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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, 2001

  [_]      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)

<TABLE>
<S>                                                          <C>
                         Delaware                                          54-1217099
              (State or other jurisdiction of                           (I.R.S. Employer
              incorporation or organization)                          Identification Number)

                   18880 Homestead Road,
                       Cupertino, CA                                       95014-0721
         (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)
</TABLE>

                                 408-863-9900
              (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. [_]

   At May 31, 2001, the aggregate market value of Registrant's voting stock
held by nonaffiliates was $4,753,011,230. For the purposes of the preceding
sentence only, "affiliates" is deemed to consist of executive officers and
directors. At May 31, 2001, there were 203,190,957 shares of the Registrant's
Common Stock, $0.01 par value, outstanding.

   Unless indicated otherwise, all Common Stock share numbers and prices have
been adjusted to reflect Rational Software Corporation's May 1995 1:3 reverse
stock split, July 1996 2:1 forward stock split, accomplished by means of a
stock dividend, and September 2000 2:1 forward stock split, accomplished by
means of a stock dividend.

   Certain sections of the Registrant's definitive Proxy Statement for the
2001 Annual Meeting of Stockholders to be held on July 19, 2001, are
incorporated by reference in Part III of this Form 10-K to the extent stated
herein.

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                    An Index to Exhibits Begins on Page 61
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   This annual report on Form 10-K contains forward-looking statements within
the meaning of the federal securities laws. These forward-looking statements
include without limitation statements regarding our expectations and beliefs
about the market and industry, our goals, plans, and expectations regarding
our products and services and product development, our intentions and
strategies regarding customers and customer relationships, our relationships
with the software development community, our intent to continue to invest
significant resources in research and development, our expectations regarding
the impact of the acquisitions of Catapulse Inc., Attol Testware and ObjecTime
Limited and related product and service offerings, our intent to acquire or
invest in other technologies, our intent to develop long-term relationships
and strategic alliances, our beliefs regarding the future success of our
products and services, our intent to extend and strengthen our life cycle
support for team-based development, our expectations and beliefs regarding
competition, competitors, the bases of competition and our ability to compete,
our beliefs regarding trademark and copyright protections, our beliefs and
expectations regarding infringement claims, our expectations and beliefs
regarding our ability to hire and retain personnel, our beliefs regarding
period to period results of operations, our expectations regarding future
growth and financial performance, our beliefs regarding the development of
industry standards, our expectations regarding international sales and our
revenues, our expectations regarding the conversion to the Euro currency, our
expectations and beliefs regarding revenue growth, our expectations regarding
our strategies and long-term strategic relationships, our expectations
regarding defects in products, our expectations regarding fluctuations in
revenues and operating results, our beliefs and expectations regarding our
existing facilities and the availability of additional space in the future,
our intent to use all available funds for the development and the operation of
our business and not to declare or pay any cash dividends, our expectations
regarding software development costs, our beliefs and expectations regarding
our results of operations and financial position, our beliefs regarding
estimates in valuing in-process research and development, our intentions and
expectations regarding deferred tax assets, our beliefs and expectations
regarding liquidity and capital resources and that cash flow from operations,
existing cash and cash equivalents and short-term investments will be
sufficient to meet our cash requirements, and our expectations regarding the
impact of recent accounting pronouncements and revenue recognition matters
relating to Catapulse. These statements are subject to risks and uncertainties
that could cause actual results and events to differ materially. These risks
and uncertainties include without limitation those identified in the section
of this annual report on Form 10-K entitled "Factors That May Affect Future
Results" below. Rational undertakes no obligation to update forward-looking
statements to reflect events or circumstances occurring after the date of this
annual report on Form 10-K.

   As used in this annual report on Form 10-K, unless the context otherwise
requires, the terms "we," "us," "the Company," and "Rational" refer to
Rational Software Corporation, a Delaware corporation, and its subsidiaries.

                                    PART I

ITEM 1--BUSINESS

Overview

   We were incorporated under the laws of Delaware in July 1982. We are a
leading provider of integrated solutions that automate the software
development process. Our integrated solutions include unified tools, software
engineering best practices, and services that allow customers to successfully
and efficiently develop and deploy software. Our solutions help customers
organize, automate, and simplify the software development process and enable
them to gain a competitive advantage by being able to more quickly develop and
deploy high-quality, mission-critical software. The focus of our business is
e-development, that is, helping customers rapidly develop high-quality
software for the Internet-connected global economy. We serve customers in
three principal categories that we refer to as business applications,
infrastructure, and embedded systems and devices:

  .  business applications customers include organizations that are
     leveraging the power of the Internet to improve their businesses by
     building business-to-business and/or business-to-consumer software. Our
     business applications customers include Charles Schwab & Co., E*Trade,
     i2 Technologies, Merrill Lynch, and Siebel Systems.

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  .  infrastructure customers are building the physical and software
     infrastructure for the Internet and include communications as well as
     operating system and "middleware" software vendors. Our infrastructure
     customers include America Online, Cisco, Ericsson, IBM, Lucent,
     Microsoft, Nokia and Sun Microsystems.

  .  embedded systems and devices customers are building devices with
     embedded software that provide connectivity to the Internet and other
     specialized networks. Our customers for embedded systems and devices
     include Hewlett-Packard, Motorola, Palm, Phillips, and Sony.

Industry Background

   The rapid growing use of technology in business and everyday life is
driving an increasing demand for software development. Software is essential
in the development of Web sites and related business systems, plays a central
role in the communication networks, and is embedded in physical devices such
as routers, hubs, and switches, as well as everyday devices such as mobile
phones, hand-held computing devices, and automobiles.

   The challenge many companies face is that their demand for software
outpaces their ability to design and build that software. Traditionally,
organizations have been able to trade off speed for quality. However, in
today's rapidly changing business environment, organizations must increase the
speed and quality of their software development; they can no longer afford to
trade one off for the other. This "software development paradox" becomes
increasingly prevalent as software becomes more business-critical.
Accordingly, it is becoming increasingly important for businesses to adopt
more effective approaches to software development.

   In addition, software is becoming more complex, requiring coordinated teams
of professionals to develop and deploy it. These teams comprise software
professionals numbering overall in the millions and spanning multiple software
engineering disciplines. These teams must work in unison to meet today's
increased speed and quality needs. An increasing number of organizations are
seeking to improve the efficiency of their software teams by addressing the
fundamentals of software development at every stage: inception, analysis,
design, development, test, and deployment. Organizations are finding that they
can improve their software development by upgrading their best practices,
applying advanced tools, and leveraging the expertise of experienced vendors.

   Our target users are professionals on software development teams employed
by businesses across a variety of industries. These software professionals
span multiple software engineering disciplines--such as analysis, design,
programming, and testing--and now number in the millions.

The Rational Solution

   Our integrated e-development solution includes software development tools,
software engineering best practices, and services that unify cross-functional
software teams while also addressing the unique needs of each member of the
team. Our solution covers the crucial phases of the software development life
cycle and automates proven software development best practices. We also offer
a range of services to our customers to help them better implement our
solution. Our goal is to help organizations increase both the speed and
quality of their software development.

   Our products and services:

  .  Reduce time-to-market. Our products help organizations improve both
     individual and team productivity, reducing the time required to develop
     and deploy quality software.

  .  Improve software quality. Our solution allows testers and developers to
     more quickly verify the reliability and functionality of their software.
     Using our solution, teams can apply more automated testing techniques
     earlier in the product development cycle to uncover errors when they are
     significantly less costly to fix.

  .  Improve application performance. We help customers identify performance
     bottlenecks and understand the impact of alternative deployment
     scenarios. Users of our solutions can estimate the performance of
     Internet and other applications under a variety of potential operating
     conditions.

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  .  Improve process maturity. Our integrated solution helps customers
     improve both the predictability and repeatability of their software
     development processes. Our products encourage teams to adopt proven
     software engineering best practices, which we deliver in an easy-to-
     access format directly from our tools.

  .  Manage change more effectively. Our products help teams track project
     status and manage changes to evolving source code. Our solution helps
     organizations leverage technical resources wherever they are located,
     and allows multiple team members to work on the same project
     simultaneously.

Our Strategy

   Our mission is to ensure the successful software development efforts of our
customers. Our strategy is to build customer relationships by offering
comprehensive solutions to the software management problem through an
integrated set of tools, best practices, and services. Key components of our
strategy include:

  .  Increasing adoption of our integrated solution. While we are the leading
     provider of integrated solutions that automate the software development
     process, we believe we are currently only serving a small portion of our
     potential market. We intend to continue to target new customers based on
     the proven benefits of our integrated solution. In addition, we intend
     to increase penetration of our existing customers by demonstrating the
     benefits of our additional products and services.

  .  Extending product leadership. We intend to continuously improve the
     functionality of our products and services to meet the evolving needs of
     our customers. We intend to continue to leverage our strong relationship
     with the software development community as well as use our industry
     knowledge and expertise to ensure that we maintain our product
     leadership. In addition, we will continue to invest significant
     resources in research and development to improve our existing products
     and develop new products.

  .  Acquiring or investing in complementary products. To achieve our
     objective of providing the most comprehensive software development
     solution, we have from time to time acquired businesses, products, or
     technologies that are complementary to our business. For example, our
     acquisition of Catapulse Inc. extends our capabilities in a hosted
     development service, which is designed to be delivered to users over the
     Internet, and our acquisition of Attol Testware extends our product line
     for our embedded systems and devices customers. We intend to acquire or
     invest in other leading technologies that address the needs of our
     customers and that we can integrate into our product family.

  .  Continuing to form key strategic alliances. We intend to continue to
     develop long-term strategic relationships with leading software and
     hardware vendors to increase our exposure to potential users and thereby
     expand our customer base. Consistent with this strategy, we have entered
     into strategic alliances with companies such as IBM, Microsoft, Intel,
     Hewlett-Packard, Sun Microsystems, and Vignette Corporation. Our
     strategic alliances provide for such things as technology cross-
     licensing, joint development projects, and joint marketing programs.

Products and Services

 Rational Unified Process

   Rapid delivery of high-quality software requires cohesive teamwork and a
predictable, well-understood process. We satisfy this need with the Rational
Unified Process, a set of software engineering best practices optimized for
rapid development of high-quality software. The Rational Unified Process
combines lessons learned from thousands of customer engagements with the
expertise of industry thought leaders. Its entire contents--including
prescriptive guidelines, templates, and examples--can be directly accessed
from any Rational tool through seamless integrations that make the process
practical. When combined with our comprehensive services and team unifying
tools, the Rational Unified Process serves as a recipe for rapid delivery of
high-quality software.

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 Rational Integrated Solutions

   Our products span the software development life cycle. They are available
in individual editions that address the unique needs of specific software
engineering disciplines, such as system definition, software design and
development, content management, system testing, change management, and defect
tracking. In addition, many of our products are available in tightly
integrated suite editions. Our suite editions unify cross-functional teams by
automating the flow of project artifacts and providing shared access to common
data. They provide an easy way for customers to acquire and deploy complete
software development solutions.

 Rational Suite

   The Rational Suite product family provides tightly integrated solutions
that make it easy for customers to acquire and deploy complete software
development solutions. We design each suite around the needs of the various
software engineering disciplines that are part of every software development
team. Each suite also includes a core set of team-unifying tools to improve
the productivity of the entire team.

  .  Rational Suite AnalystStudio is an answer to the problems facing today's
     analysts. Analysts are responsible for collecting, managing, and
     communicating project requirements to the entire team. Rational Suite
     AnalystStudio optimizes the analyst's effectiveness by combining
     powerful tools that collect enhancement requests, manage requirements
     information, and visually model use cases for better communication.

  .  Rational Suite DevelopmentStudio is a complete solution for software
     architects and developers. Architects and developers are responsible for
     designing software systems and developing code. Rational Suite
     DevelopmentStudio combines the power of visual modeling for software
     design and automated testing to improve the quality of the code before
     it is handed off to quality assurance professionals.

  .  Rational Suite DevelopmentStudio RealTime Edition provides an integrated
     solution for software teams developing complex, real-time embedded
     software applications used in cell phones, pagers, routers, hubs, and
     other products fueling the Internet economy. It combines the power of
     visual modeling and automated testing with advanced features optimized
     for the unique challenges of real-time engineering.

  .  Rational Suite TestStudio is a fully integrated suite of testing tools
     that automates test planning, test developments, test execution, and
     defect tracking. Designed for testing and quality assurance
     professionals who ensure that software systems meet quality standards as
     well as end-user requirements, it ensures that a common set of testing
     tools, methods, metrics, and data are used by the entire project team.

  .  Rational Suite ContentStudio combines software development solutions
     from Rational with content management tools from Vignette Corporation, a
     market leader in Web content management and a Rational strategic
     alliance partner -- in one integrated solution. Rational Suite
     ContentStudio makes it possible for development teams to more easily
     manage the development of sophisticated e-business applications,
     typically consisting of significant amounts of both software application
     code and content.

  .  Rational Suite Enterprise combines all of the tools of Rational Suite
     AnalystStudio, DevelopmentStudio, and TestStudio. Rational Suite
     Enterprise provides a complete software development solution in one
     easy-to-acquire package.

 Configuration and Change Management Solutions

   Our configuration and change management products unify software teams by
providing comprehensive support for development teams working in parallel on
shared project artifacts, such as source code, binary files, software models,
requirements documents, test cases, and project reports.

  .  Rational ClearCase is our software configuration management solution.
     ClearCase accelerates development cycles, ensures the accuracy of
     releases, and enables teams to reliably build and patch

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     previously shipped products. It provides secure and reliable access to
     project artifacts, allowing teams to share their work. ClearCase
     maintains a full audit trail of who changed what, when, where, and why,
     manages multiple versions of software artifacts, and reliably performs
     "builds" of software systems. Rational ClearCase MultiSite supports
     geographic distribution of software development teams working on shared
     sets of artifacts.

  .  Rational ClearQuest is a flexible defect tracking/change request
     management system for tracking and reporting on defects and other types
     of change requests throughout the development life cycle. ClearQuest
     provides reliable project metrics and is fully customizable. ClearQuest
     helps project teams ensure that change occurs in a managed fashion.

   Combined, Rational ClearCase and Rational ClearQuest offer Unified Change
Management (UCM), an automated process for managing changes to project
activities and artifacts. UCM helps teams get up and running quickly by
providing built-in project workflow and change management support. Its
activity-based approach helps teams work more intuitively by focusing on high-
level activities instead of individual changes to files.

 Requirements Management Solutions

   Rational RequisitePro is the flagship member of the Rational Requisite
family. This family of tools is designed to make requirements management
intrinsic to the development process by making requirements easy to document,
organize, and track as changes are made throughout the project life cycle.
Rational RequisitePro enables team-based requirements management. RequisitePro
is supplemented with RequisiteEnterprise, which adds support for enterprise
databases, and RequisiteWeb, which provides a Web interface for viewing and
editing RequisitePro requirements.

 Visual Modeling Solutions

  .  Rational Rose is a Unified Modeling Language (UML)-based software
     modeling tool for designing component-based applications. The UML,
     pioneered by Rational and officially adopted as a standard by the Object
     Management Group (OMG), is the industry-standard language for
     specifying, visualizing, constructing, and documenting the artifacts of
     a software system. COM, ActiveX, and JavaBean components can be reverse
     engineered to derive interfaces and determine the interrelationships of
     all components within a model. Rose gives developers the ability to mix
     and match multiple languages, such as C++, Visual Basic, and Java,
     within the same model.

  .  Rational Rose RealTime is a visual modeling environment designed
     specifically to address the needs of software teams that manage and
     deliver real-time software applications. Rational Rose RealTime combines
     market-leading visual modeling technology with advanced model execution
     and code generation technology. Rose RealTime also supports the UML.

 Automated Testing Solutions

   Our solutions for automated testing help testers and developers verify the
reliability and functionality of their software and improve its performance.

  .  Rational Robot lets the user create, modify, and run automated tests on
     Web, Enterprise Resource Planning (ERP), and client/server applications.
     This test automation solution offers reusability and portability of test
     recordings across Windows platforms to provide one recording that plays
     back on all Windows platforms. Rational TestFactory automates the
     creation of test scripts--so testers do not have to invest significant
     amounts of time developing test scripts. Robot and TestFactory are key
     components of Rational Suite TestStudio. Rational LoadTest offers load,
     stress, and multi-user testing of client/server applications. It
     automates the use of multiple transactions from a single test script,
     the creation of workloads for 10 or 10,000+ users, and the insertion of
     production-level timing characteristics.


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  .  Rational Test RealTime is designed specifically for teams creating
     complex, cross-platform software for embedded systems. Built
     specifically for testing real-time and embedded by Attol Testware, a
     company we recently acquired, Rational Test RealTime provides system,
     unit, functional, and performance testing and supports over 100 of the
     industry's most popular host and target environments.

  .  Rational Visual Test, an automated, language-independent, software-
     testing tool, is designed to test proper software functionality by
     rapidly creating tests for applications of virtually any size and
     created in any implementation language by capturing those tests for
     later reuse.

  .  Rational Purify, Rational PureCoverage, and Rational Quantify are
     designed to help developers and testers verify the reliability of their
     software. Purify employs patented object-code insertion (OCI) technology
     to executable code and automatically detects many common runtime errors.
     PureCoverage also employs OCI technology to analyze executable code and
     to report which parts of the code have not been executed and tested.
     Quantify helps developers verify software performance by measuring where
     time is spent during software execution and by providing users with
     accurate data on potential performance bottlenecks. This data tells
     users what portions of the application need to be tuned or revised to
     improve performance.

 Integrated Development Environment Solutions

   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 reuse 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 for UNIX,
Windows NT, and embedded applications.

 Technical Consulting and Customer Support Services

   We offer our customers the benefits of 20 years of experience in developing
and applying tools and proven best practices for software development. This
experience is drawn from hundreds of our software consultants working directly
with customers, and from extensive internal use of our tools. Our professional
services facilitate customer adoption of these tools and best practices,
maximizing the probability of project success. Customers are able to take full
advantage of our experience, avoid common pitfalls, and get maximum value from
their investment in our solution.

   Our partners and we offer a wide range of professional services. These
include tool and technology training delivered onsite or in public classes,
onsite implementation planning, software engineer mentoring, and architecture
and process consulting. We also offer a support program that entitles a
licensee to receive all enhancements and upgrades to the licensed product that
are published in the succeeding 12-month period, as well as certain other
support services.

 Business Alliances

   We work with numerous strategic partners for business applications,
embedded systems and devices, and infrastructure platforms and applications.
In this context, we work with vendors such as Microsoft, IBM, Intel, Sun
Microsystems, Vignette Corporation, Peoplesoft, Oracle, Hewlett-Packard, SGI,
and others. These relationships may include technology cross-licensing
arrangements and cooperative marketing relationships as well as exchange of
development plans and strategic directions. Our relationship with Microsoft
includes, among other things, Rational providing certain visual modeling
technology to Microsoft that has been included in Microsoft's Visual Studio
Products.

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 Product Development

   We believe that our success will depend largely on our ability to enhance
existing products and develop new products that meet the needs of a rapidly
evolving marketplace and increasingly sophisticated and demanding customers.
We intend to extend and strengthen our life cycle support for team-based
development by expanding our product offerings, introducing new products, and
offering higher levels of integration among our products. We use our own
software processes and tools extensively in our own software development
activities. Although we have primarily developed products internally, we may,
based on timing and cost considerations, acquire technologies or products from
third parties.

   Our research and development staff, including product development, product
support, and technical writing personnel, consisted of 1,241 employees as of
May 31, 2001. Our total research and development expenses excluding related
amortization of deferred stock based compensation were approximately $183.5
million, $102.6 million, and $71.9 million in fiscal years 2001, 2000, and
1999, respectively.

 Customers and Applications

   More than 917,000 licenses of our software products, exclusive of Rational
Visual Test, have been sold to more than 52,000 customers worldwide. No single
customer accounted for 10% or more of revenues in fiscal 2001. Our
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.

 Sales and Marketing

   We market and sell our products and services directly through our field
sales organizations, the World Wide Web, and indirectly through channels such
as value-added resellers (VARs) and distributors.

   Our direct selling approach couples sales of our integrated software
development tools with high-value technical consulting services. We have
established a major-account direct sales and technical consulting organization
in the United States, Canada, Europe, Latin America, and the Asia/Pacific
region. In most regions this direct sales organization includes a telesales
operation to augment its direct sales presence.

   Our sales, marketing, and professional services organization consisted of
2,248 employees as of May 31, 2001. This organization operates out of
corporate headquarters in Cupertino, California, operations in Lexington,
Massachusetts, and from field offices in other locations throughout North
America, Europe, and the Asia/Pacific region. Our direct international
operations are staffed almost exclusively by local personnel. Additionally, we
also have distributors and resellers in the same regions.

   In support of our sales efforts, our marketing department conducts
comprehensive programs, which include:

  .  maintenance of an extensive World Wide Web site;

  .  an electronic subscription service for news announcements about us;

  .  print and Web advertising;

  .  public relations and industry analyst communications;

  .  trade shows, technical seminars, webinars, and the annual international
     Rational User Conference;

  .  direct mail promotions and other mailings to keep our prospects and
     customers informed;

  .  creation of sales brochures, multi-media CDs, and technical papers;

  .  management of marketing activities and promotions with members of the
     Rational Unified Partners program; and

  .  internal sales product training.

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   International sales accounted for approximately 41%, 41%, and 40% of our
revenues in fiscal 2001, 2000, and 1999, respectively, and we expect that
international sales will continue to account for a significant portion of our
revenues in the future. International sales are subject to inherent risks,
including:

  .  unexpected changes in regulatory requirements and tariffs;

  .  unexpected changes in global economic conditions;

  .  difficulty in staffing and managing foreign operations;

  .  longer payment cycles;

  .  potentially adverse tax consequences;

  .  price controls or other restrictions on foreign currency;

  .  difficulty in obtaining export and import licenses;

  .  costs of localizing products for some markets;

  .  lack of acceptance of localized products in international markets; and

  .  the effects of high local wage scales and other expenses.

