**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

**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 period from                to                **

**Commission file number 000-29335**

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**WITNESS SYSTEMS, 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 to  Section 12(b) of the Act:** None** |
| Securities registered pursuant to  Section 12(g) of the Act:               |
|                                                                                      | **Title of  each class** | ** **                            | ** ** |  | **Name of  each exchange on which registered** | ** ** |
| Common  Stock, par value $.01 per share                                              |                     | NASDAQ                                |
|                                                                                      |                          |                                       |  |  |  |  |

 

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 or Section 15(d) ofthe Act. Yes o  No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor 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 amendment tothis Form 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 Act Rule 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-2of the Exchange Act). Yes o   No x

Theaggregate market value of the voting stock held by non-affiliates of theregistrant as of June 30, 2005 was 488.7 million. The number ofshares of the registrant’s common stock outstanding on February 28, 2006was 33,102,494

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**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the registrant’sdefinitive proxy statement for its annual meeting of stockholders, currentlyscheduled for May 18, 2006, are incorporated by reference in Part IIIof this report.

 

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**PART I**

**Item 1.**                        Business

This annual report on Form 10-K 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 7.

You should read TheBusiness Section in conjunction with Management’s Discussion and Analysisof Financial Condition and Results of Operations and the Consolidated FinancialStatements and Notes thereto included elsewhere in this report completely andwith the understanding that actual future results may be materially differentfrom expectations. All forward-looking statements made in this report arequalified by these cautionary statements. You are cautioned thatforward-looking statements are not guarantees of future performance and aremade only as the date of this report, and we undertake no obligation, otherthan as may be required by law, to update or revise these statements for anyreason, including to reflect changes in assumptions, the occurrence ofunanticipated events or changes in future operating results over time. Ouractual results may differ materially from 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 the performanceof their customer service representatives, or “CSR”s, wherever they may belocated in the enterprise. Our high-volume compliance applications are designedto record 100% 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 have more than 2,000customers, including more than 60 Fortune 100 companies. Our solutions are usedin a wide variety of industries worldwide, including financial services,communications services, 

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manufacturing,utilities, retail, transportation, travel and outsourcing. No individualcustomer accounted for 10% or more of our revenue in 2005, 2004 or 2003. Wemarket and sell our products through both our direct sales force and throughindirect channels. Our indirect sales channel includes reseller, distributor,original equipment manufacturer, or “OEM”, and similar arrangements with keyvendors in the contact center workforce optimization market, such as Avaya,Cisco, Nortel and Siemens. We also have strategic relationships with systemsintegrators, including Accenture, British Telecommunications, CapGemini andEDS.

**Industry Background 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.

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.

*Increasing complexity ofcustomer service operations.**  *Customer service operations at many organizationshave become increasingly complex, driven by the demand for highly available andeffective customer service. For example, contact centers have become theprimary points of customer contact for 

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organizations, asthe contact centers have evolved from providing solely inbound customer supportto handling support, service, sales, bill payment and numerous other customerinteractions. Organizations are facilitating customer service interactionsacross multiple media, including traditional voice, Web chat, instantmessaging, guided browser sessions and e-mail, and are therefore challenged tomaintain a consistently high level of customer service across all mediachannels. Moreover, as a result of recent trends toward offshore and outsourcedcontact center operations, managing and optimizing the quality of customerinteractions has become more important, 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 centraladministration. More importantly, shared access to information across allfunctions in the customer service value chain enables our customers to makeinformed decisions that can generate cost savings, improve decision making andincrease competitive advantages. We also offer related consulting andimplementation 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, dynamic 

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analysis and performancescorecard capabilities of these solutions provide organizations with businessintelligence that can lead to increased revenue, heightened service quality andimproved 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 date thesoftware agreement is signed by a new customer. Training services provide theskills and knowledge necessary to enable business and technical users toutilize the Impact 360 solutions. Training is provided at our global trainingcenters, on-site at the customers’ location or via our web-based education andtraining management system. In addition, we offer customized training programstailored to the specific needs of 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 supportoperation provides customer support services including access to major andminor releases, service packs and hot fixes, remote diagnostics andinstallation. Customer support is offered in two distinct plans with servicesthat range from 12 hour phone access Monday through Friday to 24 hours, 7 daysa week. We provide support services via the telephone, e-mail and via anon-line knowledgebase of product-related information.

**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.

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*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.

*Expand our businessthrough strategic acquisitions.**  *We intend to pursue acquisitions ofbusinesses, technologies and products that will complement our existingoperations and enhance our position in the workforce optimization market. Since2003, we have completed two significant acquisitions. In 2003 we acquiredEyretel Plc, which strengthened our market presence internationally andexpanded our capabilities in the compliance recording market, and in 2005 weacquired Blue Pumpkin Software, Inc. a leading provider of workforcemanagement products.

**Research and Development**

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 inresearch and development activities. Research and development expenditures,exclusive of acquired in-process research and development, for the years ended December 31,2005, 2004 and 2003 were $26.7 million, $20.9 million and $18.0 million,respectively. We anticipate our research and development costs as a percentageof total revenue will decrease in 2006 as compared to 2005.

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**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)         the functionality andquality of our products,

(2)         the ease of use andability of our products to operate with a variety of hardware and softwareproducts,

(3)         our ability as a singlevendor to offer a full suite of applications,

(4)         our ability to implementour products quickly,

(5)         the responsiveness of ourcustomer support, and

(6)         our reputation in themarketplace.

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 orperformance enhancing software solutions.

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:

·       productperformance, reliability and features;

·       abilityto effectively integrate products into customers’ environments;

·       userscalability and open architecture;

·       third-partyintegration;

·       qualityand speed of product implementation;

·       ease-of-usefor customers;

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·       analyticcapabilities of the product;

·       howquickly new products and product enhancements can be brought to market;

·       customersupport; and

·       pricingof products and services.

Our success will depend onour ability to compete effectively based on these factors. Further, we expectthat competition will increase as other established and emerging companiesenter our market and as new products, services and technologies are introduced.Increased competition may result in price reductions, lower gross margins andloss of market share. This could materially and adversely affect our business,financial condition and 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, that any existingor future 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.

*Trademarks and servicemarks.**  *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.

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**Availabilityof Reports and Other Information.**

Our corporate Web site is *http://www.witness.com*. We make availableon this Web site, free of charge, access to our Annual Report on Form 10-K,Quarterly Reports on Form 10-Q, 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 on Form 10-K

**Item 1A.**                RiskFactors

Our future operatingresults may vary substantially from period to period. The price of our commonstock will fluctuate in the future, and an investment in our common stock issubject to a variety of risks, including, but not limited to, the specificrisks identified below. Inevitably, some investors in our securities willexperience gains while others will experience losses depending on the prices atwhich they purchase and sell our securities. Prospective and existing investorsshould consider the following factors in evaluating our business or aninvestment in our securities. If any of the following or other risks actuallyoccurs, our business, financial condition and results of operations could beadversely affected. In that case, the trading price of our common stock coulddecline.

*Becauseour products have a long sales cycle, it is more difficult to plan our expensesand forecast 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. Material changesin our sales cycle could cause our quarterly revenue or operating results to bebelow the expectations of investors, and the price of our common stock couldfall substantially.

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

·       thecomplex nature of our products, requiring our need to educate potentialcustomers about the uses and benefits of our products;

·       competitionfor the corporate resources necessary to finance the purchase andimplementation of our products;

·       customers’budgeting and purchasing cycles;

·       economicfactors;

·       theextent of customers’ evaluation and internal approval process often requiredbefore purchasing our products and services; and

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

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*If our products andservices are not used and accepted by existing and prospective customers, ourbusiness 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:

·       notunderstand the benefits of using workforce optimization software generally or,more specifically, software which records and analyzes the interactions betweena business and its customers or which optimizes the forecasting and schedulingof employees;

·       notachieve favorable results using our software;

·       experiencetechnical difficulty in implementing our software;

·       usealternative methods such as online self-help to solve the same businessproblems our software is intended 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 ourhistory, we have experienced losses. As a result of our prior operating losses,we had an accumulated deficit of $42.3 million as of December 31,2005. We need to generate sufficient revenue to achieve sustained profitabilityand avoid incurring losses 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:

·       changesin demand for our products and services;

·       thetendency of customers to delay software purchases until the end of the fiscalquarter;

·       lengtheningof our customers’ budgeting and purchasing cycles;

·       timingof any acquisitions and related costs;

·       delaysin installations of our software;

·       varyingsales and implementation cycles for our products and services from customer tocustomer;

·       thefailure of our customers to renew their maintenance service agreements;

·       thetiming of hiring new services employees and the rate at which these employeesbecome productive; and

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·       thedevelopment and performance of our distribution channels.

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

*We may be unable tomanage and expand our international operations, which may adversely affect ourbusiness and operating results.*

We derived revenues of $84.6 million and $68.1 millionin 2005 and 2004, respectively, from customers located outside the UnitedStates. Our operations outside of the United States at December 31, 2005,consisted of operations located in Australia, Brazil, Canada, China, Germany,India, Japan, Mexico, the Netherlands, Singapore, South Africa and the UnitedKingdom. We have also established relationships with a number of internationalresellers.

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:

·       limiteddevelopment of an international market for our software and services;

·       expandingand training our international sales force and support operations;

·       highercosts of employment in certain international locations;

·       difficultiesin producing localized versions of our products;

·       politicaland economic instability;

·       potentiallyadverse tax consequences of operating in foreign countries;

·       importand export restrictions and tariffs;

·       longerpayment cycles and difficulties in collecting accounts receivable;

·       currencyfluctuations;

·       culturaldifferences which may affect workforce performance and sales processes;

·       difficultiesand expenses associated with complying with a variety of foreign laws; and

·       unexpectedchanges in regulatory requirements.

As we further expand ouroperations outside the United States, we will also face new competitors andcompetitive environments. In addition to the risks associated with our domesticcompetitors, foreign competitors may pose an even greater risk, because theymay possess a better understanding of their local markets and have betterworking relationships with local infrastructure providers and others. Inparticular, because telephone protocols and standards are unique to eachcountry, local competitors will have more experience with, and may have acompetitive advantage in, these markets. We may not be able to obtain similarlevels of knowledge, which could place us at a significant competitivedisadvantage. In addition, we 

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havelimited experience 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.

*If weare unable to maintain a productive direct sales force, our business andoperating results could be adversely affected.*

We believe that our futuresuccess will depend on maintaining a productive direct sales force.Historically, it has taken us up to six months to train new sales personnelbefore they reach an acceptable level of productivity. We have also experienceddifficulty in recruiting sales personnel with experience in computer andtelephone integration technologies. We cannot assure you that we will be ableto continue to manage turnover and hire new sales personnel to meet our needs.If the personnel we hire are less qualified than we expect, it may take us moretime to train them before they reach an acceptable level of productivity, whichcould increase our costs and reduce our revenue.

*If we are unable toexpand 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 indirectsales channel represented approximately 41% and 32% of total product revenue in2005 and 2004, respectively. We expect revenue from our indirect sales channeland, accordingly, our dependence on distribution partners, to increase as weestablish relationships with companies to resell our software worldwide. Wecannot assure you that we will be able to maintain productive relationshipswith our current partners, or that we will be able to establish similarrelationships with additional resellers on a timely basis, if at all.

Some resellers with whichwe do business have similar, and often more established, relationships with ourcompetitors, and may recommend the products and services of our competitors tocustomers instead of our software and services. We cannot provide assurancethat these distribution partners will devote adequate resources to selling oursoftware and services or that our resellers may not learn about our productsand the market for our software and services and develop and sell competingproducts and services. As a result, our relationships with resellers could leadto increased competition for 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:

·       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

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

Many of our current and potential competitors havelonger operating histories, more established business relationships, largercustomer bases, a broader range of products and services, greater name recognitionand substantially greater financial, technical, marketing, personnel,management, service, support and other resources than we do. As a result, ourcurrent and potential competitors may be able to respond more quickly to new oremerging technologies and changes in customer requirements, take betteradvantage of acquisitions and other opportunities, devote greater resources tomarketing and selling their products and services and adopt more aggressivepricing policies. We cannot assure you that our current or potentialcompetitors will not develop products comparable or superior in terms of priceand performance features to those developed 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 long standingrelationships than we do with telephone switch vendors. Our competitors may usethese business relationships to market and sell their products and compete forpotential customers. It is also possible that resellers or technology partnersmay acquire or be acquired by one or more of our competitors, which wouldfurther solidify their business relationships.

We expect that competitionwill increase as other established and emerging companies enter our market andas new products, services and technologies are introduced. Increasedcompetition may result in price reductions, lower gross margins and loss ofmarket share, any of which could materially and adversely affect our business,financial condition and results 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 asubstantial portion of our product revenues from sales of our qualitymonitoring and Workforce Management software products. We expect revenue fromthese products to continue to account for a significant portion of our revenuefor the foreseeable future. As a result, any factors affecting the markets forthese products could materially and adversely affect our business, financialcondition and results of operations. We cannot assure you that the market willcontinue to demand our current products or that we will be successful inmarketing any new or enhanced products. If our competitors release new productsthat are superior to our products in performance or price, demand for ourproducts may decline. A decline in demand for our products as a result ofcompetition, technological change or other factors would reduce our totalrevenues 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 of ourcustomers. 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 

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addition, failure todevelop new software or improve existing software products may adversely affectour ability to maintain our maintenance renewal rate which could adversely affectour revenue.

We have recentlyintroduced Impact 360, which combines a new software architecture with newcombinations of our products. Our business concept in doing so is to createincremental value for our customers and to win business away from competitorswhose product offerings are more limited and require the customer to makeadditional hardware purchases to obtain the solutions that our Impact 360product offering provides in an integrated suite. While we plan and expect thatthis lower total cost of ownership will be well received in the marketplace, wecan offer no assurance that our new Impact 360 offering will be successful. Ifour Impact 360 product offerings do not meet with commercial success, ourbusiness would be materially and adversely affected.

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

During 2004, weexpanded our software development capabilities in the Asia-Pacific region inorder to optimize 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:

·       delaysor product errors due to miscommunication between our local developmentorganization and the remote

·       developmentpersonnel affected by time, distance and language differences;

·       schedulingdelays due to lengthy ramp-up time for our new development personnel;

·       productsproduced in the Asia-Pacific region that fail to meet our quality requirements;

·       highvoluntary personnel turnover; and

·       foreignemployment and labor laws with which we are not familiar.

Our inability to meetdevelopment schedules because of our reliance on developers in the Asia-Pacificregion may affect our ability to enhance our current product line or introducenew products, which would have a material adverse affect on our financialresults and could harm our reputation. The loss of key development personnelcould have a material adverse effect on our product development process andadversely affect future product revenues.

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

Our software is used in acomplex operating environment that requires its integration with computer andtelephone networks and other business software applications. If our productsfail to function as required, we may be subject to claims for substantialdamages. Courts may not enforce provisions in our contracts that would limitour liability or otherwise protect us from liability for damages. Although wemaintain general liability insurance coverage, including coverage for errors oromissions, this coverage may not continue to be available on reasonable termsor in sufficient amounts to cover claims against us. In addition, our insurermay disclaim coverage as to any future claim. If claims exceeding the availableinsurance coverage are successfully asserted against us, or our insurer imposespremium increases, large deductibles or co-insurance requirements on us, ourbusiness, financial position, and results of operations could be adverselyaffected.

