part II—Item 6—Selected  Consolidated Financial Data;                                                                    |
| Part II—Item  7—Management’s Discussion and Analysis of Financial Condition and Results of  Operations;             |
| Part II—Item  8—Financial Statements and Supplementary Data;                                                             |
| Part II—Item 9A—Controls and Procedures; and                                                                             |
| Part IV—Item  15—Exhibits and Financial Statement Schedules.                                                             |

 

This amended  Form 10-K/A should be read in conjunctionwith our periodic filings made with the Securities and Exchange Commission(“SEC”) subsequent to the date of the Original Filing, including any amendmentsto those filings, as well as any Current Reports filed on Form 8-K subsequentto the date of the Original Filing. In addition, in accordance with applicablerules and regulations promulgated by the SEC, this Form 10-K/A includes updatedcertifications from our Chief Executive Officer and Chief Financial Officer asExhibits 31.1, 31.2, 32.1 and 32.2. 

The SEC maydisagree with the manner in which we have accounted for and reported, or notreported, the financial impact of past option grant measurement dates errorsand there may be a risk that an inquiry by the SEC could lead to circumstancesin which we may have to further restate our prior financial statements, amendprior filings with the SEC, or take other actions not currently contemplated. Anysuch circumstance could also lead to future delays in filing our subsequent SECreports and the delisting of our common stock from the Nasdaq Stock Market.

**PART I**

**Item 1.**                          Business

This Annual Report on Form 10-K/A includes “forward-lookingstatements” within the meaning of the Private Securities Litigation Report Actof 1995, Section 27A of the Securities Act and Section 21E of theSecurities Exchange Act. Typically, these statements contain the words “believes,”“anticipates,” “intends,” “expects” or similar words. In any event, anyinformation or statements made that are not statements of historical fact areforward-looking statements. These forward-looking statements are based on anumber of assumptions and involve numerous risks and uncertainties. There are anumber of important factors that could cause our actual results to differmaterially from those indicated by these forward-looking statements, includingthe factors referred to in Item 1A of Part 1 of this report “RiskFactors” beginning on page 9.

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You should read the Business section inconjunction with Management’s Discussion and Analysis of Financial Conditionand Results of Operations and the Consolidated Financial Statements and Notesthereto included elsewhere in this report completely and with the understandingthat actual future results may be materially different from expectations. Allforward-looking statements made in this report are qualified by thesecautionary statements. You are cautioned that forward-looking statements arenot guarantees of future performance and are made only as the date of thisreport, and we undertake no obligation, other than as may be required by law,to update or revise these statements for any reason, including to reflectchanges in assumptions, the occurrence of unanticipated events or changes infuture operating results over time. Our actual results may differ materiallyfrom expectations.

**Overview**

We are a leading provider of workforce optimizationsoftware and services that enable companies to optimize workforce performancein their customer service operations. Our Impact 360 solution consists ofsoftware products and services designed to optimize the workforce, processesand technology involved in the customer service function. These solutions maybe deployed throughout a customer’s enterprise—including in contact centers,back offices and branch offices—to enable the customer to capture informationderived from contacts with its customers, analyze the information in relationto key performance indicators, act upon the information to improve the overallcustomer experience, and manage the staffing, training and performancemeasurement of its personnel involved in all aspects of customer service.

Our Impact 360 solution is an integrated offering ofsoftware products that provide comprehensive workforce optimizationfunctionality, including quality monitoring and high-volume compliancerecording, workforce management, performance management and electroniclearning, or e-learning. Our quality monitoring products record multimediainteractions, including traditional voice, Web chat and email, based onuser-defined business rules to enable our customers to evaluate theperformance of their customer service representatives, or “CSR”s, wherever theymay be located in the enterprise. Our high-volume compliance applications aredesigned to record highvolume, full-time performance of the voice conversations between CSRsand customers for purposes such as compliance recording and sales verification.Our workforce management products enable our customers to develop strategicstaffing plans, deploy skilled resources and evaluate productivity of CSRs. Ourperformance management applications provide comprehensive analytics, includingperformance scorecards, and reports of customer interaction and CSRperformance. Our e-learning applications deliver ongoing training tailored toCSR needs and competencies. We also provide consulting and implementationservices, training and support to customers that use our software products.

We have more than 2,000 customers, including more than60 Fortune 100 companies. Our solutions are used in a wide variety ofindustries worldwide, including financial services, communications services,manufacturing, utilities, retail, transportation, travel and outsourcing. Noindividual customer accounted for 10% or more of our revenue in 2005, 2004 or2003. We market and sell our products through both our direct sales force andthrough indirect channels. Our indirect sales channel includes reseller,distributor, original equipment manufacturer, or “OEM”, and similararrangements with key vendors in the contact center workforce optimizationmarket, such as Avaya, Cisco, Nortel and Siemens. We also have strategicrelationships with systems integrators, including Accenture, BritishTelecommunications and EDS.

**IndustryBackground and Trends**

The workforce optimization solutions market hasevolved in recent years to address the increasing challenges faced byenterprises in managing their customer service activities effectively. Theoverall goal of workforce optimization in the customer service function is toenable companies to balance the competing objectives of maximizing customersatisfaction and increasing revenue, while at the same time controllingcustomer service costs. Customer contact centers, help desks, and billing andorder fulfillment departments regularly represent the key focal points forpersonal interaction between a business and its customers, making theeffectiveness of the CSRs critical to the overall success of the business.

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We believe several key trends are driving theworkforce optimization market, including:

*Voiceover Internet Protocol (“VoIP”) technologies.**  *The convergence of voice and datacommunications technologies, most notably through the rapid adoption of VoIP,is changing the landscape of telecommunications infrastructure. VoIP, or IPtelephony, is a software-based technology that enables the conversion of voicecommunications into data packets that can be routed over any IP-based network,as opposed to traditional circuit-switched voice transmission lines. Manycompanies are replacing legacy analog voice infrastructures in their contactcenters with VoIP telephony infrastructure to realize the many benefits ofIP-based communications, including reduced costs and enablement of advancedbusiness communication applications. These equipment upgrades typically requirenew deployments of workforce optimization solutions designed to support IPenvironments. VoIP applications also permit the customer service function toextend beyond traditional contact centers by facilitating easier access tocustomer interaction information.

*Softwaresolutions running on open systems.**  *Organizations are increasinglyseeking to deploy information technology and business software applicationsbased on open standards that run on commercially available, non-proprietaryhardware. The use of open systems, as opposed to applications that run onproprietary hardware systems offered by a single vendor, generally provides forlower cost of ownership and greater flexibility in their information technologyinfrastructures.

*Integrationof workforce optimization applications.**  *Increasingly, companies worldwideare seeking an integrated offering of workforce optimization applications,including quality monitoring and high-volume compliance recording, workforcemanagement, performance management and e-learning. By integrating theseapplications, an enterprise can reduce costs by eliminating duplicativehardware, streamlining implementation and reducing administration requirements.Integration also makes the applications easier to use through a single unifiedgraphical user interface. Most important, by integrating these applicationsunder one framework, enterprises gain the ability to manage their workforceperformance in a closed loop, including evaluating and analyzing completecustomer interactions through multiple media, identifying opportunities and performancegaps, scheduling personnel based on strengths and weaknesses, applying targetedinstruction for continuous improvement, integrating instruction into aworkforce schedule, and compensating employees based on actual performance.

*Increasingcomplexity of customer service operations.**  *Customer service operations at manyorganizations have become increasingly complex, driven by the demand for highlyavailable and effective customer service. For example, contact centers havebecome the primary points of customer contact for organizations, as the contactcenters have evolved from providing solely inbound customer support to handlingsupport, service, sales, bill payment and numerous other customer interactions.Organizations are facilitating customer service interactions across multiplemedia, including traditional voice, Web chat, instant messaging, guided browsersessions and e-mail, and are therefore challenged to maintain a consistentlyhigh level of customer service across all media channels. Moreover, as a resultof recent trends toward offshore and outsourced contact center operations,managing and optimizing the quality of customer interactions has become moreimportant, and more difficult, than ever.

**Impact 360**

Impact 360, our integrated workforce optimizationsolution, enables organizations to capture, analyze and act on cross-functionalinformation concerning workforce performance, customer interactions andcustomer service processes. Impact 360 offers a unified framework for workforceoptimization that provides organizations a holistic view of performance andenables them to leverage this information to provide more effective andefficient customer service. Our new solutions framework supports bothtraditional time division multiplexing, or TDM, switch environments and IPtelephony environments and executes on standard operating systems and hardwareplatforms.

The integrated components of our workforceoptimization solution encompass quality monitoring and high-volume compliancerecording, workforce management, performance management and e-learning. Impact360 is available as a fully integrated solution, in specific packages or asseparate applications. Impact 360 provides numerous benefits to our customers,including reduced infrastructure costs, rapid implementation and central

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administration. Moreimportantly, shared access to information across all functions in the customerservice value chain enables our customers to make informed decisions that cangenerate cost savings, improve decision making and increase competitiveadvantages. We also offer related consulting and implementation services,training and support.

The components of our solution include:

*Qualitymonitoring and high-volume compliance recording.**  *Our recording solutions enable therecording of a CSR’s multimedia interactions with a customer throughtraditional voice, Web chat, instant messaging, guided browser sessions ande-mail. The CSR’s voice interaction with a customer can be synchronized withthe CSR’s corresponding computer desktop activities, such as data entry, screennavigation and data retrieval, for review and analysis by supervisors. Qualitymonitoring selectively records interactions based on user-defined businessrules, while high-volume compliance recording stores all interactions betweenan organization’s CSRs and its customers for purposes such as legal orregulatory compliance and sales verification. Our solutions enable companies toevaluate the performance of CSRs, analyze the effectiveness of supportingsystems and enhance the quality of service being delivered.

*Workforcemanagement.**  *Ourworkforce management solutions simplify the task of forecasting and scheduling,enabling contact centers to balance cost, service level and agent preferences.Users can analyze historical data to forecast future interaction volumes andservice handle times in order to schedule the optimal number of agents, withthe required skill sets, at the necessary times. As a result, organizations canreduce costs by staffing appropriately to meet workload demands, drive businessgrowth, and improve employee effectiveness and retention.

*Performancemanagement.**  *Ourperformance management solutions provide comprehensive analysis of customerinteraction and CSR performance. Leveraging performance scorecards withindustry-accepted and user-defined key performance indicators, these solutionscombine data derived from our evaluation application with data from otherbusiness systems, such as customer relationship management software, enterpriseresource planning software and integrated telephony applications. Our solutionalso offers data visualization, search capabilities and speech analytics. Usingour solutions, supervisors can obtain a quick, streamlined view of performancerelative to strategic organizational objectives. The reporting, dynamicanalysis and performance scorecard capabilities of these solutions provideorganizations with business intelligence that can lead to increased revenue,heightened service quality and improved operational efficiencies.

*E-learning.**  *Our e-learning solutions deliverongoing training tailored to CSR competencies in order to achieve continuousperformance improvement. The e-learning management software tracks trainingcompletion and compiles transcripts to enhance CSR skills. When the e-learningapplications are integrated with other Impact 360 components, a supervisor canreview a recorded customer interaction, evaluate the CSR’s performance andprioritize customized training and lesson plans for the CSR. Our solutionenables targeted learning content to be delivered directly to a CSR’s desktopthrough a series of standardized lessons or customized lessons created fromrecorded interactions. E-learning can enable companies to reduce employeeturnover and to build customer loyalty through a more highly skilled andmotivated workforce.

**Customer 360**

Customer 360 is our approach to services, training andsupport services that accompany our Impact 360 solutions. Our service andsupport offerings are designed to enable our customers to achieve a rapidreturn on investment and realize the maximum benefit our solutions provide byenabling organizations to optimize their contact center operations. Ourservices consist of implementation services, training, business consulting andcustomer support.

The initial implementation engagement for our Impact360 solutions is typically completed within 30 to 60 days from the start dateof the implementation phase. Training services provide the skills and knowledgenecessary to enable business and technical users to utilize the Impact 360solutions. Training is provided at our global training centers, on-site at thecustomers’ location or via our web-based education and training

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management system. Inaddition, we offer customized training programs tailored to the specific needsof our customers.

Our business consulting services are designed to helpcustomers gain the most value from the Impact 360 solution to optimize thepeople, processes and technology deployed throughout their contact centeroperations.  We achieve this through aseries of workshops that focus on specific contact center business processes,performance optimization, calibration techniques, business utilization,business rules development and high-impact coaching.

The Customer 360 support operation provides customersupport services including access to major and minor releases, service packs andhot fixes, remote diagnostics and installation. Customer support is offered intwo distinct plans with services that range from 12 hour phone access Mondaythrough Friday to 24 hours, 7 days a week. We provide support services via thetelephone, e-mail and via an on-line knowledgebase of product-relatedinformation.

**Our Strategy**

Our objective is to be a leading provider of workforceoptimization software and services to help global enterprises improve allaspects of customer service, from contact center customer interactions toremote and branch offices and underlying back office processes. Key elements ofour strategy include the following:

*Extendthe breadth and depth of the Impact 360 solution.*   Webelieve Impact 360 provides today’s most comprehensive, integrated offering ofworkforce optimization products designed to manage, analyze and improve thecustomer service function. We intend to continue investing in research anddevelopment to enhance the functionality, effectiveness and ease of use of ourImpact 360 solution, as well as to expand the number of third-partyapplications with which our software can readily integrate.

*Maximizesales to existing customers.**  *We have a large installed base of customers, many ofwhich currently utilize only a subset of our workforce optimization products orhave not deployed our products in all of their contact centers or elsewherethroughout their customer service operations. We believe these customers representa significant opportunity for us to generate additional sales of complementaryproducts and services. Impact 360 has been designed to enable cross-selling andupselling of additional products to customers already utilizing our software.During 2005, approximately 75% of our license revenue was generated by sales toexisting customers.

*Capitalizeon the growing adoption of VoIP.**  *Our Impact 360 solution fullysupports VoIP telephony infrastructure. As companies upgrade to VoIP telephonyinfrastructure in their customer service operations, they will typically needto upgrade their workforce optimization solutions. This dynamic provides uswith a unique opportunity to displace competitive solutions with Impact 360,and we intend to aggressively pursue companies engaging in telephonyinfrastructure upgrades. In addition, because VoIP provides small andmedium-sized businesses with a new opportunity to deploy workforce optimizationsolutions at a more reasonable price, we have the opportunity to sell Impact 360to a segment of the market that has historically been unable to afford thesesolutions. In order to address this opportunity, we have created a version ofImpact 360 specifically designed to meet the needs of small and medium-sizedbusinesses.

*Expandour indirect sales channel.**  *Historically, the majority of our sales have beendriven by our direct sales force. In recent years, we have significantlybolstered our indirect sales channel through reseller, distributor and OEMarrangements with key hardware and service providers in the contact centermarket. For example, Avaya, an OEM provider, bundles our workforce optimizationsoftware products with sales of its converged communications (TDM and IP)infrastructure hardware solutions. We have also announced a similar OEMagreement with Nortel. We are also seeking to expand our relationships with andamong systems integrators. In addition to broadening our overall salesleverage, we believe these channel partnerships provide an efficient means toenable us to penetrate one of the fastest growing segments in the contactcenter industry, the small and medium-sized business segment.

*Expandour business through strategic acquisitions.**  *We intend to pursue acquisitions ofbusinesses, technologies and products that will complement our existingoperations and enhance our position in the

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workforce optimizationmarket. Since 2003, we have completed two significant acquisitions. In 2003 weacquired Eyretel Plc, which strengthened our market presence internationallyand expanded our capabilities in the compliance recording market, and in 2005we acquired Blue Pumpkin Software, Inc. a leading provider of workforcemanagement products.

**Research andDevelopment**

We believe our software development capabilities areessential to our strategy of enhancing our core technology, developingadditional applications, incorporating that technology and maintaining thecompetitiveness of our software. We devote a substantial portion of ourresources to developing new software and features, extending and improving oursoftware technology, debugging and quality testing our products and researchingnew technological initiatives in our market. We believe that our future successdepends in part upon our ability to continue to enhance existing software,respond to changing customer requirements and develop and introduce new orenhanced software that incorporates new technological developments and emergingindustry standards.

As of December 31, 2005, we had 270 associates(including over 176 contractors in Asia) engaged in research and developmentactivities. Research and development expenditures, exclusive of acquiredin-process research and development, for the years ended December 31,2005, 2004 and 2003 were $26.7 million, $20.8 million and $18.3 million,respectively. We anticipate our research and development costs as a percentageof total revenue will decrease in 2006 as compared to 2005.

**Competition**

Our software andservices compete in the emerging market for products that record and analyzecustomer interactions and provide electronic learning applications. This marketis intensely competitive and experiences rapid changes in technology. Webelieve that we compete effectively and that we enjoy a competitive advantagebased upon:

(1)                         thefunctionality and quality of our products,

(2)                         the easeof use and ability of our products to operate with a variety of hardware andsoftware products,

(3)                         ourability as a single vendor to offer a full suite of applications,

(4)                         ourability to implement our products quickly,

(5)                         the responsivenessof our customer support, and

(6)                         ourreputation in the marketplace.

Our competitorsinclude:

·               traditionalcall-logging vendors;

·               qualitymonitoring suppliers to the contact center industry;

·               workforcemanagement, forecasting and scheduling vendors to the call center industry;

·               electroniclearning vendors;

·               businessanalytics vendors;

·               largetelecom solution providers;

·               enterprisesoftware vendors;

·               systemsintegrators and consulting firms; and

·               new,larger and more established entities that may acquire, invest in or form jointventures with providers of recording or performance enhancing softwaresolutions.

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In addition, we have developed, and intend to continueto develop, relationships with companies that resell our software, companiesthat integrate the software with their technology and products and companiesthat provide us with customer referrals or leads. Some of these companies havesimilar, and often more established, relationships with our competitors, andmay recommend the products and services of competitors to customers instead ofour software and services. In addition, through their relationships with us,these companies could learn about our software and the market for our softwareand services and could develop and sell competing products and services.

The principalcompetitive factors in our market include:

·    product performance, reliability andfeatures;

·    ability to effectively integrate productsinto customers’ environments;

·    user scalability and open architecture;

·    third-party integration;

·    quality and speed of product implementation;

·    ease-of-use for customers;

·    analytic capabilities of the product;

·    how quickly new products and productenhancements can be brought to market;

·    customer support; and

·    pricing of products and services.

Our success will depend on our ability to competeeffectively based on these factors. Further, we expect that competition willincrease as other established and emerging companies enter our market and asnew products, services and technologies are introduced. Increased competitionmay result in price reductions, lower gross margins and loss of market share.This could materially and adversely affect our business, financial conditionand results of operations.

**Proprietary Rights**

*General.**  *Our success depends to asignificant degree on the legal protection of our software and otherproprietary technology rights. We rely on a combination of patent, tradesecret, copyright and trademark laws and confidentiality and non-disclosureagreements with employees and third parties to establish and protect ourproprietary rights. These measures may not be sufficient to protect proprietaryrights, and we cannot be certain that third parties will not misappropriate ourtechnology and use it for their own benefit. Also, most of these protections donot preclude our competitors from independently developing products withfunctionality or features substantially equivalent or superior to our software.Any failure to protect our intellectual property could have a material adverseeffect on our business.

*Licenses.**  *Our licenses are designed toprohibit unauthorized use, copying and disclosure of our software technology.When we license our software to customers, we require license agreementscontaining confidentiality terms customary in the industry in order to protectour proprietary rights in the software. These agreements generally warrant thatthe software will materially comply with written documentation. We assert thatwe own the software we distribute and have not violated the intellectualproperty rights of others. We license our products in a format that does notpermit the users to change the software code. In addition, because we treat thesource code for our products as a trade secret, all employees and third partieswho require access to the source code are first required to sign non-disclosureagreements.

*Patents.**  *As of December 31, 2005, wehad nine****U.S. and three international patentsWe cannot assure you that we will file new patent, trademark or copyrightapplications, that any future applications will be approved, 

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that any existing orfuture patents, trademarks or copyrights will adequately protect ourintellectual property or that any existing or future patents, trademarks orcopyrights will not be challenged by third parties.

*Trademarksand service marks.**  *Asof December 31, 2005, we had eight registered trademarks in the U.S. Wealso claim common law protections for other marks we use in our business.Competitors and other companies could adopt similar marks, or try to prevent usfrom using our marks, consequently impeding our ability to build brand identityand possibly leading to customer confusion. 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 30, 2002issuance of the U.S. registration for our trademark eQuality®. It is possiblethat the owner of legal rights resulting from one or more of these prior uses,U.S. trademark registrations, or U.S. trademark applications will bring legalaction to challenge our registration of and/or our continued use of thetrademark eQuality®, and may also seek compensation for damages resulting fromour use of our registered trademark if such challenging party prevails on sucha claim. As a result, we cannot assure you that our registration of thistrademark will be undisturbed, or that this use will not result in liabilityfor trademark infringement, trademark dilution, and/or unfair competition.

**Availability ofReports and Other Information.**

Our corporate Web site is *http://www.witness.com*. We make available on this Web site,free of charge, access to our Annual Reports on Forms 10-K and 10-K/A,Quarterly Reports on Forms 10-Q and 10-Q/A, Current Reports on Form 8-K,Proxy Statement on Schedule 14A and amendments to those materials filed orfurnished pursuant to Section 13(a) or 15(d) of the Securitiesand Exchange Act of 1934 as soon as reasonably practicable after weelectronically submit such materials to the Securities and Exchange Commission.In addition, the Commission’s Web site is *http://www.sec.gov.*The Commission makes available on its Web site, free of charge, reports, proxyand information statements, and other information regarding issuers, such asus, that file electronically with the Commission. Information provided on ourWeb site or on the Commission’s Web site is not part of this Annual Report onForm 10-K/A.

**Item1A.**                 RiskFactors

Our future operating results may vary substantiallyfrom period to period. The price of our common stock will fluctuate in thefuture, 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 experiencelosses depending on the prices at which they purchase and sell our securities.Prospective and existing investors should consider the following factors inevaluating our business or an investment in our securities. If any of thefollowing or other risks actually occurs, our business, financial condition andresults of operations could be adversely affected. In that case, the tradingprice of our common stock could decline.

*SECInquiry and Litigation Relating to Stock Options.*

Although a SpecialCommittee of our independent directors has completed its review of our stockoption grants and practices in the period between February 10, 2000 and August31, 2002 and management has completed its review of our option grants afterthat period, an informal inquiry by the SEC relating to our stock optiongranting practices remains pending, as does derivative and class actionlitigation against the Company and certain of its directors and officers.Although we believe that we have made appropriate corrections to theConsolidated Financial Statements set forth in this report for matters relatingto stock options, we cannot rule out the possibility that these proceedings mayrequire further adjustments to the financial results and other disclosures setforth in this report. In addition, these proceedings are likely to result inadditional legal expense that may affect our results in future periods, and mayalso result in diversion of management attention and other resources, as wellas fines, penalties, damages and other sanctions. These eventualities couldmaterially and adversely affect our business and results of operations. We cannot currently predict the ultimate outcome of these proceedings.

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*If we do not maintain compliancewith the listing requirements of the Nasdaq Stock Market, our common stockcould be delisted, which could, among other things, reduce the price of ourcommon stock and the levels of liquidity available to our stockholders.*

In connection with the Special Committee’s review andthe restatement of our Consolidated Financial Statements, we did nottimely file certain of our periodic reports with the SEC.  As a result, wewere not in compliance with the listing requirements under the Nasdaq StockMarket Rules. Following a review and hearing process with the Nasdaq StockMarket, the Nasdaq Stock Market has permitted our securities to remainlisted. However, our securities could be delisted in the future if we do notmaintain compliance with applicable listing requirements. If our securities aredelisted from the Nasdaq Stock Market, they would subsequently be transferredto the National Quotation Service Bureau, or “Pink Sheets”. The trading of ourcommon stock through the Pink Sheets may reduce the price of our commonstock and the levels of liquidity available to our stockholders. In addition,the trading of our common stock through the Pink Sheets couldmaterially and adversely affect our access to the capital markets and ourability to raise capital through alternative financing sources on termsacceptable to us, or to raise capital at all. Securities thattrade through the Pink Sheets are no longer eligible for margin loans, anda company trading through the Pink Sheets cannot avail itself of federalpreemption of state securities or “blue sky” laws, which adds substantialcompliance costs to securities issuances, including pursuant to employee optionplans, stock purchase plans and private or public offerings of securities. Ifwe are delisted in the future from the Nasdaq Stock Market and transferred tothe Pink Sheets, there could also be other negative implications,including the potential loss of confidence by suppliers, customers andemployees and the loss of institutional investor interest in our Company.

*Because ourproducts have a long sales cycle, it is more difficult to plan our expenses andforecast our results; and our operating results may fail to meet investorexpectations and may fluctuate materially from period to period, which mayadversely affect our stock price.*

It typically takes three to nine months from the timewe qualify a sales lead until we sign a sales contract with the customer. As aresult, it is difficult for us to predict the quarter in which a particularsale will occur. If our sales cycle unexpectedly lengthens for one or morelarge orders or a significant number of small orders, it would delay the timingof our revenue, but not the timing of most of our corresponding expenses.Lengthening of our sales cycle could also increase the total cost of a sale dueto additional employee time and costs associated with the sale. Materialchanges in our sales cycle could cause our quarterly revenue or operatingresults to be below the expectations of investors, and the price of our commonstock could fall substantially.

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

·       the complex nature of ourproducts, requiring our need to educate potential customers about the uses andbenefits of our products;

·       competition for thecorporate resources necessary to finance the purchase and implementation of ourproducts;

·       customers’ budgeting andpurchasing cycles;

·       economic factors;

·       the extent of customers’evaluation and internal approval process often required before purchasing ourproducts and services; and

·       delayed purchases due toannouncements of new products or enhancements by our competitors or us.

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

The market forworkforce optimization software, including software that records and analyzescustomer interactions and that forecasts and schedules employees, is stilldeveloping. Our success depends on the use and acceptance of our software andservices by existing and prospective customers. In addition, demand for oursoftware remains uncertain because our existing and potential customers may:

·       not understand the benefitsof using workforce optimization software generally or, more specifically,software which records and analyzes the interactions between a business and itscustomers or which optimizes the forecasting and scheduling of employees;

·       not achieve favorableresults using our software;

·       experience technicaldifficulty in implementing our software;

·       use alternative methodssuch as online self-help to solve the same business problems our software isintended to address; or

·       close contact centers.

*If we experiencelosses in the future, the market price of our common stock may be materiallyand adversely affected.*

Throughout much of our history, we have experiencedlosses. As a result of our prior operating losses, we had an accumulateddeficit of $52.8 million as of December 31, 2005. We need to generatesufficient revenue to achieve sustained profitability and avoid incurringlosses again in the future.

*Our quarterlyresults are difficult to predict and adverse fluctuations in operating resultscould cause our stock price to fall.*

Our quarterlyrevenue and operating results are difficult to predict and could fluctuatesignificantly from period to period. In particular, we typically derive asignificant portion of our software product revenue toward the end of eachquarter and from a small number of relatively large orders. The delay orfailure to close anticipated sales in a particular quarter could reduce ourrevenue in that quarter and subsequent quarters over which revenue for the salecould be recognized. In addition, because our revenue from installation andtraining services largely correlates with our product revenue, a decline inproduct revenue could also cause a decline in our professional services revenuein the same quarter or in subsequent quarters. Our quarterly revenue isdifficult to forecast for several reasons, including the following:

·       changes in demand for ourproducts and services;

·       the tendency of customersto delay software purchases until the end of the fiscal quarter;

·       lengthening of ourcustomers’ budgeting and purchasing cycles;

·       timing of any acquisitionsand related costs;

·       delays in installations ofour software;

·       varying sales andimplementation cycles for our products and services from customer to customer;

·       the failure of ourcustomers to renew their maintenance service agreements;

·       the timing of hiring newservices employees and the rate at which these employees become productive; and

·       the development andperformance of our distribution channels.

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As a result of these and other factors, we believethat quarter-to-quarter comparisons of our operating results may not be a goodindicator of our future performance, and you should not rely on them to predictour future performance or the performance of our stock price. If our revenue oroperating results fall below the expectations of investors or securitiesanalysts, the price of our common stock would likely decline.

*We may be unableto manage and expand our international operations, which may adversely affectour business and operating results.*

We derived revenues of $84.6 million and$68.1 million in 2005 and 2004, respectively, from customers locatedoutside the United States. Our operations outside of the United States atDecember 31, 2005, consisted of operations located in Australia, Brazil, Canada,China, Germany, India, Japan, Mexico, the Netherlands, Singapore, South Africaand the United Kingdom. We have also established relationships with a number ofinternational resellers.

With ouracquisitions of Blue Pumpkin in January 2005 and Optimis in May 2005both of which have sales outside of North America, we have expanded ourinternational operations, and we intend to continue to expand our internationaloperations through additional acquisitions, internal business expansion andstrategic business relationships. These efforts require significant managementattention and financial resources. We may not be able to successfully penetrateinternational markets or, if we do, we may not be able to grow or to maintainadequate profit margins in these markets. Because of the complex nature of ourinternational expansion, it may adversely affect our business and operatingresults. International expansion and sales are subject to many risks, includingthe following:

·       limited development of aninternational market for our software and services;

·       expanding and training ourinternational sales force and support operations;

·       higher costs of employmentin certain international locations;

·       difficulties in producinglocalized versions of our products;

·       political and economicinstability;

·       potentially adverse taxconsequences of operating in foreign countries;

·       import and exportrestrictions and tariffs;

 ·    longer payment cycles anddifficulties in collecting accounts receivable;

·       currency fluctuations;

·       cultural differences whichmay affect workforce performance and sales processes;

·       difficulties and expensesassociated with complying with a variety of foreign laws; and

·       unexpected changes inregulatory requirements.

As we further expand our operations outside the UnitedStates, we will also face new competitors and competitive environments. Inaddition to the risks associated with our domestic competitors, foreigncompetitors may pose an even greater risk, because they may possess a betterunderstanding of their local markets and have better working relationships withlocal infrastructure providers and others. In particular, because telephoneprotocols and standards are unique to each country, local competitors will havemore experience with, and may have a competitive advantage in, these markets.We may not be able to obtain similar levels of knowledge, which could place usat a significant competitive disadvantage. In addition, we have limitedexperience in developing local language versions of our products or inmarketing our products to international customers. We may not be able tosuccessfully translate, market, sell, and deliver our products internationally.

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*If we are unableto maintain a productive direct sales force, our business and operating resultscould be adversely affected.*

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

*If we are unableto expand the distribution of our products through indirect sales channels, ourbusiness and operating results could be materially adversely affected.*

Our strategy is to continue to increase the proportionof customers served through indirect sales channels, such as select resellersand a variety of strategic marketing alliances. Product revenue, excludinghardware revenue, from our indirect sales channel represented approximately 41%and 32% of total product revenue in 2005 and 2004, respectively. We expectrevenue from our indirect sales channel and, accordingly, our dependence ondistribution partners, to increase as we establish relationships with companiesto resell our software worldwide. We cannot assure you that we will be able tomaintain productive relationships with our current partners, or that we will beable to establish similar relationships with additional resellers on a timelybasis, if at all.

Some resellers with which we do business have similar,and often more established, relationships with our competitors, and mayrecommend the products and services of our competitors to customers instead ofour software and services. We cannot provide assurance that these distributionpartners will devote adequate resources to selling our software and services orthat our resellers may not learn about our products and the market for oursoftware and services and develop and sell competing products and services. Asa result, our relationships with resellers could lead to increased competitionfor us.

*Competition in ourbusiness could adversely affect our revenue, profitability and market share.*

The market forproducts that record customer interactions, forecast and schedule employees,analyze performance and/or provide electronic learning is intenselycompetitive, evolving and is subject to rapid changes in technology. We believeour principal competitors include, but are not limited to:

·       traditional call-loggingvendors;

·       quality monitoring suppliersto the contact center industry;

·       workforce management,forecasting and scheduling vendors to the call center industry;

·       electronic learningvendors;

·       business analytics vendors;

·       large telecom solutionproviders;

·       enterprise software vendors;

·       systems integrators andconsulting firms; and

·       new, larger and moreestablished entities that may acquire, invest in or form joint ventures withproviders of recording or performance enhancing software solutions.

Many of our current and potential competitors havelonger operating histories, more established business relationships, largercustomer bases, a broader range of products and services, greater namerecognition and substantially greater financial, technical, marketing,personnel, management, service, support and other resources than we do. As aresult, our current and potential competitors may be able to respond morequickly to new or

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emerging technologies andchanges in customer requirements, take better advantage of acquisitions andother opportunities, devote greater resources to marketing and selling theirproducts and services and adopt more aggressive pricing policies. We cannotassure you that our current or potential competitors will not develop productscomparable or superior in terms of price and performance features to thosedeveloped by us.

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

We expect that competition will increase as otherestablished and emerging companies enter our market and as new products,services and technologies are introduced. Increased competition may result inprice reductions, lower gross margins and loss of market share, any of whichcould materially and adversely affect our business, financial condition andresults of operations.

*Our heavy relianceon sales of our quality monitoring and workforce management software exposes usto risks of obsolescence due to changes in competitive product offerings.*

We have derived a substantial portion of our productrevenues from sales of our quality monitoring and workforce management softwareproducts. We expect revenue from these products to continue to account for asignificant portion of our revenue for the foreseeable future. As a result, anyfactors affecting the markets for these products could materially and adverselyaffect our business, financial condition and results of operations. We cannotassure you that the market will continue to demand our current products or thatwe will be successful in marketing any new or enhanced products. If ourcompetitors release new products that are superior to our products inperformance or price, demand for our products may decline. A decline in demandfor our products as a result of competition, technological change or otherfactors would reduce our total revenues and adversely affect profitability.

*If we fail todevelop new software or improve our existing software, we may not be able toremain competitive.*

The markets for our products are characterized byrapidly changing technology, frequent new product introductions andenhancements, changes in customer demands and evolving industry standards. Ourexisting products could be rendered obsolete if we fail to continue to advanceour technology. We have also found that the technological life cycles of ourproducts are difficult to estimate, partially because of changing demands ofour customers. We believe that our future success will depend on our ability tocontinue to enhance our current product line while we concurrently develop andintroduce new products that keep pace with competitive and technologicaldevelopments. These developments require us to anticipate customers’ futureneeds and to continue to make substantial product development investments.Although we are presently developing a number of product enhancements to ourproduct suites, we cannot assure you that these enhancements will be completedon a timely basis or gain customer acceptance. In addition, failure to developnew software or improve existing software products may adversely affect ourability to maintain our maintenance renewal rate which could adversely affectour revenue.

We have recently introduced Impact 360, which combinesa new software architecture with new combinations of our products. Our businessconcept in doing so is to create incremental value for our customers and to winbusiness away from competitors whose product offerings are more limited andrequire the customer to make additional hardware purchases to obtain thesolutions that our Impact 360 product offering provides in an integrated suite.While we plan and expect that this lower total cost of ownership will be wellreceived in the marketplace, we can offer no assurance that our new Impact 360offering will be successful. If our Impact 360 product offerings do not meetwith commercial success, our business would be materially and adverselyaffected.

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

We have expandedour software development capabilities in the Asia-Pacific region in order tooptimize available research and development resources and better meetdevelopment timeframes. We have limited experience with remote softwaredevelopment activities. Accordingly, there are a number of risks associatedwith this activity, including:

·       delays or product errorsdue to miscommunication between our local development organization and theremote

·       development personnelaffected by time, distance and language differences;

·       scheduling delays due tolengthy ramp-up time for our new development personnel;

·       products produced in theAsia-Pacific region that fail to meet our quality requirements;

·       high voluntary personnelturnover; and

·       foreign employment andlabor laws with which we are not familiar.

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

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

Our software is used in a complex operatingenvironment that requires its integration with computer and telephone networksand other business software applications. If our products fail to function asrequired, we may be subject to claims for substantial damages. Courts may notenforce provisions in our contracts that would limit our liability or otherwiseprotect us from liability for damages. Although we maintain general liabilityinsurance coverage, including coverage for errors or omissions, this coveragemay not continue to be available on reasonable terms or in sufficient amountsto cover claims against us. In addition, our insurer may disclaim coverage asto any future claim. If claims exceeding the available insurance coverage aresuccessfully asserted against us, or our insurer imposes premium increases,large deductibles or co-insurance requirements on us, our business, financialposition, and results of operations could be adversely affected.

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*If an originalequipment manufacturer that is part of our indirect sales channel experiencestechnical difficulties, our product sales through that channel may be adverselyaffected.*

Our indirect sales channel accounts foran increasingly large share of our total sales. When we sell our softwarethrough an original equipment manufacturer, or OEM, our software is embedded inthe OEM’s product, which we sometimes refer to as the ‘environment’ for oursoftware. When the OEM’s product uses our software, there is a risk that the ‘environment’will fail or that it will not achieve the compatibility with our product thatwe and the OEM seek. If this happens, our software might not function properly,or the OEM might sell less of it, or both, which could have a material adverseeffect on our revenues, operating cash flows and the growth of ourbusiness.

*Our software maycontain undetected errors or “bugs,” resulting in harm to our reputation andoperating results.*

Software products as complex as those offered by usmight contain undetected errors or failures when first introduced or when newversions are released. We cannot assure you, despite testing by us and bycurrent and prospective customers, that errors will not be found in newproducts or product enhancements after commercial release. Any errors found maycause substantial harm to our reputation and result in a loss in revenue andadditional unplanned expenses to remedy any defects.

*If our advancedcompliance recording applications fail to record high volume, full-timeperformance of the voice conversation of our customers’ interactions, we may besubject to liability and our reputation may be harmed.*

Many of our customers use our advanced compliancerecording applications to record and store interactions with customers toprovide back-up and verification of transactions and to guard against risksposed by lost or misinterpreted voice communications. These customers rely onour applications to record, store and retrieve voice data in a timely, reliableand efficient manner. If our applications fail to record high volume, full-timeperformance of the voice conversation of our customers’interactions or ourcustomers are unable to retrieve the recordings when necessary, we may besubject to liability and our reputation may be harmed.

*If we are unableto maintain the security of our systems, our business, financial condition andoperating results could be harmed.*

The occurrence or perception of security breaches inthe operation of our business or suffered by third parties using our productscould harm our business, financial condition and operating results. Ourcustomers use our products to compile and analyze highly sensitive orconfidential information. We may come into contact with such information ordata when we perform support or maintenance functions for our customers. Whilewe have internal policies and procedures for employees performing thesefunctions, the perception that we have improperly handled sensitive,confidential information could have a negative effect on our business. If, inhandling this information, we fail to comply with privacy or security laws, wecould incur civil liability to government agencies, customers and individualswhose privacy is compromised. If personal information is received or used fromsources outside the U.S., we could be subject to civil, administrative orcriminal liability under the laws of other countries. In addition, while weimplement sophisticated security measures, third parties may attempt to breachour security or inappropriately use our products through computer viruses,electronic break-ins and other disruptions. If successful, confidential informationmay be improperly obtained and we may be subject to lawsuits and otherliability. Any internal or external security breaches could harm ourreputation, and even the perception of security risks, whether or not valid,could inhibit market acceptance of our products.

*Fluctuations inforeign currency exchange rates could affect our financial results.*

We may experience gains and losses resulting fromfluctuations in currency exchange rates. Moreover, in locations where we priceour products in U.S. dollars, our sales could be affected adversely by declinesin foreign currencies relative to the dollar, thereby making our products moreexpensive in local currencies. In locations where we sell our products in localcurrencies, we could be competitively unable to increase our prices to reflect

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fluctuations in exchangerates. We do not use derivative instruments to manage our foreign exchangerisk, and we cannot predict the impact that future exchange rate fluctuationsmay have on our results.

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

Certain contract provisions, principallyconfidentiality and indemnification obligations in certain of our license agreements,could expose us to risks of loss that, in some cases, are not limited bycontract to a specified maximum amount. If we fail to perform to the standardsrequired by these contracts, we could be subject to additional liability andour business, financial condition and results of operations could be materiallyand adversely affected.

*If we fail toprotect our intellectual property, third parties may use our technology fortheir own benefit.*

Our success and ability to compete depends to asignificant degree upon our proprietary technology. We rely on a combination ofpatent, trade secret, copyright and trademark laws and confidentialityagreements with employees and third parties to establish and protect ourproprietary rights. These measures may not be sufficient to protect ourproprietary rights, and we cannot be certain that third parties will notmisappropriate our technology and use it for their own benefit. Also, most ofthese protections do not preclude our competitors from independently developingproducts with functionality or features substantially equivalent or superior toour software. Any infringement of our proprietary rights could negativelyaffect our future operating results.

As of December 31, 2005, we had eight registeredtrademarks in the U.S., nine****U.S. and threeinternational patents. We cannot assure you that we will file new patent ortrademark applications, that any future applications will be approved, that anyexisting or future patents, trademarks or copyrights will adequately protectour intellectual property or that any existing or future patents, trademarks orcopyrights will not be challenged by third parties.

We are aware of certain uses, U.S. trademarkregistrations, and U.S. trademark applications for our “eQuality” trademark andits variations that predate our use, and the April 2002 issuance of theU.S. registration for our trademark eQuality®. It is possible that an owner oflegal rights resulting from prior use, registrations, or applications willbring legal action to challenge our registration of and/or our use of thetrademark eQuality®, and may also seek compensation for damages resulting from ouruse this trademark. As a result, we cannot assure you that our registration ofthis trademark will be undisturbed, or that this use will not result inliability for trademark infringement, trademark dilution, and/or unfaircompetition.

Moreover, the laws of certain foreign countries do notprotect our intellectual property rights to the same extent as do the laws ofthe United States. Furthermore, policing the unauthorized use of our productsis difficult, and litigation may be necessary in the future to enforce ourintellectual property rights, to protect our trade secrets or to determine thevalidity and scope of the proprietary rights of others. Litigation could resultin substantial costs and diversion of resources and could negatively affect ourfuture operating results.

*Claims by othercompanies that our software infringes their intellectual property could requireus to incur substantial costs or prevent us from selling our software orservices.*

It is possible that third parties will claim that wehave infringed their current or future products. We expect that we and otherparticipants in our industry will be increasingly subject to infringementclaims as the number of competitors and products grows. Any claims, with orwithout merit, which are generally uninsurable, could be time-consuming, resultin costly litigation, require us to reengineer or redevelop our software, causeproduct shipment delays or require us to enter into royalty or licensingagreements, any of which could negatively affect our operating results. Anyefforts to reengineer our software or obtain licenses from third parties maynot be successful, could be extremely costly and would likely divert valuablemanagement and product development resources.

For example, claims have been asserted against us inlawsuits involving Knowlagent, IEX, STS and NICE (as described in Item 3, “LegalProceedings”, of Part I). We cannot assure you that we will be successfulin 

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defending against theclaims that have been asserted or any other claims that may be asserted. Wealso cannot assure you that such claims will not have a material adverse effecton our business, financial condition, or operations. Defending infringementclaims or other claims involves substantial costs and diversion of managementresources. In addition, to the extent we are not successful in defending suchclaims, we may be subject to injunctions with respect to the use or sale ofcertain of our products or to liabilities for damages to the claimants or tocustomers to whom we have indemnification commitments, and we may be requiredto obtain licenses which may not be available on reasonable terms. In addition,we cannot assure you that legal action claiming patent infringement will not becommenced against us, or that we would prevail in litigation given the complextechnical issues and inherent uncertainties in patent litigation. In addition,users of our software may become subject to claims if our software is allegedto infringe the intellectual property rights of others. These software userscould attempt to hold us responsible for these claims and any resulting harmthey suffer. If a patent claim against us were to be successful and we couldnot obtain a license on acceptable terms or license a substitute technology orredesign to avoid infringement, we may be prevented from distributing oursoftware or required to incur significant expense and delay in developingnon-infringing software. Such a result could have a material adverse effect onour business, financial condition and results of operations.

*If we are unableto maintain the compatibility of our software with certain other products andtechnologies, our future business would be adversely affected.*

Our software must integrate with software and hardwaresolutions provided by a number of our existing and potential competitors. Forexample, our products must integrate with phone switches made by the telephoneswitch vendors and computer telephony software applications offered by othersoftware providers. These competitors or their business partners could altertheir products so that our software no longer integrates well with them, orthey could delay or deny our access to software releases that allow us totimely adapt our software to integrate with their products. If we cannot adaptour software to changes in necessary technology, it may significantly impairour ability to compete effectively, particularly if our software must integratewith the software and hardware solutions of our competitors.

*If ourprofessional services employees do not provide installation serviceseffectively and efficiently, our customers may not use our installation servicesor may stop using our software.*

Our customers ordinarily purchase installation,training and maintenance services together with our products. The functionalityof our products is not dependent on our installation and training services. Webelieve that the speed and quality of installation services are competitivefactors in our industry. If our installation services are not satisfactory toour customers, the customers may choose not to use our installation services orthey may not license our software in the future. As a result, we would loselicensing and services revenue, and it could harm our reputation. In addition,our revenues realized from the performance of maintenance services arematerial to our operating results, and a failure to provide adequatemaintenance support to our customers would result in reduced maintenancerevenues and have an adverse effect on our operating results.