   Any material adverse effect on our international business would likely
materially and adversely affect our business, operating results, and financial
condition as a whole. There can be no assurance that we will not experience a
material adverse impact on our financial condition and results of operations
from fluctuations in foreign currencies or from macroeconomic problems in
various markets or geographies in the future.

 Product Pricing

   Our software licenses are generally perpetual, fully paid-up floating or
node-locked licenses. Floating licenses limit the number of simultaneous users
on a network instead of being associated with a specific user or computer.
Node-locked licenses limit a software license to a single computer. We also
offer other kinds of licenses, such as project licenses that provide selected
Rational tools to all the developers working on a specific project.

   We also offer a support program that entitles a licensee to receive all
enhancements and upgrades to the licensed product that are published in the
succeeding 12-month period, as well as certain other support services. Annual
fees for support generally range from 15% to 25% of the software license fee.

   Our packaged training courses are offered in the form of open-enrollment
public courses and in-house courses at customer facilities. Additionally, we
offer packaged consulting services that are generally priced on a time-and-
materials basis.

 Competition

   The industry for automating software application development and management
is extremely competitive and rapidly changing. We expect 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 lines and the availability of integrated
     suites and bundles;

  .  product architecture, functionality, and features;

  .  product quality, performance, and ease of use;

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  .  quality of support and availability of technical consulting services;
     and

  .  price.

   We face intense competition for each product in our product lines,
generally from both Windows and UNIX vendors. Because individual product sales
are often the first step in a broader customer relationship, our success will
depend in part on our ability to successfully compete with numerous
competitors at each point in their product lines.

   We face 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 ours. As a result, we must educate prospective
customers about the advantages of our products versus internally developed
software quality systems.

   We face competition from, among others, Aonix, Compaq, Computer Associates,
Compuware, Continuus Software Corporation, Cyrano, GEC-Marconi, Green Hills
Software, Hewlett-Packard, Merant, plc, Mercury Interactive Corporation,
Microsoft, Oracle, Mortice Kern Systems (MKS), Perforce Software, Princeton
Softech, Inc., Segue Software, Inc., SGI, SQL Software LTD., StarBase
Corporation, Sun Microsystems, Sybase Inc., Telelogic, Teradyne, and True
Software, as well as numerous other public and privately held software
application development and tools suppliers. We expect additional competition
from other established and emerging companies.

   We believe we are well-positioned to compete due to the combination of our:

  .  integrated family of products supporting component-based development
     throughout the software development life cycle;

  .  emphasis on controlled iterative development and visual modeling;

  .  architecture-driven process;

  .  extensive major-account direct sales and technical consulting
     organization; and

  .  supporting channels such as telesales, VARs, distributors, and the World
     Wide Web.

   We believe that the increased level of competition we observed in fiscal
2001 will continue to increase. Certain of our competitors are more
experienced than we in the development of software engineering tools,
databases, or software development products. Some of our competitors have, and
new competitors may have, larger technical staffs, more established
distribution channels, and greater financial resources than we do. There can
be no assurance that either existing or new competitors will not develop
products that are superior to our products or that achieve greater market
acceptance. Our future success will depend in large part on our ability to
increase our share of 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 our business, results of operations, and
financial condition.

 Intellectual Property

   We regard our software as proprietary and attempt to protect it under a
combination of copyright, trademark, patent, and trade-secret laws, employee
and third-party nondisclosure agreements, and other methods of protection.
Despite these precautions, it may be possible for unauthorized third parties
to copy certain portions of our products or to reverse-engineer or obtain and
use information we regard as proprietary. Although our competitive position
may be affected by our ability to protect our proprietary information, we
believe that trademark and copyright protections are less significant to our
success than are other factors, such as trade-secret protection, the
knowledge, ability, and experience of our personnel, name recognition, and
ongoing product development and support.

                                      10
<PAGE>

   Our software products are generally licensed to end users on a right-to-use
basis pursuant to a perpetual license. We license our products primarily under
"shrink-wrap" licenses (that is, 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 countries do not protect our
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, we believe that software
programs will increasingly become subject to infringement claims. There can be
no assurance that third parties will not assert infringement claims against us
in the future with respect to current or future products. Any such assertion
could require us to enter into royalty arrangements or result in costly
litigation.

 Employees

   We believe our success will depend in part on our continued ability to
attract and retain highly qualified personnel in a competitive market for
experienced and talented software engineers and sales and marketing personnel.
Our employees are not represented by any collective bargaining organization,
and we have never experienced a work stoppage. As of May 31, 2001, our
employee base was as follows:

  .  product development and support, 1,241 employees;

  .  sales, marketing, and technical consulting, 2,248 employees;

  .  finance and administration, 410 employees;

  .  total full-time personnel, 3,899 employees.

                                      11
<PAGE>

                              EXECUTIVE OFFICERS

   The following table sets forth certain information with respect to our
executive officers as of the date hereof.

<TABLE>
<CAPTION>
Name                                               Position
----                                               --------
<S>                      <C>
Paul D. Levy............ Founder and Chairman of the Board
Michael T. Devlin....... Founder, Chief Executive Officer and Director
Thomas F. Bogan......... President and Chief Operating Officer
David H. Bernstein...... Senior Vice President and General Manager, Products
Kevin J. Haar........... Senior Vice President, Worldwide Field Operations
Timothy A. Brennan...... Senior Vice President, Chief Financial Officer and Secretary
</TABLE>

   Mr. Levy, age 45, co-founded Rational in 1981 and has served as Chairman of
the Board since September 1996. Prior to April 1999, Mr. Levy also served as
Chief Executive Officer of Rational.

   Mr. Devlin, age 46, co-founded Rational in 1981, has served as Chief
Executive Officer since April 1999, and is a Director. From September 1996
until April 1999, Mr. Devlin served as President of Rational. Prior to
September 1996, Mr. Devlin served as Chairman of the Board of Rational.

   Mr. Bogan, age 49, has served as Rational's President and Chief Operating
Officer since April 2000. From April 1999 until April 2000, Mr. Bogan served
as Senior Vice President and Chief Operating Officer. From March 1997 until
April 1999, he served as Vice President and General Manager, Automated Test.
From July 1996 until March 1997, Mr. Bogan served as Senior Vice President,
Finance and Administration, Chief Financial Officer, Treasurer, and Assistant
Secretary of SQA, Inc. From 1993 to 1996, Mr. Bogan was President and Chief
Executive Officer of Pacific Data Products, Inc., a printer peripherals and
networking vendor.

   Mr. Bernstein, age 49, joined the Company in 1982 and has served as Senior
Vice President and General Manager, Products, since 1996. Prior to this, he
held various management positions with the Company, most recently Senior Vice
President and General Manager, Object Technology Products.

   Mr. Haar, age 44, joined the Company in 1986 and has served as Senior Vice
President, Worldwide Field Operations since April 2000. Prior to April 2000,
he held various management positions with the Company, most recently Senior
Vice President, The Americas Field Operations.

   Mr. Brennan, age 45, joined the Company in 1994 and has served as Senior
Vice President, Chief Financial Officer, and Secretary since January 1998.
From 1995 until 1998, Mr. Brennan served as Vice President, Finance and
Administration. From 1994 until 1995, he served as the Company's Controller.

Factors That May Affect Future Results

 Significant unanticipated fluctuations in our quarterly revenues and
 operating results may cause us not to meet securities analysts' or
 investors' expectations and may result in a decline in the prices of
 our Common Stock and our Convertible Notes.

   Our net revenues and operating results are difficult to predict and may
fluctuate significantly from quarter to quarter. If our revenues, operating
results, earnings, or future projections are below the levels expected by
securities analysts, the prices of our Common Stock and Convertible Notes are
likely to decline.

   Factors that may cause quarterly fluctuations in our operating results
include, but are not limited to:

  .  the discretionary nature of our customers' purchase and budget cycles;

  .  difficulty predicting the size and timing of customer orders;

  .  long sales cycles;


                                      12
<PAGE>

  .  seasonal variations in operating results;

  .  introduction or enhancement of our products or our competitors'
     products;

  .  changes in our pricing policies or the pricing policies of our
     competitors;

  .  an increase in our operating costs;

  .  whether we are able to expand our sales and marketing programs;

  .  the mix of our products and services sold;

  .  the level of sales incentives for our direct sales force;

  .  the mix of sales channels through which our products and services are
     sold;

  .  the mix of our domestic and international sales;

  .  an increase in the level of our product returns;

  .  unfavorable economic conditions in the technology industry;

  .  decreased spending on technology due to adverse economic conditions;

  .  fluctuations in foreign currency exchange rates;

  .  changes in accounting pronouncements applicable to us;

  .  costs associated with acquisitions; and

  .  global economic conditions.

   In addition, the timing of our product revenues is difficult to predict
because our sales cycles vary substantially from product to product and
customer to customer. We base our operating expenses on our expectations
regarding future revenue levels. As a result, if total revenues for a
particular quarter are below our expectations, we could not proportionately
reduce operating expenses for that quarter. Therefore, a revenue shortfall
would have a disproportionate effect on our operating results for that
quarter. In addition, because our service revenues are largely correlated with
our license revenues, a decline in license revenues could also cause a decline
in our service revenues in the same quarter or subsequent quarters.

   Although we have experienced growth in revenues in recent years, there can
be no assurance that, in the future, we will sustain revenue growth or be
profitable on a quarterly or annual basis. Further, the revenues and operating
income (exclusive of nonrecurring operating and acquisition related expenses)
experienced by us in recent quarters are not necessarily indicative of future
results. As a result of these and other factors, our operating results are
subject to significant variation from quarter to quarter, and we believe that
period-to-period comparisons of our results of operations are not necessarily
useful. If our operating results are below investors' or securities analysts'
expectations, the prices of our Common Stock and Convertible Notes could
decline significantly.

 There may be a possible effect from the acquisition of Catapulse on our
 future revenue recognition policy.

   Our primary revenue recognition model is to recognize license revenues upon
delivery of a software license. Catapulse's anticipated revenue recognition
model will recognize revenue based on delivery of a service over time. We
offer for sale both licenses and hosted development services as a combined
company. If the hosted development service is sold in conjunction with, or as
an option to, Rational's license, there could be an impact on our revenue
recognition policy.

 If market acceptance of our sophisticated software development tools fails to
 grow adequately, our business may suffer.

   Our future growth and financial performance will depend in part on broad
market acceptance of off-the-shelf products that address critical elements of
the software development process. Currently, the number of software

                                      13
<PAGE>

developers using our products is relatively small compared with the number of
developers using more traditional technology and products, internally
developed tools, or manual approaches. Potential customers may be unwilling to
make the significant capital investment needed to purchase our products and
retrain their software developers to build software using our products rather
than traditional techniques. Many of our customers have purchased only small
quantities of our products, and these or new customers may decide not to
broadly implement or purchase additional units of our products.

 If industry standards relating to our business do not gain general
 acceptance, we may be unable to continue to develop and market our products
 and our business may suffer.

   Our future growth and financial performance depends on the development of
industry standards that facilitate the adoption of component-based
development, as well as enhance our ability to play a leading role in the
establishment of those standards. For example, we developed the Unified
Modeling Language for visual modeling, which was adopted by the Object
Management Group, or OMG, a software industry consortium, for inclusion in its
object analysis and design facility specification. The official sanction in
the future of a competing standard by the OMG or the promulgation of a
competing standard by one or more major platform vendors could harm our
marketing and sales efforts and, in turn, our business.

 If we do not develop and enhance new and existing products to keep pace with
 technological, market, and industry changes, our revenues may decline.

   The industry for tools automating software application development and
management is characterized by rapid technological advances, changes in
customer requirements, and frequent new product introductions and
enhancements. If we fail to anticipate or respond adequately to technology
developments, industry standards, or practices and customer requirements, or
if we experience any significant delays in product development, introduction,
or integration, our products may become obsolete or unmarketable, our ability
to compete may be impaired, and our revenues may decline. We must respond
rapidly to developments related to Internet and intranet applications,
hardware platforms, operating systems, and programming languages. These
developments will require us to make substantial product-development
investments.

   In addition, rapid growth of, interest in, and use of Internet and intranet
environments are recent and emerging phenomena. Our success may depend, in
part, on the compatibility of our products with Internet and intranet
applications. We may fail to effectively adapt our products for use in
Internet or intranet environments, or to produce competitive Internet and
intranet applications.

 If we do not effectively compete with new and existing competitors, our
 revenues and operating margins will decline.

   The industry for tools that automate software development and management is
extremely competitive and rapidly changing. We expect competition to intensify
in the future. We believe our continued success will become increasingly
dependent on our ability to:

  .  support.multiple platforms, including Microsoft Windows and Windows NT,
     IBM, commercial UNIX, and Linux;

  .  use the latest technologies to support Web-based development of
     business-critical applications;

  .  develop and market a broader line of products for programming languages
     such as C++, Visual Basic, Java, Visual Java++, and Java Beans; and

  .  continually support the rapidly changing standards and technologies used
     in the development of Web-based applications as well as off-the-shelf
     products.

   We face intense competition for each of our products, generally from both
Windows and UNIX vendors. Because individual product sales often lead to a
broader customer relationship, each of our products must be

                                      14
<PAGE>

able to successfully compete with numerous competitors' offerings. Many of our
competitors or potential competitors are much larger than we are and may have
significantly more resources and more experience. Moreover, many of our
strategic partners compete with each other and this may adversely impact our
relationship with an individual partner or a number of partners.

 If we are unable to manage our growth or our announced workforce reduction,
 our business will suffer.

   We have experienced rapid growth in recent years. This growth has placed a
significant strain on our financial, operational, management, marketing, and
sales systems and resources. If we are unable to effectively manage growth,
our business, competitive position, results of operations, and financial
condition could suffer.

   To achieve and manage continued growth, we must continue to expand and
upgrade our information-technology infrastructure and its scalability,
including improvements to various operations, financial, and management
information systems, and expand, train, and manage our work force. We may not
be successful in implementing these initiatives effectively and in a timely
fashion.

   In April 2001, we announced and subsequently completed a reduction to our
workforce, which affected all parts of our organization. If we are unable to
effectively manage this workforce reduction, our business operations could be
subject to disruption and our business and results of operations could suffer.

 Our international operations expose us to greater management, collections,
 currency, intellectual property, regulatory, and other risks.

   International sales accounted for approximately 41%, 41%, and 40% of our
revenues in fiscal 2001, 2000, and 1999, respectively. We expect that
international sales will continue to account for a significant portion of our
revenues in future periods. Our business would be harmed if our international
operations experienced a material downturn. In addition, international sales
are subject to inherent risks, including:

  .  unexpected changes in regulatory requirements and tariffs;

  .  unexpected changes in global economic conditions;

  .  difficulties in staffing and managing foreign operations;

  .  longer payment cycles;

  .  potentially adverse tax consequences;

  .  price controls or other restrictions on foreign currency;

  .  difficulties in obtaining export and import licenses;

  .  costs of localizing products for some markets;

  .  lack of acceptance of localized products in international markets; and

  .  the effects of high local wage scales and other expenses.

   Our international sales are generally transacted through our international
sales subsidiaries. The revenues generated by these subsidiaries, as well as
their local expenses, are generally denominated in local currencies.
Accordingly, the functional currency of each international sales subsidiary is
the local currency. We have engaged in limited hedging activities to protect
us against losses arising from remeasuring assets and liabilities denominated
in currencies other than the functional currency of the related subsidiary. We
are also exposed to foreign exchange rate fluctuations as the financial
results of international subsidiaries are translated into U.S. dollars in
consolidation. As exchange rates vary, these results, when translated, may
vary from expectations and adversely impact our overall expected
profitability. We currently do not hedge against this exposure. Fluctuations
in foreign currencies could harm our financial condition and operating
results.

                                      15
<PAGE>

 We are subject to risks associated with the European monetary conversion.

   In January 1999, the new "Euro" currency was introduced in certain European
countries that are part of the European Monetary Union, or EMU. During 2002,
all EMU countries are expected to begin operating with the Euro as their
single currency. A significant amount of uncertainty exists as to the effect
the Euro will have on the marketplace generally and, additionally, all of the
final rules and regulations have not yet been defined and finalized by the
European Commission with regard to the Euro currency. We are currently
assessing the effect the introduction of the Euro will have on internal
accounting systems and the sales of products. We are not aware of any material
operational issues or costs associated with preparing internal systems for the
Euro. However, we do utilize third-party vendor equipment and software
products that may or may not be EMU-compliant. The failure of any critical
components to operate properly after introduction of the Euro may harm our
business or results of operations or require additional costs to remedy these
problems.

 If we lose key personnel or cannot hire enough qualified personnel, our
 ability to manage our business, develop new products, and increase our
 revenues will suffer.

   We believe that the hiring and retaining of qualified individuals at all
levels in our organization will be essential to our ability to sustain and
manage growth successfully. Competition for highly qualified technical
personnel is intense, and we may not be successful in attracting and retaining
the necessary personnel, which may limit the rate at which we can develop
products and generate sales. We will be particularly dependent on the efforts
and abilities of our senior management personnel. The departure of any of our
senior management members or other key personnel could harm our business. In
addition, merger activities can be accompanied or followed by the departure of
key personnel, which could compound the difficulty of integrating the
operations of the parties to the business combination and adversely affect our
business.

 If we fail to maintain and expand our distribution channels, our business
 will suffer.

   We currently distribute our products primarily through field sales
personnel teamed with highly trained technical support personnel, as well as
through our telesales organizations, our Web site, and indirectly through
channels such as value-added resellers and distributors. Our ability to
achieve revenue growth in the future will depend in large part on our success
in expanding our direct sales force and in maintaining a high level of
technical consulting, training, and customer support.

 We depend on strategic relationships and business alliances for continued
 growth of our business.

   Our development, marketing, and distribution strategies rely increasingly
on our ability to form 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 on the continued
cooperation of each party with us. Merger activity, such as the acquisitions
of Catapulse Inc. and Attol Testware, may disrupt these relationships or
activities, and some companies may reassess the value of their relationship
with us as a result of such merger activity. Divergence in strategy or change
in focus or competitive product offerings by any of these companies may
interfere with our ability to develop, market, sell, or support our products,
which in turn could harm our business. In addition, one or more of these
companies may use the information they gain from their relationship with us to
develop or market competing products.

 Our products could contain software defects that could reduce our revenues
 and make it more difficult for us to achieve market acceptance of our
 products.

   Complex software products such as ours often contain undetected errors, or
"bugs," or performance problems. These 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, our

                                      16
<PAGE>

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 our
products could result in loss of revenues or delays in market acceptance,
which could harm our business. Further, because we rely on our own products in
connection with the development of our software, these errors may make it more
difficult to sell our products in the future.

 If we fail to adequately protect our intellectual property rights,
 competitors may use our technology and trademarks, which could weaken our
 competitive position, reduce our revenues, and increase our costs.

   We rely on a combination of copyright, trademark, patent, and trade-secret
laws, employee and third-party nondisclosure agreements, and other
arrangements to protect our proprietary rights. Despite these precautions, it
may be possible for unauthorized third parties to copy our products or obtain
and use information that we regard as proprietary to create products that
compete against ours. In addition, some license provisions protecting against
unauthorized use, copying, transfer, and disclosure of our licensed programs
may be unenforceable under the laws of certain jurisdictions and foreign
countries.

   In addition, the laws of some countries do not protect proprietary rights
to the same extent as do the laws of the United States. To the extent that we
increase our international activities, our exposure to unauthorized copying
and use of our products and proprietary information will increase.

   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 that would relate to our products.

 We rely on software licensed from third parties that is used in our products.

   We also rely on some software that we license from third parties, including
software that is integrated with internally developed software and used in our
products to perform key functions. These third-party software licenses may not
be available to us on commercially reasonable terms or at all. Further, the
software may not be appropriately supported, maintained, or enhanced by the
licensors. The loss of licenses to or the inability to support, maintain, and
enhance any of this software could result in increased costs or in delays or
reductions in our product shipments until equivalent software could be
developed, identified, licensed, and integrated.

 Third parties could assert that our software products and services infringe
 on their intellectual property rights, which could expose us to increased
 costs and litigation.

   We expect that we 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. Third parties may assert infringement
claims against us in the future and their claims may or may not be successful.
We could incur substantial costs in defending ourselves and our customers
against their claims. Parties making their claims may be able to obtain
injunctive or other equitable relief that could effectively block our ability
to sell our products in the United States and abroad and could result in an
award of substantial damages against us. In the event of a claim of
infringement, we may be required to obtain one or more licenses from third
parties. We cannot be sure that we can obtain necessary licenses from third
parties at a reasonable cost, or at all. Defense of any lawsuit or failure to
obtain any required license could delay shipment of our products and increase
our costs.

 Promotional product versions may adversely impact our actual product sales.

   Our marketing strategy relies in part on making elements of our technology
available for no charge or at a very low price, either directly or by
incorporating these elements into products offered by third parties, such as
Microsoft, with whom we have strategic alliances. This strategy is designed to
expose our products to a broader customer base than to our historical customer
base and to encourage potential customers to purchase an upgrade

                                      17
<PAGE>

or other higher-priced products from us. We may not be able to introduce
enhancements to our full-price products or versions of our products with
intermediate functionality at a rate necessary to adequately differentiate
them from the promotional versions, particularly in cases where our partners
are distributing versions of our products with other desirable features, which
could reduce sales of our products.

 If we cannot successfully integrate our past and future acquisitions and
 achieve intended financial or strategic benefits, our revenues may decline
 and our expenses may increase.

   We have acquired a number of businesses, technologies, and products, most
recently in March 2001. If we fail to achieve the intended financial or
strategic benefits of past and future acquisitions, including the acquisitions
of Attol Testware and Catapulse Inc., our operating results will suffer.
Acquisitions entail numerous risks, including:

  .  difficulty with the assimilation of acquired operations and products;

  .  failure to achieve targeted synergies;

  .  inability to retain key employees of the acquired companies;

  .  loss of key business relationships of the acquired company; and

  .  diversion of the attention of our management team.

   In addition, if we undertake future acquisitions, we may issue dilutive
securities, assume or incur additional debt obligations, incur large, one-time
expenses, or acquire intangible assets that would result in significant future
amortization expense. Any of these events could harm our business.