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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 saleschannel accounts for an increasingly large share of our total sales. Whenwe sell our software through an original equipment manufacturer, or OEM, oursoftware is embedded in the OEM’s product, which we sometimes refer to as the ‘environment’for our software. When the OEM’s product uses our software, there is a riskthat the ‘environment’ will fail or that it will not achieve the compatibilitywith our product that we and the OEM seek. If this happens, our software mightnot function properly, or the OEM might sell less of it, or both, which couldhave a material adverse effect on our revenues, operating cash flows andthe growth of our business.

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

Software products ascomplex as those offered by us might contain undetected errors or failures whenfirst introduced or when new versions are released. We cannot assure you,despite testing by us and by current and prospective customers, that errorswill not be found in new products or product enhancements after commercialrelease. Any errors found may cause substantial harm to our reputation andresult in a loss in revenue and additional unplanned expenses to remedy anydefects.

*If our advancedcompliance recording applications fail to record 100% of our customers’interactions, we may be subject to liability and our reputation may be harmed.*

Many of our customers useour advanced compliance recording applications to record and store interactionswith customers to provide back-up and verification of transactions and to guardagainst risks posed by lost or misinterpreted voice communications. Thesecustomers rely on our applications to record, store and retrieve voice data ina timely, reliable and efficient manner. If our applications fail to record100% of our customers’interactions or our customers are unable to retrieve therecordings when necessary, we may be subject to liability and our reputationmay be harmed.

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

The occurrence orperception of security breaches in the operation of our business or suffered bythird parties using our products could harm our business, financial conditionand operating results. Our customers use our products to compile and analyzehighly sensitive or confidential information. We may come into contact withsuch information or data when we perform support or maintenance functions forour customers. While we have internal policies and procedures for employeesperforming these functions, the perception that we have improperly handledsensitive, confidential information could have a negative effect on ourbusiness. If, in handling this information, we fail to comply with privacy orsecurity laws, we could incur civil liability to government agencies, customersand individuals whose privacy is compromised. If personal information isreceived or used from sources outside the U.S., we could be subject to civil,administrative or criminal liability under the laws of other countries. Inaddition, while we implement sophisticated security measures, third parties mayattempt to breach our security or inappropriately use our products throughcomputer viruses, electronic break-ins and other disruptions. If successful,confidential information may be improperly obtained and we may be subject tolawsuits and other liability. Any internal or external security breaches couldharm our reputation, and even the perception of security risks, whether or notvalid, could inhibit market acceptance of our products.

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

We may experience gainsand losses resulting from fluctuations in currency exchange rates. Moreover, inlocations where we price our products in U.S. dollars, our sales could beaffected adversely by declines 

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inforeign 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 reflectfluctuations in exchange rates. We do not use derivative instruments to manageour foreign exchange risk, and we cannot predict the impact that futureexchange rate fluctuations may 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 contractprovisions, principally confidentiality and indemnification obligations in certainof our license agreements, could expose us to risks of loss that, in somecases, are not limited by contract to a specified maximum amount. If we fail toperform to the standards required by these contracts, we could be subject toadditional liability and our business, financial condition and results ofoperations could be materially and 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 of legalrights resulting from prior use, registrations, or applications will bringlegal action to challenge our registration of and/or our use of the trademarkeQuality®, and mayalso seek compensation for damages resulting from our use this trademark. As aresult, we cannot assure you that our registration of this trademark will beundisturbed, or that this use will not result in liability for trademarkinfringement, trademark dilution, and/or unfair competition.

Moreover, the laws ofcertain foreign countries do not protect our intellectual property rights tothe same extent as do the laws of the United States. Furthermore, policing theunauthorized use of our products is difficult, and litigation may be necessaryin the future to enforce our intellectual property rights, to protect our tradesecrets or to determine the validity and scope of the proprietary rights ofothers. Litigation could result in substantial costs and diversion of resourcesand could negatively affect our future 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 

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the number of competitorsand products grows. Any claims, with or without merit, which are generallyuninsurable, could be time-consuming, result in costly litigation, require usto reengineer or redevelop our software, cause product shipment delays orrequire us to enter into royalty or licensing agreements, any of which couldnegatively affect our operating results. Any efforts to reengineer our softwareor obtain licenses from third parties may not be successful, could be extremelycostly and would likely divert valuable management and product developmentresources.

For example, claims havebeen asserted against us in lawsuits involving Knowlagent, IEX, STS and NICE(as described in Item 3, “Legal Proceedings”, of Part I). We cannot assureyou that we will be successful in defending against the claims that have beenasserted or any other claims that may be asserted. We also cannot assure you thatsuch claims will not have a material adverse effect on our business, financialcondition, or operations. Defending infringement claims or other claimsinvolves substantial costs and diversion of management resources. In addition,to the extent we are not successful in defending such claims, we may be subjectto injunctions with respect to the use or sale of certain of our products or toliabilities for damages to the claimants or to customers to whom we haveindemnification commitments, and we may be required to obtain licenses whichmay not be available on reasonable terms. In addition, we cannot assure youthat legal action claiming patent infringement will not be commenced againstus, or that we would prevail in litigation given the complex technical issuesand inherent uncertainties in patent litigation. In addition, users of oursoftware may become subject to claims if our software is alleged to infringethe intellectual property rights of others. These software users could attemptto hold us responsible for these claims and any resulting harm they suffer. Ifa patent claim against us were to be successful and we could not obtain alicense on acceptable terms or license a substitute technology or redesign toavoid infringement, we may be prevented from distributing our software orrequired to incur significant expense and delay in developing non-infringingsoftware. Such a result could have a material adverse effect on our business,financial condition and results of operations.

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

Our software mustintegrate with software and hardware solutions provided by a number of ourexisting and potential competitors. For example, our products must integratewith phone switches made by the telephone switch vendors and computer telephonysoftware applications offered by other software providers. These competitors ortheir business partners could alter their products so that our software nolonger integrates well with them, or they could delay or deny our access tosoftware releases that allow us to timely adapt our software to integrate withtheir products. If we cannot adapt our software to changes in necessary technology,it may significantly impair our ability to compete effectively, particularly ifour software must integrate with the software and hardware solutions of ourcompetitors.

*If our professionalservices employees do not provide installation services effectively andefficiently, our customers may not use our installation services or may stopusing our software.*

Our customers ordinarilypurchase installation, training and maintenance services together with ourproducts. The functionality of our products is not dependent on ourinstallation and training services. We believe that the speed and quality ofinstallation services are competitive factors in our industry. If ourinstallation services are not satisfactory to our customers, the customers maychoose not to use our installation services or they may not license oursoftware in the future. As a result, we would lose licensing and servicesrevenue, and it could harm our reputation. In addition, our revenues realizedfrom the performance of maintenance services are material to our operatingresults, and a failure to provide adequate maintenance support to our customerswould result in reduced maintenance revenues and have an adverse effect on ouroperating results.

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*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:

·       identifyingsuitable candidates, performing appropriate due diligence, identifyingpotential liabilities and negotiating acceptable terms;

·       reducingour working capital and hindering our ability to expand or maintain ourbusiness, if we make acquisitions using cash;

·       thepotential distraction of our management, diversion of our resources anddisruption of our business;

·       retainingand motivating key employees of the acquired companies;

·       managingoperations that are distant from our current headquarters and operations;

·       enteringinto geographic markets in which we have little or no prior experience;

·       competingfor acquisition opportunities with competitors that are larger than we are orhave greater financial and other resources than we have;

·       accuratelyforecasting the financial impact of a transaction;

·       assumingliabilities of acquired companies, including litigation related to theoperation of the business prior to the acquisition;

·       maintaininggood relations with the customers and suppliers of the acquired company;

·       potentiallydilutive issuances of securities as consideration for an acquisition;

·       effectivelyintegrating acquired 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 we believeour 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:

·       developand enhance our software to remain competitive;

·       takeadvantage of future opportunities, such as acquisitions;

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·       respondto changing customer needs and our competitors’ innovations; or

·       attractand retain qualified key personnel.

Any of these events couldsignificantly harm our business 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:

·       cancellationsof orders due to unavailability of hardware;

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

·       additionaldevelopment expense to modify our products to work with new hardwareconfigurations.

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

*Failure to maintaineffective 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 of2002 imposes certain duties on us and our executives, directors and attorneys.Our efforts to comply with the requirements of Section 404 have resultedin increased general and administrative expense and a diversion of managementtime and attention from revenue-generating activities to compliance activities,and we expect these efforts to require the continued commitment of significantresources. We have reported a material weakness in internal control overfinancial reporting which we found in connection with our evaluation ofcontrols and procedures as of December 31, 2005. If we fail to maintainthe adequacy of our internal controls, we may not be able to ensure that we canconclude on an ongoing basis that we have effective internal controls overfinancial reporting. Failure to maintain effective internal controls overfinancial reporting could result in investigation and/or sanctions byregulatory authorities, and could have a material adverse effect on ourbusiness and operating results, investor confidence in our reported financialinformation, and the market price of our common stock.

*Our stock price hasbeen volatile.*

The market price of ourcommon stock has been subject to significant fluctuations in response tovariations in quarterly operating results and other factors. In addition, thestock market has experienced significant volatility that has particularlyaffected the market prices of equity securities of many technology companiesand that often has been unrelated or disproportionate to the operatingperformance of these companies. Any announcement with respect to any adversevariance in revenue or earnings from levels generally expected by securitiesanalysts or investors could have a significant adverse effect on the tradingprice of our common stock. In addition, factors such as announcements oftechnological innovations or 

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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 2.1 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 secondaryoffering of our common stock, we issued 4.7 million shares of common stock in December 2005.Also, as part of the merger consideration in our acquisition of Blue Pumpkin inJanuary 2005, we issued a total of 2.1 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.

*Our performance maybe negatively affected by macro-economic or other external influences.*

Beginning in 2000, adeclining United States economy adversely affected the performance of manybusinesses, especially within the technology sector. Reductions in the capitalbudgets of our customers and prospective customers have an adverse impact onour ability to sell our solutions. Until late in 2003, we continued toexperience effects from a weak spending environment for information technologyin both the United States and Europe, in the form of delayed and cancelledbuying decisions by customers for our software, services and hardware,deferrals by customers of service engagements previously scheduled and pressureby our customers and competitors to discount our offerings. If the currentimprovements now being seen in the general business climate do not continue,this would likely have a material adverse 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 telecommunicationsindustry continues to evolve, state, federal and foreign governments (includingsupranational governmental organizations such as the European Union) andindustry associations may increasingly regulate the monitoring oftelecommunications and telephone and Internet monitoring and recordingproducts, such as our software. We believe that increases in regulation couldcome in the form of a number of different kinds of regulations, includingregulations regarding privacy, protection of personal information such asSocial Security numbers, credit card information and employment. For example,the State of California enacted the Database Security Breach Act, whichrequires any business that suffers a computer security breach to immediatelynotify customers in California if personal information has been compromised,and the Payment Card industry has adopted regulations that require additionalsecurity regarding the storage of consumers’ credit card numbers. The adoptionof any new regulations or changes to existing regulations could cause a declinein the use of our software and could result in increased expense for us as wemodify our software to accommodate these regulations. Moreover, theseregulations could subject our customers or us to liability. Whether or notthese regulations are adopted, if we do not adequately address the privacyconcerns of consumers, companies 

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may behesitant to use our software. If any of these events occur, it could materiallyand adversely affect our business.

*If we are unable toattract 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 dependsupon the continued service of our executive officers, particularly our Chairmanand Chief Executive Officer, David Gould, and our President and Chief OperatingOfficer, Nick Discombe. We have employment agreements with Mr. Gould and Mr. Discombeand limited non-compete agreements with most of our other executive officers.However, any of our executive officers and other employees could terminate hisor her relationship with us at any time. The loss of the services of our executiveofficers or other key personnel, particularly if lost to competitors, couldmaterially 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, in October 2002,our board of directors approved, and we have implemented, a stockholder rightsplan which has the effect of causing substantial dilution to a person or groupthat attempts to acquire us on terms not approved by the board of directors.

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

**Item 1B.     UnresolvedStaff comments**

We have not received anywritten comments regarding our periodic or current reports from the staff ofthe Securities and Exchange Commission that were issued 180 days or more beforethe end of our fiscal year ended December 31, 2005, thus, no issues remainunresolved.

**Item 2.        Properties**

Our principaladministrative, marketing, product development, training and support facilitiesare located in Roswell, Georgia, a suburb of Atlanta, where we leaseapproximately 96,400 square feet under a lease that expires in 2007. We occupyapproximately 26,000 square feet in Leatherhead, United Kingdom under a leasethat expires in 2014, which includes administrative, marketing, productdevelopment and support facilities. In addition, we lease a total of 28 officesin the United States, Australia, Brazil, Canada, China, India, Japan, Mexico,the Netherlands, Singapore, South Africa, and the United Kingdom. We believeour facilities are in good operating conditions, suitable and adequate for ourcurrent and expected near-term requirements.

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**Item 3.        Legal Proceedings**

From time to time we maybe involved in legal proceedings and/or litigation arising in the ordinarycourse of our business.

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 is nowproceeding to expert discovery and summary judgment phases.

On July 20, 2004, STSSoftware 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 our motion totransfer the New York Action to the Northern District of Georgia, which has nowconsolidated the former New York Action with the Georgia Action. On July 7,2005, the Court also granted STS leave to amend its complaint to add threepatents to the dispute, namely: U.S. Patent Nos. 6,865,604; 6,871,229; and6,880,004 (respectively, “the ‘604 patent,” “the ‘229 patent,” and “the ‘004patent”; collectively, “the STS patents”), again seeking solely injunctiverelief. We answered the first amended complaint and asserted counterclaims on July 29,2005, collectively, through which we deny infringement of any valid claim ofthe STS patents and seek a declaration to that effect. The case has been set ona discovery calendar and is at a preliminary 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 products that include screen capture and synchronized screen andvoice 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 andApparatus for Simultaneously Monitoring Computer User Screen and TelephoneActivity from a Remote Location.” We have sought an injunction and moneydamages for NICE’s infringement of these two patents. NICE Inc. has answeredand counterclaimed for declaratory judgments of non-infringement andinvalidity. Since then, on February 24, 2005, we filed suit againstNICE Ltd. because of its infringing activities in violation of the ‘798and ‘220 patents, including importation of the accused NICE products. By orderdated April 5, 2005, the court has consolidated the NICE Inc. and NICELtd. actions. The case has been set on a modified discovery calendar afterconsolidation and is at a preliminary 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 

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workforcemanagement and call routing software products, including Blue Pumpkin’s PrimeTime Skills and Prime Time Enterprise products. IEX’s lawsuit seeks actualdamages, an award of treble damages pursuant to 35 U.S.C. § 284, and an awardof prejudgment interest, costs, and attorney’s fees, and an injunction againstBlue Pumpkin’s making or selling the products that IEX claims infringe its ‘355Patent.

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 U.S. Patent No. 6,952,732 (“the ‘732 Patent”),entitled “Method and apparatus for multi-contact scheduling.” Blue Pumpkin’slawsuit seeks an injunction and money damages for IEX’s infringement of the ‘732Patent.

