<PAGE>
 
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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, D.C 20549

                                    FORM 10-K
[X]      Annual report pursuant to Section 13 or 15(d) of the Securities 
         Exchange Act of 1934

                    FOR THE FISCAL YEAR ENDED MARCH 31, 1997


[_]      Transition report pursuant to Section 13 or 15(d) of the Securities 
         Exchange Act of 1934

         For the transition period from _________ to __________.

                         COMMISSION FILE NUMBER 0-12167


                          RATIONAL SOFTWARE CORPORATION
             (Exact name of Registrant as specified in its charter)


           DELAWARE                                         54-1217099
 (State or other jurisdiction of                          (I.R.S Employer
  incorporation or organization)                       Identification Number)

 2800 SAN TOMAS EXPRESSWAY, SANTA CLARA, CA                 95051-0951
  (Address of principal executive offices)                  (Zip Code)

Securities registered pursuant to Section 12(b) of the Act:        None
Securities registered pursuant to Section 12(g) of the Act:   Common Stock,
                                                                par value
                                                            $0.01 per share
                                                            (Title of Class)

                                  408-496-3600
               (Registrant's telephone number including area code)


Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter periods as the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

                                 YES [X] NO [_]

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

At June 12, 1997, the aggregate market value of Registrant's voting stock held
by nonaffiliates was $817,790,000. For the purposes of the preceding sentence
only, "affiliates" is deemed to consist of executive officers and directors. At
June 12, 1997, there were 47,659,003 shares of the Registrant's $0.01 par value
common stock outstanding.


                     AN INDEX TO EXHIBITS BEGINS ON PAGE 63

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                          RATIONAL SOFTWARE CORPORATION
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Unless indicated otherwise, all Common Stock share numbers and prices have 
been adjusted to reflect Rational Software Corporation's May 1995 3:1 reverse
stock split and July 1996 1:2 forward stock split, accomplished by means of a
stock dividend.

Unless indicated otherwise, all financial information has been restated to 
reflect Rational Software Corporation's acquisition of SQA, Inc., accounted for
as a pooling of interests.


                                     PART I

ITEM 1 -- BUSINESS

         Rational Software Corporation ("Rational" or the "Company") develops,
markets and supports a comprehensive solution for the component-based
development of software systems. Rational's objective is to ensure the success
of customers in developing and managing software systems that are strategically
important to their businesses. Rational provides an integrated family of tools
that spans the critical phases of the software development process from initial
analysis and design through delivery and maintenance. In addition, Rational
provides technical consulting, training and support services. By supporting
controlled iterative development, visual modeling and an architecture-driven
process, Rational's products and services enable customers to reduce the risk of
project failure, improve the quality of the software systems they develop,
increase developer productivity, reduce time-to-market and increase software
reusability.


INDUSTRY BACKGROUND

         General
         -------

         Software permeates products and processes encountered in almost every
aspect of daily life. Many companies base their businesses on enterprise-wide
information systems which are increasingly built as distributed systems
exploiting a company-specific intranet or the Internet. Software is at the core
of business applications ranging from equity-trading systems to inventory
management. The telecommunications business is highly dependent on software in
areas as diverse as call routing, switching, rate setting and billing. Software
is the central element of command-and-control systems in submarines and
military aircraft. Software governs the operation of machines from ordinary
office copiers and cellular phones to life-saving medical devices. As
organizations seek competitive advantage by exploiting the ongoing improvements
in microprocessor technology and the emergence of new computing platforms,
software is becoming more pervasive and more sophisticated. The success of
businesses around the world depends increasingly on their ability to construct
and modify software systems that match their changing business needs.

         Traditional software development techniques have not kept pace with
advances in computer processor technology, with the development of new platforms
such as the Internet or company-specific intranets, or with the general demand
for distributed software systems such as multi-tiered client/server
applications. Software, therefore, has increasingly become the constraint on
performance, quality, and time-to-market for many organizations. The ability to
quickly and cost-effectively create complex software applications that perform
as desired and that are easy to maintain and reuse in related applications and
products can be a critical competitive differentiator. As the number and
complexity of software applications continue to expand, it is becoming
increasingly important for businesses to migrate to a more effective approach to
software development.

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                          RATIONAL SOFTWARE CORPORATION
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         The Emergence of Component-Based Development
         --------------------------------------------

         Component-based development is a way of constructing software systems
by combining and integrating pre-engineered and pre-tested software components.
Component-based development has emerged as a powerful technique to simplify the
construction of software systems and to improve their quality. Software
components can be designed, developed, and tested once, and then combined
multiple times by other users to create new software systems in a manner
analogous to combining hardware integrated circuits to create a new electronic
device. By increasing software re-use, this approach reduces the amount of
source code that must be created in connection with the development of a new
software system, helping to reduce risk, time-to-market and cost, as well as to
improve the quality of the resulting software.


PRODUCTS AND SERVICES

         Rational supports component-based development with an extensive family
of software products covering critical phases of the software development
lifecycle, from initial analysis of requirements through detailed design,
coding, testing, debugging and maintenance. Rational's products support
individual designers and developers, development teams and project managers. The
major components of Rational's product line are Rational Rose, for visual
modeling; Rational Apex, for managing development teams and the components they
generate; RequisitePro, for requirements management; Rational Summit, for
software change management and process enforcement; SoDA, for automated
documentation generation, and SQA Suite, preVue and Visual Test, for automated
software testing and quality management. These tools work together to support
controlled iterative development, visual modeling and an architecture-driven
process in a consistent manner.


         Rational Rose: Visual Modeling Tools
         ------------------------------------

         Rational Rose is a software-engineering tool that allows users to
develop, verify and document the analysis and design model of their software
graphically. Rational Rose keeps the analysis and design model consistent
through the entire software lifecycle, making controlled iterative development
feasible. Rational Rose is used in the construction of enterprise information
systems, packaged software products, systems integration activities, and for the
construction of technical systems in industries such as telecommunications,
medical instruments, transportation and aerospace.

         The Rational Rose product line supports major platforms, including
UNIX, Windows 95 and Windows NT, and implementation languages, including C++,
Visual Basic, Java, Forte, Power Builder, and Ada that are widely used today.
Rational Rose generally supports round-trip engineering, in which the user can
go from graphical design to generation of source code, modify the resulting
source code, reverse engineer the new source code to generate a graphical
depiction of the system as it exists after being modified, and merge any changes
made in the source code

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                          RATIONAL SOFTWARE CORPORATION
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back into the model or vice versa. By keeping the graphical analysis and design
model consistent with the source code, Rational Rose supports controlled
iterative development over the lifetime of the project. Rational believes that
Rational Rose is unique in its ability to support an unlimited number of
"round-trips" with no loss of information.


         Rational Apex: Integrated Development Environment Tools
         -------------------------------------------------------

         Rational Apex is a software-engineering environment for control of
software projects. It effectively controls large-scale development efforts,
helping customers improve time-to-market while reducing risk and cost. It also
makes large-scale software re-use possible by directly managing software
architecture, significantly improving the efficiency of the overall software
development process. Rational Apex runs on UNIX platforms and is available in
versions that support the C/C++ and Ada programming languages.

         The Apex family also includes the VADS line of Ada compilers,
debuggers, and related tools for the development of highly-reliable,
high-performance embedded systems. The VADS family runs on major UNIX platforms,
and the VADS cross-compiler product family supports major embedded system
targets including the PowerPC, Motorola 680x0 and Intel architecture.


         RequisitePro:  Requirements Management Tool
         -------------------------------------------

         RequisitePro is a family of products that help users define and manage
the formal requirements for their software systems. RequisitePro runs on
Windows-based PCs, and makes use of Microsoft Word and Microsoft Access.
RequisitePro allows the user to collect and organize textual descriptions of
software requirements in the form of a structured document, which may be queried
later.

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         SQA Suite, preVue and Visual Test: Software Testing and Quality 
         ---------------------------------------------------------------
         Automation Tools
         ----------------

         Rational's solution for the automation of software quality and test is 
focused on client/server functional testing and on load/stress testing. 
Client/server functional testing is intended to determine whether a software 
application has the proper functionality (in other words, that it does what was 
intended). Load or stress testing is intended to verify that a software 
application will perform properly in the face of a given load, as measured by 
the number of simultaneous users or the level of computer network traffic.

         SQA Suite includes: SQA Robot, which allows users to create and run
automated tests; SQA Manager, which allows users to plan, manage and measure the
progress of testing projects; SQA LoadTest, which allows users to test
client/server applications under different load, stress and multi-user
scenarios; and SQA Process, which is a methodology for the automated testing of
Windows client/server applications. SQA Suite is built on the SQA Test
Repository, an open, networked database that facilitates work flow management
and defect tracking. SQA's products work with Windows application development
tools and provide advanced testing features for leading rapid application
development ("RAD") tools, including Microsoft's Visual Basic, Sybase's
PowerBuilder, Borland's Delphi, Oracle's Developer 2000 and Centura's
SQLWindows. SQA Suite provides comprehensive end-to-end testing of client/server
applications.

         preVue: The preVue family of products helps to automate software load
and stress testing, especially for very large systems. Thus preVue helps users
verify that their software will perform as desired once it is actually deployed.
preVue runs on UNIX-based workstations and is integrated with major commercial
data base management systems such as Oracle. preVue supports virtual load and
stress testing, meaning that it can use a small number of clients and servers to
simulate and test the performance of a system that is actually deployed on a
larger number of clients and servers; this makes the testing process easier and
cheaper.

         Visual Test: Visual Test, an automated, language-independent, software
testing tool, is designed to increase developers' and testers' productivity by
rapidly creating tests for applications of virtually any size and created in any
implementation language by capturing those tests for later re-use. These
capabilities enhance the ability of organizations to deploy applications for the
Windows 95 and Windows NT operating systems. Visual Test is integrated with
Microsoft Developer Studio, a desktop development environment. Rational acquired
Visual Test on October 2, 1996 from Microsoft.


         Technical Consulting and Customer Support Services
         --------------------------------------------------

         Rational's services include consulting and training that enable
customers to adopt advanced software processes and to use component-based
development effectively. Consulting services range from helping customers
implement large-scale software re-use, to working with customers to develop the
right architecture for their software systems, to helping a customer's
development team work through the first few iterations of the controlled
iterative development process. Rational also offers several standard consulting
packages and training courses that assist customers in the implementation of
controlled iterative development and the use of component-based development.


DEFINITIVE AGREEMENT TO ACQUIRE PURE ATRIA CORPORATION

         On April 7, 1997, the Company entered into an Agreement and Plan of 
Reorganization (the "Merger Agreement") providing for the acquisition of Pure
Atria Corporation ("Pure Atria") by Rational in a strategic business combination
(the "Pure Atria Merger").  Consummation of the Pure Atria Merger is contingent
upon, among other things, the Rational Stockholders' approval of the reservation
and issuance of shares of Rational Common Stock to the stockholders of Pure
Atria pursuant to the Merger Agreement and upon an amendment to the Company's

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                          RATIONAL SOFTWARE CORPORATION
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Certificate  of  Incorporation  increasing  the  authorized  number of shares of
Common Stock from 75,000,000 to 150,000,000, which, among other things, will
provide Rational with a sufficient number of authorized but unissued shares of
Common Stock to consummate the Pure Atria Merger. Consummation of the Pure Atria
Merger is also contingent upon, among other things, approval by the Pure Atria
Stockholders of the Merger Agreement and the expiration or termination of
waiting periods under the Hart-Scott-Rodino Antitrust Improvements Act of 1976,
as amended.  In the Pure Atria Merger, Wings Merger Corporation, a wholly owned
subsidiary of Rational, will be merged with and into Pure Atria, which will be
the surviving corporation and will become a wholly owned subsidiary of Rational.

         Pursuant to the Pure Atria Merger, each outstanding share of Pure Atria
Common Stock, will be converted into the right to receive 0.9 (the "Pure Atria
Exchange Ratio") shares of Rational Common Stock, and each outstanding option or
right to purchase Pure Atria Common Stock under the Pure Atria stock option
plans or the Pure Atria stock purchase plan will be assumed by Rational and will
become an option or right to purchase Rational Common Stock, with appropriate
adjustments to be made to the number of shares issuable thereunder and the
exercise price thereof based on the Pure Atria Exchange Ratio. The shares of
Rational Common Stock held by Rational stockholders immediately prior to the
Pure Atria Merger will remain unchanged by the Pure Atria Merger.

         Based upon the capitalization of Pure Atria as of the close of business
on March 31, 1997, an aggregate of approximately 38,542,000 shares of Rational
Common Stock will be issued to Pure Atria stockholders in the Pure Atria Merger
and Rational will assume options and rights to purchase Pure Atria Common Stock
for up to approximately 6,951,000 additional shares of Rational Common Stock.
Based upon the capitalization of the Company and Pure Atria as of the close of
business on March 31, 1997, immediately following the Pure Atria Merger, the
former securityholders of Pure Atria will hold approximately 45% of Rational's
outstanding voting power, and approximately 45% of the Company's capital stock
calculated on a fully diluted basis. The foregoing numbers of shares and
percentages are subject to change in the event that the capitalization of either
Rational or Pure Atria changes subsequent to March 31, 1997, and prior to the
effective time of the Pure Atria Merger.

         Pure Atria develops, markets and supports a comprehensive integrated
suite of software products that are designed to improve the software development
process and enable the production of reliable, high-quality software. Pure
Atria's products, which include ClearCase, Purify, ClearDDTS, and Performix,
comprise a family of tools for use from initial software development through
quality assurance and deployment.

RECENT ACQUISITIONS

         For a discussion of recent acquisitions by the Company, see 
"Management's Discussion and Analysis of Financial Condition and Results of 
Operation--Overview--Recent Acquisitions."

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BUSINESS ALLIANCE WITH MICROSOFT

         On October 2, 1996, Rational and Microsoft announced the formation of a
business alliance which consists of Rational's acquisition of Microsoft's
Visual Test product, technology cross-licensing, joint development projects
and joint marketing programs.

         In connection with this alliance, Rational acquired from Microsoft the
Visual Test product, a leading software testing tool. 

         The cross-licensing element of the alliance includes a five-year
license to Rational to develop and distribute, as part of Rational's products,
Microsoft's Developer Studio, an integrated development environment for Windows
95 and Windows NT.

     Rational has entered into a two-year agreement to develop a visual modeling
product,  including  certain  elements of Rational  Rose,  for  distribution  in
certain  Microsoft  development  tools  which run on Windows 95 and  Windows NT.
Rational  will be  obligated  to provide  timely  product  updates  to  maintain
compatibility with changes

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<PAGE>
 
                          RATIONAL SOFTWARE CORPORATION
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in Microsoft operating systems. Following expiration of the agreement, Microsoft
will have the option to obtain a perpetual,  non-exclusive  right to source code
for the product, including certain aspects of Rational's Rose technology.

         Rational's objective in acquiring the Visual Test product and
partnering with Microsoft is to extend Rational's product line and to increase
the use of component-based development by providing visual modeling capabilities
to developers using Microsoft's visual tools. In addition, Rational believes
that its arrangement with Microsoft will expose Rational's technology to
potential customers outside of its historical customer base. Rational expects
that changes in its pricing models and combinations of features within product
lines will be required to encourage these potential customers to purchase
Rational products. Rational's objective in entering into the cross-licensing
arrangements with Microsoft was not to generate direct product revenue from
Microsoft, and Rational does not expect such arrangements to directly result in
a material increase in product revenue.

PRODUCT DEVELOPMENT

         Rational believes that its success will depend largely upon its ability
to enhance existing products and develop new products that meet the needs of a
rapidly evolving marketplace and increasingly sophisticated and demanding
customers. Rational intends to extend and strengthen its lifecycle support for
component-based development by expanding its product offerings, introducing new
products, and offering higher levels of integration among its products. Rational
uses its own software processes and tools extensively in its own software
development activities. While Rational has primarily developed products
internally, it may, based on timing and cost considerations, acquire
technologies or products from third parties.

         Rational's research and development staff, including product
development, product support and technical writing personnel consists of 286
employees as March 31, 1997. Rational's total research and development expenses
were approximately $13.9 million, $18.3 million and $24.4 million in fiscal
years 1995, 1996, and 1997, respectively. As a result of the Company's merger
with SQA, Inc., accounted for as a pooling of interests, research and
development costs are presented on a combined basis for all periods shown.


CUSTOMERS AND APPLICATIONS

         Over 90,000 licenses of Rational's software products, exclusive of
Visual Test but inclusive of SQA Suite, have been sold to over 12,500 customers
worldwide. No single customer accounted for 10% or more of revenues in fiscal
1997. Rational's comprehensive solution of software development tools and
professional services is used by major organizations in many industry segments
to design, build and maintain complex software systems.

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                          RATIONAL SOFTWARE CORPORATION
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SALES AND MARKETING

         Rational markets and sells its products and services directly through
telesales organizations, field operations, sales organizations and indirectly
through channels such as Value Added Resellers ("VARs") and distributors.

         Rational's direct selling approach couples sales of its integrated
software tools with high-value technical consulting services. Rational has
established a major-account direct sales and technical consulting organization
in the United States, Canada, Europe, and in the Asia/Pacific/Latin America
region.

         Rational's sales, marketing and professional service organization
consists of 466 individuals, operating out of corporate headquarters in Santa
Clara, California, field offices in other locations throughout North America,
the United Kingdom, France, Germany, Sweden, Australia, Taiwan, India, South
Korea, New Zealand, Japan and Brazil. Rational's direct international
operations are staffed almost exclusively by local personnel. Rational also
has distributors and resellers in North America and additional distributors in
Spain, Ireland, Italy, Israel, Singapore, Korea, China, Japan and South
Africa.

         In support of its sales efforts, Rational's marketing department
conducts comprehensive programs which include maintenance of an extensive home
page on the World Wide Web, an electronic subscription service for news
announcements about Rational, print advertising, direct mail, public relations,
trade shows and ongoing customer communications programs. Rational also keeps
its customers informed of advances in the field through a customer newsletter,
technical papers and other mailings.

         The Company also has an extensive set of relationships with ISVs,
including Microsoft, PeopleSoft, Oracle and Intersolv. These companies work
closely with Rational on marketing and technology programs, providing customers
with a comprehensive, easy-to-use development and test solution. The marketing
relationships often involve one or more of the following programs: joint
advertising campaigns, exchange of mailing lists, reciprocal use of logos in
marketing literature and joint ventures, seminars or trade show presentations.

         International sales accounted for approximately 33%, 35% and 32% of the
Company's revenues in fiscal 1995, 1996 and 1997, respectively, and the Company
expects that international sales will continue to account for a significant
portion of the Company's revenues in future periods. International sales are
subject to inherent risks, including unexpected changes in regulatory
requirements and tariffs, difficulties in staffing and managing foreign
operations, longer payment cycles, greater difficulty in accounts receivable
collection, potentially adverse tax consequences, price controls or other
restrictions on foreign currency and difficulties in obtaining export and import
licenses. Any material adverse effect on the Company's international business
would be likely to materially and adversely affect the Company's business,
operating results and financial condition as a whole. The Company's
international sales are generally denominated in foreign currencies. From time
to time, the Company enters into short-term forward exchange contracts to hedge
against the impact of foreign currency fluctuations on accounts receivable
denominated in foreign currencies. Gains and losses on the conversion of foreign
payments into U.S. dollars may contribute to fluctuations in the Company's
results of operations. Although the Company has not

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                          RATIONAL SOFTWARE CORPORATION
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experienced  any material adverse impact to date from  fluctuations in foreign
currencies,  there can be no assurance  that the Company  will not  experience a
material  adverse  impact on its  financial  condition and results of operations
from fluctuations in foreign currencies in the future. See "Management's 
Discussion and Analysis of Financial Condition and Results of 
Operations--Overview--International Sales."

FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES

     Total revenue from international sales and related consulting and customer
support in different geographic areas is as follows at March 31, (in thousands):

<TABLE>
<CAPTION>
                            1995     1996     1997
                           ------   ------   ------
<S>                        <C>      <C>      <C>
Net Sales to Customers:
   Western Europe........  $12,776  $25,066  $31,934
   Other.................   13,086   10,873   13,924
                           -------  -------  -------
     Total                 $25,862  $35,939  $45,858
                           =======  =======  =======
</TABLE>

     "Other," above, primarily consists of sales to Canada and the Asia/Pacific 
region.

PRODUCT PRICING

         Rational's software licenses are normally perpetual, fully-paid-up
floating licenses. The floating license limits the number of simultaneous users
in a network instead of being associated with a specific user or computer.
Rational also offers other kinds of licenses, such as node-locked licenses that
limit a software license to a single computer and project licenses that provide
selected Rational tools to all the developers working on a specific project.

         The bulk of Rational's net product revenue in fiscal 1997 was derived
from sales of its Rational Rose, SQA Suite and Rational Apex product families.
Elements of the Rational Rose family range in price from $495 for a single-
user PC version of Rational Rose, to $2,400 for Rational Rose/Visual Basic on
a PC, to $8,400 for a floating license of Rational Rose/C++ on a UNIX
workstation. Elements of SQA Suite, available on Windows, range from $1,395
for SQA Manager, $3,295 for SQA Suite Team Test Edition, to $37,500 for high-
capacity versions of SQA LoadTest. Elements of the Apex family range in price
from $7,500 for an Apex C++ license on UNIX to $22,000 for an Apex Ada license
on UNIX. Rational's products are often sold in multiple quantities to teams of
software developers working together in a client/server environment. Rational
offers standard discounts based on dollar volume in a single purchase order.

         Rational also offers a support program which entitles a licensee to
receive all enhancements and upgrades to the licensed product that are published
in the succeeding twelve month period, as well as certain other support
services. Annual fees for support generally range from 15% to 20% of the
software license fee.

         Rational's packaged training courses are offered in the form of open-
enrollment public courses and in-house courses at customer facilities, which
range from $1,750 per person for a typical four-day course, to between $3,000
to $12,500 for in-house courses depending on the length of the course and the
maximum number of students in the class. Rational's packaged consulting
services range from approximately $50,000 to several hundred thousand dollars.
Currently, custom consulting is priced on a time-and-materials basis, although
Rational plans to bill more of its custom consulting on a project-by-project
basis in the future.


COMPETITION

         The industry for tools for automating software application development
and management is extremely competitive and rapidly changing. Rational expects
to continue to experience significant and increasing levels of competition in
the future. Bases of competition include corporate and product reputation,
innovation with frequent product enhancement, breadth of integrated product
line, the availability of integrated suites and bundles, product architecture,
functionality and features, product quality, performance, ease-of-use, support,
availability of technical consulting services and price. Rational faces
intense competition for each product within its product lines, generally from
both Windows and UNIX vendors. Because individual product sales are often the
first step in a broader customer relationship, Rational's success will depend
in part upon its ability to successfully compete with numerous competitors at
each point within its product line.