 Business interruptions could adversely affect our business.

   Our operations are vulnerable to interruption by fire, earthquake, power
loss, telecommunications failure and other events beyond our control. Our
facilities in the State of California are currently subject to electrical
blackouts as a consequence of a shortage of available electrical power. In the
event these blackouts continue or increase in severity, they could disrupt the
operations of our affected facilities.

ITEM 2--PROPERTIES

   Our headquarters are located in a leased facility, in Cupertino,
California, consisting of approximately 218,000 square feet of office space
occupied under leases expiring from 2006 to 2010. We also lease approximately
266,000 square feet of office space in Lexington, Massachusetts, under
multiple leases expiring in 2004 and 2005. We have large leased facilities for
field sales and software development offices in Redmond, Washington; Boulder,
Colorado; and Ottawa, Canada. We have additional leased field sales and
software development offices in the Americas, Europe, and Asia/Pacific
regions. We believe that our existing facilities are adequate to meet current
requirements, and that additional space will be available as needed to
accommodate any future expansion of the corporate locations and for any sales
and software development offices.

ITEM 3--LEGAL PROCEEDINGS

   We are not a party to any material legal proceedings. From time to time, we
are subject to legal claims. Historically, the cost of resolution of the
claims has not been significant. However, any adverse outcome to future
lawsuits against us may result in a material adverse effect on our financial
condition.

                                      18
<PAGE>

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

   On February 5, 2001, we held a special meeting of stockholders. The
following item was submitted to a vote of the stockholders:

     To approve the issuance of Rational Software Corporation Common Stock
  pursuant to a merger agreement in which Catapulse Inc. will merge with and
  into Rational and as a result of which, Catapulse stockholders will become
  stockholders of Rational.

<TABLE>
<CAPTION>
                                                                        Votes
                                                                     -----------
       <S>                                                           <C>
       For.......................................................... 134,031,737
       Against......................................................     300,622
       Abstain......................................................     385,369
       Broker Non-Vote..............................................           0
</TABLE>

     This proposal was approved.

                                      19
<PAGE>

                                    PART II

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

   Our Common Stock is traded on the Nasdaq National Market under the symbol
RATL. As of May 31, 2001, there were approximately 1,383 stockholders of
record of our Common Stock. We have not, since our formation, declared or paid
any cash dividends on our Common Stock. We intend to employ all available
funds for the development and operation of our business and, accordingly, do
not intend to declare or pay any cash dividends in the foreseeable future.

   The following table sets forth the range of high and low bids for our
Common Stock as quoted on the Nasdaq National Market for Rational Common Stock
for the periods indicated, as adjusted for a two-for-one stock split in
September 2000:

<TABLE>
<CAPTION>
                                                                   High   Low
                                                                  ------ ------
   <S>                                                            <C>    <C>
   Fiscal Year Ended March 31, 2001:
   Fourth Quarter................................................ $55.25 $17.25
   Third Quarter.................................................  70.31  25.25
   Second Quarter................................................  70.63  42.63
   First Quarter.................................................  49.31  27.00

   Fiscal Year Ended March 31, 2000:
   Fourth Quarter................................................ $52.50 $21.16
   Third Quarter.................................................  26.84  13.94
   Second Quarter................................................  20.00  13.19
   First Quarter.................................................  18.75  10.94
</TABLE>

   The foregoing reflects interdealer prices without retail markup, markdown,
or commissions and may not necessarily reflect actual transactions.

                                      20
<PAGE>

ITEM 6--SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                    Fiscal Year Ended March 31,
                          ----------------------------------------------------
                             2001        2000       1999      1998      1997
                          ----------  ----------  --------  --------  --------
                               (in thousands, except per share data)
<S>                       <C>         <C>         <C>       <C>       <C>
Consolidated Statements
 of Operations Data:
Net product revenues....  $  477,726  $  354,497  $259,335  $184,953  $185,133
Consulting and support
 revenues...............     337,209     217,693   152,481   125,717    92,735
                          ----------  ----------  --------  --------  --------
    Total revenues......     814,935     572,190   411,816   310,670   277,868
                          ----------  ----------  --------  --------  --------
Cost of product
 revenues...............      32,817      27,297    22,020    19,709    11,777
Cost of consulting and
 support revenues.......      89,227      59,607    40,848    43,356    38,305
                          ----------  ----------  --------  --------  --------
    Total cost of
     revenues...........     122,044      86,904    62,868    63,065    50,082
                          ----------  ----------  --------  --------  --------
Gross margin............     692,891     485,286   348,948   247,605   227,786
                          ----------  ----------  --------  --------  --------
Operating expenses:
  Research and
   development..........     183,509     102,565    71,869    61,560    47,239
  Sales and marketing...     330,128     220,529   172,448   138,709   108,403
  General and
   administrative.......      48,567      47,124    33,910    29,092    27,267
  Amortization of
   goodwill and
   purchased
   intangibles..........      22,370       3,120        --        --        --
  Amortization of stock
   based compensation...      14,020         281        --        --        --
  Charges for acquired
   in-process research
   and development......      15,822       3,529        --        --    56,798
  Merger and integration
   costs................          --          --    (1,200)   63,759    42,456
                          ----------  ----------  --------  --------  --------
    Total operating
     expenses...........     614,416     377,148   277,027   293,120   282,163
                          ----------  ----------  --------  --------  --------
Operating income
 (loss).................      78,475     108,138    71,921   (45,515)  (54,377)
Other income, net.......      34,709      12,857    12,721    16,689    11,586
                          ----------  ----------  --------  --------  --------
Income (loss) from
 continuing operations
 before income taxes....     113,184     120,995    84,642   (28,826)  (42,791)
Provision for income
 taxes..................      56,363      36,765    25,393     9,447     6,820
Minority interest.......     (15,323)     (1,084)       --        --        --
                          ----------  ----------  --------  --------  --------
    Net income (loss)...  $   72,144  $   85,314  $ 59,249  $(38,273) $(49,611)
                          ==========  ==========  ========  ========  ========
Net income (loss) per
 common share:
  Basic.................  $     0.38  $     0.49  $   0.35  $  (0.22) $  (0.31)
  Diluted...............  $     0.35  $     0.45  $   0.32  $  (0.22) $  (0.31)
Shares used in computing
 per share amounts:
  Basic.................     188,566     175,458   171,394   175,150   159,262
  Diluted...............     206,211     191,274   183,698   175,150   159,262
Consolidated Balance
 Sheet Data:
Cash, cash equivalents,
 and short-term
 investments............  $1,040,821  $  906,311  $259,830  $289,470  $327,395
Working capital.........     925,974     831,858   228,366   228,397   282,974
Total assets............   1,709,323   1,225,776   453,956   445,205   456,740
Long-term obligations...     583,494     501,668     3,696     6,492     3,192
Stockholders' equity....     766,254     456,307   294,372   287,176   330,109
</TABLE>

                                       21
<PAGE>

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

Overview

 General

   Our revenues are derived from product license fees and charges for
services, including technical consulting, training, and customer support. In
accordance with generally accepted accounting principles, our software license
revenues are generally recognized when a customer purchase order has been
received and accepted, the software product has been shipped, there are no
uncertainties surrounding product acceptance, the fees are fixed or
determinable, and collection is considered probable. For customer license
agreements that meet these recognition criteria, the portion of the fees
related to software licenses will generally be recognized in the current
period, while the portion of the fees related to services is recognized as the
services are performed. Revenues from consulting and training are recognized
when earned. Our license agreements 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 41%, 41%, and 40% of our revenues in
fiscal 2001, 2000, and 1999, respectively. We expect that international sales
will continue to account for a significant portion of our revenues in future
periods.

   In the fiscal year ended March 31, 2001, our revenues from product sales
grew 35%, while revenues from consulting and support grew 55%, resulting in a
net overall increase in revenues of 42%. There can be no assurance that this
revenue mix or growth in revenues trend will continue in future periods.

   Although we have experienced increasing revenues in each of the past five
fiscal years, our 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 we
will continue to experience sequentially increasing revenues or that such
seasonal fluctuations will not become more pronounced in the future.

 Acquisitions

   We completed a business combination with ObjecTime Limited in January 2000,
which was accounted for under the purchase method of accounting. Additionally,
we completed business combinations with Catapulse Inc. and Attol Testware in
2001, which were accounted for under the purchase method of accounting. See
Note 3 of Notes to Consolidated Financial Statements for details of these
combinations.

                                      22
<PAGE>

Results of Operations

   The following table sets forth the percentage of total revenues represented
by certain line items from our consolidated statements of operations for the
periods indicated:

<TABLE>
<CAPTION>
                                                               Fiscal Year
                                                                  Ended
                                                                March 31,
                                                              ----------------
                                                              2001  2000  1999
                                                              ----  ----  ----
   <S>                                                        <C>   <C>   <C>
   Net product revenues......................................  59%   62%   63%
   Consulting and support revenues...........................  41    38    37
                                                              ---   ---   ---
       Total revenues........................................ 100   100   100
                                                              ---   ---   ---
   Cost of product revenues..................................   4     5     5
   Cost of consulting and support revenues...................  11    10    10
                                                              ---   ---   ---
       Total cost of revenues................................  15    15    15
                                                              ---   ---   ---
   Gross margin..............................................  85    85    85
                                                              ---   ---   ---
   Operating expenses:
     Research and development................................  23    18    18
     Sales and marketing.....................................  41    38    42
     General and administrative..............................   5     8     8
     Amortization of goodwill and purchased intangibles......   3     1    --
     Amortization of deferred stock based compensation.......   1    --    --
     Charges for acquired in-process research and
      development............................................   2     1    --
                                                              ---   ---   ---
       Total operating expenses..............................  75    66    68
                                                              ---   ---   ---
   Income from continuing operations.........................  10    19    17
   Other income, net.........................................   4     2     3
                                                              ---   ---   ---
   Income before provision for income taxes..................  14    21    20
   Provision for income taxes................................   7     6     6
   Minority interest.........................................  (2)   --    --
                                                              ---   ---   ---
       Net income............................................   9%   15%   14%
                                                              ===   ===   ===
</TABLE>

 Fiscal Years Ended March 31, 2001 and 2000

  Revenues

   Total revenues increased 42% in fiscal 2001 compared with fiscal 2000.

   Net product revenues. Net product revenues increased $123.2 million or 35%,
in fiscal 2001 compared with fiscal 2000. This increase was a result of
continued strong customer acceptance of our existing products, including the
Rational Suite family of products, products for requirements management,
modeling, testing, change and configuration management, increased sales
capacity, and increased sales activity with customers across the majority of
our products.

   Consulting and support revenues. Consulting and support revenues increased
$119.5 million, or 55%, in fiscal 2001 compared with fiscal 2000. This
increase reflects increased revenues related to maintenance contracts, growing
demand for our consulting expertise in advanced software development practices
and continued strong sales and renewals for customer support.

   International sales. During fiscal 2001 and 2000, international revenues
from product sales and related consulting and customer support were $335.0
million and $233.0 million, respectively, representing 41% of total revenues
in both fiscal 2001 and 2000. The 44% growth in international sales during
fiscal 2001 was due

                                      23
<PAGE>

principally to increase sales and marketing activities in international
markets from all regions. Revenues from Europe increased $53.8 million, or
32%, in fiscal 2001, while revenues from the Asia/Pacific and other
international regions increased $48.1 million, or 73%. Our international sales
are principally priced in local currencies. We enter into short-term forward
currency contracts to hedge against the impact of foreign currency exchange
rate fluctuations on balance sheet exposures denominated in currencies other
than the local, or "functional," currency of our subsidiaries or us. The total
amount of these contracts is approximately offset by the underlying assets and
liabilities denominated in nonfunctional currencies and such contracts are
carried at fair market value. The associated gains and losses were not
material to our results of operations in any period presented.

  Cost of Revenues

   Cost of product revenues. Cost of product revenues consists principally of
materials, packaging and freight, amortization of purchased technology, and
royalties. Cost of product revenues increased 20% in fiscal 2001 compared with
fiscal 2000. These costs represented 7% and 8% of net product revenues in
fiscal 2001 and 2000, respectively. In fiscal 2001, the decrease in cost of
product revenues as a percentage of product sales was primarily a result of
increased efficiencies achieved in the current year by outsourcing fulfillment
activities and a reduction of printing costs for materials currently being
delivered electronically.

   Cost of consulting and support revenues. Cost of consulting and support
revenues consists principally of personnel costs for training, consulting, and
customer support. Cost of consulting and support revenues increased 50% in
fiscal 2001 compared with fiscal 2000. These costs represented 26% and 27% of
consulting and support revenues in fiscal 2001 and 2000, respectively. In
fiscal 2001, the increase in cost was primarily a result of increased
personnel costs necessary to support the growing demand for consulting,
support and education and correlates to the increase in consulting and support
revenues. The increase is in line with our increase in consulting and support
revenues in fiscal 2001.

  Operating Expenses

   Research and development. Total expenditures for research and development
(R&D) increased 79% in fiscal 2001 compared with fiscal 2000. Research and
development costs represented 23% and 18% of total revenues in fiscal 2001 and
2000, respectively. The increase in fiscal 2001 over fiscal 2000 was due to
the cost of additional personnel and related costs incurred in maintaining
existing products and developing new product releases. Additionally, the
increase was attributable to additional costs incurred by Catapulse Inc.
(Catapulse). The costs incurred by Catapulse increased to $31.9 million in
fiscal 2001 from $3.9 million in fiscal 2000.

   We did not capitalize any software development costs for our software to be
sold or marketed in fiscal 2001 and 2000 because eligible costs were not
material. We expect the amount of software development costs capitalized in
future periods will be immaterial to our 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.

   Sales and marketing. Sales and marketing expenses increased 50% in fiscal
2001 compared with fiscal 2000. These expenses represented 41% and 38% of
total revenues in fiscal 2001 and 2000, respectively. The fiscal 2001 increase
in sales and marketing expenses reflected the additional personnel,
commissions, and related costs required in sales and marketing departments to
expand our sales channels, penetrate new markets, and increase our market
share in core markets and sales and marketing costs incurred by Catapulse.

   General and administrative. General and administrative expenses increased
3% in fiscal 2001 compared with fiscal 2000. General and administrative
expenses represented 5% and 8% of total revenues in fiscal 2001 and 2000,
respectively. The fiscal 2001 increase in general and administrative expenses
resulted from increased employee-related expenses associated with staffing
requirements needed to support our expanding business.

                                      24
<PAGE>

   Amortization of goodwill, purchased intangibles, and deferred stock based
compensation. In fiscal 2001, we acquired Attol Testware, the remaining
outstanding shares of Catapulse not already owned by Rational, and certain
other intellectual property and intangible assets, which were accounted for
under the purchase method of accounting. Accordingly, we recorded goodwill and
purchased intangibles representing the excess of the purchase price paid over
the fair value of the net assets acquired. In fiscal 2000, we acquired
ObjecTime Limited, which was also accounted for under the purchase method of
accounting. The goodwill and purchased intangibles are being amortized over
their expected useful lives, which were determined to be from one to four
years. The aggregate amortization of goodwill and purchased intangibles was
$22.4 million and $3.1 million in fiscal 2001 and 2000, respectively.

   Also as part of the acquisitions of Attol Testware and the remaining
outstanding shares of Catapulse in fiscal 2001, we recorded $295.0 million of
deferred compensation relating to the unvested stock options and restricted
stock assumed in the acquisitions. The amortization of deferred stock based
compensation was approximately $14.0 million during fiscal 2001. In fiscal
2000, in connection with the grant of certain stock options to employees of
Catapulse, the results of which were consolidated with Rational's results, we
recorded deferred compensation of $3.0 million representing the difference
between the deemed value of the Common Stock for accounting purposes and the
exercise price of these options at the date of grant. The amortization of
deferred stock based compensation in fiscal 2000 was approximately $0.3
million.

   Charges for acquired in-process research and development. In connection
with the acquisitions of Attol Testware and the remaining outstanding shares
of Catapulse, we recorded charges for acquired in-process research and
development (IPR&D) in the amount of $1.7 million and $14.2 million,
respectively, in fiscal 2001. In connection with the acquisition of ObjecTime
Limited, we recorded $3.5 million of IPR&D in fiscal 2000. See Note 3 of Notes
to Consolidated Financial Statements.

  .  Purchase of the remaining outstanding shares of Catapulse not already
     owned by Rational

   In connection with the acquisition of the remaining outstanding shares of
Catapulse not already owned by Rational in fiscal 2001, we allocated $14.2
million of the total purchase price of $445.2 million to IPR&D projects. This
allocation represented the estimated fair value based on discounted cash flows
related to research and development projects. At the date of acquisition, the
development of these projects had not reached technological feasibility.
Accordingly, these costs were expensed as of the acquisition date. Management
is primarily responsible for estimating the fair value of IPR&D, which they
also determined with the assistance of an independent appraiser.

   At the acquisition date, Catapulse was developing a hosted development
service to be delivered to users over the Internet. The hosted development
service or HDS, includes a set of hosted development tools, Web based
collaboration services, a complete infrastructure for the development and
reuse of intellectual property and a secure development platform. The
technologies under development were approximately 35% complete.

   We allocated values to IPR&D based on the stage of development of each
product and service offering, the time and resources needed to complete each
product and service offering, and the expected income and associated risks.
The value assigned to acquired IPR&D was determined by estimating the costs to
develop the purchased IPR&D into commercially viable products and service
offering, estimating the resulting net cash flows from the products and
service offering, and discounting the net cash flows to their present value.
The revenue projection used to value the IPR&D was based on estimates of
relevant market sizes and growth factors, expected trends in technology, and
the nature and expected timing of new product and service introductions by
Catapulse and its competitors. The resulting net cash flows from such product
and service offering are based on management's estimates of cost of sales,
operating expenses, and income taxes from such product and service offering.

   Aggregate revenues for the developmental Catapulse product and service
offering were estimated to grow based on forecasted sales for the three years
following introduction, assuming the successful completion and

                                      25
<PAGE>

market acceptance of the major R&D programs. The estimated revenues for the
in-process projects were expected to peak within three years of acquisition
and then decline as other new products and technologies are expected to enter
the market.

   The rate utilized to discount the net cash flows to their present value was
based on an estimated cost of capital calculation. Due to the nature of the
forecast and the risks associated with the projected growth and profitability
of the developmental projects, a discount rate of 25% was considered
appropriate for the IPR&D. This discount rate was commensurate with
Catapulse's stage of development and the uncertainties in the economic
estimates described above.

   The estimates used by us in valuing IPR&D were based upon assumptions we
believe to be reasonable but which are inherently uncertain and unpredictable.
Our assumptions may be incomplete or inaccurate, and no assurance can be given
that unanticipated events and circumstances will not occur. Accordingly,
actual results may vary from the projected results. Any such variance may
result in a material adverse effect on our financial condition and results of
operations.

  .  Purchase of Attol Testware

   In connection with the acquisition of Attol Testware in fiscal 2001, we
allocated $1.7 million of the total purchase price of $30.3 million to IPR&D
projects. This allocation represented the estimated fair value based on
discounted cash flows related to incomplete research and development projects.
At the date of acquisition, the development of these projects had not reached
technological feasibility. Accordingly, these costs were expensed as of the
acquisition date. Management is primarily responsible for estimating the fair
value of IPR&D, which they also determined with the assistance of an
independent appraiser.

   At the acquisition date, Attol Testware developed and marketed test
software for the automated testing of software developed for critical systems
in the embedded and distributed software markets. The projects under
development at the valuation date represented next-generation technologies of
Attol Testing Suite, which will include significant functionality increases
and continue assurance of compatibility with Rational products. The
technologies under development were approximately 30% complete.

   We allocated values to IPR&D based on the stage of development of each
product, the time and resources needed to complete each product, and the
expected income and associated risks. The value assigned to acquired IPR&D was
determined by estimating the costs to develop the purchased IPR&D into
commercially viable products, estimating the resulting net cash flows from the
products, and discounting the net cash flows to their present value. The
revenue projection used to value the IPR&D was based on estimates of relevant
market sizes and growth factors, expected trends in technology, and the nature
and expected timing of new product introductions by Attol Testware and its
competitors. The resulting net cash flows from such products are based on
management's estimates of cost of sales, operating expenses, and income taxes
from such products.

   Aggregate revenues for the developmental Attol Testware products were
estimated to grow based on forecasted sales for the three years following
introduction, assuming the successful completion and market acceptance of the
major R&D programs. The estimated revenues for the in-process projects were
expected to peak within three years of acquisition and then decline as other
new products and technologies are expected to enter the market.

   The rate utilized to discount the net cash flows to their present value was
based on an estimated cost of capital calculation. Due to the nature of the
forecast and the risks associated with the projected growth and profitability
of the developmental projects, a discount rate of 25% was considered
appropriate for the IPR&D. This discount rate was commensurate with Attol
Testware's stage of development and the uncertainties in the economic
estimates described above.

   The estimates used by us in valuing IPR&D were based upon assumptions we
believe to be reasonable but which are inherently uncertain and unpredictable.
Our assumptions may be incomplete or inaccurate, and no

                                      26
<PAGE>

assurance can be given that unanticipated events and circumstances will not
occur. Accordingly, actual results may vary from the projected results. Any
such variance may result in a material adverse effect on our financial
condition and results of operations.

  .  Purchase of ObjecTime Limited

   In connection with the acquisition of ObjecTime Limited in fiscal 2000, we
allocated $3.5 million of the total purchase price of $58.8 million to IPR&D
projects. This allocation represented the estimated fair value based on
discounted cash flows related to incomplete research and development projects.
At the date of acquisition, the development of these projects had not reached
technological feasibility. Accordingly, these costs were expensed as of the
acquisition date. Management is primarily responsible for estimating the fair
value of IPR&D, which they also determined with the assistance of an
independent appraiser.

   At the acquisition date, ObjecTime Limited was a developer of visual design
and code generation software tools used for development of embedded software.
The projects under development at the valuation date represented next-
generation products of ObjecTime Limited, which will include making the next
releases compatible with Rational products. The technologies under development
were on average approximately 60% complete.