*We may makeacquisitions or investments that are not successful and that adversely affectour ongoing operations.*

We may acquire ormake investments in companies, products, services and technologies that webelieve complement our business and assist us in quickly bringing new productsto market. We have limited experience in making acquisitions and investments.As a result, our ability to identify and evaluate prospects, completeacquisitions and properly manage the integration of businesses is relativelyunproven. If we fail to properly evaluate and execute acquisitions orinvestments, it may have a material adverse effect on our business andoperating results. In making or attempting to make acquisitions or investments,we face a number of risks, including:

·       identifying suitablecandidates, performing appropriate due diligence, identifying potentialliabilities and negotiating acceptable terms;

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·       reducing our workingcapital and hindering our ability to expand or maintain our business, if wemake acquisitions using cash;

·       the potential distractionof our management, diversion of our resources and disruption of our business;

·       retaining and motivatingkey employees of the acquired companies;

·       managing operations thatare distant from our current headquarters and operations;

·       entering into geographicmarkets in which we have little or no prior experience;

·       competing for acquisitionopportunities with competitors that are larger than we are or have greaterfinancial and other resources than we have;

·       accurately forecasting thefinancial impact of a transaction;

·       assuming liabilities ofacquired companies, including litigation related to the operation of thebusiness prior to the acquisition;

·       maintaining good relationswith the customers and suppliers of the acquired company;

·       potentially dilutiveissuances of securities as consideration for an acquisition;

·       effectively integratingacquired companies and achieving expected synergies; and

·       the impairment of the valueof the assets acquired in any corporate acquisition.

*If we needadditional financing to maintain or expand our business, it may not beavailable on favorable terms, if at all.*

Although webelieve our current cash and borrowing capacity will be sufficient to meet ouranticipated cash needs for at least the next 12 months and the foreseeablefuture, we may need additional funds to expand or meet all of our operatingneeds. If we need additional financing, we cannot be certain that it will beavailable to us on favorable terms, or at all. If we raise additional funds byissuing equity securities or convertible debt, the ownership interest of ourstockholders could be significantly diluted, and any additional equitysecurities we issue may have rights, preferences or privileges senior to therights of our stockholders. Also, the terms of any additional financing weobtain may significantly limit our future financing and operating activities.If we need funds and cannot obtain them on acceptable terms, we may be unableto:

·       develop and enhance oursoftware to remain competitive;

·       take advantage of futureopportunities, such as acquisitions;

·       respond to changingcustomer needs and our competitors’ innovations; or

·       attract and retainqualified key personnel.

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

*Our inability tosource hardware could harm our business.*

A number ofcustomers expect us to source hardware to support the implementation of oursoftware. We seek to reduce the amount of hardware sales in the future and havetransferred the fulfillment of hardware orders to third-party distributors.Thus, we are largely dependent on third parties for the supply of hardwarecomponents to our customers. If these hardware distributors experiencefinancial, operational or quality assurance difficulties, or if there is anyother disruption in our relationships, we may be required to locate alternativehardware sources. We are subject to the following risks due to our hardwaredistribution system:

·       cancellations of orders dueto unavailability of hardware;

·       increased hardware prices,which may make our products less attractive; and

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·       additional developmentexpense to modify our products to work with new hardware configurations.

Even if we and/or our distributors are successful inlocating alternative sources of supply, alternative suppliers could increaseprices significantly. In addition, alternative components may malfunction orinteract with existing components in unexpected ways. The use of new suppliersand the modification of our products to function with new systems would requiretesting and may require further modifications, which may result in additionalexpense, diversion of management attention and other resources, inability tofulfill customer orders or delay in fulfillment, reduction in quality andreliability, customer dissatisfaction, and other adverse effects on ourreputation, business and operating results.

*Failure tomaintain effective internal controls in accordance with Section 404 of theSarbanes-Oxley Act of 2002 could have a material adverse effect on ourbusiness, operating results and stock price.*

The Sarbanes-Oxley Act of 2002 imposes certain dutieson us and our executives, directors and attorneys. Our efforts to comply withthe requirements of Section 404 have resulted in increased general andadministrative expense and a diversion of management time and attention fromrevenue-generating activities to compliance activities, and we expect theseefforts to require the continued commitment of significant resources. We havereported two material weaknesses in internal control over financial reportingwhich we found in connection with our evaluation of controls and procedures asof December 31, 2005. If we fail to maintain the adequacy of our internalcontrols, we may not be able to ensure that we can conclude on an ongoing basisthat we have effective internal controls over financial reporting. Failure tomaintain effective internal controls over financial reporting could result ininvestigation and/or sanctions by regulatory authorities, and could have amaterial adverse effect on our business and operating results, investorconfidence in our reported financial information, and the market price of ourcommon stock.

*Our stock pricehas been volatile.*

The market price of our common stock has been subjectto significant fluctuations in response to variations in quarterly operatingresults and other factors. In addition, the stock market has experiencedsignificant volatility that has particularly affected the market prices ofequity securities of many technology companies and that often has been unrelatedor disproportionate to the operating performance of these companies. Anyannouncement with respect to any adverse variance in revenue or earnings fromlevels generally expected by securities analysts or investors could have asignificant adverse effect on the trading price of our common stock. Inaddition, factors such as announcements of technological innovations or newproducts by us, our competitors or third parties, changing conditions in thecustomer relationship management software market, changes in the marketvaluations of similar companies, loss of a major customer, additions ordepartures of key personnel, changes in estimates by securities analysts,announcements of extraordinary events, such as acquisitions or litigation, orgeneral economic conditions may have an adverse effect on the market price ofour common stock.

*We recently issued4.7****million new shares during oursecondary offering of our Common stock. We also issued 1.9  million newshares and granted approximately 650,000 options to purchase shares of ourcommon stock in connection with acquisitions in 2005, which will result indilution to our existing stockholders and may cause our stock price to decline.*

During our secondary offering of our common stock, weissued 4.7 million shares of common stock in December 2005. Also, as partof the merger consideration in our acquisition of Blue Pumpkin inJanuary 2005, we issued a total of 1.9 million shares of common stockto former Blue Pumpkin shareholders. In addition, we issued employee stockoptions to purchase approximately 650,000 shares of common stock in connectionwith this acquisition and the acquisition of Optimis in May 2005. Theissuance of a significant amount of additional shares of common stock resultsin dilution to our existing shareholders and could reduce our earnings pershare, which in turn could negatively affect the market price of our commonstock. A significant amount of common stock coming on the market at any giventime could result in a decline in the price of our common stock or increasedvolatility.

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*Our performancemay be negatively affected by macro-economic or other external influences.*

Beginning in 2000, a declining United States economyadversely affected the performance of many businesses, especially within thetechnology sector. Reductions in the capital budgets of our customers andprospective customers have an adverse impact on our ability to sell oursolutions. Until late in 2003, we continued to experience effects from a weakspending environment for information technology in both the United States andEurope, in the form of delayed and cancelled buying decisions by customers forour software, services and hardware, deferrals by customers of serviceengagements previously scheduled and pressure by our customers and competitorsto discount our offerings. If the current improvements now being seen in thegeneral business climate do not continue, this would likely have a materialadverse effect on our business.

*Governmentregulation of telephone and Internet monitoring could cause a decline in theuse of our software, result in increased expenses for us or subject ourcustomers and us to liability.*

As the telecommunications industry continues toevolve, state, federal and foreign governments (including supranationalgovernmental organizations such as the European Union) and industryassociations may increasingly regulate the monitoring of telecommunications andtelephone and Internet monitoring and recording products, such as our software.We believe that increases in regulation could come in the form of a number ofdifferent kinds of regulations, including regulations regarding privacy,protection of personal information such as Social Security numbers, credit cardinformation and employment. For example, the State of California enacted theDatabase Security Breach Act, which requires any business that suffers acomputer security breach to immediately notify customers in California ifpersonal information has been compromised, and the Payment Card industry hasadopted regulations that require additional security regarding the storage ofconsumers’ credit card numbers. The adoption of any new regulations or changesto existing regulations could cause a decline in the use of our software andcould result in increased expense for us as we modify our software toaccommodate these regulations. Moreover, these regulations could subject ourcustomers or us to liability. Whether or not these regulations are adopted, ifwe do not adequately address the privacy concerns of consumers, companies maybe hesitant to use our software. If any of these events occur, it couldmaterially and adversely affect our business.

*If we are unableto attract and retain key personnel, our ability to effectively manage and growour 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 significantcompetition for individuals with the skills required to perform the services weoffer. If we are unable to attract and retain qualified personnel or if weexperience high personnel turnover, it could prevent us from effectivelymanaging and expanding our business.

Our success also depends upon the continued service ofour executive officers. Any of our executive officers and other employees couldterminate his or her relationship with us at any time. The loss of the servicesof our executive officers or other key personnel, particularly if lost tocompetitors, could materially and adversely affect our business.

*Our certificate ofincorporation and bylaws, as well as Delaware law, may inhibit a takeover ofour Company, which could limit the price investors might be willing to pay forour securities.*

Our amended and restated certificate of incorporationand bylaws, as well as Delaware law, contain provisions that might enable ourmanagement to resist a takeover of our Company. For example, our stockholderscannot take action by written consent or call a special meeting to remove ourBoard of Directors. In addition, our directors serve for staggered terms, whichmakes it difficult to remove all our directors at once. Further, inOctober 2002, our Board of Directors approved, and we have implemented, a stockholderrights plan which has the effect of causing substantial dilution to a person orgroup that attempts to acquire us on terms not approved by the Board ofDirectors.

These anti-takeover provisions might discourage, delayor prevent a change in the control of our company or a change in ourmanagement. These provisions could also discourage proxy contests and make itmore difficult 

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for you and othershareholders to elect directors and take other corporate actions. The existenceof these provisions could also limit the price that investors might be willingto pay in the future for our securitie**s.**

**Item 1B.**                 Unresolved StaffComments

We have not received any written comments regardingour periodic or current reports from the staff of the Securities and ExchangeCommission that were issued 180 days or more before the end of our fiscal yearended December 31, 2005, thus, no issues remain unresolved.

**Item 2.**                          Properties

Our principal administrative, marketing, productdevelopment, training and support facilities are located in Roswell, Georgia, asuburb of Atlanta, where we lease approximately 96,400 square feet under alease that expires in 2007. We occupy approximately 26,000 square feet inLeatherhead, United Kingdom under a lease that expires in 2014, which includesadministrative, marketing, product development and support facilities. Inaddition, we lease a total of 28 offices in the United States, Australia,Brazil, Canada, China, India, Japan, Mexico, the Netherlands, Singapore, SouthAfrica, and the United Kingdom. We believe our facilities are in good operatingconditions, suitable and adequate for our current and expected near-termrequirements.

**Item3.**                          LegalProceedings

On December 11, 2002, we filed in the UnitedStates District Court for the Northern District of Georgia, Atlanta Division, alawsuit against Knowlagent, Inc. (“Knowlagent”), which is the assignee ofUnited States (“U.S.”) Patent Nos. 6,324,282 B1 and 6,459,787 B2. Knowlagenthas accused our eQuality Now software of infringing the above patents. We filedsuit seeking a declaration that we did not and do not infringe either of thetwo patents listed above, as well as a declaration that the above patents areinvalid and unenforceable. We also filed a claim requesting that if the patentsare found to be valid, that one of our own employees be named the rightfulinventor of the patents. We also requested monetary damages in an amount equalto 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 wellas two counterclaims, alleging that we infringe and contribute to theinfringement by others of the above patents; Knowlagent seeks both monetarydamages and an injunction in connection with its counterclaim. On June 6,2005, the Court held a claim construction hearing and issued a claimconstruction order on June 8, 2005. The case is now proceeding to expertdiscovery and summary judgment phases.

On July 20, 2004, STS Software Systems Ltd. (“STSSoftware”), a wholly-owned subsidiary of NICE Systems, Ltd. (“NICE Ltd.”),filed a patent infringement suit in the U.S. District Court for the SouthernDistrict of New York against us (“New York Action”). The New York Actionasserts that our products, including eQuality ContactStore for IP, infringeUnited States (“U.S.”). Patent No. 6,122,665 (“the ‘665 patent”) and seeksonly injunctive, not monetary, relief. On the same day, we filed a declaratoryjudgment action against STS Software in the U.S. District Court for theNorthern District of Georgia (“Georgia Action”). We seek a declaration from thecourt that we have not infringed any valid claim of the ‘665 patent. By Orderentered December 16, 2004, Judge Koeltl of the U.S. District Court for theSouthern District of New York granted our motion to transfer the New YorkAction to the Northern District of Georgia, which has now consolidated theformer New York Action with the Georgia Action. On July 7, 2005, the Courtalso granted STS leave to amend its complaint to add three patents to thedispute, namely: U.S. Patent Nos. 6,865,604; 6,871,229; and 6,880,004(respectively, “the ‘604 patent,” “the ‘229 patent,” and “the ‘004 patent”;collectively, “the STS patents”), again seeking solely injunctive relief. Weanswered the first amended complaint and asserted counterclaims onJuly 29, 2005, collectively, through which we deny infringement of anyvalid claim of the STS patents and seek a declaration to that effect. The casehas been set on a discovery calendar and is at a preliminary stage.

On August 30, 2004, we filed in the United StatesDistrict Court for the Northern District of Georgia, Atlanta Division, alawsuit against NICE Systems, Inc. (“NICE Inc.”), a wholly-ownedsubsidiary of NICE Ltd., alleging patent infringement. Specifically, wehave alleged that NICE products, including the NiceUniverse products thatinclude screen capture and synchronized screen and voice capture technologies,infringe claims of U.S. Patent Nos. 5,790,798 (“the ‘798 Patent”) and 6,510,220(“the ‘220 Patent”), both entitled “Method and

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Apparatus forSimultaneously Monitoring Computer User Screen and Telephone Activity from aRemote Location.” We have sought an injunction and money damages for NICE’sinfringement of these two patents. NICE Inc. has answered and counterclaimedfor declaratory judgments of non-infringement and invalidity. Since then, onFebruary 24, 2005, we filed suit against NICE Ltd. because of itsinfringing activities in violation of the ‘798 and ‘220 patents, including importationof the accused NICE products. By order dated April 5, 2005, the court hasconsolidated the NICE Inc. and NICE Ltd. actions. The case has been set on amodified discovery calendar after consolidation and is at a preliminary stage.

In January 2001, IEX Corporation filed a lawsuitagainst Blue Pumpkin in the United States District Court for the EasternDistrict of Texas, Sherman Division, alleging that Blue Pumpkin infringed IEXCorporation’s (“IEX”) U.S. Patent No. 6,044,355 (“the ‘355 Patent”) by makingand selling certain workforce management and call routing software products,including Blue Pumpkin’s Prime Time Skills and Prime Time Enterprise products.IEX’s lawsuit seeks actual damages, an award of treble damages pursuant to 35U.S.C. § 284, and an award of prejudgment interest, costs, and attorney’s fees,and an injunction against Blue Pumpkin’s making or selling the products thatIEX claims infringe its ‘355 Patent.

On October 4, 2005, Blue Pumpkin filed in theUnited States District Court for the Northern District of Georgia, AtlantaDivision, a lawsuit against IEX Corporation alleging patent infringement.Specifically, Blue Pumpkin has alleged that IEX products infringe claims ofU.S. Patent No. 6,952,732 (“the ‘732 Patent”), entitled “Method andapparatus for multi-contact scheduling.” Blue Pumpkin’s lawsuit seeks aninjunction and money damages for IEX’s infringement of the ‘732 Patent.

On December 15, 2005, IEX and Blue Pumpkinreached an agreement to settle all claims asserted between them in both theTexas and Georgia cases, subject to a number of contingencies includingnegotiation, execution and delivery by the parties of a definite settlementagreement prior to a deadline established by the court , currentlyMarch 15, 2006. The terms of the settlement are confidential. We expect torecover more than half of the settlement amount and related litigation costsfrom the escrow fund that was established in connection with our acquisition ofBlue Pumpkin. As of December 31, 2005, we have accrued the anticipatedsettlement costs and do not expect that the settlement will require anyadditional material charges. (See Note 6 to the Consolidated FinancialStatements included elsewhere in this report for discussion of the Blue Pumpkinacquisition).

While we currently expect to reach a definitivesettlement with IEX, a number of terms that we view as significant remain undernegotiation, and we cannot assure you that we will be able to reach adefinitive settlement agreement on terms acceptable to us. If a definitivesettlement agreement is not reached, the litigations between IEX and BluePumpkin will go forward. In the case of IEX’s lawsuit against Blue Pumpkin, atrial date will be set by the court, most likely in the late spring of 2006.Blue Pumpkin’s lawsuit against IEX is in a more preliminary stage and would beunlikely to reach trial before 2007. If the litigations proceed to trial, weintend to defend against IEX’s claims vigorously and to pursue Blue Pumpkin’sclaims against IEX vigorously, but we are unable to predict the outcome ofeither case or to assess what, if any, impact an adverse result would have onour financial position, results of operations or cash flows.

On November 25, 2005, Blue Pumpkin filed in theTokyo District Court a lawsuit against P&W Solutions Co., Ltd. (“P&W”)alleging that P&W has infringed copyrights in Blue Pumpkin DirectorEnterprise Version 33 software. P&W has filed an answer, and the case is ata preliminary stage.

On January 19, 2006, we filed in the United StatesDistrict Court for the Northern District of Georgia, Atlanta Division, alawsuit against NICE Systems, Inc. and NICE Systems, Ltd. (collectively “NICE”),alleging patent infringement. Specifically, we have alleged that NICE products,including NicePerform and related products that include the ability to monitorcommunications to detect the presence of at least one predetermined parameter,infringe claims of U.S. Patent No. 6,404,857 B1 (“the ‘857 Patent”),entitled “Signal Monitoring Apparatus for Analyzing Communications.” We havesought an injunction and money damages for NICE’s infringement of the ‘857patent. NICE has not yet responded to the complaint, and this case is at apreliminary stage.

On August 29, 2006, A. Edward Miller filed ashareholder derivative lawsuit in the United States District Court for theNorthern District of Georgia (Atlanta Division) naming Witness Systems, Inc. asa nominal defendant and naming all of our current directors and a number of ourcurrent officers as defendants.  

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Millerv. Gould, et al., Civil Action No. 1:06-CV-2039 (N.D. Ga.).  The complaintalleges purported violations of federal and state law, including breaches offiduciary duty, abuse of control, constructive fraud, corporate waste, unjustenrichment, gross mismanagement and violations of certain antifraud provisionsof the federal securities laws (including Sections 10(b) and 14(a) of theSecurities Exchange Act of 1934 and Rules 10b-5 and 14a-9 thereunder) inconnection with certain stock option grants made by the Company.  Thecomplaint seeks monetary damages in unspecified amounts, disgorgement ofprofits, an accounting, rescission of stock option grants, imposition of aconstructive trust over the defendants’ stock options and proceeds derivedtherefrom, punitive damages, reimbursement of attorneys’ fees and other costsand expenses, an order directing the Company to adopt or put to a stockholdervote various proposals relating to corporate governance, and other relief asdetermined by the court.  On November 15, 2006, the Company and the otherdefendants filed a motion to dismiss the complaint in its entirety on a varietyof grounds, including plaintiffs’ failure to allege demand futility.  Rather than respond to that Motion,plaintiffs on January 9, 2007 filed an Amended Complaint.  The Company and its directors intend toreview the allegations of the Amended Complaint and respond when appropriate.

A class action securities lawsuit was filed onAugust 14, 2006, by an individual claiming to be a stockholderof the Company naming the Company and certain of its directors and officers asdefendants in connection with certain stock option grants made by theCompany.  Rosenberg v. Gould, et al., Civil Action No. 1:06-CV-1894 (N.D.Ga.).  The complaint, filed in the United States District Court for theNorthern District of Georgia, alleges violations of Section 10(b) of theSecurities Exchange Act of 1934 and Rule 10b-5 thereunder and seeks unspecifieddamages, attorneys’ fees and other costs and expenses, unspecifiedextraordinary, equitable and injunctive relief, and other relief as determinedby the court.  Neither a lead plaintiff nor lead counsel has beenappointed, nor has a response to the complaint yet been required. The Companyand the other defendants will respond to the complaint when appropriate.

On October 27,2006, the Company received a notice of informal nonpublic inquiry from the SECrequesting certain documents and information relating to the Company’s stockoption grant practices from February 2000 to the present. The Company intendsto cooperate fully with all matters related to this request.

From time to time we may be involved in other legalproceedings and/or litigation arising in the ordinary course of our businessthat might impact on our financial position, our results of operations, or ourcash flows.

**Item 4.**                          Submission of Matters to aVote of Security Holders

No matters were submitted to a vote of securityholders during the fourth quarter ended December 31, 2005.

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**PART II**

**Item5.**                          Marketfor Our Common Equity and Related Stockholder Matters and Issuer Purchases ofEquity Securities

**Common Stock-Listing on the Nasdaq Stock Market**

Our common stock trades on the Nasdaq Stock Marketunder the symbol “WITS”.  We delayed thefiling of our quarterly reports on Form 10-Q for the quarters ended June 30,2006 and September 30, 2006 until the Company was able to complete itsrestatement of previously issued Consolidated Financial Statements. As aresult, we have not been in compliance with the Nasdaq Stock Market filingrequirements for continued listing as set forth in Marketplace Rule 4310(c)(14).  We have received a letter from Nasdaq Listing Qualification Paneladvising us that we have received an extension of time through February 7, 2007to file our Quarterly Reports on Form 10-Q for the quarters ended June 30, 2006and September 30, 2006.  The Panel advised us that if we are unable tomeet the extension deadline, the Panel will issue a final determination todelist our shares and there can be no assurance that Nasdaq Listing and HearingReview Council will grant an additional extension of time to meet suchrequirements or that our common stock will remain listed on the Nasdaq StockMarket.

The followingtable sets forth, for the periods indicated, the high and low sale price pershare of the common stock on the Nasdaq Stock Market in each of the last eightquarters.
|                                     | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------------------------------|------------|----------|------------|---------|------------|
| Year Ended  December 31, 2005: |       |     |       |    |       |
| Fourth quarter                      |       | $        | 22.12      |    | $          | 18.28 |   |
| Third quarter                       |       | $        | 21.10      |    | $          | 16.90 |   |
| Second quarter                      |       | $        | 18.58      |    | $          | 15.68 |   |
| First quarter                       |       | $        | 20.00      |    | $          | 16.11 |   |
| Year Ended  December 31, 2004: |       |     |       |    |       |
| Fourth quarter                      |       | $        | 18.21      |    | $          | 14.12 |   |
| Third quarter                       |       | $        | 17.14      |    | $          | 9.64 |   |
| Second quarter                      |       | $        | 15.21      |    | $          | 10.33 |   |
| First quarter                       |       | $        | 14.05      |    | $          | 8.61 |   |

 

The closing sale price of our common stock as reportedby the Nasdaq Stock Market on February 28, 2006 was $23.43.

*DividendPolicy.**  *Wehave not paid any cash dividends on our common stock to date. Our Board ofDirectors determines whether or not we will pay dividends. The Board ofDirectors considers a number of factors in deciding whether or not to paydividends, including our earnings, our capital requirements and our financialcondition. Currently, the Board of Directors intends to retain all earnings, ifany, for use in our business operations and, accordingly, does not expect todeclare or pay any dividends in the foreseeable future.

*Rule 10b5-1—TradingPlans.**  *OurBoard of Directors approved an amendment to our insider trading policy topermit our officers, directors and other insiders to enter into trading plansor arrangements to sell shares of our common stock complying withRule 10b5-1 of the Securities Exchange Act of 1934, as amended. Tradingplans provide for sales, subject to price restrictions, daily limits and othercontingencies, of shares of our common stock.

*Holders.**  *As of February 28, 2006, wehad approximately 149 holders of record of our common stock. We believe that wehave more than 3,600 beneficial owners.

**IssuerPurchases of Equity Securities**

In 2002, our Board of Directors authorized a stockrepurchase program to spend up to $10.0 million to repurchase our commonstock. As of December 31, 2005, we had repurchased 1.0 million shares ofour common stock for $3.1 million, which were constructively retired. Asat December 31, 2005, 6.9 million shares are 

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available for repurchase.However, we have not repurchased our common stock since 2003 and do notpresently plan to repurchase additional common stock.

**Item6.**                          SelectedFinancial Data

The following selected consolidated financial datashould be read in conjunction with the Consolidated Financial Statements andNotes thereto and with “Management’s Discussion and Analysis of FinancialCondition and Results of Operations.” The Consolidated Statements of Operations data for the years endedDecember 31, 2005, 2004 and 2003 and the Consolidated Balance Sheets data as ofDecember 31, 2005 and 2004 have been derived from, and should be read inconjunction with, the audited Consolidated Financial Statements and the Notesthereto, which have been restated and are included elsewhere in this Form10-K/A. The Consolidated Statements of Operations data for the years endedDecember 31, 2002 and 2001 and the Consolidated Balance Sheets data as ofDecember 31, 2003, 2002 and 2001 have been restated to reflect the correctionof errors as noted below, but such related data have not been audited and isderived from the books and records of the Company. Our historical results ofoperations are not necessarily indicative of results of operations to beexpected for any future period.

As described in “Management’s Discussion and Analysisof Financial Condition and Results of Operations” and Note 2, “Restatement ofConsolidated Financial Statements,” of the Notes to Consolidated FinancialStatements included elsewhere in this report, our Consolidated FinancialStatements have been restated to correct errors in the recognition ofstock-based compensation expense for stock options, primarily granted in prioryears, to adjust the purchase accounting for the acquisition of Blue Pumpkin andto record additional income taxes and miscellaneous other items.  The restatement due to stock-basedcompensation expense and other items resulted in after-tax charges of $1.3million, $0.8 million, $1.2 million, $1.9 million and $4.2 million for the yearsended December 31, 2005, 2004, 2003, 2002 and 2001, respectively.   Additionally, the cumulative effect of therestated after-tax charges for the periods prior to 2001 was $1.2 million. Thereis no tax-effect of the charges related to stock-based compensation expense dueto the recognition of a valuation allowance for all of the Company’s netdeferred tax assets. The adjustments reduced previously reported dilutedearnings per common share by $0.05, $0.03, $0.05, $0.08 and $0.19 for the yearsended December 31, 2005, 2004, 2003, 2002 and 2001, respectively.

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| ** **                                       | ** ** | **Year Ended December 31,**                         | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2005(b)  As Restated   (a)**                           | ** ** | **2004  As Restated  (a)** | ** ** | **2003(c)  As Restated  (a)** | ** ** | **2002  As Restated  (d)** | ** ** | **2001   As Restated  (d)** | ** ** |
| ** **                                       | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statement of Operations Data:**                |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenue:                                         |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product                                          |       | $                                                                  | 74,186     |   | $ | 57,620 |   | $ | 46,238 |   | $ | 33,383 |   | $ | 39,926 |   |
| Services                                         |       | 111,142                                                            |       | 83,715 |   | 61,799 |   | 34,303 |   | 22,596 |   |
| Total revenue                                    |       | 185,328                                                            |       | 141,335 |   | 108,037 |   | 67,686 |   | 62,522 |   |
| Cost of revenue:                                 |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product                                          |       | 19,130                                                             |       | 13,784 |   | 11,580 |   | 1,132 |   | 602 |   |
| Services                                         |       | 42,361                                                             |       | 32,645 |   | 24,413 |   | 12,615 |   | 10,980 |   |
| Total cost of  revenue                           |       | 61,491                                                             |       | 46,429 |   | 35,993 |   | 13,747 |   | 11,582 |   |
| Gross profit                                     |       | 123,837                                                            |       | 94,906 |   | 72,044 |   | 53,939 |   | 50,940 |   |
| Operating expenses:                              |       |                                                               |       |   |   |   |   |   |   |   |   |
| Selling, general  and administrative             |       | 85,995                                                             |       | 65,808 |   | 60,823 |   | 41,624 |   | 43,805 |   |
| Research and  development                        |       | 26,717                                                             |       | 20,816 |   | 18,267 |   | 15,460 |   | 14,400 |   |
| Merger-related  and integration costs            |       | 4,532                                                              |       | 498 |   | 7,865 |   | — |   | — |   |
| Acquired  in-process research and development    |       | 9,000                                                              |       | — |   | 7,840 |   | — |   | 4,823 |   |
| Operating (loss)  income                         |       | (2,407                                                             | )          | 7,784 |   | (22,751 | ) | (3,145 | ) | (12,088 | ) |
| Interest and other  income, net                  |       | 860                                                                |       | 1,206 |   | 1,303 |   | 1,570 |   | 2,866 |   |
| (Loss) income  before provision for income taxes |       | (1,547                                                             | )          | 8,990 |   | (21,448 | ) | (1,575 | ) | (9,222 | ) |
| Provision for income  taxes                      |       | 3,024                                                              |       | 312 |   | 307 |   | 261 |   | 116 |   |
| Net (loss)  income                               |       | $                                                                  | (4,571     | ) | $ | 8,678 |   | $ | (21,755 | ) | $ | (1,836 | ) | $ | (9,338 | ) |
| Net (loss) income per  share:                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                            |       | $                                                                  | (0.17      | ) | $ | 0.37 |   | $ | (0.99 | ) | $ | (0.08 | ) | $ | (0.42 | ) |
| Net (loss) income per  share:                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Diluted                                          |       | $                                                                  | (0.17      | ) | $ | 0.33 |   | $ | (0.99 | ) | $ | (0.08 | ) | $ | (0.42 | ) |
| Weighted-average common  shares outstanding:     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                            |       | 27,221                                                             |       | 23,361 |   | 21,991 |   | 22,626 |   | 22,258 |   |
| Diluted                                          |       | 27,221                                                             |       | 26,084 |   | 21,991 |   | 22,626 |   | 22,258 |   |
| **Balance Sheet Data:**                          |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents                       |       | $                                                                  | 111,751    |   | $ | 42,641 |   | $ | 21,517 |   | $ | 30,089 |   | $ | 9,297 |   |
| Working capital                                  |       | 119,115                                                            |       | 60,114 |   | 28,697 |   | 59,435 |   | 55,953 |   |
| Total assets                                     |       | 264,394                                                            |       | 124,499 |   | 104,035 |   | 87,141 |   | 84,166 |   |
| Total stockholders’ equity                  |       | 202,284                                                            |       | 74,374 |   | 49,995 |   | 65,074 |   | 66,054 |   |

 

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| (a) |   | See Note 2, “Restatement of Consolidated Financial  Statements,” of the Notes to the Consolidated Financial Statements included  elsewhere in this report. |
|-----|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|

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| (b)    |   | We commenced the consolidation of Blue Pumpkin  Software, Inc. and Optimis Group limited on January 25, 2005 and  May 24, 2005, respectively.                                                           |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                   |
| (c)    |   | We commenced the consolidation of Eyretel plc on  March 22, 2003.                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                   |
| (d)    |   | The table below presents the impact of the  stock-based compensation adjustments to the restatement of our previously  reported Consolidated Statements of Operations for the years ended December  31, 2002 and 2001. |

 
| ** **                                                        | ** ** | **2002**                                                           | ** ** | **2001**       | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|----------------|------------|
| ** **                                                        | ** ** | **(in thousands, except per share data)** | ** ** |
| ** **                                                        | ** ** | **As   Previously   Reported**                           | ** ** | **Adjustment** | ** ** | **As restated** | ** ** | **As Previously  Eeported** | ** ** | **Adjustment** | ** ** | **As restated** | ** ** |
| **Statement of Operations Data:**                                 | ** ** | ** **                                                         | ** ** | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                                          |       |                                                               |       |           |       |   |   |   |   |   |   |   |   |
| Product                                                           |       | $                                                                  | 33,383     |           | —     |   | $ | 33,383 |   | $ | 39,926 |   | — |   | $ | 39,926 |   |
| Services                                                          |       | 34,303                                                             |       | —         |       | 34,303 |   | 22,596 |   | — |   | 22,596 |   |
| Total revenue                                                     |       | 67,686                                                             |       | —         |       | 67,686 |   | 62,522 |   | — |   | 62,522 |   |
| Cost of revenue:                                                  |       |                                                               |       |           |       |   |   |   |   |   |   |   |   |
| Product                                                           |       | 1,132                                                              |       | —         |       | 1,132 |   | 602 |   | — |   | 602 |   |
| Services                                                          |       | 12,286                                                             |       | $              | 329        |   | 12,615 |   | 10,448 |   | $ | 532 |   | 10,980 |   |
| Total cost of  revenue                                            |       | 13,418                                                             |       | 329            |       | 13,747 |   | 11,050 |   | 532 |   | 11,582 |   |
| Gross profit                                                      |       | 54,268                                                             |       | (329           | )          | 53,939 |   | 51,472 |   | (532 | ) | 50,940 |   |
| Operating expenses:                                               |       |                                                               |       |           |       |   |   |   |   |   |   |   |   |
| Selling, general  and administrative                              |       | 40,439                                                             |       | 1,185          |       | 41,624 |   | 40,968 |   | 2,837 |   | 43,805 |   |
| Research and  development                                         |       | 15,090                                                             |       | 370            |       | 15,460 |   | 13,611 |   | 789 |   | 14,400 |   |
| Acquired  in-process research and development and related charges |       | —                                                             |       | —         |       | — |   | 4,823 |   | — |   | 4,823 |   |
| Operating (loss)  income                                          |       | (1,261                                                             | )          | (1,884         | )          | (3,145 | ) | (7,930 | ) | (4,158 | ) | (12,088 | ) |
| Interest and other  income, net                                   |       | 1,570                                                              |       | —         |       | 1,570 |   | 2,866 |   | — |   | 2,866 |   |
| Income (loss)  before provision for income taxes                  |       | 309                                                                |       | (1,884         | )          | (1,575 | ) | (5,064 | ) | (4,158 | ) | (9,222 | ) |
| Provision for income  taxes                                       |       | 261                                                                |       | —         |       | 261 |   | 116 |   | — |   | 116 |   |
| Net income  (loss)                                                |       | $                                                                  | 48         |           | $          | (1,884 | ) | $ | (1,836 | ) | $ | (5,180 | ) | $ | (4,158 | ) | $ | (9,338 | ) |
| Net income (loss) per  share:                                     |       |                                                               |       |           |       |   |   |   |   |   |   |   |   |
| Basic                                                             |       | $                                                                  | 0.00       |           | $          | (0.08 | ) | $ | (0.08 | ) | $ | (0.23 | ) | $ | (0.19 | ) | $ | (0.42 | ) |
| Net income (loss) per  share:                                     |       |                                                               |       |           |       |   |   |   |   |   |   |   |   |
| Diluted                                                           |       | $                                                                  | 0.00       |           | $          | (0.08 | ) | $ | (0.08 | ) | $ | (0.23 | ) | $ | (0.19 | ) | $ | (0.42 | ) |

 

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**Item 7.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

The followingManagement’s Discussion and Analysis of Financial Condition and Results ofOperations is intended to provide investors with an understanding of theCompany’s past performance, its financial condition and its prospects andshould be read in conjunction with the Consolidated Financial Statements andNotes thereto included elsewhere in this report. Investors should carefullyreview the information contained in this report under Item1A “Risk Factors”beginning on page 9.****The followingwill be discussed and analyzed:

·       Overview

·       Stock Option Practices andRestatement of Consolidated Financial Statements

·       CriticalAccounting Policies and Estimates

·       Resultsof Operations

·       Liquidityand Capital Resources

**Overview**

We are a leading provider of workforce optimizationsoftware and services that enable companies to optimize workforce performancein their customer service operations. Our Impact 360 solution consists ofsoftware products and services designed to optimize the workforce, processesand technology involved in the customer service function. These solutions maybe deployed throughout a customer’s enterprise—including in contact centers,back offices and branch offices—to enable the customer to capture informationderived from contacts with its customers, analyze the information in relationto key performance indicators, act upon the information to improve the overallcustomer experience, and manage the staffing, training and performancemeasurement of its personnel involved in all aspects of customer service.

Our Impact 360 solution is an integrated offering ofsoftware products that provide comprehensive workforce optimizationfunctionality, including quality monitoring and high-volume compliancerecording, workforce management, performance management and electronic learning,or e-learning. Our quality monitoring products record multimedia interactions,including traditional voice, Web chat and email, based on user-defined businessrules to enable our customers to evaluate the performance of theircustomer service representatives, or “CSR”s, wherever they may be located inthe enterprise. Our high-volume compliance applications are designed to recordhigh volume, full-time performance of the voice conversations between CSRs andcustomers for purposes such as compliance recording and sales verification. Ourworkforce management products enable our customers to develop strategicstaffing plans, deploy skilled resources and evaluate productivity of CSRs. Ourperformance management applications provide comprehensive analytics, includingperformance scorecards, and reports of customer interaction and CSRperformance. Our e-learning applications deliver ongoing training tailored toCSR needs and competencies. We also provide consulting and implementationservices, training and support to customers that use our software products.

We derive product revenue by licensing software andderive services revenue by providing related installation, training,consulting, and maintenance services. We also derive a relatively small portionof product revenue by selling hardware to customers. The majority of ourproduct revenue is derived from quality monitoring (“QM”) and workforcemanagement (“WFM”) software. We sell our products through our direct salesforce and through our indirect sales channels. Our indirect sales channelsconsist of distributors, resellers, systems integrators and Original EquipmentManufacturers (“OEM”). Distributors and resellers purchase product from us at adiscount and then resell our products to end-users (or, in the case ofdistributors, to other resellers) and referral partners are paid a fee forreferring sales leads to us or for assisting us in a sales order. Systemsintegrators are information technology (“IT”) consulting service companies whorecommend our products during client engagements. Through OEM agreements, weco-develop products, which are sold by the OEM as part of their portfolio ofproducts.

We intend to continue to expand our global saleschannels by entering into new reseller, distributor, OEM and similararrangements with key vendors in the contact center workforce optimizationmarket. In 2005, 2004 

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and 2003, approximately41%, 32% and 31%, respectively**,**of ourlicense revenue has been derived from the indirect sales channel.

We plan to grow our product revenue and maintain ourcompetitive position from a technology perspective through the timelyintroduction of new products, such as pre-packaged solutions, which addcapabilities such as performance analysis and e-learning management to our corequality monitoring and workforce management solutions. We also believe themarket shift from traditional hardware based recording to VoIP represents asignificant growth opportunity and our software solutions support both of theserecording environments. In addition, we believe our product offerings can bemarketed toward branch-office and back-office initiatives for business processmonitoring, which represents a new market for us. Factors that may impact ourability to grow our product revenue, however, include our ability to remaincompetitive from a technology perspective; market acceptance of our newproducts; our ability to maintain our product pricing integrity; and ourability to expand our global sales channels.

We also plan to grow our services revenue in concertwith our product revenue. When our customers license our products, theygenerally purchase installation, training and one year of support services.Therefore, as we generate product revenue, we also generate related servicesrevenue. In addition, our customers generally renew their maintenance contractswith us each year. Therefore, our maintenance revenue increases as our customerbase increases. Factors that may influence our ability to grow our servicesrevenue, however, include our ability to continue to increase product revenues,provide services that enable and enhance our customers’ ability to improve theefficiency and effectiveness of their call center operations and our ability tomaintain a high level of customer success and satisfaction.

On January 24, 2005, we acquired Blue PumpkinSoftware, Inc. (“Blue Pumpkin”), a privately held California corporation.With this acquisition, we have expanded our workforce optimization solution toinclude advanced workforce management software and services solutions includingforecasting, scheduling, adherence and planning applications. Pursuant to theMerger Agreement and Plan of Reorganization, dated December 16, 2004 (the “MergerAgreement”), we paid $36 million in cash which was funded from our existingcash and investments and issued 1.9 million shares of Witness’ common stockvalued at $33.5 million (measured based on the date the stockconsideration became fixed pursuant to the application of a formula specifiedin the merger agreement). On May 24, 2005, the shares issued in connectionwith the acquisition were registered for resale with the Securities andExchange Commission. Pursuant to the Merger Agreement, cash of $4 million and210,000 shares of common stock valued at approximately $3.7 million on the dateof acquisition was placed into escrow fund and to be released to Witness inpartial satisfaction and settlement of claims that Witness has now broughtagainst the escrow fund, including claims for potential losses expected toresult from the settlement of the IEX litigation. The escrow fund wasestablished to compensate Witness, subject to certain limitations, forpotential losses that could result from, among other things, the IEX litigationand other specified litigations, and breaches of Blue Pumpkin’srepresentations, warranties or covenants in the Merger Agreement. See Note 6 ofthe Consolidated Financial Statements included elsewhere in this report fordiscussion of the Blue Pumpkin acquisition.

On May 23, 2005, we acquired Optimis GroupLimited (“Optimis”), a UK-based provider of workforce optimization softwaresolutions. Blue Pumpkin owned a minority interest in an operating subsidiary ofOptimis, the balance of which was acquired through the Optimis acquisition. Wepaid $5.0 million in cash and other consideration that was financed fromour existing cash and investments. Ten percent of the aggregateacquisition consideration is being held in escrow until May 23, 2006.Theescrow period may be extended in the event that there are pending claims thatare brought against the escrow fund within such period. The escrow fund isavailable to compensate Witness, subject to certain limitations, for lossesresulting from, among other things, breaches of representations, warranties orcovenants in the purchase agreement and certain pending and potential claims.In 2005, the Compensation Committee of our Board of Directors approvedstock option awards for approximately 650,000 shares of Witness common stock tocertain Blue Pumpkin and Optimis employees as an inducement to join Witness.These inducement options are, subject to standard provisions for termination,forfeiture and acceleration, and are exercisable for five years from the dateof grant. The inducement options will first become exercisable, as to25 percent of the total amount, after one year from the date of grant, andcommencing 13 months after grant and until the end of

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the47th month following grant, the options will become exercisable as to anadditional two percent per month and the balance upon the 48th month followinggrant.

During 2005, 2004 and2003, 46%, 48% and 45%, respectively, of our revenue was derived from customersoutside the United States. We had 619** **full-timeemployees**,** excluding approximately 176 contractorslocated in the Asia-Pacific region, at December 31, 2005, compared to 485at December 31, 2004 and 497 at December 31, 2003. As ofDecember 31, 2005**,** 198 full**-**time employees were located outside the United States.

**StockOption Practices and Restatement of Consolidated Financial Statements**

Beginning in late May 2006, the Company’s management initiated apreliminary internal review of the Company’s historical stock option practicesand related accounting treatment in response to general media attentionconcerning stock option grants at various public companies and shareholderinterest with respect to this particular issue. On August 8, 2006, in responseto the results of management’s preliminary internal review, our Board ofDirectors voluntarily formed a Special Committee of independent directors toreview our stock option practices and grants during the period between the dateof the Company’s initial public offering on February 10, 2000 and August 31,2002.  The Special Committee undertookits investigation with the assistance of independent counsel and accountingexperts retained by its counsel. The Special Committee reviewed all 5.7 millionstock options granted throughout the period covered by its investigation. InDecember 2006, the Special Committee completed its review and reported itsfindings and recommendations to our full Board of Directors. The SpecialCommittee did not find fraud or intentional misrepresentation in the financialreporting of the option grants that it analyzed but found inaccuracies in thedetermination of measurement dates for certain stock option grants affectingthe Company’s accounting and disclosures. For a number of these grants, theSpecial Committee found that it was likely that the stated grant date wasselected in hindsight based on price given the lack of supporting documentationand that the option price was the low price in a given month or quarter. Such grantswere found to be present during 2000 and through approximately mid-year 2001.The Special Committee concluded that it was not necessary to expand theinvestigation to cover periods after August 31, 2002. Among the various keyconsiderations in reaching this conclusion were: 1) as noted above, the SpecialCommittee did not find fraud or intentional misrepresentation in the financialreporting of the option grants that it analyzed; 2) the Special Committee’sinvestigation found that the last instance of likely grant date selection basedon stock price  occurred in mid-2001; and3) the Special Committee observed that the option granting practices of theCompany became more formal and regularized during the latter phase of theperiod subject to its review. 

In addition to the Special Committee investigation, the Company, withthe assistance of outside legal counsel, reviewed the Company’s stock optionpractices and grants for the periods subsequent to August 31, 2002. This reviewevaluated 90 percent of the 11.1 million options granted after August 31, 2002.The review was designed not only to provide a high degree of grant reviewcoverage, but also to appropriately assess the propriety of measurement datesfor each of the various types of options granted during this period.  Among others, option grant types coveredincluded: 1) new employee grants in connection with the acquisition ofbusinesses; 2) semi-annual employee ranking grants; 3) routine non-officer grantsfor such events as new hires, promotions, sales achievement, etc; and 4)officer grants, including grants to the Company’s then CEO. This review did notfind fraud or intentional misrepresentation in the financial reporting relatingto option grants but identified errors in the determination of measurementdates. However, such errors were relatively immaterial and did not exhibitevidence of selection of a favorable grant date and price in hindsight. 

In those instances during the two review periods where the fair marketvalue of our common stock at the originally stated grant date was lower thanthe fair market value on the re-determined measurement date, we concluded thatapproximately $9.7 million of additional stock-based compensation expenserelated to 4.6 million options of the 15.8 million options reviewed shouldbe recorded in accordance with Accounting Principles Board No. 25, “Accountingfor Stock Issued to Employees” (“APB No. 25”) and related interpretations.Cumulatively through December 31, 2005 we have reflected $9.5 million of thisexpense in our consolidated statements of operations. The remaining $0.2million is for options which were not fully vested as of December 31, 2005. Additionalstock-based compensation expense was recorded as follows: $0.2 million in 2005,$0.8 million in 2004, $1.2 million in 2003, $1.9 million in 2002, $4.2 millionin 2001, and $1.2 million in 2000.