On December 15, 2005,IEX and Blue Pumpkin reached an agreement to settle all claims asserted betweenthem in both the Texas and Georgia cases, subject to a number of contingenciesincluding negotiation, execution and delivery by the parties of a definitesettlement agreement prior to a deadline established by the court , currently March 15,2006. The terms of the settlement are confidential. We expect to recover morethan half of the settlement amount and related litigation costs from the escrowfund that was established with a portion of the purchase price in connectionwith our acquisition of Blue Pumpkin. As of December 31, 2005, we haveaccrued the balance of the anticipated settlement costs and do not expect thatthe settlement will require any additional material charges. (See Note 5 to theConsolidated Financial Statements included elsewhere in this report fordiscussion of the Blue 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 and related productsthat include the ability to monitor communications to detect the presence of atleast one predetermined parameter, infringe claims of U.S. Patent No. 6,404,857B1 (“the ‘857 Patent”), entitled “Signal Monitoring Apparatus for AnalyzingCommunications.” We have sought an injunction and money damages for NICE’sinfringement of the ‘857 patent. NICE has not yet responded to the complaint,and this case is at a preliminary stage.

We are not party to any significantlitigation or legal proceedings, including those summarized above, that webelieve could have a material adverse effect on our financial position, resultsof operations or cash flows.

**Item 4.        Submissionof Matters to a Vote of Security Holders**

No matters were submittedto a vote of security holders during the fourth quarter ended December 31, 2005.

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**PART II**

**Item 5.        Marketfor Our Common Equity and Related Stockholder Matters and Issuer Purchases ofEquity Securities**

**Common Stock**

Ourcommon stock trades on the Nasdaq Stock Market under the symbol “WITS”. Thefollowing table sets forth, for the periods indicated, the high and low saleprice per share of the common stock on the Nasdaq Stock Market in each of thelast eight quarters.

| ** **                          | ** ** | **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 with Rule 10b5-1of the Securities Exchange Act of 1934, as amended. Trading plans provide forsales, subject to price restrictions, daily limits and other contingencies, ofshares 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 ofDirectors 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 constructively retired. As at December 31,2005, 6.9 million shares are available for repurchase. However, we have notrepurchased our common stock since 2003 and do not presently plan to repurchaseadditional common stock.

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**Item 6.        SelectedFinancial Data**

The following selectedconsolidated financial data should be read in conjunction with the ConsolidatedFinancial Statements and Notes thereto and with “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” included elsewherein this report (in thousands except for per share data):

| ** **                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                        | ** ** | **2005(a)**                                | ** ** | **2004** | ** ** | **2003(b)** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Statement of Operations Data:**                                 |       |                                       |       |   |   |   |   |   |   |   |   |
| Revenue:                                                          |       |                                       |       |   |   |   |   |   |   |   |   |
| Product                                                           |       | $                                          | 74,186     |   | $ | 57,620 |   | $ | 46,238 |   | $ | 33,383 |   | $ | 39,926 |   |
| Services                                                          |       | 111,185                                    |       | 83,715 |   | 61,799 |   | 34,303 |   | 22,596 |   |
| Total revenue                                                     |       | 185,371                                    |       | 141,335 |   | 108,037 |   | 67,686 |   | 62,522 |   |
| Cost of revenue:                                                  |       |                                       |       |   |   |   |   |   |   |   |   |
| Product                                                           |       | 19,057                                     |       | 13,784 |   | 11,580 |   | 1,132 |   | 602 |   |
| Services                                                          |       | 42,204                                     |       | 32,594 |   | 24,278 |   | 12,286 |   | 10,448 |   |
| Total cost of revenue                                             |       | 61,261                                     |       | 46,378 |   | 35,858 |   | 13,418 |   | 11,050 |   |
| Gross profit                                                      |       | 124,110                                    |       | 94,957 |   | 72,179 |   | 54,268 |   | 51,472 |   |
| Operating expenses:                                               |       |                                       |       |   |   |   |   |   |   |   |   |
| Selling, general and  administrative                              |       | 85,718                                     |       | 65,051 |   | 60,003 |   | 40,439 |   | 40,968 |   |
| Research and development                                          |       | 26,706                                     |       | 20,856 |   | 18,036 |   | 15,090 |   | 13,611 |   |
| Merger-related and  integration costs                             |       | 4,224                                      |       | 498 |   | 7,865 |   | — |   | — |   |
| Acquired in-process  research and development and related charges |       | 9,000                                      |       | — |   | 7,840 |   | — |   | 4,823 |   |
| Operating (loss) income                                           |       | (1,538                                     | )          | 8,552 |   | (21,565 | ) | (1,261 | ) | (7,930 | ) |
| Interest and other  income, net                                   |       | 963                                        |       | 1,206 |   | 1,303 |   | 1,570 |   | 2,866 |   |
| (Loss) income before  provision for income taxes                  |       | (575                                       | )          | 9,758 |   | (20,262 | ) | 309 |   | (5,064 | ) |
| Provision for income  taxes                                       |       | 2,688                                      |       | 312 |   | 307 |   | 261 |   | 116 |   |
| Net (loss) income                                                 |       | $                                          | (3,263     | ) | $ | 9,446 |   | $ | (20,569 | ) | $ | 48 |   | $ | (5,180 | ) |
| Net (loss) income per share:                                      |       |                                       |       |   |   |   |   |   |   |   |   |
| Basic                                                             |       | $                                          | (0.12      | ) | $ | 0.40 |   | $ | (0.94 | ) | $ | 0.00 |   | $ | (0.23 | ) |
| Net (loss) income per share:                                      |       |                                       |       |   |   |   |   |   |   |   |   |
| Diluted                                                           |       | $                                          | (0.12      | ) | $ | 0.36 |   | $ | (0.94 | ) | $ | 0.00 |   | $ | (0.23 | ) |
| Weighted-average common shares outstanding:                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Basic                                                             |       | 27,419                                     |       | 23,361 |   | 21,991 |   | 22,626 |   | 22,258 |   |
| Diluted                                                           |       | 27,419                                     |       | 26,084 |   | 21,991 |   | 23,524 |   | 22,258 |   |
| **Balance Sheet Data:**                                           |       |                                       |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents                                        |       | $                                          | 111,751    |   | $ | 42,641 |   | $ | 21,517 |   | $ | 30,089 |   | $ | 9,297 |   |
| Working capital                                                   |       | 124,801                                    |       | 60,114 |   | 28,697 |   | 59,435 |   | 55,953 |   |
| Total assets                                                      |       | 261,586                                    |       | 124,499 |   | 104,035 |   | 87,141 |   | 84,166 |   |
| Total stockholders’ equity                                   |       | 206,970                                    |       | 74,374 |   | 49,995 |   | 65,074 |   | 66,054 |   |

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(a)    We commenced the consolidation of Blue Pumpkin Software, Inc.and Optimis Group limited on January 25, 2005 and May 24, 2005,respectively.

(b)   We commenced the consolidation of Eyretel plc on March 22,2003.

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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 the Company’spast performance, its financial condition and its prospects and should be readin conjunction with the Consolidated Financial Statements and Notes theretoincluded elsewhere in this report. Investors should carefully review theinformation contained in this report under Item1A “Risk Factors” beginning on page 7.****The following will be discussed and analyzed:

·       Overview

·       CriticalAccounting Policies and Estimates

·       Resultsof Operations

·       Liquidity and CapitalResources

**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 the performanceof their customer service representatives, or “CSR”s, wherever they may belocated in the enterprise. Our high-volume compliance applications are designedto record 100% 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 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 

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companies who recommendour products during client engagements. Through OEM agreements, we co-developproducts, which are sold by the OEM as part of their portfolio of products.

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 and 2003, approximately 41%, 32% and 31%, respectively**,**of our license revenue has been derived from the indirectsales 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 extended our workforce optimization solution toinclude advanced workforce management software and services solutions includingforecasting, scheduling, adherence and planning applications. Pursuant to theAcquisition Agreement and Plan of Reorganization, dated December 16, 2004(the “Acquisition Agreement”), we paid $40 million in cash which was fundedfrom our existing cash and investments and issued 2.1 million shares of Witness’common stock valued at $37.2 million (measured at 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. Approximately ten percent of the aggregate acquisitionconsideration was placed into escrow to compensate Witness, subject to certainlimitations, for potential losses that could result from, among other things,the IEX litigation and other specified litigations and breaches of Blue Pumpkin’srepresentations, warranties or covenants in the purchase agreement. BluePumpkin has tentatively reached a settlement in the litigation with IEX, and inpartial satisfaction of the potential losses expected to result from thesettlement and other claims that Witness has made against the escrow fund, theescrow fund is expected to be released to Witness. See Note 5 of theConsolidated Financial Statement 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 

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escrow fund within suchperiod. The escrow fund is available to compensate Witness, subject to certainlimitations, for losses resulting from, among other things, breaches ofrepresentations, warranties or covenants in the purchase agreement and certainpending and potential claims. In 2005, the Compensation Committee of ourBoard of Directors approved stock option awards for approximately 650,000shares of Witness common stock to certain Blue Pumpkin and Optimis employees asan inducement to join Witness. These inducement options have an exercise priceequal to the market value on the date of the grant, subject to standardprovisions for termination, forfeiture and acceleration, and are exercisablefor five years from the date of grant. The inducement options will first becomeexercisable, as to 25 percent of the total amount, after one year from thedate of grant, and commencing 13 months after grant and until the end ofthe 47th month following grant, the options will become exercisable as to an additionaltwo percent per month and the balance upon the 48th month following grant.

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

**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 financialstatements requires us to make certain estimates and judgments that affect ourreported assets, liabilities, revenue and expenses, and our related disclosureof contingent assets and liabilities. On an on-going basis, we re-evaluate ourestimates, accounting policies and judgments including those related to revenuerecognition, the collectibility of receivables, accounting for acquisitions,impairment of long-lived assets, income taxes and stock-based compensation toensure that our financial statements are presented fairly and in accordancewith Generally Accepted Accounting Principles (“GAAP”). We base our estimateson historical experience and on various assumptions that we believe to bereasonable under the circumstances. However, because future events and theireffects cannot be determined with certainty, actual results may differ fromthese estimates under different assumptions or conditions and such differencescould be material. Management believes that the following accounting policiesand estimates are critical to understanding and evaluating our reportedfinancial results. Management has reviewed these critical accounting policiesand estimates with the Audit Committee of our Board of Directors.

*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*, Modificationof SOP 97-2, Software Revenue Recognition, With Respect to CertainTransactions*. Revenue is primarily derived from licensing softwareand providing related services including maintenance. We also derive arelatively small portion of product revenue by selling hardware to customerssince our acquisition of Eyretel. Product revenue, which includes software andhardware, is recognized when persuasive evidence of an arrangement exists,delivery of the product has occurred, the fee is fixed or determinable,collection is probable and vendor specific objective evidence of fair value (“VSOE”)exists to allocate revenue to the undelivered elements of the arrangement. Wereport hardware revenue gross in accordance with Emerging Issues Task Force (“EITF”)No. 99-19,*Reporting RevenueGross as a Principal versus Net as an Agent,* because the factorsindicating gross reporting outweigh the factors indicating net reporting. Werecognize revenue using the residual method of accounting since we generallyhave VSOE 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 its fair value until those elements are delivered. 

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Consequently, productrevenue for the software and hardware may be recognized (i) upon deliveryof those products when we have VSOE on 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 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 Standards 

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(“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 asset. If the carrying amount of an asset exceeds itsestimated future cash flows, an impairment charge is recognized in the amountby which the carrying amount of the asset exceeds the fair value of the asset.The determination of estimated future cash flows, however, requires managementto make estimates. Future events and changes in circumstances may require us torecord a significant impairment charge in the period in which such events orchanges occur. Impairment testing requires considerable analysis and judgmentin determining the results. If other assumptions and estimates were used in ourevaluations, 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 ofdeferred tax 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.**  *Wehave generally not recorded compensation expense for options granted to ouremployees because all options granted under our stock option plans have anexercise price equal to the market value of the underlying common stock on thedate of grant. 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 Opinion No. 25,*Accounting for Stock Issued to Employees,*and have adopted the disclosure requirements of SFAS No. 123. The proforma disclosures of stock-based compensation include the use of certain inputfactors in calculating the fair value of stock option grants, some of whichrequire management to make estimates and use judgment

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 123R(Revised 2004),*Share-Based Payment*which, among other things, requires that compensation expense be recognized inthe financial statements for share-based awards based on the grant date fairvalue of those 

29

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awards. Itwill also require the benefits associated with tax deductions in excess ofrecognized compensation cost to be reported as a financing cash flow ratherthan as an operating cash flow as currently required. The share-basedcompensation cost will be measured based on the fair value of the equity orliability instruments issued. Effective January 1, 2006, we expect toadopt SFAS 123R using the modified prospective method. We are evaluating therequirements under SFAS 123R and expect the adoption to have a significantadverse impact on our results of operations, but not on our cash flows

**Results of Operations**

Thetable below shows operating data as a percentage of total revenue for theperiods indicated:

| ** **                                      | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                      | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| 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         |   |   |   | 46 |   |   |   | 56 |   |   |
| Research and development                        |       |                                       | 15         |   |   |   | 15 |   |   |   | 17 |   |   |
| Merger-related and integration costs            |       |                                       | 2          |   |   |   | 0 |   |   |   | 7 |   |   |
| Acquired in-process research and development    |       |                                       | 5          |   |   |   | 0 |   |   |   | 7 |   |   |
| Operating (loss) income                         |       |                                       | (1         | ) |   |   | 6 |   |   |   | (20 | ) |   |
| Interest and  other income, net                 |       |                                       | 1          |   |   |   | 1 |   |   |   | 1 |   |   |
| (Loss) income before provision for income taxes |       |                                       | 0          |   |   |   | 7 |   |   |   | (19 | ) |   |
| Provision for  income taxes                     |       |                                       | 2          |   |   |   | 0 |   |   |   | 0 |   |   |
| Net (loss) income                               |       |                                       | (2         | ) |   |   | 7 |   |   |   | (19 | ) |   |

 

*Impact of BluePumpkin and Optimis Acquisitions*

The acquisition of BluePumpkin and Optimis in 2005 increased our reported revenues in 2005 by anestimated $25 million compared to the same period in 2004. Operating expenses,expressed as a percentage of total revenue, also increased in 2005 compared tothe same period in 2004 due to a charge of $9.0 million in acquired in-processresearch and development costs, an increase of $3.7 million inmerger-related and integration costs and additional intangible assetamortization of $ 9.3 million.

***Revenue***

Total revenue increased by 31% to $185.4 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.

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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 expecthardware revenue to decline in the future. Product revenue, excluding hardwarerevenue of $5.7 million in 2005, $7.6 million in 2004 and$6.3 million in 2003, increased 37% and 25% in 2005 and 2004,respectively, compared to prior years. The increase in software revenue growthin 2005 is attributed to our expanded product line resulting from ouracquisitions of Blue Pumpkin and Optimis which are included in our resultseffective January 25, 2005 and May 24, 2005, respectively.