   We allocated values to IPR&D based on the stage of development of each
product, the time and resources needed to complete each product, and the
expected income and associated risks. The value assigned to acquired IPR&D was
determined by estimating the costs to develop the purchased IPR&D into
commercially viable products, estimating the resulting net cash flows from the
products and discounting the net cash flows to their present value. The
revenue projection used to value the IPR&D was based on estimates of relevant
market sizes and growth factors, expected trends in technology, and the nature
and expected timing of new product introductions by ObjecTime Limited and its
competitors. The resulting net cash flows from such products are based on
management's estimates of cost of sales, operating expenses, and income taxes
from such products.

   Aggregate revenues for the developmental ObjecTime Limited products were
estimated to grow based on forecasted sales for the three years following
introduction, assuming the successful completion and market acceptance of the
major R&D programs. The estimated revenues for the in-process projects were
expected to peak within three years of acquisition and then decline as other
new products and technologies are expected to enter the market.

   The rate utilized to discount the net cash flows to their present value was
based on an estimated cost of capital calculation. Due to the nature of the
forecast and the risks associated with the projected growth and profitability
of the developmental projects, a discount rate of 25% was considered
appropriate for the IPR&D. This discount rate was commensurate with
ObjecTime's stage of development and the uncertainties in the economic
estimates described above.

   The estimates used by us in valuing IPR&D were based upon assumptions we
believe to be reasonable but which are inherently uncertain and unpredictable.
Our assumptions may be incomplete or inaccurate, and no assurance can be given
that unanticipated events and circumstances will not occur. Accordingly,
actual results may vary from the projected results. Any such variance may
result in a material adverse effect on our financial condition and results of
operations.

  Minority Interest

   On February 5, 2001, we completed the acquisition of the remaining
outstanding shares of Catapulse not already owned by Rational. Catapulse was
an entity already consolidated into Rational due to the significant influence
Rational exercised over Catapulse prior to February 5, 2001. In fiscal 2001
and 2000, Catapulse incurred $46.1 million and $4.2 million, respectively, of
operating expenses and earned $2.9 million and $1.2 million, respectively, of
interest income on cash balances. Minority interest, net of tax, for fiscal
2001 and 2000 was approximately $15.3 million and $1.1 million, respectively.

                                      27
<PAGE>

  Interest Expense

   Interest expense increased $21.1 million in fiscal 2001 compared with
fiscal 2000. The increase in interest expense in fiscal 2001 was primarily a
result of the Convertible Subordinated Notes, which we sold and on which we
began incurring interest expense for the last quarter of fiscal 2000. The
total interest expense related to Convertible Subordinated Notes was
approximately $25.0 million and $4.0 million, respectively, in fiscal 2001 and
2000.

  Interest Income

   Interest income has fluctuated as a result of operating results and the
amount of cash available for investment in interest-bearing accounts. Interest
income increased $43.0 million to $59.9 million in fiscal 2001. The increase
in interest income in fiscal 2001 was due primarily to an increase in cash and
cash equivalents as a result of annual operating income, the cash received in
connection with the $500.0 million Convertible Subordinated Notes offering in
the last quarter of fiscal 2000, and interest earned by Catapulse, offset by a
reduction of cash used for repurchase of Company stock.

  Income Taxes

   The income tax provisions for fiscal 2001 and 2000 differ from tax computed
at the federal statutory income tax rate due to the impact of nondeductible
charges for acquired in-process research and development, goodwill, merger-
related costs, and foreign losses resulting in no U.S. tax benefit, as well as
foreign and state income taxes, offset by earnings permanently reinvested in
offshore operations, the realized benefit of net operating loss carryforwards,
and research credit carryforwards.

   Net cumulative undistributed earnings of the foreign subsidiaries
considered permanently reinvested amounted to approximately $70.0 million at
March 31, 2001. Accordingly, no provision for U.S. federal and state income
taxes has been provided thereon. Upon distribution of those earnings in the
form of dividends or otherwise, we would be subject to both U.S. income taxes
(subject to an adjustment for foreign tax credits) and withholding taxes
payable to the various foreign countries.

   As of March 31, 2001, we had net operating loss carryforwards for federal
income tax purposes of approximately $74.0 million that expire in years 2002
through 2021. We also had tax credit carryforwards for federal and state
purposes of approximately $15.0 million and $5.0 million, respectively, that
expire in years 2002 through 2021, if not utilized. As a result of various
public offerings and business combinations, some of our acquired entities
experienced an ownership change as defined in Section 382 of the Internal
Revenue Code. Due to the passing of time, our net operating loss carryforwards
and tax credit carryforwards are no longer subject to limitation.

   Under Statement of Financial Accounting Standards (SFAS) No. 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. SFAS 109 provides for the recognition of
deferred tax assets if realization of such assets is more likely than not.
Based on the weight of available evidence, we have provided a valuation
allowance against the future amortization of certain intangible assets. We
will continue to evaluate the realizability of the deferred tax assets on a
quarterly basis.

 Fiscal Years Ended March 31, 2000 and 1999

  Revenues

   Total revenues increased 39% in fiscal 2000 compared with fiscal 1999.

   Net product revenues. Net product revenues increased $95.2 million, or 37%,
in fiscal 2000 compared with fiscal 1999. This increase was a result of strong
customer acceptance of the Rational Suite family of products,

                                      28
<PAGE>

continued strong customer acceptance of our existing products, including
products for requirements management, modeling, testing, change, and
configuration management, increased sales capacity, and increased sales
activity with Internet-related customers across the majority of our products.

   Consulting and support revenues. Consulting and support revenues increased
$65.2 million, or 43%, in fiscal 2000 compared with fiscal 1999. This increase
reflected increased revenues related to maintenance contracts, higher demand
for our consulting expertise in advanced software development practices, and,
to a lesser extent, increased training and customer-support revenues.

   International sales. During fiscal 2000 and 1999, international revenues
from product sales and related consulting and customer support were $233.0
million and $165.2 million, representing 41% and 40% of total revenues,
respectively. The 41% growth in international sales during 2000 was due
principally to increased sales and marketing activities in international
markets. Our international sales were principally priced in local currencies.
We entered into short-term forward currency contracts to hedge against the
impact of foreign currency exchange rate fluctuations on balance sheet
exposures denominated in currencies other than the local, or "functional,"
currency of our subsidiaries or us. The total amount of these contracts was
approximately offset by the underlying assets and liabilities denominated in
nonfunctional currencies, and such contracts were carried at fair market
value. The associated gains and losses were not material to our results of
operations in any period presented.

  Cost of Revenues

   Cost of product revenues. Cost of product revenues consists principally of
materials, packaging and freight, amortization of purchased technology, and
royalties. Cost of product revenues increased 24% in fiscal 2000 compared with
fiscal 1999. These costs represented 8% of net product revenues in both fiscal
2000 and 1999. In fiscal 2000, the cost of product revenues remained
relatively fixed as a percentage of product sales as a result of improved
economies of scale associated with materials and packaging costs offset by an
increase in royalty expense.

   Cost of consulting and support revenues. Cost of consulting and support
revenues consists principally of personnel costs for training, consulting, and
customer support. Cost of consulting and support revenues increased 46% in
fiscal 2000 compared with fiscal 1999. These costs represented 27% of
consulting and support revenues in both fiscal 2000 and 1999. In fiscal 2000,
the increase in cost was primarily due to increased headcount commensurate to
the demand of growing support activities.

  Operating Expenses

   Research and development. Total expenditures for research and development
increased 43% in fiscal 2000 compared with fiscal 1999. Research and
development costs represented 18% of total revenues in both fiscal 2000 and
1999. The increase in fiscal 2000 as compared with fiscal 1999 was due
primarily to the cost of additional personnel and related costs incurred in
maintaining existing products and developing new product releases.
Additionally, the fiscal 2000 costs included $3.9 million of costs incurred by
Catapulse, the Internet venture in which Rational invested $50.0 million in
December 1999.

   We did not capitalize any software development costs in 2000 and 1999
because eligible costs were not material. We expect that the amount of
software development costs capitalized in future periods will be immaterial to
our 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 have been very
short.

   Sales and marketing. Sales and marketing expenses increased 28% in fiscal
2000 compared with fiscal 1999. These expenses represented 38% and 42% of
total revenues in fiscal 2000 and 1999, respectively. The fiscal 2000 increase
in sales and marketing expenses reflected the additional personnel,
commissions, and related

                                      29
<PAGE>

costs required in sales and marketing departments to expand our sales
channels, penetrate new markets, and increase our market share in core
markets. The fiscal 2000 decrease in sales and marketing expenses as a
percentage of total revenues reflected improved economies of scale.

   General and administrative. General and administrative expenses increased
39% in fiscal 2000 compared with fiscal 1999. General and administrative
expenses represented 8% of total revenues in both fiscal 2000 and 1999. The
fiscal 2000 increase in general and administrative expenses resulted from
increased employee-related expenses associated with staffing requirements
needed to support our expanding business.

   Amortization of goodwill, purchased intangibles, and deferred stock
compensation. In fiscal 2000, we acquired ObjecTime Limited, which was
accounted for under the purchase method of accounting. The goodwill and other
intangibles are being amortized of their respective useful lives, which were
determined to be from one to four years. The aggregate amortization of
goodwill and purchased intangibles was $3.1 million in fiscal 2000.

   In connection with the grant of certain stock options to employees of
Catapulse, a consolidated subsidiary of Rational during fiscal 2000, we
recorded deferred compensation of $3.0 million in fiscal 2000, representing
the difference between the deemed value of the Common Stock for accounting
purposes and the exercise price of these options at the date of grant. The
amortization of deferred stock based compensation associated with Catapulse
was approximately $0.3 million in fiscal 2000.

   Charges for acquired IPR&D. In connection with the acquisition of ObjecTime
Limited in fiscal 2000, we allocated $3.5 million of the purchase price to
IPR&D projects. This allocation represented the estimated fair value based on
discounted cash flows related to incomplete research and development projects.
At the date of acquisition, the development of these projects had not reached
technological feasibility. Accordingly, these costs were expensed as of the
acquisition date. Management is primarily responsible for estimating the fair
value of acquired IPR&D, which they also determined with the assistance of an
independent appraiser. See Note 3 of Notes to Consolidated Financial
Statements.

   At the acquisition date, ObjecTime Limited was a developer of visual design
and code generation software tools used for development of embedded software.
The projects under development at the valuation date represented next-
generation products of ObjecTime Limited, which will include making the next
releases compatible with Rational products. The technologies under development
were on average approximately 60% complete.

   We allocated values to IPR&D based on the stage of development of each
product, the time and resources needed to complete each product, and the
expected income and associated risks. The value assigned to acquired IPR&D was
determined by estimating the costs to develop the purchased IPR&D into
commercially viable products, estimating the resulting net cash flows from the
products, and discounting the net cash flows to their present value. The
revenue projection used to value the IPR&D was based on estimates of relevant
market sizes and growth factors, expected trends in technology, and the nature
and expected timing of new product introductions by ObjecTime Limited and its
competitors. The resulting net cash flows from such products are based on
management's estimates of cost of sales, operating expenses, and income taxes
from such products.

   Aggregate revenues for the developmental ObjecTime Limited products were
estimated to grow based on forecasted sales for the three years following
introduction, assuming the successful completion and market acceptance of the
major R&D programs. The estimated revenues for the in-process projects were
expected to peak within three years of acquisition and then decline as other
new products and technologies are expected to enter the market.

   The rate utilized to discount the net cash flows to their present value was
based on an estimated cost of capital calculation. Due to the nature of the
forecast and the risks associated with the projected growth and profitability
of the developmental projects, a discount rate of 25% was considered
appropriate for the IPR&D. This discount rate was commensurate with
ObjecTime's stage of development and the uncertainties in the economic
estimates described above.

                                      30
<PAGE>

   The estimates used by us in valuing IPR&D were based upon assumptions we
believe to be reasonable but which are inherently uncertain and unpredictable.
Our assumptions may be incomplete or inaccurate, and no assurance can be given
that unanticipated events and circumstances will not occur. Accordingly,
actual results may vary from the projected results. Any such variance may
result in a material adverse effect on our financial condition and results of
operations.

   Merger and integration costs. In fiscal 1999, we substantially completed
certain elements of the organizational integration following the July 1997
Pure Atria merger. This consisted primarily of exiting certain non-strategic
consulting activities, realignment of marketing activities, and consolidation
of certain sales offices. In the December 1998 quarter, charges related to
this activity, totaling approximately $3.3 million, were primarily for
severance costs associated with employee terminations, and charges associated
with facilities closures. These charges were offset by a reduction of
previously accrued facilities expenses related to the Pure Atria merger
totaling $4.5 million. The facilities expense reduction was due to greater-
than-expected recoveries from subleasing. The net impact in fiscal 1999 was a
merger and integration cost reduction of $1.2 million. The net cost reduction
of $1.2 million is the result of ongoing assessment and estimation of costs
associated with the prior combinations of Rational and other companies. Such
assessment will continue until all related costs are incurred or determinable.

  Minority Interest

   In fiscal 2000, our subsidiary, Catapulse, incurred $4.2 million of
operating expenses and earned $1.2 million of interest income on cash
balances. Minority interest, net of tax, for fiscal 2000 was $1.1 million.

  Interest Expense

   Interest expense increased $4.1 million in fiscal 2000 compared with fiscal
1999. The increase in interest expense in fiscal 2000 was a result of the
Convertible Subordinated Notes, which we sold and on which we began incurring
interest expense for the last quarter of fiscal 2000. Interest expense
incurred in fiscal 1999 related to interest on capital leases, which have
since expired.

  Interest Income

   Interest income fluctuated as a result of operating results and the amount
of cash available for investment in interest-bearing accounts. Interest income
increased $4.2 million to $17.0 million in fiscal 2000. The increase in
interest income in fiscal 2000 was due primarily to an increase in cash and
cash equivalents as a result of annual operating income, the fourth quarter
sale of Convertible Subordinated Notes and interest earned by Catapulse,
offset by a reduction of cash used for repurchase of Company stock in the
first half of the fiscal year, and an increase in tax exempt investments.

  Income Taxes

   The income tax provisions for fiscal 2000 and 1999 differ from tax computed
at the federal statutory income tax rate due to the impact of nondeductible
charges for acquired in-process research and development, goodwill, merger-
related costs, and foreign losses resulting in no U.S. tax benefit, as well as
foreign and state income taxes, offset by earnings permanently reinvested in
offshore operations, the realized benefit of net operating loss carryforwards,
and research credit carryforwards.

   Net undistributed earnings of the foreign subsidiaries considered
permanently reinvested amounted to approximately $24.0 million at March 31,
2000. Accordingly, no provision for U.S. federal and state income taxes has
been provided thereon. Upon distribution of those earnings in the form of
dividends or otherwise, we would be subject to both U.S. income taxes (subject
to an adjustment for foreign tax credits) and withholding taxes payable to the
various foreign countries.

                                      31
<PAGE>

   As of March 31, 2000, we had net operating loss carryforwards for federal
income tax purposes of approximately $83.0 million that expire in years 2001
through 2020. We also had tax credit carryforwards for federal and state
purposes of approximately $7.5 million and $4.0 million, respectively, that
expire in years 2001 through 2020, if not utilized. As a result of various
public offerings and business combinations, some of our acquired entities
experienced an ownership change as defined in Section 382 of the Internal
Revenue Code. Due to the passing of time, our net operating loss carryforwards
and tax credit carryforwards are no longer subject to limitation.

   Under SFAS No. 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. SFAS 109 provides
for the recognition of deferred tax assets if realization of such assets is
more likely than not. Based on the weight of available evidence, we have
provided a valuation allowance against certain foreign tax credit
carryforwards and the future amortization of certain intangible assets. We
will continue to evaluate the realizability of the deferred tax assets on a
quarterly basis.

Liquidity and Capital Resources at March 31, 2001

   As of March 31, 2001, we had cash, cash equivalents, and short-term
investments of $1.0 billion and working capital of $926.0 million. Net cash
provided by operating activities for the period ended March 31, 2001, was
composed primarily of net income plus noncash charges for depreciation and
amortization, charges for acquired IPR&D, compensation expenses related to
stock options and tax benefits from employee stock plans, and increases in
accounts payable, accrued employee benefits and accrued expenses, income taxes
payable and deferred revenues. These were offset primarily by the change in
minority interest in the loss of Catapulse Inc., increases in accounts
receivable, prepaid expenses and other assets, and decreases in accrued merger
and integration expenses and net deferred tax liability. Total cash, cash
equivalents, and short-term investments for the period ended March 31, 2000,
was $906.3 million and working capital was $831.9 million. Net cash provided
by operating activities for the period ended March 31, 2000, was composed
primarily of net income plus noncash charges for depreciation and
amortization, charges for acquired IPR&D, noncash merger and integration
costs, tax benefits from employee stock plans, increases in accrued employee
benefits and accrued expenses, income taxes payable, and deferred revenues and
a decrease in deferred tax assets. These were offset primarily by increases in
accounts receivable, and prepaid expenses and a decrease in accounts payable.

   Net cash used in investing activities resulted primarily from net purchases
and maturities and sales of short-term investments of $177.9 million in fiscal
2001, $293.2 million in fiscal 2000, and $36.6 million in fiscal 1999, and
expenditures for fixed assets and net changes in other assets of $76.2 million
in fiscal 2001, $44.2 million in fiscal 2000, and $23.2 million in fiscal
1999. Net cash used for business and product acquisitions totaled
$11.5 million in fiscal 2001 and $13.2 million in fiscal 2000. See Notes 3 and
4 of Notes to Consolidated Financial Statements.

   Net cash provided by financing activities in fiscal 2001 resulted primarily
from net proceeds from issuance of Common Stock under the employee stock plans
of $44.5 million, reissuance of treasury stock under employee stock plans of
$48.3 million, and proceeds received from minority investors in Catapulse of
$1.6 million. This was offset by $54.2 million used to repurchase Common
Stock. Net cash provided by financing activities in fiscal 2000 resulted
primarily from net proceeds from the sale of Convertible Subordinated Notes of
$484.6 million, issuance of Common Stock under the employee stock plans of
$74.6 million, and proceeds received from minority investors in Catapulse of
$25.6 million. This was offset by $61.4 million used to repurchase Common
Stock. In fiscal 1999, net cash used in financing activities resulted
primarily from $118.1 million used to repurchase Common Stock and $2.0 million
used to decrease long-term debt, offset by $36.0 million received from
issuance of Common Stock under the employee stock plans.

   In April 1998, the Board of Directors authorized the repurchase of up to
12.0 million shares of our Common Stock in the open market to be used for
general corporate purposes. We completed that repurchase program

                                      32
<PAGE>

during the September 1998 quarter. In October 1998, the Board of Directors
authorized the repurchase of an additional 12.0 million shares of our Common
Stock in the open market to be used for general corporate purposes. Through
March 31, 2001, we had repurchased a total of 20.2 million shares of our
Common Stock, including repurchases authorized in April 1998 and October 1998,
for a total cash outlay of approximately $233.7 million. In April 2001, the
Broad of Directors authorized the purchase of an additional 20.0 million
shares of our Common Stock from time to time in the open market. Repurchases
help offset dilution from stock issued under our stock option and stock
purchase plans.

   In fiscal 2000, we completed an offering of 5% Convertible Subordinated
Notes (the Notes), which mature on February 1, 2007. The interest on the Notes
is payable on February 1 and August 1 of each year, commencing August 1, 2000.
The Notes are convertible into shares of our Common Stock at any time prior to
the close of business on the maturity date, unless previously redeemed, at a
conversion price of $35.72 per share, subject to anti-dilution adjustments.

   We believe that expected cash flow from operations combined with existing
cash, cash equivalents, and short-term investments will be sufficient to meet
our cash requirements for the next 12 months and the foreseeable future.

ITEM 7(A)--QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

   We are exposed to market risk, including changes in interest rates and
currency exchange rates. To manage the volatility relating to these exposures,
we employ established policies and procedures to manage our exposure to
fluctuations in interest rates and changes in known or forecasted currency
exchange rates.

Foreign Currency Risk

   A portion of our business is conducted in currencies other than the U.S.
dollar. Changes in the value of major foreign currencies relative to the local
or "functional" currency of our subsidiaries or us may adversely affect
operating results. We enter into short-term forward foreign exchange contracts
designed to mitigate the impact of foreign currency exchange rate fluctuations
on balance sheet exposures denominated in currencies other than the
"functional" currency. The total amount of these contracts is approximately
offset by the underlying assets and liabilities denominated in nonfunctional
currencies. Forward contracts are accounted for on a mark-to-market basis.
Gains and losses on forward contracts are recognized in our Consolidated
Statements of Operations when the related transactions being hedged are
recognized or the contracts mature. Such contracts meet the criteria
established in SFAS 52, "Foreign Currency Translation for Hedge Accounting
Treatment." We are required to adopt SFAS 133, "Accounting for Derivative
Instruments and Hedging Activities" in fiscal 2002. Based on our current
hedging activities and the effectiveness of our hedging programs experienced
in fiscal 2001, the adoption of SFAS 133 is not expected to have a material
impact on our financial position or results of operations. As we find it
impractical to hedge all foreign currency exposures, we will continue to
experience foreign currency gains and losses. We do not use derivative
financial instruments for speculative trading purposes, nor do we hold or
issue leveraged derivative financial instruments.

   At March 31, 2001 and 2000, we had outstanding forward exchange contracts,
all having maturities of less than 90 days, to exchange various nonfunctional
currencies for U.S. dollars or Euros in the aggregate contracted amounts (U.S.
dollar equivalent) of $51.3 million and $47.1 million, respectively. The net
gains and losses associated with all forward exchange contracts in fiscal
2001, 2000, and 1999 are not material to the our results of operations.