According to APB No. 25, the measurement date is the first date onwhich proper approval is obtained and all of the following are known: (1) theindividual employee who is entitled to receive the option grant, (2) the numberof options that an individual employee is entitled to receive, and (3) theoption’s exercise price. To correct the grant date inaccuracies, the Companyre-determined the measurement date based on the date when all APB No. 25criteria were satisfied. In re-determining the most appropriate measurementdate of an option grant, we considered meeting minutes and other documents ofour Board of Directors, including minutes of the Compensation Committee and theOption Committee, in addition to the following data:

·       thedate on which such grants were entered into the Company’s stock option system(“option entry date”) and thereby constructively communicated to each recipientvia each recipient’s individual stock option account as administered by athird-party online broker;

·       reportson Form 4 filed with the SEC;

·       contemporaneousemails;

·       personnelfiles;

·       payrollrecords;

·       informationobtained in interviews with various current and former Company employees andBoard of Directors members; and

·       variousrecords maintained by our Human Resources department.

For grants where there was not sufficient evidence anddocumentation to support the original measurement date or to determine theprecise date when the number of options and exercise price were finalized, weused all available relevant information to form a reasonable conclusion as tothe most likely measurement date for such option grants. 

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For grants made to officers during this time, theCompany believes that the proper measurement date is the date on which suchgrants were ratified or approved by the Compensation Committee. Under theCompany’s corporate governance provisions during both periods subject toreview, the Compensation Committee was the only body authorized to approveofficer stock option grants. Therefore, officer grants could not be determinedwith finality until approval by the Compensation Committee. Of the total $9.7million additional stock-based compensation expense arising from grant datecorrections, approximately $4.2 million relates to officer grants.  

Of the total $9.7 million additional stock-basedcompensation expense arising from grant date corrections, approximately $5.5million relates to non-officer grants. Prior to the formation of the OptionCommittee in July 2001 and in lieu of sufficient evidence and documentation tosupport an earlier measurement date, the Company concluded that the bestestimate of the measurement date was the option entry date. During thispre-July 2001 period the Company’s CEO was authorized by the Company’s Board ofDirectors to grant options to non-officers, and we have concluded that allmeasurement date criteria were finalized no later than the option entry date. However,because documentation was often not sufficient to determine whether ameasurement date may have been established prior to the option entry date, weperformed a sensitivity analysis using alternative measurement dates. If weused the Company’s highest quoted stock prices observed during the periodbetween the originally stated grant dates and the option entry date, we wouldhave recognized an additional $1.7 million of stock-based compensation expense.If we used the lowest price during this period, no additional stock-basedcompensation expense would have been recorded. For all non-officer grantsduring the period after December 31, 2001, we concluded that allmeasurement date conditions were determined with finality on the date ofapproval/ratification by the Option Committee or Compensation Committee, asapplicable.

The following is a summary of the results of thereviews by the Special Committee and the Company and the impact of the primarystock-option accounting errors underlying this restatement: 

Inaccurate measurement dates for certain stock optionsgranted between February 10, 2000 and August 31, 2002

Based upon the review of all 5.7 million stock optionsgranted to officers and non-officer employees between February 10, 2000 andAugust 31, 2002, it was determined that we used inaccurate measurement datesfor 3.8 million  options.  Inaccurate measurement dates were found tohave been used for substantially all grants issued prior to 2002, whereas onlyan inconsequential number of inaccuracies were identified during the firsteight months of 2002. Of the $9.7 million of stock-based compensation expensedescribed above, approximately $9.4 million arose from grants made during thisperiod. Of this $9.4 million approximately $8.8 million can be described asresulting from the Company’s use of grant dates for which there was inadequatesupport. The remaining $0.6 million of the $9.4 million noted above is theresult of the Company’s incorrect accounting for certain options that weremodified after the initial grant date.

The discussion following each of the italicizedheadings below provides further details on the various error types identified.The specific examples discussed here account for $8.7 million of the $9.4million expense noted above. The remaining $0.7 million not specificallydiscussed below related to various generally small grants of approximately1.0 million options in total (e.g. new hires, promotions, incentive andsales achievement awards) awarded throughout this period.

*Errors arising from likely date selection inhindsight:*

As noted above, the Special Committee identifiedduring this period grant dates which were likely selected in hindsight based onstock price considerations. The following specific grants, which in theaggregate account for additional stock-based compensation expense of $7.2 millionand constitute materially all such grants in both quantity and restatementamount, are the largest examples of this error type:

·       Grantsmade in April 2000 (0.3 million options covering 134 employees, including sixofficers), December 2000 (0.5 million options covering 173 employees includingeight officers), and April 2001 (0.7 million options covering 149 employees,including eight officers) were dated prior to the dates on which finalizationand approval appears to have occurred. These grant dates also exhibitedfavorable pricing (i.e., relative stock price lows). Most of these grants weremade in conjunction with the Company’s normal practice of granting stockoptions to officers and non-officers on a semi-annual basis through an employeeperformance ranking process. The remaining awards on these dates were variousother grant types such as new hire and sales achievement options. Theadjustment of the measurement dates on these options resulted in aggregateadditional stock compensation expense of $6.0 million. 

·       Agrant of 0.2 million shares was made in August 2000 to one officer inconnection with that officer’s initial employment. For this particular grant,while the Special Committee’s investigation found sufficient evidence of grantapproval within the month of hire, adequate evidence of exercise pricedetermination could not be located until entry into the Company’s stock optionsystem. Therefore, this later date was determined to be the appropriatemeasurement date, resulting in additional stock-based compensation expense of$0.4 million. 

·       Agrant of 0.4 million shares was made to one officer with an originally statedgrant date of March 2001. Based upon the Special Committee’s review, theCompany concluded that final approval of all the terms of this grant by theCompensation Committee occurred in April 2001. Adjusting this grant to thelater measurement date resulted in additional stock-based compensation expenseof $0.8 million.

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*Errors arising during implementation of theCompany’s month-end granting process:*

During 2001, the Company’s option-granting practicesbecame more formal and regularized. The Option Committee of the Board ofDirectors was established in July 2001 and was given the authority to approvecertain non-officer employee grants. The Stock Options Committee determinedthat for non-officer new hires, promotions, and other routine grants, aconsistent practice should be established of granting options at the closingprice of the last trading day of the month in which the respective option wasawarded. Beginning in October 2001, the Company’s originally stated measurementdate for such grants was always the closing price for the month. While someevidence exists to show that the Option Committee’s practice was implementedbeginning in October 2001, the Company has concluded that it was not untilJanuary 2002 that a consistent pattern of month-end granting was establishedsuch that all measurement date criteria were determined with finality as of theend of the month.  As such, we havere-determined the measurement dates in October, November and December 2001, tobe the date on which such grants were ultimately approved/ratified in January2002. This adjustment to the originally stated measurement date for these threemonths (a total of 0.4 million options) resulted in additional stock-basedcompensation expense of approximately $0.5 million. This adjustment relatesentirely to non-officer employee grants.

*Certain other errors arising from inadequatesupport of originally stated grant date:*

In connection with a 2000 acquisition, approximately0.1 million options were granted to eleven new non-officer employees inAugust 2000. The Company’s originally stated measurement date coincided withthe closing date of the acquisition. However, we concluded that there wasinsufficient documentation available to support that these grants were approvedwith finality as of the acquisition date. Giving full consideration to thefacts and circumstances, we concluded that the date of approval by theCompensation Committee was the most appropriate measurement date for theseoptions. This adjustment to the original measurement date resulted inadditional stock-based compensation expense of $0.4 million.

*Errors arising from incorrect accounting for optionmodifications:*

We incorrectly accounted for approximately 0.2 millionstock options granted in the fourth quarter of 2000, consisting mostly ofgrants to new employees of the Company. Subsequent to the granting of these options, the Company modified theexercise price to the closing market price of the Company’s stock on December20, 2000, which was the lowest noted market closing price during the quarter.Such repricing is considered a modification of an award and requires theapplication of variable accounting. In accordance with the provisions ofFinancial Accounting Standards Board Interpretation 44, “*Accountingfor Certain Transactions involving Stock Compensation*,” wedetermined that we should have recorded an additional $0.6 million instock–based compensation expense relating to these grants during the periods2000 through 2005. The annual stock-based compensation expense (benefit)recorded for these grants was $24 thousand, $0.4 million, $0.1 million, ($0.4million), and $0.4 million in 2005, 2004, 2003, 2002 and 2001, respectively. 

Inaccurate measurement dates for certain stock optionsgranted after August 31, 2002

Based upon our review of 10.1 million of the 11.1million options granted after August 31, 2002, we concluded that we usedinaccurate measurement dates for 0.8 million options and concluded that weshould have recorded an additional $0.3 million in stock–based compensationexpense for the periods 2002 through 2005. For approximately 0.6 millionoptions granted to employees in connection with the 2005 Blue Pumpkin, Inc.acquisition, the Company initially used the date of acquisition as themeasurement date. However, we concluded that the Board of Directors’ approvaldate is the appropriate measurement date for all grants as insufficientverifiable evidence existed to support the originally-stated grant date. Thiscorrection resulted in additional stock-based compensation expense of $0.2million (included in the $0.3 million above). For the options granted (approximately 1.5 million in total) toemployees in connection with the Eryetel, plc. acquisition in 2003, the Companyhad sufficient evidence to support the original grant date for all employeesexcept a small number of employees who joined the Company after the acquisitionand were granted approximately 50 thousand shares in total. In this case theCompany relied on the option entry date to establish the measurement date.  In this respect, the Company recorded anadditional $0.1 million of stock-based compensation expense. Because the $0.1million of additional stock-based compensation expense related to non-officergrants is based on an estimate of the best measurement date (i.e., the optionentry date), the Company performed a sensitivity analysis using alternativemeasurement dates. Based on our sensitivity analysis, use of the highest quotedstock price observed during the period between the originally stated grant dateand the option entry date, would have resulted in an immaterial difference instock-based compensation expense as compared to our best estimate of thecorrect measurement date.

**OtherAdjustments in our Consolidated Financial Statements**

In connection with the restatement of our historical ConsolidatedFinancial Statements, we identified additional adjustments that needed to berecorded to our historical Consolidated Financial Statements. These adjustmentsconsisted primarily of a correction of purchase accounting relating to theacquisition of Blue Pumpkin, Inc., income taxes and miscellaneous other items. Theseadjustments resulted in an increase of approximately $1.0 million in thepreviously reported net loss in 2005. 

The cumulative effect of all the restatementadjustments to our Consolidated Balance Sheet as of December 31, 2005 resultedin an increase in the accumulated deficit of $10.5 million, an increase inadditional paid-in capital of $5.8 million and increases in assets andliabilities of $2.8 million and $7.5 million, respectively.

We have decreased previously reported net income by$1.3 million, $0.8 million, $1.2 million, $1.9 million, $4.2 million and $1.2million for the years ended December 31, 2005, 2004, 2003, 2002, 2001 and 2000,respectively. The adjustments reduced previously reported diluted earnings percommon share by $0.05, $0.03, $0.05, $0.08, $0.19 and $0.06 for the years endedDecember 31, 2005, 2004, 2003, 2002, 2001 and 2000, respectively. 

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As a result of our current determination that theexercise price for certain stock options was lower than the fair market valueon the actual measurement dates, certain options formerly classified asincentive stock options (ISOs) under the Internal Revenue Code do not qualifyto be treated as ISOs. The disqualification of ISO status results in anadditional cumulative charge of $0.1 million for federal income tax withholdingin 2006. We believe that the impact of the related interest penalties is immaterial.

Certain stock options granted with an exercise pricelower than the fair market value on the actual measurement dates had vestingafter December 31, 2004, resulting in nonqualified deferred compensation forpurposes of Section 409A of the Internal Revenue Code.  This subjects the option holders toadditional income tax, penalties and interest on the value of the optionsdeferred and in certain cases, exercised, each year.  We have implemented a plan as of December 31,2006 to allow the affected employees to minimize their tax consequences underSection 409A.  The Company does not haveany tax liability associated with Section 409A. 

We delayed the filing of our quarterly reports on Form10-Q for the quarters ended June 30, 2006 and September 30, 2006 until theCompany was able to complete restatement of previously issued ConsolidatedFinancial Statements. As a result, we have not been in compliance with theNasdaq Stock Market filing requirements for continued listing as set forth inMarketplace Rule 4310(c) (14). We have received a letter from Nasdaq ListingQualification Panel advising us that we have received an extension of timethrough February 7, 2007 to file our Quarterly Reports on Form 10-Q for thequarters ended June 30, 2006 and September 30, 2006.  The Panel advised us that if we are unable tomeet the extension deadline, the Panel will issue a final determination todelist our shares and there can be no assurance that Nasdaq Listing and HearingReview Council will grant an additional extension of time to meet suchrequirements or that our common stock will remain listed on the Nasdaq StockMarket.

**CriticalAccounting Policies and Estimates**

The discussion and analysis of our financial conditionand results of operations is based upon our Consolidated Financial Statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these ConsolidatedFinancial Statements requires us to make certain estimates and judgments thataffect our reported assets, liabilities, revenue and expenses, and our relateddisclosure of contingent assets and liabilities. On an on-going basis, were-evaluate our estimates, accounting policies and judgments including thoserelated to revenue recognition, the collectibility of receivables, accountingfor acquisitions, impairment of long-lived assets, income taxes and stock-basedcompensation to ensure that our Consolidated Financial Statements are presentedfairly and in accordance with Generally Accepted Accounting Principles (“GAAP”).We base our estimates on historical experience and on various assumptions thatwe believe to be reasonable under the circumstances. However, because futureevents and their effects cannot be determined with certainty, actual resultsmay differ from these estimates under different assumptions or conditions andsuch differences could be material. Management believes that the followingaccounting policies and estimates are critical to understanding and evaluatingour reported financial results. Management has reviewed these criticalaccounting policies and estimates with the Audit Committee of our Board ofDirectors.

*RevenueRecognition.**  *Werecognize revenue in accordance with the American Institute of Certified PublicAccountants’ Statement of Position (“SOP”) No. 97-2,*Software Revenue Recognition,* andSOP No. 98-9*, Modification of SOP97-2, Software Revenue Recognition, With Respect to Certain Transactions*.Revenue is primarily derived from licensing software and providing relatedservices including maintenance. We also derive a relatively small portion ofproduct revenue by selling hardware to customers since our acquisition ofEyretel. Product revenue, which includes software and hardware, is recognizedwhen persuasive evidence of an arrangement exists, delivery of the product hasoccurred, the fee is fixed or determinable, collection is probable and vendorspecific objective evidence of fair value (“VSOE”) exists to allocate revenueto the undelivered elements of the arrangement. We report hardware revenuegross in accordance with Emerging Issues Task Force (“EITF”) No. 99-19,*Reporting Revenue Gross as a Principal versus Net asan Agent,* because the factors indicating gross reporting outweighthe factors indicating net reporting. We recognize revenue using the residualmethod of accounting since we generally have VSOE for maintenance andprofessional services, but not for the software and hardware elements of theorder. Under the residual method, services revenue, including maintenance andprofessional services, is deferred at an amount equal to its fair value untilthose elements are delivered. Consequently, product revenue for the softwareand hardware may be recognized (i) upon delivery of

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those products when wehave VSOE on the related maintenance and professional services sold and(ii) at an amount representing the difference between the total orderamount and the amount deferred.

Services revenue includes installation, training,consulting, maintenance and reimbursable travel expenses. Revenue frominstallation, training and consulting services is recognized upon performanceof the related services and is offered and billed as separate elements ofcontracts. Reimbursable travel expenses revenue is recognized upon incurrenceof the related expenses. The functionality of the software and any hardwaresold is not dependent on installation and training services and customizationis not required to enable our customers to use our products. Maintenance isoffered as a separate element and the majority of contracts include the rightto unspecified upgrades on a when-and-if available basis. Maintenance revenueis deferred and recognized ratably over the term of the related contract.

*Allowancefor Doubtful Accounts.**  *Weperform ongoing evaluations of our customers and continuously monitorcollections and payments and estimate an allowance for doubtful accounts basedon the aging of the underlying receivables, our historical experience withwrite-offs and any specific customer collection issues that we have identified.While such credit losses have historically been within our expectations and webelieve appropriate reserves have been established, we cannot assure that wewill continue to experience the same credit loss rates that we have experiencedin the past or adequately predict future credit losses. If the financialcondition of our customers were to deteriorate and resulted in an impairment oftheir ability to make payments, additional allowances may be required whichwould result in an additional selling, general and administrative expense inthe period such determination is made.

Our revenue recognition policy is significant becauseour revenues are a key component of our results of operations. We follow veryspecific and detailed guidelines, discussed above, in measuring revenues;however, certain judgments and estimates affect the application of our revenuepolicy described above. Further, assessment of collectibility is particularlycritical in determining whether or not revenues should be recognized. We alsorecord provisions for estimated sales allowances on product and service relatedrevenues at the time the related revenues are recorded. These estimates arebased on historical sales and services allowances, analysis of customer creditsand other known factors. If future sales credits prove to be greater than thehistorical data and the estimates we used to calculate these provisions, ourrevenues could be overstated.

*Accounting forAcquisitions.**  *Accountingfor acquisitions requires management to make judgments and estimates indetermining the purchase price, the fair value of the assets and liabilitiesacquired and merger-related and integration costs. In recording the BluePumpkin and Optimis acquisitions in 2005, significant judgment was required inestimating:

·    valuationof deferred revenue,

·    valuationof intangible assets and acquired in-process research and development,

·    otherliabilities existing at the time of acquisition.

Changes to purchase price estimates are reflected asadjustments to goodwill and/or other acquired assets to the extent informationwas requested but not received at the date of acquisition. Other adjustmentsare reflected in our results of operations. In accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 142,*Goodwill and Other Intangible Assets*, goodwill andintangible assets with indefinite useful lives are not amortized, but aretested for impairment annually or more frequently if circumstances indicatetheir value may no longer be recoverable.

*Impairmentof Long-Lived Assets.**  *Long-livedassets, such as property and equipment and intangible assets, are accounted forin accordance with Statement of Financial Accounting Standard (“SFAS”) No. 144*, Accounting for Impairment or Disposal of Long-livedAssets* and are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. All of our identifiable intangible assets are amortized using thestraight-line method. Useful lives of amortizable intangible assets arereviewed annually with any changes in estimated useful lives being accountedfor prospectively over the revised remaining useful life. Recoverability ofassets to be held and used would be measured by a comparison of the carryingamount of an asset to the estimated undiscounted future cash flows expected tobe generated by the

35

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asset. If the carryingamount of an asset exceeds its estimated undiscounted future cash flows, animpairment charge is recognized in the amount by which the carrying amount ofthe asset exceeds the fair value of the asset. The determination of estimatedfuture cash flows, however, requires management to make estimates. Futureevents and changes in circumstances may require us to record a significantimpairment charge in the period in which such events or changes occur.Impairment testing requires considerable analysis and judgment in determiningthe results. If other assumptions and estimates were used in our evaluations,the results could differ significantly.

*Accountingfor Income Taxes.**  *Weaccount for income taxes in accordance with SFAS No. 109,*Accounting for Income Taxes*, whichrequires companies to recognize deferred income tax assets and liabilities fortemporary differences between the financial reporting and tax bases of recordedassets and liabilities and the expected benefits of net operating loss andcredit carryforwards. SFAS No. 109 requires that deferred income taxassets be reduced by a valuation allowance if it is more likely than not thatsome portion or all of the deferred income tax assets will not be realized. Weevaluate the realizability of our deferred income tax assets, primarilyresulting from net operating loss and credit carryforwards, and adjust ourvaluation allowance, if necessary.

If we were to recognize the tax benefit associatedwith our net operating loss carryforwards, we would expect our provision forincome tax expense in future periods to reflect an effective tax rate that willbe significantly higher than past periods. Furthermore, the utilization of deferredtax assets, primarily net operating loss carryforwards arising fromacquisitions, has resulted and will continue to result in a reduction ingoodwill and the recognition of tax expense associated with the purchaseddeferred tax assets. The adoption of SFAS 123R, as noted below, willpotentially result in tax benefits that are currently difficult to predict.

Estimates and judgments are required in determiningour worldwide income tax expense. In the ordinary course of conducting businessglobally, there are many transactions and calculations whose ultimate taxoutcome cannot be certain. Although we believe our estimates and judgments arereasonable, no assurance can be given that the final tax outcome of thesematters will not be different from what is reflected in our historical incometax provisions and accruals. Such differences could have a material impact onour income tax provision and operating results in the period in which such adetermination is made.

*Stock-BasedCompensation.**  *Wehad generally not recorded compensation expense for options granted to ouremployees because all options granted under our stock option plans wereinitially considered to have an exercise price equal to the market value of theunderlying common stock on the date of grant. However, as described in Note 2, “Restatement of Consolidated FinancialStatements,” of the Notes to the Consolidated Financial Statementsincluded elsewhere in this report, we have found inaccuracies in thedetermination of measurement dates for certain stock option grants.  In those instances where the fair marketvalue of our common stock at the originally stated grant date was lower thanthe fair market value on the redetermined measurement date, in accordance withAPB No. 25 and related interpretations, we have recorded stock-basedcompensation expense which was not recorded in our previously issuedConsolidated Financial Statements.

As permitted under SFAS No. 148,*Accounting for Stock-Based Compensation—Transitionand Disclosure*, and SFAS No. 123,*Accounting for Stock-Based Compensation*, we have elected tocontinue to apply the provisions of Accounting Principles Board OpinionNo. 25,*Accounting for Stock Issued toEmployees,* and have adopted the disclosure requirements of SFASNo. 123. The pro forma disclosures of stock-based compensation include theuse of certain input factors in calculating the fair value of stock optiongrants, some of which require management to make estimates and use judgment.

In December 2004, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 123R (Revised 2004),*Share-Based Payment* which, among otherthings, requires that compensation expense be recognized in the ConsolidatedFinancial Statements for share-based awards based on the grant date fair valueof those awards. It will also require the benefits associated with taxdeductions in excess of recognized compensation cost to be reported as afinancing cash flow rather than as an operating cash flow as currentlyrequired. The share-based compensation cost will be measured based on the fairvalue of the equity or liability instruments issued. Effective January 1,2006, we expect to adopt SFAS 123R using the modified prospective method. Weare evaluating the requirements under SFAS 123R and expect the adoption tohave a significant adverse impact on our results of operations, but not on ourcash flows

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**Results ofOperations**

The table belowshows operating data as a percentage of total revenue for the periodsindicated:
|                                                  | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                       | ** ** | **2005  As  Restated  (1)**                | ** ** | **2004  As   Restated  (1)** | ** ** | **2003  As   Restated  (1)** | ** ** |
| Revenue:                                         |       |                                       |       |   |   |   |   |
| Product                                          |       | 40                                         | %          | 41 | % | 43 | % |
| Services                                         |       | 60                                         |       | 59 |   | 57 |   |
| Total revenue                                    |       | 100                                        |       | 100 |   | 100 |   |
| Cost of revenue:                                 |       |                                       |       |   |   |   |   |
| Product                                          |       | 10                                         |       | 10 |   | 11 |   |
| Services                                         |       | 23                                         |       | 23 |   | 22 |   |
| Total cost of  revenue                           |       | 33                                         |       | 33 |   | 33 |   |
| Gross profit                                     |       | 67                                         |       | 67 |   | 67 |   |
| Operating expenses:                              |       |                                       |       |   |   |   |   |
| Selling, general  and administrative             |       | 46                                         |       | 47 |   | 56 |   |
| Research and  development                        |       | 15                                         |       | 15 |   | 17 |   |
| Merger-related  and integration costs            |       | 2                                          |       | 0 |   | 8 |   |
| Acquired  in-process research and development    |       | 5                                          |       | 0 |   | 7 |   |
| Operating (loss)  income                         |       | (1                                         | )          | 5 |   | (21 | ) |
| Interest and other  income, net                  |       | 1                                          |       | 1 |   | 1 |   |
| (Loss) income  before provision for income taxes |       | (0                                         | )          | 6 |   | (20 | ) |
| Provision for income  taxes                      |       | 2                                          |       | 0 |   | 0 |   |
| Net (loss) income                                |       | (2                                         | )          | 6 |   | (20 | ) |

 

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(1)             See Note 2, “Restatement of ConsolidatedFinancial Statements,” of the Notes to the Consolidated Financial Statements.

*Impact of Blue Pumpkin and Optimis Acquisitions*

The acquisition of Blue Pumpkin and Optimis in 2005increased our reported revenues in 2005 by an estimated $25 million compared tothe same period in 2004. Operating expenses, expressed as a percentage of totalrevenue, also increased in 2005 compared to the same period in 2004 due to acharge of $9.0 million in acquired in-process research and development costs,an increase of $3.7 million in merger-related and integration costs andadditional intangible asset amortization of $9.3 million.

***Revenue***

Total revenue increased by 31% to $185.3 millionin 2005 compared to 2004 and 31% to $141.3 million in 2004 compared to2003. The increase in total revenue can be attributed to both continued growthof our business and growth through acquisition. The number of installedcustomer sites grew to 4,209 sites at the end of 2005 from 2,799 sites at theend of 2004 and 2,341 sites at the end of 2003. International revenue increased24 % in 2005 compared to 2004 and 41% in 2004 compared to 2003. The weakeningof the U.S. dollar against certain foreign currencies increased revenue byapproximately 0.1% in 2005 compared to 2004 and 5% in 2004 compared to 2003.

Product revenue includes software revenue and hardwarerevenue. Hardware sales are incidental to our business and we are workingtoward transitioning our customers to third-party hardware suppliers. We expect

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hardware revenue todecline in the future. Product revenue, excluding hardware revenue of$5.7 million in 2005, $7.6 million in 2004 and $6.3 million in2003, increased 37% and 25% in 2005 and 2004, respectively, compared to prioryears. The increase in software revenue growth in 2005 is attributed to ourexpanded product line resulting from our acquisitions of Blue Pumpkin andOptimis which are included in our results effective January 25, 2005 andMay 24, 2005, respectively.

Product revenue as a percentage of total revenue hasdecreased slightly over the past three years due to lower hardware sales and increasedservices revenue, as discussed below. Our product pricing has remainedrelatively consistent over the past three years. The percentage of productrevenue, excluding hardware revenue, derived from our indirect sales channelincreased to 41% in 2005 from 32% in 2004 and 31% in 2003. This increaseresults from our strategy to expand our indirect sales channels.

New customers accounted for 25%, 22% and 27%,respectively, of product revenue, excluding hardware revenue, in 2005, 2004 and2003, with the balance of revenue representing follow-on revenue from ourexisting customer base. We receive follow-on revenue from our customers whenthey purchase additional user licenses or license additional applications atexisting sites and when they license our products at new sites. We expect togenerate the majority of our product revenue from existing customers during2006.

Services revenue, consisting of installation,training, consulting, maintenance support and reimbursable travel expenses,increased 33% to $111.1 million in 2005 compared to 2004 and 35% to$83.7 million in 2004 compared to 2003. The increases were due toinstallation and training services related to new product sales and due tocustomers renewing their maintenance contracts with us thereby increasing ourrecurring maintenance revenue stream. The percentage of Witness customers thathave renewed their maintenance contracts with us has historically exceeded 90%.We believe that maintenance contracts will be renewed at a comparable rateduring 2006. Our services pricing has remained consistent over the past threeyears. We expect services revenue, in absolute dollars, to increase over timedue to the compounding effect of renewals of annual maintenance contracts fromexisting customer sites and to remain relatively constant as a percentage oftotal revenue, excluding hardware revenue in 2006.

***Costof Revenue***

Total cost of revenue increased 32% to$61.5 million in 2005 compared to 2004 and 29% to $46.4 million in2004 compared to 2003. Expressed as a percent of revenue, gross profit marginshave remained constant at 67% in 2005, 2004 and 2003. Excluding hardware andthe amortization of intangible assets resulting from acquisitions, grossmargins have remained consistent at 74% in 2005, 2004 and 2003. We expect ourgross profit margin, excluding hardware and amortization of intangible assets,to remain relatively constant in 2006.

Cost of product revenue consists of amortization ofacquired technology, hardware costs, royalties due to third parties forsoftware components that are embedded in our software applications,amortization of capitalized software development costs and packaging costs.Amortization of acquired technology was $9.2 million in 2005 and$4.4 million and $4.1 million in 2004 and 2003, respectively. Theincrease in the amortization of acquired technology in 2005 was due to theacquisition of Blue Pumpkin. Cost of hardware revenue was $5.8 million$7.3 million and $5.7 million in 2005, 2004 and 2003, respectively.We will continue to incur amortization expense, but expect the cost of hardwareto decline as we work towards reducing the amount of hardware sales in thefuture. Cost of product revenue, excluding amortization of acquired technologyand hardware costs, increased 24% in 2005 compared to 2004 and 12% in 2004compared to 2003. The increase in 2005 was primarily due to increased royaltiesdue to third parties for software included in our product offerings. Expressedas a percentage of product revenue, excluding hardware, the cost of suchrevenue, excluding amortization of intangible assets was, 6%, 4% and 5% in2005, 2004 and 2003, respectively. As we develop upgrades of our existingproducts and add new offerings to our product suite, we may add additionalthird-party technology into our products, which would increase the cost ofproduct revenue in the future.

Cost of services revenue for installation, training,consulting and maintenance services include personnel costs and relatedexpenses and allocated overhead. Personnel costs include salaries, bonuses andbenefits. Cost of services revenue increased 29% to $42.4 million in 2005compared to 2004 due primarily to an increase in the number of employees andcontractors engaged in customer support services mainly as a result of the Blue

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Pumpkin and Optimisacquisitions. Cost of services revenue increased 34% to $32.6 million in 2004compared to 2003 primarily due to an increase in the number of employeesengaged in installation, training, consulting, and customer support services primarilydue to the Eyretel acquisition. Cost of services revenue as a percentage ofservices revenue decreased to 38% in 2005 from 39% in 2004 and 2003. Weanticipate that our services margins will remain relatively constant in 2006.We expect our customer service organization to continue to grow over time and,therefore, we anticipate that our cost of services revenue, in absolutedollars, will increase as we grow our customer base.

***OperatingExpenses***

*Selling,**General and Administrative.*   Selling,general and administrative (“SG&A”) expense consists primarily of personnelcosts, sales commissions, marketing programs, professional fees, theamortization of certain intangible, stock-based compensation and provisions forbad debt expense. SG&A expense increased 31% to $86.0 million in 2005compared to 2004 due primarily to higher amortization expenses and theincreased size of our Company due to acquisitions of Blue Pumpkin and Optimis.SG&A expense increased 8% to $65.8 million in 2004 compared to 2003.This increase was due to the increased size of our Company after the Eyretelacquisition and due to a full-year of amortization of intangible assetsacquired in 2003. In 2006, we expect SG&A expense to increase in absolutedollars but decrease as a percentage of total revenue due to anticipatedrevenue growth as compared to the same period in 2005.

*Research**and Development.*   Research and development (“R&D”)expenses consist primarily of personnel and consulting costs to support productdevelopment, and allocated overhead. R&D costs are generally expensed asincurred and include software development costs incurred prior to theestablishment of technological feasibility. Costs incurred subsequent toestablishing technological feasibility are capitalized and amortized over theirestimated useful lives to cost of product revenue. As of December 31, 2005and 2004, $0.5 million and $0.8 million, respectively, in softwaredevelopment costs were capitalized of which $0.5 million and $0.4 million****was amortized to cost of product revenue in 2005 and 2004,respectively. R&D expenses increased 28% to $26.7 million in 2005compared to 2004 primarily due to the increased number of employees engaged inresearch and development activities as a result of the Blue Pumpkinacquisition. R&D expenses increased 14% to $20.8 million in 2004compared to 2003 due to an increased number of contractors engaged in researchand development activities. We expect total R&D expense to increase inabsolute dollars but decrease as a percentage of total revenue during 2006 ascompared to 2005.

*Merger-related**and IntegrationCosts.**   Weincurred merger-related and integration costs of $4.5 million in 2005,primarily due to the Blue Pumpkin and Optimis acquisitions. We incurredmerger-related costs of $0.5 million during 2004 and $7.9 million during 2003due to the Eyretel acquisition. The 2005 merger-related and integration costsare comprised primarily of costs of transitional employees and othercontractors, travel costs, legal costs and advertising costs. InMarch 2003, our Board of Directors agreed to pay a bonus of£1.0 million to our COO in connection with the Eyretel acquisition andsubsequent integration. In March 2004, £0.4 million of this bonus waspaid and the remaining balance of £0.6 million was paid inMarch 2005.*

*Acquired**In-Process Research and Development.  **During 2005, we estimated that $9.0million of the purchase price of Blue Pumpkin represented acquired in-processresearch and development (“IPR&D”) that had not yet reached technologicalfeasibility as defined by SFAS No. 86,*Accounting for the Costof Computer Software to Be Sold, Leased or Otherwise Marketed,*and had no alternative future use.Accordingly, these amounts were immediately charged to expense upon consummationof the acquisition. The value of the IPR&D was determined with theassistance of an independent third-party appraiser by utilizing a discountedcash flow methodology, focusing on the income-producing capabilities of thein-process technologies and taking into consideration: stage of completion;complexity of work to date and to complete; anticipated product development andintroduction schedules; forecasted product sales cycles; internal and externalrisk factors; revenue and operating expense estimates; contributory assetcharges, and costs already incurred and the expected costs to complete.*

In 2003, we determined that $7.8 million of thepurchase price of Eyretel represented acquired in-process research anddevelopment (“IPR&D”) that had not yet reached technological feasibility asdefined by SFAS 

39

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No. 86, *Accounting for the Cost of Computer Software to BeSold, Leased or Otherwise Marketed,* and had no alternative futureuse. Accordingly, these amounts were immediately charged to expense uponconsummation of the acquisition. The value of the IPR&D was calculated withthe assistance of an independent third-party appraiser by utilizing adiscounted cash flow methodology, focusing on the income-producing capabilitiesof the in-process technologies and taking into consideration: stage ofcompletion; complexity of work to date and to complete; anticipated productdevelopment 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 coststo complete.

***Interestand Other Income, Net***

Interest and otherincome, net for year 2005, 2004 and 2003, respectively is as follows (inthousands)
|                               | ** ** | **2005  As Restated (1)** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|-------------------------------------|------------|----------|------------|----------|------------|
| Interest income               |       | $                                   | 1,137      |     | $          | 1,010    |       | $ | 780 |   |
| Foreign currency (loss)  gain |       | (173                                | )          | 256      |       | 353      |       |
| Other (expense) income        |       | (104                                | )          | (60      | )          | 170      |       |
|                          |       | $                                   | 860        |     | $          | 1,206    |       | $ | 1,303 |   |

 

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(1) See Note 2, “Restatement of Consolidated FinancialStatements,” of the Notes to the Consolidated Financial Statements includedelsewhere in this report.

Interest and other income, net decreased 29% to $0.9 millionin 2005 compared to 2004 due primarily to a decreased interest income resultingfrom lower investment balances as a result of the acquisitions of Blue Pumpkinand Optimis. Interest and other income, net decreased 7% to $1.2 millionin 2004 compared to 2003 due primarily to decreased interest income resultingfrom lower yields and lower investment balances as a result of the acquisitionof Eyretel which was paid for in cash. We expect that interest and otherincome, net will increase in 2006 compared to 2005 due to higher cash andinvestment balances resulting from our common stock offering in December 2005.

***Provisionfor Income Taxes***

We recorded a provision for federal alternativeminimum tax, deferred taxes and foreign income tax in 2005, a provision forfederal alternative minimum tax and foreign income tax in 2004 and a provisionfor foreign income tax in 2003, net of federal tax benefits. Of the $3.0million provision for the year ended December 31, 2005, $2.5 millionrelated to the utilization of a portion of the of deferred income taxassets, primarily net operating loss carry-forwards, acquired in the 2005acquisition of Blue Pumpkin. Because a full valuation allowance was recordedagainst these assets, the benefit from the utilization of these deferred incometax assets in 2005 was credited as a reduction to goodwill.

The provision for income taxes in 2005, 2004 and 2003benefited from the utilization of net operating loss carryforwards from prioryears. We have net operating loss carryforwards aggregating $81.3 millionfor U.S. income tax purposes and $38.1 million for foreign income taxpurposes remaining as of December 31, 2005. We expect that the provisionfor income taxes in 2006 will benefit from the utilization of these netoperating loss carryforwards. However, the utilization of certain net operatingloss carryforwards arising from acquisitions will result in a reduction of thevaluation allowance for deferred income tax assets and goodwill or intangibleassets and the recognition of deferred income tax expense.

**Quarterly Results of Operations**

The following tables present unaudited quarterlystatements of operations data for each of the last eight quarters in thetwo-year period ended December 31, 2005, as well as the percentage oftotal revenue represented by each item. The information has been derived fromour unaudited Consolidated Financial Statements, which have been prepared onsubstantially the same basis as the audited Consolidated Financial Statementscontained in

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this report. Theunaudited Consolidated Financial Statements contain all adjustments, consistingonly of normal recurring adjustments that we consider to be necessary topresent fairly this information when read in conjunction with the ConsolidatedFinancial Statements and Notes thereto appearing elsewhere in this report. Theresults of operations for any quarter are not necessarily indicative of theresults to be expected for any future period.
| ** **                                       | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|
| ** **                                       | ** ** | **Dec. 31,   2005**    | ** ** | **Sept. 30,  2005** | ** ** | **Jun. 30,  2005(a)** | ** ** | **Mar. 31,  2005(a)** | ** ** | **Dec. 31,  2004** | ** ** | **Sept. 30,  2004** | ** ** | **Jun. 30,  2004** | ** ** | **Mar. 31,  2004** | ** ** |
| ** **                                       | ** ** | **(in thousands)**          | ** ** |
| ** **                                       | ** ** | **As Restated (1)**    | ** ** |
| Revenue:                                         |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                          |       | $                                | 20,595     |   | $ | 18,306 |   | $ | 18,918 |   | $ | 16,368 |   | $ | 15,655 |   | $ | 13,925 |   | $ | 14,138 |   | $ | 13,902 |   |
| Services                                         |       | 30,254                           |       | 28,843 |   | 27,253 |   | 24,791 |   | 23,053 |   | 21,332 |   | 20,280 |   | 19,050 |   |
| Total revenue                                    |       | 50,849                           |       | 47,149 |   | 46,171 |   | 41,159 |   | 38,708 |   | 35,257 |   | 34,418 |   | 32,952 |   |
| Cost of revenue:                                 |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                          |       | 5,326                            |       | 4,543 |   | 4,928 |   | 4,332 |   | 3,423 |   | 2,737 |   | 3,714 |   | 3,910 |   |
| Services                                         |       | 11,223                           |       | 10,810 |   | 10,793 |   | 9,535 |   | 8,272 |   | 8,046 |   | 8,362 |   | 7,965 |   |
| Total cost of  revenue                           |       | 16,549                           |       | 15,353 |   | 15,721 |   | 13,867 |   | 11,695 |   | 10,783 |   | 12,076 |   | 11,875 |   |
| Gross profit                                     |       | 34,300                           |       | 31,796 |   | 30,450 |   | 27,292 |   | 27,013 |   | 24,474 |   | 22,342 |   | 21,077 |   |
| Operating expenses:                              |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general  and administrative             |       | 22,751                           |       | 21,667 |   | 21,577 |   | 19,998 |   | 17,489 |   | 16,694 |   | 15,762 |   | 15,863 |   |
| Research and  development                        |       | 6,680                            |       | 6,945 |   | 6,895 |   | 6,198 |   | 5,560 |   | 5,489 |   | 4,969 |   | 4,798 |   |
| Merger-related  and integration costs            |       | 889                              |       | 1,059 |   | 925 |   | 1,659 |   | (177 | ) | 152 |   | 155 |   | 368 |   |
| Acquired  in-process research and development    |       | —                           |       | — |   | — |   | 9,000 |   | — |   | — |   | — |   | — |   |
| Operating income  (loss)                         |       | 3,980                            |       | 2,125 |   | 1,053 |   | (9,563 | ) | 4,141 |   | 2,139 |   | 1,456 |   | 48 |   |
| Interest and other  income, net                  |       | 420                              |       | 245 |   | 56 |   | 138 |   | 463 |   | 435 |   | 137 |   | 171 |   |
| Income (loss)  before provision for income taxes |       | 4,400                            |       | 2,370 |   | 1,109 |   | (9,425 | ) | 4,604 |   | 2,574 |   | 1,593 |   | 219 |   |
| Provision for income  taxes                      |       | 552                              |       | 1,822 |   | 617 |   | 33 |   | 211 |   | (68 | ) | 144 |   | 25 |   |
| Net income (loss)                                |       | $                                | 3,848      |   | $ | 548 |   | $ | 492 |   | $ | (9,458 | ) | $ | 4,393 |   | 2,642 |   | $ | 1,449 |   | $ | 194 |   |
|                                                  |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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| (a)    |   | We commenced the consolidation of Blue Pumpkin  Software, Inc and Optimis on January 25, 2005 and May 23, 2005,  respectively. |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                     |
| (1)    |   | See Note 2, “Restatement of Consolidated Financial  Statements,” of the Notes to Consolidated Financial Statements.            |

 

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| ** **                                       | ** ** | **Three Months Ended**                                                           | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Dec. 31,  2005**                                                                    | ** ** | **Sept. 30,  2005** | ** ** | **Jun. 30,  2005(a)** | ** ** | **Mar. 31,  2005 (a)** | ** ** | **Dec. 31,  2004** | ** ** | **Sept. 30,  2004** | ** ** | **Jun. 30,  2004** | ** ** | **Mar. 31,  2004** | ** ** |
| ** **                                       | ** ** | **(as a percentage of total revenue)  As Restated (1)** | ** ** |
| Revenue:                                         |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                          |       | 40                                                                                         | %          | 39 | % | 41 | % | 40 | % | 40 | % | 39 | % | 41 | % | 42 |   |
| Services                                         |       | 60                                                                                         |       | 61 |   | 59 |   | 60 |   | 60 |   | 61 |   | 59 |   | 58 |   |
| Total revenue                                    |       | 100                                                                                        |       | 100 |   | 100 |   | 100 |   | 100 |   | 100 |   | 100 |   | 100 |   |
| Cost of revenue:                                 |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                          |       | 10                                                                                         |       | 10 |   | 11 |   | 11 |   | 9 |   | 8 |   | 11 |   | 12 |   |
| Services                                         |       | 22                                                                                         |       | 23 |   | 23 |   | 23 |   | 21 |   | 23 |   | 24 |   | 24 |   |
| Total cost of revenue                            |       | 32                                                                                         |       | 33 |   | 34 |   | 34 |   | 30 |   | 31 |   | 35 |   | 36 |   |
| Gross profit                                     |       | 68                                                                                         |       | 67 |   | 66 |   | 66 |   | 70 |   | 69 |   | 65 |   | 64 |   |
| Operating expenses:                              |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general  and administrative             |       | 45                                                                                         |       | 46 |   | 47 |   | 48 |   | 45 |   | 46 |   | 46 |   | 48 |   |
| Research and  development                        |       | 13                                                                                         |       | 15 |   | 15 |   | 15 |   | 14 |   | 16 |   | 15 |   | 15 |   |
| Merger-related  and integration costs            |       | 2                                                                                          |       | 2 |   | 2 |   | 4 |   | 0 |   | 0 |   | 0 |   | 1 |   |
| Acquired  in-process research and development    |       | 0                                                                                          |       | 0 |   | 0 |   | 22 |   | 0 |   | 0 |   | 0 |   | 0 |   |
| Operating income  (loss)                         |       | 8                                                                                          |       | 4 |   | 2 |   | (23 | ) | 11 |   | 7 |   | 4 |   | 0 |   |
| Interest and other  income, net                  |       | 1                                                                                          |       | 1 |   | 0 |   | 0 |   | 1 |   | 1 |   | 0 |   | 1 |   |
| Income (loss)  before provision for income taxes |       | 9                                                                                          |       | 5 |   | 2 |   | (23 | ) | 12 |   | 8 |   | 4 |   | 1 |   |
| Provision for income  taxes                      |       | 1                                                                                          |       | 4 |   | 1 |   | 0 |   | 1 |   | 0 |   | 0 |   | 0 |   |
| Net income (loss)                                |       | 8                                                                                          | %          | 1 | % | 1 | % | (23 | )% | 11 | % | 8 | % | 4 | % | 1 | % |

 

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| (a)    |   | We commenced the consolidation of Blue Pumpkin  Software, Inc and Optimis on January 25, 2005 and May 23, 2005,  respectively. |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                     |
| (1)    |   | See Note 2, “Restatement of Consolidated Financial  Statements,” of the Notes to Consolidated Financial Statements.            |

 

The increase intotal revenue, beginning in the first and second quarters of 2005, reflects theconsolidation of Blue Pumpkin and Optimis, which were acquired inJanuary and May 2005, respectively. Our second and fourth quartersgenerally have higher product revenue than the first and third quarters due toour customers’ budgeting and spending patterns. Hardware sales included inproduct revenue in 2005 and 2004, respectively are as follows (in millions):
| ** ** | ** ** | **Three Months Ended** | ** ** |
|------------|------------|----------------------------------|------------|
| ** ** | ** ** | **Dec. 31,  2005**          | ** ** | **Sept. 30,  2005** | ** ** | **Jun. 30,  2005** | ** ** | **Mar. 31,  2005** | ** ** | **Dec. 31,  2004** | ** ** | **Sept. 30,  2004** | ** ** | **Jun. 30,  2004** | ** ** | **Mar. 31,  2004** | ** ** |
| Revenue:   |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Hardware   |       | $                                | 1.7        |   | $ | 0.8 |   | $ | 1.9 |   | $ | 1.3 |   | $ | 2.2 |   | $ | 1.2 |   | $ | 2.0 |   | $ | 2.3 |   |
|            |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Threemonth period ended March 31, 2005 (restated) compared to March 31, 2004(restated)**

*Revenue*

Total revenueincreased 25% in the first quarter of 2005, as compared to the first quarter of2004, to $41.2 million.  The increase in total revenue can be attributedto both continued growth of our business and sales and related services derivedfrom our Blue Pumpkin acquisition.  In addition, the first quarter of 2005was adversely affected by a 3% or $1.0 million decrease in hardware revenuefrom the first quarter of 2004.  During the first quarter of 2005, weinstalled an additional 117 customer sites and, with the inclusion of BluePumpkin, we ended the quarter with 3,846 installed customer sites as of March31, 2005 versus approximately 2,444 at March 31, 2004.