Product revenue as a percentage of total revenue hasdecreased slightly over the past three years due to lower hardware sales andincreased services revenue, as discussed below. Our product pricing hasremained relatively consistent over the past three years. The percentage ofproduct revenue, excluding hardware revenue, derived from our indirect saleschannel increased to 41% in 2005 from 32% in 2004 and 31% in 2003. Thisincrease results 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 andreimbursable travel expenses, increased 33% to $111.2 million in 2005compared to 2004 and 35% to $83.7 million in 2004 compared to 2003. Theincreases were due to installation and training services related to new productsales and due to customers renewing their maintenance contracts with us therebyincreasing our recurring maintenance revenue stream. The percentage of Witnesscustomers that have renewed their maintenance contracts with us hashistorically exceeded 90%. We believe that maintenance contracts will berenewed at a comparable rate during 2006. Our services pricing has remainedconsistent over 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 in 2006.

***Costof Revenue***

Total cost of revenue increased 32% to$61.3 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 the acquisitionof Blue Pumpkin. Cost of hardware revenue was $5.8 million $7.3 millionand $5.7 million in 2005, 2004 and 2003, respectively. 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 24% in 2005 compared to 2004 and 12% in 2004 compared to 2003.The increase in 2005 was primarily due to increased royalties due to thirdparties for software included in our product offerings. Expressed as apercentage of product revenue, excluding 

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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 revenuefor installation, training, consulting and maintenance services includepersonnel costs and related expenses and allocated overhead. Personnel costsinclude salaries, bonuses and benefits. Cost of services revenue increased 29%to $42.2 million in 2005 compared to 2004 due primarily to an increase inthe number of employees and contractors engaged in customer support servicesmainly as a result of the Blue Pumpkin and Optimis acquisitions. Cost ofservices revenue increased 34% to $32.6 million in 2004 compared to 2003primarily due to an increase in the number of employees engaged ininstallation, training, consulting, and customer support services primarily dueto 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 assets and provisions for bad debt expense.SG&A expense increased 32% to $85.7 million in 2005 compared to 2004due primarily to higher amortization expenses and the increased size of ourCompany due to acquisitions of Blue Pumpkin and Optimis. SG&A expenseincreased 8% to $65.1 million in 2004 compared to 2003. This increase wasdue to the increased size of our company after the Eyretel acquisition and dueto a full-year of amortization of intangible assets acquired in 2003. In 2006,we expect SG&A expense to increase in absolute dollars but decrease as apercentage of total revenue due to anticipated revenue growth as compared tothe 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 Pumpkin acquisition.R&D expenses increased 16% to $20.9 million in 2004 compared to 2003due to an increased number of contractors engaged in research and developmentactivities. We expect total R&D expense to increase in absolute dollars butdecrease as a percentage of total revenue during 2006 as compared to 2005.

*Merger-related**and IntegrationCosts.**   Weincurred merger-related and integration costs of $4.2 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. In March 2003,our Board of Directors agreed to pay a bonus of £1.0 million to our COO inconnection with the Eyretel acquisition and subsequent integration. In March 2004,£0.4 million of this bonus was paid and the remaining balance of£0.6 million was paid in March 2005.*

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*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 uponconsummation of the acquisition. The value of the IPR&D was determined 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.*

In 2003, we determined that$7.8 million of the purchase price of Eyretel represented acquiredin-process research and development (“IPR&D”) that had not yet reachedtechnological feasibility as defined by SFAS 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***

Interestand other income, net for year 2005, 2004 and 2003, respectively is as follows(in thousands)

| ** **                    | ** ** | **2005**         | ** ** | **2004**     | ** ** | **2003**         | ** ** |
|-------------------------------|------------|------------------|------------|--------------|------------|------------------|------------|
| Interest income               |       | $ 1,240     |       | $ 1,010 |       | $  780 |       |
| Foreign currency  (loss) gain |       | (173             | )          | 256          |       | 353              |       |
| Other (expense)  income       |       | (104             | )          | (60          | )          | 170              |       |
|                          |       | $  963 |       | $ 1,206 |       | $ 1,303     |       |

 

Interest and other income,net decreased 20% to $1.0 million in 2005 compared to 2004 due primarilyto a decreased interest income resulting from lower investment balances as aresult of the acquisitions of Blue Pumpkin and Optimis. Interest and otherincome, net decreased 7% to $1.2 million in 2004 compared to 2003 dueprimarily to decreased interest income resulting from lower yields and lowerinvestment balances as a result of the acquisition of Eyretel which was paidfor in cash. We expect that interest and other income, net will increase in2006 compared to 2005 due to higher cash and investment balances resulting fromour 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 provisions forfederal alternative minimum tax and foreign income tax in 2004 and provisionsfor foreign income tax in 2003, net of federal tax benefits. Of the $2.7million provision for the year ended December 31, 2005, $2.1 millionrelated to the utilization of a portion of the of deferred income taxassets, primarily net operating loss carry-forwards, acquired in the 2005 acquisitionof Blue Pumpkin. Because a full valuation allowance was recorded against theseassets, the benefit from the utilization of these deferred income tax assets in2005 was credited as a reduction to goodwill.

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The provision for incometaxes in 2005, 2004 and 2003 benefited from the utilization of net operatingloss carryforwards from prior years. We have net operating loss carryforwardsaggregating $82.2 million for U.S. income tax purposes and$37.7 million for foreign income tax purposes remaining as of December 31,2005. We expect that the provision for income taxes in 2006 will benefit fromthe utilization of these net operating loss carryforwards. However, theutilization of certain net operating loss carryforwards arising fromacquisitions will result in a reduction of the valuation allowance for deferredincome tax assets and goodwill or intangible assets and the recognition ofdeferred income tax expense.

**QuarterlyResults of Operations**

The following tablespresent unaudited quarterly statements of operations data for each of the lasteight quarters in the two-year period ended December 31, 2005, as well asthe percentage of total revenue represented by each item. The information hasbeen derived from our unaudited consolidated financial statements, which havebeen prepared on substantially the same basis as the audited consolidatedfinancial statements contained in this report. The unaudited consolidatedfinancial statements contain all adjustments, consisting only of normalrecurring adjustments that we consider to be necessary to present fairly thisinformation when read in conjunction with the Consolidated Financial Statementsand Notes thereto appearing elsewhere in this report. The results of operationsfor any quarter are not necessarily indicative of the results to be expectedfor 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)**          | ** **    |                     |
| 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 |   |   |

 

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| ** **                                        | ** ** | **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** | ** ** |
| ** **                                        | ** ** | **(as a percentage of total revenue)** | ** ** |
| 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 |   |   |   | 47 |   |   |
| Research and  development                         |       |                                                            | 13         |   |   |   | 15 |   |   |   | 15 |   |   |   | 15 |   |   |   | 14 |   |   |   | 16 |   |   |   | 15 |   |   |   | 15 |   |   |
| Merger-related and  integration costs             |       |                                                            | 1          |   |   |   | 2 |   |   |   | 2 |   |   |   | 4 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 1 |   |   |
| Acquired  in-process research and  development    |       |                                                            | 0          |   |   |   | 0 |   |   |   | 0 |   |   |   | 22 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Operating income  (loss)                          |       |                                                            | 9          |   |   |   | 5 |   |   |   | 2 |   |   |   | (23 | ) |   |   | 11 |   |   |   | 7 |   |   |   | 4 |   |   |   | 1 |   |   |
| Interest and other  income, net                   |       |                                                            | 1          |   |   |   | 1 |   |   |   | 0 |   |   |   | 0 |   |   |   | 1 |   |   |   | 1 |   |   |   | 0 |   |   |   | 0 |   |   |
| Income (loss)  before provision for  income taxes |       |                                                            | 10         |   |   |   | 6 |   |   |   | 2 |   |   |   | (23 | ) |   |   | 12 |   |   |   | 8 |   |   |   | 4 |   |   |   | 1 |   |   |
| Provision for  income taxes                       |       |                                                            | 0          |   |   |   | 4 |   |   |   | 1 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |
| Net income (loss)                                 |       |                                                            | 10         |   |   |   | 2 |   |   |   | 1 |   |   |   | (23 | ) |   |   | 12 |   |   |   | 8 |   |   |   | 4 |   |   |   | 1 |   |   |

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(a)              We commenced the consolidation of Blue PumpkinSoftware, Inc and Optimis on January 25, 2005 and May 23, 2005,respectively.

Theincrease in total revenue, beginning in the first and second quarters of 2005,reflects the consolidation of Blue Pumpkin and Optimis, which were acquired in January andMay 2005, respectively. Our second and fourth quarters generally have higherproduct revenue than the first and third quarters due to our customers’budgeting and spending patterns. Hardware sales included in product revenue in2005 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 |   |   |

 

Gross profit margins were negatively impacted in 2005due primarily to the increase in the merger-related and integration expense asa result of Blue Pumpkin and Optimis acquisitions. Total operatingexpenses, excluding merger-related costs and acquired IPR&D, decreased as apercentage of total revenue during 2005 and 2004 as revenue growth exceededcost increases. In 2005, we recorded $4.4 million of intangible assetsamortization expense associated with the Blue Pumpkin and Optimis acquisition.

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

35

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**Liquidity and Capital 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$64.7 million from $60.1 million at December 31, 2004 to$124.8 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 $4.3 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 salesoutstanding (“DSO”) at December 31, 2005 was 72 days, an increase of 6days from December 31, 2004. This increase in DSO and the decrease indeferred revenue of $4.1 million in 2005, was primarily due to timingdifferences in payments received from customers. We expect our DSO to remain inthe 70 day range and our deferred revenue balance to increase in 2006. Deferredrevenue decreased $4.1 million in 2005 as a result of year-end maintenancerenewal invoices outstanding.

Net cash flows used in investing activities increasedduring 2005 to $33.0 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 ($45.2 million or $41.5 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$4.3 million net of cash and cash equivalents acquired). In 2003, we used $10.0million in net cash flows in investing activities from 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.

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 atleast $5.5 million in capital expenditures in 2006 primarily for computerequipment and software. We believe that our capital expenditures may increaseover the next several years as we expand our facilities and acquire equipmentto support the expansion of our research and development activities andinternal management and information systems. We believe that our existing cashand investment balances, together with our anticipated cash flows fromoperations, will be sufficient to meet our working capital and capitalexpenditures for at least the next twelve months. In addition, theavailability under our line of credit may be used to fund working capitalrequirements or future merger or acquisition transactions.

36

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*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 foreign currenciescompared to the U.S. dollar, the translation of our subsidiaries cashdenominated 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 at December 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, Cummulative translation adjustment changesresulted in a decrease in stockholders’ equity of $1.9 million in 2005 andan increase of $1.0 million in 2004, respectively. Net foreign exchange (loss)gains reflected in our operating results were ($0.2) million,$0.3 million, and $0.4 million in 2005, 2004 and 2003, respectively.

Exposure to market raterisk for changes in interest rates relates to our investment portfolio and anypotential borrowing. Our investments are made with capital preservation andliquidity as our primary objectives. We generally hold only high-gradeinvestments such as commercial paper, corporate bonds, auction rate securitiesand U.S. government agency securities. To reduce our balance sheet exposure tovariations in asset values, our investment policy guidelines specify that weinvest in the highest investment grade securities and maintain a weightedaverage maturity of nine months or less for our entire portfolio. Ourinvestment portfolio may contain securities with maturities of up to threeyears. While this minimizes our interest rate risk to asset values, our resultsare exposed to fluctuations in interest income due to changes in market rates.

*ContractualObligations and Off Balance Sheet Arrangements*

As of December 31,2005, our contractual cash obligations associated with lease obligations,operational restructuring and merger-related costs are as follows (inthousands):

| ** **                   | ** ** | **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 |   |   |
|                              |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

**Item 7A.**                Qualitativeand Quantitative Disclosures About Market Risk

See Management’sDiscussion and Analysis of Financial Condition and Results of Operations, Item7 of Part II of this Report for a discussion of market risk.

**Item 8.**                        FinancialStatements and Supplementary Data

Our consolidated financialstatements, together with related notes and the reports of KPMG LLP, ourindependent registered public accounting firm, are set forth on the pages indicatedin Item 15.

37

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

None.

**Item 9A.     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 evaluation as of December 31, 2005, under the supervision and theparticipation of our management, including our chief executive officer and chieffinancial officer, of the design and operation of these disclosure controls andprocedures pursuant to Exchange Act Rule 13a-15(c). Based upon thatevaluation, our chief executive officer and chief financial officer concludedthat our disclosure controls and procedures were not effective due to amaterial weakness discussed in Management’s Report on Internal Control OverFinancial Reporting on page F-2 hereof.

*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 materialweakness referenced above:

·  Revise our policies and procedures related tothe capitalization and depreciation of property and equipment including theaddition of control procedures over the review of information input into ouraccounting system;

·  Revise our control procedures through theaddition of more effective controls to ensure the accrual of certain period-endoperating expenses; and

·  Implement formal policies, includingquantitative and qualitative analysis, over the documentation and evaluation ofunsubstantiated differences that individually or in the aggregate should be timelyrecorded.

*Management’s Report onInternal Control over Financial Reporting.**  *See Part IV, Item 15page F-2 for management’s report on internal control over financialreporting.

38

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**PART III**

Certain informationrequired by Part III is omitted from this Report in that the Company willfile a definitive proxy statement within 120 days after the end ofthis fiscal year pursuant to Regulation 14A (the “Proxy Statement”) forits 2006 Annual Meeting of Stockholders proposed to be held on May 18,2006, and the information included therein is incorporated herein by reference.

**Item 10.**                 Directorsand Executive Officers of Registrant

*Code of Ethics*

We have adopted a Code ofEthics within the meaning of Item 406(b) of Regulation S-K. ThisCode of Ethics applies to our principal executive officer, principal financialofficer and principal accounting officer. This Code of Ethics is publiclyavailable on our website at *http://www.witness.com*.If we make 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 fourbusiness days of 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 rules.

The other informationrequired by this Item is incorporated by reference from the ProxyStatement under the headings “Election of Directors” and “ExecutiveCompensation.”

**Item 11.**                 ExecutiveCompensation

The information requiredby this Item is incorporated by reference from the Proxy Statement underthe heading “Executive Compensation.”

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

The information requiredby this Item is incorporated by reference from the Proxy Statement underthe heading “Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters.”

**Item 13.**                 CertainRelationships and Related Transactions

The information requiredby this Item is incorporated by reference from the Proxy Statement underthe heading “Executive Compensation.”

**Item 14.**                 PrincipalAccountant Fees and Services

The information requiredby this Item is incorporated by reference from the Proxy Statement underthe heading “Audit Fees and Services.”