Interest Rate Risk

   Our exposure to market rate risk for changes in interest rates relates
primarily to our investment portfolio. All our short-term investments are
classified as available-for-sale and are recorded at amounts that approximate
fair value based on quoted market prices at March 31, 2001 and 2000. Realized
gains and losses and declines in

                                      33
<PAGE>

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. Realized gains and losses on sales of
available-for-sale securities were immaterial for the years ended March 31,
2001 and 2000. Unrealized gains on available-for-sale securities are included
in accumulated other comprehensive loss, which is a separate component of
stockholders' equity, and totaled approximately $3.6 million, net of tax, at
March 31, 2001. There were no significant unrealized holding gains or losses
on such securities at March 31, 2000. Our Convertible Subordinated Notes were
issued at a fixed interest rate and with fixed conversion rates and therefore
do not expose us to the risk of earnings or cash flow loss due to change in
market interest rates. The table below presents notional amounts and related
weighted-average interest rates by year of maturity for our investment
portfolio and long-term debt obligations at March 31, 2001:

<TABLE>
<CAPTION>
                           2001      2002     2003     2004    2005   Thereafter   Total     Fair Value
                         --------  --------  -------  ------  ------- ---------- ----------  ----------
<S>                      <C>       <C>       <C>      <C>     <C>     <C>        <C>         <C>
Cash equivalents
 Fixed rate............. $129,947        --       --      --       --        --  $  129,947  $  129,805
 Average rate...........     5.11%       --       --      --       --        --        5.11%
 Variable rate.......... $200,428        --       --      --       --        --  $  200,428  $  200,428
 Average rate...........     4.98%       --       --      --       --        --        4.98%
Short-term investments
 Fixed rate............. $205,976  $319,208  $57,610  $6,032       --        --  $  588,826  $  594,873
 Average rate...........     6.32%     6.24%    5.35%   5.31%      --        --        6.17%
Auction rate preferred
 Fixed rate............. $ 82,231        --       --      --       --        --  $   82,231  $   82,231
 Average rate...........     5.35%       --       --      --       --        --        5.35%
                         --------  --------  -------  ------  -------  --------  ----------  ----------
Total investments
 Securities............. $618,582  $319,208  $57,610  $6,032       --        --  $1,001,432  $1,007,337
                         ========  ========  =======  ======  =======  ========  ==========  ==========
 Average rate...........     5.50%     6.24%    5.35%   5.31%      --        --        5.71%
                         ========  ========  =======  ======  =======  ========  ==========
Long-term debt
 Fixed rate.............       --        --       --      --       --  $500,000  $  500,000  $  416,900
                         ========  ========  =======  ======  =======  ========  ==========  ==========
 Average rate...........       --        --       --      --       --      5.00%       5.00%
                         ========  ========  =======  ======  =======  ========  ==========
</TABLE>

                                      34
<PAGE>

ITEM 8--FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

               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, 2001 and 2000, and the related
consolidated statements of operations, stockholders' equity, and cash flows
for each of the three years in the period ended March 31, 2001. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

   We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

   In our opinion the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Rational
Software Corporation at March 31, 2001 and 2000, and the consolidated results
of its operations, and its cash flows for each of the three years in the
period ended March 31, 2001, in conformity with accounting principles
generally accepted in the United States.

                                          /s/ Ernst & Young llp

Palo Alto, California
April 16, 2001

                                      35
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

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

<TABLE>
<CAPTION>
                                                              March 31,
                                                        ----------------------
                                                           2001        2000
                                                        ----------  ----------
<S>                                                     <C>         <C>
Assets
Current assets:
  Cash and cash equivalents............................ $  363,717  $  413,230
  Short-term investments...............................    677,104     493,081
  Accounts receivable, net of allowance for doubtful
   accounts of $3,317 and $3,259 in 2001 and 2000,
   respectively........................................    206,099     148,818
  Deferred tax assets..................................     16,727       9,384
  Prepaid expenses and other assets....................     21,902      10,671
                                                        ----------  ----------
    Total current assets...............................  1,285,549   1,075,184
Property and equipment, net............................    103,239      52,440
Goodwill and purchased intangibles, net................    294,824      54,064
Other assets, net......................................     25,711      44,088
                                                        ----------  ----------
    Total assets....................................... $1,709,323  $1,225,776
                                                        ==========  ==========
Liabilities and stockholders' equity
Current liabilities:
  Accounts payable..................................... $   23,909  $    8,496
  Accrued employee benefits............................     68,624      49,290
  Income taxes payable.................................     30,788      24,323
  Other accrued expenses...............................     49,753      33,257
  Current portion of accrued merger and integration
   costs...............................................     19,970       5,147
  Deferred revenues....................................    166,531     122,813
                                                        ----------  ----------
    Total current liabilities..........................    359,575     243,326
Long-term deferred tax liabilities.....................     57,900          --
Convertible subordinated notes.........................    500,000     500,000
Long-term portion of accrued merger and integration
 costs.................................................     25,284         700
Other accrued liabilities..............................        310         968
                                                        ----------  ----------
    Total liabilities..................................    943,069     744,994
                                                        ----------  ----------
Minority interest......................................         --      24,475
                                                        ----------  ----------
Stockholders' equity:
  Common Stock, $0.01 par value, 500,000 shares
   authorized, 217,501 and 199,244 shares issued in
   2001 and 2000, respectively.........................      2,175       1,992
  Additional paid-in capital...........................  1,236,517     708,492
  Receivable from stockholders.........................       (645)         --
  Deferred stock compensation..........................   (272,256)     (2,763)
  Treasury stock, 15,541 and 18,758 shares in 2001 and
   2000, respectively..................................   (192,417)   (180,851)
  Retained earnings (Accumulated deficit)..............     11,445     (60,699)
  Accumulated other comprehensive loss.................    (18,565)     (9,864)
                                                        ----------  ----------
    Total stockholders' equity.........................    766,254     456,307
                                                        ----------  ----------
    Total liabilities and stockholders' equity......... $1,709,323  $1,225,776
                                                        ==========  ==========
</TABLE>

                 See Notes to Consolidated Financial Statements

                                       36
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                     Year Ended March 31,
                                                  ----------------------------
                                                    2001      2000      1999
                                                  --------  --------  --------
<S>                                               <C>       <C>       <C>
Net product revenues............................. $477,726  $354,497  $259,335
Consulting and support revenues..................  337,209   217,693   152,481
                                                  --------  --------  --------
  Total revenues.................................  814,935   572,190   411,816
                                                  --------  --------  --------
Cost of product revenues.........................   32,817    27,297    22,020
Cost of consulting and support revenues..........   89,227    59,607    40,848
                                                  --------  --------  --------
  Total cost of revenues.........................  122,044    86,904    62,868
                                                  --------  --------  --------
Gross margin.....................................  692,891   485,286   348,948
                                                  --------  --------  --------
Operating expenses:
  Research and development expenses..............  183,509   102,565    71,869
  Sales and marketing expenses...................  330,128   220,529   172,448
  General and administrative expenses............   48,567    47,124    33,910
  Amortization of goodwill and purchased
   intangibles...................................   22,370     3,120        --
  Amortization of deferred stock based
   compensation..................................   14,020       281        --
  Charges for acquired in-process research and
   development...................................   15,822     3,529        --
  Merger and integration costs...................       --        --    (1,200)
                                                  --------  --------  --------
    Total operating expenses.....................  614,416   377,148   277,027
                                                  --------  --------  --------
Operating income.................................   78,475   108,138    71,921
Interest expense.................................   25,235     4,132        37
Interest income..................................   59,944    16,989    12,758
                                                  --------  --------  --------
  Income before income taxes.....................  113,184   120,995    84,642
Provision for income taxes.......................   56,363    36,765    25,393
Minority interest................................  (15,323)   (1,084)       --
                                                  --------  --------  --------
Net income....................................... $ 72,144  $ 85,314  $ 59,249
                                                  ========  ========  ========
Net income per share--basic...................... $   0.38  $   0.49  $   0.35
                                                  ========  ========  ========
Shares used in computing net income per share--
 basic...........................................  188,566   175,458   171,394
                                                  ========  ========  ========
Net income per share--diluted.................... $   0.35  $   0.45  $   0.32
                                                  ========  ========  ========
Shares used in computing net income per share--
 diluted.........................................  206,211   191,274   183,698
                                                  ========  ========  ========
</TABLE>


                 See Notes to Consolidated Financial Statements

                                       37
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                                     Retained    Accumulated
                     Common Stock  Additional  Receivable    Deferred                Earnings       Other         Total
                    --------------  Paid-In       From        Stock     Treasury   (Accumulated Comprehensive Stockholders'
                    Shares  Amount  Capital   Stockholders Compensation   Stock      Deficit)       Loss         Equity
                    ------- ------ ---------- ------------ ------------ ---------  ------------ ------------- -------------
<S>                 <C>     <C>    <C>        <C>          <C>          <C>        <C>          <C>           <C>
Balance at March
31, 1998........... 177,950 $1,780 $  493,828       --             --   $  (1,340)  $(205,262)    $ (1,830)     $ 287,176
Exercise of common
stock options......   7,106     69     27,710       --             --          --          --           --         27,779
Issuance of common
stock under
Employee Stock
Purchase Plans.....   1,706     17      8,250       --             --          --          --           --          8,267
Tax benefit from
employee stock
plans..............      --     --     32,021       --             --          --          --           --         32,021
Treasury stock
repurchases........      --     --         --       --             --    (118,148)         --           --       (118,148)
Comprehensive
income:
 Cumulative
 translation
 adjustment........      --     --         --       --             --          --          --       (1,972)        (1,972)
 Net income........      --     --         --       --             --          --      59,249           --         59,249
                    ------- ------ ----------    -----      ---------   ---------   ---------     --------      ---------
   Total
   comprehensive
   income..........
Balance at March
31, 1999........... 186,762 $1,866 $  561,809       --             --   $(119,488)  $(146,013)    $ (3,802)     $ 294,372
Exercise of common
stock options......  10,488    105     64,527       --             --          --          --           --         64,632
Issuance of common
stock under
Employee Stock
Purchase Plans.....   1,252     13      9,923       --             --          --          --           --          9,936
Tax benefit from
employee stock
plans..............      --     --     36,825       --             --          --          --           --         36,825
Compensation
expense............      --     --        484       --             --          --          --           --            484
Deferred stock
compensation.......      --     --      3,044       --      $  (3,044)         --          --           --             --
Amortization of
deferred stock
compensation.......      --     --         --       --            281          --          --           --            281
Issuance of common
stock in
conjunction with
acquisition........     742      8     31,880       --             --          --          --           --         31,888
Treasury stock
repurchases........      --     --         --       --             --     (61,363)         --           --        (61,363)
Comprehensive
income:
 Cumulative
 translation
 adjustment........      --     --         --       --             --          --          --       (6,062)        (6,062)
 Net income........      --     --         --       --             --          --      85,314           --         85,314
                    ------- ------ ----------    -----      ---------   ---------   ---------     --------      ---------
   Total
   comprehensive
   income..........
Balance at March
31, 2000........... 199,244 $1,992 $  708,492       --      $  (2,763)  $(180,851)  $ (60,699)    $ (9,864)     $ 456,307
Exercise of common
stock options, net
of repurchases.....   5,293     53     36,657       --             --      42,640          --           --         79,350
Issuance of common
stock under
Employee Stock
Purchase Plans.....   1,007     11     13,403       --             --          --          --           --         13,414
Tax benefit from
employee stock
plans..............      --     --     85,857       --             --          --          --           --         85,857
Amortization of
deferred stock
compensation.......      --     --         --       --         14,020          --          --           --         14,020
Issuance of common
stock in
conjunction with
acquisitions.......  11,957    119    392,108    $(645)      (283,513)         --          --           --        108,069
Treasury stock
repurchases........      --     --         --       --             --     (54,206)         --           --        (54,206)
Comprehensive
income:
 Cumulative
 translation
 adjustment........      --     --         --       --             --          --          --      (12,277)       (12,277)
 Unrealized gain
 on investments....      --     --         --       --             --          --          --        3,576          3,576
 Net income........      --     --         --       --             --          --      72,144           --         72,144
                    ------- ------ ----------    -----      ---------   ---------   ---------     --------      ---------
   Total
   comprehensive
   income..........
Balance at March
31, 2001........... 217,501 $2,175 $1,236,517    $(645)     $(272,256)  $(192,417)  $  11,445     $(18,565)     $ 766,254
                    ======= ====== ==========    =====      =========   =========   =========     ========      =========
<CAPTION>
                    Comprehensive
                       Income
                    -------------
<S>                 <C>
Balance at March
31, 1998...........
Exercise of common
stock options......
Issuance of common
stock under
Employee Stock
Purchase Plans.....
Tax benefit from
employee stock
plans..............
Treasury stock
repurchases........
Comprehensive
income:
 Cumulative
 translation
 adjustment........   $ (1,972)
 Net income........     59,249
                    -------------
   Total
   comprehensive
   income..........   $ 57,277
                    =============
Balance at March
31, 1999...........
Exercise of common
stock options......
Issuance of common
stock under
Employee Stock
Purchase Plans.....
Tax benefit from
employee stock
plans..............
Compensation
expense............
Deferred stock
compensation.......
Amortization of
deferred stock
compensation.......
Issuance of common
stock in
conjunction with
acquisition........
Treasury stock
repurchases........
Comprehensive
income:
 Cumulative
 translation
 adjustment........   $ (6,062)
 Net income........     85,314
                    -------------
   Total
   comprehensive
   income..........   $ 79,252
                    =============
Balance at March
31, 2000...........
Exercise of common
stock options, net
of repurchases.....
Issuance of common
stock under
Employee Stock
Purchase Plans.....
Tax benefit from
employee stock
plans..............
Amortization of
deferred stock
compensation.......
Issuance of common
stock in
conjunction with
acquisitions.......
Treasury stock
repurchases........
Comprehensive
income:
 Cumulative
 translation
 adjustment........   $(12,277)
 Unrealized gain
 on investments....      3,576
 Net income........     72,144
                    -------------
   Total
   comprehensive
   income..........   $ 63,443
                    =============
Balance at March
31, 2001...........
</TABLE>

                 See Notes to Consolidated Financial Statements

                                       38
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                    Year Ended March 31,
                                                -------------------------------
                                                  2001       2000       1999
                                                ---------  ---------  ---------
<S>                                             <C>        <C>        <C>
Operating activities:
Net income....................................  $  72,144  $  85,314  $  59,249
Adjustments to reconcile net income to net
 cash provided by operating activities:
  Charges for acquired in-process research and
   development................................     15,822      3,529         --
  Depreciation................................     25,374     18,860     14,285
  Amortization................................     30,617      7,570      4,480
  Compensation expense related to stock
   options....................................     14,020        765         --
  Tax benefit from employee stock plans.......     85,857     36,825     32,021
  Noncash merger and integration costs........         --      2,338      5,699
  Minority interest in loss of Catapulse
   Inc........................................    (15,323)    (1,084)        --
  Changes in operating assets and liabilities:
   Accounts receivable........................    (55,933)   (54,806)   (20,988)
   Prepaid expenses and other, net............    (11,050)    (1,040)    (1,937)
   Deferred tax...............................    (44,274)    13,497    (11,035)
   Other assets...............................     (9,182)        --         --
   Accounts payable...........................     14,470     (5,641)       586
   Accrued employee benefits and other accrued
    expenses..................................     34,831     31,209      1,418
   Income taxes payable.......................      6,017      4,671      4,393
   Accrued merger and integration expenses....    (18,965)       428    (32,106)
   Deferred revenues..........................     43,718     44,164     23,516
                                                ---------  ---------  ---------
Net cash provided by operating activities.....    188,143    186,599     79,581
                                                ---------  ---------  ---------

Investing activities:
Purchase of short-term investments............   (914,587)  (524,642)  (327,012)
Maturities and sales of short-term
 investments..................................    736,723    231,426    290,388
Purchases of property and equipment...........    (76,173)   (24,474)   (21,742)
Net changes in other investment assets........         --    (19,738)    (1,454)
Business combinations, net of cash acquired...    (11,478)   (13,208)        --
                                                ---------  ---------  ---------
Net cash used in investing activities.........   (265,515)  (350,636)   (59,820)
                                                ---------  ---------  ---------

Financing activities:
Principal payments under long-term debt and
 capital lease obligations....................         --         --     (1,951)
Net proceeds from sale of Convertible Notes...         --    484,600         --
Net proceeds from issuance of Common Stock....     44,512     74,568     36,046
Net proceeds from reissuance of treasury
 stock........................................     48,252         --         --
Purchases of treasury stock...................    (54,206)   (61,363)  (118,148)
Proceeds from minority investors in Catapulse
 Inc..........................................      1,578     25,559         --
                                                ---------  ---------  ---------
Net cash provided by (used in) financing
 activities...................................     40,136    523,364    (84,053)
                                                ---------  ---------  ---------
Effect of changes in foreign currency exchange
 rate on cash.................................    (12,277)    (6,062)    (1,972)
                                                ---------  ---------  ---------
Net increase (decrease) in cash and cash
 equivalents..................................    (49,513)   353,265    (66,264)
Cash and cash equivalents at beginning of
 year.........................................    413,230     59,965    126,229
                                                ---------  ---------  ---------
Cash and cash equivalents at end of year......  $ 363,717  $ 413,230  $  59,965
                                                =========  =========  =========

Supplemental disclosure of cash flow
 information:
Cash paid for income taxes....................  $   9,023  $   4,077  $   4,100
Cash paid for interest........................     24,842         --         --

Noncash investing and financing activities:
Unrealized gains on available-for-sale
 securities, net of taxes.....................  $   3,576         --         --
Deferred stock compensation...................    283,513      3,044         --
Common stock issued in connection with
 acquisitions.................................    391,582     31,888         --
</TABLE>

                 See Notes to Consolidated Financial Statements

                                       39
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                March 31, 2001

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 companies
that depend on their ability to develop and deploy software. The Company
provides an integrated suite of software products and services designed to
improve the software development process.

   The accompanying consolidated financial statements include the accounts of
the Company and its subsidiaries. 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.

   Revenue recognition. The Company recognizes revenues in accordance with the
American Institute of Certified Public Accountants (AICPA) Statement of
Position (SOP) 97-2, "Software Revenue Recognition," as amended. Revenues from
software license agreements are recognized when persuasive evidence of an
agreement exists, delivery of the product has occurred, the fee is fixed or
determinable, and collectibility is probable. The Company uses the residual
method to recognize revenues when a license agreement includes one or more
elements to be delivered at a future date and evidence of the fair value of
all undelivered elements exists. Under the residual method, the fair value of
the undelivered elements is deferred and the remaining portion of the
arrangement fee is recognized as revenues. If evidence of the fair value of
one or more undelivered elements does not exist, revenues are deferred and
recognized when delivery of those elements occurs or when fair value can be
established. If the fee due from the customer is not fixed or determinable,
revenues are recognized as cash is received from the customer, assuming all
other revenue recognition criteria have been met. The Company considers all
arrangements with payment terms longer than normal not to be fixed or
determinable. Revenue arrangements with resellers are recognized when shipped
to the end users.

   Services revenues include consulting services, post-contract customer
support and training. Consulting revenues and the related cost of services are
recognized on a time and materials basis; however, revenues from certain
fixed-price contracts are recognized on the percentage of completion basis in
accordance with AICPA SOP 81-1, "Accounting for Performance of Construction-
Type and Certain Production-Type Contracts," which involves the use of
estimates. Actual results could differ from those estimates and, as a result,
future gross margin on such contracts may be more or less than anticipated.
The amount of consulting contracts recognized on a percentage of completion
basis has not been material to date. Software maintenance agreements provide
technical support and the right to unspecified upgrades on an if-and-when
available basis. Post-contract customer support revenues are recognized
ratably over the term of the support period (generally one year) and training
and other service revenues are recognized as the related services are
provided. The unrecognized portion of amounts paid in advance for licenses and
services is recorded as deferred revenues.

   Translation of local currencies. The Company's international subsidiaries
operate primarily using local functional currencies. Accordingly, all assets
and liabilities of these subsidiaries are translated using exchange rates in
effect at the end of the period, and revenues and costs are translated using
average exchange rates for the period. The resulting cumulative translation
adjustments are presented as a separate component of stockholders' equity.
Realized and unrealized exchange gains or losses from transaction adjustments
are reflected in operations and have not been material.

                                      40
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


   Earnings per share. Calculation of earnings per share is as follows (in
thousands, except per share amounts) and reflects a two-for-one stock split in
September 2000:

<TABLE>
<CAPTION>
                                                          Year Ended March 31,
                                                         -----------------------
                                                          2001    2000    1999
                                                         ------- ------- -------
   <S>                                                   <C>     <C>     <C>
   Numerator:
   Net income..........................................  $72,144 $85,314 $59,249
                                                         ======= ======= =======
   Denominator:
   Denominator for basic net income per share--weighted
    average shares (weighted average shares outstanding
    during the period, excluding weighted average
    shares subject to repurchase)......................  188,566 175,458 171,394
   Weighted average shares subject to repurchase.......      774      --      --
   Incremental common shares attributable to shares
    issuable under employee stock plans (Treasury Stock
    Method)............................................   16,871  15,816  12,304
                                                         ------- ------- -------
   Denominator for diluted net income per share--
    weighted average shares and assumed conversions....  206,211 191,274 183,698
                                                         ======= ======= =======
   Net income per share--basic.........................  $  0.38 $  0.49 $  0.35
                                                         ======= ======= =======
   Net income per share--diluted.......................  $  0.35 $  0.45 $  0.32
                                                         ======= ======= =======
</TABLE>

   The effect of options to purchase 6,397,529 and 302,036 shares of Common
Stock was not included in the computation of the 2001 and 2000 diluted
earnings per share, respectively, because the options' exercise price was
greater than the average market price of common shares. The effect of
converting 13,997,760 shares of Common Stock from outstanding Convertible
Notes issued in 2000 was not included in diluted earnings per share because
the assumed conversion would be anti-dilutive.

   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 of the Company's short-term investments are classified as available-
for-sale and are recorded at amounts that approximate fair value based on
quoted market prices at March 31, 2001 and 2000. Unrealized holding gains and
losses on available-for-sale securities, net of tax, are recorded in
stockholders' equity. Realized gains or 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 is recorded at
cost and is depreciated over its useful life, which is generally three to
seven years, 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.