Product revenueincludes software revenue and hardware revenue.  Because hardware salesare incidental to our core business, we are working towards transitioning ourcustomers to third-party hardware suppliers and, as a result, expect hardwarerevenue to decline in the future.  Product revenue of $15.1 million,excluding hardware revenue of $1.3 million in the first quarter of 2005 (and $2.3million in the same period in 2004), increased $3.5 million or 30% in the firstquarter of 2005.  Approximately $1.2 million of this increase reflects therevenue from our expanded product line resulting from our acquisition of BluePumpkin which we began consolidating on January 24, 2005.

Product revenue asa percentage of total revenue has been decreasing over the previous three yearsdue to increased services revenue, as discussed below. Our product pricing hasremained reasonably consistent over the previous three years.

New customersaccounted for 21% and 22%, respectively, of product revenue, excluding hardwarerevenue, during the first quarter of 2005 and 2004.  We receive follow-onrevenue from our existing customers when they purchase additional user licensesor license additional applications at existing sites and when they license ourproducts at new sites.  We expect to continue receiving the majority ofour product revenue from existing customers during 2005.

Services revenue,consisting of installation, training, consulting, maintenance support andreimbursable travel expenses, increased 30% to $24.8 million in the firstquarter of 2005 compared to the first quarter of 2004.  This increase wasdue to the installation and training services related to new product sales anddue to customers renewing their maintenance contracts with us therebyincreasing our recurring maintenance revenue stream.  Approximatelyone-third of the increase in services revenue in 2005 can be attributed to theBlue Pumpkin acquisition consummated January 24, 2005.  The percentage ofWitness customers that have renewed their maintenance contracts with us hashistorically exceeded 90%.  We believe that maintenance contracts will berenewed at a comparable rate during 2005.  Our services pricing hasremained consistent over the past three years.  We expect servicesrevenue, in absolute dollars, to increase over time due to the compoundingeffect of renewals of annual maintenance contracts from existing customer sitesand to remain relatively constant as a percentage of total revenue, excludinghardware revenue, throughout 2005.

*Cost ofRevenue*

Total cost ofrevenue increased 17% to $13.9 million in the first quarter of 2005 compared tothe first quarter of 2004.  Expressed as a percent of revenue, grossprofit margins increased to 66% in the first quarter of 2005 compared to 64% inthe same period in 2004.  This increase resulted primarily fromproductivity gains achieved in the professional services organization. Excluding hardware cost of revenue and the amortization of intangible assetsresulting from acquisitions, gross profit margins increased slightly to 74% inthe first quarter of 2005 from 73% in the first quarter of 2004.  Weexpect our gross profit margin, excluding hardware and amortization ofintangible assets, to remain relatively constant throughout 2005.

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Cost of productrevenue consists of amortization of acquired technology, hardware costs,royalties due to third parties for software components that are embedded in oursoftware applications, amortization of capitalized software development costsand packaging costs.  Amortization of acquired technology was $1.9 millionin the first quarter of 2005 compared to $1.4 million in the same period in2004.  Cost of hardware revenue was $1.3 million in the first quarter of2005 and $2.0 million in the same period of 2004.  We will continue toincur amortization expense, but expect the cost of hardware to decline as wework towards reducing the amount of hardware sales in the future.  Cost ofproduct revenue, excluding amortization of acquired technology and hardwarecosts, increased 108% in the first quarter of 2005 compared to the same periodin 2004.  This increase was due to increased royalties due to thirdparties for software components that are embedded in our softwareapplications.  Such royalties increased as a result of an increase insales of software applications containing third party softwarecomponents.  The cost of product revenue expressed as a percentage ofproduct revenue, excluding hardware and amortization of intangible assets was6% and 4% in the first quarter of 2005 and 2004, respectively.  As wedevelop upgrades of our existing products and add new offerings to our productsuite, we may embed third-party technology into our software, which wouldincrease the cost of product revenue in the future.

Cost of servicesrevenue for installation, training, consulting and maintenance services includepersonnel costs and related expenses and allocated overhead.  Personnelcosts include salaries, bonuses and benefits.  Cost of services revenueincreased 20% to $9.5 million in the first quarter of 2005 compared to the sameperiod in 2004 due primarily to an increase in the number of employees engagedin customer support services primarily as a result of the Blue Pumpkinacquisition.  Cost of services revenue as a percentage of services revenuedecreased to 38% of total services revenue in the first quarter of 2005 from42% in the same period in 2004 due to productivity improvements in theprofessional services group.  We anticipate that our services margins willremain relatively consistent with 2005 throughout the remainder of theyear.  We expect our customer service organization to continue to grow overtime and, therefore, we anticipate that our cost of services revenue, inabsolute dollars, will increase as we grow our customer base.  During thelatter half of 2004, we began expanding our customer support organization inthe Asia-Pacific region; however, we have not incurred any significantincremental costs associated with this initiative in 2005.

*OperatingExpenses*

*Selling,General and Administrative.*  Selling, general andadministrative (‘‘SG&A’’) expense consists primarily of personnel costs,sales commissions, marketing programs, professional fees, the amortization ofcertain intangible assets and provisions for bad debt expense.  SG&Aexpense increased 26% to $20.0 million in the first quarter of 2005 compared tothe same period in 2004 due primarily to higher amortization expenses and theincreased size of our Company due to the acquisition of Blue Pumpkin.  In2005, we expect SG&A expense to increase in absolute dollars but decreaseas a percentage of total revenue due to anticipated revenue growth.

*Researchand Development*.   Research and development (‘‘R&D’’)expenses consist primarily of personnel and consulting costs to support productdevelopment, and allocated overhead.  R&D costs are generally expensedas incurred and include software development costs incurred prior to theestablishment of technological feasibility. Costs incurred subsequent toestablishing technological feasibility are capitalized and amortized over theirestimated useful lives to cost of product revenue.  As of March 31, 2005and 2004, $0.1 million and $0, respectively, in software development costs werecapitalized.  R&D expenses increased 29% to $6.2 million in the firstquarter of 2005 compared to the same period in 2004 due to the increased numberof employees engaged in research and development activities as a result of theBlue Pumpkin acquisition.  We expect total R&D expense to increase inabsolute dollars but decrease as a percentage of total revenue during 2005 ascompared to 2004.

*Merger-relatedCosts.* During 2005 and 2004, we incurred merger-related costspertaining to the acquisition of Blue Pumpkin that closed in January 2005 andthe Eyretel acquisition in March 2003.  Merger-related costs totaled $1.7million in the first quarter of 2005 and included $1.6 million of Blue Pumpkinintegration expenses.

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Merger-relatedcosts incurred in the first quarter of 2004 totaled $0.4 million and related tothe partial accrual of a bonus payable to Eyretel’s former Chief ExecutiveOfficer, now our Chief Operating Officer (“COO”).  Our Board of Directorsagreed to pay a bonus of £1.0 million to our COO in connection with the Eyretelacquisition and subsequent integration.  In March 2004, £0.4 million ofthis bonus was paid and the remaining balance of £0.6 million (or $1.1 millionas of March 31, 2005) was paid in March 2005.

*AcquiredIn-Process Research and Development*.  During the firstquarter of 2005, we estimated that $9.0 million of the purchase price of BluePumpkin represented acquired in-process research and development (‘‘IPR&D’’)that had not yet reached technological feasibility as defined by SFAS No. 86,Accounting for the Cost of Computer Software to Be Sold, Leased or OtherwiseMarketed, and had no alternative future use.  Accordingly, these amountswere immediately charged to expense upon consummation of the acquisition. The value of the IPR&D was determined with the assistance of an independentthird-party appraiser by utilizing a discounted cash flow methodology, focusingon the income-producing capabilities of the in-process technologies and takinginto consideration: stage of completion; complexity of work to date and tocomplete; anticipated product development and introduction schedules;forecasted product sales cycles; internal and external risk factors; revenue andoperating expense estimates; contributory asset charges, and costs alreadyincurred and the expected costs to complete.

*Interestand Other Income, Net*

Interest and otherincome, net consists primarily of interest earned on funds available forinvestment and foreign currency transaction gains and losses on settlement ofcontracts denominated in currencies other than the local currency. Interest and other income, net decreased slightly to $0.1 million in the firstquarter of 2005 compared to $0.2 million in the same period in 2004 dueprimarily to decreased interest income resulting from lower investment balancesas a result of the acquisition of Blue Pumpkin.  We expect that interestand other income, net will decrease in 2005 compared to 2004 due to lower cashand investment balances.

*Provisionfor Income Taxes*

We recorded aprovision for federal alternative minimum tax and foreign income tax of $33,000and $25,000, respectively, in the first quarter of 2005 and 2004.  As ofDecember 31, 2004, we have net operating loss carryforwards aggregating $31.4million for U.S. tax purposes and $44.4 million for foreign tax purposes. The provisions for income taxes benefited from the utilization of net operatingloss carryforwards from prior years.  However, the utilization of certainnet operating loss carryforwards arising from acquisitions might result in afuture reduction of intangible assets and the recognition of deferred incometax expense.

**Threemonth period ended June 30, 2005 (restated) compared to June 30, 2004(restated)**

*Revenue*

Total revenueincreased 34% in the second quarter of 2005, as compared to the second quarterof 2004, to $46.2 million.  The increase in total revenue can beattributed to both continued growth of our business and sales and related servicesderived from our Blue Pumpkin acquisition, which expanded our workforceoptimization solution.

Product revenueincludes software revenue and hardware revenue.  Because hardware salesare incidental to our business, we are working towards transitioning ourcustomers to third-party hardware suppliers and, as a result, expect hardwarerevenue to decline in the future.  For the three months ended June 30,2005, hardware revenue was $1.9 million compared to $2.0 million during2004.  Software revenue for the three months ended June 30, 2005 increased40%, as compared to the same year ago period.

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Product revenue asa percentage of total revenue has been decreasing over the previous three yearsdue to increased services revenue, as discussed below. Our product pricing hasremained relatively consistent over the previous three years.

New customersaccounted for 18% and 19%, respectively, of product revenue, excluding hardwarerevenue, during the second quarter of 2005 and 2004.  We receive follow-onrevenue from our existing customers when they purchase additional user licensesor license additional applications at existing sites and when they license ourproducts at new sites.  We expect to continue receiving the majority ofour product revenue from existing customers during 2005.  During thesecond quarter of 2005, we installed an additional 133 customer sites and, withthe inclusion of Blue Pumpkin, we ended the quarter with 3,979 installedcustomer sites as of June 30, 2005 versus approximately 2,549 at June 30, 2004.

Services revenue,consisting of installation, training, consulting, maintenance support andreimbursable travel expenses, increased 34% in the three months ended June 30,2005, as compared to the same year ago period.  This increase was due tothe installation and training services related to new product sales and due tocustomers renewing their maintenance contracts with us thereby increasing ourrecurring maintenance revenue stream.  The percentage of Witness customersthat have renewed their maintenance contracts with us has historically exceeded90%.  We believe that maintenance contracts will be renewed at acomparable rate during 2005.  Our services pricing has remained consistentover the past three years.  We expect services revenue, in absolutedollars, to increase over time due to the compounding effect of renewals ofannual maintenance contracts from existing customer sites and to remainrelatively constant as a percentage of total revenue, excluding hardwarerevenue, throughout 2005.

*Cost of Revenue*

Total cost ofrevenue increased 30% in the three months ended June 30, 2005, as compared tothe same year ago period.  Expressed as a percent of revenue, gross profitmargins increased to 66% for the three months ended June 30, 2005 as comparedto 65% for the same year ago period.  This increase resulted primarilyfrom productivity gains achieved in the professional servicesorganization.  Excluding hardware cost of revenue and the amortization ofintangible assets resulting from acquisitions, gross profit margins haveremained consistent at 75% in the three months ended June 30, 2005 and2004.  We expect our gross profit margin, excluding hardware andamortization of intangible assets, to continue to remain relatively constantthroughout 2005.

Cost of productrevenue consists of amortization of acquired technology, hardware costs,royalties due to third parties for software components that are embedded in oursoftware applications, amortization of capitalized software development costsand packaging costs.  For the three months ended June 30, 2005,amortization of acquired technology of $2.4 million, increased 77% as comparedto the same year ago period.  We will continue to incur amortizationexpense, but expect the cost of hardware to decline as we work towards reducingthe amount of hardware sales in the future.  For the three months endedJune 30, 2005, cost of product revenue, excluding amortization of acquiredtechnology and hardware costs, of $0.6 million increased 36% as compared to thesame year ago period.  This increase was due to increased royalties due tothird parties for software components that are embedded in our softwareapplications.  Such royalties increased as a result of an increase insales of software applications containing third party softwarecomponents.  For the three months ended June 30, 2005, expressed as apercentage of product revenue and excluding hardware and amortization ofintangible assets, the cost of product revenue, was 3% as compared to 3% forthe same year ago period.  As we develop upgrades of our existing productsand add new offerings to our product suite, we may embed third-party technologyinto our software, which would increase the cost of product revenue in thefuture.

Cost of servicesrevenue for installation, training, consulting and maintenance services includepersonnel costs and related expenses and allocated overhead.  Personnelcosts include salaries, bonuses and benefits and allocated overhead.  Costof services revenue increased 29% in the three months ended June 30, 2005, ascompared to the same year ago period due primarily to an increase in the numberof employees engaged in customer support services mainly as a result of theBlue Pumpkin and Optimis acquisitions.  Cost of services

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revenue as a percentageof services revenue was 40% in the second quarter of 2005, compared to 41% inthe second quarter of 2004.  We anticipate that our services margins willremain relatively constant throughout 2005.  We expect our customer serviceorganization to continue to grow over time and, therefore, we anticipate thatour cost of services revenue, in absolute dollars, will increase as we grow ourcustomer base.

*Operating Expenses*

*Selling,General and Administrative.*  Selling, general andadministrative expense (‘‘SG&A’’) consists primarily of personnel costs,sales commissions, marketing programs, professional fees, the amortization ofcertain intangible assets and provisions for bad debt expense. For the threemonths ended June 30, 2005, SG&A expense of $21.6 million increased 37% ascompared to the same year ago period.  This increase is due primarily tohigher amortization expenses and the increased size of our Company due toacquisitions of Blue Pumpkin and Optimis.  In 2005, we expect SG&Aexpense to increase in absolute dollars but decrease as a percentage of totalrevenue due to anticipated revenue growth as compared to the same period in2004.

*Researchand Development.*  Research and development (‘‘R&D’’)expenses consist primarily of personnel and consulting costs to support productdevelopment and allocated overhead.  R&D costs are generally expensedas incurred and include software development costs incurred prior to theestablishment of technological feasibility. Costs incurred subsequent to establishingtechnological feasibility are capitalized and amortized over their estimateduseful lives to cost of product revenue.  As of June 30, 2005, we reported$37 thousand in capitalized but unamortized software development costs wascapitalized.  R&D expenses increased 39% in the three months endedJune 30, 2005 as compared to the same year ago period due to the increasednumber of employees engaged in research and development activities as a resultof the Blue Pumpkin acquisition.  We expect total R&D expense toincrease in absolute dollars but decrease as a percentage of total revenueduring 2005 as compared to 2004.

*Merger-relatedand Integration Costs.* We incurred merger-related andintegration costs of $0.9 million in the three months ended June 30, 2005,primarily Blue Pumpkin and Optimis integration expenses.  Merger-relatedand integration costs incurred in the three months ended June 30, 2004 totaled$0.2 million and related to the final accrual of a bonus payable to Eyretel’sformer Chief Executive Officer.  Merger-related and integration costs arecomprised primarily of costs of transitional employees and other contractors,travel costs, legal costs and advertising costs.

*Interest and Other Income, Net*

Interest and otherincome, net consists primarily of interest earned on funds available forinvestment and foreign currency transaction gains and losses on settlement ofcontracts denominated in currencies other than the local currency. Interest and other income, net decreased 59% in the three months ended June 30,2005, as compared to the same year ago period due primarily to decreasedinterest income resulting from lower investment balances as a result of theacquisitions of Blue Pumpkin and Optimis.  We expect that interest andother income, net will decrease in 2005 compared to 2004 due to lower cash andinvestment balances.

*Provision for Income Taxes*

We recorded a provision for income tax of $0.6 millionand $0.1 million, respectively, during the three months ended June 30, 2005 and2004.  The provision is comprised of U.S. federal alternative minimumincome tax, expense relating to the utilization of purchased net operating losscarryforwards and foreign income tax, primarily from withholding.  AtDecember 31, 2004, we had net operating loss carryforwards aggregating $31.4million for U.S. tax purposes and $44.4 million for foreign tax purposes. The provision for income taxes in 2005 and 2004 benefited from the utilizationof net operating loss carryforwards from prior years.  However, the utilizationof certain net operating loss carryforwards arising from acquisitions resultsin a reduction of intangible assets and the recognition of income taxes.

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**Threemonth period ended September 30, 2005 (restated) compared to September 30, 2004(restated)**

*Revenue*

Total revenueincreased 34% in the third quarter of 2005, as compared to the third quarter of2004, to $47.1 million. The increase in total revenue can be attributed to bothcontinued growth of our business and sales and related services derived fromour Blue Pumpkin acquisition, which expanded our workforce optimizationsolution.

Product revenueincludes software revenue and hardware revenue. Because hardware sales areincidental to our business, we are working towards transitioning our customersto third-party hardware suppliers and, as a result, expect hardware revenue todecline in the future. For the three months ended September 30, 2005,hardware revenue was $0.8 million compared to $1.2 million during 2004.Software revenue for the three months ended September 30, 2005 increased38% as compared to the same year ago period. More than half of the increase insoftware revenue growth in 2005 is attributed to our expanded product lineresulting from our acquisitions of Blue Pumpkin and Optimis which we beganconsolidating upon acquisition in 2005.

Product revenue asa percentage of total revenue has decreased over the past three years due tolower hardware sales and increased services revenue, as discussed below. Ourproduct pricing has remained relatively consistent over the previous threeyears.

New customersaccounted for 41% and 30%, respectively, of product revenue, excluding hardwarerevenue, during the third quarters of 2005 and 2004. We receive follow-onrevenue from our existing customers when they purchase additional user licensesor license additional applications at existing sites and when they license ourproducts at new sites. We expect to continue receiving the majority of ourproduct revenue from existing customers during 2005.

Services revenue,consisting of installation, training, consulting, maintenance support andreimbursable travel expenses, increased 35% in the three months endedSeptember 30, 2005 as compared to the same year ago period. This increasewas due to the installation and training services related to new product salesand due to customers renewing their maintenance contracts with us therebyincreasing our recurring maintenance revenue stream. The Blue Pumpkin andOptimis acquisitions during 2005 accounted for approximately half of theincrease in services revenue in 2005. The percentage of Witness customers thathave renewed their maintenance contracts with us has historically exceeded 90%.We believe that maintenance contracts will be renewed at a comparable rate during2005. Our services pricing has remained consistent over the past three years.We expect services revenue, in absolute dollars, to increase over time due tothe compounding effect of renewals of annual maintenance contracts fromexisting customer sites and to remain relatively constant as a percentage oftotal revenue, excluding hardware revenue, for the remainder of 2005.

*Cost of Revenue*

Total cost ofrevenue increased 42% in the three months ended September 30, 2005,respectively, as compared to the same year ago period. Expressed as a percentof revenue, gross profit margins decreased to 67% from 69% for the three monthsended September 30, 2005 as compared to the same year ago period. Thethird quarter decrease is due to an increase in royalties due to third partiesresulting from changes in product mix during the quarter.

Cost of productrevenue consists of amortization of acquired technology, hardware costs,royalties due to third parties for software components that are embedded in oursoftware applications, amortization of capitalized software development costsand packaging costs. For the three months ended September 30, 2005,amortization of acquired technology of $2.3 million increased 109% as comparedto the same year ago period due to the acquisition of Blue Pumpkin. For thethree months ended September 30, 2005, cost of hardware revenue of $0.8million decreased 27% as compared to the same year ago period. We will continueto incur amortization expense, but expect the cost of hardware to decline as wework towards reducing the amount of hardware sales in the future. For the threemonths ended September 30, 2005, cost of product revenue of $1.3 million,excluding

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amortization of acquiredtechnology and hardware costs, increased 117% as compared to the same year agoperiod. This increase was due to increased royalties due to third parties forsoftware components that are embedded in our software applications. Such royaltiesincreased as a result of an increase in sales of software applicationscontaining third party software components. For the three months endedSeptember 30, 2005, expressed as a percentage of product revenue andexcluding hardware and amortization of intangible assets, the cost of productrevenue, was 7% as compared to 4% for the same year ago period. As we developupgrades of our existing products and add new offerings to our product suite,we may embed additional third-party technology into our software, which wouldincrease the cost of product revenue in the future.

Cost of servicesrevenue for installation, training, consulting and maintenance services includepersonnel costs and related expenses and allocated overhead. Personnel costsinclude salaries, bonuses and benefits and allocated overhead. Cost of servicesrevenue increased 34% in the three months ended September 30, 2005, ascompared to the same year ago period due primarily to an increase in the numberof employees engaged in customer support services mainly as a result of theBlue Pumpkin and Optimis acquisitions. Cost of services revenue as a percentageof services revenue was 37% in the third quarter of 2005, compared to 38% inthe third quarter of 2004. We anticipate that our services margins will remainrelatively constant for the remainder of 2005. We expect our customer serviceorganization to continue to grow over time and, therefore, we anticipate thatour cost of services revenue, in absolute dollars, will increase as we grow ourcustomer base.

*Operating Expenses*

*Selling,General and Administrative.*   Selling, general andadministrative expense (“SG&A”) consists primarily of personnel costs,sales commissions, marketing programs, professional fees, the amortization ofcertain intangible assets and provisions for bad debt expense. For the threemonths ended September 30, 2005, SG&A expense of $21.7 millionincreased of 30% as compared to the same year ago periods. This increase is dueprimarily to higher amortization expenses and the increased size of our Companydue to acquisitions of Blue Pumpkin and Optimis. In 2005, we expect SG&Aexpense to increase in absolute dollars but decrease as a percentage of totalrevenue due to anticipated revenue growth as compared to the same period in2004.

*Researchand Development.*   Research and development (“R&D”)expenses consist primarily of personnel and consulting costs to support productdevelopment and allocated overhead. R&D costs are generally expensed asincurred and include software development costs incurred prior to theestablishment of technological feasibility. Costs incurred subsequent toestablishing technological feasibility are capitalized and amortized over theirestimated useful lives to cost of product revenue. As of September 30,2005, we reported $0.3 million in unamortized software development costs.R&D expenses increased 27% in the three months ended September 30,2005, as compared to the same year ago period due to the increased number ofemployees engaged in research and development activities as a result of theBlue Pumpkin acquisition.

*Merger-relatedand Integration Costs.  *Merger-related andintegration costs during the three months ended September 30, 2005 were $1.1million and related primarily to legal costs and costs associated withtransitional employees and other contractors. Merger-related and integrationcosts incurred in the same year ago period were less than $0.2 million. Weincurred merger-related and integration costs during the three months endedSeptember 30, 2005, primarily due to Blue Pumpkin and Optimis integrationexpenses. Merger-related and integration costs incurred during the three monthsended September 30, 2004 related to Eyretel integration expense. Merger-relatedand integration costs are comprised primarily of costs of transitionalemployees and other contractors, travel costs, legal costs and advertisingcosts.

*Interest and Other Income, Net*

Interest and otherincome, net consists primarily of interest earned on funds available forinvestment and foreign currency transaction gains and losses on settlement ofcontracts denominated in currencies other than the local currency. Interest andother income, net decreased 43% in the three months ended September 30,2005, as compared to the same year ago period due primarily to decreasedinterest income resulting from lower investment balances as a result of theacquisitions of Blue Pumpkin and Optimis. We expect that interest and otherincome, net will decrease in 2005 compared to 2004 due to lower cash andinvestment balances.

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*Provision for Income Taxes*

We recorded aprovision for income tax of $1.8 million during the three months endedSeptember 30, 2005. Of the total provision during the three months endedSeptember 30, 2005, $1.6 million related to the utilization ofdeferred tax assets, primarily net operating loss carry-forwards, acquiredduring the 2005 acquisition of Blue Pumpkin Software, Inc. The reductionof valuation allowances established on acquired deferred tax assets in 2005 isreflected as a reduction to goodwill. The remainder of the provision isprimarily comprised of U.S. federal alternative minimum income tax expenseand foreign income tax, primarily from withholding. For the same period during2004, the tax expense was a benefit of $(0.1) million due primarily to U.S.federal alternative minimum tax expense.

AtSeptember 30, 2005, we had net operating loss carryforwards aggregating to$78.1million for U.S. tax purposes and $41.8 million for foreign tax purposes.The provision for income taxes prior to 2005 generally benefited from therecognition of deferred tax assets for which we had previously provided avaluation allowance in prior years. However, when the net operating loss carryforwards being utilized arise from acquisitions, this results in a modificationof the purchase price allocated to intangible assets and recognition of incometax expense.

Our quarterly operating results, particularly productrevenues, have experienced significant fluctuations in the past and we expectthat this pattern will continue in the future. For instance, quarterly resultsmay fluctuate based on the timing of sales due to customer calendar-yearbudgeting cycles, slow summer purchasing patterns and compensation policiesthat tend to compensate sales personnel, typically in the latter half of theyear, for achieving annual quotas. As a result of the foregoing and otherfactors, we believe that quarter-to-quarter comparisons of results are notnecessarily meaningful, and such comparisons should not be relied upon asindications of future performance

**Liquidity andCapital Resources**

At December 31, 2005, we had $126.6 millionin total cash and cash equivalents and investments, compared to$76.5 million at December 31, 2004. Working capital also increased by$59.0 million from $60.1 million at December 31, 2004 to$119.1 million at December 31, 2005. The increase is due to proceedsfrom the common stock offering during December 2005, offset by the cashportion of the acquisitions of Blue Pumpkin and Optimis

Cash flows provided by operating activities****in 2005 were $6.2 million compared to $22.8 million inthe same year-ago period. The cash flows provided by operations in 2005 weresignificantly impacted by payments of restructuring accruals and merger-relatedand integration costs and an increase in accounts receivable resulting fromacquisitions. There are no significant merger-related and restructuring costsremaining as of December 31, 2005. Our accounts receivable days sales outstanding(“DSO”) at December 31, 2005 was 72 days, an increase of 6 days fromDecember 31, 2004. This increase in DSO and the decrease in deferredrevenue of $4.1 million in 2005, was primarily due to timing differences inpayments received from customers. We expect our DSO to remain in the 70 dayrange and our deferred revenue balance to increase in 2006. Deferred revenuedecreased $4.1 million in 2005 as a result of year-end maintenance renewalinvoices outstanding.

Net cash flows used in investing activities increasedduring 2005 to $34.9 million compared to $18.3 million in the same year-agoperiod due to the acquisitions of Blue Pumpkin and Optimis. The cash portion ofthe Blue Pumpkin acquisition ($41.4 million or $37.5 million net of cash andcash equivalents acquired) was funded in part through the sale of investmentsecurities totaling $30.9 million. We also paid $5.6 million for Optimis (or$4.4 million net of cash and cash equivalents acquired). In 2003, we used $10.0million in net cash flows in investing activities for the acquisition ofEyretel, offset by the net proceeds of our investments. Capital expenditures of$5.7 million, $3.2 million and $2.2 million in 2005, 2004 and 2003,respectively, were primarily for computer equipment and leasehold improvements.

Net cash flows provided by financing activities in2005 were $100.1 million compared to $13.3 million in 2004. The increasewas due to $88.8 million in proceeds from the secondary offering of commonstock completed in December 2005. Net cash flows provided by financingactivities were $13.3 million and $1.3 million in 2004 and 2003, respectively,primarily due to proceeds from the exercise of stock options.

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At December 31, 2005, we had $12.8 millionavailable under a line of credit, which was net of outstanding letters ofcredit of $2.2 million. The letters of credit secure the lease on ourcorporate headquarters facility and have decreasing schedules that ultimatelyexpire in 2007. At our election, borrowings under the line of credit bearinterest at the bank’s prime rate, or LIBOR plus 300 basis points, and arelimited to 85% of eligible accounts receivable, as defined by the agreement.The revolving line of credit is secured by all of our assets and requirescompliance with various covenants, including liquidity ratios and tangible networth requirements, among others. As of December 31, 2005, we were incompliance with all bank covenants.

We anticipate spending at least $5.5 million incapital expenditures in 2006 primarily for computer equipment and software. Webelieve that our capital expenditures may increase over the next several yearsas we expand our facilities and acquire equipment to support the expansion ofour research and development activities and internal management and informationsystems. We believe that our existing cash and investment balances, togetherwith our anticipated cash flows from operations, will be sufficient to meet ourworking capital and capital expenditures for at least the nexttwelve months. In addition, the availability under our line of credit maybe used to fund working capital requirements or future merger or acquisitiontransactions.

Quarterly Liquidity and Capital Resources

As of March 31,June 30 and September 30, 2005, we had $12.3 million, $12.7 million and 12.8million, respectively, available for borrowing under our line of credit. At ourelection, borrowings under the line of credit bear interest at the bank’s primerate, or LIBOR plus 300 basis points and are limited to 85% of eligibleaccounts receivable, as defined by the agreement. The revolving line of creditis secured by all of our assets and requires compliance with various covenants,including liquidity ratios and tangible net worth requirements, among others.We were in compliance with all bank covenants during each of the last eightquarters in the two-year period ended December 31, 2005.

*Market Risk*

Our market risk exposure primarily relates tofluctuations in foreign exchange rates and interest rates. Except for the hedgetransaction entered into in connection with the Eyretel acquisition, we havenot entered into derivative or hedging transactions to manage risk inconnection with such fluctuations. Due to the relative weakness of foreigncurrencies compared to the U.S. dollar, the translation of our subsidiariescash denominated in foreign currencies reduced our December 31, 2005 cashbalances by $2.3 million. Due to the relative strength of foreign currenciescompared to the U.S. dollar during 2004 and 2003, foreign currency translationscontributed $3.4 million and $4.1 million to our cash balances atDecember 31, 2004 and 2003, respectively.

Within our foreign-based operations, wheretransactions may be denominated in foreign currencies, we are subject to marketrisk with respect to fluctuations in the relative value of currencies.Currently, we have foreign-based operations in Australia, Brazil, Canada,China, Germany, India, Japan, Mexico, the Netherlands, Singapore, South Africaand the United Kingdom that conduct transactions in either the local currencyof the location or U.S. dollars. We are exposed to adverse movements in foreigncurrency exchange rates because we translate foreign currencies into U.S.dollars for reporting purposes. Cumulative translation adjustment changesresulted in a decrease in stockholders’ equity of $ 1.9 million in 2005and an increase of $1.0 million in 2004. Net foreign exchange (loss) gainsreflected in our operating results were ($0.2) million, $0.3 million,and $0.4 million in 2005, 2004 and 2003, respectively.

Exposure to market rate risk for changes in interestrates relates to our investment portfolio and any potential borrowing. Ourinvestments are made with capital preservation and liquidity as our primaryobjectives. We generally hold only high-grade investments such as commercialpaper, corporate bonds, auction rate securities and U.S. government agencysecurities. To reduce our balance sheet exposure to variations in asset values,our investment policy guidelines specify that we invest in the highestinvestment grade securities and maintain a weighted average maturity of ninemonths or less for our entire portfolio. Our investment portfolio may containsecurities with maturities of up to three years. While this minimizes ourinterest rate risk to asset values, our results are exposed to fluctuations ininterest income due to changes in market rates.

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*Contractual Obligations and Off Balance SheetArrangements*

As ofDecember 31, 2005, our contractual cash obligations associated with leaseobligations, operational restructuring and merger-related costs are as follows(in thousands):
| ** **                   | ** ** | **Payments Due by Period** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **Total**                                 | ** ** | **Less than 1  Year** | ** ** | **2 - 3  Years** | ** ** | **4 - 5  Years** | ** ** | **After 5 Years** | ** ** |
| Operating lease  obligations |       | $                                         | 17,851     |   | $ | 4,557 |   | $ | 5,920 |   | $ | 3,145 |   | $ | 4,229 |   |
|                              |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We have entered into a software licensing agreementwhich requires us to pay approximately $1.2 million and $1.3 millionin 2006 and 2007, respectively, for the right to distribute a vendor’s softwareas part of our workforce optimization solution. These amounts have beenrecorded as accrued expenses and other long-term liabilities as ofDecember 31, 2005. Implied interest expense associated with these paymentsis not significant.

On April 6, 2006, Blue Pumpkin and IEX reached anagreement to settle all claims asserted between. As part of the finalsettlement, Witness paid $8.25 million to IEX’s parent company, in April2006 and agreed to make six annual payments of $0.5 million($3.0 million in total) from April 2007 through 2012.

As of December 31, 2005, we did not have anyother material contractual commitments or any off-balance sheet arrangements.

**Item 7A.**                 Qualitative andQuantitative Disclosures About Market Risk

See Management’s Discussion and Analysis of FinancialCondition and Results of Operations, Item 7 of Part II of this Report fora discussion of market risk.

**Item8.**                          FinancialStatements and Supplementary Data

Our Consolidated Financial Statements, together withrelated notes and the reports of KPMG LLP, our independent registered publicaccounting firm, are set forth on the pages indicated in Item 15.

**Item 9.**                          Changesin and Disagreements with Accountants on Accounting and Financial Disclosures

None.

**Item9A.**                 Controlsand Procedures.

*Evaluation of DisclosureControls and Procedures.**  *We maintain disclosure controls and proceduresdesigned to provide reasonable assurance that information required to bedisclosed in the periodic reports we file with the Securities and ExchangeCommission (“SEC”) is recorded, processed, summarized and reported accuratelyand within the time periods specified in the rules of the SEC. We carriedout an initial evaluation as of December 31, 2005, under the supervisionand the participation of our management, including our chief executive officer andchief financial officer, of the design and operation of these disclosurecontrols and procedures pursuant to Exchange Act Rule 13a-15(c). Basedupon that evaluation, our chief executive officer (“CEO”) and chief financialofficer (“CFO”)concluded that our disclosure controls and procedures were noteffective due to a material weakness discussed in Management’s Report onInternal Control Over Financial Reporting. In light of the conclusions reachedbelow under *Restatement of Consolidated Financial Statements,Special Committee and Company Findings*, we re-evaluated Management’sReport on Internal Control Over Financial Reporting as of December 31, 2005 asset forth in this Form 10-K/A.  Basedupon that evaluation, our CEO and CFO determined that there was an additionalmaterial weakness in our internal control over financial reporting relating to determinationof the cost of an acquired enterprise in a business combination.

*Changes in InternalControls.**  *Therewas no change in internal control over financial reporting that occurred duringthe three months ended December 31, 2005 that has materially affected, oris reasonably likely to materially affect, our internal control over financialreporting.

We are currently in theprocess of implementing the following remediation steps to address the materialweaknesses referenced above:

·       Revise our policies andprocedures related to the capitalization and depreciation of property andequipment including the addition of control procedures over the review ofinformation input into our accounting system;

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·       Revise our controlprocedures through the addition of more effective controls to ensure theaccrual of certain period-end operating expenses;

·       Implement formal policies,including quantitative and qualitative analysis, over the documentation andevaluation of unsubstantiated differences that individually or in the aggregateshould be timely recorded; and

·       Createa detailed acquisition accounting checklist in order to ensure purchase priceconsideration is complete and adequately recorded.

*Restatementof Consolidated Financial Statements, Special Committee and Company Findings*

Beginning in late May 2006, the Company’s managementinitiated a preliminary internal review of the Company’s historical stockoption practices and related accounting treatment in response to general mediaattention concerning stock option grants at various public companies andshareholder interest with respect to this particular issue. On August 8, 2006,in response to the results of management’s preliminary internal review, ourBoard of Directors voluntarily formed a Special Committee of independentdirectors to review our stock option practices and grants during the periodbetween the date of the Company’s initial public offering on February 10, 2000and August 31, 2002.  The SpecialCommittee undertook its investigation with the assistance of independentcounsel and accounting experts retained by its counsel. The Special Committeereviewed all 5.7 million stock options granted throughout the period covered byits investigation. In December 2006, the Special Committee completed its reviewand reported its findings and recommendations to our full Board of Directors. TheSpecial Committee did not find fraud or intentional misrepresentation in thefinancial reporting of the option grants that it analyzed but foundinaccuracies in the determination of measurement dates for certain stock optiongrants affecting the Company’s accounting and disclosures. For a number ofthese grants, the Special Committee found that it was likely that the statedgrant date was selected in hindsight based on price given the lack ofsupporting documentation and that the option price was the low price in a givenmonth or quarter. Such grants were found to be present during 2000 and throughapproximately mid-year 2001. 

In addition to the Special Committee investigation,the Company, with the assistance of outside legal counsel, reviewed the Company’sstock option practices and grants for the periods subsequent to August 31,2002. This review evaluated 90 percent of the 11.1 million options grantedafter August 31, 2002. This review did not find fraud or intentionalmisrepresentation in the financial reporting relating to option grants but dididentify errors in the determination of measurement dates. However, such errorswere relatively immaterial and did not exhibit evidence of selection of afavorable grant date and price in hindsight. 

In those instances during the two review periods wherethe fair market value of our common stock at the originally stated grant datewas lower than the fair market value on the redetermined measurement date, inaccordance with Accounting Principles board No. 25, “Accounting for Stock Issuedto Employees” (“APB No. 25”) and related interpretations, we concluded that weshould have recorded stock-based compensation expense which was not accountedfor in our previously issued Consolidated Financial Statements.

As described in Note 2, “Restatement of ConsolidatedFinancial Statements,” of the Notes to Consolidated Financial Statements, ourConsolidated Financial Statements have been restated to correct errors in therecognition of stock-based compensation expense for previously granted stock options.

Following the Special Committee’s findings andrecommendations, and in an effort to strengthen our corporate governancemechanisms, the Board of Directors voted to separate the positions of Chairmanof the Board and CEO and elected Mr. Dan Lautenbach, a member of the Company’sBoard of Directors since 2002 and a member of the Special Committee, asChairman of the Board, effective December 6, 2006.  Mr. Lautenbach succeeded Mr. David Gould, whovoluntarily agreed to step down as Chairman of the Board of Directors.

In addition,following the Special Committee’s findings and recommendations, Mr. Gouldvoluntarily agreed to resign from his position as CEO and as a member of theCompany’s Board of Directors effective January 3, 2007.  The Board of Directors appointed Mr. NicholasDiscombe, the Company’s former President and Chief Operating Officer, as theCompany’s new CEO and as a member of the Company’s Board of Directors effectiveJanuary 3, 2007.

In furtherresponse to the Special Committee’s recommendations, and in a further effort tostrengthen our management and controls and corporate governance mechanisms, wehave named a new General Counsel and plan to realign certain responsibilitiesin financial reporting areas. Management believes that the above measures 

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will address the findingsand recommendations of the Special Committee and strengthen our management andcontrols and corporate governance mechanism.

We believe thatour practices for granting stock options and determining measurement dates asof December 31, 2005 are appropriate and that adequate controls are inplace. Most of the $9.5 million additional stock-based compensation reflectedin our restated Consolidated Financial Statements resulted from the use ofinaccurate measurement dates during 2000 and 2001.  Since 2001, the Company has implementedimprovements in its processes, personnel and practices to enhance its internalcontrols over the issuance of stock option grants.  Examples of these improvements include:

i)                 Change in process:  Beginning in 2002, the Company enhanced itsinternal controls over stock option grant practices and reduced the risk ofusing inaccurate measurement dates by complying with the new SEC requirement offiling Form 4s within two days of the date of grant.

ii)              Changein personnel:  A number of people withprior public company experience joined the Company in 2001and 2002 and becameresponsible for key elements of the stock option process.  New additions included the Chief FinancialOfficer, the Chairman of the Compensation Committee of the Board of Directorsand the Director of Human Resources.

iii)           Changein practices:  The internal practices ofdocumenting, approving, recording and reporting stock options grants have beenenhanced and become more formalized, especially since 2004, when the processbecame subject to internal control assessments pursuant to the Sarbanes OxleyAct.

As furtherdescribed in Note 2, “Restatement of Consolidated Financial Statements,” of theNotes to Consolidated Financial Statements, our Consolidated FinancialStatements have been restated to correct errors in recording our purchase priceconsideration associated with the acquisition of Blue Pumpkin.  Such errors have been corrected in this Form10-K/A.  As described in Management’sReport on Internal Control over Financial Reporting, these errors weredetermined to be an additional material weakness in our internal control overfinancial reporting as of December 31, 2005.  Management of the Company is in the processof implementing remediation steps to address this material weakness.

*Management’s Report on Internal Control overFinancial Reporting.*   SeePart IV, Item 15 page F-2 for management’s report on internalcontrol over financial reporting.

**Item 9B.Other Information**

Effective December 6, 2006, Mr. David Gould resignedas the Chairman of the Board of Directors and was replaced by Mr. DanLautenbach, a member of the Company’s Board of Directors since 2002 and amember of the Special Committee. Effective January 3, 2007, Mr. David Gouldvoluntarily stepped down as the Company’s CEO and was replaced by Mr. NicholasDiscombe, who has served as the Company’s President and Chief Operating Officersince April 2003.

**PART III**

Certain information required by Part III isomitted from this Report in that the Company will file a definitive proxystatement within 120 days after the end of this fiscal year pursuant toRegulation 14A (the “Proxy Statement”) for its 2006 Annual Meeting ofStockholders proposed to be held on May 18, 2006, and the informationincluded therein is incorporated herein by reference.

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**Item 10.**                   Directors andExecutive Officers of Registrant

*Code of Ethics*

We have adopted a Code of Ethics within the meaning ofItem 406(b) of Regulation S-K. This Code of Ethics applies toour principal executive officer, principal financial officer and principalaccounting officer. This Code of Ethics is publicly available on our website at*http://www.witness.com*. If wemake substantive amendments to this Code of Ethics or grant any waiver,including any implicit waiver, we will disclose the nature of such amendment orwaiver on our website or in a report on Form 8-K within four business daysof such amendment or waiver.

*Audit CommitteeFinancial Expert*

Our Board of Directors has determined that at leastone person serving on the Audit Committee is an “audit committee financialexpert” as defined under Item 401(h) of Regulation S-K. JoelKatz, the Chairman of the Audit Committee, is an “audit committee financialexpert” and is independent as defined under applicable SEC and Nasdaq StockMarket rules.

The other information required by this Item isincorporated by reference from the Proxy Statement under the headings “Electionof Directors” and “Executive Compensation.”

**Item 11.**                   ExecutiveCompensation

The information required by this Item isincorporated by reference from the Proxy Statement under the heading “ExecutiveCompensation.”

**Item 12.**                   SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

The information required by this Item isincorporated by reference from the Proxy Statement under the heading “SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.”

**Item 13.**                   CertainRelationships and Related Transactions

The information required by this Item isincorporated by reference from the Proxy Statement under the heading “ExecutiveCompensation.”

**Item 14.**                   Principal AccountantFees and Services

The information required by this Item isincorporated by reference from the Proxy Statement under the heading “AuditFees and Services.”