         Rational faces competition from software development tools and
processes developed internally by customers, including ad hoc integrations of
numerous stand-alone development tools. Customers may be reluctant to purchase
products offered by independent vendors such as the Company. As a result, the 
Company must educate prospective customers as to the advantages of the 
Company's products versus internally developed software quality systems.

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         Rational faces competition from, among others, Intersolv, Inc.,
Platinum Technology, Inc., Select Software Tools plc, Cayenne, Oracle, IBM
Corporation ("IBM"), Sun Microsystems, and Sybase Inc. as well as numerous
privately held tool suppliers offering traditional CASE tools that compete
with the Rational Rose approach to visual modeling and component-based
development. Rational's RequisitePro requirements management product faces
competition from companies such as GEC-Marconi. Rational's software testing
tools--SQA Suite, Rational Visual Test and preVue--face competition from
Compuware, Mercury Interactive Corporation, Segue Software, Inc., Intersolv,
Inc., Computer Associates, Platinum Technologies, Terodyne, Cyrano, SQL Bench
International, Inc., and several private companies offering testing automation
tools. Microsoft, Compuware, Oracle, Sybase and several of the major UNIX
platform vendors, including Sun Microsystems, Hewlett Packard, Digital
Equipment Corporation, Silicon Graphics Inc., and IBM, also compete with
Rational with respect to software quality products and testing tools, with
testing products customized to certain of their other software products.
Rational Apex for C/C++ faces competition from, among others, major UNIX
platform vendors such as Sun Microsystems, Hewlett-Packard and Digital
Equipment Corporation, which have C/C++ compilers and debuggers and in some
cases programming environments for their platforms. In addition, numerous
privately held companies offer compilers, debuggers and programming
environments which compete with Rational Apex. The Rational Summit product
line faces competition from various suppliers offering products with change
management functions, including Continuous Software Corporation, Hewlett
Packard, True Software, SQL Software, LTD., Intersolv, Inc., Sun Microsystems
and IBM. Rational's Apex Ada and VADs product lines face competition from
Aonix, Green Hills Software, Inc. and a large number of other suppliers
offering Ada products for native and embedded systems.

         Rational believes that the major competitive factors in its markets are
corporate and product reputation, breadth of coverage by an integrated product
line, product architecture, functionality and features, product quality,
performance, ease-of-use, quality of support, availability of technical
consulting services and price. Rational believes that its combination of an
integrated family of products supporting component-based development throughout
the software development lifecycle and its emphasis on controlled iterative
development, visual modeling and an architecture-driven process, coupled with
its extensive major-account direct sales and technical consulting organization
and the supporting channels such as VARs, telesales and the World Wide Web, are
effective selling tools.

         Rational believes that the increased level of competition it observed
in fiscal 1997 will continue to increase. Certain of Rational's competitors
are more experienced than Rational in the development of software-engineering
tools, databases or software-development products. Some of Rational's
competitors have, and new competitors may have, larger technical staffs, more
established distribution channels and greater financial resources than
Rational. There can be no assurance that either existing or new competitors
will not develop products that are superior to Rational's products or that
achieve greater market acceptance. Rational's future success will depend in
large part upon its ability to increase its share of its target markets and to
license additional products and product enhancements to existing customers. 
Future competition may result in price reductions, reduced margins or loss of 
sales which in turn would have a material adverse effect on the Company's 
business, results of operations and financial condition.

INTELLECTUAL PROPERTY

         Rational regards its software as proprietary and attempts to protect it
under a combination of copyright, trademark and trade secret laws, employee and
third-party non-disclosure agreements and other methods of protection. Despite
these precautions, it may be possible for unauthorized third parties to copy
certain portions of

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Rational's  products  or to  reverse  engineer  or  obtain  and use  information
Rational regards as proprietary.  While Rational's  competitive  position may be
affected  by its  ability  to  protect  its  proprietary  information,  Rational
believes that  trademark  and  copyright  protections  are less  significant  to
Rational's  success than other  factors,  such as trade secret  protection,  the
knowledge,  ability and experience of Rational's personnel, name recognition and
ongoing product development and support.

         Rational's software products are generally licensed to end users on a
"right to use" basis pursuant to a perpetual license. Rational licenses its
products primarily under "shrink wrap" licenses (i.e., licenses included as part
of the product packaging). Shrink wrap licenses are not negotiated with or
signed by individual licensees and purport to take effect upon the opening of
the product package. Certain provisions of such licenses, including provisions
protecting against unauthorized use, copying, transfer and disclosure of the
licensed program, may be unenforceable under the laws of certain jurisdictions.
In addition, the laws of some foreign countries do not protect Rational's
proprietary rights to the same extent as do the laws of the United States.

         As the number of software products in the industry increases and the
functionality of these products further overlaps, Rational believes that
software programs will increasingly become subject to infringement claims. There
can be no assurance that third parties will not assert infringement claims
against Rational in the future with respect to current or future products. Any
such assertion could require Rational to enter into royalty arrangements or
result in costly litigation.

EMPLOYEES

         As of March 31, 1997, Rational employed 845 full-time personnel,
including 286 in product development and support, 466 in sales, marketing and
technical consulting and 93 in finance and administration. Rational's employees
are not represented by any collective bargaining organization, and Rational has
never experienced a work stoppage. Rational believes its success will depend in
part on its continued ability to attract and retain highly qualified personnel
in a competitive market for experienced and talented software engineers and
sales and marketing personnel.

EXECUTIVE OFFICERS

         The executive officers of Rational and their ages as of June 12, 1997
are as follows: 

<TABLE> 
<CAPTION>                                                                                                      
Name                    Age       Position                                                    
----                    ---       --------
<S>                     <C>       <C> 
Paul D. Levy             41       Chief Executive Officer
Michael T. Devlin        42       President
Robert T. Bond           54       Senior Vice President, Chief Operating Officer, Chief
                                   Financial Officer, and Secretary
David H. Bernstein       45       Senior Vice President and General Manager, Products
John R. Lovitt           52       Senior Vice President Worldwide Field Operations
Thomas F. Bogan          45       Vice President and General Manager, SQA Business Unit
Timothy A. Brennan       41       Vice President, Finance and Administration
Frederick J. Ciaramaglia 49       Vice President, Research and Development
James P. Cluchey         49       Vice President, European Operations
William T. Dedrick       41       Vice President, Channel and Telesales Operations
Kevin J. Haar            40       Vice President, Major Accounts, North American Field
                                   Operations
</TABLE> 
                                       12
<PAGE>
 
                          RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

<TABLE> 
<S>                        <C>      <C> 
Roger A. Hodskins          41       Vice President, Business Development
Ivar Jacobson              58       Vice President, Business Engineering
Dean Leffingwell           47       Vice President and General Manager, Requirements
                                      Management Business Products
Joseph N. Marasco          51       Vice President and General Manager Programming
                                      Environments
Gregory L. Meyers          40       Vice President and General Manager, Rose Business Unit
Richard P. Reitman         44       Vice President, Process and Project Management Products
Gerard J. Rudisin          43       Vice President, Corporate Marketing and Technical Marketing
Eric L. Schurr             39       Vice President, Product Marketing Commercial IS Products
</TABLE> 

     Paul D. Levy co-founded  Rational in 1981. He is currently  Chairman of the
Board and Chief Executive  Officer.  Prior to September 1996, Mr. Levy served as
President  and Chief  Executive  Officer of Rational. Mr. Levy is a director of
Peerless Systems Corporation. Mr. Levy is the son-in-law of Mr. Campbell.

     Michael T. Devlin  co-founded  Rational in 1981. He is currently  President
and a director.  Prior to September  1996,  Mr. Devlin served as Chairman of the
Board of Rational.

     Robert T. Bond joined  Rational in 1983 as Vice President of Marketing.  In
1990, he was named Senior Vice  President and General  Manager of  International
Field  Operations.  In April,  1996 he was named  Senior Vice  President,  Chief
Operating Officer,  Chief Financial Officer and Secretary of Rational.

     David H. Bernstein joined Rational in 1982 as Vice President, Product
Development. In 1991, Mr. Bernstein was named Vice President and General Manager
of the Ada Business Unit. Mr. Bernstein was named Vice President and General
Manager, Object Technology Products, and Senior Vice President and General
Manager, Object Technology Products in 1994 and 1995, respectively. In May 1996,
Mr. Bernstein was named Senior Vice President and General Manager, Products.

     John R. Lovitt joined Rational as a Regional Manager responsible for
sales and marketing in 1986. In 1990, he was promoted to Vice President, and
subsequently to Senior Vice President, North American Field Operations. In
November 1996, Mr. Lovitt was promoted to Senior Vice President, Worldwide Field
Operations where he is responsible for worldwide field sales and marketing and
technical services.

                                       13
<PAGE>

                          RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

     Thomas F. Bogan joined Rational as Vice President and General Manager,
SQA Business Unit when Rational acquired SQA, Inc. Prior to joining Rational,
Mr. Bogan served as Senior Vice President, Finance & Administration, Chief
Financial Officer, Treasurer, and Assistant Secretary of SQA, Inc. since July
1996. Prior to joining SQA, Mr. Bogan was President and Chief Executive Officer
of Pacific Data Products, Inc., a printer peripherals and networking vendor from
1993 to 1996. From 1987 to 1993, Mr. Bogan was President and Chief Executive 
Officer of Avatar Corporation, a provider of Macintosh networking and 
connectivity solutions. Mr. Bogan is a director of American Service Group, Inc.

     Timothy A. Brennan is Vice President, Finance and Administration. He joined
Rational as Corporate  Controller in 1994.  From 1987 to 1994,  Mr. Brennan held
various financial  management and  controllership  positions with The ASK Group,
Inc.

     Frederick J.  Ciaramaglia  joined Rational as Vice President,  Research and
Development  when Rational  acquired SQA, Inc.  Prior to joining  Rational,  Mr.
Ciaramaglia  served as Vice  President,  Research and  Development  of SQA since
March 1994. From 1992 to 1994, Mr.  Ciaramaglia served as Senior Vice President,
Development at Clinical  Information  Advantages,  Inc., a computerized  patient
record software  products company.  Mr.  Ciaramaglia was a founder of Softbridge
Microsystems, Inc., a software development company and served as its Senior Vice
President, Technology from 1983 to 1992.

     James P. Cluchey joined Rational as Vice President, European Operations
when Rational acquired SQA, Inc. Prior to joining Rational, Mr. Cluchey served
as Vice President, Managing Director of European Operations of SQA since January
1995. From 1993 to 1995, Mr. Cluchey served as Vice President Europe of ST
Europe PLC, a sales force automation software company and a subsidiary of the
Dun and Bradstreet group. From 1991 to 1993, Mr. Cluchey served as Vice
President Europe of Datalogix Europe, the European division of Datalogix
International, Inc. a software applications company.

     William T. Dedrick joined Rational as Vice President, Channels and
Telesales Operations when Rational acquired SQA, Inc. Prior to joining Rational,
Mr. Dedrick served as Vice President, U.S. Sales of SQA since 1993. From 1992 to
1993, Mr. Dedrick served as Vice President, North American Sales of Easel
Corporation, a software development company.

     Kevin J. Haar is Vice  President,  Major  Accounts,  North  American  Field
Operations. He joined Rational in 1986 as an account representative in the field
sales  force.  Since  then,  he has held a number of  positions,  most  recently
District  Manager  and Eastern  Regional  Manager.

     Roger A. Hodskins joined Rational as Vice President, Business
Development when Rational acquired SQA, Inc. Prior to joining Rational, Mr.
Hodskins served as Vice President, Strategic Alliances of SQA since January
1996. Mr. Hodskins joined SQA in February 1992 as the Director of Alternate
Channels and was appointed Vice President, Enterprise Partners in January 1995.
From 1988 to 1992, Mr. Hodskins served as Manager, Geographic Information
Systems and Senior International Marketing Manager of Wang Laboratories, Inc.

     Ivar Jacobson joined Rational as Vice President, Business Engineering
in 1995, when Rational acquired Objectory AB. Prior to joining Rational, Mr.
Jacobson served as President of Objectory AB from 1990 to 1991, and as Vice
President of Objectory AB from 1991 to 1995.

                                       14
<PAGE>
 
                          RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

Executive Officer of Avatar Corporation,  a provider of Macintosh networking and
connectivity solutions. Mr. Bogan is a director of American Service Group, Inc.

     Dean A. Leffingwell joined Rational as Vice President and General
Manager, Requirements Management Business Products, when Rational acquired
Requisite, Inc. Prior to joining Rational, Leffingwell served as Chief
Executive Officer of Requisite, Inc., which he co-founded in 1994. Prior to
1994, Leffingwell served as Chairman of Colorado MEDtech, Inc., where he
continues to serve as a director.

     Joseph N. Marasco is Vice President and General Manager, Programming
Environments. He joined Rational in 1986 as a product manager. He has since held
various positions in Rational, including Director of Product Marketing, Director
of Consulting Services and Director of Engineering for the Apex product line and
Vice President and General Manager, Windows Application Construction Products.

     Gregory L. Meyers is Vice President and General Manager, Rose Business 
Unit. Mr. Meyers joined Rational as Director of Rose Development in 1995, when
Rational acquired Palladio Software Corporation. In April 1996, Mr. Meyers was
named Vice President and General Manager, Object Modeling Products. Prior to
joining Rational, Mr. Meyers served as Project Manager at General Electric
Medical Systems from 1990 to 1992, and as Chief Architect, Software Tools at
Palladio Software Corporation from 1992 to 1995.

     Richard P. Reitman joined Rational in 1982. From 1991 to 1993, he
served as Product Architect, and from 1993 until 1996 he served as Chief Product
Architect of Rational. Mr. Reitman now serves as Vice President, Process and
Project Management Products. Since March 1996, Mr. Reitman has also been
Chairman and Secretary of Reitman Corp. Medical Regulatory Consulting, a
business consulting firm unaffiliated with Rational.

     Gerard J. Rudisin is Vice President, Corporate Marketing and Technical
Marketing. Mr. Rudisin joined Rational in 1991 as Director of Marketing for
Rational's Ada products. In 1993 he was named Vice President, Corporate
Marketing.

     Eric L. Schurr joined Rational as Vice President, Product Marketing
Commercial IS Products when Rational acquired SQA, Inc. Prior to joining
Rational, Mr. Schurr served as Vice President, Product Management and Marketing
since April 1994. Mr. Schurr joined SQA in November 1992 as the Director of
Marketing. From 1983 to 1992, Mr. Schurr held various field, technical and
marketing positions at Cognos, most recently as Director, Marketing Support.
From 1980 through 1983, Mr. Schurr was an analyst at The Standard Oil Company.

                                      15
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

FACTORS THAT MAY AFFECT FUTURE RESULTS

Fluctuations In Operating Results.
---------------------------------

    Revenue in any quarter is substantially dependent on orders booked and 
shipped in that quarter. Because staffing and operating expenses are based on 
anticipated revenue levels, and a high percentage of the costs are fixed, small 
variations in the timing of the recognition of specific revenues could cause 
significant variations in operating results from quarter to quarter.
Historically, the Company has earned a substantial portion of its revenues in
the last weeks of the quarter. To the extent these trends continue, the failure
to achieve such revenues in the last weeks of any given quarter will have a
material adverse effect on the Company's financial results for that quarter. The
Company's revenue is difficult to forecast due to the fact that Rational's 
sales cycles, from initial evaluation to purchase, vary substantially
from customer to customer and from product to product, and because the markets
for Rational's products are rapidly evolving. In addition, the Company's results
will be affected by the number, timing and significance of new product
announcements by it and its competitors, its ability to develop, introduce and
market new and enhanced and integrated versions of its products on a timely
basis, the level of product and price competition, changes in operating
expenses, changes in average selling prices and product mix, any changes in its
sales incentive strategy, the experience level of and any changes in sales
personnel, any changes in sales cycles, the mix of direct and indirect sales,
product returns and general economic factors, among others. The Company's sales
will also be sensitive to existing and prospective customers' budgeting
practices and to potential cutbacks in defense spending, which has historically
been a significant factor for Rational.

     Although Rational has experienced increasing revenues in each of the past 
twelve quarters, its sales compensation structure has historically resulted in 
revenues for the first quarter of a fiscal year being lower than revenues for 
the fourth quarter of the prior fiscal year. There can be no assurance that 
similar fluctuations will not occur again in the future.

     Rational recorded a net loss for the quarter and year ended March 31, 1997,
primarily as a result of certain one-time charges associated with acquisitions 
of businesses and assets in the second half of the fiscal year. Rational may 
experience unanticipated costs related to these or other acquisitions in future 
periods, and difficulties in integrating these or other acquisitions into 
Rational's operations may materially and adversely affect Rational's results of 
operations and financial condition in the future.

     The Company estimates that direct transaction costs associated with the 
anticipated acquisition of Pure Atria Corporation ("Pure Atria") will total 
approximately $15 million, which will result in a non-recurring charge to 
operations upon consummation of such transaction. The Company expects to incur
a non-recurring charge to operations of between $40 million and $60 million, 
primarily in the quarter ending September 30, 1997, the quarter in which such
transaction is expected to be consummated, to reflect costs associated with 
integrating the two companies. Actual costs may substantially exceed such 
estimates, unanticipated expenses associated with the integration of the two 
companies may arise, or the Company may incur additional material charges in 
subsequent quarters to reflect additional costs associated with the integration
of the two companies. Total costs associated with such transaction are
anticipated to result in an operating loss and a net loss for the Company's 
quarter ending September 30, 1997, and for the fiscal year ending March 31, 
1998, and could negatively impact financial results in future periods for 
the reasons discussed above.

     Although Rational has experienced growth in revenues in recent years, there
can be no assurance that, in the future, Rational will sustain revenue growth or
be profitable on a quarterly or annual basis. Further, the revenues and 
operating income (exclusive of nonrecurring operating, restructuring and 
merger-related expenses) experienced by Rational in recent quarters are not 
necessarily indicative of future results, and period-to-period comparisons of 
Rational's financial results should not be relied upon as an indication of 
future performance. Fluctuations in operating results may also result in 
volatility in the prices of Rational's Common Stock.

     Due to all of the foregoing factors, it is possible that in some future 
quarter Rational's operating results will be below the expectations of public 
market analysts and investors. In such event, the price of Rational's Common 
Stock would likely be materially adversely affected, and significant declines in
stock prices frequently result in costly and lengthy securities litigation, with
its attendant costs, distraction and liability exposure.


Volatility Of Stock Price.
-------------------------

     The market price of the Company's Common Stock has been, and is likely to
continue to be, volatile. Factors such as new product announcements or changes
in product pricing policies by the Company or its competitors, quarterly
fluctuations in the Company's operating results, announcements of technical
innovations, announcements relating to strategic relationships or acquisitions,
changes in earnings estimates by analysts and general conditions in the
component-based software development market, among other factors, may have a
significant impact on the market price of the Company's Common Stock. Should the
Company fail to introduce products on the schedule expected, the Company's stock
price could be adversely affected.

     Any shortfall in anticipated operating results could have an immediate 
and significant adverse effect on the market price of the Company's Common 
Stock. The Company's net income per share may decrease as a result of the 
proposed Pure Atria Merger, and potential business synergies, if achieved, of 
Rational and Pure Atria may not offset any such dilution. Further, the Company
will incur substantial merger-related charges primarily in the quarter in 
which the Merger is consummated. Rational expects the Merger to be accretive 
in the long-term. However, this forward-looking statement may not prove to be 
an accurate prediction due to unforseen changes, inaccurate or incomplete 
assumptions regarding the current business or future prospects of either or 
both of the companies, or other reasons. Rational expects that the proposed 
Pure Atria Merger may be dilutive in the initial periods following its 
effective time, and there can be no assurance as to when the Merger will 
become accretive, if ever. Any failure of the proposed Pure Atria Merger to 
meet expectations as to potential business synergies or any failure of the 
proposed Pure Atria Merger to be accretive in any quarter could have an 
immediate and significant adverse effect on the market price of the Company's 
Common Stock.

     Statements or changes in opinions, ratings, or earnings estimates made by
brokerage firms or industry analysts relating to the market for software and 
high technology company stocks or relating to Rational specifically have 
restulted, and could in the future result, in an immediate and adverse effect 
on the market price of Rational's Common Stock. Statements by financial or 
industry analysts regarding the extent of the dilution in Rational's net 
income per share resulting from operating results, the proposed Pure Atria 
Merger or other developments and the extent to which such analysts expect 
potential business synergies to offset such dilution can be expected to 
contribute to volatility in the market price of Rational's Common Stock. In 
addition, in recent years the stock market in general, and the shares of 
technology companies in particular, have experienced extreme price 
fluctuations. This volatility has had a substantial effect on the market 
prices of securities issued by many companies, including Rational, in certain 
cases for reasons unrelated to the operating performance of the specific 
companies. These broad market fluctuations may adversely affect the market 
price of the Rational Common Stock.

                                       16
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

Risks Associated With Recent And Future Acquisitions.
----------------------------------------------------

     During approximately the past three years, and the past year in particular,
Rational has made a number of strategic acquisitions. Rational acquired SQA, 
Inc., Performance Awareness Corporation, Requisite, Inc., Softlab AB, and 
Software 9000 in the quarter ended March 31, 1997; the Visual Test product
from Microsoft in October 1996; and made other acquisitions in earlier
periods. On April 7, 1997, Rational entered into a definitive agreement to
acquire Pure Atria Corporation (the "Pure Atria Agreement"). See "Business -
Definitive Agreement to Acquire Pure Atria Corporation." Acquisitions may
result in the diversion of management's attention from day-to-day operations
and may include numerous other risks, including difficulties in the
integration of operations, products and personnel. To the extent that
acquisitions have in the past resulted,or may in the future result, in a
diversion of resources or that efforts to integrate recent and future
acquisitions fail, there could be a material adverse effect on Rational's
business, results of operations and financial condition. Acquisitions have the
potential to result in dilutive issuances of equity securities, the incurrence
of debt, and amortization expenses related to goodwill and other intangible
assets. Rational management has historically evaluated on an ongoing basis the
strategic opportunities available to the Company. Rational may in the near-or
long-term future pursue acquisitions of complementary products, technologies
or businesses. Pursuant to the terms of the Pure Atria Agreement, while the 
Pure Atria Merger is pending, Rational is limited in its ability to undertake
material acquisitions without first obtaining the consent of Pure Atria. As a
result, future acquisition opportunities which the Rational Board might consider
to be advantageous to Rational, could be materially more difficult to pursue,
and could be lost to competitors of Rational.