39

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**PART IV**

**Item 15.**                 Exhibitsand Financial Statement Schedules

a)                Thefollowing documents are filed as part of this report:

|        | ** ** | ** **                                                                                             | ** ** | **Page** | ** ** |
|--------|------------|--------------------------------------------------------------------------------------------------------|------------|----------|------------|
| 1.     |       | Financial  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                                                                           |       | F-6      |       |   |
|   |       | Consolidated Statements of Operations                                                                  |       | F-7      |       |   |
|   |       | Consolidated Statements of Stockholders’ Equity                                                   |       | F-8      |       |   |
|   |       | Consolidated Statements of Cash Flows                                                                  |       | F-9      |       |   |
|   |       | Notes to Consolidated Financial Statements                                                             |       | F-10     |       |   |
| 2.     |       | Financial  Statement Schedule                                                                          |       |     |       |   |
|   |       | Schedule  II—Valuation and Qualifying Accounts                                                    |       | F-36     |       |   |
| 3.     |       | Signatures                                                                                             |       | F-37     |       |   |

 

(c)           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                                                                                                                                                                                                                                                                                                           |
| 10.5(2)          |       | Amendment No. 1 to  the Company’s Amended and Restated Stock Incentive Plan                                                                                                                                                                                                                                                                               |

40

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| 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*    |   | Amendment No.1 to  the Witness Systems, Inc. Amended and restated Stock Incentive plan                                              |

41

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| 10.35* |   | Amended &  Restated Employee Stock Purchase Plan.                                                        |
|--------|--------|-------------------------------------------------------------------------------------------------------------------|
| 10.36* |   | Form of Inducement Grant for Contractors who  will become employee of Witness Systems Software India PVT Ltd |
| 21.1*  |   | List of subsidiaries                                                                                              |
| 23.1*  |   | Report of Independent  Registered Public Accounting Firm on Consolidated Financial Statement  Schedule            |
| 23.2*  |   | Consent of Independent  Registered Public Accounting Firm                                                         |
| 23.3*  |   | 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:

(c)           Exhibits

----

*                    Filedherewith

(1)          Incorporated byreference to exhibits previously filed with the Company’s RegistrationStatement on Form S-1 (File No. 333-91383)

(2)          Incorporated byreference to exhibits previously filed with the Company’s RegistrationStatement on Form S-8 (File No. 333-67416)

(3)          Incorporated byreference to exhibits previously filed with the Company’s Quarterly Report on Form 10-Qfor the period ended June 30, 2000

(4)          Incorporatedby reference to exhibits previously filed with the Company’s Annual Report on Form 10-Kfor the year ended December 31, 1999

(5)          Incorporatedby reference to exhibits previously filed with the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2000

(6)          Incorporatedby reference to exhibits previously filed with the Company’s Quarterly Reporton Form 10-Q for the period ended September 30, 2002

(7)*         *Incorporated by reference to exhibitspreviously filed with the Company’s Current Report on Form 8-K on November 4,2002

(8)*         *Incorporated by reference to exhibitspreviously filed with the Company’s Quarterly Report on Form 10-Qfor the period ended June 30, 2003

(9)*         *Incorporated by reference to exhibitspreviously filed with the Company’s Annual Report on Form 10-K forthe year ended December 31, 2003

(10)*  *Incorporated by reference to exhibits previouslyfiled with the Company’s Quarterly Report on Form 10-Q for theperiod ended March 31, 2004

(11)*  *Incorporated by reference to exhibits previouslyfiled with the Company’s Quarterly Report on Form 10-Q for theperiod ended September 30, 2004

(12)*  *Incorporated by reference to exhibits previouslyfiled with the Company’s Current Report on Form 8-K on January 27,2005

(13)*  *Incorporated by reference to exhibits previouslyfiled with the Company’s Annual Report on Form 10-K for the yearended December 31, 2004

(14)*  *Incorporated by reference to exhibits previouslyfiled with the Company’s Quarterly Report on Form 10-Q for the periodended March 31, 2005

(15)*  *Incorporated by reference to exhibits previouslyfiled with the Company’s Quarterly Report on Form 10-Q for the periodended June 30, 2005

42

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIESIndex to ConsolidatedFinancial Statements**
|                                                                                                                                                        | ** ** | **Page** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| 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                                                                                     |       | F-6      |       |
| Consolidated Statements of Operations for the years  ended December 31, 2005, 2004, and 2003                                                      |       | F-7      |       |
| Consolidated  Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the  years ended December 31, 2005, 2004, and 2003 |       | F-8      |       |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2005, 2004,  and 2003                                                     |       | F-9      |       |
| Notes  to Consolidated Financial Statements                                                                                                            |       | F-10     |       |
| Schedule II—Valuation and Qualifying Accounts                                                                                                     |       | F-36     |       |
| Signatures                                                                                                                                             |       | F-37     |       |

 

F-1

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**Management’s Report on Internal Control Over FinancialReporting**

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 Actof 1934. The Company maintains accounting and internal control systems whichare intended to provide reasonable assurance that assets are safeguardedagainst loss 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 todesign into 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 weakness:

Our policies and procedures over account reconciliationsand management’s review of estimates and account balances were not designed toa sufficient level of precision to prevent or detect misstatements that couldhave a material effect on the consolidated financial statements. As a result,there were errors to the consolidated financial statements that were notidentified or recorded by management. This deficiency resulted in more than aremote likelihood that a material misstatement to the consolidated financialstatements would not be prevented or detected.

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.March 16, 2006

F-2

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**Reportof Independent Registered Public Accounting Firmon Internal Control Over Financial Reporting**

The Board of DirectorsWitness Systems, Inc.:

We have audited management’s assessment, included inthe accompanying Management’s Reporton Internal Control over Financial Reporting (page F-2),**that Witness Systems, Inc.did not maintain effective internal control over financial reporting as ofDecember 31, 2005, because of the effect of the material weaknessidentified in management’s assessment and described below, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO)*.*WitnessSystems, Inc.’s management is responsible for maintaining effectiveinternal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and an opinion on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures 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 reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or 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.

A material weakness is a control deficiency, orcombination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. The following material weaknesshas been identified and included in management’s assessment:

The Company’s policies and procedures over accountreconciliations and management’s reviews of estimates and account balances werenot 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 were errors to the consolidated financialstatements that were not identified or recorded by management. This deficiencyresulted in more than a remote likelihood that a material misstatement to theconsolidated financial statements would not be prevented or detected.

F-3

----

We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theconsolidated balance sheet of Witness Systems, Inc. and subsidiaries as ofDecember 31, 2005, and the related consolidated statement of operations,stockholders’ equity and comprehensive income (loss), and cash flows for theyear ended December 31, 2005. This material weakness was 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, which expressed an unqualified opinion on those consolidated financial statements.

In our opinion,management’s assessment that Witness Systems, Inc. did not maintaineffective internal control over financial reporting as of December 31,2005, is fairly stated, in all material respects, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO)*.*Also,in our opinion, because of the effect of the material weakness described aboveon the achievement of the objectives of the control criteria, WitnessSystems, Inc. has not maintained effective internal control over financialreporting as of December 31, 2005, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO)*.*

| Atlanta, Georgia    |
|---------------------|
| March 16, 2006 |

 

F-4

----

**Reportof Independent Registered Public Accounting Firm on Consolidated FinancialStatements**

The Board of DirectorsWitness Systems, Inc.:

We have audited the accompanying consolidated balancesheets of Witness Systems, Inc. and subsidiaries as of December 31,2005 and 2004, and the related consolidated statements of operations,stockholders’ equity and comprehensive income (loss), and cash flows for eachof the years in the three-year period ended December 31, 2005. Theseconsolidated financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Witness Systems, Inc. and subsidiaries as of December 31,2005 and 2004, and the results of their operations and their cash flows foreach of the years in the three-year period ended December 31, 2005, inconformity with U.S. generally accepted accounting principles.

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of WitnessSystems, Inc.’s internal control over financial reporting as of December 31,2005, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO), and our report dated March 16, 2006 expressed an unqualifiedopinion on management’s assessment of, and an adverse opinion on the effectiveoperation of, internal control over financial reporting.
| /s/ KPMG LLP         |
|----------------------|
| Atlanta, Georgia     |
| March 16,  2006 |

 

F-5

----

**WITNESS SYSTEMS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(In thousands, except share data)**

| ** **                                                                                                                                                                                            | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                                                            |       |                  |       |   |   |
| Current assets:                                                                                                                                                                                       |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                             |       | $                     | 111,751    |   | $ | 42,641 |   |
| Investments                                                                                                                                                                                           |       | 14,886                |       | 33,842 |   |
| 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                                                                                                                                                                                  |       | 172,317               |       | 106,282 |   |
| Intangible  assets, net                                                                                                                                                                               |       | 36,389                |       | 10,802 |   |
| Goodwill                                                                                                                                                                                              |       | 40,697                |       | — |   |
| Property and  equipment, net                                                                                                                                                                          |       | 7,796                 |       | 6,197 |   |
| Other assets                                                                                                                                                                                          |       | 4,387                 |       | 1,218 |   |
|                                                                                                                                                                                                  |       | $                     | 261,586    |   | $ | 124,499 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                                                  |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                      |       | $                     | 3,795      |   | $ | 4,454 |   |
| Accrued expenses                                                                                                                                                                                      |       | 21,891                |       | 16,308 |   |
| Deferred revenue                                                                                                                                                                                      |       | 23,778                |       | 25,406 |   |
| Total current liabilities                                                                                                                                                                             |       | 49,464                |       | 46,168 |   |
| Other long-term  liabilities                                                                                                                                                                          |       | 4,409                 |       | 3,703 |   |
| Deferred income  tax liabilities                                                                                                                                                                      |       | 743                   |       | 254 |   |
| Total liabilities                                                                                                                                                                                     |       | 54,616                |       | 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; 32,822,193 and 24,476,289 shares issued and outstanding at  December 31, 2005 and 2004, respectively                                |       | 328                   |       | 245 |   |
| Additional paid-in capital                                                                                                                                                                            |       | 245,889               |       | 108,247 |   |
| Accumulated deficit                                                                                                                                                                                   |       | (42,323               | )          | (39,060 | ) |
| Accumulated other comprehensive income                                                                                                                                                                |       | 3,076                 |       | 4,942 |   |
| Total stockholders’ equity                                                                                                                                                                       |       | 206,970               |       | 74,374 |   |
|                                                                                                                                                                                                  |       | $                     | 261,586    |   | $ | 124,499 |   |

 

See accompanying notes to consolidated financial statements.

F-6

----

**WITNESS SYSTEMS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTSOF OPERATIONS(In thousands, except per share data)**

| ** **                                      | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:                                        |       |                                        |       |   |   |   |   |
| Product                                         |       | $                                           | 74,186     |   | $ | 57,620 |   | $ | 46,238 |   |
| Services                                        |       | 111,185                                     |       | 83,715 |   | 61,799 |   |
| Total revenue                                   |       | 185,371                                     |       | 141,335 |   | 108,037 |   |
| Cost of revenue:                                |       |                                        |       |   |   |   |   |
| Product                                         |       | 19,057                                      |       | 13,784 |   | 11,580 |   |
| Services                                        |       | 42,204                                      |       | 32,594 |   | 24,278 |   |
| Total cost of revenue                           |       | 61,261                                      |       | 46,378 |   | 35,858 |   |
| Gross profit                                    |       | 124,110                                     |       | 94,957 |   | 72,179 |   |
| Operating expenses:                             |       |                                        |       |   |   |   |   |
| Selling, general and administrative             |       | 85,718                                      |       | 65,051 |   | 60,003 |   |
| Research and development                        |       | 26,706                                      |       | 20,856 |   | 18,036 |   |
| Merger-related and integration costs            |       | 4,224                                       |       | 498 |   | 7,865 |   |
| Acquired in-process research and development    |       | 9,000                                       |       | — |   | 7,840 |   |
| Operating (loss) income                         |       | (1,538                                      | )          | 8,552 |   | (21,565 | ) |
| Interest and  other income, net                 |       | 963                                         |       | 1,206 |   | 1,303 |   |
| (Loss) income before provision for income taxes |       | (575                                        | )          | 9,758 |   | (20,262 | ) |
| Provision for  income taxes                     |       | 2,688                                       |       | 312 |   | 307 |   |
| Net (loss) income                               |       | $                                           | (3,263     | ) | $ | 9,446 |   | $ | (20,569 | ) |
| Net (loss) income per  share:                   |       |                                        |       |   |   |   |   |
| Basic                                           |       | $                                           | (0.12      | ) | $ | 0.40 |   | $ | (0.94 | ) |
| Diluted                                         |       | $                                           | (0.12      | ) | $ | 0.36 |   | $ | (0.94 | ) |
| Weighted-average common  shares outstanding:    |       |                                        |       |   |   |   |   |
| Basic                                           |       | 27,419                                      |       | 23,361 |   | 21,991 |   |
| Diluted                                         |       | 27,419                                      |       | 26,084 |   | 21,991 |   |

 

See accompanying notes to consolidated financial statements.

F-7

----

**WITNESS SYSTEMS, INC.AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY ANDCOMPREHENSIVE INCOME (LOSS)**

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

**(In thousands)**

| ** **                                                               | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated** | ** ** | **Notes  Receivable** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Total  Stockholders’** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|-----------------|------------|-----------------------|------------|-----------------------------------------------|------------|-------------------------------|------------|
| ** **                                                               | ** ** | **Number**            | ** ** | **Amount**              | ** ** | **Capital**     | ** ** | **Deficit**           | ** ** | **for Stock**                            | ** ** | **(loss)**                    | ** ** | **Equity** | ** ** |
| Balance at  December 31, 2002                                       |       |                  | 22,036     |                    |       |            | 220        |                  |       |                                          | $          | 94,260                        |       |   |   | $ | (27,937 | ) |   |   | $ | (1,470 | ) |   |   | $ | 1 |   |   |   | $ | 65,074 |   |   |
| Exercise of stock  options and warrants                                  |       |                  | 285        |                    |       |            | 3          |                  |       |                                          | 1,102      |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,105 |   |   |
| 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 | ) |   |
| 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                                                                 |       |                  | —     |                    |       |            | —     |                  |       |                                          | —     |                          |       |   | (20,569 | ) |   |   | — |   |   |   |   |   |   |   | (20,569 | ) |   |
| Total  comprehensive loss                                                |       |                  |       |                    |       |            |       |                  |       |                                          |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   | (16,584 | ) |   |
| Balance at  December 31, 2003                                       |       |                  | 22,170     |                    |       |            | 222        |                  |       |                                          | 94,293     |                          |       |   | (48,506 |   |   |   |   |   |   |   | 3,986 |   |   |   | 49,995 |   |   |
| Exercise of stock  options                                               |       |                  | 2,224      |                    |       |            | 22         |                  |       |                                          | 13,052     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 13,074 |   |   |
| Tax benefit on  exercised stock options                                  |       |                  | —     |                    |       |            | —     |                  |       |                                          | 214        |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 214 |   |   |
| Shares issued  under employee stockpurchase plan                         |       |                  | 82         |                    |       |            | 1          |                  |       |                                          | 688        |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 689 |   |   |
| Comprehensive income:                                                    |       |                  |       |                    |       |            |       |                  |       |                                          |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Change in  cumulative foreign currency translation adjustment       |       |                  | —     |                    |       |            | —     |                  |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | 959 |   |   |   | 959 |   |   |
| Change in unrealized  gains (losses) on investments, net                 |       |                  | —     |                    |       |            | —     |                  |       |                                          | —     |                          |       |   | — |   |   |   | — |   |   |   | (3 | ) |   |   | (3 | ) |   |
| Net Income                                                               |       |                  | —     |                    |       |            | —     |                  |       |                                          | —     |                          |       |   | 9,446 |   |   |   | — |   |   |   | — |   |   |   | 9,446 |   |   |
| Total  comprehensive income                                              |       |                  |       |                    |       |            |       |                  |       |                                          |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 10,402 |   |   |
| Balance at  December 31, 2004                                       |       |                  | 24,476     |                    |       |            | 245        |                  |       |                                          | 108,247    |                          |       |   | (39,060 | ) |   |   | — |   |   |   | 4,942 |   |   |   | 74,374 |   |   |
| Exercise of stock  options                                               |       |                  | 1,462      |                    |       |            | 14         |                  |       |                                          | 10,493     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 10,507 |   |   |
| Tax benefit on  exercised stock options                                  |       |                  | —     |                    |       |            | —     |                  |       |                                          | 217        |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 217 |   |   |
| Shares issued  under employee stock purchase plan                   |       |                  | 69         |                    |       |            | 1          |                  |       |                                          | 1,034      |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,035 |   |   |
| Stock issuance—Blue  Pumpkin                                        |       |                  | 2,100      |                    |       |            | 21         |                  |       |                                          | 37,212     |                          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 37,233 |   |   |
| Secondary stock  offering                                                |       |                  | 4,715      |                    |       |            | 47         |                  |       |                                          | 88,686     |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   | 88,733 |   |   |
| 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                                                                 |       |                  | —     |                    |       |            | —     |                  |       |                                          | —     |                          |       |   | (3,263 | )) |   |   | — |   |   |   | — |   |   |   | (3,263 | ) |   |
| Total  comprehensive loss                                                |       |                  |       |                    |       |            |       |                  |       |                                          |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   | (5,129 | ) |   |
| Balance at  December 31, 2005                                       |       |                  | 32,822     |                    |       |            | $          | 328                   |       |                                          |       | $                             | 245,889    |   |   |   | $ | (42,323 | )) |   |   | $ | — |   |   |   | $ | 3,076 |   |   |   | $ | 206,970 |   |   |
|                                                                          |            |                       |            |                         |            |                 |            |                       |            |                                               |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to consolidated financial statements.