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**PART IV**

**Item 15.**                   Exhibits andFinancial Statement Schedules

a)                                      Thefollowing documents are filed as part of this report:
| 1.     |   | Financial  Statements                                                                                                    |   |   |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------|--------|--------|
|   |   | Management’s  Report on Internal Control Over Financial Reporting                                                   |   |   |
|   |   | Report of Independent  Registered Public Accounting Firm on Internal Control Over Financial  Reporting                   |   |   |
|   |   | Report of Independent  Registered Public Accounting Firm on Consolidated Financial Statements                            |   |   |
|   |   | Consolidated Balance  Sheets as of December 31, 2005 and 2004 (as restated)                                              |   |   |
|   |   | Consolidated  Statements of Operations for the years ended December 31, 2005, 2004 and 2004  (as restated)               |   |   |
|   |   | Consolidated Statements of Stockholders’ Equity for  the years ended December 31, 2005, 2004 and 2003 (as restated) |   |   |
|   |   | Consolidated Statements  of Cash Flows for the years ended December 31, 2005, 2004 and 2003 (as  restated)               |   |   |
|   |   | Notes to  Consolidated Financial Statements (as restated)                                                                |   |   |
| 2.     |   | Financial Statement Schedule                                                                                             |   |   |
|   |   | Schedule  II—Valuation and Qualifying Accounts                                                                      |   |   |
| 3.     |   | Signatures                                                                                                               |   |   |

 

(b)                                 Exhibits
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                     |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(12)         |       | Merger Agreement and Plan of Reorganization by and  among Witness Systems, Inc., Baron Acquisition Corporation, Blue Pumpkin  Software, Inc., and, solely with respect to Article VIII and  Article IX, Laurence R. Hootnick as Shareholder Agent and The U.S. Stock  Transfer Corporation as Depository Agent dated December 16, 2004     |
| 3.1(2)          |       | Fifth Amended and Restated Certificate of  Incorporation of the Company                                                                                                                                                                                                                                                                                             |
| 3.2(1)          |       | Amended and Restated Bylaws of the Company                                                                                                                                                                                                                                                                                                                          |
| 3.3(7)          |       | Form of Certificate of Designation for  Series A Junior Participating Preferred Stock                                                                                                                                                                                                                                                                     |
| 4.1(2)          |       | See Exhibit 3.1 for provisions of the Fifth  Amended and Restated Certificate of Incorporation of the Company defining  rights of the holders of Common Stock of the Company.                                                                                                                                                                                  |
| 4.2(4)          |       | See Exhibit 3.2 for provisions of the Amended  and Restated Bylaws of the Company defining rights of the holders of Common  Stock of the Company                                                                                                                                                                                                               |
| 4.3(1)          |       | Specimen Stock Certificate                                                                                                                                                                                                                                                                                                                                          |
| 4.4(7)          |       | Form of Rights Agreement, dated  October 25, 2002, between the Company and SunTrust Bank which includes  the form of Certificate of Designation for the Series A Junior  Participating Preferred Stock as Exhibit A, the form of Rights  Certificate as Exhibit B and the Summary of Rights to Purchase Preferred  Stock as Exhibit C |
| 10.1(3)         |       | Lease Agreement between the Company and Colonial  Center at Mansell Overlook/Colonial Business Center dated July 28, 2000                                                                                                                                                                                                                                      |
| 10.2(9)         |       | Lease Agreement between Eyretel plc and Cornhill  Insurance plc at Kings Court dated December 24, 1999                                                                                                                                                                                                                                                         |
| 10.3(13)        |       | Lease Agreement between the Company and Mission  Towers, LLC at Freedom Circle Drive dated February 18, 2005                                                                                                                                                                                                                                                   |
| 10.4(1)         |       | Amended and Restated Stock Incentive Plan of the  Company                                                                                                                                                                                                                                                                                                           |

 

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| Exhibit  Number | ** ** | **Description**                                                                       |
|-----------------|------------|---------------------------------------------------------------------------------------|
| 10.5(2)         |       | Amendment No. 1 to the Company’s Amended and  Restated Stock Incentive Plan |

 

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| Exhibit  Number | ** ** | **Description**                                                                                                                          |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------|
| 10.6(19)        |       | Amendment No. 2 to the Company’s Amended and  Restated Stock Incentive Plan                                                    |
| 10.7(5)         |       | Form of Stock Option Grant Certificate                                                                                              |
| 10.8(4)         |       | Employee Stock Purchase Plan of the Company                                                                                              |
| 10.11(9)        |       | Director and Key Executive Stock Ownership Incentive  Policy                                                                             |
| 10.12(13)       |       | Form of Inducement Grant for Employees of Blue  Pumpkin                                                                             |
| 10.13(1)        |       | Employment Agreement entered into between  David B. Gould and the Company effective February 2, 1999                           |
| 10.14(1)        |       | Amendment No. 1 to Employment Agreement entered  into between David B. Gould and the Company, dated as of August 2,  1999 |
| 10.15(1)        |       | Restricted Stock Award Agreement dated  March 31, 1999, between the Company and David Gould                                    |
| 10.16(8)        |       | Employment Agreement entered into between  Nicholas S. Discombe and the Company, dated as of June 29, 2003                     |
| 10.17(1)        |       | Form of Indemnification Agreement for executive  officers and directors of the Company                                              |
| 10.18(11)       |       | Form of Change of Control Agreement entered  into with certain senior officers of the company                                       |
| 10.19(1)        |       | Subsidiary License and Distribution Agreement                                                                                            |
| 10.20(6)        |       | Loan and Security Agreement between the Company and  Silicon Valley Bank dated April 3, 2002                                   |
| 10.21(6)        |       | Loan Modification Agreement between the Company and  Silicon Valley Bank dated November 12, 2002                                    |
| 10.22(6)        |       | Revolving Promissory Note between the Company and  Silicon Valley Bank dated November 12, 2002                                      |
| 10.23(9)        |       | Second Loan Modification Agreement between the  Company and Silicon Valley Bank dated May 14, 2003                                  |
| 10.24(9)        |       | Third Loan Modification Agreement between the  Company and Silicon Valley Bank dated November 13, 2003                              |
| 10.25(10)       |       | Fourth Loan Modification Agreement between the  Company and Silicon Valley Bank dated January 8, 2004                               |
| 10.26(10)       |       | Fifth Loan Modification Agreement between the  Company and Silicon Valley Bank dated March 10, 2004                                 |
| 10.27(13)       |       | Sixth Loan Modification Agreement between the  Company and Silicon Valley Bank dated January 12, 2005                               |
| 10.28(14)       |       | Seventh Loan Modification Agreement between the  Company and Silicon Valley Bank dated March 10, 2005                               |
| 10.29(14)       |       | Amended and Restated Stock Incentive Plan                                                                                                |
| 10.30(14)       |       | Amended and Restated Stock Incentive Plan                                                                                                |
| 10.31(15)       |       | Eight Loan Modification Agreement between the  Company and Silicon Valley Bank dated March 31, 2005                                 |
| 10.32(15)       |       | Amended and Restated Stock Incentive Plan                                                                                                |
| 10.33(15)       |       | Amended and Restated Stock Incentive Plan                                                                                                |
| 10.34(16)       |       | Amendment No.1 to the Witness Systems, Inc.  Amended and restated Stock Incentive plan                                              |
| 10.35(16)       |       | Amended & Restated Employee Stock Purchase  Plan.                                                                               |
| 10.36(16)       |       | Form of Inducement Grant for Contractors who  will become employee of Witness Systems Software India PVT Ltd                        |
| 21.1(16)        |       | List of subsidiaries                                                                                                                     |
| 23.1*           |       | Report of Independent Registered Public Accounting  Firm on Consolidated Financial Statement Schedule                                    |

 

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| Exhibit  Number | ** ** | **Description**                                                                |
|-----------------|------------|--------------------------------------------------------------------------------|
| 23.2*           |       | Consent of Independent Registered Public Accounting  Firm                      |
| 23.3(16)        |       | Consent of Independent Business Valuation Experts                              |
| 31.1*           |       | Certificate of the Chief Executive Officer                                     |
| 31.2*           |       | Certificate of the Chief Financial Officer                                     |
| 32.1*           |       | Certifications Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |

 

The following documentsare filed as part of this report:

----

| *    |   | Filed herewith                                                                                                                                                   |
|------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (1)  |   | Incorporated by reference to exhibits previously  filed with the Company’s Registration Statement on Form S-1 (File  No. 333-91383)               |
| (2)  |   | Incorporated by reference to exhibits previously  filed with the Company’s Registration Statement on Form S-8 (File  No. 333-67416)               |
| (3)  |   | Incorporated by reference to exhibits previously  filed with the Company’s Quarterly Report on Form 10-Q for the period  ended June 30, 2000      |
| (4)  |   | Incorporated by reference to exhibits previously  filed with the Company’s Annual Report on Form 10-K for the year ended  December 31, 1999       |
| (5)  |   | Incorporated by reference to exhibits previously  filed with the Company’s Annual Report on Form 10-K for the year ended  December 31, 2000       |
| (6)  |   | Incorporated by reference to exhibits previously  filed with the Company’s Quarterly Report on Form 10-Q for the period  ended September 30, 2002 |
| (7)  |   | Incorporated by reference to exhibits previously  filed with the Company’s Current Report on Form 8-K on November 4,  2002                        |
| (8)  |   | Incorporated by reference to exhibits previously  filed with the Company’s Quarterly Report on Form 10-Q for the period  ended June 30, 2003      |
| (9)  |   | Incorporated by reference to exhibits previously  filed with the Company’s Annual Report on Form 10-K for the year ended  December 31, 2003       |
| (10) |   | Incorporated by reference to exhibits previously  filed with the Company’s Quarterly Report on Form 10-Q for the period  ended March 31, 2004     |
| (11) |   | Incorporated by reference to exhibits previously  filed with the Company’s Quarterly Report on Form 10-Q for the period  ended September 30, 2004 |
| (12) |   | Incorporated by reference to exhibits previously  filed with the Company’s Current Report on Form 8-K on January 27,  2005                        |
| (13) |   | Incorporated by reference to exhibits previously  filed with the Company’s Annual Report on Form 10-K for the year ended  December 31, 2004       |
| (14) |   | Incorporated by reference to exhibits previously  filed with the Company’s Quarterly Report on Form 10-Q for the period  ended March 31, 2005     |
| (15) |   | Incorporated by reference to exhibits previously  filed with the Company’s Quarterly Report on Form 10-Q for the period  ended June 30, 2005      |
| (16) |   | Incorporated by reference to exhibits previously  filed with the Company’s Annual Report on Form 10-K for the year ended  December 31, 2005       |

 

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** **

**WITNESSSYSTEMS, INC. AND SUBSIDIARIES**

**Index to ConsolidatedFinancial Statements**
| Management’s Report on  Internal Control Over Financial Reporting                                                                                               |   | F-2  |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------|--------|
| Report of  Independent Registered Public Accounting Firm on Internal Control Over  Financial Reporting                                                               |   | F-3  |   |
| Report of  Independent Registered Public Accounting Firm on Consolidated Financial  Statements                                                                       |   | F-5  |   |
| Consolidated Balance  Sheets as of December 31, 2005 and 2004 (as restated)                                                                                     |   | F-6  |   |
| Consolidated  Statements of Operations for the years ended December 31, 2005, 2004,  and 2003 (as restated)                                                     |   | F-7  |   |
| Consolidated  Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the  years ended December 31, 2005, 2004, and 2003 (as restated) |   | F-8  |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2005, 2004,  and 2003 (as restated)                                                     |   | F-9  |   |
| Notes  to Consolidated Financial Statements (as restated)                                                                                                            |   | F-10 |   |
| Schedule  II—Valuation and Qualifying Accounts                                                                                                                  |   | F-49 |   |
| Signatures                                                                                                                                                           |   | F-50 |   |

 

F-1

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**Management’s Report onInternal Control Over Financial Reporting**

The management of the Company is responsible forestablishing and maintaining adequate internal control over financial reportingas defined in Rule 13a-15(f) under the Securities Exchange Act of1934. The Company maintains accounting and internal control systems which areintended to provide reasonable assurance that assets are safeguarded againstloss from unauthorized use or disposition, transactions are executed inaccordance with management’s authorization and accounting records are reliablefor preparing financial statements in accordance with accounting principlesgenerally accepted in the United States.

Internal control over financial reporting cannotprovide absolute assurance of achieving financial reporting objectives becauseof its inherent limitations. Internal control over financial reporting is aprocess that involves human diligence and compliance and is subject to lapsesin judgment and breakdowns resulting from human failures. Internal control overfinancial reporting also can be circumvented by collusion or impropermanagement override. Because of such limitations, there is a risk that materialmisstatements may not be prevented or detected on a timely basis by internalcontrol over financial reporting. However, these inherent limitations are knownfeatures of the financial reporting process. Therefore, it is possible to designinto the process safeguards to reduce, though not eliminate, this risk.

A material weakness in internal control over financialreporting is defined by Public Company Accounting Oversight Board (“PCAOB”)Auditing Standard No.2 as a significant deficiency, or combination ofsignificant deficiencies, that results in more than remote likelihood that amaterial misstatement of the annual or interim financial statements will not beprevented or detected.

As of December 31, 2005, management conducted anassessment of the effectiveness of our internal control over financialreporting based upon the framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (“COSO”), *InternalControl-Integrated Framework*. Based on this assessment, managementconcluded that as of December 31, 2005, we did not maintain effectivecontrol over financial reporting, due to the following material weaknesses:

Our policies andprocedures over account reconciliations and management’s review of estimatesand account balances were not designed to a sufficient level of precision toprevent or detect misstatements that could have a material effect on theConsolidated Financial Statements. As a result, there were errors to theConsolidated Financial Statements that were not identified or recorded bymanagement. This deficiency resulted in more than a remote likelihood that amaterial misstatement to the Consolidated Financial Statements would not beprevented or detected.

Since the Company’s original 2005 Form 10-K was filedon March 17, 2006, an additional material weakness in the Company’s internalcontrol over financial reporting as of December 31, 2005 has been identified.At December 31, 2005, the Company did not have effective policies andprocedures to determine the cost of an acquired enterprise in a businesscombination in accordance with U.S. generally accepted accounting principles.Specifically, the Company’s policies and procedures did not provide forappropriate consideration of funds held in escrow for pre-acquisitioncontingencies. This material weakness resulted in errors in restricted cash,accrued liabilities, and shareholders’ equity as of December 31, 2005. Thecorrection of these accounting errors was reflected in the restated ConsolidatedFinancial Statements included in this Form 10-K/A.

Management’s assessment of the effectiveness ofinternal control over financial reporting as of December 31, 2005 has beenaudited by KPMG LLP, an independent registered public accounting firm. Theirreport appears immediately after this report.

Witness Systems, Inc. February 7, 2007

F-2

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** **

**Report of IndependentRegistered Public Accounting Firmon Internal Control Over Financial Reporting**

The Board of Directors

Witness Systems, Inc.:

We have auditedmanagement’s assessment, included in the accompanying Management’s Report onInternal Control over Financial Reporting (as restated) (page F-2), thatWitness Systems, Inc. did not maintain effective internal control overfinancial reporting as of December 31, 2005, because of the effect of thematerial weaknesses identified in management’s assessment, based on criteriaestablished in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO). Witness Systems, Inc.’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon management's assessment and an opinion on the effectiveness of the Company’sinternal control over financial reporting based on our audit.

We conducted ouraudit in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether effectiveinternal control over financial reporting was maintained in all materialrespects. Our audit included obtaining an understanding of internal controlover financial reporting, evaluating management's assessment, testing andevaluating the design and operating effectiveness of internal control, andperforming such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

A company’sinternal control over financial reporting is a process designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. A company's internal control over financial reporting includes thosepolicies and procedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonable assurancethat transactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat receipts and expenditures of the company are being made only in accordancewith authorizations of management and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements. 

Because of itsinherent limitations, internal control over financial reporting may not preventor detect misstatements.  Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

Amaterial weakness is a control deficiency, or combination of controldeficiencies, that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected. The following material weaknesses have been identifiedand included in management's assessment: 

(1)             AtDecember 31, 2005, the Company’s policies and procedures over accountreconciliations and management’s reviews of estimates and account balances werenot

F-3

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designed to a sufficient level of precision to prevent or detectmisstatements that could have a material effect on the consolidated financialstatements.  As a result, there wereerrors to the consolidated financial statements that were not identified orrecorded by management.  

(2)    Since the Company’s original 2005 Form 10-Kwas filed on March 17, 2006, an additional material weakness in the Company’sinternal control over financial reporting as of December 31, 2005 has beenidentified.  At December 31, 2005, theCompany did not have effective policies and procedures to determine the cost ofan acquired enterprise in a business combination in accordance with U.S.generally accepted accounting principles. Specifically, the Company’s polices and procedures did not provide forappropriate consideration of funds held in escrow for pre-acquisition contingencies.  This material weakness resulted in errors inrestricted cash, accrued liabilities, and shareholders’ equity as of December31, 2005.  The correction of theseaccounting errors was reflected in the restated consolidated financialstatements included in this Form 10-K/A.   

Each of theaforementioned material weaknesses in internal control over financial reportingindividually resulted in more than a remote likelihood that a materialmisstatement of the Company’s interim or annual financial statements would nothave been prevented or detected.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheet of Witness Systems, Inc. andsubsidiaries as of December 31, 2005 (as restated), and the relatedconsolidated statements of operations, stockholders’ equity and comprehensiveincome (loss), and cash flows for the year ended December 31, 2005 (asrestated). The aforementioned material weaknesses were considered indetermining the nature, timing, and extent of audit tests applied in our auditof the 2005 consolidated financial statements, and this report does not affectour report dated March 16, 2006, except as to Note 2, which is as of February7, 2007, which expressed an unqualified opinion on those consolidated financialstatements.

In our opinion,management's assessment that Witness Systems, Inc. did not maintain effectiveinternal control over financial reporting as of December 31, 2005, is fairlystated, in all material respects, based on criteria established in InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Also, in our opinion, becauseof the effect of the material weaknesses described above on the achievement ofthe objectives of the control criteria, Witness Systems, Inc. has notmaintained effective internal control over financial reporting as of December31, 2005, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO).

Management and wepreviously concluded that the Company did not maintain effective internalcontrol over financial reporting as of December 31, 2005 because of thematerial weakness described in (1) above. In connection with the restatement of the Company’s consolidatedfinancial statements described in Note 2 to the consolidated financialstatements, management determined that the material weakness described in (2)above also existed as of December 31, 2005. Accordingly, management and we have restated our respective reports oninternal control over financial reporting to include this additional materialweakness.

Atlanta, GeorgiaMarch 16, 2006, except as to paragraph 6 ofManagement’s Report on Internal Control overFinancial Reporting (as restated) which is as ofFebruary 7, 2007

F-4

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**Report of IndependentRegistered Public Accounting Firm on Consolidated Financial Statements**

The Board of Directors

WitnessSystems, Inc.:

Wehave audited the accompanying consolidated balance sheets of Witness Systems,Inc. and subsidiaries as of December 31, 2005 and 2004, and the relatedconsolidated statements of operations, stockholders’ equity and comprehensiveincome (loss), and cash flows for each of the years in the three-year periodended December 31, 2005.  Theseconsolidated financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudits.

Weconducted our audits in accordance with the standards of the Public Company AccountingOversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Witness Systems,Inc. and subsidiaries as of December 31, 2005 and 2004, and the results oftheir operations and their cash flows for each of the years in the three-yearperiod ended December 31, 2005, in conformity with U.S. generally acceptedaccounting principles.

Theconsolidated financial statements as of December 31, 2005 and 2004 and for eachof the years in the three-year period ended December 31, 2005 have beenrestated as discussed in Note 2.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of WitnessSystems, Inc.’s internal control over financial reporting as of December31, 2005, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO), and our report dated March 16, 2006, except as to Paragraph 6of Management’s Report on Internal Control over Financial Reporting (asrestated) which is as of February 7, 2007, expressed an unqualifiedopinion on management’s assessment of, and an adverse opinion on the effectiveoperation of, internal control over financial reporting. 

Atlanta, Georgia

March 16, 2006, except as toNote 2,

whichis as of February 7, 2007

F-5

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** **

**WITNESSSYSTEMS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

**(In thousands, except share data)**
| ** **                                                                                                                                                                                             | ** ** | **December 31,**     | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                                                                                                                                                             | ** ** | **2005  As  Restated(1)** | ** ** | **2004  As  Restated(1)** | ** ** |
| **ASSETS**                                                                                                                                                                                             |       |                      |       |   |   |
| Current assets:                                                                                                                                                                                        |       |                      |       |   |   |
| Cash and cash  equivalents                                                                                                                                                                             |       | $                         | 111,751    |   | $ | 42,641 |   |
| Investments                                                                                                                                                                                            |       | 14,886                    |       | 33,842 |   |
| Restricted cash  held in escrow                                                                                                                                                                        |       | 4,000                     |       | — |   |
| Accounts  receivable, net of allowance of $3,283 at December 31, 2005 and $3,250  at December 31, 2004                                                                                  |       | 40,218                    |       | 25,681 |   |
| Prepaid and  other current assets                                                                                                                                                                      |       | 5,462                     |       | 4,118 |   |
| Total current  assets                                                                                                                                                                                  |       | 176,317                   |       | 106,282 |   |
| Intangible assets, net                                                                                                                                                                                 |       | 36,389                    |       | 10,802 |   |
| Goodwill                                                                                                                                                                                               |       | 40,319                    |       | — |   |
| Property and equipment,  net                                                                                                                                                                           |       | 7,796                     |       | 6,197 |   |
| Other assets                                                                                                                                                                                           |       | 3,573                     |       | 1,218 |   |
|                                                                                                                                                                                                   |       | $                         | 264,394    |   | $ | 124,499 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         |       |                      |       |   |   |
| Current liabilities:                                                                                                                                                                                   |       |                      |       |   |   |
| Accounts payable                                                                                                                                                                                       |       | $                         | 3,795      |   | $ | 4,454 |   |
| Accrued expenses                                                                                                                                                                                       |       | 29,651                    |       | 16,308 |   |
| Deferred revenue                                                                                                                                                                                       |       | 23,756                    |       | 25,406 |   |
| Total current  liabilities                                                                                                                                                                             |       | 57,202                    |       | 46,168 |   |
| Other long-term  liabilities                                                                                                                                                                           |       | 4,165                     |       | 3,703 |   |
| Deferred income tax  liabilities                                                                                                                                                                       |       | 743                       |       | 254 |   |
| Total  liabilities                                                                                                                                                                                     |       | 62,110                    |       | 50,125 |   |
| 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; 32,612,193 and 24,476,289  shares issued and outstanding at December 31, 2005 and 2004,  respectively                                |       | 326                       |       | 245 |   |
| Additional  paid-in capital                                                                                                                                                                            |       | 251,712                   |       | 117,446 |   |
| Accumulated  deficit                                                                                                                                                                                   |       | (52,830                   | )          | (48,259 | ) |
| Accumulated  other comprehensive income                                                                                                                                                                |       | 3,076                     |       | 4,942 |   |
| Total  stockholders’ equity                                                                                                                                                                       |       | 202,284                   |       | 74,374 |   |
|                                                                                                                                                                                                   |       | $                         | 264,394    |   | $ | 124,499 |   |

 

----

**(1) See Note 2, “Restatement of ConsolidatedFinancial Statements,” of the Notes to the Consolidated Financial Statements**.

**Seeaccompanying notes to Consolidated Financial Statements.**

F-6

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**WITNESSSYSTEMS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(In thousands, exceptper share data)**
| ** **                                      | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2005  As  Restated(1)**                   | ** ** | **2004  As  Restated(1)** | ** ** | **2003  As  Restated(1)** | ** ** |
| Revenue:                                        |       |                                        |       |   |   |   |   |
| Product                                         |       | $                                           | 74,186     |   | $ | 57,620 |   | $ | 46,238 |   |
| Services                                        |       | 111,142                                     |       | 83,715 |   | 61,799 |   |
| Total revenue                                   |       | 185,328                                     |       | 141,335 |   | 108,037 |   |
| Cost of revenue:                                |       |                                        |       |   |   |   |   |
| Product                                         |       | 19,130                                      |       | 13,784 |   | 11,580 |   |
| Services                                        |       | 42,361                                      |       | 32,645 |   | 24,413 |   |
| Total cost of revenue                           |       | 61,491                                      |       | 46,429 |   | 35,993 |   |
| Gross profit                                    |       | 123,837                                     |       | 94,906 |   | 72,044 |   |
| Operating  expenses:                            |       |                                        |       |   |   |   |   |
| Selling, general and administrative             |       | 85,995                                      |       | 65,808 |   | 60,823 |   |
| Research and development                        |       | 26,717                                      |       | 20,816 |   | 18,267 |   |
| Merger-related and integration costs            |       | 4,532                                       |       | 498 |   | 7,865 |   |
| Acquired in-process research and development    |       | 9,000                                       |       | — |   | 7,840 |   |
| Operating (loss) income                         |       | (2,407                                      | )          | 7,784 |   | (22,751 | ) |
| Interest and  other income, net                 |       | 860                                         |       | 1,206 |   | 1,303 |   |
| (Loss) income before provision for income taxes |       | (1,547                                      | )          | 8,990 |   | (21,448 | ) |
| Provision for income  taxes                     |       | 3,024                                       |       | 312 |   | 307 |   |
| Net (loss) income                               |       | $                                           | (4,571     | ) | $ | 8,678 |   | $ | (21,755 | ) |
| Net (loss)  income per share:                   |       |                                        |       |   |   |   |   |
| Basic                                           |       | $                                           | (0.17      | ) | $ | 0.37 |   | $ | (0.99 | ) |
| Diluted                                         |       | $                                           | (0.17      | ) | $ | 0.33 |   | $ | (0.99 | ) |
| Weighted-average  common shares outstanding:    |       |                                        |       |   |   |   |   |
| Basic                                           |       | 27,221                                      |       | 23,361 |   | 21,991 |   |
| Diluted                                         |       | 27,221                                      |       | 26,084 |   | 21,991 |   |

 

----

**(1) See Note 2, “Restatement of ConsolidatedFinancial Statements,” of the Notes to the Consolidated Financial Statements**.

**Seeaccompanying notes to Consolidated Financial Statements.**

F-7

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** **

**WITNESS SYSTEMS, INC.AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTSOF STOCKHOLDERS’ EQUITY ANDCOMPREHENSIVE INCOME (LOSS)**

**Years EndedDecember 31, 2005, 2004 and 2003**

**(In thousands)**
|                                                                          | ** ** | ** **                                       | ** ** | ** **              | ** ** | ** **                             | ** ** | ** **                             | ** ** | **Accumulated  Other**                        | ** ** | ** **                            | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                               | ** ** | **Common Stock  As Restated (1)** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated**                        | ** ** | **Notes  Receivable**                  | ** ** | **Comprehensive  Income**                     | ** ** | **Total  Stockholders’**         | ** ** |
| ** **                                                               | ** ** | **Number**                                       | ** ** | **Amount **        | ** ** | **Capital  As Restated (1)** | ** ** | **Deficit  As Restated (1)** | ** ** | **for Stock  As Restated (1)** | ** ** | **(loss)  As Restated (1)** | ** ** | **Equity   As Restated (1)** | ** ** |
| Balance at  December 31, 2002  -As Previously reported              |       | 22,036                                           |       | $                       | 220        |                                   | $          | 94,260                                 |       | $                                             | (27,937    | )                                     | $          | (1,470 | ) | $ | 1 |   | $ | 65,074 |   |
| Adjustments to  opening stockholders’ equity                        |       |                                             |       |                    |       | 7,245                                  |       | (7,245                                 | )          |                                          |       |                                  |       | — |   |
| Balance at  December 31, 2002-As Restated                           |       | 22,036                                           |       | 220                     |       | 101,505                                |       | (35,182                                | )          | (1,470                                        | )          | 1                                     |       | 65,074 |   |
| Exercise of stock  options and warrants                                  |       | 285                                              |       | 3                       |       | 973                                    |       | —                                 |       | —                                        |       | —                                |       | 976 |   |
| Shares issued  under employee stock purchase plan                   |       | 162                                              |       | 2                       |       | 557                                    |       | —                                 |       | —                                        |       | —                                |       | 559 |   |
| Repayment of  notes receivable for stock and related interest receivable |       | (108                                             | )          | (1                      | )          | (985                                   | )          | —                                 |       | 1,470                                         |       | —                                |       | 484 |   |
| Stock repurchases                                                        |       | (205                                             | )          | (2                      | )          | (641                                   | )          | —                                 |       | —                                        |       | —                                |       | (643 | ) |
| Stock-based  compensation expense                                        |       | —                                           |       | —                  |       | 1,315                                  |       | —                                 |       | —                                        |       | —                                |       | 1,315 |   |
| Comprehensive  income:                                                   |       |                                             |       |                    |       |                                   |       |                                   |       |                                          |       |                                  |       |   |   |
| Change in cumulative foreign currency translation adjustment             |       | —                                           |       | —                  |       | —                                 |       | —                                 |       | —                                        |       | 4,158                                 |       | 4,158 |   |
| Change in unrealized gains (losses) on investments,  net                 |       | —                                           |       | —                  |       | —                                 |       | —                                 |       | —                                        |       | (173                                  | )          | (173 | ) |
| Net loss (As Restated)                                                   |       | —                                           |       | —                  |       | —                                 |       | (21,755                                | )          | —                                        |       | —                                |       | (21,755 | ) |
|                                                                     |       |                                             |       |                    |       |                                   |       |                                   |       |                                          |       |                                  |       |   |   |
| Total comprehensive loss                                                 |       |                                             |       |                    |       |                                   |       |                                   |       |                                          |       |                                  |       | (17,770 | ) |
| Balance at  December 31, 2003-As Restated                           |       | 22,170                                           |       | 222                     |       | 102,724                                |       | (56,937                                | )          | —                                        |       | 3,986                                 |       | 49,995 |   |
| Exercise of stock  options                                               |       | 2,224                                            |       | 22                      |       | 12,993                                 |       | —                                 |       | —                                        |       | —                                |       | 13,015 |   |
| Tax benefit on  exercised stock options                                  |       | —                                           |       | —                  |       | 214                                    |       | —                                 |       | —                                        |       | —                                |       | 214 |   |
| Shares issued  under employee stock purchase plan                        |       | 82                                               |       | 1                       |       | 688                                    |       |                                   |       |                                          |       |                                  |       | 689 |   |
| Stock-based  compensation expense                                        |       | —                                           |       | —                  |       | 827                                    |       | —                                 |       | —                                        |       | —                                |       | 827 |   |
| Comprehensive  income:                                                   |       |                                             |       |                    |       |                                   |       |                                   |       |                                          |       |                                  |       |   |   |
| Change in cumulative foreign currency translation  adjustment            |       | —                                           |       | —                  |       | —                                 |       | —                                 |       | —                                        |       | 959                                   |       | 959 |   |
| Change in unrealized gains (losses) on investments,  net                 |       | —                                           |       | —                  |       | —                                 |       | —                                 |       | —                                        |       | (3                                    | )          | (3 | ) |
| Net Income (As Restated)                                                 |       | —                                           |       | —                  |       | —                                 |       | 8,678                                  |       | —                                        |       | —                                |       | 8,678 |   |
|                                                                     |       |                                             |       |                    |       |                                   |       |                                   |       |                                          |       |                                  |       |   |   |
| Total comprehensive income                                               |       |                                             |       |                    |       |                                   |       |                                   |       |                                          |       |                                  |       | 9,634 |   |
| Balance at  December 31, 2004- As Restated                          |       | 24,476                                           |       | 245                     |       | 117,446                                |       | (48,259                                | )          | —                                        |       | 4,942                                 |       | 74,374 |   |
| Exercise of stock  options                                               |       | 1,462                                            |       | 14                      |       | 10,434                                 |       | —                                 |       | —                                        |       | —                                |       | 10,448 |   |
| Tax benefit on  exercised stock options                                  |       | —                                           |       | —                  |       | 222                                    |       | —                                 |       | —                                        |       | —                                |       | 222 |   |
| Shares issued  under employee stock purchase plan                   |       | 69                                               |       | 1                       |       | 1,034                                  |       | —                                 |       | —                                        |       | —                                |       | 1,035 |   |
| Stock  issuance—Blue Pumpkin                                        |       | 1,890                                            |       | 19                      |       | 33,509                                 |       | —                                 |       | —                                        |       | —                                |       | 33,528 |   |
| Secondary stock  offering                                                |       | 4,715                                            |       | 47                      |       | 88,686                                 |       |                                   |       |                                          |       |                                  |       | 88,733 |   |
| Stock-based  compensation expense                                        |       | —                                           |       | —                  |       | 381                                    |       | —                                 |       | —                                        |       | —                                |       | 381 |   |
| Comprehensive  loss:                                                     |       |                                             |       |                    |       |                                   |       |                                   |       |                                          |       |                                  |       |   |   |
| Change in cumulative foreign currency translation  adjustment            |       | —                                           |       | —                  |       | —                                 |       | —                                 |       | —                                        |       | (1,875                                | )          | (1,875 | ) |
| Change in unrealized gains (losses) on investments,  net                 |       | —                                           |       | —                  |       | —                                 |       | —                                 |       | —                                        |       | 9                                     |       | 9 |   |
| Net loss (As Restated)                                                   |       | —                                           |       | —                  |       | —                                 |       | (4,571                                 | )          | —                                        |       | —                                |       | (4,571 | ) |
| Total comprehensive loss                                                 |       |                                             |       |                    |       |                                   |       |                                   |       |                                          |       |                                  |       | (6,437 | ) |
|                                                                     |       |                                             |       |                    |       |                                   |       |                                   |       |                                          |       |                                  |       |   |   |
| Balance at  December 31, 2005-As Restated                           |       | 32,612                                           |       | $                       | 326        |                                   | $          | 251,712                                |       | $                                             | (52,830    | )                                     | $          | — |   | $ | 3,076 |   | $ | 202,284 |   |

 

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(1)See Note 2, “Restatement of Consolidated Financial Statements,” of the Notes tothe Consolidated Financial Statements.

See accompanying notes to Consolidated Financial Statements.

F-8

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**WITNESSSYSTEMS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(In thousands)**
| ** **                                                                                          | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2005  As Restated (1)**         | ** ** | **2004  As Restated (1)** | ** ** | **2003  As Restated(1)** | ** ** |
| Cash flows from  operating activities:                                                              |       |                                        |       |   |   |   |   |
| Net (loss) income                                                                                   |       | $                                           | (4,571     | ) | $ | 8,678 |   | $ | (21,755 | ) |
| Adjustments to reconcile net (loss) income to net  cash provided by (used in) operating activities: |       |                                        |       |   |   |   |   |
| In-process research and development                                                                 |       | 9,000                                       |       | — |   | 7,840 |   |
| Amortization of intangible assets                                                                   |       | 15,201                                      |       | 5,911 |   | 5,913 |   |
| Depreciation and amortization of property and  equipment                                            |       | 4,394                                       |       | 3,175 |   | 3,805 |   |
| Provision for accounts receivable                                                                   |       | 3,224                                       |       | 1,908 |   | 3,047 |   |
| Deferred income taxes                                                                               |       | 2,253                                       |       | — |   | — |   |
| Stock-based compensation expense                                                                    |       | 381                                         |       | 827 |   | 1,315 |   |
| Other non-cash items, net                                                                           |       | 233                                         |       | 842 |   | 146 |   |
| Changes in operating assets and liabilities:                                                        |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                                 |       | (14,281                                     | )          | 5,068 |   | (7,212 | ) |
| Prepaid and other assets                                                                            |       | 1,511                                       |       | (3,043 | ) | 3,146 |   |
| Accounts payable                                                                                    |       | (2,565                                      | )          | (92 | ) | (2,875 | ) |
| Accrued expenses                                                                                    |       | (1,633                                      | )          | 626 |   | (1,217 | ) |
| Deferred revenue                                                                                    |       | (4,132                                      | )          | 3,978 |   | 5,295 |   |
| Accrued restructuring and integration costs                                                         |       | (2,815                                      | )          | (5,085 | ) | (1,511 | ) |
| Net cash provided by (used in) operating activities                                                 |       | 6,200                                       |       | 22,793 |   | (4,063 | ) |
| Cash flows from  investing activities:                                                              |       |                                        |       |   |   |   |   |
| Capital expenditures                                                                                |       | (5,746                                      | )          | (3,204 | ) | (2,163 | ) |
| Purchases of investments                                                                            |       | (14,553                                     | )          | (40,076 | ) | (30,045 | ) |
| Proceeds from maturities of investments                                                             |       | —                                      |       | 4,500 |   | 5,304 |   |
| Proceeds from sales of investments                                                                  |       | 33,625                                      |       | 20,440 |   | 40,728 |   |
| Acquisition of Eyretel plc, net of cash acquired of  $38,814                                        |       | —                                      |       | — |   | (21,413 | ) |
| Acquisition of Blue Pumpkin Software, Inc, net of  cash acquired of $3,917                          |       | (37,477                                     | )          | — |   | — |   |
| Acquisition of Optimis Group Ltd, net of cash  acquired of $1,287                                   |       | (4,256                                      | )          | — |   | — |   |
| Restricted cash held in escrow                                                                      |       | (4,000                                      | )          | — |   | — |   |
| Purchase of other business assets                                                                   |       | (2,514                                      | )          | — |   | (2,385 | ) |
| Net cash used in investing activities                                                               |       | (34,921                                     | )          | (18,340 | ) | (9,974 | ) |
| Cash flows from  financing activities:                                                              |       |                                        |       |   |   |   |   |
| Proceeds from exercise of stock options                                                             |       | 10,448                                      |       | 13,015 |   | 976 |   |
| Proceeds from employee stock purchase plan                                                          |       | 1,035                                       |       | 689 |   | 559 |   |
| Proceeds from sale of common stock                                                                  |       | 88,733                                      |       | — |   | — |   |
| Repayments of notes receivable from stockholders                                                    |       | —                                      |       | — |   | 484 |   |
| Stock repurchases                                                                                   |       | —                                      |       | — |   | (643 | ) |
| Other                                                                                               |       | (105                                        | )          | (401 | ) | (49 | ) |
| Net cash provided by financing activities                                                           |       | 100,111                                     |       | 13,303 |   | 1,327 |   |
| Effect of exchange rate changes on cash                                                             |       | (2,280                                      | )          | 3,368 |   | 4,138 |   |
| Net increase (decrease) in cash and cash equivalents                                                |       | 69,110                                      |       | 21,124 |   | (8,572 | ) |
| Cash and cash  equivalents at beginning of year                                                     |       | 42,641                                      |       | 21,517 |   | 30,089 |   |
| Cash and cash  equivalents at end of year                                                           |       | $                                           | 111,751    |   | $ | 42,641 |   | $ | 21,517 |   |
| Supplemental  cash flow information:                                                                |       |                                        |       |   |   |   |   |
| Cash paid for interest                                                                              |       | $                                           | 14         |   | $ | — |   | $ | 86 |   |
| Cash paid for income taxes                                                                          |       | $                                           | 488        |   | $ | 245 |   | $ | 229 |   |
| Non-cash financing  activities:                                                                     |       |                                        |       |   |   |   |   |
| Repayments of  notes receivable and interest from stockholders                                      |       | $                                           | —     |   | $ | — |   | $ | 986 |   |

 

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**(**1) See Note 2,“Restatement of Consolidated Financial Statements,” of the Notes to theConsolidated Financial Statements.

**Seeaccompanying notes to Consolidated Financial Statements.**

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**WITNESS SYSTEMS, INC. ANDSUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2005, 2004 and 2003**

 

**1.   Summaryof Significant Accounting Policies**

***Business—******Witness***Systems, Inc.(“Witness”) is a publicly traded company that provides workforce optimizationsoftware and services that enable companies to optimize workforce performancein their customer service operations. Our Impact 360 solution consists ofsoftware products and services designed to optimize the workforce, processesand technology involved in the customer service function. Our qualitymonitoring products record multimedia interactions, including traditionalvoice, Web chat and email, based on user-defined business rules to enableour customers to evaluate the performance of their customer servicerepresentatives, or CSRs, wherever they may be located in the enterprise. Ourhigh-volume compliance applications are designed to record high volume,full-time performance of the voice conversations between CSRs and customers forpurposes such as compliance recording and sales verification. Our workforcemanagement products enable our customers to develop strategic staffing plans,deploy skilled resources and evaluate productivity of CSRs. Our performancemanagement applications provide comprehensive analytics, including performancescorecards, and reports of customer interaction and CSR performance. Oure-learning applications deliver ongoing training tailored to CSR needs andcompetencies. We also provide consulting and implementation services, trainingand support to customers that use our software products.

We are headquartered in Roswell, Georgia withoperations in the United States, Australia, Brazil, Canada, China, Germany,India, Japan, Mexico, the Netherlands, Singapore, South Africa and the UnitedKingdom. We were originally incorporated in 1988 in Georgia and werereincorporated in Delaware in 1997.

***Principles ofConsolidation and Reclassifications—******The***ConsolidatedFinancial Statements include the financial statements of Witness Systems, Inc.and its wholly-owned subsidiaries. All significant intercompany balances andtransactions have been eliminated in consolidation. Certain prior year amountshave been reclassified to conform to the current year presentation.

***Use of Estimates—***TheConsolidated Financial Statements have been prepared in accordance withaccounting principles generally accepted in the United States. The preparationof these Consolidated Financial Statements requires us to make certainestimates and judgments that affect our reported assets, liabilities, revenuesand expenses, and our related disclosure of contingent assets and liabilities.We base our estimates on historical experience and on various assumptions thatwe believe to be reasonable under the circumstances. Actual results may differfrom these estimates under different assumptions or conditions.

***Cash and CashEquivalents and Investments—******Cash*** andcash equivalents consist of cash on deposit, money market accounts, commercialpaper and U.S. Government agency securities. All highly liquid investments withoriginal maturities of three months or less at the time of purchase areclassified as cash equivalents.

Investments are classified as available for sale andare carried at fair market value. Unrealized holding gains and losses on suchinvestments are reported as a separate component of accumulated othercomprehensive income until realized. If a decline in fair value is determinedto be other than temporary, the cost basis of the individual security iswritten down to fair value as a new cost basis resulting in a realized loss.Realized gains and losses from sales are based on the specific identificationmethod. Our investments are presented as current assets as they represent theinvestment of cash available to be used in current operations within the nextyear.

***Restricted cashheld in escrow—***Pursuant to the Blue Pumpkin MergerAgreement discussed in Note 6, “Blue Pumpkin Acquisition,” cash of $4.0 millionwas placed in escrow on the date of acquisition. The escrow fund wasestablished to compensate Witness, subject to certain limitations, forpotential losses that could result from, among other things, the IEX litigationand other specified litigation. The escrow fund is reflected as restricted cashheld in escrow on our Consolidated Balance Sheet as of December 31, 2005.

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***Allowance forDoubtful Accounts—***We perform ongoing evaluationsof our customers and continuously monitor collections and payments and estimatean allowance for doubtful accounts based on the aging of the underlyingreceivables, our historical experience with write-offs and any specificcustomer collection issues that we have identified. While such credit losseshave historically been within our expectations and we believe appropriate reserveshave been established, we cannot assure that we will continue to experience thesame credit loss rates that we have experienced in the past or adequatelypredict future credit losses. If the financial condition of our customers wereto deteriorate and resulted in an impairment of their ability to make payments,additional allowances may be required which would result in additional selling,general and administrative expense in the period such determination is made.

***Property andEquipment—******Property*** andequipment are stated at cost, less accumulated depreciation and amortization.Property and equipment are depreciated and amortized using the straight-linemethod over the estimated useful lives of the assets. Leasehold improvementsare amortized using the straight-line method over the shorter of the estimatedlife of the asset or the remaining term of the lease. Property and equipmentgenerally has the following estimated useful lives and is comprised of thefollowing amounts (in thousands):
|                                                 | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Computer equipment (2  years)                   |       | $                     | 9,038      |   | $ | 5,069 |   |
| Software (2 - 3  years)                    |       | 4,187                 |       | 3,093 |   |
| Other equipment (5  years)                      |       | 4,221                 |       | 3,725 |   |
| Furniture and fixtures  (5 years)               |       | 711                   |       | 690 |   |
| Leasehold improvements                          |       | 3,354                 |       | 3,111 |   |
|                                            |       | 21,511                |       | 15,688 |   |
| Less accumulated  depreciation and amortization |       | 13,715                |       | 9,491 |   |
|                                            |       | $                     | 7,796      |   | $ | 6,197 |   |

 

Depreciation and amortization on property andequipment was $4.4 million**,** $3.2 millionand $3.8 million in 2005, 2004 and 2003, respectively.

***Long-Lived Assets—******As*** requiredby Statement of Financial Accounting Standards (“SFAS”) No. 144*, Accounting for Impairment or Disposal of Long-livedAssets*, long-lived assets are reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amount of anasset may not be recoverable. Recoverability of assets to be held and usedwould be measured by a comparison of the carrying amount of an asset to theestimated undiscounted future cash flows expected to be generated by the asset.If the carrying amount of an asset exceeds its undiscounted estimated futurecash flows, an impairment charge is recognized in the amount by which thecarrying amount of the asset exceeds the fair value of the asset. To date, noevents or changes in circumstances have occurred that would require us to testlong-lived assets for recoverability.

***Goodwill andIntangible Assets—***Goodwill and intangible assetsare accounted for in accordance with SFAS No.142, *Goodwill and intangible assets*. This statement requires thatgoodwill and intangible assets with indefinite lives should not be amortized,but should be tested for impairment on an annual basis, or more often if anevent occurs or circumstances change that would more likely than not reduce thefair value of a reporting unit below its carrying amount.

***RevenueRecognition and Deferred Revenue—******We***recognizerevenue in accordance with the American Institute of Certified PublicAccountants’ Statement of Position (“SOP”) 97-2, *Software Revenue Recognition*,

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and SOP 98-9, *Modification of* SOP 97-2, *Software Revenue Recognition, With Respect to CertainTransactions*. Revenue is primarily derived from licensing softwareand providing related services including maintenance. Product revenue, whichcan include software and hardware, is recognized when persuasive evidence of anagreement exists, delivery of the product has occurred, the fee is fixed ordeterminable, collection is probable and vendor specific objective evidence offair value (“VSOE”) exists to allocate revenue to the undelivered elements ofthe arrangement. The Company reports hardware revenue gross in accordance withEmerging Issues Task Force No. 99-19, *ReportingRevenue Gross as a Principal versus Net as an Agent,* because thefactors indicating gross reporting outweigh the factors indicating netreporting. We recognize revenue using the residual method of accounting whencustomer orders contain multiple element arrangements, including the sale oflicensed software, hardware, maintenance, and professional services. We haveVSOE for maintenance and professional services, but not for the software andhardware elements of the order. Under the residual method, services revenue,including maintenance and professional services, is deferred at an amount equalto VSOE until those elements are delivered. Consequently, product revenue forthe software and hardware may be recognized (i) upon delivery of thoseproducts when we have VSOE for the related maintenance and professionalservices sold and (ii) at an amount representing the difference betweenthe total order amount and the amount deferred.

Services revenue includes installation, training,consulting, maintenance and reimbursable travel expenses. Revenue frominstallation, training and consulting services is recognized upon performanceof the related services and is offered and billed as separate elements ofcontracts. Reimbursable travel expenses revenue is recognized upon incurrenceof the related expenses. The functionality of the software and any hardwaresold is not dependent on installation and training services and customizationis not required to enable our customers to use our products. Maintenance isoffered as a separate element and the majority of contracts include the rightto unspecified upgrades on a when-and-if available basis. Maintenance revenueis deferred and recognized ratably over the term of the related maintenancecontract.