Dependence Upon Market Growth And Development Of Industry Standards.
-------------------------------------------------------------------

     Rational's future growth and financial performance will depend in part upon
continued growth in the need for and sales of tools for automating software 
application development and management. Sales of these products may not continue
to grow or the Company may be unable to respond effectively to evolving customer
requirements. The number of software developers using Rational's products is 
relatively small compared to the number of developers using more traditional 
technology and products. The adoption of the Company's products by software 
programmers who have traditionally used other technology requires re-orientation
to significantly different programming methods. The acceptance of the Company's 
products, therefore, may not expand beyond sophisticated programmers who are 
early adopters of the technology. Furthermore, potential customers may be 
unwilling to make the investment required to retrain programmers to build 
software using the Company's products rather than traditional programming 
techniques. Many of Rational's customers have purchased only small quantities of
the Company's products, and these or new customers may decide not to broadly 
implement or purchase additional units of such products.

     Rational's future growth and financial performance may depend upon the 
development of industry standards that facilitate the adoption of 
component-based development, as well as Rational's ability to play a leading 
role in the establishment of those standards. The Company has developed the 
Unified Modeling Language ("UML") for visual modeling and has submitted an 
application to the Object Management Group ("OMG"), an industry consortium, for 
inclusion of the UML in their Object Analysis and Design Facility specification.
Competing standards, including some that support the UML as well as other 
notations, also are expected to be submitted to the OMG. The official sanction 
of a competing standard by the OMG could have a material adverse effect on 
Rational's marketing and sales efforts and, in turn, on Rational's business, 
operating results and financial condition.

Expansion Of Product Lines; Dependence Upon New Product Introductions.
----------------------------------------------------------------------

     The Company believes that its continued success will depend in part upon
its ability to provide a tightly integrated line of software application
development tools, as well as integrated product suites and bundles, that
support software development for a number of implementation languages. This will
require the Company to modify and enhance its current products and to continue
to develop, introduce and integrate new products. The Company also believes its 
continued success will become increasingly dependent on its ability to support
the Microsoft platform, including Windows 95 and Windows NT operating systems. 
The Company believes that it will be particularly important to successfully 
develop and market a broader line of products for C++, Visual Basic, Java and 
other implementation languages in order to be successful in its efforts to 
broaden its customer base and to further increase its share within its existing
market segments. The Company may be unable to successfully develop and market 
such a broad line of products, or may encounter unexpected difficulties and 
delays in integrating new products with existing product lines.

     Rational has plans to introduce new products and enhanced versions of 
current products during the next few fiscal quarters. Delay in the start of 
shipment of new, enhanced or integrated products, suites and bundles would 
have an adverse effect on the Company's revenues, gross profit and operating 
income. As a result of Rational's business alliance with Microsoft, certain of
Rational's new product releases are expected to be tightly integrated with new
releases of certain Microsoft products. To the extent that scheduled Microsoft
product releases are delayed, there could be a material adverse effect on 
Rational's revenues from new products. 

    Rational attempts to make adequate allowances in its product release 
schedules for both internal and beta-site testing of product performance. 
Because of the complexity of the Company's products, however, the release of new
products may be postponed should test results indicate the need for redesign and
retesting, or should the Company elect to add product enhancements in response 
to beta customer feedback.


                                       17
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

COMPETITION

         The industry for tools for automating software application development
and management is extremely competitive and rapidly changing. Rational expects
to continue to experience significant and increasing levels of competition in
the future. Bases of competition include corporate and product reputation,
innovation with frequent product enhancement, breadth of integrated product
line, the availability of integrated suites and bundles, product architecture,
functionality and features, product quality, performance, ease-of-use, support,
availability of technical consulting services and price. Rational faces
intense competition for each product within its product lines, generally from
both Windows and UNIX vendors. Because individual product sales are often the
first step in a broader customer relationship, Rational's success will depend
in part upon its ability to successfully compete with numerous competitors at
each point within its product line.

         Rational faces competition from software development tools and
processes developed internally by customers, including ad hoc integrations of
numerous stand-alone development tools. Customers may be reluctant to purchase
products offered by independent vendors such as the Company. As a result, the 
Company must educate prospective customers as to the advantages of the 
Company's products versus internally developed software quality systems.

         Rational faces competition from, among others, Intersolv, Inc.,
Platinum Technology, Inc., Select Software Tools plc, Cayenne, Oracle, IBM
Corporation ("IBM"), Sun Microsystems, and Sybase Inc. as well as numerous
privately held tool suppliers offering traditional CASE tools that compete
with the Rational Rose approach to visual modeling and component-based
development. Rational's RequisitePro requirements management product faces
competition from companies such as GEC-Marconi. Rational's software testing
tools--SQA Suite, Rational Visual Test and preVue--face competition from
Compuware, Mercury Interactive Corporation, Segue Software, Inc., Intersolv,
Inc., Computer Associates, Platinum Technologies, Terodyne, Cyrano, SQL Bench
International, Inc., and several private companies offering testing automation
tools. Microsoft, Compuware, Oracle, Sybase and several of the major UNIX
platform vendors, including Sun Microsystems, Hewlett Packard, Digital
Equipment Corporation, Silicon Graphics Inc., and IBM, also compete with
Rational with respect to software quality products and testing tools, with
testing products customized to certain of their other software products.
Rational Apex for C/C++ faces competition from, among others, major UNIX
platform vendors such as Sun Microsystems, Hewlett-Packard and Digital
Equipment Corporation, which have C/C++ compilers and debuggers and in some
cases programming environments for their platforms. In addition, numerous
privately held companies offer compilers, debuggers and programming
environments which compete with Rational Apex. The Rational Summit product
line faces competition from various suppliers offering products with change
management functions, including Continuous Software Corporation, Hewlett
Packard, True Software, SQL Software, LTD., Intersolv, Inc., Sun Microsystems
and IBM. Rational's Apex Ada and VADs product lines face competition from
Aonix, Green Hills Software, Inc. and a large number of other suppliers
offering Ada products for native and embedded systems.

         Rational believes that the increased level of competition it observed
in fiscal 1997 will continue to increase. Certain of Rational's competitors
are more experienced than Rational in the development of software-engineering
tools, databases or software-development products. Some of Rational's
competitors have, and new competitors may have, larger technical staffs, more
established distribution channels and greater financial resources than
Rational. There can be no assurance that either existing or new competitors
will not develop products that are superior to Rational's products or that
achieve greater market acceptance. Rational's future success will depend in
large part upon its ability to increase its share of its target markets and to
license additional products and product enhancements to existing customers. 
Future competition may result in price reductions, reduced margins or loss of 
sales which in turn would have a material adverse effect on the Company's 
business, results of operations and financial condition.


Dependence Upon Sales Force And Other Channels Of Distribution.
------------------------------------------------------------

     Rational currently distributes its products primarily through field sales
personnel teamed with highly trained technical support personnel. Rational
believes that a high level of technical consulting, training and customer
support is essential to maintaining its competitive position, and has found
that the ability to deliver a high level of technical consulting, training and
customer support is an important selling point with respect to its products.
While complementary to Rational's products, the services provided by these
personnel have historically yielded lower margins for Rational than the
Company's product business. If these services constitute a higher proportion
of total revenues in the future, the Company's margins will be adversely
affected. Rational markets and sells its products and services directly
through telesales organizations, field operations, sales organizations and
indirectly through channels such as VARs and distributors. There can be no
assurance that such channels will be successful in increasing sales of the
Company's products or in reducing its sales costs on a percentage basis.


                                       18
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

Dependence on Key Personnel.
---------------------------

     Rational believes that the hiring and retaining of qualified individuals at
all levels in the Company will be essential to the Company's ability to manage 
growth successfully, and there can be no assurance that the Company will be 
successful in attracting and retaining the necessary personnel. The Company will
be particularly dependent upon the efforts and abilities of its senior 
management personnel. The departure of any of the senior management members or 
other key personnel of the Company could have a material adverse effect on the 
Company's business, financial condition, or results of operations depending upon
the timing of the departure, changes in the Company's business prior to such 
time, the availability of qualified personnel to replace them, and whether such 
personnel depart singly contemporaneously, or as a group, among other factors.
Merger activities, such as the proposed acquisition of Pure Atria, can be
accompanied or followed by the departure of key personnel, which can compound
the difficulty of integrating the operations of the parties to the business
combination.  None of the Rational executive officers is subject to any
agreement not to compete or severance agreement with Rational.

     The ability of the Company to attract and retain the highly trained 
technical personnel that are integral to its direct sales and product
development teams may limit the rate at which the Company can develop products
and generate sales. Competition for qualified personnel in the software
industry is intense, and there can be no assurance that the Company will be
successful in attracting and retaining such personnel. Merger activities, such
as the proposed acquisition of Pure Atria, may have a destabilizing effect on
employee retention at all levels within the Company. Departures of existing
personnel, particularly in key technical, sales, marketing or management
positions, can be disruptive and can result in departures of other existing
personnel, which in turn could have a material adverse effect upon the
Company's business, operating results and financial condition.

     A traditional means of retaining employees following declines in a 
corporation's stock price, such as those experienced recently by Rational, is 
to reprice "underwater" stock options, both to offer an equity incentive to 
existing employees and to avoid inequities relative to new employees offered 
lower-priced options. However, attempts to address potential employee 
attrition by repricing employee stock options could be negatively interpreted 
by analysts and investors and possibly negatively affect the proposed 
pooling-of-interests accounting treatment for the proposed Pure Atria Merger. 
As long as substantial numbers of options remain underwater, Rational, may 
suffer employee attrition in excess of historical rates, which could have a 
material adverse effect on the Company's business, results of operations and 
financial condition.



                                       19
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

Rapid Technological Change.
--------------------------

     The industry for tools for automating software application development and
management is characterized by rapid technological advances, changes in customer
requirements and frequent new product introductions and enhancements. The
introduction of products embodying new technologies and the emergence of new
industry standards and practices can render existing products obsolete and
unmarketable. The Company must respond rapidly to developments related to
Internet and intranet applications, hardware platforms, operating systems and
applicable programming languages. Such developments will require the Company to
make substantial product development investments. Any failure by the Company to
anticipate or respond adequately to technology developments and customer
requirements, or any significant delays in product development, introduction or
integration could result in a loss of competitiveness or revenue. To the extent
the Company does not respond to technological change or evolving customer
requirements with new products or product enhancements, such new products or
product enhancements may fail to achieve market acceptance.

     In addition, rapid growth of interest in and use of Internet and intranet
environments is a recent and emerging phenomenon. The Company's success may
depend, in part, on the compatibility of its products with Internet and intranet
applications. The Company may fail to effectively adapt its products for use in
Internet or intranet environments or to produce competitive Internet and
intranet applications.

     Rational believes that factors affecting the ability of its products to
achieve broad consumer acceptance include product performance, price, ease of
adoption, displacement of existing approaches and adaptation to rapid
technological change and competitive product offerings. The Company may be
unable to respond promptly and effectively to the challenges of technological
change and its competitors' innovations, and it is possible that the Company
will be unable to achieve the necessary market acceptance, or compete
effectively, in new markets.

Dependence On Strategic Relationships.
-------------------------------------

     Rational's development, marketing and distribution strategies rely
increasingly on its ability to form long-term strategic relationships with major
software and hardware vendors, many of whom are substantially larger than
Rational. These business relationships often consist of cooperative marketing
programs, joint customer seminars, lead referrals or joint development projects.
Although certain aspects of some of these relationships are contractual in
nature, many important aspects of these relationships depend upon the
continued cooperation of each party with Rational. Merger activity, such as
the proposed acquisition of Pure Atria, may disrupt these relationships or
activities, and certain partners may reassess the value of their relationship
with Rational as a result of such merger activity. Divergence in strategy
between Rational and any given partner, a change in focus by any given
partner, or competitive product offerings introduced by any given partner, may
interfere with Rational's ability to develop, market, sell or support its
products, which in turn would have a material adverse effect on Rational's
business, results of operations and financial condition. See "- Business 
Alliance with Microsoft."

                                       20
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------


Business Alliance With Microsoft.
--------------------------------

     On October 2, 1996, Rational and Microsoft announced the formation of a 
business alliance which consists of Rational's acquisition of Microsoft's Visual
Test product, technology cross-licensing, joint development projects and joint 
marketing programs. While Rational believes that Microsoft's current strategy in
relation to the enterprise information systems market is based on 
component-based development, there can be no assurance that this strategy will 
continue or that, if it does continue, Microsoft's emphasis or priorities will 
not change in the future, resulting in less attention and fewer resources being 
devoted to Microsoft's relationship with Rational. Although certain aspects of 
the business alliance are contractual in nature, many important aspects of the 
relationship depend on the continued cooperation of the two companies, and there
can be no assurance that Rational and Microsoft will be able to work together 
successfully over an extended period of time. In addition, there can be no 
assurance that Microsoft will not use the information it gains in its 
relationship with Rational to develop or market competing products.

Acquisition Of The Visual Test Product.
--------------------------------------

     The Company acquired the Visual Test product from Microsoft on October 2,
1996.  There can be no assurance that Rational will be able to successfully
incorporate Visual Test into its integrated family of products, or that it will
be able to achieve significant sales of the Visual Test product.  Many potential
customers for Visual Test differ from the Company's historical customer base in
terms of component-based software development expertise, purchasing processes,
financial resources and expectations regarding software-engineering tools.
There can be no assurance that the Company will not encounter unanticipated
concerns of Visual Test customers that are different from the concerns of the
Company's traditional customers, or that the Company will have the
infrastructure and experience necessary to adequately respond to the volume and
type of such concerns.

     Rational has granted Microsoft a non-exclusive, perpetual license to the
Visual Test product source code for the purpose of creating derivative works and
for the purpose of distributing portions of the Visual Test product and
derivative works as part of Microsoft products that do not directly compete
with the Visual Test product in the software testing tools area. There can be
no assurance that Microsoft will not use such rights to create and distribute
products that compete with other Rational products. Rational has also granted
Microsoft a five-year option to obtain a license to incorporate certain elements
of Visual Test technology into Microsoft development tool products, including
Visual Basic, Visual C++ and Visual J++. Should Microsoft exercise such right,
sales of the Visual Test product by Rational could be materially and adversely
impacted. See "--Fluctuations in Operating Results."


Licensing Of Rose Technology To Microsoft.
-----------------------------------------

     In October 1996, Microsoft and Rational entered into a two-year agreement
providing for the inclusion of a subset of the Rational Rose visual modeling
technology in future versions of Microsoft's enterprise-oriented visual tools.
The Company's objective in entering into this arrangement is to expose the
Company's technology to a broader customer base, and is not to generate direct
product revenue from Microsoft. The Company expects that changes in the
Company's pricing models and combinations of features within product lines
will be required to appeal to this customer base, and there can be no
assurance that such changes will achieve customer acceptance. Rational does
not expect the licensing of its Rose technology to Microsoft to directly
result in a material increase in product revenue. In addition, there can be no
assurance that developers introduced to the Rose technology incorporated into
Microsoft products will become purchasers of Rational products in the future.
Rational has granted Microsoft the option to obtain a perpetual, non-exclusive
right to source code for certain aspects of Rational's Rose technology after
the expiration of the agreement. While Rational believes that Microsoft's and
Rational's strategies currently are complementary, there can be no assurance
that Microsoft will not use this right to develop and market competing
products in the future.


                                       21
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                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------


Dependence Upon Major Operating Systems.
---------------------------------------

     Many of Rational's major products have historically been licensed for use 
principally on certain versions of the UNIX platform. These products constitute 
a substantial portion of Rational's product and service revenues. Any factors
adversely affecting the demand for, or use of, the UNIX operating system that
would require changes to Rational's products would have a material adverse
effect upon the business, operating results and financial condition of Rational.
Likewise, other of Rational's major products have historically been licensed for
use purely on the Windows operating system. These products also constitute a
substantial portion of Rational's product and service revenues. Any factors
adversely affecting the demand for, or use of, the Windows operating system that
would require changes to Rational's products would have a material adverse
effect upon the business, operating results and financial condition of Rational.
In addition, any changes to the underlying components of or interfaces to the
UNIX or Windows operating systems that would require changes to Rational's
products for those platforms would materially adversely affect Rational if it
were not able to successfully develop or implement such changes in a timely
fashion.


Adverse Impact Of Promotional Product Versions On Actual Product Sales.
----------------------------------------------------------------------

     The Company's marketing strategy relies in part on making elements of its
technology available for no charge or at a very low price, either directly or by
incorporating such elements into products offered by the Company's partners,
such as Microsoft. This strategy is designed to expose the Company's products
to a broader customer base than its historical customer base, and to encourage
potential customers to purchase an upgrade or other higher-priced product from
the Company. There can be no assurance that the Company will be able to
introduce enhancements to its full-price products or versions of its products
with intermediate functionality at a rate necessary to adequately
differentiate them from the promotional versions, particularly in cases where
the Company's partners are distributing versions of the Company's products
with other desirable features.


                                       22
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

Management Of Growth.
--------------------

     Rational has experienced rapid growth, particularly as a result of its
acquisitions, and the Company is experiencing a period of aggressive product
introductions that have placed, and may continue to place, a significant strain
on its financial, operational, management, marketing and sales systems and
resources, including its personnel. Projects such as the expansion of or
enhancements to product lines, efforts to address broader markets and to expand
distribution channels, numerous acquisitions as described in "Risks Associated
with Recent and Future Acquisitions'' and business alliances such as the recent
arrangement between Rational and Microsoft, when added to the day-to-day
activities of Rational, have placed and will continue to place further strain on
management resources and personnel. If Rational's management is unable to
effectively manage growth, its business, competitive position, results of
operations and financial condition will be materially and adversely affected.

Risk Of Software Defects.
------------------------

     Software products as complex as those sold by the Company often contain
undetected errors, or "bugs," or performance problems. Such defects are most
frequently found during the period immediately following the introduction of
new products or enhancements to existing products. Despite extensive product
testing prior to introduction, the Company's products have in the past
contained software errors that were discovered after commercial introduction.
Errors or performance problems may also be discovered in the future. Any
future software defects discovered after shipment of the Company's products
could result in loss of revenues or delays in market acceptance, which could
have a material adverse effect on the Company's business, operating results or
financial condition. Further, because the Company relies on its own products
in connection with the development of its software, any such errors could make
it more difficult to sell such products in the future. Rational attempts to
make adequate allowance in its new product release schedule for both internal
and beta-site testing of product performance. Because of the complexity of the
Company's products, however, the release of new products by the Company may be
postponed should test results indicate the need for redesign and retesting, or
should the Company elect to add product enhancements in response to beta
customer feedback.

Risks Associated with International Operations.
----------------------------------------------

     International sales accounted for approximately 33%, 35%, and 32% of
Rational's revenues in fiscal 1995, 1996 and 1997, respectively. Rational
expects that international sales will continue to account for a significant
portion of the Company's revenues in future periods. International sales are
subject to inherent risks, including unexpected changes in regulatory
requirements and tariffs, difficulties in staffing and managing foreign
operations, longer payment cycles, greater difficulty in accounts receivable
collection, potentially adverse tax consequences, price controls or other
restrictions on foreign currency, difficulties in obtaining export and import
licenses, costs of localizing products for foreign markets, lack of acceptance
of localized products in foreign markets, and the efforts of high local wage
scales and other expenses. Any material adverse effect on the Company's
international business would be likely to materially and adversely affect the
Company's business, operating results and financial condition as a whole.
Rational's international sales are generally denominated in foreign
currencies. Rational has engaged in only limited hedging activities. Gains and
losses on the conversion of foreign payments into U.S. dollars may contribute
to fluctuations in the Company's results of operations. Although the Company
has not experienced a material adverse impact to date from fluctuations in
foreign currencies, there can be no assurance that the Company will not
experience a material adverse impact on its financial condition and results of
operations from fluctuations in foreign currencies in the future. See
Management's Discussion and Analysis of Financial Condition and Results of
Operations - Results of Operations -International Sales."


                                       23
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

Limited Protection of Intellectual Property and Proprietary Rights.
------------------------------------------------------------------

     Rational relies on a combination of copyright, trademark and trade secret
laws, employee and third-party nondisclosure agreements and other methods to
protect its proprietary rights. Despite these precautions, it may be possible
for unauthorized third parties to copy certain portions of the Company's
products or reverse engineer or obtain and use information that Rational
regards as proprietary. Rational generally licenses its software products to
end-users on a "right to use" basis pursuant to a perpetual license. Rational
licenses its products primarily under "shrink-wrap" licenses (i.e., licenses
included as part of the product packaging). Shrink-wrap licenses are not
negotiated with or signed by individual licensees, and purport to take effect
upon the opening of the product package. Certain license provisions protecting
against unauthorized use, copying, transfer and disclosure of the licensed
program may be unenforceable under the laws of certain jurisdictions and
foreign countries. In addition, the laws of some foreign countries do not
protect proprietary rights to the same extent as do the laws of the United
States. There can be no assurance that these protections will be adequate. To
the extent that the Company increases its international activities, its
exposure to unauthorized copying and use of its products and proprietary
information will increase.

     The scope of United States patent protection in the software industry is
not well defined and will evolve as the United States Patent and Trademark
Office grants additional patents. Because patent applications in the United
States are not publicly disclosed until the patent is issued, applications may
have been filed which would relate to Rational's products.

     Rational also relies on certain software that it licenses from third
parties, including software that is integrated with internally developed
software and used in its products to perform key functions. There can be no
assurance that these third-party software licenses will continue to be available
to the Company on commercially reasonable terms, or that the software will be
appropriately supported, maintained or enhanced by the licensors. The loss of
licenses to, or inability to support, maintain and enhance any of such software
could result in increased costs, or in delays or deductions in product shipments
until equivalent software could be developed, identified, licensed and
integrated, which would materially adversely affect the Company's business,
operating results and financial condition.

Risks of Litigation.
-------------------

     Competitors and potential competitors may resort to litigation as a means
of competition. Such litigation or other legal disputes may be costly and expose
the Company to new claims that it may not have anticipated. In the past,
Rational has instituted litigation against several companies. Although patent
and intellectual property disputes in the software area have often been settled
through licensing, cross-licensing or similar arrangements, costs associated
with such arrangements may be substantial. Any litigation involving the Company,
whether as plaintiff or defendant, regardless of the outcome, may result in
substantial costs and expenses to the Company and significant diversion of
effort by the Company's technical and management personnel. In addition, there
can be no assurance that litigation, either instituted by or against the
Company, will not be necessary to resolve issues that may arise from time to
time in the future. Any such litigation could have a material adverse effect
upon the Company's business, operating results and financial condition.