F-8

----

**WITNESS SYSTEMS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTSOF CASH FLOWS(In thousands)**

| ** **                                                                                          | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Cash  flows from operating activities:                                                              |       |                                        |       |   |   |   |   |
| Net (loss) income                                                                                   |       | $                                           | (3,263     | ) | $ | 9,446 |   | $ | (20,569 | ) |
| 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                                                                               |       | 1,940                                       |       | — |   | — |   |
| Other non-cash items, net                                                                           |       | 279                                         |       | 901 |   | 275 |   |
| Changes in operating assets and liabilities:                                                        |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                                 |       | (14,281                                     | )          | 5,068 |   | (7,212 | ) |
| Prepaid and other assets                                                                            |       | 697                                         |       | (3,043 | ) | 3,146 |   |
| Accounts payable                                                                                    |       | (2,613                                      | )          | (92 | ) | (2,875 | ) |
| Accrued expenses                                                                                    |       | (1,388                                      | )          | 626 |   | (1,217 | ) |
| Deferred revenue                                                                                    |       | (4,110                                      | )          | 3,978 |   | 5,295 |   |
| Accrued restructuring and  integration costs                                                        |       | (2,815                                      | )          | (5,085 | ) | (1,511 | ) |
| Net cash provided by (used  in) operating activities                                                |       | 6,265                                       |       | 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 $3,728                          |       | (41,477                                     | )          | — |   | — |   |
| Acquisition of Optimis  Group Ltd, net of cash acquired of $1,287                                   |       | (4,321                                      | )          | — |   | — |   |
| Purchase of other business  assets                                                                  |       | (2,514                                      | )          | — |   | (2,385 | ) |
| Net cash used in investing  activities                                                              |       | (34,986                                     | )          | (18,340 | ) | (9,974 | ) |
| Cash  flows from financing activities:                                                              |       |                                        |       |   |   |   |   |
| Proceeds from exercise of  stock options                                                            |       | 10,450                                      |       | 12,614 |   | 1,018 |   |
| Proceeds from employee  stock purchase plan                                                         |       | 978                                         |       | 689 |   | 559 |   |
| Proceeds from secondary  offering, net                                                              |       | 88,848                                      |       | — |   | — |   |
| Repayments of notes  receivable from stockholders                                                   |       | —                                      |       | — |   | 484 |   |
| Stock repurchases                                                                                   |       | —                                      |       | — |   | (734 | ) |
| Other                                                                                               |       | (165                                        | )          | — |   | — |   |
| 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                                       |       | $                                           | —     |   | $ | — |   | $ | 985 |   |

 

See accompanying notes to consolidated financial statements.

F-9

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED 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 100% of the voiceconversations between CSRs and customers for purposes such as compliancerecording and sales verification. Our workforce management products enable ourcustomers to develop strategic staffing plans, deploy skilled resources andevaluate productivity of CSRs. Our performance management applications providecomprehensive analytics, including performance scorecards, and reports ofcustomer interaction and CSR performance. Our e-learning applications deliverongoing training tailored to CSR needs and competencies. We also provideconsulting and implementation services, training and support to customers thatuse 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***consolidated financial statements include the financial statements ofWitness Systems, Inc. and its wholly-owned subsidiaries. All significantintercompany balances and transactions have been eliminated in consolidation.Certain prior year amounts have been reclassified to conform to the currentyear presentation.

***Use of Estimates—******The***consolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States. The preparationof these financial statements requires us to make certain estimates andjudgments that affect our reported assets, liabilities, revenues and expenses,and our related disclosure of contingent assets and liabilities. We base ourestimates on historical experience and on various assumptions that we believeto be reasonable under the circumstances. Actual results may differ from theseestimates 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 is writtendown to fair value as a new cost basis resulting in a realized loss. Realizedgains and losses from sales are based on the specific identification method.Our investments are presented as current assets as they represent theinvestment of cash available to be used in current operations within the nextyear.

F-10

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

***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 appropriatereserves have been established, we cannot assure that we will continue toexperience the same credit loss rates that we have experienced in the past oradequately predict future credit losses. If the financial condition of ourcustomers were to deteriorate and resulted in an impairment of their ability tomake payments, additional allowances may be required which would result inadditional selling, general and administrative expense in the period suchdetermination is made.

***Property and Equipment—******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 $3.9 million**,** $3.2 millionand $3.8 million in 2005, 2004 and 2003, respectively.

***Long-Lived Assets—******As*****required by Statement of Financial Accounting Standards (“SFAS”)no. 144*, Accounting for Impairment orDisposal of Long-lived Assets*, long-lived assets are reviewed forimpairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable. Recoverability of assets tobe held and used would be measured by a comparison of the carrying amount of anasset to the estimated undiscounted future cash flows expected to be generatedby the asset. If the carrying amount of an asset exceeds its 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 Statement of Financial AccountingStandards (‘SFAS”) No.142, *Goodwill andintangible assets*. This statement requires that goodwill andintangible assets with indefinite lives should not be amortized, but 

F-11

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

should be tested forimpairment on an annual basis, or more often if an event occurs orcircumstances change that would more likely than not reduce the fair value of areporting unit below its carrying amount.

***Revenue Recognitionand Deferred Revenue—******We***recognizerevenue in accordance with the American Institute of Certified PublicAccountants’ Statement of Position (“SOP”) 97-2, *Software Revenue Recognition*, 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, *Reporting Revenue Gross as a Principal versus Net as an Agent,*because the factors indicating gross reporting outweigh the factors indicatingnet reporting. We recognize revenue using the residual method of accountingwhen customer orders contain multiple element arrangements, including the saleof licensed software, hardware, maintenance, and professional services. Wegenerally have VSOE for maintenance and professional services, but not for thesoftware and hardware elements of the order. Under the residual method,services revenue, including maintenance and professional services, is deferredat an amount equal to VSOE until those elements are delivered. Consequently,product revenue for the software and hardware may be recognized (i) upondelivery of those products when we have VSOE for the related maintenance andprofessional services sold and (ii) at an amount representing thedifference between the 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 of amounts collected fromcustomers for products and services that have not met the criteria for revenuerecognition.

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

F-12

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 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 the Financial Accounting Standards Board’s (“FASB”) Statement of FinancialAccounting Standards (“SFAS”) No. 86, *Accountingfor the Costs 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 current and future productrevenue. At each balance sheet date, the unamortized software development costsare compared to the net realizable value of the underlying product and to theextent any unamortized capitalized costs exceed the net realizable value of theasset, those costs are written off. As of December 31, 2005, and 2004,unamortized software development costs were $1.2 million and $0.4 million,respectively, and are included in other assets on the accompanying consolidatedbalance sheets. During 2005 and 2004, $0.5 million and $0.4 million insoftware development costs were amortized to cost of product revenue. We didnot have any software development cost amortization 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$3.3 million and 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, training personnelon products acquired, establishing the infrastructure and consolidating theoperations of the acquired company. Merger-related costs also include costsrelated to Witness lease terminations and severance associated with Witnessemployee terminations resulting from closures and terminations during themerger integration process. We account for merger-related costs in accordancewith SFAS No. 146, *Accounting for CostsAssociated with Exit or Disposal Activities*, which requires that aliability for a cost associated with an exit or disposal activity only berecognized when the liability is incurred.

In accounting for acquisitions, we accrue for certainloss contingencies that exist at the date of acquisition. We reduce suchliabilities as those contingencies are resolved or if we determine that thecontingency no longer represents a probable loss. Any adjustments to theseliabilities are reflected as adjustments to goodwill and/or other acquiredassets to the extent information was requested but not received at the date ofacquisition. Other adjustments are reflected in our results of operations,except as prescribed by Emerging Issues Task Force (“EITF”) No. 95-3,*Recognition of Liabilities in Connectionwith a Purchase Business Combination*.

***Stock-BasedCompensation.****  *Wegenerally do not record compensation expense for options granted to ouremployees because all options granted under our stock option plans have anexercise price equal to the market value of the underlying common stock on thedate of grant. As permitted under SFAS No. 148,*Accounting for Stock-Based Compensation—Transition and Disclosure*,and SFAS No. 123,*Accounting for*

F-13

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

*Stock-BasedCompensation*, we have elected to continue to apply theprovisions of Accounting Principles Board Opinion No. 25,*Accounting for Stock Issued to Employees,*and have adopted the disclosure requirements of SFAS No. 123. The proforma disclosures of stock-based compensation include the use of certain inputfactors in calculating the fair value of stock option grants, some of whichrequire management to make estimates and use judgment. See “Recent AccountingPronouncement” below for further discussion on our adoption of SFAS No.123R

Thefollowing table illustrates the effect on net (loss) income and net (loss)income per share if we had applied the fair value method as prescribed by SFAS No. 123(in thousands, except per share data):

| ** **                                                                                               | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Reported net  (loss) income                                                                              |       | $                                          | (3,263     | ) | $ | 9,446 |   | $ | (20,569 | ) |
| Add: Stock-based  employee compensation expense included in reported net (loss) income, net of  tax      |       | 59                                         |       | 59 |   | 129 |   |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards |       | (13,097                                    | )          | (8,444 | ) | (7,893 | ) |
| Pro forma net (loss) income                                                                              |       | $                                          | (16,301    | ) | $ | 1,061 |   | $ | (28,333 | ) |
| Net (loss) income per share:                                                                             |       |                                       |       |   |   |   |   |
| Reported basic                                                                                           |       | $                                          | (0.12      | ) | $ | 0.40 |   | $ | (0.94 | ) |
| Pro forma basic                                                                                          |       | $                                          | (0.59      | ) | $ | 0.05 |   | $ | (1.29 | ) |
| Reported diluted                                                                                         |       | $                                          | (0.12      | ) | $ | 0.36 |   | $ | (0.94 | ) |
| Pro forma diluted                                                                                        |       | $                                          | (0.59      | ) | $ | 0.04 |   | $ | (1.29 | ) |

 

See Note 12 for a description of the optionpricing assumptions used to estimate the fair value of equity instrumentsgranted to employees.

***Income Taxes—******We*********account for income taxes inaccordance with SFAS No. 109, *Accountingfor Income Taxes*, which requires companies to recognize deferredincome tax assets and liabilities using enacted tax rates for the effect oftemporary differences between the book and tax bases of recorded assets andliabilities. The effect on deferred income tax assets and liabilities of achange in tax rates is recognized in income in the period that includes theenactment date. SFAS No. 109 also requires that deferred income tax assetsbe reduced by a valuation allowance if it is more likely than not that someportion or all of the deferred income tax asset will not be realized. Weevaluate the realizability of our deferred income tax assets and establish avaluation allowance to reduce our deferred income tax assets based on anassessment of the likelihood of their realization. We consider certain relevantcriteria including deferred income tax liabilities that can be used to offsetdeferred income tax assets, estimates of future taxable income of appropriatecharacter within the carry forward period available, and tax planningstrategies.

***Net Income (Loss)Per Share—******We*********calculate net income (loss) pershare pursuant to SFAS No. 128, *EarningsPer Share*. Basic net income (loss) per share is calculated bydividing our net income (loss) by the weighted average number of sharesoutstanding during the period. When the effects are not anti-dilutive, dilutednet income (loss) per share is computed by dividing our net income (loss) bythe weighted average 

F-14

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

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 2 for further information.)

***Fair Value ofFinancial Instruments—******At*********December 31, 2005 and 2004, our financialinstruments included cash and cash equivalents, investments, accountsreceivable and accounts payable. We believe the carrying values of cash andcash equivalents, accounts receivable and accounts payable approximate fairvalues because of the short-term maturities of these instruments. Our investmentsare carried at fair value.

***Foreign Currency—******Generally,*** thefunctional 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, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments,* which addresses thedetermination as to when an investment is considered impaired, whether thatimpairment is other than temporary, and the measurement of an impairmentloss. This FSP also includes accounting considerations subsequent to therecognition of an other-than-temporary impairment and requires certaindisclosures about unrealized losses that have not been recognized as other-than-temporaryimpairments. The guidance in this FSP amends FASB Statements No. 115,*Accounting for Certain Investments in Debtand Equity Securities, and No. 124, Accounting for Certain InvestmentsHeld by Not-for-Profit Organizations*, and APB Opinion No. 18*, The Equity Method of Accounting for Investments inCommon Stock*. This FSP is effective for reporting periodsbeginning after December 15, 2005. We do not believe the adoption ofthis FSP will have a material impact on our financial statements.

In December 2004, the FASB issued SFAS No. 123R(Revised 2004),*Share-Based Payment*which, among other things, requires that compensation expense be recognized inthe financial statements for share-based awards based on the grant date fairvalue of those awards. It will also require the benefits associated with taxdeductions in excess of recognized compensation cost be reported as a financingcash flow rather than as an operating cash flow as currently required. Theshare-based compensation cost will be measured based on the fair value of theequity or liability instruments issued. Effective January 1, 2006, weexpect to adopt SFAS 123R using the modified prospective method. We areevaluating the requirements under SFAS 123R and expect the adoption tohave a significant adverse impact on our results of operations, but not on ourcash flows.

In November 2005, theFASB issued FSP FAS123(R)-3, *TransitionElection to Accounting for the Tax Effects of Share-Based Payment Awards.*ThisFSP requires an entity 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 SFAS No. 123(R) usingthe modified prospective method may make a one-time election to adopt thetransition method described in this FSP. An entity may take up to one year fromthe later of its initial adoption of SFAS No. 123(R) or the effectivedate of this FSP to evaluate its available transition alternatives and make itsone-time election. 

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

This FSPbecame effective in November 2005. We continue to evaluate the impact thatthe adoption of this FSP could have on our financial statements.