Our revenue recognition policy is significant becauseour revenues are a key component of our results of operations. We follow veryspecific and detailed guidelines in measuring revenues; however, certainjudgments and estimates affect the application of our revenue policy describedabove. Further, assessment of collectibility is particularly critical indetermining whether or not revenues should be recognized. We also recordprovisions for estimated sales allowances on product and service relatedrevenues at the time the related revenues are recorded. These estimates arebased on historical sales and services allowances, analysis of customer creditsand other known factors. If future sales credits prove to be greater than thehistorical data and the estimates we used to calculate these provisions, ourrevenues could be overstated.

Deferred revenue consists primarily of amounts collectedfrom customers for products and services that have not met the criteria forrevenue recognition.

***Advertising Costs—******Advertising***costs are expensed as incurred. Advertising expenses were $0.5 million in 2005and $0.3 million in each of the years 2004 and 2003.

***Research andDevelopment Costs—******Research*** anddevelopment costs consist primarily of personnel and consulting costs involvedwith product development and allocated overhead. These costs are expensed asincurred and include software development costs incurred prior to theestablishment of technological feasibility.

***SoftwareDevelopment Costs—******In***accordancewith SFAS No. 86, *Accounting for theCosts of Computer Software to be sold, leased, or Otherwise Marketed,*softwaredevelopment costs are expensed until technological feasibility of the producthas been established and are capitalized commencing upon the establishment oftechnological feasibility through the time of general release to customers.Amortization of software development costs begins when the product is availablefor general release and is amortized using the greater of: (1) thestraight-line method over the expected life of the product or (2) theratio of current product revenue to the total of 

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current and futureproduct revenue. At each balance sheet date, the unamortized softwaredevelopment costs are compared to the net realizable value of the underlyingproduct and to the extent any unamortized capitalized costs exceed the netrealizable value of the asset, those costs are written off. As ofDecember 31, 2005, and 2004, unamortized software development costs were$1.2 million and $0.4 million, respectively, and are included in otherassets on the accompanying consolidated balance sheets. During 2005 and 2004,$0.5 million and $0.4 million in software development costs were amortizedto cost of product revenue. We did not have any software development costamortization in 2003.

We have entered into a software licensing agreementfor the right to distribute a vendor’s software as part of our workforceoptimization solution. Unamortized cost as of December 31, 2005 is $2.5 millionand will be amortized through 2008.

***Merger-RelatedCosts and Purchase Price Contingencies—******Merger-related***costsinclude expenses that are directly related to a merger, including costs relatedto integrating the software products of the acquired company, trainingpersonnel on products acquired, establishing the infrastructure andconsolidating the operations of the acquired company. Merger-related costs alsoinclude costs related to Witness lease terminations and severance associatedwith Witness employee terminations resulting from closures and terminationsduring the merger integration process. We account for merger-related costs inaccordance with SFAS No. 146, *Accountingfor Costs Associated with Exit or Disposal Activities*, whichrequires that a liability for a cost associated with an exit or disposalactivity only be recognized when the liability is incurred.

In accounting for acquisitions, we accrue for certain losscontingencies that exist at the date of acquisition. We reduce such liabilitiesas those contingencies are resolved or if we determine that the contingency nolonger represents a probable loss. Any adjustments to these liabilities arereflected as adjustments to goodwill and/or other acquired assets to the extentinformation was requested but not received at the date of acquisition. Otheradjustments are reflected in our results of operations, except as prescribed byEmerging Issues Task Force (“EITF”) No. 95-3, *Recognition of Liabilities in Connection with a Purchase BusinessCombination*.

***Stock-BasedCompensation.****  *Wegenerally did not record compensation expense for options granted to ouremployees because all options granted under our stock option plans wereinitially considered to have an exercise price equal to the market value of theunderlying common stock on the date of grant. However, as described in Note 2,“Restatement of Consolidated Financial Statements,” we have foundinaccuracies in the determination of measurement dates for certain stock optiongrants. In those instances where the fair market value of our common stock atthe originally stated grant date was lower than the fair market value on theredetermined measurement date, in accordance with APB No. 25 and relatedinterpretations, we have recorded stock-based compensation expense which wasnot recorded in our previously issued Consolidated Financial Statements.

As permitted under SFAS No. 148,*Accounting for Stock-Based Compensation—Transitionand Disclosure*, and SFAS No. 123,*Accounting for Stock-Based Compensation*, we have elected tocontinue to apply the provisions of Accounting Principles Board OpinionNo. 25,*Accounting for Stock Issued toEmployees,* and have adopted the disclosure requirements of SFASNo. 123. The pro forma disclosures of stock-based compensation include theuse of certain input factors in calculating the fair value of stock optiongrants, some of which require management to make estimates and use judgment.See “Recent Accounting Pronouncement” below for further discussion on ouradoption of SFAS No. 123R.

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The following table illustrates the effect on net(loss) income and net (loss) income per share if we had applied the fair valuemethod as prescribed by SFAS No. 123 (in thousands, except per sharedata):
|                                                                                                          | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2005  As Restated (1)**         | ** ** | **2004  As Restated(1)** | ** ** | **2003  As Restated(1)** | ** ** |
|                                                                                                     |       |                                        |       |   |   |   |   |
| Reported net  (loss) income                                                                              |       | $                                           | (4,571     | ) | $ | 8,678 |   | $ | (21,755 | ) |
| Add: Stock-based  employee compensation expense included in reported net (loss) income, net of  tax      |       | 381                                         |       | 827 |   | 1,315 |   |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards |       | (13,597                                     | )          | (9,282 | ) | (9,139 | ) |
| Pro forma net  (loss) income                                                                             |       | $                                           | (17,787    | ) | $ | 223 |   | $ | (29,579 | ) |
| Net (loss)  income per share:                                                                            |       |                                        |       |   |   |   |   |
| Reported basic                                                                                           |       | $                                           | (0.17      | ) | $ | 0.37 |   | $ | (0.99 | ) |
| Pro forma basic                                                                                          |       | $                                           | (0.65      | ) | $ | 0.01 |   | $ | (1.35 | ) |
| Reported diluted                                                                                         |       | $                                           | (0.17      | ) | $ | 0.33 |   | $ | (0.99 | ) |
| Pro forma  diluted                                                                                       |       | $                                           | (0.65      | ) | $ | 0.01 |   | $ | (1.35 | ) |

 

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**(1) See Note 2, “Restatement of ConsolidatedFinancial Statements,” of the Notes to the Consolidated Financial Statements**.

***Income Taxes—******We*** accountfor income taxes in accordance with SFAS No. 109, *Accounting for Income Taxes*, whichrequires companies to recognize deferred income tax assets and liabilitiesusing enacted tax rates for the effect of temporary differences between thebook and tax bases of recorded assets and liabilities. The 

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effect on deferred incometax assets and liabilities of a change in tax rates is recognized in income inthe period that includes the enactment date. SFAS No. 109 also requiresthat deferred income tax assets be reduced by a valuation allowance if it ismore likely than not that some portion or all of the deferred income tax assetwill not be realized. We evaluate the realizability of our deferred income taxassets and establish a valuation allowance to reduce our deferred income taxassets based on an assessment of the likelihood of their realization. Weconsider certain relevant criteria including deferred income tax liabilitiesthat can be used to offset deferred income tax assets, estimates of futuretaxable income of appropriate character within the carry forward periodavailable, and tax planning strategies.

***Net Income (Loss)Per Share—******We*** calculatenet 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 theweighted average number of shares outstanding during the period. When theeffects are not anti-dilutive, diluted net income (loss) per share is computedby dividing our net income (loss) by the weighted average number of sharesoutstanding and the dilutive impact of all dilutive stock options. The dilutiveimpact of stock options is determined by applying the treasury stock method.(See Note 3 for further information.)

***Fair Value ofFinancial Instruments—******At***December 31,2005 and 2004, our financial instruments included cash and cash equivalents,investments, accounts receivable and accounts payable. We believe the carryingvalues of cash and cash equivalents, accounts receivable and accounts payableapproximate fair values because of the short-term maturities of theseinstruments. Our investments are carried at fair value.

***Foreign Currency—******Generally,***the functional currency has been determined to be the local currency for ourforeign subsidiaries. As a result, those subsidiaries’ assets and liabilitiesare translated at year-end exchange rates and income statement items aretranslated at average exchange rates prevailing during the year. Suchtranslation adjustments are recorded as a component of stockholders’ equity andother comprehensive income (loss).

Net gains (losses) from foreign currency denominatedtransactions are included in interest and other income, net and were$(0.2) million, $0.3 million and $0.4 million in 2005, 2004 and2003, respectively.

***Recent AccountingPronouncements—***In November 2005, the FASBissued Staff Position (“FSP”) FAS115-1/124-1, *TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments,* which addresses the determination as to when aninvestment is considered impaired, whether that impairment is other thantemporary, and the measurement of an impairment loss. This FSP alsoincludes accounting considerations subsequent to the recognition of another-than-temporary impairment and requires certain disclosures aboutunrealized losses that have not been recognized as other-than-temporary impairments. Theguidance in this FSP amends FASB Statements No. 115, *Accounting for Certain Investments in Debt and EquitySecurities,*andNo. 124,*Accounting for CertainInvestments Held by Not-for-Profit Organizations*, and APBOpinion No. 18*, The Equity Method ofAccounting for Investments in Common Stock*. This FSP iseffective for reporting periods beginning after December 15, 2005. Wedo not believe the adoption of this FSP will have a material impact on ourConsolidated Financial Statements.

In December 2004, the FASB issued SFASNo. 123R (Revised 2004),*Share-BasedPayment* which, among other things, requires that compensationexpense be recognized in the financial statements for share-based awards basedon the grant date fair value of those awards. It will also require the benefitsassociated with tax deductions in excess of recognized compensation cost bereported as a financing cash flow rather than as an operating cash flow ascurrently required. The share-based compensation cost will be measured based onthe fair value of the equity or liability instruments issued. EffectiveJanuary 1, 2006, we expect to adopt SFAS 123R using the modifiedprospective method. We are evaluating the requirements under SFAS 123R andexpect the adoption to have a significant adverse impact on our results ofoperations, but not on our cash flows.

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In November 2005, the FASB issued FSP FAS123(R)-3,*Transition Election to Accounting for theTax Effects of Share-Based Payment Awards.*This FSP requires anentity to follow either the transition guidance for theadditional-paid-in-capital pool as prescribed in SFAS No. 123(R), *Share-Based Payment*, or the alternativetransition method as described in the FSP. An entity that adopts SFASNo. 123(R) using the modified prospective method may make a one-timeelection to adopt the transition method described in this FSP. An entity maytake up to one year from the later of its initial adoption of SFASNo. 123(R) or the effective date of this FSP to evaluate itsavailable transition alternatives and make its one-time election. This FSPbecame effective in November 2005. We continue to evaluate the impact thatthe adoption of this FSP could have on our Consolidated Financial Statements.

**2.   Restatementof Consolidated Financial Statements**

Beginning in late May 2006, the Company’s management initiated apreliminary internal review of the Company’s historical stock option practicesand related accounting treatment in response to general media attentionconcerning stock option grants at various public companies and shareholderinterest with respect to this particular issue. On August 8, 2006, in responseto the results of management’s preliminary internal review, our Board ofDirectors voluntarily formed a Special Committee of independent directors toreview our stock option practices and grants during the period between the dateof the Company’s initial public offering on February 10, 2000 and August 31,2002.  The Special Committee undertookits investigation with the assistance of independent counsel and accountingexperts retained by its counsel. The Special Committee reviewed all 5.7 millionstock options granted throughout the period covered by its investigation. In December2006, the Special Committee completed its review and reported its findings andrecommendations to our full Board of Directors. The Special Committee did notfind fraud or intentional misrepresentation in the financial reporting of theoption grants that it analyzed but found inaccuracies in the determination ofmeasurement dates for certain stock option grants affecting the Company’saccounting and disclosures. For a number of these grants, the Special Committeefound that it was likely that the stated grant date was selected in hindsightbased on price given the lack of supporting documentation and that the optionprice was the low price in a given month or quarter. Such grants were found tobe present during 2000 and through approximately mid-year 2001. The SpecialCommittee concluded that it was not necessary to expand the investigation tocover periods after August 31, 2002. Among the various key considerations inreaching this conclusion were: 1) as noted above, the Special Committee did notfind fraud or intentional misrepresentation in the financial reporting of theoption grants that it analyzed; 2) the Special Committee’s investigation foundthat the last instance of likely grant date selection based on stock price  occurred in mid-2001; and 3) the SpecialCommittee observed that the option granting practices of the Company becamemore formal and regularized during the latter phase of the period subject toits review. 

In addition to the Special Committee investigation, the Company, withthe assistance of outside legal counsel, reviewed the Company’s stock optionpractices and grants for the periods subsequent to August 31, 2002. This reviewevaluated 90 percent of the 11.1 million options granted after August 31, 2002.The review was designed not only to provide a high degree of grant reviewcoverage, but also to appropriately assess the propriety of measurement datesfor each of the various types of options granted during this period.  Among others, option grant types coveredincluded: 1) new employee grants in connection with the acquisition ofbusinesses; 2) semi-annual employee ranking grants; 3) routine non-officergrants for such events as new hires, promotions, sales achievement, etc; and 4)officer grants, including grants to the Company’s then CEO. This review did notfind fraud or intentional misrepresentation in the financial reporting relatingto option grants but identified errors in the determination of measurementdates. However, such errors were relatively immaterial and did not exhibitevidence of selection of a favorable grant date and price in hindsight. 

In those instances during the two review periods where the fair marketvalue of our common stock at the originally stated grant date was lower thanthe fair market value on the re-determined measurement date, we concluded thatapproximately $9.7 million of additional stock-based compensation expenserelated to 4.6 million options of the 15.8 million options reviewed shouldbe recorded in accordance with Accounting Principles Board No. 25, “Accountingfor Stock Issued to Employees” (“APB No. 25”) and related interpretations.Cumulatively through December 31, 2005 we have reflected $9.5 million of thisexpense in our consolidated statements of operations. The remaining $0.2 millionis for options which were not fully vested as of December 31, 2005. Additionalstock-based compensation expense was recorded as follows: $0.2 million in 2005,$0.8 million in 2004, $1.2 million in 2003, $1.9 million in 2002, $4.2 millionin 2001, and $1.2 million in 2000.

According to APB No. 25, the measurement date is the first date onwhich proper approval is obtained and all of the following are known: (1) theindividual employee who is entitled to receive the option grant, (2) the numberof options that an individual employee is entitled to receive, and (3) theoption’s exercise price. To correct the grant date inaccuracies, the Companyre-determined the measurement date based on the date when all APB No. 25criteria were satisfied. In re-determining the most appropriate measurementdate of an option grant, we considered meeting minutes and other documents ofour Board of Directors, including minutes of the Compensation Committee and theOption Committee, in addition to the following data:

·       thedate on which such grants were entered into the Company’s stock option system(“option entry date”) and thereby constructively communicated to each recipientvia each recipient’s individual stock option account as administered by athird-party online broker;

·       reportson Form 4 filed with the SEC;

·       contemporaneousemails;

·       personnelfiles;

·       payrollrecords;

·       informationobtained in interviews with various current and former Company employees andBoard of Directors members; and

·       variousrecords maintained by our Human Resources department.

For grants where there was not sufficient evidence anddocumentation to support the original measurement date or to determine theprecise date when the number of options and exercise price were finalized, weused all available relevant information to form a reasonable conclusion as tothe most likely measurement date for such option grants. 

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For grants made to officers during this time, theCompany believes that the proper measurement date is the date on which suchgrants were ratified or approved by the Compensation Committee. Under theCompany’s corporate governance provisions during both periods subject toreview, the Compensation Committee was the only body authorized to approveofficer stock option grants. Therefore, officer grants could not be determinedwith finality until approval by the Compensation Committee. Of the total $9.7million additional stock-based compensation expense arising from grant datecorrections, approximately $4.2 million relates to officer grants.  

Of the total $9.7 million additional stock-basedcompensation expense arising from grant date corrections, approximately $5.5million relates to non-officer grants. Prior to the formation of the OptionCommittee in July 2001 and in lieu of sufficient evidence and documentation tosupport an earlier measurement date, the Company concluded that the bestestimate of the measurement date was the option entry date. During thispre-July 2001 period the Company’s CEO was authorized by the Company’s Board ofDirectors to grant options to non-officers, and we have concluded that allmeasurement date criteria were finalized no later than the option entry date. Forall non-officer grants during the period after December 31, 2001, weconcluded that all measurement date conditions were determined with finality onthe date of approval/ratification by the Option Committee or CompensationCommittee, as applicable.

The following is a summary of the results of thereviews by the Special Committee and the Company and the impact of the primarystock-option accounting errors underlying this restatement: 

Inaccurate measurement dates for certain stock optionsgranted between February 10, 2000 and August 31, 2002

Based upon the review of all 5.7 million stock optionsgranted to officers and non-officer employees between February 10, 2000 andAugust 31, 2002, it was determined that we used inaccurate measurement datesfor 3.8 million  options.  Inaccurate measurement dates were found tohave been used for substantially all grants issued prior to 2002, whereas onlyan inconsequential number of inaccuracies were identified during the firsteight months of 2002. Of the $9.7 million of stock-based compensation expensedescribed above, approximately $9.4 million arose from grants made during thisperiod. Of this $9.4 million approximately $8.8 million can be described asresulting from the Company’s use of grant dates for which there was inadequatesupport. The remaining $0.6 million of the $9.4 million noted above is theresult of the Company’s incorrect accounting for certain options that weremodified after the initial grant date.

The discussion following each of the italicizedheadings below provides further details on the various error types identified.The specific examples discussed here account for $8.7 million of the $9.4million expense noted above. The remaining $0.7 million not specificallydiscussed below related to various generally small grants of approximately1.0 million options in total (e.g. new hires, promotions, incentive andsales achievement awards) awarded throughout this period.

*Errors arising from likely date selection inhindsight:*

As noted above, the Special Committee identifiedduring this period grant dates which were likely selected in hindsight based onstock price considerations. The following specific grants, which in theaggregate account for additional stock-based compensation expense of $7.2million and constitute materially all such grants in both quantity andrestatement amount, are the largest examples of this error type:

·       Grantsmade in April 2000 (0.3 million options covering 134 employees, including sixofficers), December 2000 (0.5 million options covering 173 employees includingeight officers), and April 2001 (0.7 million options covering 149 employees,including eight officers) were dated prior to the dates on which finalizationand approval appears to have occurred. These grant dates also exhibitedfavorable pricing (i.e., relative stock price lows). Most of these grants weremade in conjunction with the Company’s normal practice of granting stockoptions to officers and non-officers on a semi-annual basis through an employeeperformance ranking process. The remaining awards on these dates were variousother grant types such as new hire and sales achievement options. Theadjustment of the measurement dates on these options resulted in aggregateadditional stock compensation expense of $6.0 million. 

·       Agrant of 0.2 million shares was made in August 2000 to one officer inconnection with that officer’s initial employment. For this particular grant,while the Special Committee’s investigation found sufficient evidence of grantapproval within the month of hire, adequate evidence of exercise pricedetermination could not be located until entry into the Company’s stock optionsystem. Therefore, this later date was determined to be the appropriatemeasurement date, resulting in additional stock-based compensation expense of$0.4 million. 

·       Agrant of 0.4 million shares was made to one officer with an originally statedgrant date of March 2001. Based upon the Special Committee’s review, theCompany concluded that final approval of all the terms of this grant by theCompensation Committee occurred in April 2001. Adjusting this grant to thelater measurement date resulted in additional stock-based compensation expenseof $0.8 million.

F-17

----

*Errors arising during implementation of theCompany’s month-end granting process:*

During 2001, the Company’s option-granting practicesbecame more formal and regularized. The Option Committee of the Board ofDirectors was established in July 2001 and was given the authority to approvecertain non-officer employee grants. The Stock Options Committee determinedthat for non-officer new hires, promotions, and other routine grants, aconsistent practice should be established of granting options at the closingprice of the last trading day of the month in which the respective option wasawarded. Beginning in October 2001, the Company’s originally stated measurementdate for such grants was always the closing price for the month. While someevidence exists to show that the Option Committee’s practice was implementedbeginning in October 2001, the Company has concluded that it was not untilJanuary 2002 that a consistent pattern of month-end granting was establishedsuch that all measurement date criteria were determined with finality as of theend of the month.  As such, we havere-determined the measurement dates in October, November and December 2001, tobe the date on which such grants were ultimately approved/ratified in January2002. This adjustment to the originally stated measurement date for these threemonths (a total of 0.4 million options) resulted in additional stock-basedcompensation expense of approximately $0.5 million. This adjustment relatesentirely to non-officer employee grants.

*Certain other errors arising from inadequatesupport of originally stated grant date:*

In connection with a 2000 acquisition, approximately0.1 million options were granted to eleven new non-officer employees inAugust 2000. The Company’s originally stated measurement date coincided withthe closing date of the acquisition. However, we concluded that there wasinsufficient documentation available to support that these grants were approvedwith finality as of the acquisition date. Giving full consideration to thefacts and circumstances, we concluded that the date of approval by theCompensation Committee was the most appropriate measurement date for theseoptions. This adjustment to the original measurement date resulted inadditional stock-based compensation expense of $0.4 million.

*Errors arising from incorrect accounting for optionmodifications:*

We incorrectly accounted for approximately 0.2 millionstock options granted in the fourth quarter of 2000, consisting mostly ofgrants to new employees of the Company. Subsequent to the granting of these options, the Company modified theexercise price to the closing market price of the Company’s stock on December20, 2000, which was the lowest noted market closing price during the quarter.Such repricing is considered a modification of an award and requires theapplication of variable accounting. In accordance with the provisions ofFinancial Accounting Standards Board Interpretation 44, “*Accountingfor Certain Transactions involving Stock Compensation*,” wedetermined that we should have recorded an additional $0.6 million instock–based compensation expense relating to these grants during the periods2000 through 2005. The annual stock-based compensation expense (benefit)recorded for these grants was $24 thousand, $0.4 million, $0.1 million, ($0.4million), and $0.4 million in 2005, 2004, 2003, 2002 and 2001, respectively. 

Inaccurate measurement dates for certain stock optionsgranted after August 31, 2002

Based upon our review of 10.1 million of the 11.1million options granted after August 31, 2002, we concluded that we usedinaccurate measurement dates for 0.8 million options and concluded that weshould have recorded an additional $0.3 million in stock–based compensationexpense for the periods 2002 through 2005. For approximately 0.6 millionoptions granted to employees in connection with the 2005 Blue Pumpkin, Inc.acquisition, the Company initially used the date of acquisition as themeasurement date. However, we concluded that the Board of Directors’ approvaldate is the appropriate measurement date for all grants as insufficientverifiable evidence existed to support the originally-stated grant date. Thiscorrection resulted in additional stock-based compensation expense of $0.2million (included in the $0.3 million above). For the options granted (approximately 1.5 million in total) toemployees in connection with the Eryetel, plc. acquisition in 2003, the Companyhad sufficient evidence to support the original grant date for all employeesexcept a small number of employees who joined the Company after the acquisitionand were granted approximately 50 thousand shares in total. In this case theCompany relied on the option entry date to establish the measurement date.  In this respect, the Company recorded anadditional $0.1 million of stock-based compensation expense. 

**OtherAdjustments in our Consolidated Financial Statements**

In connection with the restatement of our historical ConsolidatedFinancial Statements, we identified additional adjustments that needed to berecorded to our historical Consolidated Financial Statements. These adjustmentsconsisted primarily of a correction of purchase accounting relating to theacquisition of Blue Pumpkin, Inc., income taxes and miscellaneous other items.These adjustments resulted in an increase of approximately $1.0 million in thepreviously reported net loss in 2005. 

The cumulative effect of all the restatementadjustments to our Consolidated Balance Sheet as of December 31, 2005 resultedin an increase in the accumulated deficit of $10.5 million, an increase inadditional paid-in capital of $5.8 million and increases in assets andliabilities of $2.8 million and $7.5 million, respectively.

F-18

----

We have decreased previously reported net income(loss) and diluted earnings per common share as follows (in thousands, exceptper share data):
| Fiscal Year               | ** ** | **Stock – Based  Compensation  Expense** | ** ** | **Other Items** | ** ** | **Total decrease in  Net Income  (loss)** | ** ** | **Decrease in  Diluted Earnings  Per Share** | ** ** |
|--------------------------------|------------|---------------------------------------------------------|------------|----------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------------|------------|
| 2000                           |       | $                                                       | 1,203      |                 | —     |                                                | $          | 1,203                                                       |       | $ | 0.06 |   |
| 2001                           |       | 4,158                                                   |       | —               |       | 4,158                                               |       | $                                                           | 0.19       |   |
| 2002                           |       | 1,884                                                   |       | —               |       | 1,884                                               |       | $                                                           | 0.08       |   |
| Total 2000 –  2002 impact |       | 7,245                                                   |       | —               |       | 7,245                                               |       |                                                        |       |
| 2003                           |       | 1,186                                                   |       | —               |       | 1,186                                               |       | $                                                           | 0.05       |   |
| 2004                           |       | 768                                                     |       | —               |       | 768                                                 |       | $                                                           | 0.03       |   |
| 2005                           |       | 322                                                     |       | $                    | 986        |                                                | 1,308      |                                                        | $          | 0.05 |   |
| Total                          |       | $                                                       | 9,521      |                 | $          | 986                                                 |       | $                                                           | 10,507     |   |   |   |

 

The table below providesa summary of the stock-based compensation expense for the years ended December31, 2002, 2001 and 2000 (in thousands):
| Fiscal Year                                       | ** ** | **As Previously  Reported** | ** ** | **Adjustment** | ** ** | **As Restated** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|----------------|------------|----------------------|------------|
| 2002                                                   |       | $                                | 115        |           | $          | 1,884                |       | $ | 1,999 |   |
| 2001                                                   |       | $                                | 171        |           | $          | 4,158                |       | $ | 4,329 |   |
| 2000                                                   |       | $                                | 271        |           | $          | 1,203                |       | $ | 1,474 |   |
| Adjustment to retained earnings  as of January 1, 2003 |       |                             |       | $              | 7,245      |                 |       |   |

 

The table below reflects the quarterly adjustments toour net income (loss) during years 2005 and 2004 (in thousands):
| Quarterly period ended | ** ** | **Stock – Based  Compensation  Expense** | ** ** | **Other Items** | ** ** | **Total  adjustments to  Net Income  (loss)** | ** ** |
|----------------------------------|------------|---------------------------------------------------------|------------|----------------------|------------|---------------------------------------------------------|------------|
| March 2004                       |       | $                                                       | 276        |                 | —     |                                                    | $          | 276 |   |
| June 2004                        |       | 65                                                      |       | —               |       | 65                                                      |       |
| September 2004                   |       | 301                                                     |       | —               |       | 301                                                     |       |
| December 2004                    |       | 126                                                     |       | —               |       | 126                                                     |       |
| March 2005                       |       | 98                                                      |       | —               |       | 98                                                      |       |
| June 2005                        |       | 84                                                      |       | —               |       | 84                                                      |       |
| September 2005                   |       | 82                                                      |       | —               |       | 82                                                      |       |
| December 2005                    |       | 58                                                      |       | 986                  |       | 1,044                                                   |       |
|                                  |            |                                                         |            |                      |            |                                                         |            |  |  |

 

The followingtable reflects the detailed income taxes and miscellaneous other adjustmentsreflected in our Consolidated Statement of Operations for the year endedDecember 31, 2005 (in thousands):
| Description                                                  | ** ** | ** ** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|
| Purchased  software licences and related maintenance expense |       | $          | 299        |   |
| Lease exit costs                                             |       | 308        |       |
| Income taxes                                                 |       | 336        |       |
| Other                                                        |       | 43         |       |
|                                                         |       | $          | 986        |   |

 

F-19

----

We determined that, at the date of the acquisition ofBlue Pumpkin Software, Inc. (“Blue Pumpkin”), it was not beyond a reasonabledoubt that the cash and common stock held in escrow pursuant to the MergerAgreement and Plan of Reorganization would be issued to the former shareholdersof Blue Pumpkin.  Therefore, inaccordance with SFAS No. 141,*BusinessCombinations*, we have adjusted the consideration paid in theacquisition of Blue Pumpkin Software, Inc. (“Blue Pumpkin”) from $77.2 millionto $69.5 million to properly reduce the purchase price for the $4.0 million incash and 210,000 shares of common stock that were held in escrow.  As a result, the December 31, 2005 balancesheet reflects a reduction in equity by approximately $3.7 million and therecognition of $4.0 million in restricted cash. In addition, we adjusted accrued expenses by approximately $7.7 millionto reflect the $11.2 million estimated cost to settle all claims with IEX. SeeNote 6, “Blue Pumpkin Acquisition,” for additional discussion related to theacquisition.

We have restated the following Consolidated FinancialStatements to reflect the additional stock-based compensation, purchaseaccounting, income taxes and miscellaneous other items:

·                  ConsolidatedStatements of Operations for years ended December 31, 2005, 2004 and 2003;

·                  ConsolidatedBalance Sheets as of December 31, 2005 and 2004;

·                  ConsolidatedStatements of Cash Flows for the years ending December 31, 2005, 2004 and 2003;and

·                  ConsolidatedStatements of Stockholders’ Equity and Comprehensive Income (Loss) for theyears ending December 31, 2005, 2004 and 2003.

·                  Certainamounts in Notes 1, 3, 6, 8, 9, 10, 13, 14 and 15 have been restated to reflectthe adjustments below.

***Impact of the Financial StatementAdjustments on the Consolidated Statements of Operations***

**The table below presents the impact of theConsolidated Financial Statements adjustment related to restatement of ourpreviously reported Consolidated Statements of Operations for the years endedDecember 31, 2005, 2004 and, 2003:**

F-20

----

**(In thousands, except per share data)**

 
| ** **                                      | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | ** **                                  | ** ** | **2005** | ** ** | ** ** | ** ** | ** ** | ** ** | **2004** | ** ** | ** ** | ** ** | ** ** | ** ** | **2003** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **As  Previously  Reported**                | ** ** | **Adjustments** | ** ** | **As  Restated** | ** ** | **As  Previously  Reported** | ** ** | **Adjustments** | ** ** | **As  Restated** | ** ** | **As  Previously  Reported** | ** ** | **Adjustments** | ** ** | **As  Restated** | ** ** |
| Revenue:                                        |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                         |       | $                                           | 74,186     |   | — |   | $ | 74,186 |   | $ | 57,620 |   | — |   | $ | 57,620 |   | $ | 46,238 |   | — |   | $ | 46,238 |   |
| Services                                        |       | 111,185                                     |       | $ | (43 | )(1) | 111,142 |   | 83,715 |   | — |   | 83,715 |   | 61,799 |   | — |   | 61,799 |   |
| Total revenue                                   |       | 185,371                                     |       | (43 | ) | 185,328 |   | 141,335 |   | — |   | 141,335 |   | 108,037 |   | — |   | 108,037 |   |
| Cost of revenue:                                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                         |       | 19,057                                      |       | 73 |  (2) | 19,130 |   | 13,784 |   | — |   | 13,784 |   | 11,580 |   | — |   | 11,580 |   |
| Services                                        |       | 42,204                                      |       | 157 |  (3) | 42,361 |   | 32,594 |   | $ | 51 |  (4) | 32,645 |   | 24,278 |   | $ | 135 | (4) | 24,413 |   |
| Total cost of revenue                           |       | 61,261                                      |       | 230 |   | 61,491 |   | 46,378 |   | 51 |   | 46,429 |   | 35,858 |   | 135 |   | 35,993 |   |
| Gross profit                                    |       | 124,110                                     |       | (273 | ) | 123,837 |   | 94,957 |   | (51 | ) | 94,906 |   | 72,179 |   | (135 | ) | 72,044 |   |
| Operating  expenses:                            |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative             |       | 85,718                                      |       | 277 |  (4) | 85,995 |   | 65,051 |   | 757 |  (4) | 65,808 |   | 60,003 |   | 820 | (4) | 60,823 |   |
| Research and development                        |       | 26,706                                      |       | 11 |  (4) | 26,717 |   | 20,856 |   | (40 | )(4) | 20,816 |   | 18,036 |   | 231 | (4) | 18,267 |   |
| Merger-related and integration costs            |       | 4,224                                       |       | 308 |  (5) | 4,532 |   | 498 |   | — |   | 498 |   | 7,865 |   | — |   | 7,865 |   |
| Acquired in-process research and development    |       | 9,000                                       |       | — |   | 9,000 |   | — |   | — |   | — |   | 7,840 |   | — |   | 7,840 |   |
| Operating (loss) income                         |       | (1,538                                      | )          | (869 | ) | (2,407 | ) | 8,552 |   | (768 | ) | 7,784 |   | (21,565 | ) | (1,186 | ) | (22,751 | ) |
| Interest and  other income, net                 |       | 963                                         |       | (103 | )(6) | 860 |   | 1,206 |   | — |   | 1,206 |   | 1,303 |   | — |   | 1,303 |   |
| (Loss) income before provision for income taxes |       | (575                                        | )          | (972 | ) | (1,547 | ) | 9,758 |   | (768 | ) | 8,990 |   | (20,262 | ) | (1,186 | ) | (21,448 | ) |
| Provision for  income taxes                     |       | 2,688                                       |       | 336 |  (7) | 3,024 |   | 312 |   | — |   | 312 |   | 307 |   | — |   | 307 |   |
| Net (loss) income                               |       | $                                           | (3,263     | ) | $ | (1,308 | ) | $ | (4,571 | ) | $ | 9,446 |   | $ | (768 | ) | $ | 8,678 |   | $ | (20,569 | ) | $ | (1,186 | ) | $ | (21,755 | ) |
| Net (loss) income  per share:                   |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                           |       | $                                           | (0.12      | ) | $ | (0.05 | ) | $ | (0.17 | ) | $ | 0.40 |   | $ | (0.03 | ) | $ | 0.37 |   | $ | (0.94 | ) | $ | (0.05 | ) | $ | (0.99 | ) |
| Diluted                                         |       | $                                           | (0.12      | ) | $ | (0.05 | ) | $ | (0.17 | ) | $ | 0.36 |   | $ | (0.03 | ) | $ | 0.33 |   | $ | (0.94 | ) | $ | (0.05 | ) | $ | (0.99 | ) |
| Weighted-average  common shares outstanding:    |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                           |       | 27,419                                      |       | (198 | ) | 27,221 |   | 23,361 |   |   |   | 23,361 |   | 21,991 |   |   |   | 21,991 |   |
| Diluted                                         |       | 27,419                                      |       | (198 | ) | 27,221 |   | 26,084 |   |   |   | 26,084 |   | 21,991 |   |   |   | 21,991 |   |

 

(1)   Adjustment to recognizeservices revenue at cost plus a normal profit margin for acquired maintenancecontracts.

(2)   Adjustment to reflectproduct costs associated with purchased software licenses for resale.

(3)   $34 adjustment to reflectadditional stock compensation expense and $123 adjustment to reflect cost ofmaintenance associated with purchased software licenses.

(4)   Adjustment to reflectadditional stock compensation expense.

(5)   Adjustment to reflect theaccrual of costs associated with vacated leases in accordance with SFAS No.146.

(6)   Adjustment to recordinterest expense.

(7)   Adjustmentto income taxes to properly reflect the tax bases of newly acquired assets.

*** ***

F-21

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***Impact of the Financial StatementAdjustments on the Consolidated Balance Sheets***

**The table below presents the impact of theConsolidated Financial Statements adjustments related to restatement of ourpreviously reported consolidated balance sheets as of December 31, 2005 andDecember 31, 2004 (in thousands):**
| ** **                                                                                                                                                                                            | ** ** | **December 31,**        | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **2005**                     | ** ** | **2004** | ** ** |
| ** **                                                                                                                                                                                            | ** ** | **As  Previously  Reported** | ** ** | **Adjustments** | ** ** | **As  Restated** | ** ** | **As  Previously  Reported** | ** ** | **Adjustments** | ** ** | **As  Restated** | ** ** |
| **ASSETS**                                                                                                                                                                                            | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                                                       |       |                         |       |   |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                             |       | $                            | 111,751    |   | — |   | $ | 111,751 |   | $ | 42,641 |   | — |   | $ | 42,641 |   |
| Investments                                                                                                                                                                                           |       | 14,886                       |       | — |   | 14,886 |   | 33,842 |   | — |   | 33,842 |   |
| Restricted cash held in escrow                                                                                                                                                                        |       | —                       |       | 4,000 |  (1) | 4,000 |   | — |   | — |   | — |   |
| Accounts receivable, net of allowance of $3,283 at  December 31, 2005 and $3,250 at December 31, 2004                                                                                       |       | 40,218                       |       | — |   | 40,218 |   | 25,681 |   | — |   | 25,681 |   |
| Prepaid and other current assets                                                                                                                                                                      |       | 5,462                        |       | — |   | 5,462 |   | 4,118 |   | — |   | 4,118 |   |
| Total current assets                                                                                                                                                                                  |       | 172,317                      |       | 4,000 |   | 176,317 |   | 106,282 |   | — |   | 106,282 |   |
| Intangible  assets, net                                                                                                                                                                               |       | 36,389                       |       | — |   | 36,389 |   | 10,802 |   | — |   | 10,802 |   |
| Goodwill                                                                                                                                                                                              |       | 40,697                       |       | (378 | )(2) | 40,319 |   | — |   | — |   | — |   |
| Property and  equipment, net                                                                                                                                                                          |       | 7,796                        |       | — |   | 7,796 |   | 6,197 |   | — |   | 6,197 |   |
| Other assets                                                                                                                                                                                          |       | 4,387                        |       | (814 | )(3) | 3,573 |   | 1,218 |   | — |   | 1,218 |   |
|                                                                                                                                                                                                  |       |                         |       |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                                                                                                  |       | $                            | 261,586    |   | $ | 2,808 |   | $ | 264,394 |   | $ | 124,499 |   | — |   | $ | 124,499 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current  liabilities:                                                                                                                                                                                 |       |                         |       |   |   |   |   |   |   |   |   |   |   |
| Accounts payable                                                                                                                                                                                      |       | $                            | 3,795      |   | — |   | $ | 3,795 |   | $ | 4,454 |   | — |   | $ | 4,454 |   |
| Accrued expenses                                                                                                                                                                                      |       | 21,891                       |       | $ | 7,760 |  (4) | 29,651 |   | 16,308 |   | — |   | 16,308 |   |
| Deferred revenue                                                                                                                                                                                      |       | 23,778                       |       | (22 | )(5) | 23,756 |   | 25,406 |   | — |   | 25,406 |   |
|                                                                                                                                                                                                  |       |                         |       |   |   |   |   |   |   |   |   |   |   |
| Total current liabilities                                                                                                                                                                             |       | 49,464                       |       | 7,738 |   | 57,202 |   | 46,168 |   | — |   | 46,168 |   |
| Other long-term  liabilities                                                                                                                                                                          |       | 4,409                        |       | (245 | )(6) | 4,165 |   | 3,703 |   | — |   | 3,703 |   |
| Deferred income  tax liabilities                                                                                                                                                                      |       | 743                          |       | — |   | 743 |   | 254 |   | — |   | 254 |   |
|                                                                                                                                                                                                  |       |                         |       |   |   |   |   |   |   |   |   |   |   |
| Total liabilities                                                                                                                                                                                     |       | 54,616                       |       | 7,494 |   | 62,110 |   | 50,125 |   | — |   | 50,125 |   |
| 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; 32,612,193 and 24,476,289 shares issued and outstanding at  December 31, 2005 and 2004, respectively                                |       | 328                          |       | (2 | )(7) | 326 |   | 245 |   | — |   | 245 |   |
| Additional paid-in capital                                                                                                                                                                            |       | 245,889                      |       | 5,823 |  (7) | 251,712 |   | 108,247 |   | 9,199 |   | 117,446 |   |
| Accumulated deficit                                                                                                                                                                                   |       | (42,323                      | )          | (10,507 | ) | (52,830 | ) | (39,060 | ) | (9,199 | ) | (48,259 | ) |
| Accumulated other comprehensive income                                                                                                                                                                |       | 3,076                        |       | — |   | 3,076 |   | 4,942 |   | — |   | 4,942 |   |
| Total stockholders’ equity                                                                                                                                                                       |       | 206,970                      |       | (4,686 | ) | 202,284 |   | 74,374 |   | — |   | 74,374 |   |
|                                                                                                                                                                                                  |       | $                            | 261,586    |   | $ | 2,808 |   | $ | 264,394 |   | $ | 124,499 |   | — |   | $ | 124,499 |   |

 

(1)   Adjustment to reflect cashheld in escrow as restricted.

(2)   Adjustment to recognizedeferred tax assets and maintenance contracts acquired in the acquisition ofBlue Pumpkin.

(3)   Adjustment to reflectdiscount on long term obligation related to purchased software licenses.

(4)   $7,723 adjustment to recordthe liability associated with the settlement of IEX and $37 of othermiscellaneous accruals including the current portion of the lease exit costaccrual.

(5)   Adjustment to reflectacquired maintenance contracts at fair value at the date of acquisition.

(6)   $258 adjustment to reflectthe accrual of costs associated with vacated leases in accordance with SFAS No.146 and approximately $503 adjustment to reflect the discount on long termobligations associated with the cost of purchased software licenses.

(7)   $3.7 million adjustment toreduce additional paid-in capital for shares held in escrow in connection withthe acquisition of Blue Pumpkin and approximately $9.5 million increase due tocumulative impact of stock compensation expense.