     Rational expects that software product developers will be increasingly
subject to infringement claims as the number of products and competitors grows
and the functionality of products in different industry segments overlaps. There
can be no assurance that third parties will not assert infringement claims
against the Company in the future or that such claims will not be successful.
The Company could incur substantial costs in defending itself and its customers
against any such claims. Parties making such claims may be able to obtain
injunctive or other equitable relief that could effectively block the Company's
ability to sell its products in the United States and abroad, and could result
in an award of substantial damages. In the event of a claim of infringement, the
Company and its customers may be required to obtain one or more licenses from
third parties. There can be no assurance that the Company or its customers could
obtain necessary licenses from third parties at a reasonable cost or at all.
Defense of any lawsuit or failure to obtain any such required license would have
a material adverse effect on the Company's business, results of operations and
financial condition.


Deferred Tax Assets.
-------------------

     Based upon the weight of available evidence, which includes the Company's
historical operating performance and the reported cumulative net loss for the
prior three years, the Company has provided a full valuation allowance against
its net deferred tax assets as it is more likely than not that the deferred
tax assets will not be realized.


ITEM 2 -- PROPERTIES

     Rational's headquarters are located in a leased facility, located in Santa
Clara, California, consisting of approximately 94,000 square feet of office
space occupied under a lease expiring in January 2001, with a renewal option for
an additional five years. Rational also leases approximately 80,800 square feet
of office space in Burlington, Massachusetts under a lease expiring in July
1999; approximately 24,300 square feet of office space in Raleigh, North
Carolina under a lease expiring in June 2003; approximately 16,300 square feet
of office space 

                                       24
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

in Aloha, Oregon under a lease expiring in January 1999, and approximately
22,900 square feet of office space in McLean, Virginia under a lease expiring in
February 2001. In North America, Rational leases additional facilities and
offices including locations in Alabama, California, Colorado, Connecticut,
Florida, Illinois, Maryland, Massachusetts, New Hampshire, New Jersey, New York,
Ohio, Pennsylvania, Texas, Virginia, Washington, Wisconsin, and Canada. Rational
also leases facilities and offices outside of North America, including locations
in Bangalore, London, Munich, Paris, Sao Paolo, Seoul, Sydney, Stockholm,
Taipei, Tokyo, and Wellington. Rational believes that its existing facilities
and offices, together with additional space available to it, are adequate to
meet its requirements for the foreseeable future.


ITEM 3 -- LEGAL PROCEEDINGS

     On December 1, 1995, a complaint was filed against the Company relating to
the Company's preliminary acquisition negotiations with IDE, which were
subsequently terminated.  The complaint was settled in March 1997, within 
amounts previously reserved for.

     On December 16, 1996, the Company filed a lawsuit against Silicon Graphics,
Inc. ("SGI") arising from SGI's failure to pay certain royalties due to the 
Company under a software license agreement entered into between the Company's 
predecessor, Verdix Corporation, and SGI.  SGI has filed an answer denying the 
Company's allegations, and also filed a cross-complaint against the Company for 
unspecified damages for alleged wrongdoing arising out of the license agreement 
with SGI. The Company denies the allegations and intends to vigorously defend 
SGI's claims.

ITEM 4 -- SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     On February 26, 1997, at a Special Meeting of the Company's security
holders, the following matters were submitted to a vote:

     (1) The reservation and issuance of shares of Rational Common Stock, par
value $0.01 per share, to the stockholders of SQA, Inc. ("SQA") pursuant to an
Agreement and Plan of Reorganization, dated November 12, 1996, by and among
Rational, SQA and Sunshine Acquisition Corp., a wholly owned subsidiary of
Rational ("SQA Merger Sub"), providing, among other things, (i) for the merger
of SQA Merger Sub with and into SQA, resulting in SQA becoming a wholly owned
subsidiary of Rational, (ii) for the conversion of outstanding shares of Common
Stock, par value $0.01 per share, of SQA ("SQA Common Stock") into the right to
receive 0.86 (the "SQA Exchange Ratio") shares of Rational Common Stock, and
(iii) that each outstanding option or right to purchase SQA Common Stock under
the SQA stock option plans, the SQA stock purchase plan and outstanding warrants
will be assumed by Rational and will become an option or right to purchase
Rational Common Stock, with appropriate adjustments to be made to the number of
shares issuable thereunder and the exercise price thereof based on the SQA
Exchange Ratio.

     (2) The adoption of the Rational 1997 Stock Option Plan, including the
reservation thereunder of 1,000,000 shares of Rational Common Stock plus all
shares of Rational Common Stock available for issuance under pre-existing
Rational option plans (exclusive of the Stock Option Plan for Directors) for
which there are no options to purchase outstanding at the time of the approval.

     These were the only matters submitted to a vote of the Company's security
holders during the last quarter of its fiscal year ended March 31, 1997.

     In connection with the acquisition of SQA, Inc. Ronald H. Nordin became a
director, and subsequently resigned on April 5, 1997.

                                       25
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

                                       26
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

     The results of the vote at the meeting were as follows:

On proposal number 1 
regarding the Merger:                 VOTES
---------------------               ----------  
                For:                30,279,997
            Against:                    74,929
            Abstain:                    39,718
           Non Vote:                 3,429,937
                                              

On proposal number 2
regarding the 
reservation of 
Rational Common Stock:                VOTES
---------------------               ----------  
                For:                23,274,845
            Against:                10,493,478
            Abstain:                    56,258
           Non Vote:                         0 

 

                                       27
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

                                    PART II

ITEM 5 -- MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

     The Company's Common Stock is traded on the NASDAQ National Market under
the symbol RATL.  As of June 12, 1997, there were 998 shareholders of record
of the Company's Common Stock. The Company has not, since its formation,
declared or paid any cash dividends on its Common Stock. The Company intends
to employ all available funds for the development of its business and,
accordingly, does not intend to declare or pay any cash dividends in the
foreseeable future.

     The following table sets forth the range of high and low sales prices
reported on the Nasdaq National Market for Rational Common Stock for the periods
indicated:

<TABLE>
<CAPTION>
                                      HIGH    LOW
                                     ------  ------
<S>                                  <C>     <C>
Fiscal Year Ended March 31, 1997:
     Fourth Quarter................  $40.88  $17.00
     Third Quarter.................   44.25   29.75
     Second Quarter................   36.00   17.50
     First Quarter.................   33.13   19.00

Fiscal Year Ended March 31, 1996:
     Fourth Quarter................  $20.75  $ 7.94
     Third Quarter.................   12.00    6.81
     Second Quarter................    9.31    6.56
     First Quarter.................    6.88    5.25 
</TABLE>

Recent Sales of Unregistered Securities
---------------------------------------

     In connection with the Company's acquisition of Objectory AB
("Objectory"), in October, 1995, the Company issued 1,496,718 shares of its
Common Stock as consideration for its purchase of all of the outstanding
capital stock of Objectory. The issuance of such shares was exempt from
registration pursuant to Section 4(2) of the Securities Act of 1933, as
amended.

     As partial consideration for the acquisition of all of the outstanding
capital stock of Palladio Software Corporation, the Company issued 66,666
shares of its Common Stock.  The issuance of such shares was exempt from
registration pursuant to Section 4(2) of the Securities Act of 1933, as amended.


ITEM 6 -- SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                FISCAL YEAR ENDED MARCH 31,                    
                                                              ----------------------------------               
                                                    1993        1994        1995          1996      1997       
                                                  -------     -------     --------      --------   -------     
                                                              (IN THOUSANDS, EXCEPT PER SHARE DATA)            
<S>                                               <C>         <C>          <C>           <C>        <C>        
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Net product revenue............................   $46,752      $43,194      $42,611      $ 64,743   $ 91,696
Consulting and support revenue.................    24,894       28,804       34,738        39,209     53,677
                                                  -------      -------      -------      --------   --------
  Total revenue................................    71,646       71,998       77,349       103,952    145,373
                                                  -------      -------      -------      --------   --------
Cost of product revenue........................    10,380       12,007        7,148         7,826      9,134
Cost of consulting and support revenue.........    11,291       13,758       18,875        20,823     26,566
                                                  -------      -------      -------      --------   --------
  Total cost of revenue........................    21,671       25,765       26,023        28,649     35,700
                                                  -------      -------      -------      --------   --------
  Gross profit.................................    49,975       46,233       51,326        75,303    109,673

Operating expenses:
  Research and development.....................    19,618       20,971       13,914        18,305     24,445
  Sales and marketing..........................    22,595       22,949       28,454        41,000     50,656
  General and administrative...................     7,924        7,778        7,892        11,690     16,996
</TABLE> 

                                       28
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                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                FISCAL YEAR ENDED MARCH 31,                    
                                                              ----------------------------------               
                                                    1993        1994        1995          1996      1997       
                                                  -------     -------     --------      --------   -------     
                                                              (IN THOUSANDS, EXCEPT PER SHARE DATA)            
<S>                                               <C>         <C>          <C>           <C>        <C>        
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
  Charges for acquired in-process                 
   research and development....................        --           --           --         8,700     56,798
Merger and restructuring costs.................     2,500        9,922       (1,100)           --      7,201
                                                  -------      -------      -------      --------   --------
  Total operating expenses.....................    52,637       61,620       49,160        79,695    156,085
                                                  -------      -------      -------      --------   --------
  Income (loss) from continuing operations.....    (2,662)     (15,387)       2,166        (4,392)   (46,412)
Other income, net..............................       487          298          496         1,830      7,917
                                                  -------      -------      -------      --------   --------
  Income (loss) from continuing                   
   operations before income taxes..............    (2,175)     (15,089)       2,622        (2,562)   (38,495)
Provision for income taxes.....................     1,504          404          406         1,028      4,459
                                                  -------      -------      -------      --------   --------
  Income (loss) from continuing operations.....    (3,679)     (15,493)       2,256        (3,590)   (42,954)

Discontinued operations:
  Income (loss) from discontinued operations...     (1,515)          --           --            --         --
  Income (loss) on disposal....................      (296)        (175)          --            --         --
                                                  -------      -------      -------      --------   --------
Net income (loss)..............................   $(5,490)    $(15,668)     $ 2,256      $ (3,590)  $(42,954)
                                                  =======     ========      =======      ========   ========
Income (loss) from continuing operations          
  per common share.............................                             $   .08      $   (.10)   $  (.98)

Net income (loss) per common share.............                             $   .08      $   (.10)   $  (.98)
                                                                                                     
Shares used in computing per share amounts.....                              29,745        35,938     43,702

Cash, cash equivalents and short-term             
 investments...................................   $15,021      $15,084      $13,282       $89,089   $230,018
Working capital................................    21,932        6,077        9,350        80,359    207,291
Total assets...................................    51,229       41,485       42,022       126,139    302,790
Long-term obligations..........................     5,683        7,809        3,675         2,189      3,192
Redeemable convertible preferred stock.........     1,021        4,866        7,896            --         --
Stockholders' equity...........................    25,178        2,885        6,038        86,627    239,911
</TABLE>


ITEM 7 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

     The statements contained in Management's Discussion and Analysis of
Financial Condition and Results of Operations include "forward-looking"
information within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and
are subject to the safe harbor created by those sections. Rational's actual
future results could differ materially from those projected in the forward-
looking information.  See "Factors That May Affect Future Results."  Rational
assumes no obligation to update the forward-looking information or such factors.

                                       29
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                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

OVERVIEW

     General
     -------

     Rational's revenue is derived from product license fees and charges for
services, including technical consulting, training and customer support. In
accordance with generally accepted accounting principles, Rational recognizes
software license revenue upon shipment to the customer if collection is
probable and remaining company obligations are insignificant, and recognizes
customer-support revenue over the term of the maintenance agreement. Revenue
from consulting and training is recognized when earned. Rational's license
agreements generally do not provide a right of return, and reserves are
maintained for potential credit losses, of which there have been only
immaterial amounts.

     International sales accounted for 33%, 35% and 32% of Rational's revenues
in fiscal 1995, 1996, and 1997, respectively.  Rational expects that
international sales will continue to account for a significant portion of
Rational's revenues in future periods. See "Factors That May Affect Future 
Results - Risks Associated with International Operations," "-Limited Protection
of Intellectual Property and Proprietary Rights."

     In the fiscal year ended March 31, 1997, Rational's revenues from
consulting and support grew at a slower rate than revenues from product sales,
contributing to increasing gross margins. However, this trend was less
pronounced than in fiscal 1996.  There can be no assurance that this trend will
continue in future periods. See "Factors That May Affect Future Results
- Fluctuations in Operating Results," "- Expansion of Product Lines; 
Dependence Upon New Product Introductions," "- Dependence Upon Growth of 
Emerging Industries; Development of Industry Standards."

     Although Rational has experienced increasing revenues in each of the past
twelve quarters, Rational's sales compensation structure has historically
contributed to revenues for the first quarter of a fiscal year being lower than
revenues for the fourth quarter of the prior fiscal year. There can be no
assurance that Rational will continue to experience increasing revenues or
that similar fluctuations will not occur again in the future. See "Factors That
May Affect Future Results - Fluctuations in Operating Results."

     As a result of the Company's acquisition of SQA, Inc., accounted for as a
pooling of interests, the information herein and the accompanying consolidated
financial statements are presented on a combined basis for all periods
presented, as described in more detail below.

     Recent Acquisitions
     -------------------

     On February 25, 1997, the Company acquired all the outstanding shares of
capital stock of SQA, Inc.("SQA"), a Delaware corporation, by issuing
approximately 6,997,000 shares of Common Stock. SQA is primarily involved in
developing and marketing integrated software products for the automated testing
and quality management of Windows-based client/server applications. SQA's
statements of operations for the three fiscal years ended December 31, 1996,
1995 and 1994 have been combined with Rational's fiscal years ended March 31,
1997, 1996, and 1995. SQA's results of operations for the three months ended
March 31, 1997, therefore, are not reflected in the consolidated statement of
operations but have been included in the combined Company's balance sheet 
in accumulated deficit at March 31, 1997. 

     On March 31, 1997 the Company acquired all the outstanding shares of 
capital stock of Performance Awareness Corporation. The Company also assumed the
outstanding Performance Awareness employee stock options. Performance Awareness
develops, markets and supports automated software quality products and related
services that provide global solutions for the global software testing market.
The aggregate purchase price (including direct acquisition costs) was $32.9
million, including the fair value of options that were assumed by the
Company. The Company has accounted for the acquisition using the purchase
method.
     On March 31, 1997, the Company acquired all the outstanding shares of
capital stock of Software 9000, a New Zealand software development company. The
aggregate purchase price (including direct acquisition costs) was $425,000.
The Company has accounted for the acquisition using the purchase method. 

     On February 4, 1997, the Company acquired all the outstanding shares of
capital stock of Softlab AB, a Swedish developer of custom engineering tools,
integrated software development environments and software development processes.
The aggregate purchase price (including direct acquisition costs) was $9.5
million. The Company has accounted for the acquisition using the purchase
method. 

     On February 5, 1997, the Company acquired all the outstanding shares of
capital stock of Requisite Inc., a Colorado-based provider of software
requirements-management tools and training. The aggregate purchase price
(including direct acquisition costs) was $8.6 million. The Company has accounted
for the acquisition using the purchase method. 

     The combined purchase price paid for Performance Awareness Corporation,
Software 9000, Softlab AB, and Requisite, Inc. was allocated to purchase
tangible and intangible assets based upon discounted cash flow valuation
techniques.  The aggregate amount of the purchase price related to the present
value of the estimated cash flows expected to be generated from technologies
which at the acquisition date had not yet reached the point of technological
feasibility and did not have an alternative future use was charged to operations
during the fourth quarter of fiscal 1997 and totaled $39.1 million.  Intangible
assets included developed technology, assembled workforce, and customer base in
the aggregate amount of  $16.5 million and will be amortized over their
estimated useful lives of three to five years. The Company plans to continue
devoting efforts to developing commercially viable products from the acquired
in-process research and development. 

                                       30
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

     In October 1995, Rational signed a definitive agreement to purchase all the
outstanding stock of Objectory AB, a Swedish software development company, in
exchange for 1,496,718 shares of Common Stock. The acquisition was accounted for
using the purchase method. In addition, in the third quarter of fiscal 1996,
Rational incurred approximately $14.5 million of one-time charges and operating
expenses primarily associated with Rational's acquisition of Objectory AB and
the subsequent restructuring and shaping of Rational's business, including an
$8.7 million write-off of acquired in-process research and development costs in
connection with the Objectory AB acquisition. The in-process research and
development amount represented the present value of the estimated cash flow
expected to be generated by the Objectory AB related technology, which at the
acquisition date had not yet reached the point of technological feasibility and
does not have an alternative future use. Rational plans to continue devoting
efforts to developing commercially viable products from the acquired in-process
research and development. Specifically, Rational intends to integrate the
Objectory AB technology with its existing technology. 
 
     On March 31, 1994, the Company, a publicly traded corporation formerly
known as Verdix Corporation, completed the merger with Rational, a privately
held corporation (old Rational), and changed its name to Rational Software
Corporation (the "Verdix Merger"). The transaction was accounted for as a
pooling-of-interests business combination and involved the issuance of
approximately 14.3 million additional shares of Common Stock. 

    See "Factors that May Affect Future Results - Risks Associated with Recent
or Future Acquisitions."


       Microsoft Relationship
       ----------------------

     On October 2, 1996, Rational and Microsoft announced the formation of a
business alliance that consists of Rational's acquisition of Microsoft's Visual
Test product, technology cross-licensing, joint development projects and joint-
marketing programs. The purchase price of the Visual Test product consisted of a
single $23 million cash payment. Rational's operating results for the quarter
ending December 31, 1996, were reduced by a non-recurring charge of $17.6
million associated with the acquisition of the Visual Test product. The charge
to operations for acquired in-process research and development represents the
present value of the estimated cash flow expected to be generated by Visual
Test related technology, which at the acquisition date had not yet reached the
point of technological feasibility and does not have an alternative future
use. Rational plans to continue devoting effort to developing commercially
viable products from the acquired in-process research and development. More
specifically, Rational intends to exploit networked computing resources to
accelerate the testing process. Amounts attributed to other purchased
intangible assets are being amortized to operations over their estimated
useful lives, which in most cases are two to four years. Rational's objective
in entering into the cross-licensing arrangements with Microsoft was not to
generate direct product revenue from Microsoft, and Rational does not expect
such arrangements to directly result in a material increase in product
revenue. See "Factors that May Affect Future Results - Business Alliance with 
Microsoft," "- Acquisition of Visual Test Product," "- Dependence Upon 
Strategic Relationships."

       Public Offerings
       ----------------

       In October 1996, Rational completed a public offering of 5,188,094 shares
of its Common Stock, resulting in proceeds to Rational, net of underwriting
discounts and other related expenses, of approximately $186,000,000. Rational
incurred a non-recurring expense of approximately $1,200,000 in the quarter
ending December 31, 1996 in connection with its contractual commitment to
reimburse certain of its stockholders for the underwriting discount applicable
to the 684,631 shares of Common Stock sold by them in the October 1996 public
offering, as well as certain of such stockholders' other fees and expenses in
connection with the public offering. 

       In June 1995, Rational completed a public offering of 5,759,000 shares of
its Common Stock, resulting in proceeds to Rational, net of underwriting 
discounts and other related expenses, of approximately $29,945,000. 

                                       31
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------


RESULTS OF OPERATIONS

     The following table sets forth for the periods indicated the percentage of
total revenue represented by certain line items from Rational's Consolidated
Statements of Operations:
<TABLE>
<CAPTION>
                                           FISCAL YEAR ENDED MARCH 31,
                                          ------------------------------ 
                                            1995       1996       1997
                                          --------   --------   --------
<S>                                       <C>        <C>        <C>
Net product revenue..........................   55%        62%       63%
Consulting and support revenue...............   45         38        37

                                              ----       ----      ----
Total revenue................................  100        100       100
Cost of product revenue......................    9          8         6
Cost of consulting and support revenue.......   24         20        18

                                              ----       ----      ----
Total cost of revenue........................   33         28        24

                                              ----       ----      ----
Gross profit.................................   67         72        76

Operating expenses:
Research and development.....................   18         18        17
Sales and marketing..........................   37         39        35
General and administrative...................   10         11        12
Charges for acquired in-process..............   --          8        39
 research and development
Merger and restructuring costs...............   (1)        --         5
                                              ----       ----      ----
</TABLE> 

                                       32
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                               FISCAL YEAR ENDED MARCH 31,
                                              ------------------------------ 
                                                1995       1996       1997
                                              --------   --------   --------
<S>                                            <C>        <C>       <C>
Total operating expenses.....................   64         77       107
                                               ---        ---       ---
Income (loss) from continuing operations.....    3         (4)      (32)
Other income, net............................    1          2         5
                                               ---        ---       ---
Income (loss) before provision for                                       
 income taxes................................    3         (2)      (27) 
Provision for income taxes...................    1          1         3
                                               ---        ---       ---
Net income (loss)............................    3%        (3)%     (30)%
                                               ===        ===       ===
</TABLE>

See "Factors that May Affect Future Results - Fluctuations in Operating 
Results."

FISCAL YEARS ENDED MARCH 31, 1997, 1996 AND 1995

REVENUE

     Total revenue increased 40% in fiscal 1997 over fiscal 1996, and 34% in 
fiscal 1996 over fiscal 1995.

     Net product revenue.  Net product revenue increased 42% in fiscal 1997 over
     -------------------
fiscal 1996 and 52% in fiscal 1996 over fiscal 1995. The increase in net
product revenue in fiscal 1997 and 1996 was due to continued strong customer
acceptance of Rational's visual modeling tools (the Rational Rose family) and
the introduction of new versions of the Rational Apex product for the C/C++
application construction environment. In addition, revenues were favorably
impacted by increasing SQA revenues each year. Rational's visual modeling
tools revenue grew in excess of 100% during fiscal 1996 from the prior year.
See "Factors That May Affect Future Results-Fluctuation in Operating
Results," "-Risks Associated with Recent or Future Acquisitions," 
"-Dependence Upon Growth of Emerging Industries; Development of Industry
Standards," "-Expansion of Product Lines; Dependence Upon New Product
Introductions," "-Competition."