**2.   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**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net (loss) income                                                                  |       | $                                          | (3,263     | ) | $ | 9,446 |   | $ | (20,569 | ) |
| Weighted average  shares of common stock and common stock equivalents outstanding: |       |                                       |       |   |   |   |   |
| Basic                                                                              |       | 27,419                                     |       | 23,361 |   | 21,991 |   |
| Dilutive effect of stock options computed using the  treasury stock method         |       | —                                     |       | 2,723 |   | — |   |
| Diluted common shares and share equivalents  outstanding                           |       | 27,419                                     |       | 26,084 |   | 21,991 |   |
| Net (loss) income  per share:                                                      |       |                                       |       |   |   |   |   |
| Basic                                                                              |       | $                                          | (0.12      | ) | $ | 0.40 |   | $ | (0.94 | ) |
| Diluted                                                                            |       | $                                          | (0.12      | ) | $ | 0.36 |   | $ | (0.94 | ) |

 

We have excluded alloutstanding stock options from the calculation of diluted net loss per commonshare for 2005 and 2003 because we reported a loss in these periods and allsuch securities are anti-dilutive. The total number of share equivalentsexcluded from the calculations of historical diluted net loss per common sharefor 2005 and 2003 were 2,695,822 and 954,423, respectively, calculated usingthe treasury stock method. (See Note 12 for further information on stockoptions.) In 2005, 2004 and 2003, 348,467, 461,087 and 4,392,990 stock options,respectively, were excluded from the computation of diluted earnings per sharebecause they had exercise prices that exceeded the average fair market value ofour common stock for those periods, and therefore had an anti-dilutive effect.

F-16

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

**3.   Cashand Cash Equivalents and Investments**

Theamortized cost, gross unrealized loss and fair market value of cash and cashequivalents and investments available for sale as of December 31, 2005 and2004 were as 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         |       | $                       | 1,436      |           |       | —     |       |   |   | $ | (5 | ) |   | $ | 1,431 |   |
| U.S. Government agency  securities |       | 2,326                   |       |           |       |       |       |   | — |   |   | 2,326 |   |
| Commercial paper                   |       | 6,882                   |       |           | —     |       |       |   | (1 | ) |   | 6,881 |   |
| Certificates of deposit            |       | 4,248                   |       |           | —     |       |       |   | — |   |   | 4,248 |   |
| Total investments                  |       | $                       | 14,892     |           |       | —     |       |   |   | $ | (6 | ) |   | $ | 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 at December 31,2005 relates mainly to one corporate debt security with an A plus rating with afair market value of $ 1.4 million. As of December 31, 2005, the corporatedebt security had not been in a loss position for more than 12 months, andwe believe this impairment to be temporary. At December 31, 2004, the fairmarket value of investments with remaining maturity dates ranging from91 days to one year totaled $21.4 million, investments with maturitydates ranging from one to three years totaled $7.4 million, andinvestments with maturities greater than three years totaled $5.0 million. Incontemplation of funding the Blue Pumpkin acquisition, we recognized a loss 

F-17

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

of $0.1 millionduring 2004, resulting from the write-down of amortized cost to fair value atDecember 31, 2004. We recognized $0.2 million of securities gainsduring 2003 due to the liquidation of our investment portfolio during 2003 tofund the Eyretel acquisition.

We recorded interestincome of $1.2 million, $1.0 million and $0.8 million during2005, 2004 and 2003, respectively.

**4.   Intangible Assets**

Thefollowing tables 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 |   |

 

Theincrease in the intangible assets balances in 2005 is primarily due to theacquisition of Blue Pumpkin and Optimis as discussed in Notes 5 and 6. Theacquired technology and trademarks are being amortized using the straight-linemethod over three and four years, respectively, and the distributionarrangements, customer list and patents are being amortized using thestraight-line method over five years. The intangible assets and relatedamortization expenses are subject to foreign currency translation and deferred incometax adjustments. Amortization of intangible assets included in the accompanyingcondensed consolidated statements 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-18

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

Theestimated future 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 |   |

 

**5.   Blue Pumpkin 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 $40 million in cash which was funded from our existingcash and investments and issued 2.1 million shares of Witness’ common stockvalued at $37.2 million (measured at the date the stock considerationbecame fixed pursuant to the application of a formula specified in the mergeragreement). On May 24, 2005, the shares issued in connection with theacquisition were registered for resale with the Securities and ExchangeCommission. Approximately ten percent of the aggregate merger consideration wasplaced into escrow fund and is expected to be released to Witness in partialsatisfaction and settlement of claims that Witness has brought against the escrowfund, including claims for potential losses expected to result from thesettlement of the IEX litigation. The escrow fund is available to compensateWitness, subject to certain limitations, for potential losses that could resultfrom, among other things, the IEX litigation and other specified litigations,and breaches of Blue Pumpkin’s representations, warranties or covenants in theMerger Agreement (See Note 15 to the Consolidated Financial Statements fordiscussion on Blue Pumpkin legal proceedings).

We commencedconsolidation of Blue Pumpkin on January 25, 2005 and the acquisition wasaccounted for using the purchase method of accounting in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 141,*Business Combinations*. The following summarizesthe total purchase price for Blue Pumpkin (in thousands):

| Value of Witness  Systems, Inc. common stock issued |   | $      | 33,700 |   |
|----------------------------------------------------------|--------|--------|--------|--------|
| Cash  consideration                                      |   | 36,000 |   |
| Value of common  stock and cash held in escrow           |   | 7,500  |   |
| Direct  acquisition costs                                |   | 5,400  |   |
|                                                     |   | $      | 82,600 |   |

 

F-19

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

Underthe purchase method of accounting, the total purchase price is allocated toBlue Pumpkin’s net tangible and intangible assets based upon their estimatedfair value as of the date of the acquisition with any amount paid in excess ofthe fair value of the net assets recorded as goodwill. Based upon the purchaseprice and review of the net assets acquired and liabilities assumed, thepurchase price allocation, 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                             |   | 34,700  |   |
| In-process  research and development |   | 9,000   |   |
| Other long term  assets              |   | 100     |   |
| Total assets acquired                |   | 92,800  |   |
| Current liabilities                  |   | (3,600  | )      |
| Litigation  accrual                  |   | (3,500  | )      |
| Deferred revenue                     |   | (1,700  | )      |
| Restructuring  accruals              |   | (1,400  | )      |
| Total liabilities assumed            |   | (10,200 | )      |
|                                 |   | $       | 82,600 |   |

 

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.

F-20

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

The key considerations underlying the valuation ofacquired in-process research and development from Blue Pumpkin are as follows:a) guidance from the Financial Accounting Standards Board (“FASB”) 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 to complete thetechnology; and d) the numerous technical, cost, market, and timing risks weface before the technology becomes technologically feasible.

Unauditedpro forma information reflecting the acquisition of Blue Pumpkin as if itoccurred on January 1, 2004 is as follows (in thousands, except per shareamounts):

| ** **                                | ** ** | **Year ended  December 31,** | ** ** |
|-------------------------------------------|------------|----------------------------------------|------------|
| ** **                                | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Total revenues                            |       | $                                      | 186,446    |   | $ | 175,213 |   |
| Net income (loss)                         |       | $                                      | 3,347      |   | $ | (3,740 | ) |
| Net income (loss)  per share—basic   |       | $                                      | 0.12       |   | $ | (0.15 | ) |
| Net income (loss)  per share—diluted |       | $                                      | 0.11       |   | $ | (0.15 | ) |
| Weighted average  shares—basic       |       | 27,594                                 |       | 25,461 |   |
| Weighted average  shares—diluted     |       | 30,290                                 |       | 25,461 |   |

 

The pro forma resultsinclude adjustments for the amortization expense of intangible assets arisingfrom the acquisition and the reversal of interest income assuming the cashportion of the purchase was paid from available cash. In addition, the proforma results do not reflect any adjustments for IPR&D charges, because oftheir non-recurring nature, and cost savings and synergies that we believewould have resulted had the acquisition occurred on January 1, 2004.

**6.**   OptimisAcquisition

On May 23, 2005, weacquired Optimis Group Limited (“Optimis”), a UK-based provider of workforceoptimization software solutions. Blue Pumpkin owned a minority interest in anoperating subsidiary of Optimis, the balance of which was acquired through theOptimis acquisition. We paid $5.0 million in cash and other consideration,which was financed from our existing cash and investments. Ten percent of theaggregate merger consideration is being held in escrow until May 23, 2006,one year after the closing date of the Merger. The escrow period may beextended in the event that there are pending claims that are brought againstthe escrow fund within such one-year period. The escrow fund is available tocompensate Witness, subject to certain limitations, for losses resulting from,among other things, breaches of representations, warranties or covenants in theMerger Agreement and certain pending and potential claims.

Wecommenced the consolidation of Optimis on May 24, 2005 and the acquisitionwas accounted for using the purchase method of accounting in accordance withSFAS No. 141,*Business Combinations*.The following summarizes the total purchase price for Optimis (in thousands):

| Cash and other  consideration |   | $   | 5,000  |   |
|-------------------------------|--------|-----|--------|--------|
| Direct  acquisition costs     |   | 700 |   |
|                          |   | $   | 5,700  |   |

 

F-21

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

Underthe purchase method of accounting, the total purchase price is allocated toOptimis’ net tangible and intangible assets based upon their estimated fairvalue as of the date of the acquisition with any amount paid in excess of thefair value of the net assets recorded as goodwill. Based upon the purchaseprice and review of the net assets acquired and liabilities assumed, thepurchase 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 ofidentifiable intangible assets were determined using both an income and a costapproach taking into consideration the nature, risks, historical patterns,economic characteristics, and future considerations of the assets.

**7.   Eyretel Acquisition**

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.

Thefollowing summarizes the total purchase price for Eyretel (in thousands):

| Cash  consideration       |   | $     | 55,269 |   |
|---------------------------|--------|-------|--------|--------|
| Direct  acquisition costs |   | 4,458 |   |
|                      |   | $     | 59,727 |   |

 

F-22

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

Underthe purchase method of accounting, the total purchase price is allocated toEyretel’s net tangible and intangible assets based upon their estimated fairvalues as of the date of the acquisition. The final purchase price allocationis as follows (in thousands):

| 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., an independentthird-party appraiser, using either an income or cost approach taking intoconsideration the nature, risks, historical patterns, economic characteristics,and future considerations of the assets. We estimated that $7.8 million ofthe purchase price of Eyretel represented acquired in-process research anddevelopment (“IPR&D”) related to developing enhancements and new productsfor the voice and data recording, quality monitoring and analysis industry thathad not yet reached technological feasibility and had no alternative futureuse. Accordingly, these amounts were immediately charged to expense uponconsummation of the acquisition. We calculated the value of the IPR&D byutilizing a discounted cash flow methodology, focusing on the income-producingcapabilities of the in-process technologies and taking into consideration:stage of completion; complexity of work to date and to complete; anticipatedproduct development and introduction schedules; forecasted product salescycles; internal and external risk factors; revenue and operating expenseestimates; contributory asset charges; and costs already incurred and theexpected costs to complete.

Unauditedpro forma information reflecting the acquisition of Eyretel as if it occurredon January 1, 2003 is as follows (in thousands, except per share amounts):

| ** **                                      | ** ** | **2003** | ** ** |
|-------------------------------------------------|------------|----------|------------|
| Total revenues                                  |       | $        | 121,958    |   |
| Net loss                                        |       | (25,219  | )          |
| Net loss per  share—basic and diluted      |       | $        | (1.15      | ) |
| Weighted average  shares—basic and diluted |       | 21,991   |       |

 

F-23

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

The pro forma resultsabove include adjustments for the amortization expense of intangible assetsarising from the acquisition and the reduction of interest income assuming thepurchase was paid from available cash. In addition, the pro forma resultsexclude the IPR&D charge and certain merger-related and other costsdirectly attributable to the acquisition.

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

As a result of the BluePumpkin and Optimis acquisitions in 2005, we recorded $ 2.4 million incertain acquisition-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 |   |

 

F-24

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

Thefollowing table summarizesall merger-related and integration costs that were charged to expense duringthe years ended December 31, 2005, 2004 and 2003 (in thousands):

| ** **                                       | ** ** | **2005** | ** ** | **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:                                    |       |     |       |     |       |     |       |
| Merger-related and integration costs             |       | 4,125    |       | 203      |       | —   |       |
|                                             |       | $        | 4,224      |     | $          | 498      |       | $ | 7,865 |   |

 

During 2005, we incurredmerger-related and integration costs pertaining to the acquisitions of BluePumpkin and Optimis comprised primarily of legal costs, transitional employeesand other contractors, travel costs and advertising costs. Merger-related andintegration costs incurred in 2004 and 2003 totaled $0.5 million and $7.8,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.

**9.   Accrued Expenses**

Accruedexpenses consisted of the following (in thousands):

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Accrued  commissions, compensation and benefits |       | $                     | 6,249      |   | $ | 6,762 |   |
| Other accrued  acquisition liabilities          |       | 4,978                 |       | 2,337 |   |
| Legal accruals                                  |       | 4,036                 |       | 481 |   |
| Other accrued  expenses                         |       | 6,628                 |       | 6,728 |   |
|                                            |       | $                     | 21,891     |   | $ | 16,308 |   |

 

**10.   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 of December 31,2005, we were in compliance with all bank covenants.

F-25

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

As of December 31,2005, we had no amounts outstanding under the line of credit and the amountavailable for borrowing was $12.8 million, which was net of outstandingletters of credit of **$**2.2 million.The letters of credit secure the lease on our corporate headquarters facilityand have decreasing schedules that ultimately expire in 2007. In addition, wehave a £0.3 million letter of****creditsecuring our premises in the United Kingdom.

**11.   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 constructively retired. The Company has notrepurchased its common stock since 2003 and does not presently plan torepurchase additional common stock.

**12.   Employee Benefit 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) the2003 Non-employee Director Stock Option Global Plan (the “Director Plan”).

*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 on June 15,2004 and 122,500 options were granted under this Policy.

F-26

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

During 2005, 603,500 stock options were granted tocertain Blue Pumpkin and Optimis employees as an inducement to join Witness.These inducement options have an exercise price equal to the market value onthe date of the grant, 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 to 25percent of the total amount, after one year from the date of grant, andcommencing 13 months after grant and until the end of the 47th month followinggrant, the options will become exercisable as to an additional two percent permonth and the balance upon the 48th month following grant.

*2003Plan—**In*connection with the Eyretelacquisition, we established the 2003 Plan for former Eyretel employees. The2003 Plan became effective in June 2003, allowing us to grant shares ofcommon stock in the form of stock options. No stock options were granted toformer Eyretel employees under the 2003 Plan in 2004 or 2005. During 2005,28,466 stock options were granted under the 2003 Plan. At December 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.

*DirectorPlan—**The*Director Plan became effectivein 2003 and grants continuing non-employee members of the Board of Directorsnon-qualified options to purchase shares of our common stock pursuant to aformula award. During 2005, 48,000 stock options were granted under theDirector Plan. At December 31, 2005, there were 500,000 shares authorizedfor issuance, of which 388,000 shares remain available for future grant.

Each plan remains in effect until the earlier of thetenth anniversary of its effective date or the date on which all reservedshares have been issued or are no longer available for use. Options grantedunder these plans during 2005, 2004 and 2003 were non-qualified stock options thatwere granted at a price greater than or equal to the fair value of the stock onthe grant date. 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 yearsended December 31, 2005, 2004 and 2003, in deferred stock compensationcharges for certain option grants issued under the Policy and certain 1999stock grants. There was no unamortized deferred stock compensation balance at December 31,2005.