F-22

----

***Impact of the Financial StatementAdjustments on the Consolidated Statements of Cash Flows***

The restatement of the Consolidated Statements of CashFlows for the years ending December 31, 2005, 2004 and 2003 due to recording ofadditional non-cash stock-based compensation expense and other adjustments didnot affect our cash flows from financing activities. The table below reflectsadjustments to our cash flows (in thousands):

F-23

----

 
| ** **                                                                                           | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                           | ** ** | ** **                                  | ** ** | **2005** | ** ** | ** ** | ** ** | ** ** | ** ** | **2004** | ** ** | ** ** | ** ** | ** ** | ** ** | **2003** | ** ** | ** ** | ** ** |
| ** **                                                                                           | ** ** | **As  Previously   Reported**          | ** ** | **Adjustment** | ** ** | **As  Restated** | ** ** | **As  Previously   Reported** | ** ** | **Adjustment** | ** ** | **As  Restated** | ** ** | **As  Previously   Reported** | ** ** | **Adjustment** | ** ** | **As  Restated** | ** ** |
| Cash flows from  operating activities:                                                               |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net  (loss) income                                                                                   |       | $                                           | (3,263     | ) | $ | (1,308 | ) | $ | (4,571 | ) | $ | 9,446 |   | $ | (768 | ) | $ | 8,678 |   | $ | (20,569 | ) | $ | (1,186 | ) | (21,755 | ) |
|                                                                                                 |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Adjustments  to reconcile net (loss) income to net cash provided by (used in) operating  activities: |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| In-process  research and development                                                                 |       | 9,000                                       |       | — |   | 9,000 |   | — |   | — |   | — |   | 7,840 |   | — |   | 7,840 |   |
| Amortization  of intangible assets                                                                   |       | 15,201                                      |       | — |   | 15,201 |   | 5,911 |   | — |   | 5,911 |   | 5,913 |   | — |   | 5,913 |   |
| Depreciation  and amortization of property and equipment                                             |       | 4,394                                       |       | — |   | 4,394 |   | 3,175 |   | — |   | 3,175 |   | 3,805 |   | — |   | 3,805 |   |
| Provision  for accounts receivable                                                                   |       | 3,224                                       |       | — |   | 3,224 |   | 1,908 |   | — |   | 1,908 |   | 3,047 |   | — |   | 3,047 |   |
| Deferred  income taxes                                                                               |       | 1,940                                       |       | 313 |   | 2,253 |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Stock-based  compensation expense                                                                    |       | 59                                          |       | 322 |   | 381 |   | 59 |   | 768 |   | 827 |   | 129 |   | 1,186 |   | 1,315 |   |
| Other  non-cash items, net                                                                           |       | 220                                         |       | 13 |   | 233 |   | 842 |   | — |   | 842 |   | 146 |   | — |   | 146 |   |
| Changes  in operating assets and liabilities:                                                        |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Accounts  receivable                                                                                 |       | (14,281                                     | )          | — |   | (14,281 | ) | 5,068 |   | — |   | 5,068 |   | (7,212 | ) | — |   | (7,212 | ) |
| Prepaid  and other assets                                                                            |       | 697                                         |       | 814 |   | 1,511 |   | (3,043 | ) | — |   | (3,043 | ) | 3,146 |   | — |   | 3,146 |   |
| Accounts  payable                                                                                    |       | (2,613                                      | )          | 48 |   | (2,565 | ) | (92 | ) | — |   | (92 | ) | (2,875 | ) | — |   | (2,875 | ) |
| Accrued  expenses                                                                                    |       | (1,388                                      | )          | (245 | ) | (1,633 | ) | 626 |   | — |   | 626 |   | (1,217 | ) | — |   | (1,217 | ) |
| Deferred  revenue                                                                                    |       | (4,110                                      | )          | (22 | ) | (4,132 | ) | 3,978 |   | — |   | 3,978 |   | 5,295 |   | — |   | 5,295 |   |
| Accrued  restructuring and integration costs                                                         |       | (2,815                                      | )          | — |   | (2,815 | ) | (5,085 | ) | — |   | (5,085 | ) | (1,511 | ) | — |   | (1,511 | ) |
| Net  cash provided by (used in) operating activities                                                 |       | 6,265                                       |       | (65 | ) | 6, 200 |   | 22, 793 |   | — |   | 22,793 |   | (4,063 | ) | — |   | (4,063 | ) |
|                                                                                                 |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash flows from  investing activities                                                                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Capital  expenditures                                                                                |       | (5,746                                      | )          | — |   | (5,746 | ) | (3,204 | ) | — |   | (3,204 | ) | (2,163 | ) | — |   | (2,163 |   |
| Purchases  of investments                                                                            |       | (14,553                                     | )          | — |   | (14,553 |   | (40,076 | ) | — |   | (40,076 |   | (30,045 | ) | — |   | (30,045 | ) |
| Proceeds  from maturities of investments                                                             |       | —                                      |       | — |   | — |   | 4,500 |   | — |   | 4,500 |   | 5,304 |   | — |   | 5,304 |   |
| Proceeds  from sales of investments                                                                  |       | 33,625                                      |       | — |   | 33,625 |   | 20,440 |   | — |   | 20,440 |   | 40,728 |   | — |   | 40,728 |   |
| Acquisition  of Eyretel plc, net of cash acquired of $38,814                                         |       | —                                      |       | — |   | — |   | — |   | — |   | — |   | (21,413 | ) | — |   | (21,413 | ) |
| Acquisition  of Blue Pumpkin Software, Inc, net of cash acquired of $3,728                           |       | (41,477                                     | )          | 4,000 |   | (37,477 | ) | — |   | — |   | — |   | — |   | — |   | — |   |
| Acquisition  of Optimis Group Ltd, net of cash acquired of $1,287                                    |       | (4,321                                      | )          | 65 |   | (4,256 | ) | — |   | — |   | — |   | — |   | — |   | — |   |
| Restricted  cash held in escrow                                                                      |       | —                                      |       | (4,000 | ) | (4,000 | ) | — |   | — |   | — |   | — |   | — |   | — |   |
| Purchase  of other business assets                                                                   |       | (2,514                                      | )          |   |   | (2,514 | ) | — |   | — |   | — |   | (2,385 | ) | — |   | (2,385 | ) |
| Net cash used in  investing activities                                                               |       | $                                           | (34,986    | ) | $ | 65 |   | $ | (34,921 | ) | $ | (18,340 | ) | — |   | $ | (18,340 | ) | $ | (9,974 | ) | — |   | $ | (9,974 | ) |
| Cash flows from  financing activities:                                                               |       |                                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Proceeds from exercise  of stock options                                                             |       | 10,448                                      |       | — |   | 10,448 |   | 12,614 |   | 401 |   | 13,015 |   | 976 |   | — |   | 976 |   |
| Proceeds from employee  stock purchase plan                                                          |       | 1,035                                       |       | — |   | 1,035 |   | 689 |   | — |   | 689 |   | 559 |   | — |   | 559 |   |
| Proceeds from sale of  common stock                                                                  |       | 88,733                                      |       | — |   | 88,733 |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Repayments of notes  receivable from stockholders                                                    |       | —                                      |       | — |   | — |   | — |   | — |   | — |   | 484 |   | — |   | 484 |   |
| Stock repurchases                                                                                    |       | —                                      |       | — |   | — |   | — |   | — |   | — |   | (643 | ) | — |   | (643 | ) |
| Other                                                                                                |       | (105                                        | )          | — |   | (105 | ) | — |   | (401 | ) | (401 | ) | (49 | ) | — |   | (49 | ) |
| Net cash provided by  financing activities                                                           |       | 100,111                                     |       | — |   | 100,111 |   | 13,303 |   | — |   | 13,303 |   | 1,327 |   | — |   | 1,327 |   |
| Effect of exchange rate  changes on cash                                                             |       | (2,280                                      | )          | — |   | (2,280 | ) | 3,368 |   | — |   | 3,368 |   | 4,138 |   | — |   | 4,138 |   |
| Net increase (decrease)  in cash and cash equivalents                                                |       | 69,110                                      |       | — |   | 69,110 |   | 21,124 |   | — |   | 21,124 |   | (8,572 | ) | — |   | 8,572 |   |
| Cash and cash  equivalents at beginning of year                                                      |       | 42,641                                      |       | — |   | 42,641 |   | 21,517 |   | — |   | 21,517 |   | 30,089 |   | — |   | 30,089 |   |
| Cash and cash  equivalents at end of year                                                            |       | 111,751                                     |       | — |   | 111,751 |   | 42,641 |   | — |   | 42,641 |   | 21,517 |   | — |   | 21,517 |   |
|                                                                                                      |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

** **

F-24

----

**Restatement of Quarterly Results of Operations(Unaudited) Consolidated Financial Statements**

The table below presents the impact of theConsolidated Financial Statements adjustments related to restatement of ourpreviously reported (unaudited) quarterly Statements of Operations data foreach of the last eight quarters in the two-year period ended December 31, 2005:
| ** **                                      | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **Dec. 31,   2005**    | ** ** | **Sept. 30,  2005** | ** ** | **Jun. 30,  2005** | ** ** | **Mar. 31,  2005** | ** ** | **Dec. 31,  2004** | ** ** | **Sept. 30,  2004** | ** ** | **Jun. 30,  2004** | ** ** | **Mar. 31,  2004** | ** ** |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **As Previously reported** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                        |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                         |       | $                                | 20,595     |   | $ | 18,306 |   | $ | 18,918 |   | $ | 16,368 |   | $ | 15,655 |   | $ | 13,925 |   | $ | 14,138 |   | $ | 13,902 |   |
| Services                                        |       | 30,297                           |       | 28,843 |   | 27,253 |   | 24,791 |   | 23,053 |   | 21,332 |   | 20,280 |   | 19,050 |   |
| Total revenue                                   |       | 50,892                           |       | 47,149 |   | 46,171 |   | 41,159 |   | 38,708 |   | 35,257 |   | 34,418 |   | 32,952 |   |
| Cost of revenue:                                |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                         |       | 5,253                            |       | 4,543 |   | 4,928 |   | 4,332 |   | 3,423 |   | 2,737 |   | 3,714 |   | 3,910 |   |
| Services                                        |       | 11,095                           |       | 10,801 |   | 10,784 |   | 9,525 |   | 8,259 |   | 8,036 |   | 8,363 |   | 7,936 |   |
| Total cost of revenue                           |       | 16,348                           |       | 15,344 |   | 15,712 |   | 13,857 |   | 11,682 |   | 10,773 |   | 12,077 |   | 11,846 |   |
| Gross profit                                    |       | 34,544                           |       | 31,805 |   | 30,459 |   | 27,302 |   | 27,026 |   | 24,484 |   | 22,341 |   | 21,106 |   |
| Operating  expenses:                            |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative             |       | 22,696                           |       | 21,601 |   | 21,505 |   | 19,913 |   | 17,388 |   | 16,422 |   | 15,702 |   | 15,539 |   |
| Research and development                        |       | 6,682                            |       | 6,938 |   | 6,892 |   | 6,195 |   | 5,548 |   | 5,470 |   | 4,963 |   | 4,875 |   |
| Merger-related and integration costs            |       | 581                              |       | 1,059 |   | 925 |   | 1,659 |   | (177 | ) | 152 |   | 155 |   | 368 |   |
| Acquired in-process research and development    |       | —                           |       | — |   | — |   | 9,000 |   | — |   | — |   | — |   | — |   |
| Operating income (loss)                         |       | 4,585                            |       | 2,207 |   | 1,137 |   | (9,465 | ) | 4,267 |   | 2,440 |   | 1,521 |   | 324 |   |
| Interest and  other income, net                 |       | 523                              |       | 245 |   | 56 |   | 138 |   | 463 |   | 435 |   | 137 |   | 171 |   |
| Income (loss) before provision for income taxes |       | 5,108                            |       | 2,452 |   | 1,193 |   | (9,327 | ) | 4,730 |   | 2,875 |   | 1,658 |   | 495 |   |
| Provision for  income taxes                     |       | 216                              |       | 1,822 |   | 617 |   | 33 |   | 211 |   | (68 | ) | 144 |   | 25 |   |
| Net income  (loss)                              |       | $                                | 4,892      |   | $ | 630 |   | $ | 576 |   | $ | (9,360 | ) | $ | 4,519 |   | 2,943 |   | $ | 1,514 |   | $ | 470 |   |
| Net income (loss) per  share:                   |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                           |       | $                                | 0.17       |   | $ | 0.02 |   | $ | 0.02 |   | $ | (0.36 | ) | $ | 0.19 |   | $ | 0.12 |   | $ | 0.07 |   | $ | 0.02 |   |
| Diluted                                         |       | $                                | 0.15       |   | $ | 0.02 |   | $ | 0.02 |   | $ | (0.36 | ) | $ | 0.17 |   | $ | 0.11 |   | $ | 0.06 |   | $ | 0.02 |   |
| Weighted-average common  shares outstanding:    |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                           |       | 28,863                           |       | 27,475 |   | 27,078 |   | 26,261 |   | 24,326 |   | 23,631 |   | 23,013 |   | 22,462 |   |
| Diluted                                         |       | 31,354                           |       | 29,887 |   | 29,513 |   | 26,261 |   | 27,088 |   | 26,202 |   | 26,108 |   | 25,201 |   |

 

 

F-25

----

 
| ** **                                      | ** ** | **Adjustments to the  Three Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                      | ** ** | **Dec. 31,  2005**                                        | ** ** | **Sept. 30,  2005** | ** ** | **Jun. 30,  2005** | ** ** | **Mar. 31,  2005** | ** ** | **Dec. 31,  2004** | ** ** | **Sept. 30,  2004** | ** ** | **Jun. 30,  2004** | ** ** | **Mar. 31,  2004** | ** ** |
| ** **                                      | ** ** | ** **                                                     | ** ** | ** ** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:  Services                              |       | $                                                              | (43        | ) | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Cost of revenue:                                |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                         |       | 73                                                             |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Services                                        |       | 128                                                            |       | $ | 9 |   | $ | 9 |   | $ | 10 |   | $ | 13 |   | $ | 10 |   | $ | (1 | ) | $ | 29 |   |
|                                            |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating  expenses:                            |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative             |       | 55                                                             |       | 66 |   | 72 |   | 85 |   | 101 |   | 272 |   | 60 |   | 324 |   |
| Research and development                        |       | (2                                                             | )          | 7 |   | 3 |   | 3 |   | 12 |   | 19 |   | 6 |   | (77 | ) |
| Merger-related and integration costs            |       | 308                                                            |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Operating income (loss)                         |       | (605                                                           | )          | (82 | ) | (84 | ) | (255 | ) | (126 | ) | (301 | ) | (65 | ) | (276 | ) |
| Interest and other income                       |       | (103                                                           | )          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) before provision for income taxes |       | (708                                                           | )          | (82 | ) | (84 | ) | (98 | ) | (126 | ) | (301 | ) | (65 | ) | (276 | ) |
| Provision for income tax                        |       | 336                                                            |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Net income  (loss)                              |       | $                                                              | (1,044     | ) | $ | (82 | ) | $ | (84 | ) | $ | (98 | ) | $ | (126 | ) | $ | (301 | ) | $ | (65 | ) | $ | (276 | ) |

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **Dec. 31,  2005**          | ** ** | **Sept. 30,  2005** | ** ** | **Jun. 30,  2005** | ** ** | **Mar. 31,  2005** | ** ** | **Dec. 31,  2004** | ** ** | **Sept. 30,  2004** | ** ** | **Jun. 30,  2004** | ** ** | **Mar. 31,  2004** | ** ** |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **As Restated** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                        |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                         |       | $                                | 20,595     |   | $ | 18,306 |   | $ | 18,918 |   | $ | 16,368 |   | $ | 15,655 |   | $ | 13,925 |   | $ | 14,138 |   | $ | 13,902 |   |
| Services                                        |       | 30,254                           |       | 28,843 |   | 27,253 |   | 24,791 |   | 23,053 |   | 21,332 |   | 20,280 |   | 19,050 |   |
| Total revenue                                   |       | 50,849                           |       | 47,149 |   | 46,171 |   | 41,159 |   | 38,708 |   | 35,257 |   | 34,418 |   | 32,952 |   |
| Cost of revenue:                                |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product                                         |       | 5,326                            |       | 4,543 |   | 4,928 |   | 4,332 |   | 3,423 |   | 2,737 |   | 3,714 |   | 3,910 |   |
| Services                                        |       | 11,223                           |       | 10,810 |   | 10,793 |   | 9,535 |   | 8,272 |   | 8,046 |   | 8,362 |   | 7,965 |   |
| Total cost of revenue                           |       | 16,549                           |       | 15,353 |   | 15,721 |   | 13,867 |   | 11,695 |   | 10,783 |   | 12,076 |   | 11,875 |   |
| Gross profit                                    |       | 34,300                           |       | 31,796 |   | 30,450 |   | 27,292 |   | 27,013 |   | 24,474 |   | 22,342 |   | 21,077 |   |
| Operating  expenses:                            |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative             |       | 22,751                           |       | 21,667 |   | 21,577 |   | 19,998 |   | 17,489 |   | 16,694 |   | 15,762 |   | 15,863 |   |
| Research and development                        |       | 6,680                            |       | 6,945 |   | 6,895 |   | 6,198 |   | 5,560 |   | 5,489 |   | 4,969 |   | 4,798 |   |
| Merger-related and integration costs            |       | 889                              |       | 1,059 |   | 925 |   | 1,659 |   | (177 | ) | 152 |   | 155 |   | 368 |   |
| Acquired in-process research and development    |       | —                           |       | — |   | — |   | 9,000 |   | — |   | — |   | — |   | — |   |
| Operating income (loss)                         |       | 3,980                            |       | 2,125 |   | 1,053 |   | (9,563 | ) | 4,141 |   | 2,139 |   | 1,456 |   | 48 |   |
| Interest and  other income, net                 |       | 420                              |       | 245 |   | 56 |   | 138 |   | 463 |   | 435 |   | 137 |   | 171 |   |
| Income (loss) before provision for income taxes |       | 4,400                            |       | 2,370 |   | 1,109 |   | (9,425 | ) | 4,604 |   | 2,574 |   | 1,593 |   | 219 |   |
| Provision for  income taxes                     |       | 552                              |       | 1,822 |   | 617 |   | 33 |   | 211 |   | (68 | ) | 144 |   | 25 |   |
| Net income  (loss)                              |       | $                                | 3,848      |   | $ | 548 |   | $ | 492 |   | $ | (9,458 | ) | $ | 4,393 |   | $ | 2,642 |   | $ | 1,449 |   | $ | 194 |   |
| Net income (loss) per  share:                   |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                           |       | $                                | 0.13       |   | $ | 0.02 |   | $ | 0.02 |   | $ | (0.36 | ) | $ | 0.18 |   | $ | 0.11 |   | $ | 0.06 |   | $ | 0.01 |   |
| Diluted                                         |       | $                                | 0.12       |   | $ | 0.02 |   | $ | 0.02 |   | $ | (0.36 | ) | $ | 0.16 |   | $ | 0.10 |   | $ | 0.06 |   | $ | 0.01 |   |
| Weighted-average common  shares outstanding:    |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                           |       | 28,654                           |       | 27,265 |   | 26,868 |   | 26,098 |   | 24,326 |   | 23,631 |   | 23,013 |   | 22,462 |   |
| Diluted                                         |       | 31,565                           |       | 30,097 |   | 29,676 |   | 26,098 |   | 27,088 |   | 26,202 |   | 26,108 |   | 25,201 |   |

** **

F-26

----

**Restatementof Quarterly Condensed Consolidated Balance Sheets (Unaudited)**

Thefollowing table sets forth certain unaudited Condensed quarterly financial datafor the years ended December 31, 2005 and 2004. This information has beenprepared on the same basis as the Condensed Financial Statements and allnecessary adjustments have been included in the amounts below to present fairlythe selected quarterly information when read in conjunction with theConsolidated Financial Statements and notes thereto. Historical quarterly financialresults and trends may not be indicative of future results. The table belowalso discloses the impact of the restatement on quarterly financialinformation.

**Consolidated Balance Sheets Forthe Fiscal Year Ended December 31, 2005 (in thousands, except share data):**
| ** **                                                                                                                                                                                             | ** ** | **March 31, 2005**      | ** ** | **June 30, 2005** | ** ** | **September 30, 2005**  | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                             | ** ** | **As  Previously  Reported** | ** ** | **As  Restated**       | ** ** | **As  Previously  Reported** | ** ** | **As  Restated** | ** ** | **As  Previously  Reported** | ** ** | **As  Restated** | ** ** |
| **ASSETS**                                                                                                                                                                                             |       |                         |       |                   |       |                         |       |   |   |   |   |   |   |
| Current assets:                                                                                                                                                                                        |       |                         |       |                   |       |                         |       |   |   |   |   |   |   |
| Cash  and cash equivalents                                                                                                                                                                             |       | $                            | 29,020     |                   | $          | 29,020                       |       | $ | 29,982 |   | $ | 29,982 |   | $ | 33,090 |   | $ | 33,090 |   |
| Investments                                                                                                                                                                                            |       | 2,914                        |       | 2,914                  |       | 984                          |       | 984 |   | 1,493 |   | 1,493 |   |
| Restricted  cash                                                                                                                                                                                       |       | —                       |       | 4,000                  |       | —                       |       | 4,000 |   | — |   | 4,000 |   |
| Accounts  receivable, net                                                                                                                                                                              |       | 32,286                       |       | 32,286                 |       | 34,428                       |       | 34,428 |   | 37,502 |   | 37,502 |   |
| Prepaid  and other current assets                                                                                                                                                                      |       | 4,723                        |       | 4,723                  |       | 4,362                        |       | 4,362 |   | 6,519 |   | 6,519 |   |
| Total  current assets                                                                                                                                                                                  |       | 68,943                       |       | 72,943                 |       | 69,756                       |       | 73,756 |   | 78,604 |   | 82,604 |   |
| Intangible assets, net                                                                                                                                                                                 |       | 45,313                       |       | 45,313                 |       | 43,781                       |       | 43,781 |   | 39,711 |   | 39,711 |   |
| Goodwill                                                                                                                                                                                               |       | 35,728                       |       | 28,028                 |       | 40,481                       |       | 32,781 |   | 37,635 |   | 29,935 |   |
| Property and equipment,  net                                                                                                                                                                           |       | 7,352                        |       | 7,352                  |       | 7,404                        |       | 7,404 |   | 7,656 |   | 7,656 |   |
| Other assets                                                                                                                                                                                           |       | 2,554                        |       | 2,554                  |       | 2,952                        |       | 2,952 |   | 879 |   | 879 |   |
|                                                                                                                                                                                                   |       | $                            | 159,890    |                   | $          | 156,190                      |       | $ | 164,374 |   | $ | 160,674 |   | $ | 164,485 |   | $ | 160,785 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         |       |                         |       |                   |       |                         |       |   |   |   |   |   |   |
| Current liabilities:                                                                                                                                                                                   |       |                         |       |                   |       |                         |       |   |   |   |   |   |   |
| Accounts  payable                                                                                                                                                                                      |       | $                            | 6,851      |                   | $          | 6,851                        |       | $ | 7,451 |   | $ | 7,451 |   | $ | 4,381 |   | $ | 4,381 |   |
| Accrued  expenses                                                                                                                                                                                      |       | 20,085                       |       | 20,085                 |       | 16,705                       |       | 16,705 |   | 18,275 |   | 18,275 |   |
| Deferred  revenue                                                                                                                                                                                      |       | 24,445                       |       | 24,445                 |       | 28,896                       |       | 28,896 |   | 26,229 |   | 26,229 |   |
| Total  current liabilities                                                                                                                                                                             |       | 51,381                       |       | 51,381                 |       | 53,052                       |       | 53,052 |   | 48,885 |   | 48,885 |   |
| Other long-term liabilities                                                                                                                                                                            |       | 3,611                        |       | 3,611                  |       | 3,365                        |       | 3,365 |   | 3,338 |   | 3,338 |   |
| Deferred income tax  liabilities                                                                                                                                                                       |       | 244                          |       | 244                    |       | 238                          |       | 238 |   | 942 |   | 942 |   |
| Total  liabilities                                                                                                                                                                                     |       | 55,236                       |       | 55,236                 |       | 56,655                       |       | 56,655 |   | 53,165 |   | 53,165 |   |
| 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                                                                                                                                            |       | 269                          |       | 267                    |       | 273                          |       | 271 |   | 278 |   | 276 |   |
| Additional  paid-in capital                                                                                                                                                                            |       | 147,757                      |       | 153,357                |       | 150,628                      |       | 156,311 |   | 154,303 |   | 160,068 |   |
| Accumulated  deficit                                                                                                                                                                                   |       | (48,420                      | )          | (57,718                | )          | (47,841                      | )          | (57,222 | ) | (47,214 | ) | (56,677 | ) |
| Accumulated  other comprehensive income                                                                                                                                                                |       | 5,048                        |       | 5,048                  |       | 4,659                        |       | 4,659 |   | 3,953 |   | 3,953 |   |
| Total  stockholders’ equity                                                                                                                                                                       |       | 104,654                      |       | 100,954                |       | 107,719                      |       | 104,019 |   | 111,320 |   | 107,620 |   |
|                                                                                                                                                                                                   |       | $                            | 159,890    |                   | $          | 156,190                      |       | $ | 164,374 |   | $ | 160,674 |   | $ | 164,485 |   | $ | 160,785 |   |

 

F-27

----

**Consolidated Balance Sheets Forthe Fiscal Year Ended December 31, 2004 (in thousands, except share data):**
| ** **                                                                                                                                                                                            | ** ** | **March 31, 2004**      | ** ** | **June 30, 2004** | ** ** | **September 30, 2004**  | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **As  Previously  Reported** | ** ** | **As  Restated**       | ** ** | **As  Previously  Reported** | ** ** | **As  Restated** | ** ** | **As  Previously  Reported** | ** ** | **As  Restated** | ** ** |
| **ASSETS**                                                                                                                                                                                            |       |                         |       |                   |       |                         |       |   |   |   |   |   |   |
| Current assets:                                                                                                                                                                                       |       |                         |       |                   |       |                         |       |   |   |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                             |       | $                            | 37,157     |                   | $          | 37,157                       |       | $ | 30,029 |   | $ | 30,029 |   | $ | 36,417 |   | $ | 36,417 |   |
| Investments                                                                                                                                                                                           |       | 11,181                       |       | 11,181                 |       | 22,316                       |       | 22,316 |   | 26,530 |   | 26,530 |   |
| Accounts receivable, net                                                                                                                                                                              |       | 28,347                       |       | 28,347                 |       | 28,438                       |       | 28,438 |   | 27,694 |   | 27,694 |   |
| Prepaid and other current assets                                                                                                                                                                      |       | 5,172                        |       | 5,172                  |       | 4,262                        |       | 4,262 |   | 4,906 |   | 4,906 |   |
| Total current assets                                                                                                                                                                                  |       | 81,857                       |       | 81,857                 |       | 85,045                       |       | 85,045 |   | 95,547 |   | 95,547 |   |
| Intangible  assets, net                                                                                                                                                                               |       | 15,237                       |       | 15,237                 |       | 13,390                       |       | 13,390 |   | 11,907 |   | 11,907 |   |
| Goodwill                                                                                                                                                                                              |       | 0                            |       | 0                      |       | 0                            |       | 0 |   | 0 |   | 0 |   |
| Property and  equipment, net                                                                                                                                                                          |       | 5,726                        |       | 5,726                  |       | 5,769                        |       | 5,769 |   | 6,057 |   | 6,057 |   |
| Other assets                                                                                                                                                                                          |       | 1,169                        |       | 1,169                  |       | 1,659                        |       | 1,659 |   | 1,399 |   | 1,399 |   |
|                                                                                                                                                                                                  |       | $                            | 103,989    |                   | $          | 103,989                      |       | $ | 105,863 |   | $ | 105,863 |   | $ | 114,910 |   | $ | 114,910 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         |       |                         |       |                   |       |                         |       |   |   |   |   |   |   |
| Current  liabilities:                                                                                                                                                                                 |       |                         |       |                   |       |                         |       |   |   |   |   |   |   |
| Accounts payable                                                                                                                                                                                      |       | $                            | 3,498      |                   | $          | 3,498                        |       | $ | 4,698 |   | $ | 4,698 |   | $ | 4,601 |   | $ | 4,601 |   |
| Accrued expenses                                                                                                                                                                                      |       | 19,649                       |       | 19,649                 |       | 14,715                       |       | 14,715 |   | 15,942 |   | 15,942 |   |
| Deferred revenue                                                                                                                                                                                      |       | 21,148                       |       | 21,148                 |       | 22,449                       |       | 22,449 |   | 23,179 |   | 23,179 |   |
| Total current liabilities                                                                                                                                                                             |       | 44,295                       |       | 44,295                 |       | 41,862                       |       | 41,862 |   | 43,722 |   | 43,722 |   |
| Other long-term  liabilities                                                                                                                                                                          |       | 4,443                        |       | 4,443                  |       | 4,252                        |       | 4,252 |   | 4,129 |   | 4,129 |   |
| Deferred income  tax liabilities                                                                                                                                                                      |       | 282                          |       | 282                    |       | 239                          |       | 239 |   | 119 |   | 119 |   |
| Total liabilities                                                                                                                                                                                     |       | 49,020                       |       | 49,020                 |       | 46,353                       |       | 46,353 |   | 47,970 |   | 47,970 |   |
| 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                                                                                                                                           |       | 228                          |       | 228                    |       | 234                          |       | 234 |   | 242 |   | 242 |   |
| Additional paid-in capital                                                                                                                                                                            |       | 98,048                       |       | 106,755                |       | 101,536                      |       | 110,309 |   | 106,109 |   | 115,183 |   |
| Accumulated deficit                                                                                                                                                                                   |       | (48,036                      | )          | (56,743                | )          | (46,522                      | )          | (55,295 | ) | (43,579 | ) | (52,653 | ) |
| Accumulated other comprehensive income                                                                                                                                                                |       | 4,729                        |       | 4,729                  |       | 4,262                        |       | 4,262 |   | 4,168 |   | 4,168 |   |
| Total stockholders’ equity                                                                                                                                                                       |       | 54,969                       |       | 54,969                 |       | 59,510                       |       | 59,510 |   | 66,940 |   | 66,940 |   |
|                                                                                                                                                                                                  |       | $                            | 103,989    |                   | $          | 103,989                      |       | $ | 105,863 |   | $ | 105,863 |   | $ | 114,910 |   | $ | 114,910 |   |

 

 

F-28

----

**3.   Net (Loss) Income Per Share**

Thefollowing is a reconciliation of the numerator and denominator used in thecalculation of basic and diluted net (loss) income per share (in thousands,except per share data):
|                                                                                    | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005  As Restated  (1)**            | ** ** | **2004   As Restated  (1)** | ** ** | **2003  As Restated  (1)** | ** ** |
| Net (loss)  income                                                                 |       | $                                          | (4,571     | ) | $ | 8,678 |   | $ | (21,755 | ) |
| Weighted average  shares of common stock and common stock equivalents outstanding: |       |                                       |       |   |   |   |   |
| Basic                                                                              |       | 27,221                                     |       | 23,361 |   | 21,991 |   |
| Dilutive effect of stock options computed using the  treasury stock method         |       | —                                     |       | 2,723 |   | — |   |
| Diluted common shares and share equivalents  outstanding                           |       | 27,221                                     |       | 26,084 |   | 21,991 |   |
| Net (loss)  income per share:                                                      |       |                                       |       |   |   |   |   |
| Basic                                                                              |       | $                                          | (0.17      | ) | $ | 0.37 |   | $ | (0.99 | ) |
| Diluted                                                                            |       | $                                          | (0.17      | ) | $ | 0.33 |   | $ | (0.99 | ) |

----

(1) SeeNote 2, “Restatement of Consolidated Financial Statements,”

We have excluded all outstanding stock options fromthe calculation of diluted net loss per common share for 2005 and 2003 becausewe reported a loss in these periods and all such securities are anti-dilutive.The total number of share equivalents excluded from the calculations ofhistorical diluted net loss per common share for 2005 and 2003 were 2,695,822and 954,423, respectively, calculated using the treasury stock method. (SeeNote 13 for further information on stock options.) In 2005, 2004 and 2003,348,467, 461,087 and 4,392,990 stock options, respectively, were excluded fromthe computation of diluted earnings per share because they had exercise pricesthat exceeded the average fair market value of our common stock for thoseperiods, and therefore had an anti-dilutive effect.

F-29

----

**4.   Cash andCash Equivalents and Investments**

The amortizedcost, gross unrealized loss and fair market value of cash and cash equivalentsand investments available for sale as of December 31, 2005 and 2004 wereas follows:
|                                    | ** ** | ** ** | ** ** | **Unrealized**          | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|-------------------------|------------|------------|------------|
| **December 31, 2005**    | ** ** | **Cost**   | ** ** | **Gain**                | ** ** | **Loss**   | ** ** | **Market** | ** ** |
| ** **                         | ** ** | ** ** | ** ** | **(In thousands)** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents:        |       |       |       |                    |       |       |       |   |   |
| Cash                               |       | $          | 17,115     |                    | —     |       | —     |   | $ | 17,115 |   |
| Money market  funds                |       | 68,833     |       | —                  |       | —     |       | 68,833 |   |
| Commercial paper                   |       | 25,803     |       | —                  |       | —     |       | 25,803 |   |
| Total cash and  cash equivalents   |       | $          | 111,751    |                    | —     |       | —     |   | $ | 111,751 |   |
| Investments:                       |       |       |       |                    |       |       |       |   |   |
| Corporate debt  securities         |       | $          | 1,433      |                    | —     |       | $          | (2 | ) | $ | 1,431 |   |
| U.S. Government  agency securities |       | 2,326      |       |                    |       | —     |       | 2,326 |   |
| Commercial paper                   |       | 6,881      |       | —                  |       |       |       | 6,881 |   |
| Certificates of  deposit           |       | 4,248      |       | —                  |       | —     |       | 4,248 |   |
| Total investments                  |       | $          | 14,888     |                    | —     |       | $          | (2 | ) | $ | 14,886 |   |

 
|                                    | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|----------------|------------|------------|------------|
| **December 31, 2004**    | ** ** | **Cost**   | ** ** | **Gain**       | ** ** | **Loss**   | ** ** | **Market** | ** ** |
| Cash and cash  equivalents:        |       |       |       |           |       |       |       |   |   |
| Cash                               |       | $          | 12,064     |           | —     |       | —     |   | $ | 12,064 |   |
| Money market  funds                |       | 24,537     |       | —         |       | —     |       | 24,537 |   |
| Commercial paper                   |       | 3,766      |       | —         |       | —     |       | 3,766 |   |
| U.S. Government  agency securities |       | 2,274      |       |           |       |       |       | 2,274 |   |
| Total cash and  cash equivalents   |       | $          | 42,641     |           | —     |       | —     |   | $ | 42,641 |   |
| Investments:                       |       |       |       |           |       |       |       |   |   |
| Corporate debt  securities         |       | $          | 13,736     |           | —     |       | $          | (11 | ) | $ | 13,725 |   |
| U.S. Government  agency securities |       | 11,940     |       | —         |       | —     |       | 11,940 |   |
| Auction rate  securities           |       | 5,000      |       | —         |       | —     |       | 5,000 |   |
| Commercial paper                   |       | 2,509      |       | —         |       | —     |       | 2,509 |   |
| Certificate of  deposit            |       | 668        |       | —         |       | —     |       | 668 |   |
| Total investments                  |       | $          | 33,853     |           | —     |       | $          | (11 | ) | $ | 33,842 |   |

 

At December 31, 2005, the fair market value ofinvestments with remaining maturity dates ranging from 91 days to one yeartotaled $13.5 million and an investment with a maturity date of 13 monthstotaled $1.4 million. The unrealized holding losses of $6,000 atDecember 31, 2005 relates mainly to one corporate debt security with an Aplus rating with a fair market value of $1.4 million. As of December 31,2005, the corporate debt security had not been in a loss position for more than12 months, and we believe this impairment to be temporary. At December 31,2004, the fair market value of investments with remaining maturity datesranging from 91 days to one year totaled $21.4 million, investmentswith maturity dates ranging from one to three years totaled $7.4 million,and investments with maturities greater than three years totaled $5.0 million.In contemplation of funding the Blue Pumpkin acquisition, we recognized a lossof $0.1 million during 2004, resulting from the write-down of amortizedcost to fair value at December 31, 2004. We recognized $0.2 million 

F-30

----

of securities gainsduring 2003 due to the liquidation of our investment portfolio during 2003 tofund the Eyretel acquisition.

We recorded interest income of $1.2 million,$1.0 million and $0.8 million during 2005, 2004 and 2003,respectively.

**5.   IntangibleAssets**

The followingtables present the components of intangible assets (in thousands):
|                            | ** ** | **December 31, 2005** | ** ** |
|----------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Gross  Amount**               | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
| Acquired technology        |       | $                               | 35,979     |   | $ | 17,762 |   | $ | 18,217 |   |
| Customer list              |       | 21,506                          |       | 5,558 |   | 15,948 |   |
| Distribution  arrangements |       | 4,263                           |       | 2,369 |   | 1,894 |   |
| Trademarks                 |       | 1,124                           |       | 1,032 |   | 92 |   |
| Patents                    |       | 391                             |       | 153 |   | 238 |   |
|                       |       | $                               | 63,263     |   | $ | 26,874 |   | $ | 36,389 |   |

 
|                            | ** ** | **December 31, 2004** | ** ** |
|----------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Gross  Amount**               | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
| Acquired technology        |       | $                               | 15,588     |   | $ | 9,664 |   | $ | 5,924 |   |
| Customer list              |       | 2,336                           |       | 915 |   | 1,421 |   |
| Distribution  arrangements |       | 4,343                           |       | 1,536 |   | 2,807 |   |
| Trademarks                 |       | 1,237                           |       | 789 |   | 448 |   |
| Patents                    |       | 295                             |       | 93 |   | 202 |   |
|                       |       | $                               | 23,799     |   | $ | 12,997 |   | $ | 10,802 |   |

 

The increase inthe intangible assets balances in 2005 is primarily due to the acquisition ofBlue Pumpkin and Optimis as discussed in Notes 6 and 7. The acquiredtechnology and trademarks are being amortized using the straight-line methodover three and four years, respectively, and the distribution arrangements,customer list and patents are being amortized using the straight-line methodover five years. The intangible assets and related amortization expenses aresubject to foreign currency translation and deferred income tax adjustments.Amortization of intangible assets included in the accompanying consolidatedstatements of operations is as follows (in thousands):
|                                              | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Included in:                                 |       |                                       |       |   |   |   |   |
| Cost of product  revenue                     |       | $                                          | 9,154      |   | $ | 4,441 |   | $ | 4,139 |   |
| Selling, general  and administrative expense |       | 6,047                                      |       | 1,470 |   | 1,774 |   |
|                                         |       | $                                          | 15,201     |   | $ | 5,911 |   | $ | 5,913 |   |

 

F-31

----

The estimatedfuture amortization expense of the intangible assets as of December 31,2005 is as follows (in thousands):
| 2006   |   | $      | 12,936 |   |
|--------|--------|--------|--------|--------|
| 2007   |   | 11,689 |   |
| 2008   |   | 10,591 |   |
| 2009   |   | 1,035  |   |
| 2010   |   | 138    |   |
|   |   | $      | 36,389 |   |

 

**6.   BluePumpkin Acquisition**

On January 24, 2005, we acquired Blue PumpkinSoftware, Inc. (“Blue Pumpkin”), a privately held California corporation.With this acquisition, we have expanded our workforce optimization solution toinclude advanced workforce management software and services solutions includingforecasting, scheduling, adherence and planning applications. Pursuant to theMerger Agreement and Plan of Reorganization, dated December 16, 2004 (the “MergerAgreement”), we paid $36 million in cash which was funded from our existingcash and investments and issued 1.9 million shares of Witness’ common stockvalued at $33.5 million (measured based on the date the stockconsideration became fixed pursuant to the application of a formula specifiedin the merger agreement). On May 24, 2005, the shares issued in connectionwith the acquisition were registered for resale with the Securities andExchange Commission. Pursuant to the Merger Agreement, cash of $4 million and210,000 shares of common stock valued at approximately $3.7 million on the dateof acquisition were placed into an escrow fund to be released to Witness inpartial satisfaction and settlement of claims that Witness has now broughtagainst the escrow fund, including claims for potential losses expected toresult from the settlement of the IEX litigation. The escrow fund wasestablished to compensate Witness, subject to certain limitations, forpotential losses that could result from, among other things, the IEX litigationand other specified litigations, and breaches of Blue Pumpkin’srepresentations, warranties or covenants in the Merger Agreement (See Notes 16and 17 to the Consolidated Financial Statements for discussion on Blue Pumpkinlegal proceedings and settlement).

We commencedconsolidation of Blue Pumpkin on January 25, 2005 and the acquisition wasaccounted for using the purchase method of accounting in accordance with SFASNo. 141,*Business Combinations*.The following summarizes the total purchase price for Blue Pumpkin (inthousands):
| Value of Witness  Systems, Inc. common stock issued |   | $      | 33,500 |   |
|----------------------------------------------------------|--------|--------|--------|--------|
| Cash consideration                                       |   | 36,000 |   |
| Direct acquisition  costs                                |   | 5,400  |   |
|                                                     |   | $      | 74,900 |   |

 

F-32

----

Under the purchasemethod of accounting, the total purchase price is allocated to Blue Pumpkin’snet tangible and intangible assets based upon their estimated fair value as ofthe date of the acquisition with any amount paid in excess of the fair value ofthe net assets recorded as goodwill. Based upon the purchase price and reviewof the net assets acquired and liabilities assumed, the purchase priceallocation, is as follows (in thousands):

| Cash and investments                 |   | $       | 3,900  |   |
|--------------------------------------|--------|---------|--------|--------|
| Other current assets                 |   | 6,400   |   |
| Property and equipment,  net         |   | 700     |   |
| Acquired technology                  |   | 21,000  |   |
| Customer relationships               |   | 17,000  |   |
| Goodwill                             |   | 34,400  |   |
| In-process research and  development |   | 9,000   |   |
| Other long term assets               |   | 400     |   |
| Total assets  acquired               |   | 92,800  |   |
| Current liabilities                  |   | (3,600  | )      |
| Litigation accrual                   |   | (11,200 | )      |
| Deferred revenue                     |   | (1,700  | )      |
| Restructuring accruals               |   | (1,400  | )      |
| Total  liabilities assumed           |   | (17,900 | )      |
|                                 |   | $       | 74,900 |   |

 

The fair values of identifiable intangible assets weredetermined with the assistance of Taylor Consulting Group, Inc., anindependent third-party appraiser using both an income and a cost approachtaking into consideration the nature, risks, historical patterns, economiccharacteristics, and future considerations of the assets. As of the closingdate of the merger, technological feasibility of the in-process research anddevelopment (“IPR&D”) had not been established and the technology had noalternative future use. Accordingly, we charged the value of the IPR&D atthe date of the acquisition to expense. The amount of the purchase priceallocated to IPR&D was based on established valuation techniques used inthe software industry. The fair value assigned to the acquired IPR&D wasdetermined using a discounted cash flow methodology, which discounts expectedfuture cash flows to present value.

The key assumptions used in the valuation include,among others, expected completion date of the in-process projects identified asof the acquisition date, estimated cost to complete the projects, revenuecontributions and expense projections assuming the resulting product hasentered the market, and discount rates based on the risks associated with thedevelopment life cycle of the in-process technology acquired. The discountrates used in the present value calculations are obtained from aweighted-average cost of capital analysis, adjusted upward to account for theinherent uncertainties surrounding the successful development of the IPR&D,the expected profitability levels of such technology, and the uncertainty oftechnological advances that could potentially impact the estimates. We assumethe pricing model for the resulting product of the acquired IPR&D to bestandard within its industry. We did not take into consideration anyconsequential amount of expense reductions from integrating the acquiredIPR&D with other existing in process or completed technology.

The key considerations underlying the valuation ofacquired in-process research and development from Blue Pumpkin are as follows:a) guidance from the  SFAS No. 2,*Accounting for Research and Development Costs*and FASB Interpretation No. 4,*Applicability of FASB Statement No. 2 to Business Combinations Accountedfor by the Purchase Method*; b) percent completed as of theacquisition date; c) estimated costs to date, as well as costs 

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to complete thetechnology; and d) the numerous technical, cost, market, and timing risks weface before the technology becomes technologically feasible.

Unaudited proforma information reflecting the acquisition of Blue Pumpkin as if it occurredon January 1, 2004 is as follows (in thousands, except per share amounts):
|                                           | ** ** | **Year ended  December 31,** | ** ** |
|-------------------------------------------|------------|----------------------------------------|------------|
| ** **                                | ** ** | **2005  As Restated (1)**    | ** ** | **2004  As Restated  (1)** | ** ** |
| Total revenues                            |       | $                                      | 186,403    |   | $ | 175,213 |   |
| Net income (loss)                         |       | $                                      | 2,039      |   | $ | (4,508 | ) |
| Net income (loss) per  share—basic   |       | $                                      | 0.07       |   | $ | (0.18 | ) |
| Net income (loss) per  share—diluted |       | $                                      | 0.07       |   | $ | (0.18 | ) |
| Weighted average  shares—basic       |       | 27,396                                 |       | 25,251 |   |
| Weighted average shares—diluted      |       | 29,943                                 |       | 25,251 |   |

----

(1) See Note 2,” Restatement of Consolidated FinancialStatements.”

The pro forma results include adjustments for theamortization expense of intangible assets arising from the acquisition and thereversal of interest income assuming the cash portion of the purchase was paidfrom available cash. In addition, the pro forma results do not reflect anyadjustments for IPR&D charges, because of their non-recurring nature, andcost savings and synergies that we believe would have resulted had theacquisition occurred on January 1, 2004.

**7.**   OptimisAcquisition

On May 23, 2005, we acquired Optimis GroupLimited (“Optimis”), a UK-based provider of workforce optimization softwaresolutions. Blue Pumpkin owned a minority interest in an operating subsidiary ofOptimis, the balance of which was acquired through the Optimis acquisition. Wepaid $5.0 million in cash and other consideration, which was financed fromour existing cash and investments. Ten percent of the aggregate merger considerationis being held in escrow until May 23, 2006, one year after the closingdate of the Merger. The escrow period may be extended in the event that thereare pending claims that are brought against the escrow fund within suchone-year period. The escrow fund is available to compensate Witness, subject tocertain limitations, for losses resulting from, among other things, breaches ofrepresentations, warranties or covenants in the Merger Agreement and certainpending and potential claims.

We commenced the consolidationof Optimis on May 24, 2005 and the acquisition was accounted for using thepurchase method of accounting in accordance with SFAS No. 141,*Business Combinations*. The followingsummarizes the total purchase price for Optimis (in thousands):
| Cash and other consideration |   | $   | 5,000  |   |
|------------------------------|--------|-----|--------|--------|
| Direct  acquisition costs    |   | 700 |   |
|                         |   | $   | 5,700  |   |

 

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Under the purchasemethod of accounting, the total purchase price is allocated to Optimis’ nettangible and intangible assets based upon their estimated fair value as of thedate of the acquisition with any amount paid in excess of the fair value of thenet assets recorded as goodwill. Based upon the purchase price and review ofthe net assets acquired and liabilities assumed, the purchase price allocation,is as follows (in thousands):
| Cash and investments       |   | $      | 1,300  |   |
|----------------------------|--------|--------|--------|--------|
| Other current assets       |   | 1,500  |   |
| Customer relationships     |   | 2,500  |   |
| Goodwill                   |   | 5,900  |   |
| Other long term assets     |   | 100    |   |
| Total assets  acquired     |   | 11,300 |   |
| Current liabilities        |   | (3,100 | )      |
| Deferred revenue           |   | (1,500 | )      |
| Restructuring accruals     |   | (1,000 | )      |
| Total  liabilities assumed |   | (5,600 | )      |
|                       |   | $      | 5,700  |   |

 

The fair values of identifiable intangible assets weredetermined using both an income and a cost approach taking into considerationthe nature, risks, historical patterns, economic characteristics, and futureconsiderations of the assets.

**8.   EyretelAcquisition**

During the first quarter of 2003, we acquired acontrolling interest in Eyretel. We paid 25 pence per share for a totalpurchase price of approximately £35.3 million, or $55.3 million,excluding shares owned by Eyretel’s employee stock option trust at the time ofacquisition and other acquisition costs. The acquisition extended our presencein international markets and expanded our product line by adding a full-timecompliance recording solution. We commenced the consolidation of Eyretel’sresults on March 22, 2003, the date we assumed majority ownership ofEyretel. The acquisition was accounted for using the purchase method ofaccounting.