     Consulting and support revenue. Consulting and support revenue increased
     ------------------------------
37% in fiscal 1997 over fiscal 1996 and 13% in fiscal 1996 over fiscal 1995.
These increases reflected higher demand for Rational's consulting expertise in
object modeling and advanced software-development practices, and, to a lesser
extent, increased training and customer-support revenues. The increase in fiscal
1997 consulting and support revenue is also due in part to revenue resulting
from the Company's recent acquisitions from the date of acquisition to the end
of the fiscal year. In fiscal 1996, the decline in year-over-year growth from
fiscal 1995 was due primarily to Rational's decision to forgo certain consulting
revenue opportunities with existing customers in favor of presales investment
with new customers. See "Factors that May Affect Future Results-Expansion of 
Product Lines; Dependence Upon New Product Introductions," "-Dependence Upon 
Sales Force and Other Channels of Distribution."
 
     International sales. During fiscal 1997, 1996 and 1995, international
     -------------------
revenues from product sales and related consulting and customer support were
$45.9 million, $35.9 million, and $25.9 million, representing 32%, 35% and 33%
of total revenues, respectively. The growth in international sales over this
period was due principally to increased sales and marketing activities in
international markets. Rational's international sales are priced in foreign
currencies. Rational has attempted to limit its exposure to fluctuations in
foreign currencies

                                       33
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

from time to time by utilizing a hedging strategy for existing receivables
denominated in foreign currencies. At March 31, 1997, Rational had certain
forward foreign exchange contracts all having maturities of approximately 35
days, to exchange various European currencies for U.S. dollars in the amount of
$7,397,000. Rational's results of operations during fiscal 1997, 1996 and 1995
were favorably impacted by changes in foreign exchange rates. The impact of
using actual exchange rates throughout the year compared to exchange rates at
the beginning of the year was to decrease income from operations in fiscal 1997
by approximately $370,000, and to increase income from operations by
approximately $100,000 and $500,000 in fiscal 1996 and 1995, respectively. See
"Factors that may Affect Future Results-Rules Associated with International 
Operations;" "-Limited Protection of Intellectual Property."


COST OF REVENUE

     Cost of product revenue. Cost of product revenue consists principally of
     -----------------------
materials, packaging and freight, and royalties. Cost of product revenue
increased 17% in fiscal 1997 over fiscal 1996 and 9% in fiscal 1996 over fiscal
1995.These costs represented 10%, 12%, and 17% of net product revenue in fiscal
1997, 1996, and 1995, respectively. In fiscal 1997 and 1996, the decrease in
product cost as a percentage of product revenue was due mainly to lower royalty
expense resulting from a decrease in third party product sales. See "Factors 
that May Affect Future Results-Dependence Upon Sales Force and Other Channels
of Distribution."


     Cost of consulting and support revenue. Cost of consulting and support
     --------------------------------------
revenue consists principally of personnel costs for training, consulting, and
customer support. Cost of consulting and support increased 28% in fiscal 1997
over fiscal 1996 and 10% in fiscal 1996 over fiscal 1995. These costs
represented 49%, 53% and 54% of consulting and support revenue in fiscal 1997,
1996 and 1995, respectively. These increases were the result of additional
personnel and personnel-related expenses needed to perform professional services
in object modeling, advanced software-development practices, and business
process engineering. The cost decreases as a percentage of consulting and
support revenue resulted from an overall higher mix of support services which
generally have a higher gross margin than consulting services.


OPERATING EXPENSES

     Research and development.  Total expenditures for research and development
     ------------------------
increased 34% in fiscal 1997 over fiscal 1996 and 32% in fiscal 1996 over
fiscal 1995. Research and development costs represented 17%, 18% and 18% of
total revenue in fiscal 1997, 1996 and 1995, respectively. The increase in
fiscal 1997 was due primarily to the cost of additional personnel and related
costs incurred in maintaining existing products and developing new product
releases. The increase in fiscal 1996 was due primarily to expenses incurred
following the October 1995 acquisition of Objectory AB. See "Factors That May 
Affect Future Results-Rapid Technological Change."

     Rational did not capitalize any software-development costs in fiscal 1997,
1996 and 1995 because eligible costs were not material. Rational expects that
the amount of software-development costs capitalized in future periods will be
immaterial to Rational's results of operations and financial position because
the time period and the engineering effort required between demonstration of a
product's economic and technological feasibility and the date of product release
has been very short. See "Factors That May Affect Future Results-Risk of 
Software Defects," "-Expansion of Product Lines; Dependence Upon New Product 
Introductions."

     Sales and marketing.  Sales and marketing expenses increased 24% in fiscal
     -------------------
1997 over fiscal 1996 and 44% in fiscal 1996 over fiscal 1995. These expenses
represented 35%, 39% and 37% of total revenue in fiscal 1997, 1996 and

                                       34
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

1995, respectively. The fiscal 1997 and 1996 increases in sales and marketing
expenses reflect the additional personnel, commissions and related costs
required in sales and marketing departments to expand Rational's sales
channels, to penetrate new markets, and to increase its market share in core
markets. Fiscal 1996 also included expenses associated with Objectory AB since
the acquisition in October 1995. See "Factors That May Affect Future Results-
Dependence Upon Sales Force and Other Channels of Distribution."

     General and administrative. General and administrative expenses increased
     --------------------------
45% in fiscal 1997 over fiscal 1996 and 48% in fiscal 1996 over fiscal 1995.
General and administrative expenses represented 12%, 11% and 10% of total
revenue in fiscal 1997, 1996 and 1995, respectively. The increased expense for
the fiscal 1997 period resulted from increased employee-related expenses
associated with staffing requirements needed to support the Company's expanding
business, and the reimbursements of approximately $1,200,000 in expenses of
certain of its stockholders for the underwriting discount applicable to the
shares of common stock sold by them, as well as certain fees and expenses of
such stockholders' legal counsel incurred in connection with the Company's
October 1996 public stock offering. In addition, amortization of purchased
intangible assets, included in general and administrative expenses, increased to
$1,675,000 in fiscal 1997 from $442,000 in fiscal 1996 as a result of the
Company's merger and acquisition activity in fiscal 1997. The increase in
general and administrative expenses in fiscal 1996 is due primarily to expenses
associated with Objectory AB since the acquisition in October 1995, to
amortization of goodwill and other purchased intangibles resulting from the
Objectory acquisition, and to a lesser extent to an increase in the reserve
for doubtful accounts. See "Factors That May Affect Future Results-Management
of Growth," "-Risks Associated with Recent or Future Acquisitions."

     Charges for acquired in-process research and development.  In-process
     --------------------------------------------------------
research and development represents the present value of the estimated cash flow
expected to be generated by acquired technology which at the acquisition date
has not yet reached the point of technological feasibility and does not have an
alternative future use.  In fiscal 1997, writeoffs associated with acquired in-
process research and development included $17,658,000 related to the acquisition
of the Visual Test product, $5,711,000 related to the acquisition of Requisite,
Inc., $6,067,000 related to the acquisition of Softlab AB, and $27,362,000
related to the acquisition of Performance Awareness Corporation.  In fiscal
1996, acquired in-process research and development of $8,700,000 was charged
to operations during Rational's third fiscal quarter in connection with the
acquisition of Objectory AB. See "Factors that May Affect Future 
Results-Risks Associated with Recent or Future Acquisitions."

     Merger and restructuring costs. Merger-related expenses of $7.2 million
     ------------------------------
were recorded in fiscal 1997 related to the merger of Rational and SQA, to
accrue administrative costs, severance costs associated with employee
terminations, costs associated with conforming employee benefits plans, charges
associated with the closure of duplicate facilities and asset writedowns related
to duplicate business systems.  The actions related to severance and
administrative costs are substantially complete. During fiscal 1995 Rational
recorded expense reductions of $1.1 million relating to the reversal of the rent
accrual associated with the closing of facilities. The accrual was reduced as a
result of greater-than-anticipated recoveries through subleases of certain
facilities reserved at the time of the Verdix Merger. See "Factors That May 
Affect Future Results-Risks Associated with Recent or Future Acquisitions," 
"-Management of Growth."

       The Company estimates that direct transaction costs associated with the
anticipated acquisition of Pure Atria Corporation will total approximately $15
million, which will result in a non-recurring charge to operations upon
consummation of such transaction. The Company expects to incur a non-recurring 
charge to operations of between $40 million and $60 million, primarily in the 
quarter ending September 30, 1997, the quarter in which such transaction is 
expected to be consummated, to reflect costs associated with integrating the two
companies. Actual costs may substantially exceed such estimates, unanticipated 
expenses associated with the integration of the two companies may arise, or the 
Company may incur additional material charges in subsequent quarters to reflect 
additional costs associated with the integration of the two companies. Total 
costs associated with such transaction are anticipated to result in an operating
loss and a net loss for the Company's quarter ending September 30, 1997, and
for the fiscal year ending March 31, 1998, and could negatively impact
financial results in future periods for the reasons discussed above. See
"Factors That May Affect Future Results--Risks Associated with Recent or
Future Acquisitions," "-Management of Growth."

OTHER INCOME, NET

     Other income, net consists of interest income, interest expense, gains and
losses on foreign currency transactions and miscellaneous items of income and
expense.  Other income has fluctuated as a result of 

                                       35
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------


operating results, the amount of cash available for investment in interest-
bearing accounts, and the extent of foreign currency transactions. Other income,
net, increased $6.1 million to $7.9 million in fiscal 1997 and $1.3 million to
$1.8 million in fiscal 1996. The increases are due primarily to interest earned
on cash generated from secondary public offerings completed by Rational which
were completed in October 1996 and June 1995, and from the initial public
offering completed by SQA, Inc. in December 1995. See "Factors That May Affect
Future Results - Fluctuations in Operating Results."


INCOME TAXES

     The tax provisions for 1997 and 1996 differ from tax computed at the 
federal statutory income tax rate primarily due to the impact of non-tax 
deductible charges for acquired in-process research & development and 
merger-related costs, as well as foreign and state income taxes, offset by the
benefit of net operating loss carryforwards. The tax provision for 1995 
differs from tax computed at the federal statuatory income tax rate primarily 
due to foreign and state income taxes, offset by the benefit of net operating 
loss carryforwards.

     As of March 31, 1997, Rational had net operating loss carryforwards for 
federal income tax purposes of approximately $69 million that expire in 1997 
through 2012. In addition, Rational had approximately $3.9 million of tax 
credit carryforwards which expire in years 1997 through 2012 if not utilized. 
As a result of the common stock sale in June 1995, Rational incurred a change 
in ownership as defined under Section 382 of the Code. Accordingly, 
approximately $29,000,000 of the Company's net operating loss carryfowards and 
$3,100,000 of the tax credit carryforwards will be subject to an annual 
limitation regarding their utilization against taxable income in future years. 
Such losses and credits will be available to offset the income tax liability 
attributable to annual taxable income of approximately $8,700,000.

     Under Statement of Financial Accounting Standards No. 109 (FAS 109), 
deferred tax assets and liabilities are determined based on differences 
between financial reporting and tax bases of assets and liabilities and are 
measured using the enacted tax rates and laws that will be in effect when the 
differences are expected to reverse. FAS 109 provides for the recognition of 
deferred tax assets if realization of such assets is more likely than not. 
Based upon the weight of available evidence, which includes Rational's' 
historical operating performance, and the reported cumulative net losses for 
the prior three years, the Company has provided a full valuation allowance 
against its net deferred tax assets. The Company intends to evaluate the 
realizability of the deferred tax assets on a quarterly basis. See Note 10 of 
Notes to Consolidated Financial Statements. See "Factors That May Affect 
Future Results - Deferred Tax Assets."

LIQUIDITY AND CAPITAL RESOURCES AT MARCH 31, 1997

     As of March 31, 1997, Rational had cash, cash equivalents and short-term
investments of $230 million and working capital of $207 million. Net cash
provided by operating activities for the period ending March 31, 1997 was
composed primarily of a net loss that was offset by non-cash charges for
acquired in-process research and development, depreciation and amortization,
plus an increase in accounts payable and accrued merger and integration costs
offset by an increase in accounts receivable.

     The Company's investing activities consisted primarily of business and
product acquisitions totaling $70 million in fiscal 1997 (See Notes 3 and 4 of
Notes to Consolidated Financial Statements).  The Company's investment activity
also included the purchase and sale of short-term investments, and expenditures
for fixed assets, which totaled $9.1 million in fiscal 1997, and $3.6 million in
fiscal 1996.

     Financing activities generated $198 million for fiscal 1997, of which
approximately $186 million was generated by the public offering of the Company's
Common Stock in October 1996. In fiscal 1997, the Company also received net
proceeds of approximately $12 million from the issuance of Common Stock upon the
exercise of Common Stock options. In fiscal 1996, financing activities generated
$65 million, of which $29 million was generated by the initial public offering
of SQA in December 1995, and $29 million was generated by the public offering of
the Company's Common Stock in

                                       36
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

June 1995. Fiscal 1996 financing activities also included net proceeds of
approximately $4 million from the issuance of redeemable, convertible preferred
stock by SQA, and approximately $3.4 million from the issuance of Common Stock
upon the exercise of Common Stock options. In fiscal 1996, $2.6 million was used
to decrease long-term debt and capital lease obligations.

     The Company believes that expected cash flow from operations combined with
existing cash and cash equivalents and short-term investments will be sufficient
to meet its cash requirements for the foreseeable future. See "Factors That 
May Affect Future Results - Fluctuations in Operating Results," "- Risks
Related to Recent or Future Acquisitions."


ITEM 7(A)- QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
     None.



ITEM 8 -- FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                                       37
<PAGE>
 
               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
 
The Board of Directors and Stockholders
Rational Software Corporation
 
  We have audited the accompanying consolidated balance sheets of Rational
Software Corporation as of March 31, 1996 and 1997, and the related
consolidated statements of operations, redeemable convertible preferred stock
and stockholders' equity and cash flows for each of the three years in the
period ended March 31, 1997. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audits. In February
1997, the Company merged with SQA, Inc. in a transaction which was accounted
for as a pooling of interests. We did not audit the financial statements of
SQA, Inc. for the years prior to fiscal 1997, which statements reflect total
assets constituting 32% of the related 1996 consolidated financial statement
totals, and which statements reflect net income (loss) of approximately
($2,422,000) and $431,000 of related 1995 and 1996 consolidated financial
statement totals, respectively. Those statements were audited by other
auditors whose report has been furnished to us, and our opinion, insofar as it
relates to data included for SQA, Inc. is based solely on the report of the
other auditors.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits and the report of other
auditors provide a reasonable basis for our opinion.
 
  In our opinion, based on our audits and the report of the other auditors,
the consolidated financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Rational Software
Corporation at March 31, 1996 and 1997, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
March 31, 1997, in conformity with generally accepted accounting principles.
 
                                          /s/ Ernst & Young LLP
 
San Jose, California
April 22, 1997
 
                                      38
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                   FISCAL YEAR ENDED MARCH 31,
                                                   ---------------------------
                                                    1995     1996      1997
                                                   -------  -------  --------
<S>                                                <C>      <C>      <C>
Net product revenue............................... $42,611  $64,743  $ 91,696
Consulting and support revenue....................  34,738   39,209    53,677
                                                   -------  -------  --------
  Total revenue...................................  77,349  103,952   145,373
Cost of product revenue...........................   7,148    7,826     9,134
Cost of consulting and support revenue............  18,875   20,823    26,566
                                                   -------  -------  --------
  Total cost of revenue...........................  26,023   28,649    35,700
                                                   -------  -------  --------
  Gross margin....................................  51,326   75,303   109,673
Product research and development expenses.........  13,914   18,305    24,445
Sales and marketing expenses......................  28,454   41,000    50,646
General and administrative expenses...............   7,892   11,690    16,995
Charges for acquired in-process research and
 development......................................     --     8,700    56,798
Merger and restructuring costs (credit)...........  (1,100)     --      7,201
                                                   -------  -------  --------
  Total operating expenses........................  49,160   79,695   156,085
                                                   -------  -------  --------
  Operating income (loss).........................   2,166   (4,392)  (46,412)
Other income, net.................................     496    1,830     7,917
                                                   -------  -------  --------
  Income (loss) before income taxes...............   2,662   (2,562)  (38,495)
Provision for income taxes........................     406    1,028     4,459
                                                   -------  -------  --------
Net income (loss)................................. $ 2,256  ($3,590) ($42,954)
                                                   =======  =======  ========
Net income (loss) per common share................   $0.08  ($0.10)   ($0.98)
Shares used in computing per share amounts........  29,745   35,938    43,702
</TABLE>
 
 
 
                See Notes to Consolidated Financial Statements.
 
                                      39
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
                          CONSOLIDATED BALANCE SHEETS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                               MARCH 31,
                                                           -------------------
                                                             1996      1997
                                                           --------  ---------
                          ASSETS
                          ------
<S>                                                        <C>       <C>
Current assets:
  Cash and cash equivalents............................... $ 80,378  $ 227,493
  Short-term investments..................................    8,711      2,525
  Accounts receivable, net of allowance for doubtful
   accounts of $1,286 in 1996 and $1,960 in 1997..........   26,043     33,565
  Prepaid expenses and other assets.......................    2,550      3,395
                                                           --------  ---------
    Total current assets..................................  117,682    266,978
Property and equipment, net...............................    6,247     13,291
Other assets, net.........................................    2,210     22,521
                                                           --------  ---------
    Total assets.......................................... $126,139  $ 302,790
                                                           ========  =========

           LIABILITIES AND STOCKHOLDERS' EQUITY
           ------------------------------------
Current liabilities:
  Accounts payable........................................ $  3,802  $   9,981
  Accrued employee benefits...............................    9,225     12,269
  Other accrued expenses..................................    5,182      8,255
  Current portion of accrued merger and restructuring
   expenses...............................................      575      9,236
  Deferred revenue........................................   17,885     17,936
  Current portion of long-term debt and lease
   obligations............................................      654      2,010
                                                           --------  ---------
    Total current liabilities.............................   37,323     59,687
Accrued rent..............................................      880        535
Long-term accrued merger and restructuring expenses.......    1,309        916
Long-term debt............................................      --       1,741
                                                           --------  ---------
    Total liabilities.....................................   39,512     62,879
                                                           --------  ---------
Commitments and contingencies
Stockholders' equity:
  Common stock, $.01 par value, 75,000 shares authorized,
   issued and outstanding 40,211 shares in 1996 and 47,684
   shares in 1997.........................................      402        477
  Additional paid-in capital..............................  155,336    356,270
  Treasury stock..........................................   (1,340)    (1,340)
  Accumulated deficit.....................................  (67,905)  (115,006)
  Cumulative translation adjustment.......................      134       (490)
                                                           --------  ---------
    Total stockholders' equity............................   86,627    239,911
                                                           --------  ---------
    Total liabilities and stockholders' equity............ $126,139  $ 302,790
                                                           ========  =========
</TABLE>
 
                See Notes to Consolidated Financial Statements.
 
                                      40
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
           CONSOLIDATED STATEMENT OF REDEEMABLE CONVERTIBLE PREFERRED
                         STOCK AND STOCKHOLDERS' EQUITY
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                        REDEEMABLE
                                        CONVERTIBLE
                                      PREFERRED STOCK
                                      ----------------
                                      SHARES   AMOUNT                     STOCKHOLDERS' EQUITY
                                      ------  --------  ------------------------------------------------------
                                      COMMON STOCK      ADDITIONAL                       CUMULATIVE      TOTAL
                                      -------------      PAID-IN   TREASURY  ACCUMULATED TRANSLATION STOCKHOLDERS'
                                      SHARES AMOUNT      CAPITAL    STOCK      DEFICIT   ADJUSTMENT     EQUITY
                                      ------ ------     ---------- --------- ----------- ----------- -------------
<S>                                   <C>     <C>
BALANCE AT MARCH 31, 1994.....         4,060  $  4,866   
Issuance of Series C preferred     
 stock........................         2,172     3,030
Exercise of stock options.....     
Issuance of common stock......           --        --
Issuance of treasury stock....           --        --
Net income....................           --        --
                                      ------  --------
BALANCE AT MARCH 31, 1995.....         6,232     7,896
Issuance of Series D preferred     
 stock........................         1,393     4,455
Conversion of redeemable           
 preferred stock to common         
 stock........................        (7,625)  (12,351)
Issuance of common stock, net      
 of $808 in costs.............           --        --
Issuance of common stock, net      
 of $852 in costs.............           --        --
Issuance of common stock for       
 the acquisition of Objectory      
 AB...........................           --        --
Exercise of common stock           
 options......................     
Issuance of common stock under     
 Employee Stock Purchase           
 Plan.........................           --        --
Cumulative translation             
 adjustment...................           --        --
Net loss......................           --        --
                                      ------  --------
BALANCE AT MARCH 31, 1996.....           --        --
Issuance of common stock, net      
 of expenses of $675..........     
Exercise of common stock           
 options......................           --        --
Issuance of common stock......     
Issuance of common stock under     
 Employee Stock Purchase           
 Plan.........................           --        --
Stock options issued in            
 business combination.........           --        --
Tax benefit from option            
 transactions.................           --        --
Cumulative translation             
 adjustment...................           --        --
Net loss......................           --        --
Net transactions of SQA from       
 January 1, 1997 to March 31,      
 1997.........................           --        --
                                      ------  --------
BALANCE AT MARCH 31, 1997.....           --        --
                                      ======  ========
BALANCE AT MARCH 31, 1994.....        24,874      $249  $ 70,601  $(1,394)   $ (66,571)    $ --       $  2,885
Issuance of Series C preferred     
 stock........................           --    --            (22)     --           --        --            (22)
Exercise of stock options.....           221     2           636                                           638
Issuance of common stock......            66     1           226      --           --        --            227
Issuance of treasury stock....           --    --            --        54          --        --             54
Net income....................           --    --            --       --         2,256       --          2,256
                                      ------ ------     --------  -------    ---------     -------    --------
BALANCE AT MARCH 31, 1995.....        25,161   252        71,441   (1,340)     (64,315)      --          6,038
Issuance of Series D preferred     
 stock........................           --    --            (20)     --           --        --            (20)
Conversion of redeemable           
 preferred stock to common         
 stock........................         4,575    46        12,305      --           --        --         12,351
Issuance of common stock, net      
 of $808 in costs.............         1,720    17        28,935      --           --        --         28,952
Issuance of common stock, net      
 of $852 in costs.............         5,759    57        29,888      --           --        --         29,945
Issuance of common stock for       
 the acquisition of Objectory      
 AB...........................         1,497    15         8,754      --           --        --          8,769
Exercise of common stock           
 options......................         1,349    14         3,585                                         3,599
Issuance of common stock under     
 Employee Stock Purchase           
 Plan.........................           150     1           448      --           --        --            449
Cumulative translation             
 adjustment...................           --    --            --       --           --        134           134
Net loss......................           --    --            --       --        (3,590)      --         (3,590)
                                      ------ ------     --------  -------    ---------     -------    --------
BALANCE AT MARCH 31, 1996.....        40,211   402       155,336   (1,340)     (67,905)      134        86,627
Issuance of common stock, net      
 of expenses of $675..........         5,188    52       186,304      --           --        --        186,356
Exercise of common stock           
 options......................         1,216    12         4,703      --           --        --          4,715
Issuance of common stock......           258     3         4,369      --           --        --          4,372
Issuance of common stock under     
 Employee Stock Purchase           
 Plan.........................           787     8         2,927      --           --        --          2,935
Stock options issued in            
 business combination.........           --    --          1,600      --           --        --          1,600
Tax benefit from option            
 transactions.................           --                  880                   --        --            880
Cumulative translation             
 adjustment...................           --    --            --       --           --       (624)         (624)
Net loss......................           --    --            --       --       (42,954)      --        (42,954)
Net transactions of SQA from       
 January 1, 1997 to March 31,      
 1997.........................            24   --            151      --        (4,147)      --         (3,996)
                                      ------ ------     --------  -------    ---------     -------    --------
BALANCE AT MARCH 31, 1997.....        47,684  $477      $356,270  $(1,340)   $(115,006)    $(490)     $239,911
</TABLE>
 
                See Notes to Consolidated Financial Statements.
 