   Long Lived Assets. In accordance with Statement of Financial Accounting
Standards (SFAS) No. 121, "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to be Disposed of," the Company is required to
review for impairment 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. The
Company identifies and records impairment losses, as circumstances dictate, on

                                      41
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001

long-lived assets used in operations when events and circumstances indicate
that the assets are impaired and the undiscounted cash flows estimated to be
generated by those assets are less than the carrying amounts of these assets.
Such events or circumstances include, but are not limited to, a significant
decrease in the fair value of the underlying business, a significant change in
the benefits realized from the acquired business, or a significant change in
the operations of the acquired business. If assets are considered to be
impaired, the impairment to be recognized is measured by the amount by which
the carrying amount of the asset exceeds its fair market value. The Company's
long-lived assets consist primarily of purchased intangibles, goodwill and
property and equipment. Changes in the economy, the business in which the
Company operates, and the Company's own relative performance could change the
assumptions used to evaluate the recovery of goodwill and purchased
intangibles. The Company monitors the preceding factors to identify events or
circumstances, which would cause the Company to test for impairment and revise
its assumptions on the estimated recovery of goodwill and purchased
intangibles. In management's opinion, no material impairment loss exists at
March 31, 2001.

   Goodwill and purchased intangibles. Goodwill represents the excess purchase
price of net tangible and intangible assets acquired in business combinations
over their estimated fair value. Purchased intangibles primarily represent
developed and core technology, and assembled workforce. Goodwill and purchased
intangibles are being amortized on a straight-line basis over their estimated
useful lives, which range from one to four years. The Company reviews goodwill
and purchased intangibles to assess recoverability from future operations
using undiscounted cash flows. In management's opinion, no material impairment
exists at March 31, 2001. Accumulated amortization of goodwill and other
intangibles was $96.5 million and $65.8 million as of March 31, 2001 and 2000,
respectively.

   Stock based compensation. The Company has elected to follow Accounting
Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to
Employees," and related interpretations in accounting for its employee stock
options, because the alternative fair value accounting provided for under SFAS
123, "Accounting for Stock-Based Compensation," 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, and accordingly, no compensation expense is
recorded. The Company recognizes compensation expense for those options
granted with an exercise price less than the fair value of the underlying
Common Stock at the date of grant.

   Fair value of financial instruments. The carrying values reported in the
balance sheet for cash and cash equivalents and short-term investments
approximate fair value. The fair value of short-term investments and long-term
debt is based on quoted market prices. As of March 31, 2001, the quoted market
value for long-term debt was approximately $416.9 million.

   Advertising costs. The Company expenses advertising costs as incurred.
Advertising costs totaled $19.3 million, $10.1 million, and $6.6 million for
the years ended March 31, 2001, 2000, and 1999, respectively.

   401(k) plan. The Company has a 401(k) Retirement Plan (the "Plan") that
allows eligible employees to contribute up to 15% of their annual compensation
to the Plan, subject to certain limitations. Starting July 1, 2000, the
Company has matched employee contributions at a rate of 3% of salary, up to a
maximum of $2,000. Employee contributions vest immediately, whereas the
Company's matching contributions vest at a rate of 0% after the employee's
first year of service, 50% after the second year of service and 100% after the
third year of service. The Company recognized matching contribution expense of
$2.5 million, $0, and $0 in fiscal 2001, 2000 and 1999, respectively.

                                      42
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


   Reclassifications. Certain prior-year amounts have been reclassified to
conform to current-year presentation.

   Derivatives. The Company uses short-term forward foreign exchange contracts
to hedge a portion, but not all, of its firm commitments denominated in
foreign currencies. The terms of currency instruments used for hedging
purposes are generally consistent with the timing of the committed
transactions being hedged. The purpose of the Company's foreign currency
management is to mitigate the impact of foreign currency exchange rate
fluctuations on balance sheet exposures denominated in currencies other than
the " functional" currency. The total amount of these contracts is
approximately offset by the underlying assets and liabilities denominated in
nonfunctional currencies. Forward contracts are accounted for on a mark-to-
market basis and are included in prepaid expenses and other assets on the
Company's Consolidated Balance Sheets. Gains and losses on forward exchange
contracts are recognized in the Company's Consolidated Statements of
Operations when the related transactions being hedged are recognized or the
contracts mature. As the Company finds it impractical to hedge all foreign
currency exposures, the Company will continue to experience foreign currency
gains and losses. The Company does not use derivative financial instruments
for speculative trading purposes, nor does it hold or issue leveraged
derivative financial instruments.

   Recent pronouncements. In June 1998, the Financial Accounting Standards
Board (FASB) issued SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities." SFAS 133 is effective for all fiscal quarters of fiscal
years beginning after June 15, 2000. SFAS 133 requires that all derivative
instruments be recorded on the balance sheet at their fair value. Changes in
the fair value of derivatives are recorded each period in either current
earnings or other comprehensive income, depending on whether a derivative is
designated as part of a hedge transaction and, if it is, the type of hedge
transaction. For fair value hedge transactions in which the Company is hedging
changes in fair value of an asset, liability, or firm commitment, changes in
the fair value of the derivative instrument will generally be offset in the
income statement by changes in the fair value of the hedged item. For cash
flow hedge transactions, in which the Company is hedging the variability of
cash flows related to a variable-rate asset, liability, or a forecasted
transaction, changes in the fair value of the derivative instrument will be
reported in other comprehensive income. The gains and losses on the derivative
instrument that are reported in other comprehensive income will be
reclassified as earnings in the periods in which earnings are impacted by the
variability of the cash flows of the hedged item. The ineffective portion of
all hedges will be recognized in current earnings. The Company will adopt SFAS
133 in fiscal 2002. Adoption of SFAS 133 is not expected to have a material
impact on the Company's consolidated financial statements.

   In March 2000, the Financial Accounting Standards Board issued
Interpretation No. 44, (FIN 44), "Accounting for Certain Transactions
Involving Stock Compensation--an Interpretation of APB 25." This
Interpretation clarifies (a) the definition of employee for purposes of
applying Opinion 25, (b) the criteria for determining whether a plan qualifies
as a non compensatory plan, (c) the accounting consequence of various
modifications to the terms of a previously fixed stock option or award, and
(d) the accounting for an exchange of stock compensation awards in a business
combination. This Interpretation became effective July 1, 2000, but certain
conclusions in this Interpretation cover specific events that occurred after
either December 15, 1998 or January 12, 2000. To the extent that this
Interpretation covers events occurring during the period after December 15,
1998 or January 12, 2000, but before the effective date of July 1, 2000, the
effects of applying this Interpretation are recognized on a prospective basis
from July 1, 2000. As a result of the Company's adoption of this guidance in
July 2000, the Company recorded approximately $295.0 million of deferred
stock-based compensation in conjunction with the acquisitions of Catapulse
Inc. and Attol Testware, of which $14.0 million was expensed in the current
year.

   In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin (SAB) No. 101, "Revenue Recognition in Financial
Statements," referred to as SAB 101. SAB 101 summarizes certain

                                      43
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001

of the SEC staff's views in applying generally accepted accounting principles
to revenue recognition in financial statements. In June 2000, the SEC issued
SAB 101B, "Second Amendment: Revenue Recognition in Financial Statements," to
defer the effective date of the implementation of SAB 101 until the fourth
quarter of fiscal 2001. The adoption of SAB 101 did not have a significant
impact on earnings or the financial position of the Company.

   On February 14, 2001, the Financial Accounting Standards Board (FASB)
issued a limited revision of its September 7, 1999 Exposure Draft, "Business
Combinations and Intangible Assets," that proposes to significantly change the
accounting for goodwill acquired in a purchase business combination. Under the
revised proposal, goodwill would not be amortized but would be reviewed for
impairment, using a complex methodology different from the original proposal,
when an event occurs indicating the potential for impairment. Goodwill
impairment charges would be presented as a separate line item with the
operating section of the income statements. The nonamortization approach would
apply to previously recorded goodwill as well as goodwill arising from
acquisitions completed after the application of the new standard. Amortization
of the remaining book value of goodwill would cease and the new impairment-
only approach would apply. FASB expects to release the final Statement in July
2001.

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, short-term investments, and accounts receivable. The Company's
investment policy limits its exposure to concentrations of credit risk for
cash equivalents and short-term investments. The Company sells its products
primarily to major corporations that develop software, and systems integrators
that serve a wide variety of international 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. No single customer accounted for 10% or more of total revenues
for all periods presented.

   International sales. International sales account for approximately 41%, 41%
and 40% of the Company's revenues in fiscal 2001, 2000 and 1999, respectively,
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.

   A portion of the Company's business is conducted in currencies other than
the U.S. dollar. Changes in the value of major foreign currencies relative to
the local, or "functional" currency of the Company or its subsidiaries may
adversely affect operating results. The Company enters into short-term forward
foreign exchange contracts designed to mitigate the impact of foreign currency
exchange rate fluctuations on balance sheet exposures denominated in
currencies other than the "functional" currency. The total amount of these
contracts is approximately offset by the underlying assets and liabilities
denominated in nonfunctional currencies. Forward contracts are accounted for
on a mark-to-market basis. Gains and losses on forward contracts are
recognized in the Company's Consolidated Statements of Operations when the
related transactions being hedged are recognized or the contracts mature. Such
contracts meet the criteria established in SFAS 52, "Foreign Currency
Translation for Hedge Accounting Treatment." As the Company finds it
impractical to hedge all foreign currency exposures, the Company will continue
to experience foreign currency gains and losses. The Company does not use
derivative financial instruments for speculative trading purposes, nor does it
hold or issue leveraged derivative financial instruments.

                                      44
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


   At March 31, 2001 and 2000, the Company had outstanding forward exchange
contracts, all having maturities of less than 90 days, to exchange various
nonfunctional currencies for U.S. dollars or Euros in the aggregate contracted
amounts (U.S. dollar equivalent) of $51.3 million and $47.1 million,
respectively. Three major U.S. multinational banks are counterparty to all
these contracts. The gains and losses associated with all forward exchange
contracts when combined with the gains and losses on the underlying exposures
hedged in fiscal 2001, 2000, and 1999 were not material to the Company's
results of operations.

3. Acquisitions

   Purchase of Catapulse Inc. On February 5, 2001, the Company completed the
acquisition of the remaining outstanding shares of Catapulse Inc. (Catapulse)
not already owned by Rational. Catapulse was a development stage company,
which was developing a hosted development service to be delivered to users
over the Internet. Under the terms of the definitive agreement, Rational
issued 0.0825 shares of Rational Common Stock for each outstanding share of
Catapulse capital stock at the time the acquisition was consummated. In
addition, each outstanding convertible security of Catapulse, including
options and other rights to purchase Catapulse Common Stock was assumed by
Rational in the acquisition of the remaining shares and became exercisable for
a number of shares of Rational Common Stock based on the fixed exchange ratio.
In connection with this acquisition of the remaining shares, the Company
acquired all of the outstanding shares of capital stock of Catapulse not
already owned by Rational in exchange for 11,444,956 shares of the Company's
Common Stock. In addition, options of Catapulse were converted into options to
purchase approximately 1,018,740 shares of the Company's Common Stock.

   In December 1999, Rational invested $50.0 million in Catapulse, and
Rational's investment represented approximately 37% of the voting power of the
outstanding capital stock of Catapulse. In addition, two of Rational's
officers represented an approximate additional 29% of the voting power of the
outstanding capital stock of Catapulse. Catapulse's Board of Directors
comprised five directors, four of whom served on Rational's Board of
Directors. Also, in July 2000, Catapulse entered into agreements with Rational
whereby Rational would develop and license technology, under Rational's
intellectual property rights, to Catapulse for the products and services,
which were to be provided to Catapulse's customers on an exclusive basis.
Because of these factors, Rational exercised significant influence over
Catapulse and as a result Catapulse has been consolidated into Rational for
financial reporting purposes since December 1999, with outside ownership of
Catapulse reflected as minority interest through February 5, 2001.

   The total purchase price of Catapulse, including acquisition-related costs
of approximately $55.3 million, was approximately $445.2 million. The
acquisition was accounted for under the purchase method of accounting and the
total purchase price was allocated based on an independent appraisal as
follows (in thousands):

<TABLE>
   <S>                                                              <C>
   Acquired developed and core technology.......................... $  25,952
   Acquired contract...............................................     9,299
   Acquired in-process research and development (IPR&D)............    14,167
   Acquired assembled workforce....................................     5,822
   Acquired goodwill...............................................   201,480
   Deferred stock based compensation on unvested stock and stock
    options........................................................   288,762
   Net deferred tax liability......................................  (114,220)
   Net book value of acquired assets and liabilities which
    approximate fair value.........................................    13,931
                                                                    ---------
     Total purchase price.......................................... $ 445,193
                                                                    =========
</TABLE>

                                      45
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


   The purchase price allocation resulted in a $14.2 million charge related to
the value of acquired IPR&D in the fourth quarter of fiscal 2001. The value of
acquired IPR&D represents the appraised value of technology in the development
stage that had not yet reached economic and technological feasibility. In
reaching this determination, the Company used a present value net income
approach, which computed the fair value of the subject asset based on a
discounted cash flow analysis rate on the anticipated income stream of the
related product revenues and considered, among other factors, the stage of
development of each product and service offering, the time and resources
needed to complete each product and service offering, and expected income and
associated risks. The Company also used the present value net income method to
allocate values to developed or core technology as well as an acquired
contract. The rates utilized to discount the cash flows to their present value
were based on an estimated cost of capital calculation. Due to the nature of
the forecast and the risks associated with the projected growth and
profitability of the developmental projects, the discount rates of 25%, 20%,
and 15% were considered appropriate for IPR&D, developed or core technology
and an acquired contract, respectively. The deferred stock based compensation,
which relates to the intrinsic value of unvested stock options and restricted
stock assumed in the acquisition, is presented as a reduction of stockholders'
equity and is being amortized over the vesting period of the applicable
options or restricted stock using the straight-line method. The acquired
developed technology, acquired contract, assembled workforce and goodwill are
being amortized on a straight-line basis over periods from two to four years,
which are the estimated useful lives of these acquired assets. At March 31,
2001, cumulative amortization of goodwill, purchased intangibles and deferred
stock based compensation associated with this acquisition totaled $22.9
million.

   The Company has formulated an exit plan effective at the date of the
acquisition with respect to duplicate facilities, assets with no future
economic benefit, relocation of key Catapulse employees to better align and
integrate their responsibilities, as well as involuntary termination of
certain Catapulse employees whose responsibilities were redundant or not
deemed necessary. The exit plan has been initiated as of March 31, 2001, and
is expected to be completed in fiscal 2002. Total severance pay, relocation
costs, asset write-off, and lease cancellation costs of the plan, expected to
be approximately $37.0 million, have been included in the purchase price
allocation.

   Purchase of Attol Testware. On March 27, 2001, the Company completed the
acquisition of Attol Testware (Attol). Attol was a France-based company that
focused on testing of embedded software systems. Under the terms of the share
purchase agreement, the Company acquired all of the outstanding shares of
capital stock of Attol in exchange for approximately $12.3 million of cash and
466,006 shares of Rational Common Stock.

   The total purchase price of Attol, including acquisition-related costs of
approximately $7.9 million, was approximately $30.3 million. The acquisition
was accounted for under the purchase method of accounting and the total
purchase price was allocated based on an independent appraisal as follows (in
thousands):

<TABLE>
   <S>                                                                <C>
   Acquired developed and core technology............................ $ 3,665
   Acquired IPR&D....................................................   1,655
   Acquired assembled workforce......................................     576
   Acquired customer base and trade name.............................     917
   Acquired goodwill.................................................  18,919
   Deferred stock based compensation on unvested stock and stock
    options..........................................................   6,276
   Net deferred tax liability........................................  (4,573)
   Net book value of acquired assets and liabilities which
    approximate fair value...........................................   2,820
                                                                      -------
     Total purchase price............................................ $30,255
                                                                      =======
</TABLE>

                                      46
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


   The purchase price allocation resulted in a $1.7 million charge related to
the value of acquired IPR&D in the fourth quarter of fiscal 2001. The value of
acquired IPR&D represents the appraised value of technology in the development
stage that had not yet reached economic and technological feasibility. In
reaching this determination, the Company used a present value net income
approach and considered, among other factors, the stage of development of each
product, the time and resources needed to complete each product, and expected
income and associated risks. The Company also used the present value net
income method to allocate values to developed technology and core technology.
The rates utilized to discount the cash flows to their present value were
based on an estimated cost of capital calculation. Due to the nature of the
forecast and the risks associated with the projected growth and profitability
of the developmental projects, the discount rates of 25%, 20%, and 15% were
considered appropriate for IPR&D, core technology and developed technology,
respectively. The deferred stock based compensation, which relates to the
intrinsic value of unvested stock options and restricted stock assumed in the
acquisition is presented as a reduction of stockholders' equity and is being
amortized over the vesting period of the applicable options or restricted
stock using the straight-line method. The developed technology, core
technology, customer base, trade name and goodwill are being amortized on a
straight-line basis over periods from two to four years, the estimated useful
lives of these acquired assets. The amortization of deferred stock based
compensation, goodwill and intangible assets associated with this acquisition
will result in an aggregate quarterly charge of approximately $2.4 million in
fiscal 2002. The results of Attol are included in consolidated results of
operation from March 27, 2001.

   The Company has formulated an exit plan effective at the date of the
acquisition with respect to assets with no future economic benefit and
involuntary termination of certain Attol employees whose responsibilities were
redundant or not deemed necessary. The exit plan has been initiated as of
March 31, 2001, and will be completed in fiscal 2002. Total severance pay and
asset write-off costs of the plan, expected to be approximately $405,000, have
been included in the purchase price allocation.

   The following table presents unaudited pro forma consolidated results for
the Company assuming the acquisitions of Catapulse and Attol were consummated
as of the beginning of each period. The pro forma results have been adjusted
to exclude the charges of IPR&D recorded in fiscal 2001 and include
amortization of deferred stock based compensation and amortization of goodwill
and purchased intangibles. This information may not necessarily be indicative
of the future combined results of operations of the Company (in thousands,
except per share amounts).

<TABLE>
<CAPTION>
                                                            Year Ended March
                                                                   31,
                                                            ------------------
                                                              2001      2000
                                                            --------  --------
                                                               (Unaudited)
   <S>                                                      <C>       <C>
   Revenues................................................ $818,515  $575,096
   Net loss................................................  (20,788)  (25,704)
   Basic and diluted net loss per share.................... $  (0.10) $  (0.14)
</TABLE>

   Purchase of ObjecTime Limited. On January 13, 2000, the Company completed
the acquisition of ObjecTime Limited (OTL). OTL was a developer of visual
design and code generation software tools used for development of embedded
software. The Company acquired all outstanding shares of OTL capital stock in
exchange for approximately $9.0 million in cash and 371,400 shares of the
Company's Common Stock. The Company also assumed all outstanding options to
purchase OTL Common Stock in exchange for options to purchase 358,546 shares
of the Company's Common Stock. Prior to the consummation of this deal, the
Company held a 19.9% ownership in OTL from an initial investment of
approximately $9.0 million made in December 1997.

                                      47
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


   The total purchase price of OTL, including the prior investment and
acquisition-related costs of approximately $6.0 million, was approximately
$58.8 million. The acquisition was accounted for under the purchase method of
accounting and the total purchase price was allocated based on an independent
appraisal as follows (in thousands):

<TABLE>
   <S>                                                                  <C>
   Acquired developed technology......................................  $ 1,610
   Acquired core technology...........................................    4,250
   Acquired IPR&D.....................................................    3,529
   Acquired workforce.................................................    1,427
   Acquired goodwill and other intangibles............................   45,151
   Net book value of acquired assets and liabilities which approximate
    fair value........................................................    2,865
                                                                        -------
     Total purchase price.............................................  $58,832
                                                                        =======
</TABLE>

   The purchase price allocation resulted in a $3.5 million charge related to
the value of acquired IPR&D in the fourth quarter of fiscal 2000. The value of
acquired IPR&D represents the appraised value of technology in the development
stage that had not yet reached economic and technological feasibility. In
reaching this determination, the Company used a present value net income
approach and considered, among other factors, the stage of development of each
product, the time and resources needed to complete each product, and expected
income and associated risks. The Company also used the present value net
income method to allocate values to developed technology and core technology.
The rates utilized to discount the cash flows to their present value were
based on an estimated cost of capital calculation. Due to the nature of the
forecast and the risks associated with the projected growth and profitability
of the developmental projects, the discount rates of 25%, 20%, and 15% were
considered appropriate for IPR&D, core technology and developed technology,
respectively. The developed technology, core technology, goodwill, and other
intangibles are being amortized on a straight-line basis over periods from one
to four years, which are the estimated useful lives of these acquired assets.
The results of OTL are included in consolidated results of operation from
January 13, 2000.

   The Company formulated an exit plan effective at the date of the
acquisition with respect to duplicate facilities, assets with no future
economic benefit, relocation of key OTL employees to better align and
integrate their responsibilities, and involuntary termination of certain OTL
employees whose responsibilities were redundant or not deemed necessary. The
exit plan was initiated in fiscal 2000, and was completed in fiscal 2001.