The followingsummarizes the total purchase price for Eyretel (in thousands):
| Cash consideration        |   | $     | 55,269 |   |
|---------------------------|--------|-------|--------|--------|
| Direct acquisition  costs |   | 4,458 |   |
|                      |   | $     | 59,727 |   |

 

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Under the purchasemethod of accounting, the total purchase price is allocated to Eyretel’s nettangible and intangible assets based upon their estimated fair values as of thedate of the acquisition. The final purchase price allocation is as follows (inthousands):
| Cash and investments                      |   | $       | 38,814 |   |
|-------------------------------------------|--------|---------|--------|--------|
| Other current assets                      |   | 22,438  |   |
| Property and equipment,  net              |   | 2,597   |   |
| Identifiable intangible  assets acquired: |   |    |   |
| Acquired  technology                      |   | 10,700  |   |
| Distribution  arrangements                |   | 4,124   |   |
| Customer lists                            |   | 1,956   |   |
| Trademarks                                |   | 1,007   |   |
| In-process research and  development      |   | 7,840   |   |
| Total assets  acquired                    |   | 89,476  |   |
| Restructuring accruals                    |   | (5,254  | )      |
| Deferred revenue                          |   | (5,512  | )      |
| Other current  liabilities                |   | (16,165 | )      |
| Other long-term  liabilities              |   | (2,536  | )      |
| Deferred income taxes                     |   | (282    | )      |
| Total  liabilities assumed                |   | (29,749 | )      |
|                                      |   | $       | 59,727 |   |

 

The fair values of identifiable intangible assets weredetermined with the assistance of Taylor Consulting Group, Inc., anindependent third-party appraiser, using either an income or cost approachtaking into consideration the nature, risks, historical patterns, economiccharacteristics, and future considerations of the assets. We estimated that$7.8 million of the purchase price of Eyretel represented acquiredin-process research and development (“IPR&D”) related to developingenhancements and new products for the voice and data recording, qualitymonitoring and analysis industry that had not yet reached technologicalfeasibility and had no alternative future use. Accordingly, these amounts wereimmediately charged to expense upon consummation of the acquisition. Wecalculated the value of the IPR&D by utilizing a discounted cash flowmethodology, focusing on the income-producing capabilities of the in-processtechnologies and taking into consideration: stage of completion; complexity ofwork to date and to complete; anticipated product development and introductionschedules; forecasted product sales cycles; internal and external risk factors;revenue and operating expense estimates; contributory asset charges; and costsalready incurred and the expected costs to complete.

Unaudited proforma information reflecting the acquisition of Eyretel as if it occurred onJanuary 1, 2003 is as follows (in thousands, except per share amounts):
|                                                | ** ** | **2003   As Restated (1)** | ** ** |
|------------------------------------------------|------------|-------------------------------------------|------------|
| Total revenues                                 |       | $                                         | 121,958    |   |
| Net loss                                       |       | (26,405                                   | )          |
| Net loss per  share—basic and diluted     |       | $                                         | (1.20      | ) |
| Weighted average shares—basic and diluted |       | 21,991                                    |       |

----

(1) See Note 2,” Restatement of Consolidated FinancialStatements.”

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The pro forma results above include adjustments forthe amortization expense of intangible assets arising from the acquisition andthe reduction of interest income assuming the purchase was paid from availablecash. In addition, the pro forma results exclude the IPR&D charge andcertain merger-related and other costs directly attributable to theacquisition.

**9.   Acquisition-RelatedRestructuring Accruals and Merger-Related and Integration Costs**

As a result of the Blue Pumpkin and Optimisacquisitions in 2005, we recorded $ 2.4 million in certainacquisition-related restructuring accruals primarily related to personnelreductions. As a result of the Eyretel acquisition, we recorded $0.2 millionand $4.9 million in 2004 and 2003, respectively, in certain acquisition-relatedrestructuring accruals comprised of Eyretel personnel reductions, the closingof certain Eyretel facilities and the accrual of abandoned leased premises. Allsuch costs met the criteria for accrual as outlined in EITF No. 95-3,*Recognition of Liabilities in Connectionwith a Purchase Business Combination,* and were included in theassets acquired and liabilities assumed in the purchase of Blue Pumpkin,Optimis and Eyretel. The following table summarizes the restructuring accrualactivity (in thousands):
|                                                           | ** ** | **Severance  and Benefits** | ** ** | **Facilities** | ** ** | **Total** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|------------|----------------|------------|-----------|------------|
| Accrual at  December 31, 2003                        |       | $                                | 384        |           | $          | 1,936     |       | $ | 2,320 |   |
| Adjustment to acquisition-related restructuring  accruals |       | (203                             | )          | 393            |       | 190       |       |
| Cash payments                                             |       | (181                             | )          | —         |       | (181      | )          |
| Amounts credited to rent expenses                         |       | —                           |       | (488           | )          | (488      | )          |
| Foreign exchange translation                              |       | —                           |       | 203            |       | 203       |       |
| Accrual at  December 31, 2004                        |       | —                           |       | 2,044          |       | 2,044     |       |
| Acquisition-related restructuring accruals                |       | 1,972                            |       | 462            |       | 2,434     |       |
| Cash payments                                             |       | (1,976                           | )          |           |       | (1,976    | )          |
| Amounts credited to rent expenses                         |       | —                           |       | (223           | )          | (223      | )          |
| Foreign exchange translation                              |       | 4                                |       | (210           | )          | (206      | )          |
| Accrual at  December 31, 2005                        |       | —                           |       | 2,073          |       | 2,073     |       |
| Less: Long-term portion                                   |       | —                           |       | 1,583          |       | 1,583     |       |
| Current portion at  December 31, 2005                |       | $                                | —     |           | $          | 490       |       | $ | 490 |   |

 

The following tablesummarizes all merger-related and integration costs that were charged toexpense during the years ended December 31, 2005, 2004 and 2003 (in thousands):

 
|                                                  | ** ** | **2005  As Restated   (See Note 2)** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------|------------|----------|------------|----------|------------|
| Eyretel:                                         |       |                                                     |       |     |       |     |       |
| Merger-related and integration costs             |       | $                                                        | —     |     | $          | (543     | )          | $ | 6,067 |   |
| Bonus expense                                    |       | 99                                                       |       | 838      |       | 933      |       |
| Cost of sterling-based forward exchange contract |       | —                                                   |       | —   |       | 865      |       |
| Blue Pumpkin and  Optimis:                       |       |                                                     |       |     |       |     |       |
| Merger-related and integration costs             |       | 4,433                                                    |       | 203      |       | —   |       |
|                                             |       | $                                                        | 4,532      |     | $          | 498      |       | $ | 7,865 |   |

 

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During 2005, we incurred merger-related andintegration costs pertaining to the acquisitions of Blue Pumpkin and Optimiscomprised primarily of legal costs, transitional employees and othercontractors, travel costs and advertising costs. Merger-related and integrationcosts incurred in 2004 and 2003 totaled $0.5 million and $7.8 million,respectively and related to the acquisition of Eyretel. The 2003 merger-relatedand integration costs included severance and lease terminations, bonus expenserelated primarily to the accrual of a bonus payable to Eyretel’s former ChiefExecutive Officer, now our Chief Operating Officer (“COO”); and the cost of aforward exchange contract that was executed in order to fix the price of theEyretel acquisition in US dollars. Our Board of Directors agreed to pay a bonusof £1.0 million to our COO in connection with the Eyretel acquisition andsubsequent integration. In March 2004, £0.4 million of this bonus was paidand the remaining balance of £0.6 million (or $1.1 million as of March 31,2005) was paid in March 2005.

**10.   AccruedExpenses**

Accrued expensesconsisted of the following (in thousands):
|                                                 | ** ** | **December 31,**               | ** ** |
|-------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                      | ** ** | **2005  As Restated (1)** | ** ** | **2004** | ** ** |
| Accrued commissions,  compensation and benefits |       | $                                   | 8,322      |   | $ | 6,762 |   |
| Other accrued  acquisition liabilities          |       | 936                                 |       | 2,337 |   |
| Legal accruals                                  |       | 11,759                              |       | 481 |   |
| Other accrued expenses                          |       | 8,634                               |       | 6,728 |   |
|                                            |       | $                                   | 29,651     |   | $ | 16,308 |   |

----

(1) See Note 2,” Restatement of Consolidated FinancialStatements.” and Note 6, “Blue Pumpkin Acquisition.”

**11.   Line ofCredit**

In March 2005, we extended the maturity date onour $15.0 million line of credit to March 2006. At our election,borrowings under the line of credit bear interest at the bank’s prime rate,which was 7.25% on December 31, 2005, or LIBOR plus 300 basis points.Borrowings under the revolving line of credit are limited to 85% of eligibleaccounts receivable, as defined by the agreement. The revolving line of creditis secured by all of our assets and requires compliance with various covenants,including liquidity ratios and EBITDA requirements, among others. As ofDecember 31, 2005, we were in compliance with all bank covenants.

As of December 31, 2005, we had no amountsoutstanding under the line of credit and the amount available for borrowing was$12.8 million, which was net of outstanding letters of credit of **$**2.2 million. The letters of credit secure the lease onour corporate headquarters facility and have decreasing schedules thatultimately expire in 2007. In addition, we have a £0.3 million letter of****credit securing our premises in the United Kingdom.

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**12.   Stockholders’Equity**

***Comprehensive Income—******Accumulated***othercomprehensive income consisted of the following (in thousands):
|                                                      | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Cumulative foreign  currency translation adjustments |       | $                     | 3,078      |   | $ | 4,953 |   |
| Unrealized loss on  investments                      |       | (2                    | )          | (11 | ) |
|                                                 |       | $                     | 3,076      |   | $ | 4,942 |   |

 

***Stock Repurchases—******In*** 2002, ourBoard of Directors authorized a stock repurchase program to spend up to$10.0 million to repurchase our common stock. As of December 31,2005, we had repurchased 1.0 million shares of our common stock for$3.1 million, which were retired. The Company has not repurchased itscommon stock since 2003 and does not presently plan to repurchase additionalcommon stock.

**13.   EmployeeBenefit Plans**

***Stock IncentivePlans—******We***havethree stock incentive plans: (i) the 1999 Stock Incentive Plan (the “1999Plan”); (ii) the 2003 Broad Based Option Plan (the “2003 Plan”); and(iii) the 2003 Non-employee Director Stock Option Global Plan (the “DirectorPlan”).

*1999Plan—**Under*the 1999 Plan, we may grantshares of common stock in the form of stock options, restricted stock awards,or stock appreciation rights to employees and key persons affiliated withWitness, as defined. In 2001, our stockholders modified a provision toincrease, without further approval required, the number of shares authorizedeach year beginning on January 1, 2002 by a number equal to the lesser of10% of the total number of shares of common stock then outstanding or 3,000,000shares. During 2005, 2,214,335 stock options were granted under the 1999 Plan.At December 31, 2005, there were 12,892,232 shares authorized forissuance, of which 131,112 shares remain available for future grant

In 2003, we adopted the Director and Key ExecutiveStock Ownership Incentive Policy (the “Policy”) under the 1999 Plan. The Policyintended to promote the interests of Witness and its stockholders byencouraging members of the Board of Directors and key executives to purchaseshares of our common stock. Under the Policy, an eligible person who purchasedat least 500 shares and up to 3,000 shares of our common stock in the openmarket was automatically and immediately granted five options from our 1999Plan for each share purchased, with an exercise price equal to the closingprice of our common stock on the date of purchase. One-half of the optionsvested on the first anniversary of the grant date, and the remaining optionsvested in 12 equal monthly installments thereafter. The Policy expired onJune 15, 2004 and 122,500 options were granted under this Policy.

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During 2005, 603,500stock options were granted to certain Blue Pumpkin and Optimis employees as aninducement to join Witness. The inducement options are exercisable for fiveyears from the date of grant and will first become exercisable, as to 25 percentof the total amount, after one year from the date of grant, and commencing 13months after grant and until the end of the 47th month following grant, theoptions will become exercisable as to an additional two percent per month andthe balance upon the 48th month following grant.

*2003 Plan—**In*connection withthe Eyretel acquisition, we established the 2003 Plan for former Eyretelemployees. The 2003 Plan became effective in June 2003, allowing us togrant shares of common stock in the form of stock options. No stock optionswere granted to former Eyretel employees under the 2003 Plan in 2004 or 2005.During 2005, 28,466 stock options were granted under the 2003 Plan. AtDecember 31, 2005, there were 1.6 million****sharesauthorized for issuance, of which 396,853 shares remain available for futuregrant. We do not anticipate increasing the number of shares available forissuance under the 2003 Plan.

*Director Plan—**The*Director Planbecame effective in 2003 and grants continuing non-employee members of theBoard of Directors non-qualified options to purchase shares of our common stockpursuant to a formula award. During 2005, 48,000 stock options were grantedunder the Director Plan. At December 31, 2005, there were 500,000 sharesauthorized for issuance, of which 388,000 shares remain available for futuregrant.

Each plan remains ineffect until the earlier of the tenth anniversary of its effective date or thedate on which all reserved shares have been issued or are no longer availablefor use. Option vesting terms typically range from two to four years. Optionsgranted since July 1, 2004, have five-year terms from the date of grant.Options granted prior to July 1, 2004 have ten-year terms from the date ofthe grant. These plans provide for accelerated option vesting terms inconnection with a change in control. To the extent that this occurs, we mayhave a future charge.

We incurred$0.1 million for each of the years ended December 31, 2005, 2004 and2003, in stock compensation charges for certain option grants issued under thePolicy and certain 1999 stock grants. 

The following summarizesstock option activity under all stock option plans:
|                                    | ** ** | **Number  of shares** | ** ** | **Weighted-  average  exercise price** | ** ** |
|------------------------------------|------------|----------------------------|------------|---------------------------------------------|------------|
| Balance at  December 31, 2002 |       | 5,606,117                  |       | $                                           | 8.12       |   |
| Granted                            |       | 4,362,150                  |       | 4.27                                        |       |
| Exercised                          |       | (284,843                   | )          | 3.58                                        |       |
| Cancelled                          |       | (1,061,194                 | )          | 7.60                                        |       |
| Balance at  December 31, 2003 |       | 8,622,230                  |       | 6.39                                        |       |
| Granted                            |       | 2,316,254                  |       | 11.12                                       |       |
| Exercised                          |       | (2,223,636                 | )          | 5.66                                        |       |
| Cancelled                          |       | (992,689                   | )          | 7.81                                        |       |
| Balance at  December 31, 2004 |       | 7,722,159                  |       | 7.83                                        |       |
| Granted                            |       | 2,865,835                  |       | 17.65                                       |       |
| Exercised                          |       | (1,461,628                 | )          | 7.15                                        |       |
| Cancelled                          |       | (551,920                   | )          | 11.67                                       |       |
| Balance at  December 31, 2005 |       | 8,574,446                  |       | 10.98                                       |       |
|                                    |            |                            |            |                                             |            |  |

 

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The following tablesummarizes information about stock options outstanding at December 31,2005
| Outstanding                                 | ** ** | ** **      | ** ** |
|---------------------------------------------|------------|-----------------|------------|
| ** **                                  | ** ** | ** **      | ** ** | **Weighted-** | ** ** | **Weighted-** | ** ** | **Exercisable** | ** ** |
| ** **                                  | ** ** | ** **      | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                  | ** ** | **Number**      | ** ** | **Remaining** | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Average** | ** ** |
| **Range of Exercise Prices** | ** ** | **Outstanding** | ** ** | **Life** | ** ** | **Price** | ** ** | **of shares** | ** ** | **Exercise Price** | ** ** |
| $1.42 - $6.00                               |       | 2,526,855       |       | 6.5 years |   | $ | 4.14 |   | 1,270,333 |   | $ | 3.52 |   |
| $6.25 - $11.95                              |       | 2,414,558       |       | 5.9 years |   | 9.30 |   | 1,411,284 |   | 8.75 |   |
| $12.15 - $16.97                             |       | 2,276,931       |       | 4.7 years |   | 15.73 |   | 651,021 |   | 14.19 |   |
| $17.25 - $34.00                             |       | 1,356,102       |       | 4.5 years |   | 18.75 |   | 35,038 |   | 20.68 |   |
|                                        |       | 8,574,446       |       | 5.5 years |   | 10.98 |   | 3,367,676 |   | 7.95 |   |
|                                             |            |                 |            |  |  |  |  |  |  |  |  |  |  |

 

During the years ended2003, 2004 and 2005, we recognized $1.2 million, $0.8 million and$0.3 million, respectively, of stock-based compensation expense. As ofDecember 31, 2005, there was $0.2 million of total unrecognized APB No. 25compensation expense related to unvested share-based compensation arrangements.

The following are thefair values and assumptions used in calculating the pro forma option expenseamounts under SFAS No. 123 which are disclosed in Note 1. Theweighted-average grant date fair value of stock options granted during 2005,2004, and 2003 was $7.52, $5.77 and $2.31 per share, respectively, using theBlack-Scholes option-pricing model with the following weighted-averageassumptions:
|                         | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|-------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Volatility              |       | 53        | %          | 88        | %          | 98        | %          |
| Risk-free interest rate |       | 3.9       | %          | 3.1       | %          | 2.6       | %          |
| Expected life           |       | 3.5 years |       | 2.5 years |       | 2.5 years |       |
| Expected dividend yield |       | 0         | %          | 0         | %          | 0         | %          |

 

***Employee Stock Purchase Plan—******Through***December 31, 2005, our employee stock purchase plan (“ESPP”) allowed ouremployees 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 thesemi-annual option period. Effective January 1, 2006, the ESPP allows ouremployees to purchase shares of common stock at a price per share of 95% of thefair market value at the end of each quarterly option period. The ESPP includesa provision to increase, without further approval required, the number ofshares authorized each year on January 1 by a number equal to the lesserof 2% of the total number of shares of common stock then outstanding or 900,000shares. As of December 31, 2005, 491,532****sharesof common stock have been issued under the ESPP.

The weighted-average fairvalue of the employee’s purchase rights under the ESPP granted during 2005,2004 and 2003 was $5.50, $3.77 and $1.74 per share, respectively, using theBlack-Scholes option-pricing model with the same weighted-average assumptionsas for the stock incentive plans except for the expected life assumption whichwas six months.

***Retirement Plans—******We*** have aU.S. tax-qualified defined contribution plan under Section 401(k) ofthe Internal Revenue Code (the “401(k) Plan”). Employees are eligible toparticipate the first of the month following their date of hire. The401(k) Plan allows participants to contribute up to 100% of eligiblecompensation, subject to U.S. Internal Revenue Service limitations. The401(k) Plan also provides for discretionary employer matchingcontributions. We also have a personal savings plan (“Savings Plan”) for ourUnited Kingdom employees. In accordance with the Inland Revenue limitations,employees are eligible to invest of up to 35% of base salary in the SavingsPlan, which includes employer contributions ranging from 5% to 7% of employeecompensation. We contributed $0.5 million, $0.8 million and $0.6 millionto the 401(k) Plan and Savings Plan in 2005, 2004 and 2003, respectively.

***Stockholder’s Rights Plan—******We*** have astockholder rights plan (the “Rights Plan”) which has the effect of causingsubstantial dilution to a person or group that attempts to acquire Witness onterms not approved by the Board of Directors. Under the Rights Plan, we issueda dividend of one right for each share of our common stock, par value of $0.01per share, held by stockholders of record as of the close of business onNovember 4, 2002. Each right will entitle stockholders to purchase oneunit of a share of our Series A Junior Participating Preferred Stock for$25.00. The rights generally will be exercisable only upon the occurrence ofcertain events, and will expire on November 4, 2012.

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The Rights Plan has nopresent dilutive effect on our capital structure, nor does it affect reportedearnings 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 therights, was taxable to our shareholders or Witness.

***Change of Control—******Our*** seniorofficers, including our named executive officers noted in our 2004 annual proxystatement, have change of control agreements, which in general, provide theofficers with severance benefits in the event of a change in control asdefined. The agreements provide for Witness to pay the officer a multiple ofhis, or her, base salary and bonus, in a lump sum, as well as a minimum prorata bonus for the year in which the change of control occurs, and payment ofCOBRA continuation coverage, life insurance premiums and long-term disabilityinsurance premiums for a fixed period of time. In addition, the agreementsprovide for a gross-up payment for certain U.S. federal excise taxes that mightresult from the receipt of the severance payments. The severance payments varyby seniority, and involve multiples of 1.0, 1.5 or 2.0 times base salary andbonus. In the change of control agreements other than those for our ChiefExecutive Officer (“CEO”), Chief Operating Officer (“COO”) and Chief FinancialOfficer (“CFO”), payments are made only if there is both a change of control ofWitness and a termination of employment of the officer without cause (or aconstructive termination) as determined by the terms of the respectiveagreements.

***Sale of additional shares of common stock—***InDecember 2005, we issued 4.7 million additional shares of common stockresulting in $88.8 million in net proceeds.

**14.   Income Taxes**

Income (losses) before income taxes from foreignoperations were $(0.2) million, ($1.2) million and ($3.7) million in 2005, 2004and 2003, respectively. Income (losses) before income taxes from U.S.operations were ($1.3) million, 10.2 million and $(17.8) million in2005, 2004 and 2003, respectively.

We recorded a provision for income tax of $3.0 millionduring the year ended December 31, 2005, of which $2.5 millionrelated to the utilization of a portion of the $21.6 million of deferredincome tax assets, primarily net operating loss carry-forwards, acquired duringthe 2005 acquisition of Blue Pumpkin Software, Inc. A full valuationallowance has been recorded against these assets. The reversal of valuationallowances associated with these deferred income tax assets in 2005 wascredited as a reduction to goodwill. The remainder of the provision isprimarily comprised of U.S. federal alternative minimum income tax expenseand foreign income tax, primarily from withholding, and an income tax benefitfrom the reduction of deferred income tax liabilities in foreign jurisdictions.For the same periods during 2004 and 2003, the tax expense of $0.3 million wasprimarily related to U.S. federal alternative minimum income tax expense and foreignincome tax.

The components of theprovision for income tax expense for 2005, 2004 and 2003 are as follows(in thousands):

|                  | ** ** | **2005  As  Restated (1)** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------|------------|---------------------------------|------------|----------|------------|----------|------------|
| Federal          |       | $                               | 235        |     | $          | 213      |       | $ | (40 | ) |
| State            |       | —                          |       | —   |       | —   |       |
| Foreign          |       | 535                             |       | 186      |       | 347      |       |
| Total current    |       | 770                             |       | 399      |       | 307      |       |
| Federal deferred |       | 2,454                           |       | —   |       | —   |       |
| Foreign deferred |       | (200                            | )          | (87      | )          | —   |       |
| Total deferred   |       | 2,254                           |       | (87      | )          | —   |       |
| Total            |       | $                               | 3,024      |     | $          | 312      |       | $ | 307 |   |

 

(1)    See Note 2,“Restatement of Consolidated Financial Statements.”

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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 incometaxes as a result of the following (in thousands):
|                                                                                                          | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2005  As  Restated**                     | ** ** | **2004  As  Restated** | ** ** | **2003  As  Restated** | ** ** |
| Computed “expected” tax  (benefit) expense                                                     |       | $                                          | (525       | ) | $ | 3,056 |   | $ | (7,292 | ) |
| Increase (decrease) in  income taxes resulting from:                                                     |       |                                       |       |   |   |   |   |
| State income  taxes, net of federal income taxes                                                         |       | (468                                       | )          | 256 |   | (768 | ) |
| In-process  research & development                                                              |       | 3,060                                      |       | — |   | 2,666 |   |
| Distribution  from foreign subsidiary                                                                    |       | 539                                        |       | — |   | — |   |
| (Decrease)  increase in valuation allowance for deferred income tax assets                               |       | 467                                        |       | (2,793 | ) | 6,590 |   |
| Foreign tax  credits                                                                                     |       | (588                                       | )          | — |   | — |   |
| Research and  experimentation credits                                                                    |       | (500                                       | )          | (665 | ) | (460 | ) |
| Nondeductible  meals & entertainment                                                            |       | 264                                        |       | 225 |   | 155 |   |
| Income tax  effect attributable to foreign operations at different rates, including  foreign withholding |       | 525                                        |       | 162 |   | (321 | ) |
| Other, net                                                                                               |       | 250                                        |       | 71 |   | (263 | ) |
|                                                                                                     |       | $                                          | 3,024      |   | $ | 312 |   | $ | 307 |   |

 

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

|                                                                                  | ** ** | **December 31,**  | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                       | ** ** | **2005  As  Restated** | ** ** | **2004  As  Restated** | ** ** |
| Deferred income tax  assets:                                                     |       |                   |       |   |   |
| Allowance for doubtful  accounts                                                 |       | $                      | 1,498      |   | $ | 940 |   |
| Accrued expenses and  other                                                      |       | 617                    |       | 229 |   |
| Property and equipment  depreciation                                             |       | 1,477                  |       | 1,013 |   |
| Identifiable intangible  assets amortization                                     |       | 10,467                 |       | — |   |
| Stock-based  compensation                                                        |       | 1,697                  |       | 1943 |   |
| Net operating losses,  research and experimentation and foreign tax credits |       | 39,884                 |       | 15,357 |   |
| Foreign deferred income  tax assets, principally net operating losses            |       | 13,404                 |       | 15,693 |   |
| Gross deferred  income tax assets                                                |       | 69,044                 |       | 35,175 |   |
| Valuation  allowance for deferred income tax assets                              |       | (56,092                | )          | (32,716 | ) |
| Net deferred  income tax assets                                                  |       | 12,952                 |       | 2,459 |   |
| Deferred income tax  liabilities:                                                |       |                   |       |   |   |
| Intangible  assets                                                               |       | (13,695                | )          | (2,713 | ) |
| Net deferred income tax  liabilities                                             |       | $                      | 743        |   | $ | 254 |   |

 

The net change in the valuation allowance for deferredincome tax assets for 2005, 2004 and 2003 was an increase of$23.3 million, $4.6 million and $16.7 million, respectively. Thevaluation allowance increase in 2005 is comprised of ($0.5) million for currentactivity (of which $0.5 million was related to changes in foreign tax rates),$5.3 million due to stock option deductions, and $18.5 million foradditional deferred income tax assets, primarily acquired in the Blue Pumpkinacquisition. Included in the valuation allowance for deferred income tax assetsas of December 31, 2005 is $19.2 million from the Blue Pumpkin acquisitionand $2.1 million from the Eyretel acquisition in 2003, which, when reversed,will result in the reduction of goodwill or intangible assets.

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At December 31,2005, we had net operating loss, research and experimentation credit, andforeign tax credit carryforwards for U.S. federal income tax purposes of $81.3 million,$6.8 million and $0.6 million, respectively, which expire in varyingamounts beginning in the year 2012. We also have incurred net foreign losses inthe amount of $38.1 million as of December 31, 2005, which areavailable to offset future taxable income in their respective foreignjurisdictions. These foreign losses expire in varying amounts beginning in2006.

As of December 31,2005, the U.S. and U.K. net operating loss carryforwards include tax deductionsof approximately $32.1 million and $4.9 million, respectively,resulting from the exercise of stock options. In accordance with APB OpinionNo. 25, any income tax benefit derived from these tax deductions isreflected as additional paid-in capital at the time we recognize any suchincome tax benefit. During 2005, the Company also recognized as tax expenseapproximately $ 0.2 million of alternative minimum tax (AMT) that would havebeen payable had there been no stock option deductions. Actual stock optiondeductions incurred for income tax purposes results in no actual payment ofAMT. A “hypothetical” deferred income tax asset is created by the AMT expenseincurred.

**15.   Segment andGeographic Information**

We consider ourselves tobe in a single industry segment, specifically licensing and servicing ofsoftware applications to the customer interaction recording and analysismarket. Our chief operating decision maker receives financial information bygeographic region; however, our operating segments are aggregated into onereportable segment based upon similar economic characteristics, products,services and delivery methods.

World-wide annual revenuebased on customer location is as follows (in thousands):
|                | ** ** | **Year Ended December 31,** | ** ** |
|----------------|------------|--------------------------------------------|------------|
| ** **     | ** ** | **2005  As Restated**                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States  |       | $                                          | 100,817    |   | $ | 73,268 |   | $ | 59,830 |   |
| United Kingdom |       | 48,804                                     |       | 39,166 |   | 24,009 |   |
| Rest of world  |       | 35,707                                     |       | 28,901 |   | 24,198 |   |
| Total          |       | $                                          | 185,328    |   | $ | 141,335 |   | $ | 108,037 |   |

 

The rest of world revenuewas derived primarily from customers located in Australia, Canada, China, Indiaand Japan. No individual customer accounted for more than 10% of consolidatedrevenue during 2005, 2004 or 2003, or accounts receivable at December 31,2005 or 2004.

Long-lived assets,including goodwill and intangible assets, by geography are as follows (inthousands):
|                | ** ** | **December 31,**      | ** ** |
|----------------|------------|----------------------------|------------|
| ** **     | ** ** | **2005  As Restated** | ** ** | **2004** | ** ** |
| United States  |       | $                          | 71,430     |   | $ | 5,518 |   |
| United Kingdom |       | 10,824                     |       | 8,533 |   |
| Rest of world  |       | 2,250                      |       | 2,948 |   |
| Total          |       | $                          | 84,504     |   | $ | 16,999 |   |

 

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**16.   Commitments andContingencies**

***Operating Commitments—******We*** leaseoffice facilities, including our corporate headquarters, and certain officefurniture and equipment under various noncancelable operating lease agreements.Future minimum payments under leases with remaining terms greater than one yearat December 31, 2005, and for the next five years and in the aggregate areas follows (in thousands):

| December 31, | ** ** | ** ** | ** ** |
|-------------------|------------|------------|------------|
| 2006              |       | $          | 4,557      |   |
| 2007              |       | 4,168      |       |
| 2008              |       | 1,752      |       |
| 2009              |       | 1,775      |       |
| 2010              |       | 1,370      |       |
| Thereafter        |       | 4,229      |       |
|              |       | $          | 17,851     |   |

 

Lease expense for theyears ended December 31, 2005, 2004, and 2003 was **$**5.7million, $5.7 million and $5.6 million, respectively.

We have entered into asoftware licensing agreement which requires us to pay approximately$1.2 million and $1.3 million in 2006 and 2007, respectively, for theright to distribute a vendor’s software as part of our workforce optimizationsolution. These amounts have been recorded as accrued expenses and otherlong-term liabilities as of December 31, 2005. Implied interest expenseassociated with these payments is not significant.

***Legal Proceedings***.

On December 11,2002, we filed in the United States District Court for the Northern District ofGeorgia, Atlanta Division, a lawsuit against Knowlagent, Inc. (“Knowlagent”),which is the assignee of United States (“U.S.”) Patent Nos. 6,324,282 B1 and6,459,787 B2. Knowlagent has accused our eQuality Now software of infringingthe above patents. We filed suit seeking a declaration that we did not and donot infringe either of the two patents listed above, as well as a declarationthat the above patents are invalid and unenforceable. We also filed a claimrequesting that if the patents are found to be valid, that one of our ownemployees be named the rightful inventor of the patents. We also requestedmonetary damages in an amount equal to the amount that Knowlagent has receivedfrom its use of the above patents. On December 31, 2002, Knowlagent filedits answer to our complaint as well as two counterclaims, alleging that weinfringe and contribute to the infringement by others of the above patents;Knowlagent seeks both monetary damages and an injunction in connection with itscounterclaim. On June 6, 2005, the Court held a claim construction hearingand issued a claim construction order on June 8, 2005. The case will nowproceed to expert discovery and summary judgment phases.

On July 20, 2004,STS Software Systems Ltd. (“STS Software”), a wholly-owned subsidiary ofNICE Systems, Ltd. (“NICE Ltd.”), filed a patent infringement suit in theU.S. District Court for the Southern District of New York against us (“New YorkAction”). The New York Action asserts that our products, including eQualityContactStore for IP, infringe United States (“U.S.). Patent No. 6,122,665(“the ‘665 patent”) and seeks only injunctive, not monetary, relief. On thesame day, we filed a declaratory judgment action against STS Software in theU.S. District Court for the Northern District of Georgia (“Georgia Action”). Weseek a declaration from the court that we have not infringed any valid claim ofthe ‘665 patent. By Order entered December 16, 2004, Judge Koeltl of theU.S. District Court for the Southern District of New York granted ourmotion to transfer the New York Action to the Northern District of Georgia,which has now consolidated the former New York Action with the Georgia Action.On July 7, 2005, the Court also granted STS leave to amend its complaintto add three patents to the dispute, namely: U.S. Patent Nos. 6,865,604;6,871,229; and 6,880,004 (respectively, “the ‘604 patent,” “the ‘229 patent,”and “the ‘004 patent”; collectively, “the STS patents”), again seeking solelyinjunctive relief. We answered the first amended complaint and assertedcounterclaims on July 29, 2005, collectively, through which we denyinfringement of any valid claim of the STS patents and seek a declaration tothat effect. The case has been set on a discovery calendar and is at apreliminary stage.

On August 30, 2004,we filed in the United States District Court for the Northern District ofGeorgia, Atlanta Division, a lawsuit against NICE Systems, Inc. (“NICEInc.”), a wholly-owned subsidiary of NICE Ltd., alleging patentinfringement. Specifically, we have alleged that NICE products, including theNiceUniverse

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productsthat include screen capture and synchronized screen and voice capturetechnologies, infringe claims of U.S. Patent Nos. 5,790,798 (“the ‘798 Patent”)and 6,510,220 (“the ‘220 Patent”), both entitled “Method and Apparatus forSimultaneously Monitoring Computer User Screen and Telephone Activity from aRemote Location.” We have sought an injunction and money damages for NICE’sinfringement of these two patents. NICE Inc. has answered and counterclaimedfor declaratory judgments of non-infringement and invalidity. Since then, onFebruary 24, 2005, we filed suit against NICE Ltd. because of itsinfringing activities in violation of the ‘798 and ‘220 patents, includingimportation of the accused NICE products. By order dated April 5, 2005,Judge Pannell has consolidated the NICE Inc. and NICE Ltd. actions. The casehas been set on a modified discovery calendar after consolidation and is at apreliminary stage.

In January 2001, IEXCorporation filed a lawsuit against Blue Pumpkin in the United States DistrictCourt for the Eastern District of Texas, Sherman Division, alleging that BluePumpkin infringed IEX Corporation’s (“IEX”) U.S. Patent No. 6,044,355(“the ‘355 Patent”) by making and selling certain workforce management and callrouting software products, including Blue Pumpkin’s Prime Time Skills and PrimeTime Enterprise products. IEX’s lawsuit seeks actual damages, an award oftreble damages pursuant to 35 U.S.C. § 284, an award of prejudgment interest,costs, and attorney’s fees, and an injunction against Blue Pumpkin’s making orselling the products that IEX claims infringe its ‘355 Patent.

On October 4, 2005,Blue Pumpkin filed in the United States District Court for the NorthernDistrict of Georgia, Atlanta Division, a lawsuit against IEX Corporationalleging patent infringement. Specifically, Blue Pumpkin has alleged that IEXproducts infringe claims of Blue Pumpkin’s U.S. Patent No. 6,952,732 (“the‘732 Patent”), entitled “Method and apparatus for multi-contact scheduling.”Blue Pumpkin’s lawsuit seeks an injunction and money damages for IEX’sinfringement of the ‘732 Patent.

On December 15,2005, IEX and Blue Pumpkin reached a tentative agreement to settle all claimsasserted between them in both the Texas and Georgia cases, subject to a numberof contingencies including negotiation, execution and delivery by the partiesof a definite settlement agreement prior to a deadline established by thecourt, currently March 15, 2006. The terms of the settlement agreement areconfidential. We expect to recover more than half of the settlement amount andrelated litigation costs from the escrow fund that was established inconnection with our acquisition of Blue Pumpkin. As of December 31, 2005,we have accrued the anticipated settlement costs and do not expect that the settlementwill require any additional material charges. (See Note 6 to the ConsolidatedFinancial Statements included elsewhere in this report for discussion of theBlue Pumpkin acquisition).

While we currently expectto reach a definitive settlement with IEX, a number of terms that we view assignificant remain under negotiation, and we cannot assure you that we will beable to reach a definitive settlement agreement on terms acceptable to us. If adefinitive settlement agreement is not reached, the litigations between IEX andBlue Pumpkin will go forward. In the case of IEX’s lawsuit against BluePumpkin, a trial date will be set by the court, most likely in the late springof 2006. Blue Pumpkin’s lawsuit against IEX is in a more preliminary stage andwould be unlikely to reach trial before 2007. If the litigations proceed totrial, we intend to defend against IEX’s claims vigorously and to pursue BluePumpkin’s claims against IEX vigorously, but we are unable to predict theoutcome of either case or to assess what, if any, impact an adverse resultwould have on our financial position, results of operations or cash flows.

On November 25,2005, Blue Pumpkin filed in the Tokyo District Court a lawsuit against P&WSolutions Co., Ltd. (“P&W”) alleging that P&W has infringed copyrightsin Blue Pumpkin Director Enterprise Version 33 software. P&W has filed ananswer, and the case is at a preliminary stage.

On January 19, 2006,we filed in the United States District Court for the Northern District ofGeorgia, Atlanta Division, a lawsuit against NICE Systems, Inc. and NICESystems, Ltd. (collectively “NICE”), alleging patent infringement.Specifically, we have alleged that NICE products, including NicePerform andrelated products that include the ability to monitor communications to detectthe presence of at least one predetermined parameter, infringe claims of ourU.S. Patent No. 6,404,857 B1 (“the ‘857 Patent”), entitled “SignalMonitoring Apparatus for Analyzing Communications.” We have sought aninjunction and money damages for NICE’s infringement of the ‘857 patent. NICEhas not yet responded to the complaint, and this case is at a preliminarystage.

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From time to time we maybe involved in other legal proceedings and/or litigation arising in theordinary course of our business that might impact on our financial position,our results of operations, or our cash flows.

***Indemnifications and Warranties—******We***moreoften than not indemnify our customers against damages and costs resulting fromclaims of patent, copyright, or trademark infringement associated with use ofour software in its software licensing agreements. We have historically notmade any payments under such indemnifications. However, we continue to monitorthe conditions that are subject to the indemnifications to identify whether itis probable that a loss has occurred, and would recognize any such losses underthe indemnifications when those losses are probable and estimable. In addition,we warrant to customers that our software products operate substantially inaccordance with the software product’s specifications. Historically, no costshave been incurred related to software product warranties and none are expectedin the future, and as such no accruals for warranty costs have been made.

**17.   Subsequent Events(unaudited)**

On April 6, 2006, Blue Pumpkin and IEX reached anagreement to settle all claims asserted between them. As part of the finalsettlement, Witness paid $8.25 million to IEX’s parent company in April 2006and agreed to make six annual payments of $0.5 million ($3.0 million in total)from April 2007 through 2012. Prior to and in contemplation of such settlement,Witness reached an agreement with the former shareholders of Blue Pumpkin (“BPshareholders”) in February 2006 whereby Witness would issue the shares ofcommon stock originally placed in escrow as a part of the Merger Agreement tothe BP shareholders for proceeds of approximately $3.1 million. Theseshares were issued at a discount of approximately $1.35 million, which wasrecorded as a charge to earnings in the Company’s Consolidated Statement ofOperations for the three months ended March 31, 2006. As a part of thisagreement, the BP shareholders released any and all claims on the funds held inescrow which were subsequently released to Witness during the three monthsended March 31, 2006.

On August 29, 2006, A.Edward Miller filed a shareholder derivative lawsuit in the United StatesDistrict Court for the Northern District of Georgia (Atlanta Division) namingWitness Systems, Inc. (the “Company”) as a nominal defendant and naming all ofour current directors and a number of our current officers as defendants. Miller v. Gould, et al., Civil Action No. 1:06-CV-2039 (N.D. Ga.).  Thecomplaint alleges purported violations of federal and state law, includingbreaches of fiduciary duty, abuse of control, constructive fraud, corporatewaste, unjust enrichment, gross mismanagement and violations of certainantifraud provisions of the federal securities

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laws(including Sections 10(b) and 14(a) of the Securities Exchange Act of 1934 andRules 10b-5 and 14a-9 thereunder) in connection with certain stock optiongrants made by the Company.  The complaint seeks monetary damages inunspecified amounts, disgorgement of profits, an accounting, rescission ofstock option grants, imposition of a constructive trust over the defendants’stock options and proceeds derived therefrom, punitive damages, reimbursementof attorneys’ fees and other costs and expenses, an order directing the Companyto adopt or put to a stockholder vote various proposals relating to corporategovernance, and other relief as determined by the court.  On November 15,2006, the Company and the other defendants filed a motion to dismiss thecomplaint in its entirety on a variety of grounds, including plaintiffs’failure to allege demand futility. Rather than respond to that Motion, plaintiffs on January 9, 2007 filedan Amended Complaint.  The Company andits directors intend to review the allegations of the Amended Complaint andrespond when appropriate.

A class action securities lawsuit was filed onAugust 14, 2006, by an individual claiming tobe a stockholder of the Company naming the Company and certain of itsdirectors and officers as defendants in connection with certain stock optiongrants made by the Company.  Rosenberg v. Gould, et al., Civil Action No.1:06-CV-1894 (N.D. Ga.).  The complaint, filed in the United StatesDistrict Court for the Northern District of Georgia, alleges violations ofSection 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunderand seeks unspecified damages, attorneys’ fees and other costs and expenses,unspecified extraordinary, equitable and injunctive relief, and other relief asdetermined by the court.  Neither a lead plaintiff nor lead counsel hasbeen appointed, nor has a response to the complaint yet been required. TheCompany and the other defendants will respond to the complaint whenappropriate.

On October 27, 2006, the Company received a notice ofinformal nonpublic inquiry from the Securities and Exchange Commissionrequesting certain documents and information relating to the Company’s stockoption grant practices from February 2000 to the present. Witness Systemsintends to cooperate fully with all matters related to this request.

*Acquisition of Exametric, Inc.*

On October 2, 2006, we acquired Exametric, Inc.(“Exametric”), a leading software solutions company specializing in workforcemanagement and optimization for the financial service industry.  The acquisition was structured as a merger ofExametric with a newly-formed, wholly-owned subsidiary of Witness (WitnessEnterprise Solutions).  The totalconsideration paid for Exametric was approximately $23 million.   Approximately $2.4 million of the aggregateconsideration will be held in escrow until October 2, 2007, or longer, ifclaims are brought against the escrow fund and remain pending on thatdate.  The escrow fund will be availableto indemnify Witness for losses resulting from, among other things, breaches ofrepresentations, warranties, covenants and certain transaction costs.

*Acquisition of Demos Consulting Group Ltd.*

Also on October 2, 2006, we acquired Demos ConsultingGroup Ltd. also known as Demos Solutions (“Demos”), a leading productivitysolution provider for the financial services industry.  The acquisition was structured as Demos witha newly-formed, wholly-owned subsidiary of Witness (Witness EnterpriseSolutions).  The total consideration paidfor Demos was approximately $6 million plus the potential for an earn-out of upto $18 million based on the growth of the business over the next severalyears.  Ten percent (10%) of the initialconsideration plus ten percent (10%) of any earn-out earned will be held inescrow until October 2, 2007, or longer, if claims are brought against theescrow fund and remain pending on that date. The escrow fund will be available to indemnify Witness for lossesresulting from, among other things, breaches of representations, warranties andcovenants.

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**Schedule II**

**Valuation and QualifyingAccounts(In thousands)**
| ** **                         | ** ** | **Balance at  Beginning of  Year** | ** ** | **Charged  against  Revenue** | ** ** | **Charged  to  Expense** | ** ** | **Deductions** | ** ** | **Balance at  End of  Year** | ** ** |
|------------------------------------|------------|----------------------------------------------|------------|-------------------------------|------------|--------------------------|------------|----------------|------------|----------------------------------------|------------|
| Allowance for Doubtful  Accounts:  |       |                                         |       |                          |       |                     |       |           |       |                                   |       |
| Year ended  December 31, 2005 |       | $                                            | 3,250      |                          | $          | 2,849                    |       | $              | 587        |                                   | $          | (3,403 | ) | $ | 3,283 |   |
| Year ended  December 31, 2004 |       | 2,840                                        |       | 1,395                         |       | 513                      |       | (1,498         | )          | 3,250                                  |       |
| Year ended  December 31, 2003 |       | 1,574                                        |       | 268                           |       | 2,779                    |       | (1,781         | )          | 2,840                                  |       |
|                                    |            |                                              |            |                               |            |                          |            |                |            |                                        |            |  |  |  |  |  |

 

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**SIGNATURES**

Pursuant to therequirements of Section 13 of 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.
| Dated: February 7, 2007 |     | WITNESS SYSTEMS, INC. |
|-------------------------|----------|-----------------------|
|                    |     |                  |
|                    |     | By:                   | /s/  WILLIAM  F.EVANS |
|                    |     |                  | William F.Evans |
|                    | * * | * *              | *Executive  Vice President and Chief Financial Officer* |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons in the capacities and on the dateindicated
| /s/  NICK DISCOMBE     | * * | *Chief Executive Officer and Director* |   | February 7, 2007 |
|----------------------------------|----------|----------------------------------------|--------|------------------|
| Nick Discombe                    | * * | * *                               |   |             |
|                             | * * | * *                               |   |             |
| /s/  WILLIAM  F. EVANS | * * | *Executive Vice President and Chief*   |   | February 7, 2007 |
| William F. Evans                 | * * | *Financial  Officer*                   |   |             |
|                             | * * | * *                               |   |             |
| /s/  TOM  BISHOP       | * * | *Director*                             |   | February 7, 2007 |
| Tom Bishop                       | * * | * *                               |   |             |
|                             | * * | * *                               |   |             |
| /s/  THOMAS  J. CROTTY | * * | *Director*                             |   | February 7, 2007 |
| Thomas J. Crotty                 | * * | * *                               |   |             |
|                             | * * | * *                               |   |             |
| /s/  JOEL  G. KATZ     | * * | *Director*                             |   | February 7, 2007 |
| Joel G. Katz                     | * * | * *                               |   |             |
|                             | * * | * *                               |   |             |
| /s/  DAN  LAUTENBACH   | * * | *Chairman of the Board*                |   | February 7, 2007 |
| Dan Lautenbach                   | * * | * *                               |   |             |
|                             | * * | * *                               |   |             |
| /s/  PETER  SINISGALLI | * * | *Director*                             |   | February 7, 2007 |
| Peter Sinisgalli                 | * * | * *                               |   |             |

 

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