                                      41
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                     1995     1996      1997
                                                    -------  -------  --------
<S>                                                 <C>      <C>      <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net income (loss)................................ $ 2,256  $(3,590) $(42,954)
  Adjustments to reconcile net income to net cash
   provided by operating activities:
    Charges for acquired in-process research and
     development...................................     --     8,700    56,798
    Depreciation...................................   4,361    3,873     4,063
    Amortization...................................     678      842     1,675
    Compensation expense for stock option grants...     --       229       145
    Changes in operating assets and liabilities
      Accounts receivable..........................  (4,145)  (4,550)   (9,083)
      Prepaids and other, net......................     402     (947)      829
      Accounts payable.............................   1,161   (1,336)    5,122
      Accrued employee benefits and accrued
       expenses....................................  (1,564)   2,296    (2,392)
      Deferred revenue.............................   1,181    9,367       (23)
      Accrued merger and restructuring expenses....  (4,062)    (329)    8,268
                                                    -------  -------  --------
    Net cash provided by operating activities......     268   14,555    22,448
                                                    -------  -------  --------
CASH FLOWS FROM INVESTING ACTIVITIES:
  Purchases of short-term investments..............  (2,369) (11,124)  (10,611)
  Maturities and sales of short-term investments...   7,581    3,449    16,824
  Purchase of property and equipment...............  (3,361)  (3,608)   (9,143)
  Additions to capitalized software costs..........    (154)     --        --
  Business combinations, net of cash acquired......     --       279   (69,992)
                                                    -------  -------  --------
    Net cash provided by (used in) investing
     activities....................................   1,697  (11,004)  (72,922)
CASH FLOWS FROM FINANCING ACTIVITIES:
  Principal payments under long-term debt and
   capital lease obligations.......................  (2,463)  (2,569)     (644)
  Net proceeds from issuance of common stock.......     865   62,715   198,233
  Net proceeds from the sale of redeemable
   convertible preferred stock, net of issuance
   costs...........................................   3,008    4,435       --
  Other............................................      35      --        --
                                                    -------  -------  --------
    Net cash provided by financing activities......   1,445   64,581   197,589
Net increase in cash and cash equivalents..........   3,410   68,132   147,115
Cash and cash equivalents at beginning of year.....   8,836   12,246    80,378
                                                    -------  -------  --------
Cash and cash equivalents at end of year........... $12,246  $80,378  $227,493
                                                    =======  =======  ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
  Cash paid:
    Income taxes...................................     199      355       929
    Interest paid..................................     101      107        12
NON-CASH INVESTING AND FINANCING ACTIVITIES:
  Conversion of redeemable preferred stock to
   common stock....................................     --    12,351       --
  Options issued in business combination...........     --       --      1,600
  Tax benefit from option transactions.............     --       --        880
  Note payable issued for business combination.....     --       --      2,800
</TABLE>
 
                See Notes to Consolidated Financial Statements.
 
                                      42
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
                                MARCH 31, 1997
 
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
 
  Organization and basis of presentation. Rational Software Corporation (the
Company) was incorporated under the laws of Delaware on July 28, 1982. The
Company develops, markets and supports a comprehensive solution for the
component-based development of software systems.
 
  The accompanying consolidated financial statements include the accounts of
the Company and its wholly-owned subsidiaries including SQA, Inc. (SQA), which
was merged with the Company effective February 26, 1997. The historical
consolidated financial statements of the Company for all periods prior to such
merger date have been restated to reflect the merger, which has been accounted
for as a pooling-of-interests. The consolidated financial statements for all
periods include results of the Company's operations and balance sheet data on
a March 31 fiscal year basis and SQA's results on a December 31, fiscal year
basis. All intercompany transactions and balances have been eliminated upon
consolidation.
 
  Use of estimates. The preparation of the financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
 
  In March 1995, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 121 (FAS 121), "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,"
which requires the Company to review for impairment of long-lived assets
certain identifiable intangibles and goodwill related to those assets whenever
events or changes in circumstances indicate that the carrying amount of an
asset might not be recoverable. In certain situations, an impairment loss
would be recognized. FAS 121 became effective for the Company on April 1,
1996. The adoption of FAS 121 did not have a material effect on the Company's
consolidated results of operations.
 
  Revenue recognition. The Company recognizes revenue and related costs from
the sale of its software products and systems upon shipment to the customer if
collection is probable and remaining Company obligations are insignificant.
Revenue from software royalties, whether they are advance payments that are
nonrefundable or minimum royalty guarantees payable over a fixed period, is
recorded when the earnings process is complete and collection is considered
probable. Revenue from consulting services is recognized when earned. Customer
support revenue is deferred and recognized on a straight-line basis over the
period covered by the customer-support agreements. Contract revenue, which
generally represents special or custom engineering development under milestone
payments, is recognized in conformity with Accounting Research Bulletin No.
45, "Long-Term Construction Type Contracts", using the relevant guidance in
SOP 81-1, "Accounting for Performance of Construction-Type and Certain
Production-Type Contracts".
 
  Software capitalization. Computer software development costs are capitalized
after the economic and technological feasibility of a new product is
established. Capitalized costs are amortized on a product basis over the
estimated economic life of a general-release product, which generally does not
exceed three years. The annual amortization is the greater of the amount
computed using the straight-line method or the amount computed using the ratio
of current revenue to the total of current and anticipated future revenues.
Capitalized software-development costs are also written down periodically to
net realizable value based on an analysis of anticipated future revenues.
Research and development costs prior to the establishment of the economic and
technological feasibility of a product are expensed as incurred.
 
  There were no capitalized software development costs as of March 31, 1996
and 1997. For the years ended March 31, 1995, 1996 and 1997, software
amortization was $472,000, $329,000 and $0, respectively.
 
                                      43
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                MARCH 31, 1997
 
  Translation of foreign currencies. Accounts denominated in foreign
currencies have been translated in accordance with Statement of Financial
Accounting Standards No. 52. The functional currency for the Company's
international sales operations is the U.S. dollar, with the exception of its
Swedish subsidiary for which the functional currency is the local currency.
Gains and losses resulting from the remeasurement of the foreign currency
financial statements of the sales operations into U.S dollars are included in
other income. Gains and losses resulting from foreign currency translation of
the Swedish subsidiary are accumulated as a separate component of
stockholders' equity.
 
  Other income. During the year ended March 31, 1997, other income consisted
primarily of interest earned on the Company's excess cash, cash equivalents
and short-term investments and interest expense. It also included gains and
losses on foreign currency transactions.
 
  Net income (loss) per share. Net loss per share is computed using the
weighted average number of common shares outstanding during the period. Net
income per share is computed using the weighted average number of common and
dilutive common equivalent shares outstanding during the period. Common stock
equivalents consist of stock options using the treasury stock method and
redeemable convertible preferred stock.
 
  Cash, cash equivalents and short-term investments. Cash equivalents are
highly liquid investments with original maturity dates of three months or less
at the date of acquisition. Investments with maturity dates of greater than
three months are considered to be short-term investments.
 
  All the Company's cash equivalents and short-term investments are classified
as available-for-sale under the provisions of Statement of Financial
Accounting Standards No. 115 (FAS 115), "Accounting for Certain Investments in
Debt and Equity Securities." Investments are carried at amortized cost which
approximates estimated fair value based on quoted market prices at March 31,
1996 and 1997.
 
  Under FAS 115, management classifies investments as trading, available-for-
sale, or held-to-maturity at the time of purchase and periodically reevaluates
such designation. Debt securities are classified as held-to-maturity when the
Company has the positive intent and ability to hold the securities to
maturity. Held-to-maturity securities are stated at amortized cost with
corresponding premiums or discounts amortized over the life of the investment
to interest income. Debt securities not classified as held-to-maturity are
classified as available-for-sale and reported at fair market value.
Unrecognized gains and losses and declines in value judged to be other than
temporary on available-for-sale securities are included in interest income.
The cost of securities sold is based on the specific identification method.
 
  Property and equipment. The Company's property and equipment are recorded at
cost, which is generally depreciated over three- to five-year periods using
the straight-line method. The cost of furniture and equipment under capital
leases is recorded at the lower of the present value of the minimum lease
payments or the fair value of the asset and is amortized over the shorter of
the term of the related lease or the estimated useful life of the asset.
Leasehold improvements are depreciated over the remaining life of the lease.
 
  Stock-based compensation. The Company has elected to follow Accounting
Principles Board Opinion No. 25, "Accounting for Stock issued to Employees"
(APB 25) and related Interpretations in accounting for its employee stock
options because the alternative fair value accounting provided for under FASB
Statement No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"),
requires use of option valuation models that were not developed for use in
valuing employee stock options. The Company generally grants stock options for
a fixed number of shares to employees with an exercise price equal to the fair
value of the shares at the date of grant, accordingly, no compensation expense
is recorded. The Company recognizes compensation expense for those options
granted with an exercise price less than fair value.
 
                                      44
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                MARCH 31, 1997
 
  Fair value of financial instruments. The carrying values reported in the
balance sheet for cash and cash equivalents, short-term investments and long-
term debt approximate fair value. The fair value of short-term investments is
based on quoted market prices.
 
  Advertising costs. The Company expenses advertising costs as incurred.
Advertising costs totaled $1,362,000, $2,109,000 and $2,618,000 for the years
ended March 31, 1995, 1996 and 1997, respectively.
 
  Reclassifications. Certain prior year amounts have been reclassified to
conform with current year presentation.
 
  Recent pronouncements. In February 1997, the Financial Accounting Standards
Board issued Statement No. 128, Earnings per Share, which is required to be
adopted on March 31, 1998. At that time, the Company will be required to
change the method currently used to compute earnings per share and to restate
all prior periods. Under the new requirements for calculating primary earnings
per share, the dilutive effect of stock options will be excluded.
 
2. RISKS DUE TO CONCENTRATIONS
 
  Concentrations of credit risk. Financial instruments that potentially
subject the Company to concentrations of credit risk consist primarily of cash
equivalents and accounts receivable. The Company's investment policy limits
its exposure to concentrations of credit risk for cash equivalents. The
Company sells its products primarily to major corporations and systems
integrators that serve a wide variety of U.S. and foreign markets. Collateral
or deposits generally are not required from customers who demonstrate a
positive credit record and sound financial condition. The Company maintains
reserves for potential credit losses and such losses have been within
management's expectations.
 
  International sales. International sales currently account for approximately
one-third of the Company's revenues, and the Company expects that
international sales will continue to account for a significant portion of the
Company's revenues in future periods. Any material adverse effect on the
Company's international business would have a material adverse effect on the
Company's financial statements. Also, the Company's international sales are
generally denominated in foreign currencies. Losses on the conversion of
foreign-denominated receivables into U.S. dollars may have a material adverse
effect on the Company's financial statements.
 
  From time to time the Company enters into short-term forward exchange
contracts to hedge against the impact of foreign currency fluctuations on
accounts receivable denominated in foreign currencies. The total amount of
these contracts is offset by the underlying foreign currency denominated
accounts receivable. The gains or losses on the contracts are included in
income as the contracts expire and are offset by gains and losses on the
underlying receivables being hedged. At March 31, 1997, the Company had
outstanding forward exchange contracts, all having maturities of approximately
35 days, to exchange various European currencies for US dollars in the
amounts of $7,397,000. Neither the carrying amount nor the fair value of these
foreign currency forward exchange contracts was material at March 31, 1997.
One major U.S. multinational bank is counterparty to all these contracts. The
associated gains and losses are not material to the Company's results of
operations. There were no forward exchange contracts outstanding at March 31,
1996.
 
                                      45
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                MARCH 31, 1997
 
3. MERGER WITH SQA, INC.
 
  On February 26, 1997, the Company acquired SQA, Inc.("SQA"), a company
incorporated in Delaware, through the merger of a wholly-owned subsidiary of the
Company with and into SQA, pursuant to which the Company issued approximately
6,997,000 shares of common stock. In addition, each outstanding option or right
to purchase SQA common stock under various stock option and purchase plans were
assumed by the Company and became an option or right to purchase the Company's
common stock after giving affect to the 0.86 exchange ratio. SQA is primarily
involved in developing and marketing integrated software products for the
automated testing and quality management of Windows-based client/server
applications. The acquisition was accounted for a pooling-of-interests, and
accordingly, the Company's historical consolidated financial statements have
been restated to include the results for SQA for all periods presented. The
following information shows revenue and net income (loss) of the separate
companies for the periods preceding the combination. Information relating to SQA
is for the year ended December 31, 1996, 1995 and 1994 respectively (in
thousands):

<TABLE>
<CAPTION>
                                          RATIONAL             MERGER
                                          SOFTWARE    SQA,    RELATED
                                         CORPORATION  INC.    EXPENSES  COMBINED
                                         ----------- -------  --------  --------
<S>                                      <C>         <C>      <C>       <C>
Year ended March 31, 1997
  Revenue...............................  $121,264   $24,109  $   --    $145,373
  Net income (loss).....................   (40,518)    4,765   (7,201)   (42,954)
Year ended March 31, 1996
  Revenue ..............................  $ 91,107   $12,845  $   --    $103,952
  Net income (loss).....................    (4,021)       31      --      (3,590)
Year ended March 31, 1995
  Revenue ..............................  $ 72,899   $ 4,450  $   --    $ 77,349
  Net income (loss).....................     4,678    (2,422)     --      (2,256)
</TABLE>
 
  Revenue and net loss of SQA for the three-month period ended March 31, 1997,
the period which is excluded in the accompanying financial statements was
$2,351,000 and $4,147,000, respectively. Included in the accompanying
consolidated statement of operations for the year ended March 31, 1997 are
merger-related expenses totaling $7,201,000 consisting primarily of charges
for investment banking and professional fees of $3,100,000, severance costs of
$1,767,000 associated with employee terminations and charges of $2,334,000
incurred as a result of the closing of duplicate facilities, other merger-
related administrative costs and asset write-downs. As of March 31, 1997 the
Company has paid out or charged $3,842,000 against the related merger accrual.
 
4. PURCHASE OF VISUAL TEST PRODUCT AND BUSINESS COMBINATIONS
 
  VISUAL TEST PRODUCT. During October 1996 the Company purchased the Visual
Test product from Microsoft Corporation. The aggregate purchase price
(including direct acquisition costs) was $23,146,000 in cash, which has been
allocated to the fair value of the assets acquired, including in-process
research and development. Acquired in-process research and development
represents the present value of the estimated cash flows expected to be
generated by Visual Test related technology, which at the acquisition date had
not yet reached the point of technological feasibility and does not have an
alternative future use. The value of the in-process research and development
was charged to operations on the acquisition date.
 
  REQUISITE, INC. During February 1997 the Company acquired all of the
outstanding shares of common stock of Requisite, Inc. a Colorado-based provider
of software requirements-management tools and training pursuant to a statutory
share exchange under Colorado law. The aggregate purchase price (including
direct acquisition costs) was $8,631,000. The Company also assumed the
outstanding Requisite employee stock options in exchange for stock options to
purchase 6,450 shares of common stock of the Company.
 
                                      46
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                MARCH 31, 1997
 
  SOFTLAB AB. During February 1997 the Company acquired all the outstanding
shares of common stock of Softlab AB, a developer of custom software-
engineering tools, integrated software-development environments, and software-
development processes based in Sweden. The aggregate purchase price (including
direct acquisition costs) was $6,732,000 in cash, plus notes payable totaling
approximately $2,800,000. The notes are due in two equal installments on the
first and second anniversary of the closing date.
 
  PERFORMANCE AWARENESS CORPORATION. During March 1997 the Company acquired
all the outstanding shares of capital stock of Performance Awareness
Corporation for cash and assumed the outstanding Performance Awareness
employee stock options in exchange for options to purchase 250,000 shares of
the Company's Common Stock. Performance Awareness develops, markets and
supports automated software quality products and related services that provide
solutions for the software testing market. The aggregate purchase price
(including direct acquisition costs) was $32,929,000 in cash and fair value of
options which were assumed by the Company.
 
  SOFTWARE 9000. Also during March 1997, the Company acquired all the
outstanding shares of common stock of Software 9000, a New Zealand software
distribution company. The aggregate purchase price was $425,000 (including
direct acquisition costs).
 
  OBJECTORY AB. During October 1995, the Company signed a definitive agreement
to purchase all the outstanding stock of Objectory AB, a Swedish software
development company, in exchange for 1,496,718 shares of common stock.
 
  The Company has accounted for the acquisitions of Requisite, Inc., Softlab
AB, Performance Awareness, Software 9000 and Objectory AB using the purchase
method, and accordingly, the operating results of the respective companies are
included in the consolidated results of the Company from the date of
acquisition. The consolidated balance sheets include the assets and
liabilities of these businesses at March 31, 1997. The total purchase price
paid for the Visual Test product and of each acquisition was allocated based
upon discounted cash flow valuation techniques and is summarized as of March
31, as follows (in thousands):
 
<TABLE>
<CAPTION>
                                               1997                          1996
                          ------------------------------------------------ ---------
                          VISUAL                      PERFORMANCE
                           TEST   REQUISITE, SOFTLAB   AWARENESS  SOFTWARE OBJECTORY
                          PRODUCT    INC.      AB     CORPORATION   9000      AB
                          ------- ---------- -------  ----------- -------- ---------
<S>                       <C>     <C>        <C>      <C>         <C>      <C>
Property and equipment..  $   --    $  132   $  508     $   894     $ 16    $   188
Intangible assets.......    5,488    2,447    3,632      10,094      366      1,216
Severance and facility
 accruals...............      --       --      (163)     (3,573)     --        (312)
Net assets (liabilities)
 acquired...............      --       341     (512)     (1,848)      43     (1,022)
In-process research and
 development............   17,658    5,711    6,067      27,362      --       8,700
                          -------   ------   ------     -------     ----    -------
                          $23,146   $8,631   $9,532     $32,929     $425    $ 8,770
                          =======   ======   ======     =======     ====    =======
</TABLE>
 
  Intangible assets include developed technology, assembled workforce,
customer base, trade name and covenant not-to-compete. The estimated average
useful life of these assets is four years. Accumulated amortization of
intangible assets totaled $2,184,000 and $509,000 at March 31, 1997 and 1996,
respectively. In-process research and development represents the present value
of the estimated cash flows expected to be generated by the related technology
from the Visual Test product and from each acquisition, which at the date of
purchase had not yet reached the point of technological feasibility and does
not have an alternative future use. Therefore, in accordance with generally
accepted accounting principles, the in-process research and development was
written off and charged to operations during the quarter in which the purchase
took place.
 
                                      47
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                MARCH 31, 1997
 
  The following unaudited pro forma combined results of operations of the
Company for fiscal 1996 and 1997, had the business combinations occurred at
the beginning of each fiscal year presented, including non-recurring charges
for acquired in-process technology of $8,700,000 and $56,798,000 in 1996 and
1997, respectively, are as follows:
 
<TABLE>
<CAPTION>
                                                               1996      1997
                                                             --------  --------
                                                              (IN THOUSANDS,
                                                             EXCEPT PER SHARE
                                                                   DATA)
      <S>                                                    <C>       <C>
      Net revenue........................................... $118,880  $158,606
      Net loss.............................................. $(10,419) $(50,059)
      Net loss per share.................................... $  (0.28) $  (1.15)
</TABLE>
 
  The unaudited pro forma information is presented for illustrative purposes
only and is not necessarily indicative of the operating results that would
have occurred had the transactions been completed at the beginning of the
periods indicated, nor is it necessarily indicative of future operating
results.
 
5. CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
 
  The Company's cash equivalents and short-term investments as of March 31,
1996 and 1997 are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                                 1996     1997
                                                                ------- --------
      <S>                                                       <C>     <C>
      Cash and cash equivalents:
        Cash................................................... $ 7,998 $ 10,518
        Money market funds.....................................  35,470  169,305
        Commercial paper.......................................   3,470   11,875
        U.S. Government........................................  33,440   35,795
                                                                ------- --------
          Total................................................ $80,378 $227,493
                                                                ======= ========
      Short-term investments:
        U.S. government........................................ $ 4,745 $    --
        Commercial paper.......................................   3,908    2,465
        Certificates of deposit................................      58       60
                                                                ------- --------
          Total................................................ $ 8,711 $  2,525
                                                                ======= ========
</TABLE>
 
  Realized gains and losses on sales of available-for-sale securities were
immaterial for the years ended March 31, 1996 and 1997. There were no
significant unrealized holding gains or losses on such securities at March 31,
1996 and 1997.
 
                                      48
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                MARCH 31, 1997
 
6. PROPERTY AND EQUIPMENT
 
  Property and equipment at March 31, 1996 and 1997 is as follows (in
thousands):
 
<TABLE>
<CAPTION>
                                                               1996      1997
                                                             --------  --------
     <S>                                                     <C>       <C>
     Computer, office and manufacturing equipment........... $ 23,816  $ 27,686
     Office furniture.......................................    2,192     3,031
     Leasehold improvements.................................    1,228     2,342
                                                             --------  --------
                                                               27,236    33,059
     Accumulated depreciation and amortization..............  (20,989)  (19,768)
                                                             --------  --------
     Net property and equipment............................. $  6,247  $ 13,291
                                                             ========  ========
</TABLE>
 
7. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
 
  In November 1989, the Company entered into a product development and loan
agreement with International Business Machines (IBM) whereby the Company
received interest-free loans of $8,700,000 to develop certain proprietary
software products in which the Company retains full ownership rights. In
exchange, the Company granted IBM distribution and marketing rights to the
products under development, the right to evaluate all of the Company's
technology for a period of five years, and an agreement to refrain from
undertaking any other development that would impair its ability to perform
under the agreement. The Company also provides consulting to IBM in certain
technology areas. The loans were fully repaid as of March 31, 1997.
 