   The unaudited pro forma consolidated results for the Company had the
acquisition been consummated at the beginning of each period, excluding the
charge for acquired IPR&D recorded in fiscal 2000, are as follows (in
thousands, except per share amounts):

<TABLE>
<CAPTION>
                                                              Year Ended March
                                                                     31,
                                                              -----------------
                                                                2000     1999
                                                              -------- --------
                                                                 (Unaudited)
   <S>                                                        <C>      <C>
   Revenues.................................................. $581,701 $422,681
   Net income................................................   87,476   56,056
   Diluted net income per share.............................. $   0.91 $   0.61
</TABLE>

                                      48
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


4. Short-Term Investments

   The Company's short-term investments are as follows (in thousands):

<TABLE>
<CAPTION>
                                                   March 31, 2001
                                      ----------------------------------------
                                                                     Estimated
                                               Unrealized Unrealized   Fair
                                        Cost     Gains      Losses     Value
                                      -------- ---------- ---------- ---------
   <S>                                <C>      <C>        <C>        <C>
   Bank certificates of deposit...... $  2,097   $    5      $ --    $  2,102
   U.S. treasury and agency
    obligations......................  158,794    1,899        --     160,693
   Municipal obligations.............  117,682      108       (10)    117,780
   Corporate securities..............  392,484    4,114       (69)    396,529
                                      --------   ------      ----    --------
     Total........................... $671,057   $6,126      $(79)   $677,104
                                      ========   ======      ====    ========
</TABLE>

<TABLE>
<CAPTION>
                                                   March 31, 2000
                                      ----------------------------------------
                                                                     Estimated
                                               Unrealized Unrealized   Fair
                                        Cost     Gains      Losses     Value
                                      -------- ---------- ---------- ---------
   <S>                                <C>      <C>        <C>        <C>
   Bank certificates of deposit...... $ 50,077    $ --       $ --    $ 50,077
   U.S. treasury and agency
    obligations......................  169,755      --         --     169,755
   Municipal obligations.............  126,376      --         --     126,376
   Corporate securities..............  146,873      --         --     146,873
                                      --------    ----       ----    --------
     Total........................... $493,081    $ --       $ --    $493,081
                                      ========    ====       ====    ========
</TABLE>

   Realized gains and losses on sales of available-for-sale securities were
immaterial for the years ended March 31, 2001 and 2000. Unrealized holding
gains or losses, net of taxes, were included in accumulated other
comprehensive loss, which is a separate component of stockholders' equity, and
totaled approximately $3.6 million as of March 31, 2001. There were no
significant unrealized holding gains or losses on such securities at March 31,
2000.

   Debt securities at March 31, 2001 and 2000, by contractual maturity, are
shown below (in thousands). Expected maturities may differ from contractual
maturities because issuers of the securities may have the right to prepay
obligations.

<TABLE>
<CAPTION>
                                                                  March 31,
                                                              -----------------
                                                                2001     2000
                                                              -------- --------
   <S>                                                        <C>      <C>
   Short-term investments:
     Due in one year or less................................. $394,588 $243,357
     Due in one to five years................................  282,516  249,724
                                                              -------- --------
       Total................................................. $677,104 $493,081
                                                              ======== ========
</TABLE>

                                      49
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


5. Property and Equipment

   Property and equipment is as follows (in thousands):

<TABLE>
<CAPTION>
                                                                 March 31,
                                                             ------------------
                                                               2001      2000
                                                             --------  --------
   <S>                                                       <C>       <C>
   Computer and office equipment............................ $112,957  $ 82,838
   Office furniture.........................................   21,413    13,957
   Leasehold improvements...................................   22,427    13,850
   Construction in progress.................................   21,088     5,687
                                                             --------  --------
                                                              177,885   116,332
   Accumulated depreciation and amortization................  (74,646)  (63,892)
                                                             --------  --------
   Net property and equipment............................... $103,239  $ 52,440
                                                             ========  ========
</TABLE>

6. Accrued Merger and Integration Expenses

   Merger expenses consist principally of transaction fees for investment
bankers, attorneys, accountants, financial printing, and other related
charges. Integration costs include severance and other employee-related
charges, elimination of redundant facilities, write-off of excess property and
equipment and certain intangible assets, and other professional fees. Details
of the merger and integration provisions recorded over the past three years
are as follows (in thousands):

<TABLE>
<CAPTION>
                                     Severance
                                     and Other     Asset
                                     Employee-  Write-Offs
                         Transaction  Related    and Lease
                            Costs     Charges  Cancellations  Other    Total
                         ----------- --------- ------------- -------  --------
<S>                      <C>         <C>       <C>           <C>      <C>
Accrued as of March 31,
 1998...................  $  1,207    $ 8,344     $13,898    $ 4,445  $ 27,894
Change in estimate......    (1,078)      (668)     (4,585)     5,131    (1,200)
Noncash charges.........        --         --      (2,927)    (2,772)   (5,699)
Cash payments...........      (129)    (7,043)     (1,600)    (6,804)  (15,576)
                          --------    -------     -------    -------  --------
Accrued as of March 31,
 1999...................  $     --    $   633     $ 4,786    $    --  $  5,419
Provision recorded at
 acquisition of OTL.....     1,124      1,311       1,510      2,083     6,028
Noncash charges.........        --         --      (1,464)      (874)   (2,338)
Cash payments...........      (458)    (1,539)       (180)    (1,085)   (3,262)
                          --------    -------     -------    -------  --------
Accrued as of March 31,
 2000...................  $    666    $   405     $ 4,652    $   124  $  5,847
Provision recorded at
 acquisition of
 Catapulse and Attol....    15,290      5,987      31,430     10,450    63,157
Noncash charges.........        --     (4,784)     (1,342)    (1,027)   (7,153)
Cash payments...........   (13,873)      (651)     (1,859)      (214)  (16,597)
                          --------    -------     -------    -------  --------
Accrued as of March 31,
 2001...................  $  2,083    $   957     $32,881    $ 9,333  $ 45,254
                          ========    =======     =======    =======  ========
</TABLE>

   Severance and other employee-related charges. As a result of the mergers,
certain technical support, customer service, distribution, sales, marketing,
and administrative functions were combined and reduced. Approximately 15, 29,
and 26 employees were terminated in fiscal 2001, 2000, and 1999, respectively,
as a result of this activity. The Company also committed to pay noncontingent
retention bonuses, commissions, and relocation costs to other employees of the
acquired companies, and these costs have been included in the accrual.

                                      50
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


   Asset write-offs and lease cancellations. In connection with acquisitions,
the Company has consolidated duplicate offices and written off certain assets
with no future economic benefit. The accrual in merger and integration
expenses includes lease payments resulting from the planned closure of these
facilities, which are expected to continue through the lease term, or
penalties associated with early termination of the leases. Certain intangibles
that will have no benefit to the combined operations were written off.
Redundant property and equipment were either disposed of or written down to
their estimated net realizable value.

   Other. Other expenses specific to the Catapulse, Attol, and OTL
acquisitions included costs associated with communication of the merger to
employees, existing offices, and costs accrued to provide future support and
maintenance for former Catapulse, Attol, and OTL customers.

7. Convertible Subordinated Notes

   During February 2000, Rational completed an offering of $500.0 million of
Convertible Subordinated Notes (the "Notes"), to qualified institutional
buyers in reliance on Rule 144A under the Securities Act of 1933, as amended.
Interest on the 5% Notes, which mature on February 1, 2007, is payable on
February 1 and August 1 of each year, commencing August 1, 2000. The Notes are
convertible into shares of Rational Common Stock at any time prior to the
close of business on the maturity date, unless previously redeemed, at a
conversion price of $35.72 per share, subject to anti-dilution adjustments.
This is equivalent to a conversion rate of 27.9966 shares of Common Stock per
$1,000 of principal amount due at maturity. The Notes are redeemable, in whole
or in part, at the option of the Company on or after February 5, 2003, and
upon at least 30 days', but no more than 60 days', notice. The redemption
price, expressed as a percentage of principal plus accrued interest through
the date of the redemption, is as follows for the 12-month periods beginning
in February of the following years:

<TABLE>
<CAPTION>
                                                                      Redemption
     Year                                                               Price
     ----                                                             ----------
     <S>                                                              <C>
     2003............................................................  102.857%
     2004............................................................  102.143%
     2005............................................................  101.429%
     2006............................................................  100.714%
</TABLE>

   In the event of a change of control, as defined with respect to the Notes,
each holder of the Notes may require the Company to repurchase its Notes, in
whole or in part, for cash or, at the Company's option, for Common Stock
(valued at 95% of the average last reported sale prices for the five trading
days immediately preceding the repurchase date) at a repurchase price of 100%
of the principal amount of the Notes to be repurchased, plus accrued interest
to the repurchase date. The Notes are unsecured and subordinated in right of
payment in full to all existing and future Senior Indebtedness of the Company.
Expenses associated with the offering of approximately $15.4 million were
deferred in other assets and are being amortized over the term of the Notes.
The Company has reserved 13,997,760 shares of Common Stock for conversion of
the Notes.

                                      51
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


8. Commitments and Contingencies

   The Company leases its primary office space under operating leases. Rental
expense for facilities was approximately $24.6 million, $15.1 million, and
$12.3 million for the fiscal years ended March 31, 2001, 2000, and 1999,
respectively. Estimated future rents from sublease agreements are $106,000
annually in both fiscal 2002 and 2003. Future minimum rental payments, net of
sublease income, are as follows for the fiscal years indicated as of March 31
(in thousands):

<TABLE>
     <S>                                                                <C>
     2002.............................................................. $ 36,470
     2003..............................................................   34,979
     2004..............................................................   32,047
     2005..............................................................   25,004
     2006..............................................................   16,294
     Thereafter........................................................   31,105
                                                                        --------
                                                                        $175,899
                                                                        ========
</TABLE>

   As of March 31, 2001, the Company had letters of credit outstanding in the
amount of $62,500, $4,161,447, and $256,784 guaranteeing certain rental
payments at its office locations in Lexington, Massachusetts; Cupertino,
California; and New York City, New York, respectively. In addition, the
Company assumed a letter of credit with International Business Machines
Corporation ("IBM") totaling $1,985,823 in connection with the Catapulse
acquisition. As part of a strategic business alliance between Catapulse and
IBM, IBM agreed to provide services to Catapulse in exchange for an upfront
payment of $1,237,477 related to development work expected to occur through
December 31, 2001, and monthly recurring fees of $661,941 commencing upon
IBM's completion of the development work and continuing for 37 months. The
monthly recurring fees are related to ongoing services to be provided by IBM.
Catapulse may terminate the arrangement by paying a termination fee of up to
$1,985,823. Catapulse was required under the arrangement to obtain a letter of
credit in the amount of a minimum termination charge.

   Legal matters. The Company is not a party to any material legal
proceedings. From time to time, the Company is subject to legal claims.
Historically, the cost of resolution of the claims has not been significant.
However, any adverse outcome to future lawsuits against the Company may result
in a material adverse effect on the Company's financial condition.

9. Stockholders' Equity

   Stock split. The Company's Board of Directors authorized a two for one
stock split of the Company's Common Stock for stockholders of record on August
17, 2000. The transfer agent distributed shares resulting from the stock split
on September 5, 2000. All share and per-share numbers contained herein reflect
this stock split. The Company Board also approved an increase in the Company's
authorized shares of Common Stock to 500 million shares.

   Stock repurchase program. In April 1998, the Company's Board of Directors
authorized the purchase of up to 12 million shares of the Company's Common
Stock from time to time in the open market. The Company completed the
repurchase of these 12 million shares by August 1998 for an aggregate cost of
approximately $98.4 million. In October 1998, the Company's Board of Directors
authorized the purchase of an additional 12 million shares. As of March 31,
2001, the Company had repurchased approximately 8.2 million shares of its
Common Stock under this program for an aggregate cost of approximately $135.3
million.

                                      52
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


   The stock repurchase program is intended to help offset the dilution
resulting from shares issued under the Company's employee stock plans. The
timing and size of any future stock repurchases are subject to market
conditions, stock prices, and the Company's cash position and other cash
requirements in the future.

   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 2000 Director Option Plan, the 1997 Stock Option
Plan, and the 1997 Supplemental 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 value in the case of nonstatutory options, or 100% of
fair value in the case of incentive stock options, determined on the date that
the option is granted. Under these plans, the Company has reserved 58,341,254
shares for issuance at March 31, 2001. Options generally expire 10 years from
the date of grant.

   Activity under the plans including options assumed by the Company in
mergers (adjusted for exchange ratios) is summarized as follows:

<TABLE>
<CAPTION>
                                                       Options Outstanding
                                                    ---------------------------
                                         Shares                     Weighted
                                        Available                   Average
                                        for Grant     Options    Exercise Price
                                       -----------  -----------  --------------
     <S>                               <C>          <C>          <C>
     Balance at March 31, 1998........   1,428,328   35,134,852      $ 6.29
       Additional shares authorized...   8,900,000           --          --
       Granted........................ (12,277,874)  12,277,874        7.66
       Exercised......................          --   (7,105,694)       3.98
       Canceled.......................   7,966,482   (7,966,482)      10.20
       Expired or retired.............  (2,642,086)          --          --
                                       -----------  -----------      ------
     Balance at March 31, 1999........   3,374,850   32,340,550      $ 6.32
       Additional shares authorized...  36,728,264           --          --
       Granted........................ (17,613,354)  17,613,354       20.26
       Exercised......................          --  (10,496,602)       6.21
       Canceled.......................   2,159,546   (2,159,546)       9.46
       Expired or retired.............    (808,178)          --          --
                                       -----------  -----------      ------
     Balance at March 31, 2000........  23,841,128   37,297,756      $12.55
       Additional shares authorized...   8,360,713           --          --
       Granted and assumed............ (20,202,592)  20,202,592       42.46
       Exercised......................          --  (10,634,530)       6.71
       Canceled.......................   1,675,644   (1,675,644)      22.08
       Expired or retired.............    (523,813)          --          --
                                       -----------  -----------      ------
     Balance at March 31, 2001........  13,151,080   45,190,174      $26.96
                                       ===========  ===========      ======
</TABLE>

   In April 1998, the Company entered into agreements with certain executive
officers to reprice (at the closing price for the Company's Common Stock on
April 2, 1998, of $6.69) employee stock options for an aggregate of
approximately 3.4 million shares of Common Stock. All employees participating
in the repricing agreed to certain limitations on the disposition of repriced
options.

   In connection with the acquisitions of Catapulse and Attol in fiscal 2001,
and pursuant to FIN 44, the Company recorded approximately $295.0 million of
deferred compensation relating to the unvested stock options

                                      53
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001

and restricted stock assumed in the acquisitions (see Note 3). Deferred
compensation recorded in connection with the Catapulse acquisition was
reversed for options canceled or forfeited. The amortization of deferred stock
based compensation in connection with Catapulse and Attol was approximately
$14.0 million during fiscal 2001. In fiscal 2000 the Company recorded deferred
stock compensation of approximately $3.0 million representing the difference
between the exercise price and the deemed fair value of Catapulse, the results
of which were consolidated with Rational's results, Common Stock on the date
such stock options were granted. The Company also recorded amortization of
deferred stock based compensation of approximately $0.3 million in fiscal
2000. Amortization of deferred stock based compensation is allocable as
follows (in thousands):

<TABLE>
<CAPTION>
                                                              Year Ended March
                                                                     31,
                                                              -----------------
                                                               2001   2000 1999
                                                              ------- ---- ----
     <S>                                                      <C>     <C>  <C>
     Research and development................................ $ 3,645 $281 $ --
     Sales and marketing.....................................   5,608   --   --
     General and administrative..............................   4,767   --   --
                                                              ------- ---- ----
       Total................................................. $14,020 $281 $ --
                                                              ======= ==== ====
</TABLE>

   At March 31, 2000, the Company had approximately $2.8 million of remaining
unamortized deferred compensation. Additionally, as a result of accelerating
the vesting period on certain stock options, the Company recorded compensation
expense of $484,000, which was included in general and administrative
expenses.

   At March 31, 2001, options to purchase 12,698,627 shares of Common Stock
were exercisable and unrestricted at a weighted average exercise price of
$14.75. At March 31, 2001, the range of options outstanding and exercisable
was as follows:

<TABLE>
<CAPTION>
                                                             Options Exercisable
                                Options Outstanding            and Unrestricted
                       ------------------------------------- --------------------
                                   Weighted Average Weighted             Weighted
                                      Remaining     Average              Average
        Range of         Shares      Contractual    Exercise   Number    Exercise
     Exercise Prices   Outstanding   Life (years)    Price   Exercisable  Price
     ---------------   ----------- ---------------- -------- ----------- --------
     <S>               <C>         <C>              <C>      <C>         <C>
     $0.0009-$5.56      6,921,473        6.36        $ 4.75   4,671,997   $ 4.48
      $5.59-$11.97      4,936,983        7.11          8.54   2,564,896     8.03
     $12.00-$15.38      5,022,682        8.33         14.88   1,663,063    14.73
     $15.56-$25.78      2,900,622        8.60         21.57     789,073    21.75
     $26.16-$26.16      6,028,273        8.84         26.16   1,233,373    26.16
     $27.00-$33.88      4,520,230        9.52         28.80     807,537    30.99
     $34.81-$47.41      3,414,423        9.35         39.87      96,630    38.06
     $48.92-$48.92      5,591,648        9.54         48.92     532,431    48.92
     $49.21-$54.63      4,992,340        9.56         50.73     335,888    50.12
     $57.22-$67.75        861,500        9.48         64.03       3,739    60.24
                       ----------        ----        ------  ----------   ------
                       45,190,174        8.48        $26.96  12,698,627   $14.75
                       ==========        ====        ======  ==========   ======
</TABLE>

   At March 31, 2000, options to purchase 11,009,876 shares of Common Stock
were exercisable and unrestricted at a weighted average exercise price of
$6.63. At March 31, 1999, options to purchase 9,744,994 shares of Common Stock
were exercisable and unrestricted at a weighted average exercise price of
$5.83.

   Employee Stock Purchase Plans. During fiscal 1999, all remaining shares
previously approved by the stockholders for the "1994 Employee Stock Purchase
Plan" were issued. In July 1998, shareholders approved

                                      54
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001

the "1998 Employee Stock Purchase Plan" with an initial 4 million shares
reserved. Under both plans, substantially all employees may purchase Common
Stock through payroll deductions at a price equal to 85% of the lower of fair
values as of the date of the employee's entrance into the plan or the end of
each six-month purchase period. Employees may elect to have up to 10% of their
compensation withheld to purchase company stock, with a value not to exceed
$25,000 in any calendar year. During fiscal 2001, approximately
1,006,906 shares were issued under the plans.

   Stock based compensation. Pro forma information regarding net income (loss)
and earnings (loss) per share is required by SFAS 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 SFAS 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>
                                                       Year Ended March 31,
                                                   -----------------------------
                                                   Stock Options       ESPP
                                                   -------------- --------------
                                                   2001 2000 1999 2001 2000 1999
                                                   ---- ---- ---- ---- ---- ----
     <S>                                           <C>  <C>  <C>  <C>  <C>  <C>
     Expected life (in years)..................... 3.27 3.60 3.35 0.49 0.62 0.60
     Expected volatility.......................... 0.98 0.76 0.72 0.91 0.74 0.67
     Risk-free interest rate...................... 5.63 6.10 5.21 5.51 5.61 5.15
</TABLE>

   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 is as follows (in thousands, except
for per share amounts):

<TABLE>
<CAPTION>
                                                       Year Ended March 31,
                                                     --------------------------
                                                       2001      2000    1999
                                                     ---------  ------- -------
     <S>                                             <C>        <C>     <C>
     Net income (loss):
       As reported.................................. $  72,144  $85,314 $59,249
       Pro forma....................................  (147,460)  20,089  13,635
     Basic net income (loss) per share:
       As reported.................................. $    0.38  $  0.49 $  0.35
       Pro forma....................................     (0.78)    0.11    0.08
     Diluted net income (loss) per share:
       As reported.................................. $    0.35  $  0.45 $  0.32
       Pro forma....................................     (0.78)    0.11    0.07
</TABLE>

   The effects of applying SFAS 123 in this pro forma disclosure are not
indicative of future amounts. SFAS 123 does not apply to awards made prior to
1995. Additional awards in future years are anticipated.

   The weighted average fair value of options granted at market value during
fiscal 2001, 2000, and 1999 was $28.25, $12.02, and $3.88 per share,
respectively. The weighted average fair value of employee stock purchase
rights during fiscal 2001, 2000, and 1999 was $18.49, $5.20, and $2.41 per
share, respectively.

                                      55
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


10. Income Taxes

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

<TABLE>
<CAPTION>
                                                           March 31,
                                                   ----------------------------
                                                     2001      2000      1999
                                                   --------  --------  --------
     <S>                                           <C>       <C>       <C>
     Income before income taxes:
       United States.............................  $ 29,572  $ 68,072  $ 51,372
       Foreign...................................    83,612    52,923    33,270
                                                   --------  --------  --------
           Total.................................  $113,184  $120,995  $ 84,642
                                                   --------  --------  --------
     Provision for income taxes:
       Current:
         Federal.................................  $    184  $     --  $  1,469
         State...................................        52        56     3,120
         Foreign.................................    14,346     8,656     3,904
                                                   --------  --------  --------
           Total.................................  $ 14,582  $  8,712  $  8,493
                                                   --------  --------  --------
       Deferred:
         Federal.................................  $(34,552) $ (8,498) $(13,858)
         State...................................    (9,524)     (274)   (1,263)
                                                   --------  --------  --------
           Total.................................  $(44,076) $ (8,772) $(15,121)
                                                   --------  --------  --------
     Income tax benefits attributable to employee
      stock plan activity allocated to
      stockholders' equity.......................  $ 85,857  $ 36,825  $ 32,021
                                                   --------  --------  --------
       Total.....................................  $ 56,363  $ 36,765  $ 25,393
                                                   ========  ========  ========
</TABLE>

   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 (in thousands):

<TABLE>
<CAPTION>
                                                      Year Ended March 31,
                                                    --------------------------
                                                      2001     2000     1999
                                                    --------  -------  -------
     <S>                                            <C>       <C>      <C>
     Income tax provision at the federal statutory
      rate........................................  $ 39,614  $42,348  $29,625
     State income taxes, net of federal benefit...     6,343    4,781    5,502
     Tax benefit of net operating loss
      carryforwards...............................        --       --   (7,027)
     Tax benefit of research credit
      carryforwards...............................    (9,108)  (6,336)  (3,000)
     Nondeductible charges for acquired in-process
      research and development, and goodwill......     7,897    2,285       --
     Foreign taxes in excess of U.S. statutory
      rates.......................................     4,600      603    1,333
     Foreign earnings permanently reinvested in
      foreign operations..........................   (16,100)  (8,400)      --
     Nondeductible losses attributable to
      Catapulse Inc...............................    14,836    1,047       --
     Foreign losses not resulting in a U.S. tax
      benefit.....................................     4,121    1,077       --
     Change in valuation allowance................     3,245       --   (1,474)
     Other........................................       915     (640)     434
                                                    --------  -------  -------
       Total......................................  $ 56,363  $36,765  $25,393
                                                    ========  =======  =======
</TABLE>

                                      56
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


   Significant components of the Company's deferred tax assets are as follows
(in thousands):

<TABLE>
<CAPTION>
                                                                March 31,
                                                            -------------------
                                                              2001       2000
                                                            ---------  --------
     <S>                                                    <C>        <C>
     Deferred tax assets:
       Net operating loss carryforwards.................... $  24,593  $ 31,939
       Tax credit carryforwards............................    20,352    10,052
       Allowances, reserves, and accrued expenses..........    18,645    10,943
       Property and equipment..............................     2,331        --
       Intangibles and capitalized expenses................    76,280     6,699
       Other...............................................     2,365     1,466
                                                            ---------  --------
         Gross deferred tax assets.........................   144,566    61,099
         Less valuation allowance..........................   (27,009)   (8,517)
                                                            ---------  --------
         Total deferred tax assets.........................   117,557    52,582
                                                            ---------  --------
     Deferred tax liabilities:
       Unrealized investment gains.........................    (2,330)       --
       Unremitted earnings of foreign subsidiaries.........   (17,485)  (12,848)
       Acquired intangibles................................  (135,788)   (2,651)
       Property and equipment..............................        --    (1,408)
       Other...............................................    (3,127)       --
                                                            ---------  --------
         Total deferred tax liabilities....................  (158,730)  (16,907)
                                                            ---------  --------
     Net deferred tax assets (liabilities)................. $ (41,173) $ 35,675
                                                            =========  ========
</TABLE>

   The valuation allowance increased by $18.5 million and decreased by $2.6
million in 2001 and 2000, respectively. In 2001, the $18.5 million increase
was primarily attributable to capitalized research and development expenses.
In 2000, the $2.6 million decrease was primarily attributable to previously
unbenefited research and development tax credits.