F-27

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

Thefollowing summarizes stock 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      |   |   |

 

The following tablesummarizes information about stock options outstanding at December 31,2005

| **Outstanding**                             | ** ** | **Exercisable** | ** ** |
|---------------------------------------------|------------|-----------------|------------|
| **Range of Exercise Prices** | ** ** | ** **      | ** ** | **Number  Outstanding** | ** ** | **Weighted-  Average  Remaining  Life** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  of shares** | ** ** | **Weighted-  Average  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 |   |   |

r

The followingare the fair values and assumptions used in calculating the pro forma optionexpense amounts 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 StockPurchase Plan—******Through*** December 31,2005, our employee stock purchase plan (“ESPP”) allowed our employees topurchase shares of common stock at a price per share that is 85% of the lesserof the fair market value as of the beginning or end of the semi-annual optionperiod. Effective January 1, 2006, the ESPP allows our employees topurchase shares of common stock at a price per share 

F-28

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

of 95% of the fair marketvalue at the end of each quarterly option period. The ESPP includes a provisionto increase, without further approval required, the number of shares authorizedeach year on January 1 by a number equal to the lesser of 2% of the totalnumber of shares of common stock then outstanding or 900,000 shares. As of December 31,2005, 491,532****shares of common stock have beenissued under the ESPP.

The weighted-average fair value of the employee’spurchase rights under the ESPP granted during 2005, 2004 and 2003 was $5.50,$3.77 and $1.74 per share, respectively, using the Black-Scholes option-pricingmodel with the same weighted-average assumptions as for the stock incentiveplans except for the expected life assumption which was six months.

***Retirement Plans—******We*********have a U.S. tax-qualified definedcontribution plan under Section 401(k) of the Internal Revenue Code(the “401(k) Plan”). Employees are eligible to participate the first ofthe month following their date of hire. The 401(k) Plan allowsparticipants to contribute up to 100% of eligible compensation, subject to U.S.Internal Revenue Service limitations. The 401(k) Plan also provides fordiscretionary employer matching contributions. We also have a personal savingsplan (“Savings Plan”) for our United Kingdom employees. In accordance with theInland Revenue limitations, employees are eligible to invest of up to 35% ofbase salary in the Savings Plan, which includes employer contributions rangingfrom 5% to 7% of employee compensation. We contributed $0.5 million, $0.8 millionand $0.6 million to the 401(k) Plan and Savings Plan in 2005, 2004and 2003, respectively.

***Stockholder’sRights Plan—******We*********have a stockholder rights plan (the“Rights Plan”) which has the effect of causing substantial dilution to a personor group that attempts to acquire Witness on terms not approved by the Board ofDirectors. Under the Rights Plan, we issued a dividend of one right for eachshare of our common stock, par value of $0.01 per share, held by stockholdersof record as of the close of business on November 4, 2002. Each right willentitle stockholders to purchase one unit of a share of our Series AJunior Participating Preferred Stock for $25.00. The rights generally will beexercisable only upon the occurrence of certain events, and will expire on November 4,2012.

The Rights Plan has no present dilutive effect on ourcapital structure, nor does it affect reported earnings per share or change theway our shares of common stock are traded. Neither the adoption of the RightsPlan, nor the dividend distribution of the rights, was taxable to ourshareholders or Witness.

***Change of Control—******Our*********senior officers, including ournamed executive officers noted in our 2004 annual proxy statement, have changeof control agreements, which in general, provide the officers with severancebenefits in the event of a change in control as defined. The agreements providefor Witness to pay the officer a multiple of his, or her, base salary andbonus, in a lump sum, as well as a minimum pro rata bonus for the year in whichthe change of control occurs, and payment of COBRA continuation coverage, lifeinsurance premiums and long-term disability insurance premiums for a fixedperiod of time. In addition, the agreements provide for a gross-up payment forcertain U.S. federal excise taxes that might result from the receipt of theseverance payments. The severance payments vary by seniority, and involvemultiples of 1.0, 1.5 or 2.0 times base salary and bonus. In the change ofcontrol agreements other than those for our Chief Executive Officer (“CEO”),Chief Operating Officer (“COO”) and Chief Financial Officer (“CFO”), paymentsare made only if there is both a change of control of Witness and a terminationof employment of the officer without cause (or a constructive termination) asdetermined by the terms of the respective agreements.

F-29

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

**13.   Income Taxes**

Income (losses) before income taxes from foreignoperations were $0.1 million, ($1.1) million and ($4.0) million in 2005, 2004and 2003, respectively. Income (losses) before income taxes from U.S.operations were ($0.7) million, 10.9 million and $(16.3) million in2005, 2004 and 2003, respectively.

We recorded a provision for income tax of $2.7 millionduring the year ended December 31, 2005, of which $2.1 millionrelated to the utilization of a portion of the $17.1 million of deferred incometax assets, primarily net operating loss carry-forwards, acquired during the2005 acquisition of Blue Pumpkin Software, Inc. A full valuation allowancehas been recorded against these assets. The utilization of these deferred incometax assets in 2005 was credited as a reduction to goodwill. The remainder ofthe provision is primarily comprised of U.S. federal alternative minimumincome tax expense and foreign income tax, primarily from withholding, and anincome tax benefit from the reduction of deferred income tax liabilities inforeign jurisdictions. For the same periods during 2004 and 2003, the taxexpense of $0.3 million was primarily related to U.S. federal alternativeminimum income tax expense and foreign income tax.

Thecomponents of the provision for income tax expense for 2005, 2004 and 2003 areas follows (in thousands):

| ** **       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal          |       | $        | 213        |     | $          | 213      |       | $ | (40 | ) |
| State            |       | —   |       | —   |       | —   |       |
| Foreign          |       | 535      |       | 186      |       | 347      |       |
| Total current    |       | 748      |       | 399      |       | 307      |       |
| Federal deferred |       | 2,140    |       | —   |       | —   |       |
| Foreign deferred |       | (200     | )          | (87      | )          | —   |       |
| Total deferred   |       | 1,940    |       | (87      | )          | —   |       |
| Total            |       | $        | 2,688      |     | $          | 312      |       | $ | 307 |   |

 

F-30

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

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

| ** **                                                                                              | ** ** | **Year ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Computed  “expected” tax (benefit) expense                                                    |       | $                                          | (196       | ) | $ | 3,318 |   | $ | (6,889 | ) |
| Increase (decrease) in  income taxes resulting from:                                                    |       |                                       |       |   |   |   |   |
| State income taxes, net of federal income taxes                                                         |       | (429                                       | )          | 181 |   | (793 | ) |
| In-process research & development                                                              |       | 3,060                                      |       | — |   | 2,666 |   |
| Distribution from foreign subsidiary                                                                    |       | 539                                        |       | — |   | — |   |
| (Decrease) increase in valuation allowance for  deferred income tax assets                              |       | (513                                       | )          | (2,992 | ) | 6,241 |   |
| 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 |       | 510                                        |       | 158 |   | (323 | ) |
| Other, net                                                                                              |       | 541                                        |       | 87 |   | (290 | ) |
|                                                                                                    |       | $                                          | 2,688      |   | $ | 312 |   | $ | 307 |   |

 

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

| ** **                                                                  | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                  | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Deferred income tax  assets:                                                |       |                  |       |   |   |
| Allowance for  doubtful accounts                                            |       | $                     | 1,498      |   | $ | 940 |   |
| Accrued expenses  and other                                                 |       | 623                   |       | 215 |   |
| Property and  equipment depreciation                                        |       | 1,063                 |       | 1,013 |   |
| Identifiable  intangible assets amortization                                |       | 5,913                 |       | — |   |
| Net operating  losses, research and experimentation and foreign tax credits |       | 40,241                |       | 15,302 |   |
| Foreign deferred  income tax assets, principally net operating losses       |       | 13,281                |       | 15,679 |   |
| Gross deferred income tax assets                                            |       | 62,619                |       | 33,149 |   |
| Valuation allowance for deferred income tax assets                          |       | (49,600               | )          | (30,703 | ) |
| Net deferred income tax assets                                              |       | 13,019                |       | 2,446 |   |
| Deferred income tax  liabilities:                                           |       |                  |       |   |   |
| Intangible assets                                                           |       | (13,762               | )          | (2,700 | ) |
| Net deferred  income tax liabilities                                        |       | $                     | 743        |   | $ | 254 |   |

 

The net change in thevaluation allowance for deferred income tax assets for 2005, 2004 and 2003 wasan increase of $18.9 million, $5.3 million and $16.5 million,respectively. The valuation allowance increase 

F-31

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

in 2005is comprised of ($0.5) million for current activity (of which $0.2 million wasrelated to changes in foreign tax rates), $5.6 million due to stock optiondeductions, and $13.8 million for additional deferred income tax assets,primarily acquired in the Blue Pumpkin acquisition. Included in the valuationallowance for deferred income tax assets as of December 31, 2005 is $15.0million from the Blue Pumpkin acquisition and $2.1 million from the Eyretelacquisition in 2003, which, when realized, will result in the recognition oftax expense and the reduction of goodwill or intangible assets.

At December 31, 2005,we had net operating loss, research and experimentation credit, and foreign taxcredit carryforwards for U.S. federal income tax purposes of$82.2 million, $6.8 million and $0.6 million, respectively, whichexpire in varying amounts beginning in the year 2012. We also have incurred netforeign losses in the amount of $37.8 million as of December 31,2005, which are available to offset future taxable income in their respectiveforeign jurisdictions. These foreign losses expire in varying amounts beginningin 2006.

As of December 31,2005, the U.S. and U.K. net operating loss carryforwards include tax deductionsof approximately $31.9 million and $4.9 million, respectively,resulting from the exercise of stock options. In accordance with APB Opinion No. 25,any income tax benefit derived from these tax deductions is reflected asadditional paid-in capital at the time we recognize any such income taxbenefit. During 2005, the Company also recognized as tax expense approximately$ 0.2 million of alternative minimum tax (AMT) that would have been payable hadthere been no stock option deductions. Actual stock option deductions incurredfor income tax purposes results in no actual payment of AMT. A “hypothetical”deferred income tax asset is created by the AMT expense incurred.

**14.   Segmentand Geographic 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-wideannual revenue based on customer location is as follows (in thousands):

| ** **     | ** ** | **Year Ended December 31,** | ** ** |
|----------------|------------|--------------------------------------------|------------|
| ** **     | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States  |       | $                                          | 100,817    |   | $ | 73,268 |   | $ | 59,830 |   |
| United Kingdom |       | 48,847                                     |       | 39,166 |   | 24,009 |   |
| Rest of world  |       | 35,707                                     |       | 28,901 |   | 24,198 |   |
| Total          |       | $                                          | 185,371    |   | $ | 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.

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

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

| ** **     | ** ** | **December 31,** | ** ** |
|----------------|------------|-----------------------|------------|
| ** **     | ** ** | **2005**              | ** ** | **2004** | ** ** |
| United States  |       | $                     | 68,339     |   | $ | 5,518 |   |
| United Kingdom |       | 10,824                |       | 8,533 |   |
| Rest of world  |       | 5,719                 |       | 2,948 |   |
| Total          |       | $                     | 84,882     |   | $ | 16,999 |   |

 

**15.   Commitmentsand Contingencies**

***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 a softwarelicensing agreement which requires us to pay approximately $1.2 millionand $1.3 million in 2006 and 2007, respectively, for the right todistribute a vendor’s software as part of our workforce optimization solution.These amounts have been recorded as accrued expenses and other long-termliabilities as of December 31, 2005. Implied interest expense associatedwith these payments is not significant.

***Legal Proceedings—******From*** time totime we may be involved in legal proceedings and/or litigation arising in theordinary course of our business.

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 

F-33

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

Courtheld a claim construction hearing and issued a claim construction order on June 8,2005. The case will now proceed to expert discovery and summary judgmentphases.

On July 20, 2004, STSSoftware 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 products that include screen capture and synchronized screen andvoice 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 andApparatus for Simultaneously Monitoring Computer User Screen and TelephoneActivity from a Remote Location.” We have sought an injunction and moneydamages for NICE’s infringement of these two patents. NICE Inc. has answeredand counterclaimed for declaratory judgments of non-infringement andinvalidity. Since then, on February 24, 2005, we filed suit againstNICE Ltd. because of its infringing activities in violation of the ‘798and ‘220 patents, including importation of the accused NICE products. By orderdated April 5, 2005, Judge Pannell has consolidated the NICE Inc. and NICELtd. actions. The case has been set on a modified discovery calendar afterconsolidation and is at a preliminary 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.

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005, 2004 and 2003**

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 with aportion of the purchase price in connection with our acquisition of Blue Pumpkin.As at December 31, 2005, we have accrued the balance of the anticipatedsettlement costs and do not expect that the settlement will require anyadditional material charges. (See Note 5 to the Consolidated FinancialStatements included elsewhere in this report for discussion of the Blue Pumpkinacquisition).

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 and related productsthat include the ability to monitor communications to detect the presence of atleast one predetermined parameter, infringe claims of our U.S. Patent No. 6,404,857B1 (“the ‘857 Patent”), entitled “Signal Monitoring Apparatus for AnalyzingCommunications.” We have sought an injunction and money damages for NICE’sinfringement of the ‘857 patent. NICE has not yet responded to the complaint,and this case is at a preliminary stage. .

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

***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.

F-35

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**Schedule II**

**Valuationand Qualifying Accounts(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 |   |   |
|                                    |            |                                              |            |                               |            |                          |            |                |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-36

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**SIGNATURES**

Pursuantto the requirements of Section 13 of 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

| Dated: March 16, 2006 | WITNESS SYSTEMS, INC. |
|----------------------------|-----------------------|
|                            | By:                   | /s/  DAVID B. GOULD |
|                       |                  | David B. Gould |
|                       |                  | *Chairman  of the Board and  Chief Executive Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons in the capacities and on the dateindicated

| /s/  DAVID B. GOULD   |   | *Chairman  of the Board and Chief*    | * * | March 16, 2006 |
|---------------------------------|--------|---------------------------------------|----------|---------------------|
| David B. Gould                  |   | *Executive  Officer*                  | * * |                |
| /s/  WILLIAM F. EVANS |   | *Executive  Vice President and Chief* | * * | March 16, 2006 |
| William F. Evans                |   | *Financial  Officer*                  | * * |                |
| /s/  TOM BISHOP       |   | *Director*                            | * * | March 16, 2006 |
| Tom Bishop                      |   | * *                              | * * |                |
| /s/  THOMAS J. CROTTY |   | *Director*                            | * * | March 16, 2006 |
| Thomas J. Crotty                |   | * *                              | * * |                |
| /s/  JOEL G. KATZ     |   | *Director*                            | * * | March 16, 2006 |
| Joel G. Katz                    |   | * *                              | * * |                |
| /s/  DAN LAUTENBACH   |   | *Director*                            | * * | March 16, 2006 |
| Dan Lautenbach                  |   | * *                              | * * |                |
| /s/  TERRY OSBORNE    |   | *Director*                            | * * | March 16, 2006 |
| Terry Osborne                   |   | * *                              | * * |                |
| /s/  PETER SINISGALLI |   | *Director*                            | * * | March 16, 2006 |
| Peter Sinisgalli                |   | * *                              | * * |                |

 

F-37

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