  The Company leases certain equipment and furniture under capitalized lease
obligations. The related obligations under capitalized leases represent the
present value of future minimum lease payments. Assets capitalized under
leases totaled $3,979,000 and $4,524,000 at March 31, 1996 and 1997,
respectively. Long-term debt and capitalized lease obligations consist of the
following at March 31 (in thousands):
 
<TABLE>
<CAPTION>
                                                               1996    1997
                                                               -----  -------
     <S>                                                       <C>    <C>
     Long-term debt payable to IBM............................ $ 488  $   --
     Note payable to former Softlab AB shareholders...........   --     2,800
     Present value of capital lease obligation................   166      416
     Other....................................................   --       535
                                                               -----  -------
                                                                 654    3,751
     Less current portion of capital lease obligations and
      debt....................................................  (654)  (2,010)
                                                               -----  -------
     Due after one year....................................... $ --   $ 1,741
                                                               =====  =======
</TABLE>
 
                                      49
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                MARCH 31, 1997
 
8. COMMITMENTS AND CONTINGENCIES
 
  Commitments. The Company leases its primary office space under operating
  -----------
leases. Rental expense for facilities was approximately $2,070,000, $2,750,000
and $3,520,000 for the years ended March 31, 1995, 1996 and 1997,
respectively. As a result of merger-related activity at March 31, 1997, the
Company has accrued $1,339,000 of estimated costs of future rent associated
with the excess office space. Estimated future rents from sublease agreements
are $501,000, $358,000, and $119,000 in fiscal 1998, 1999 and 2000,
respectively. Future minimum rental payments, net of sublease income, at March
31, 1997 are as follows for the fiscal years indicated (in thousands):
 
<TABLE>
     <S>                                                                 <C>
     1998............................................................... $ 5,127
     1999...............................................................   4,743
     2000...............................................................   3,443
     2001...............................................................   2,043
     2002...............................................................     471
     Thereafter.........................................................     495
                                                                         -------
                                                                         $16,322
                                                                         =======
</TABLE>


  Legal Matters. On December 1, 1995, a complaint was filed against the
  -------------
Company relating to the Company's preliminary acquisition negotiations with
Interactive Development Environments, which were subsequently terminated. The
complaint was settled in March 1997, within amounts previously reserved for.

     On December 16, 1996, the Company filed a lawsuit against Silicon Graphics,
Inc. ("SGI") arising from SGI's failure to pay certain royalties due to the 
Company under a software license agreement entered into between the Company's 
predecessor, VERDIX Corporation, and SGI.  SGI has filed an answer denying the 
Company's allegations, and also filed a cross-complaint against the Company for 
unspecified damages for alleged wrongdoing arising out of the license agreement 
with SGI. The Company denies the allegations and intends to vigorously defend 
SGI's claims. 

     From time to time the Company is subject to legal claims. Historically, the
cost of resolution of the claims has not been significant, and the Company is
not aware of any asserted or unasserted claims pending against it, including the
suits mentioned above, the resolution of which would have a material adverse
impact on the operations or financial position of the Company.

9. STOCKHOLDERS' EQUITY
 
  Common stock. In July 1996, the Company's Board of Directors and
stockholders approved a two-for-one stock split payable in the form of a stock
dividend to stockholders. All share and per share information have been
adjusted to reflect this change.
 
  During October 1996, the Company sold 5,188,000 shares of common stock in a
public offering. Net proceeds from the sale were $186,356,000 after deducting
underwriting discounts, commissions, and other related expenses.
 
  Stock options. The Company provides equity incentives to employees and
directors by means of incentive stock options and nonstatutory options which
historically have been provided under various stock option plans. The Company
now issues options from the Stock Option Plan for Directors and the 1997 Stock
Option Plan. Stock options generally vest over a period of four years. Under
these plans, the Company may grant either nonstatutory or incentive stock
options and the option price per share cannot be less than 85% of fair market
value in the case of nonstatutory options, or 100% of fair market value in the
case of incentive stock options, determined on the date that the option is
granted. Under these plans, the Company has reserved 8,468,200 shares for
issuance at March 31, 1997. Options expire at various dates ranging from 5 to 10
years from the date of grant.
 
  In July, 1995, an amendment was approved during the annual meeting of the
Company's stockholders that established a new formula for determining the size
of directors grants and that lengthened the vesting period of directors
grants. The compensation expense recognized during fiscal 1996 and 1997 as a
result of this change was $229,000 and $145,000, respectively.
 
                                      50
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                 MARCH 31, 1997
 
  Activity under all plans is summarized as follows:
 
<TABLE>
<CAPTION>
                                                      SHARES UNDER OUTSTANDING
                                                              OPTIONS
                                                     ---------------------------
                                                                    WEIGHTED-
                                    SHARES AVAILABLE                 AVERAGE
                                       FOR GRANT       OPTIONS    EXERCISE PRICE
                                    ---------------- -----------  --------------
<S>                                 <C>              <C>          <C>
Balance at March 31, 1994.........      3,422,832      3,234,918      $ 2.64
  Granted.........................     (2,723,378)     2,723,378        2.61
  Exercised.......................            --       (221,003)        2.71
  Canceled........................        338,077      (338,077)        3.61
  Expired.........................       (448,620)           --          --
                                      -----------    -----------      ------
Balance at March 31, 1995.........        588,911      5,399,216        2.56
Additional shares authorized......      1,952,532            --          --
  Granted.........................    (1,679,429)      1,679,429        7.44
  Exercised.......................            --     (1,349,398)        2.50
  Canceled........................        244,975      (244,975)        2.50
  Expired.........................        (16,860)           --          --
                                      -----------    -----------      ------
Balance at March 31, 1996.........      1,090,129      5,484,272        4.11
Additional shares authorized......      3,250,000            --          --
Expiration of SQA option plans....       (123,036)           --          --
  Granted.........................     (4,328,634)     4,328,634       24.48
  Exercised.......................            --      (1,215,624)       3.66
  Canceled........................        554,317       (554,317)      15.75
  Expired.........................        (13,226)           --          --
Net transactions of SQA during the
 period from January 1, 1997 to
 March 31, 1997...................        (94,385)        90,070       32.98
                                      -----------    -----------      ------
Balance at March 31, 1997.........        335,165      8,133,035      $14.54
                                      ===========    ===========      ======
</TABLE>
 
                                      51
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                MARCH 31, 1997
 
  At March 31, 1996 options to purchase 1,585,514 shares of common stock were
exercisable at a weighted-average exercise price of $2.92. At March 31, 1997
the range of options outstanding and exercisable is as follows:
 
<TABLE>
<CAPTION>
                                OPTIONS OUTSTANDING        OPTIONS EXERCISABLE
                          -------------------------------- --------------------
                                       WEIGHTED
                                        AVERAGE   WEIGHTED             WEIGHTED
                                       REMAINING  AVERAGE              AVERAGE
       RANGE OF             NUMBER    CONTRACTUAL EXERCISE   NUMBER    EXERCISE
     EXERCISE PRICES      OUTSTANDING    LIFE      PRICE   EXERCISABLE  PRICE
     ---------------      ----------- ----------- -------- ----------- --------
     <S>                  <C>         <C>         <C>      <C>         <C>
     $0.29-$0.29.........    359,537     4.68      $ 0.29     205,865   $ 0.29
     $0.87-$3.47.........  2,441,461     5.46        2.65   1,365,270     2.77
     $3.75-$7.06.........    713,296     7.67        6.16     240,035     5.57
     $7.69-$12.31........    437,338     8.63        9.37      74,596     9.06
     $13.57-$19.75.......  1,729,381     9.77       17.50      54,187    14.21
     $20.63-$29.14.......  1,672,345     8.23       26.28      31,193    24.89
     $31.06-$39.56.......    779,677     8.72       37.21       9,331    37.33
                           ---------     ----      ------   ---------   ------
                           8,133,035     7.59      $14.54   1,980,477   $ 3.92
                           =========     ====      ======   =========   ======
</TABLE>
 
  Employee stock purchase plan. The Company has an employee stock purchase
plan ("ESPP") under which substantially all employees may purchase common
stock through payroll deductions at a price equal to 85% of the lower of fair
market values as of the beginning or end of the offering period. Stock
purchases under the plan are limited to the lessor of 10% of an employee's
compensation or $25,000 per year. At March 31, 1997, 931,000 shares had been
issued under the Plan and 269,000 shares were reserved for issuance.
 
  Stock-based compensation. Pro forma information regarding net income (loss)
and earnings (loss) per share is required by FAS 123 for awards granted or
modified after December 31, 1994 as if the Company had accounted for its
stock-based awards to employees under the fair value method of FAS 123. The
fair value of the Company's stock-based awards to employees was estimated
using a Black-Scholes option pricing model. The Black-Scholes model requires
the input of highly subjective assumptions including the expected stock price
volatility. Because the Company's stock-based awards to employees have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its stock-
based awards to employees. The fair value of the Company's stock-based awards
to employees was estimated assuming no expected dividends and the following
weighted-average assumptions:
 
<TABLE>
<CAPTION>
                                                               STOCK
                                                              OPTIONS    ESPP
                                                             --------- ---------
                                                             1996 1997 1996 1997
                                                             ---- ---- ---- ----
     <S>                                                     <C>  <C>  <C>  <C>
     Expected life (years).................................. 3.47 3.52  0.5  0.5
     Expected volatility.................................... 0.62 0.59 0.76 1.02
     Risk-free interest rate................................ 5.79 6.52 5.64 5.38
</TABLE>
 
                                      52
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                MARCH 31, 1997
 
  For pro forma purposes, the estimated fair value of the Company's stock-
based awards to employees is amortized over the options' vesting period (for
options) and the six-month purchase period (for stock purchases under the
ESPP). The Company's pro forma information for the years ended March 31, is as
follows (in thousands, except for loss per share information):
 
<TABLE>
<CAPTION>
                                                               1996      1997
                                                              -------  --------
     <S>                                                      <C>      <C>
     Net loss:
       As reported........................................... $(3,590) $(42,954)
       Pro forma.............................................  (5,367)  (54,663)
     Net loss per share:
       As reported........................................... $ (0.10) $  (0.98)
       Pro forma.............................................   (0.15)    (1.25)
</TABLE>
 
  Because FAS 123 is applicable only to awards granted subsequent to December
31, 1994, its pro forma effect will not be fully reflected until approximately
1999 and is not expected to be indicative of the effects on net income (loss)
and net income (loss) per share in future years.
 
  The weighted-average fair value of options granted at market value during
fiscal 1996 and 1997 was $3.81 and $11.74 per share, respectively. The
weighted-average fair value of employee stock purchase rights during fiscal
1996 and 1997 was $1.35 and $4.65 per share, respectively.
 
10. INCOME TAXES
 
  Pretax income (loss) from continuing operations is as follows at March 31
(in thousands):
 
<TABLE>
<CAPTION>
                                                        1995   1996      1997
                                                       ------ -------  --------
     <S>                                               <C>    <C>      <C>
     Domestic......................................... $2,404 $(4,002) $(41,538)
     Foreign..........................................    258   1,440     3,043
                                                       ------ -------  --------
         Total........................................ $2,662 $(2,562) $(38,495)
                                                       ====== =======  ========
</TABLE>
 
  The provision for income taxes consists of the following at March 31 (in
thousands):
 
<TABLE>
<CAPTION>
                                                             1995   1996   1997
                                                             ----- ------ ------
     <S>                                                     <C>   <C>    <C>
     Current
       Federal.............................................. $ 100 $   28 $2,029
       State................................................    70     52    730
       Foreign..............................................   236    948  1,700
                                                             ----- ------ ------
         Total.............................................. $ 406 $1,028 $4,459
                                                             ===== ====== ======
</TABLE>
 
 
                                      53
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                MARCH 31, 1997
 
  The provision for income taxes differs from the amount of income tax
determined by applying the applicable U.S. statutory federal income tax rate
as a result of the following differences for the years ended March 31 (in
thousands):
 
<TABLE>
<CAPTION>
                                                     1995    1996      1997
                                                     -----  -------  --------
   <S>                                               <C>    <C>      <C>
   Income tax (benefit) at the federal statutory
    rate............................................ $ 932    $(897) $(13,473)
   Net operating loss carryforwards utilized .......  (720)  (1,616)   (6,361)
   Nondeductible charges for acquired in-process
    research and development........................   --     3,045    19,879
   State income taxes...............................    46       52       474
   Foreign taxes....................................   148      444     1,700
   Merger related costs.............................   --       --      1,103
   Other............................................   --       --      1,137
                                                     -----  -------  --------
       Total........................................ $ 406  $ 1,028  $  4,459
                                                     =====  =======  ========
</TABLE>
 
  Significant components of the Company's deferred tax assets are as follows
at March 31 (in thousands):
 
<TABLE>
<CAPTION>
                                                              1996      1997
                                                            --------  --------
   <S>                                                      <C>       <C>
   Net operating loss carryforwards........................ $ 18,324  $ 24,605
   Tax credit carryforwards................................    3,492     3,862
   Acquired intangibles....................................      --      4,357
   Reserves and accruals not currently deductible..........    3,301     2,815
   Depreciation............................................    1,323       660
   Other...................................................      802     2,153
                                                            --------  --------
   Total deferred tax assets...............................   27,242    38,452
   Valuation allowance for deferred tax assets.............  (27,242)  (38,452)
                                                            --------  --------
                                                            $    --   $    --
                                                            ========  ========
</TABLE>
 
  The valuation allowance increased by $5,647,000 and $11,210,000 in 1996 and
1997, respectively. Approximately $14,119,000 of the valuation allowance is
attributable to stock options, the benefit of which will be credited to
additional paid-in capital when realized.
 
  FASB Statement 109 provides for the recognition of deferred tax assets if
realization of such assets is more likely than not. Based upon the weight of
available evidence, which includes the Company's historical operating
performance and the reported cumulative net loss for the prior three years,
the Company has provided a full valuation allowance against its net deferred
tax assets. The Company will evaluate the realizability of the deferred tax
asset on a quarterly basis.
 
  At March 31, 1997, the Company had net operating loss carryforwards for
federal income tax purposes of approximately $69,000,000 and tax credit
carryforwards of $3,900,000 that expire in 1997 through 2012. As a result of
the sale of common stock in June 1995, the Company incurred a change in stock
ownership as defined under Section 382 of the Internal Revenue Code of 1986.
Accordingly, approximately $29,000,000 of the Company's net operating loss
carryforwards and $3,100,000 of the tax credit carryforwards will be subject
to an annual limitation regarding their utilization against taxable income in
future years. Such losses and credits will be available to offset the income
tax liability attributable to annual taxable income of approximately
$8,700,000.
 
11. MAJOR CUSTOMERS, RELATED PARTIES, AND INTERNATIONAL SALES.
 
  IBM divested its shares of the Company's outstanding stock during the
secondary offering in the first quarter of fiscal 1996. IBM owned
approximately 13% of the Company's outstanding stock at the end of 1995 and
sales
 
                                      54
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
                                MARCH 31, 1997
to IBM amounted to 3% of the Company's revenue in 1995. Sales to Lockheed
Martin Corporation, which had a representative on the Board through September
1995, amounted to 2%, and 4% of the Company's revenue in 1995 and 1996,
respectively.
 
  The Company also derives revenues from the sale of its products to customers
in international geographic areas. Total revenue from international sales and
related consulting and customer support in different geographic areas is as
follows at March 31, (in thousands):
 
<TABLE>
<CAPTION>
                                                        1995    1996     1997
                                                       ------- ------- --------
   <S>                                                 <C>     <C>     <C>
   Net Sales to Customers:
     Western Europe................................... $12,776 $25,066 $ 31,934
     Other............................................  13,086  10,873   13,924
                                                       ------- ------- --------
       Total.......................................... $25,862 $35,939 $ 45,858
                                                       ======= ======= ========
</TABLE>
 
  "Other," as used above, primarily consists of sales to Canada and the
 Asia/Pacific region.
 
12. QUARTERLY INFORMATION (UNAUDITED)
 
  The following table presents unaudited quarterly operating results for each
of the Company's eight quarters in the two-year period ended March 31, 1997.
 
<TABLE>
<CAPTION>
                                                      QUARTER ENDED
                                            -----------------------------------
                                            JUNE 30 SEPT. 30 DEC. 31   MARCH 31
                                            ------- -------- --------  --------
   <S>                                      <C>     <C>      <C>       <C>
   1997
   Total revenue........................... $32,002 $34,025  $ 39,057  $ 40,289
   Gross margin............................  24,054  25,754    29,697    30,168
   Operating income(loss)..................   4,956   5,718   (13,743)  (43,343)
   Net income(loss)........................   5,093   5,872   (11,836)  (42,083)
   Net income (loss) per share.............    0.11    0.13     (0.26)    (0.89)
   1996
   Total revenue........................... $22,065 $24,579  $ 27,445  $ 29,863
   Gross margin............................  15,627  18,075    20,073    21,528
   Operating income (loss).................     662   1,840   (11,022)    4,128
   Net income (loss).......................     750   2,171   (10,874)    4,363
   Net income (loss) per share.............    0.02    0.06     (0.29)     0.10
</TABLE>
 
13. SUBSEQUENT EVENTS
 
  On April 7, 1997, the Company entered into an Agreement and Plan of
Reorganization (the "Merger Agreement") providing for the merger of Pure Atria
Corporation ("Pure Atria") with and into Wings Merger Corporation, a wholly
owned subsidiary of the Company. Pursuant to the Merger Agreement, all of the
outstanding shares of Pure Atria common stock will be converted into the right
to receive 0.9 shares of Rational common stock (the "Exchange Ratio") and each
outstanding option or right to purchase shares of Pure Atria common stock will
be assumed by the Company and become options and rights to purchase shares of
the Company's common stock with appropriate adjustments made to the price and
number of shares issuable upon exercise of such options or rights based on the
Exchange Ratio. The consummation of the merger requires approval by the
Company's stockholders of the reservation and issuance of the shares of the
Company's common stock to be issued in the merger. The Company expects to
account for the Merger as a pooling of interests and issue approximately
45,493,000 shares in exchange for all outstanding common stock and upon exercise
of outstanding options of Pure Atria.
 
  The Board of Directors has also authorized an increase in the authorized
number of shares of common stock from 75,000,000 to 150,000,000, subject to
stockholder approval, to provide Rational a sufficient number of shares of
common stock to consummate the merger.

ITEM 9 -- DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

     None. 
          
                                      55
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

                                    PART III

ITEM 10 -- DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

       The directors of Rational and their ages as of June 12, 1997 are as
follows:

<TABLE>
<CAPTION>
           NAME             AGE        POSITION
           ----             ---        --------
<S>                         <C>  <C>
Paul D. Levy................ 41  Chairman of the Board
Michael T. Devlin........... 42  Director
James S. Campbell(2)........ 70  Director
Daniel H. Case III(2)....... 39  Director
Leslie G. Denend(1)......... 56  Director
John E. Montague(2)......... 43  Director
Allison R. Schleicher(1).... 53  Director
----------
</TABLE>
(1)  Member of Compensation Committee
(2)  Member of Audit Committee
 
       Paul D. Levy (see Item 1 "Executive Officers")

                                       56
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

     Michael T. Devlin (see Item 1 "Executive Officers")

     James S. Campbell has been a director of Rational since 1990. Since 1987,
he has been the Managing Director of Management Partners International
Corporation, a management and consulting firm specializing in technology
companies. He serves on the national board of directors of United We Stand
America, Inc. and is a Director of Applied Voice Technology, Inc. Mr. Campbell
is the father-in-law of Mr. Levy.

     Daniel H. Case III has been a director of Rational since 1993. Since 1994,
he has been President and Chief Executive Officer of Hambrecht & Quist Group, an
investment banking firm. From 1992 to 1994 he served as President and Co-Chief
Executive Officer of Hambrecht & Quist Group. Previously he held various
positions with Hambrecht & Quist Group. He is a director of Hambrecht & Quist
Group and Electronics Arts, Inc.

     Leslie G. Denend has been a director of Rational since 1993. Since 1993, he
has been the President and Chief Executive Officer of Network General
Corporation, a supplier of local and wide area computer network communications
management systems. From 1990 to 1992, he was President of Vitalink
Communications. He is a director of Network General Corporation, McAfee
Corporation and Proxim, Inc.

     John E. Montague has been a director of Rational since 1994. Since March
15, 1995, he has been Vice President, Financial Strategies at Lockheed Martin
Corporation. Previously, he was Vice President, Corporate Development and
Investor Relations at Martin Marietta Corporation. From 1988 to 1991, he was
Director, Corporate Development at Martin Marietta Corporation.

     Allison R. Schleicher has been a director of Rational since 1990. Since
1967, he has been with IBM Corporation in various executive and management
positions. Most recently in 1994, he was appointed Vice President, Finance of
IBM Credit Corporation. Mr. Schleicher is a director of IBM Credit Corporation.

                                       57
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------


ITEM 11 -- EXECUTIVE COMPENSATION

                          FY 1997 ANNUAL COMPENSATION
                          ---------------------------
<TABLE>
<CAPTION>
                                                                     ALL OTHER     
        NAME                 YEAR      SALARY ($)     BONUS ($)     COMP ($)(1)    
        ----                 ----      ----------     --------     ------------    
<S>                          <C>       <C>            <C>          <C>             
Paul D. Levy...............  1997       $325,008      $180,000       $  348        
                             1996       $240,000      $ 82,374       $  348        
                             1995       $220,000      $      0       $  348        

Michael T. Devlin..........  1997       $325,008      $180,000       $  348        
                             1996       $240,000      $ 82,374       $  348        
                             1995       $220,000      $      0       $  348        

Robert T. Bond.............  1997       $250,008      $139,000       $  348        
                             1996       $185,000      $ 67,729       $  348        
                             1995       $185,000      $      0       $3,652(2)(3)  

David H. Bernstein.........  1997       $275,004      $ 78,000       $  348        
                             1996       $220,000      $ 80,000       $  348        
                             1995       $220,000      $      0       $  348        

John R. Lovitt.............  1997       $195,000      $135,000       $3,348(3)
                             1996       $180,000      $ 62,238       $  348        
                             1995       $170,000      $      0       $  348         
</TABLE>
-----------
(1) Includes $348 in premiums paid pursuant to a long-term disability plan
    through which the Company provides long-term disability income insurance for
    all its employees. In the event of an insured officer's disability, the
    officer may be eligible after three consecutive months of disability for a
    monthly benefit of 60% of his tax-free monthly earnings up to a $6,000 per
    month maximum.