   Net undistributed earnings of the foreign subsidiaries considered
permanently reinvested amounted to approximately $70.0 million at March 31,
2001. Accordingly, no provision for U.S. federal and state income taxes has
been provided thereon. Upon distribution of those earnings in the form of
dividends or otherwise, the Company would be subject to both U.S. income taxes
(subject to an adjustment for foreign tax credits) and withholding taxes
payable to the various foreign countries.

   SFAS No. 109 provides for the recognition of deferred tax assets if
realization of such assets is more likely than not. Based on the weight of
available evidence, the Company has provided a valuation allowance against the
future amortization of certain intangible assets. The Company will continue to
evaluate the realizability of the deferred tax assets on a quarterly basis.

   At March 31, 2001, the Company had net operating loss carryforwards for
federal income tax purposes of approximately $74.0 million that expire in 2002
through 2021. The Company also had tax credit carryforwards for federal and
state purposes of approximately $15.0 million and $5.0 million, respectively,
that expire in 2002 through 2021, if not utilized. As a result of various
public offerings and business combinations, the Company and some of its
acquired entities experienced an ownership change as defined in Section 382 of
the Internal Revenue Code. Due to the passing of time, the Company's net
operating loss carryforwards and tax credit carryforwards are no longer
subject to limitation.

                                      57
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


11. Segment Information

   The Company adopted SFAS 131 for the fiscal year ended March 31, 1999. The
Company's software products and related services are developed and marketed to
support heterogeneous environments in a broad customer base. Management uses
one measurement of profitability for its business within a single operating
segment. The Company markets its software products and related services in the
United States, Europe, and other parts of the world.

   Geographic revenues and long-lived asset information are as follows (in
thousands):

<TABLE>
<CAPTION>
                                                         Year Ended March 31,
                                                      --------------------------
                                                        2001     2000     1999
                                                      -------- -------- --------
     <S>                                              <C>      <C>      <C>
     Revenues:
       United States................................. $479,923 $339,116 $246,650
       Europe........................................  221,341  167,507  121,848
       Asia/Pacific..................................   79,110   45,906   26,207
       Other.........................................   34,561   19,661   17,111
                                                      -------- -------- --------
       Consolidated.................................. $814,935 $572,190 $411,816
                                                      ======== ======== ========
     Long-lived assets:
       United States................................. $255,800 $ 87,272 $ 60,178
       Europe........................................  123,781    6,816    6,117
       Asia/Pacific..................................    5,128    3,273    3,102
       Other.........................................   39,065   53,231      305
                                                      -------- -------- --------
       Consolidated.................................. $423,774 $150,592 $ 69,702
                                                      ======== ======== ========
</TABLE>

   "Other" represents Canada and Latin America regions. Export sales out of
the U.S. have been made primarily to customers in Europe, Australia, and
Canada and represent less than 10% of U.S. revenues in all periods.

12. Subsequent Events

   Stock repurchase program. In April 2001, the Company's Board of Directors
authorized the purchase of an additional 20 million shares of the Company's
Common Stock from time to time in the open market.

   Stock options. In April 2001, the Company's Board of Directors approved an
increase of the aggregate number of shares of Common Stock available for
issuance under the 1997 Supplemental Plan from 700,000 shares to 15.7 million
shares.

   Workforce reduction. In April 2001, the Company announced that it would
reduce its workforce by approximately 10 percent, or a total of approximately
400 positions affecting all parts of the organization. These actions will
result in an estimated charge to the quarter ended June 2001 of approximately
$15 million to $20 million, which includes severance and other employee-
related charges and write-offs of excess property and equipment.

                                      58
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2001


13. 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, 2001
(in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                                  Quarter Ended
                                    ------------------------------------------
                                    June 30  September 30 December 31 March 31
                                    -------- ------------ ----------- --------
     <S>                            <C>      <C>          <C>         <C>
     Fiscal 2001:
       Total revenues.............. $170,297   $187,501    $215,457   $241,680
       Gross margin................  145,633    158,625     182,698    205,935
       Operating income............   22,584     19,251      28,671      7,699
       Net income..................   19,361     19,689      26,533      6,561
       Net income per share--
        basic......................     0.11       0.11        0.14       0.03
       Net income per share--
        diluted....................     0.10       0.10        0.13       0.03

     Fiscal 2000:
       Total revenues.............. $117,423   $128,161    $146,187   $180,419
       Gross margin................   99,800    109,165     124,218    152,103
       Operating income............   17,823     24,396      31,855     34,064
       Net income..................   14,693     19,325      25,380     25,916
       Net income per share--
        basic......................     0.08       0.11        0.14       0.14
       Net income per share--
        diluted....................     0.08       0.10        0.13       0.13
</TABLE>

                                      59
<PAGE>

ITEM 9--CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
       FINANCIAL DISCLOSURE

   None.

                                   PART III

ITEM 10--DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

   The information required by Item 10 of Form 10-K with respect to our
directors is incorporated by reference from the information contained in the
section entitled "Election of Directors" in our proxy statement for the 2001
annual meeting of stockholders, a copy of which will be filed with the
Securities and Exchange Commission before the meeting date. The information
required by Item 10 with respect to compliance with Section 16(a) of the
Securities Exchange Act of 1934 is incorporated by reference from the
information contained in the section entitled "Section 16(a) Beneficial
Ownership Reporting Compliance" in our proxy statement for the 2001 annual
meeting of stockholders. For information with respect to our executive
officers, see the section entitled "Executive Officers" located in Part I of
this report.

ITEM 11--EXECUTIVE COMPENSATION

   The information required by Item 11 of Form 10-K is incorporated by
reference from the information contained in the sections entitled "Executive
Compensation," "Board Member Compensation," "Compensation Committee Interlocks
and Insider Participation," "Compensation Committee Report," and "Performance
Graph" in our proxy statement for the 2001 annual meeting of stockholders.

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

   The information required by Item 12 of Form 10-K is incorporated by
reference from the information contained in the section entitled "Beneficial
Ownership of Common Stock" in our proxy statement for the 2001 annual meeting
of stockholders.

ITEM 13--CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   The information required by Item 13 of Form 10-K is incorporated by
reference from the information contained in the section entitled "Certain
Relationships and Related Transactions" in our proxy statement for the 2001
annual meeting of stockholders.

                                    PART IV

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

(a) 1. FINANCIAL STATEMENTS

   See Item 8 of this report.

2. FINANCIAL STATEMENT SCHEDULES

   See Item 14(d) of this report.

                                      60
<PAGE>

3. EXHIBITS

<TABLE>
<CAPTION>
  Exhibit
    No.    Description of Exhibits
 --------- -----------------------
 <C>       <S>
  2.1(1)   Amended and Restated Agreement and Plan of Reorganization dated as
           of November 27, 2000, by and among the Registrant, Catapulse Inc.,
           and certain other parties.
  3.1(2)   Certificate of Incorporation of the Registrant, as amended.
  3.2(3)   Amendment to Certificate of Incorporation of the Registrant.
  3.3(4)   Bylaws of the Registrant, as amended.
  4.1      Reference is made to Exhibits 3.1, 3.2, and 3.3.
  4.2(5)   Specimen Common Stock Certificate.
  4.3(4)   Indenture by and between Registrant and State Street Bank and Trust
           Company of California, N.A., dated as of February 2, 2000, with
           respect to 5% Convertible Subordinated Notes due February 1, 2007.
  4.4(4)   Registration Rights Agreement of the Registrant, dated as of
           February 2, 2000, with respect to 5% Convertible Subordinated Notes
           due February 1, 2007.
  4.5(6)   Registration Rights Agreement by and among the Registrant and
           selling stockholders of Attol Testware.
 10.1(2)   *Relocation Agreement with David H. Bernstein.
 10.2(7)   *Form of Employment Agreement.
 10.3(7)   *Form of Employment Agreement with Registrant's Chief Executive
           Officer.
 10.4(7)   *Form of Stock Option Repricing Agreement.
 10.5(8)   *Form of Director and Officer Indemnification Agreement.
 10.6(9)   *Rational Software Corporation Stock Option Plan for Directors.
 10.7(10)  *Form of Stock Option Agreements for the Rational Software
           Corporation Stock Option Plan for Directors.
 10.8(11)  Agreement and Plan of Acquisition and Arrangement by and among the
           Registrant, Rational International, 3037936 Nova Scotia Company,
           1386501 Ontario Limited, 1386503 Ontario Limited, and ObjecTime
           Limited.
 10.9(12)  *1997 Stock Plan.
 10.10(13) *1998 Employee Stock Purchase Plan.
 10.11     *1998 Indian Stock Option Plan.
 10.12(14) *2000 Director Option Plan.
 10.13(15) *1997 Supplemental Stock Plan.
 10.14(1)  *Form of Restricted Stock and Lock-up Agreement by and between the
           Registrant and certain executive officers of the Registrant.
 10.15(16) *Bonus Agreement between the Registrant and Kevin J. Haar.
 10.16(16) *Relocation Loan Agreement between the Registrant and Kevin J. Haar.
 10.17(16) *Pledge Agreement between the Registrant and Kevin J. Haar.
</TABLE>


                                       61
<PAGE>

<TABLE>
<CAPTION>
 Exhibit
   No.   Description of Exhibits
 ------- -----------------------
 <C>     <S>
 10.18   *Relocation Agreement between the Registrant and David H. Bernstein.
 10.19   *Promissory Note between the Registrant and David H. Bernstein.
 10.20   *Stand-Alone Stock Option Agreement between the Registrant and Michael
         T. Devlin.
 10.21   *Security Agreement between the Registrant and Allison R. Schleicher.
 21.1    Subsidiaries of the Registrant.
 23.1    Consent of Ernst & Young LLP, independent auditors.
 24.1    Power of Attorney (contained on signature page of this report).
</TABLE>
--------
 (1) Incorporated by reference to the Registrant's registration statement on
     Form S-4 (File No. 333-51940) filed with the SEC on December 15, 2000, as
     amended on January 2, 2001.

 (2) Incorporated by reference to the Registrant's quarterly report on Form
     10-Q filed with the SEC on November 14, 1997.

 (3) Incorporated by reference to the Registrant's quarterly report on Form
     10-Q filed with the SEC on November 13, 2000.

 (4) Incorporated by reference to the Registrant's annual report on Form 10-K
     filed with the SEC on May 1, 2000.

 (5) Incorporated by reference to the Registrant's Amendment No. 1 to its Form
     S-3 registration statement (File No. 33-91740) filed with the SEC on May
     31, 1995.

 (6) Incorporated by reference to the Registrant's registration statement on
     Form S-3 filed with the SEC on April 10, 2001.

 (7) Incorporated by reference to the Registrant's annual report on Form 10-K
     filed with the SEC on June 1, 1998.

 (8) Incorporated by reference to the Registrant's registration statement on
     Form S-4 (File No. 333-19669) filed with the SEC on January 13, 1997, as
     amended on January 17, 1997.

 (9) Incorporated by reference to the Registrant's current report on Form 8-K
     filed with the SEC on October 2, 1996.

(10) Incorporated by reference to the Registrant's registration statement on
     Form S-8 (File No. 33-97042) filed with the SEC on September 18, 1995.

(11) Incorporated by reference to the Registrant's current report on Form 8-K
     filed with the SEC on January 21, 2000.

(12) Incorporated by reference to the Registrant's registration statement on
     Form S-8 filed with the SEC on October 15, 1999.

(13) Incorporated by reference to the Registrant's registration statement on
     Form S-8 filed with the SEC on January 22, 1999.

(14) Incorporated by reference to the Registrant's registration statement on
     Form S-8 filed with the SEC on November 13, 2000.

(15) Incorporated by reference to the Registrant's registration statement on
     Form S-8 filed with the SEC on May 14, 2001.

(16)  Incorporated by reference to the Registrant's current report on Form 10-
      Q filed with the SEC on January 30, 2001.

  *  Indicates those exhibits that are management contracts or compensatory
     plans or arrangements required to be filed as an exhibit to this form.

                                      62
<PAGE>

(b) REPORTS ON FORM 8-K

   On February 9, 2001, the Company filed Form 8-K, reporting under Item 2,
regarding the closing of the acquisition of all of the remaining outstanding
shares of Catapulse Inc. not already owned by Rational.

(c) EXHIBITS

   See Item 14(a)(3) of this report.

(d) FINANCIAL STATEMENT SCHEDULES

   The following financial statement schedule of the Company for each of the
years ended March 31, 2001, 2000, and 1999, 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.

                         RATIONAL SOFTWARE CORPORATION

                SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
                  Years Ended March 31, 2001, 2000, and 1999
                                (in thousands)

<TABLE>
<CAPTION>
                                       Balance at                       Balance
                                       Beginning                        at End
                                       of Period  Additions Deductions of Period
                                       ---------- --------- ---------- ---------
<S>                                    <C>        <C>       <C>        <C>
March 31, 2001
  Allowance for doubtful accounts.....   $3,259     $589      $(531)    $3,317
March 31, 2000
  Allowance for doubtful accounts.....   $3,226     $287      $(254)    $3,259
March 31, 1999
  Allowance for doubtful accounts.....   $3,638     $ --      $(412)    $3,226
</TABLE>

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

                                      63
<PAGE>

                                  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

<TABLE>
<S>                  <C>
Date: June 18, 2001           /s/ Timothy A. Brennan
                     ----------------------------------------
                                 Timothy A. Brennan,
                               Senior Vice President,
                       Chief Financial Officer, and Secretary
</TABLE>

                               POWER OF ATTORNEY

   KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Thomas F. Bogan and Timothy A. Brennan,
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:

<TABLE>
<CAPTION>
             Signature                           Title                    Date
             ---------                           -----                    ----

<S>                                  <C>                           <C>
         /s/ Paul D. Levy            Founder and Chairman of the     June 18, 2001
____________________________________ Board
             Paul D. Levy

      /s/ Michael T. Devlin          Founder, Chief Executive        June 18, 2001
____________________________________ Officer, and Director
          Michael T. Devlin

       /s/ Thomas F. Bogan           President and Chief             June 18, 2001
____________________________________ Operating Officer
           Thomas F. Bogan

      /s/ Timothy A. Brennan         Senior Vice President, Chief    June 18, 2001
____________________________________ Financial Officer, and
          Timothy A. Brennan          Secretary (principal
                                      financial officer and
                                      principal accounting
                                      officer)

       /s/ Leslie G. Denend          Director                        June 18, 2001
____________________________________
           Leslie G. Denend

       /s/ John E. Montague          Director                        June 18, 2001
____________________________________
           John E. Montague

    /s/ Allison R. Schleicher        Director                        June 18, 2001
____________________________________
        Allison R. Schleicher
</TABLE>

                                      64
<PAGE>

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
  Exhibit
    No.    Description of Exhibits
 --------- -----------------------
 <C>       <S>
  2.1(1)   Amended and Restated Agreement and Plan of Reorganization dated as
           of November 27, 2000, by and among the Registrant, Catapulse Inc.,
           and certain other parties.
  3.1(2)   Certificate of Incorporation of the Registrant, as amended.
  3.2(3)   Amendment to Certificate of Incorporation of the Registrant.
  3.3(4)   Bylaws of the Registrant, as amended.
  4.1      Reference is made to Exhibits 3.1, 3.2, and 3.3.
  4.2(5)   Specimen Common Stock Certificate.
  4.3(4)   Indenture by and between Registrant and State Street Bank and Trust
           Company of California, N.A., dated as of February 2, 2000, with
           respect to 5% Convertible Subordinated Notes due February 1, 2007.
  4.4(4)   Registration Rights Agreement of the Registrant, dated as of
           February 2, 2000, with respect to 5% Convertible Subordinated Notes
           due February 1, 2007.
  4.5(6)   Registration Rights Agreement by and among the Registrant and
           selling stockholders of Attol Testware.
 10.1(2)   *Relocation Agreement with David H. Bernstein.
 10.2(7)   *Form of Employment Agreement.
 10.3(7)   *Form of Employment Agreement with Registrant's Chief Executive
           Officer.
 10.4(7)   *Form of Stock Option Repricing Agreement.
 10.5(8)   *Form of Director and Officer Indemnification Agreement.
 10.6(9)   *Rational Software Corporation Stock Option Plan for Directors.
 10.7(10)  *Form of Stock Option Agreements for the Rational Software
           Corporation Stock Option Plan for Directors.
 10.8(11)  Agreement and Plan of Acquisition and Arrangement by and among the
           Registrant, Rational International, 3037936 Nova Scotia Company,
           1386501 Ontario Limited, 1386503 Ontario Limited, and ObjecTime
           Limited.
 10.9(12)  *1997 Stock Plan.
 10.10(13) *1998 Employee Stock Purchase Plan.
 10.11     *1998 Indian Stock Option Plan.
 10.12(14) *2000 Director Option Plan.
 10.13(15) *1997 Supplemental Stock Plan.
 10.14(1)  *Form of Restricted Stock and Lock-up Agreement by and between the
           Registrant and certain executive officers of the Registrant.
 10.15(16) *Bonus Agreement between the Registrant and Kevin J. Haar.
 10.16(16) *Relocation Loan Agreement between the Registrant and Kevin J. Haar.
 10.17(16) *Pledge Agreement between the Registrant and Kevin J. Haar.
</TABLE>


                                       65
<PAGE>

<TABLE>
<CAPTION>
 Exhibit
   No.   Description of Exhibits
 ------- -----------------------
 <C>     <S>
 10.18   *Relocation Agreement between the Registrant and David H. Bernstein.
 10.19   *Promissory Note between the Registrant and David H. Bernstein.
 10.20   *Stand-Alone Stock Option Agreement between the Registrant and Michael
         T. Devlin.
 10.21   *Security Agreement between the Registrant and Allison R. Schleicher.
 21.1    Subsidiaries of the Registrant.
 23.1    Consent of Ernst & Young LLP, independent auditors.
 24.1    Power of Attorney (contained on signature page of this report).
</TABLE>
--------
 (1) Incorporated by reference to the Registrant's registration statement on
     Form S-4 (File No. 333-51940) filed with the SEC on December 15, 2000, as
     amended on January 2, 2001.

 (2) Incorporated by reference to the Registrant's quarterly report on Form
     10-Q filed with the SEC on November 14, 1997.

 (3) Incorporated by reference to the Registrant's quarterly report on Form
     10-Q filed with the SEC on November 13, 2000.

 (4) Incorporated by reference to the Registrant's annual report on Form 10-K
     filed with the SEC on May 1, 2000.

 (5) Incorporated by reference to the Registrant's Amendment No. 1 to its Form
     S-3 registration statement (File No. 33-91740) filed with the SEC on May
     31, 1995.

 (6) Incorporated by reference to the Registrant's registration statement on
     Form S-3 filed with the SEC on April 10, 2001.

 (7) Incorporated by reference to the Registrant's annual report on Form 10-K
     filed with the SEC on June 1, 1998.

 (8) Incorporated by reference to the Registrant's registration statement on
     Form S-4 (File No. 333-19669) filed with the SEC on January 13, 1997, as
     amended on January 17, 1997.

 (9) Incorporated by reference to the Registrant's current report on Form 8-K
     filed with the SEC on October 2, 1996.

(10) Incorporated by reference to the Registrant's registration statement on
     Form S-8 (File No. 33-97042) filed with the SEC on September 18, 1995.

(11) Incorporated by reference to the Registrant's current report on Form 8-K
     filed with the SEC on January 21, 2000.

(12) Incorporated by reference to the Registrant's registration statement on
     Form S-8 filed with the SEC on October 15, 1999.

(13) Incorporated by reference to the Registrant's registration statement on
     Form S-8 filed with the SEC on January 22, 1999.

(14) Incorporated by reference to the Registrant's registration statement on
     Form S-8 filed with the SEC on November 13, 2000.

(15) Incorporated by reference to the Registrant's registration statement on
     Form S-8 filed with the SEC on May 14, 2001.

(16) Incorporated by reference to the Registrant's current report on Form 10-Q
     filed with the SEC on January 30, 2001.

  *  Indicates those exhibits that are management contracts or compensatory
     plans or arrangements required to be filed as an exhibit to this form.

                                      66