(2) Includes a $304 interest differential reimbursed to Mr. Bond pursuant to the
    Rational Stock Option Financial Assistance Plan that was adopted on Sept.
    29, 1983, to assist optionees in the financing of their purchase of options
    granted under the Rational 1983 Incentive Stock Option Plan. Mr. Bond repaid
    the loan in fiscal year 1996.

(3) Includes $3,000 earned by each of Mr. Bond and Mr. Lovitt as an award for
    ten years of service with the Company.

                                       58
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------


OPTION GRANTS IN LAST FISCAL YEAR

      The following table sets forth information with respect to each of the
named executive officers of the Company concerning the grant of stock options
during the last fiscal year and the potential realizable value at certain
assumed rates of stock price appreciation.

      The total number of shares of Common Stock subject to options granted 
pursuant to options in fiscal year 1997 were 4,344,561 (includes options 
granted under SQA option plans as well as Rational option plans).

<TABLE>
<CAPTION>
                                     INDIVIDUAL GRANTS                            POTENTIAL        
                      --------------------------------------------------     REALIZABLE VALUE AT    
                        NUMBER OF     % OF TOTAL                            ASSUMED ANNUAL RATES OF  
                        SHARES OF       OPTIONS                             STOCK PRICE APPRECIATION 
                      COMMON STOCK    GRANTED TO    EXERCISE                  FOR OPTION TERM (1)    
                       UNDERLYING    EMPLOYEES IN     PRICE    EXPIRATION   ------------------------                         
NAME                  OPTIONS (#)    FISCAL YEAR    ($/SHARE)     DATE        5%($)        10%($)
----                  ------------   ------------   --------   ---------    ---------    -----------
<S>                   <C>            <C>            <C>        <C>          <C>          <C>
Paul D. Levy               200,000      4.60%         $28.19      8/26/06    3,545,708     8,985,520
                           200,000      4.60%         $39.56       1/2/07    4,975,814    12,609,690
                           325,000      7.48%         $18.25      3/18/07    3,730,131     9,452,885

Michael T. Devlin          200,000      4.60%         $28.19      8/26/06    3,545,708     8,985,520
                           200,000      4.60%         $39.56       1/2/07    4,975,814    12,609,690
                           325,000      7.48%         $18.25      3/18/07    3,730,131     9,452,885

Robert T. Bond             130,000      2.99%         $28.19      8/27/06    2,304,710     5,840,588
David H. Bernstein          90,000      2.07%         $28.19      8/27/06    1,595,569     4,043,484
John R. Lovitt              90,000      2.07%         $28.19      8/27/06    1,595,569     4,043,484
---------
</TABLE>
(1) The Potential Realizable Value is calculated based on the fair market value
    on the date of grant, which is equal to the exercise price, assuming that
    the stock appreciates in value from the date of grant until the end of the
    option term at the annual rate specified (5% and 10%). Potential Realizable
    Value is net of the option exercise price. The assumed rates of appreciation
    are specified in rules of the Securities and Exchange Commission, and do not
    represent the Company's estimate or projection of future stock price. Actual
    gains, if any, resulting from stock option exercises and Common Stock
    holdings are dependent on the future performance of the Common Stock and
    overall stock market conditions, as well as the option holder's continued
    employment through the exercise/vesting period. There can be no assurance
    that the amounts reflected in this table will be achieved.


           OPTION EXERCISES IN LAST FISCAL YEAR AND YEAR-END VALUES

      The following table sets forth information with respect to each of the 
named executive officers of the Company concerning the exercise of stock
options during the last fiscal year and the fiscal year 1997 year-end value of
all unexercised options held by such individuals.

<TABLE>
<CAPTION>
                                                         NUMBER OF SECURITIES
                                                             UNDERLYING               DOLLAR VALUE OF UNEXERCISED,
                          NUMBER OF                    UNEXERCISED OPTIONS HELD       IN-THE-MONEY OPTIONS HELD 
                           SHARES        DOLLAR           AT MARCH 31, 1997              AT MARCH 31, 1997(1)       
                         ACQUIRED ON      VALUE      ---------------------------    ------------------------------
        NAME              EXERCISE      REALIZED     EXERCISABLE   UNEXERCISABLE     EXERCISABLE     UNEXERCISABLE
        ----             ----------   ------------   -----------   -------------    -------------   --------------
<S>                      <C>          <C>            <C>           <C>              <C>             <C>           
Paul D. Levy...........   125,000     $2,476,910             0         600,000      $        0      $5,426,250 
Michael T. Devlin......   125,000     $2,690,250             0         600,000      $        0      $5,426,250
Robert T. Bond.........         0     $        0        94,498          80,834      $1,649,219      $1,342,916
David H. Bernstein.....         0     $        0        26,666          53,334      $  482,255      $  964,545
John R. Lovitt.........   105,330     $2,501,022        51,109          75,557      $  894,398      $1,280,759
----------
</TABLE>
(1) Value based on market value of the Company's Common Stock at date of
    exercise, or at March 31, 1997 (the last business day of the fiscal year),
    minus the exercise price. The market value at March 31, 1997, was $20.625
    per share.

                                       59
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

Director Compensation.
---------------------

Rational pays directors' fees only to directors who are neither employees of the
Company nor serving on the Board pursuant to contractual arrangements with the
Company.  Directors' fees are paid at the rate of $1,250 per Board meeting
attended, with no additional  fee being paid for attendance at committee
meetings.  Directors are also reimbursed reasonable out- of- pocket expenses in
connection with attending meetings.  Directors who are not employees of the
Company participate in the Directors' Stock Option Plan. 

Compensation Committee Interlocks and Insider Participation
-----------------------------------------------------------

No interlocking relationships exist between the Company's Board of Directors 
or Officers Compensation Committee and the board of directors or compensation 
committee of any other company.

                                       60
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------


ITEM 12 -- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT


RATIONAL PRINCIPAL STOCKHOLDERS

     The following table sets forth the beneficial ownership of Rational's
Common Stock as of June 12, 1997, by (i) all persons known to Rational to
be the beneficial owners of more than 5% of Rational's Common Stock, (ii)
Rational's Chief Executive Officer and the four most highly compensated
executive officers other than the Chief Executive Officer, (iii) each of
Rational's directors and (iv) all directors and executive officers as a group.
The information on beneficial ownership in the table and the footnotes below is
based upon Rational's records, Schedule 13D and 13G filings and information
supplied to Rational by the listed person or entity.

     The following table has been prepared in accordance with Rule 13d-3 of the
Exchange Act and discloses all securities beneficially owned by the named
persons as of June 12, 1997, plus all securities which such persons have a
right to acquire through the exercise of options or other rights within 60 days
of June 12, 1997.

<TABLE>
<CAPTION>
                                          SHARES BENEFICIALLY OWED
                                          ------------------------
DIRECTORS, OFFICERS AND 5% STOCKHOLDERS      NUMBER       PERCENT
----------------------------------------  -----------   -----------
<S>                                       <C>           <C>
Pure Atria Corporation..................         -(1)          -(1)
  18880 Homestead Road
  Cupertino, CA  95014
The Kaufmann Fund, Inc..................     4,010,000       8.41%
  140 East 45th Street, 43rd Floor
  New York, NY 10017
Robert T. Bond(2).......................       155,323          *
Paul D. Levy(3).........................       152,085          *
Michael T. Devlin(4)....................       152,085          *
John R. Lovitt(5).......................       130,284          *
David H. Bernstein(6)...................        56,668          *
Leslie G. Denend(7).....................        46,666          *
Daniel H. Case III (8)..................        40,497          *
Allison R. Schleicher(9)................        25,666          *
James S. Campbell(10)...................        19,416          *
John E. Montague........................           602          *
All current directors and current       
 executive officers as a group
 (24 persons)(11).......................     1,825,590        3.74%
---------
</TABLE>

 *  Less than one percent.

(1) In connection with the proposed acquisition by the Company of Pure Atria,
    Pure Atria has the option to acquire, under certain circumstances pursuant
    to a Stock Option Agreement by and between Rational and Pure Atria dated as
    of April 7, 1997, up to 19.9% of the outstanding Common Stock of the Company
    on the date the option first becomes exercisable.  If such shares are
    acquired, Pure Atria will have the sole voting power and sole dispositive
    power over such shares.  Also in connection with the Pure Atria Merger, Pure
    Atria shares voting power over 116,873 shares of the Company's Common Stock
    with the directors of Rational pursuant to certain voting agreements between
    such directors and Pure Atria dated as of April 7, 1997.  Pure Atria does
    not have shared dispositive power with respect to such shares.  If the Pure
    Atria Merger is consummated, Pure Atria's option to purchase Rational Common
    Stock will not become exercisable, and the voting agreements will have
    terminated.  See "Business - Definitive Agreement to Acquire Pure Atria 
    Corporation."

                                       61
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

(2)  Includes 130,331 shares purchasable by Mr. Bond within 60 days of
     June 12, 1997, upon exercise of outstanding stock options.

(3)  Includes 152,083 shares purchasable by Mr. Levy within 60 days of 
     June 12, 1997, upon exercise of outstanding stock options.

(4)  Includes 152,083 shares purchasable by Mr. Devlin within 60 days of 
     June 12, 1997, upon exercise of outstanding stock options.

(5)  Includes 86,665 shares purchasable by Mr. Lovitt within 60 days of
     June 12, 1997, upon exercise of outstanding stock options.

(6)  Includes 26,666 shares purchasable by Mr. Bernstein within 60 days of
     June 12, 1997, upon exercise of outstanding stock options.

(7)  Includes 46,664 shares purchasable by Mr. Denend within 60-days of
     June 12, 1997, upon exercise of outstanding stock options.

(8)  Includes 4,166 shares purchasable by Mr. Case within 60 days of
     June 12, 1997, upon exercise of outstanding stock options.

(9)  Includes 20,664 shares purchasable by Mr. Schleicher within 60 days of
     June 12, 1997, upon exercise of outstanding stock options.

(10) Includes 8,332 shares purchasable by Mr. Campbell within 60 days of
     June 12, 1997, upon exercise of outstanding stock options. 

(11) Includes 1,062,785 shares purchasable within 60 days of June 12, 1997,
     upon exercise of outstanding stock options. 


ITEM 13 -- CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

        Daniel H. Case III, a director and stockholder of the Company, is the
President and Chief Executive Officer of Hambrecht & Quist LLC ("H&Q"). H&Q was
a managing underwriter of the Company's public offerings which took place in
June 1995 and October 1996, respectively, and received certain discounts and
commissions, and was indemnified by the Company, with respect thereto. H&Q also
provided financial advisory services to Rational in connection with the merger
of SQA, Inc. in February 1997. H&Q received an initial payment of $250,000 upon
delivery of its fairness opinion in connection with the SQA Merger, and was paid
an additional $750,000 upon consummation of the SQA Merger as well as
reimbursement for reasonable out-of-pocket expenses incurred in connection with
its services. H&Q is providing financial advisory services to Rational in
connection with the Pure Atria Merger. H&Q was paid in an initial payment of
$2.0 million upon delivery of its fairness opinion in connection with the Pure
Atria Merger. H&Q will be paid an additional $3.3 million upon consummation of
the Pure Atria Merger. H&Q will also be reimbursed for reasonable out-of-pocket
expenses incurred in connection with its services in connection with the Pure
Atria Merger. H&Q may in the future provide other investment banking services or
financial advisory services to the Company as well as continue to provide
research coverage of the Company or make a market in its publicly traded
securities, although there is no agreement between the Company and H&Q relating
to such activities.

    In connection with the Company's October 1996 public offering, Ivar 
Jacobson, Vice President, Business Engineering, sold 412,544 shares of
Rational Common Stock. Pursuant to a contractual obligation undertaken in
connection with its acquisition of Objectory, the Company reimbursed Mr.
Jacobson for the underwriting discount applicable to such shares. The amount
so reimbursed was $701,324.80.



                                       62
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

                                    PART IV

ITEM 14 -- EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a)  1.   FINANCIAL STATEMENTS

          See Item 8 of this Form 10-K.

     2.   FINANCIAL STATEMENT SCHEDULES

          The following financial statement schedule of the Company for each of
the years ended March 31, 1997, 1996 and 1995 is filed as part of this Form 10-K
and should be read in conjunction with the Consolidated Financial Statements, 
and related notes thereto, of the Company.
                                                                          Page
                                                                         Number
                                                                         ------
          Schedule II -- Valuation and Qualifying Accounts ...........     S-1

          Schedules other than those listed above have been omitted since they 
are either not required, not applicable, or the information is otherwise 
included.

     3.   EXHIBITS

        Exhibit      
------  -------

 2.01   Reorganization Agreement among Verdix Corporation, Rational Acquisition
        Corporation, and Rational, dated December 15, 1993, is incorporated
        herein by reference to Appendix A filed with the Registrant's
        Registration Statement on Form S-4, dated February 25, 1994
        (Registration No. 33-75724).

 2.02   Agreement and Plan of Reorganization dated November 12, 1996 by and
        among Rational Software Corporation, Sunshine Acquisition Corp., and
        SQA, Inc., is incorporated herein by reference to Appendix A filed
        with the Registrant's Registration Statement on Form S-4, dated
        January 13, 1997, as amended on January 17, 1997 (File No. 333-19669).

 2.03   Stock Purchase Agreement by and among Rational Software Corporation,
        Performance Awareness Corporation ("PAC"), and all of the Stockholders
        of PAC is incorporated herein by reference to Exhibit 2.1 filed with the
        Registrant's Form 8-K Current Report dated March 31, 1997 (File No. 0-
        12167)("March 1997 8-K").

 2.04   Agreement and Plan of Reorganization among Rational Software
        Corporation, Wings Merger Corporation, and Pure Atria Corporation,
        dated April 7, 1997, is incorporated herein by reference to Exhibit
        2.1 filed with the Registrant's Form 8-K Current Report dated April 14,
        1997.

 3.01   Restatement of the Certificate of Incorporation of the Registrant, dated
        August 30, 1996 is incorporated herein by reference to Exhibit 4.01
        filed with the Company's Form S-3 Registrant Statement on October 3,
        1996 (Registration No. 333-13313).

 3.02   Amendment to Section 3.2 of Bylaws of the Registrant hereof.

 4.01   Reference is made to Exhibits 3.01 and 3.02.

 4.02   Specimen of Common Stock Certificate is incorporated herein by reference
        to Exhibit 4.06 filed with the Registrant's Amendment No. 1 to Form S-3 
        Registration Statement on May 31, 1995 (File No. 3391740).


                                      63
<PAGE>
 
10.01   Form of the Registrant's Indemnification Agreement is incorporated
        herein by reference to Exhibit 10.01 filed with the Registrant's
        Registration Statement on Form S-4 (Registration No. 333-19669), filed
        on January 13, 1997, as amended on January 17, 1997.

10.02   *Agreement for Purchase and Sale of Assets between the Registrant and
        Microsoft Corporation, dated October 2, 1996, is incorporated herein by
        reference to Exhibit 1 filed with the Registrant's Form 8-K Current
        Report dated October 2, 1996 as amended by Exhibit 1 filed with the
        Registrant's Form 8-K/A Current Report dated October 16, 1996.

10.03   *Development and License Agreement between the Registrant and Microsoft
        Corporation, dated September 24, 1996, is incorporated herein by
        reference to Exhibit 2 filed with the Registrant's Form 8-K Current
        Report dated October 2, 1996 as amended by Exhibit 2 filed with the
        Registrant's Form 8-K/A Current Report dated October 16, 1996.

10.04   **Rational Software Corporation Stock Option Plan for Directors is
        incorporated herein by reference to Exhibit 1 filed with the
        Registrant's Form 8-K Current Report dated October 2, 1996.

10.05   **Form of Stock Option Agreements for the Rational Software Corporation
        Stock Option Plan for Directors is incorporated herein by reference to
        Exhibit 4.6 filed with the Registrant's Form S-8 Registration Statement
        on September 18, 1995 (Registration No. 33-97042).

10.06   Reference is made to Exhibits 2.01, 2.02, 2.03, and 2.04.

10.07   Voting Agreement dated April 7, 1997 by and among Rational Software
        Corporation, a Delaware corporation, and certain stockholders of Pure
        Atria Corporation, a Delaware corporation, is incorporated herein by
        reference to Exhibit 99.2 filed with the Registrant's Form 8-K Current
        Report dated April 14, 1997.

10.08   Voting Agreement dated April 7, 1997 by and between Pure Atria
        Corporation, a Delaware corporation, and certain stockholders of
        Rational Software Corporation, a Delaware corporation, is incorporated
        herein by reference to Exhibit 99.3 filed with the Registrant's Form 8-K
        Current Report dated April 14, 1997.

10.09   Stock Option Agreement dated April 7, 1997, by and between Pure Atria
        Corporation, a Delaware corporation, and Rational Software
        Corporation, a Delaware corporation (granting Rational an option to
        purchase Pure Atria Common Stock), is incorporated herein by reference
        to Exhibit 99.4 filed with the Registrant's Form 8-K Current Report
        dated April 14, 1997.

10.10   Stock Option Agreement dated April 7, 1997 by and between Pure Atria
        Corporation, a Delaware corporation, and Rational Software
        Corporation, a Delaware corporation (granting Pure Atria an option to
        purchase Rational Common Stock), is incorporated herein by reference
        to Exhibit 99.5 filed with the Registrant's Form 8-K Current Report
        dated April 14, 1997.

11.01   Statement of computation of the Registrant's per share earnings.

21.01   Subsidiaries of the Registrant.

23.01   Consent of Ernst & Young LLP.

24.01   Power of Attorney is contained on the signature pages of this 
        Registration Statement.

27.01   Financial Data Schedule.
------------------
 * Confidential Treatment Requested.
** Indicates those exhibits that are management contracts or compensatory plans
   or arrangements required to be filed as an exhibit to this form.

(b)  REPORTS ON FORM 8-K

     The Company filed one report on Form 8-K with the Securities and Exchange
     Commission during the last quarter of the fiscal year ended March 31, 1997,
     on February 27, 1997, reporting under Item 2 of Form 8-K Rational's
     acquisition of SQA on February 26, 1997. The following financial
     statements were filed:

        Financial statements of business acquired, prepared pursuant to Rule
     3.05 of Regulation S-X were incorporated by reference to Rational's
     Registration Statement on Form S-4 (File No. 333-19669) filed with the
     Securities and Exchange Commission on Janury 13, 1997, as amended on
     January 17, 1997.

        On a Form 8-K/A filed on May 12, 1997, the following financial
     statements were also filed:

        Pro forma financial information required pursuant to Article 11 of
     Regulation S-X.

                                      64
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------

                                   SIGNATURES

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

                               RATIONAL SOFTWARE CORPORATION
                         
Date:   June 19, 1997          /s/ Robert T. Bond
        -----------------      ------------------------------------------------
                               Robert T. Bond, Senior Vice President,
                               Chief Operating Officer, Chief Financial Officer
                               and Secretary


                               POWER OF ATTORNEY

KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Paul D. Levy and Robert T. Bond, jointly
and severally, as such person's true and lawful attorneys-in-fact and agents,
each  with full power of substitution, for such person, in any and all
capacities, to sign any and all amendments (including post-effective amendments)
to this report on Form 10-K, and to file with same, with all exhibits thereto
and other documents in connection therewith, with the Securities and Exchange
Commission, granting unto said attorneys-in-fact and agents, full power and
authority to do and perform each and every act and thing requisite and necessary
to be done in connection therewith, as full to all intents and purposes as such
person might or could do in person, hereby ratifying and confirming all that
said attorney-in-fact and agent, or his substitutes, may do or be done by virtue
hereof.

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, this Report has been signed below by the following persons on
behalf of the Registrant and in the capacities and on the dates indicated:


Date:  June 19, 1997                     /s/ Paul D. Levy
                                        ----------------------------------
                                        Paul D. Levy, Chairman of the Board and
                                        Chief Executive Officer, Director       
 
Date:  June 19, 1997                     /s/ Michael T. Devlin
                                        -----------------------------------
                                        Michael T. Devlin,      
                                        President, Director
                                        
Date:  June  19, 1997                    /s/ Robert T. Bond
                                        -----------------------------------
                                        Robert T. Bond, Senior Vice President
                                        Chief Operating Officer, Chief Financial
                                        Officer and Secretary
 
Date:  June 19, 1997                     /s/ James S. Cambell
                                        -------------------------------------
                                        James S. Campbell, Director
 
Date:  June  19, 1997                    /s/ Daniel H. Case III
                                        -------------------------------------
                                        Daniel H. Case III, Director
 
                                       65
<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION
--------------------------------------------------------------------------------


Date:  June 19, 1997                     /s/ Leslie G. Denend
                                        -------------------------------------
                                        Leslie G. Denend, Director
 
Date:  June 19, 1997                     /s/ John E. Montague
                                        -------------------------------------
                                        John E. Montague, Director
 
Date:  June 19, 1997                     /s/ Allison R. Schleicher
                                        -------------------------------------
                                        Allison R. Schleicher, Director
 
Date:  June 19, 1997                     /s/ Timothy A. Brennan
                                        -------------------------------------
                                        Timothy A. Brennan, Vice President, 
                                        Finance and Administration (Principal
                                        Accounting Officer)

                                       66

<PAGE>
 
                         RATIONAL SOFTWARE CORPORATION

               SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
                   Years Ended March 31, 1997, 1996 and 1995

                          Balance at                                Balance at
                          Beginning                                 Ending of
                          of Period     Additions    Deductions       Period
                          ----------    ---------    ----------     ----------
March 31, 1997
  Allowance for doubtful
    accounts              $1,286,015     $929,869    $ 255,884      $1,960,000

March 31, 1996
  Allowance for doubtful
    accounts                 569,600      824,648     (108,233)      1,286,015

March 31, 1995
  Allowance for doubtful
    accounts                 639,088      272,000     (341,488)        569,600

                                      S-1

<PAGE>
 
                          LIST OF ATTACHED EXHIBITS
                          -------------------------

 3.03   Amendment to Section 3.2 of Bylaws of the Registrant.

11.01   Statement of Computation of the Registrant's per share earnings.

21.01   List of Subsidiaries of Registrant.

23.01   Consent of Ernst & Young, LLP.

27.01   Financial Data Schedule.

For documents incorporated by reference, see Item 14(a)(3) above.