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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                               ---------------

                                   FORM 10-K

             ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934

                   For the Fiscal Year Ended March 31, 2000

           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. [X]

   At March 31, 2000, the aggregate market value of Registrant's voting stock
held by nonaffiliates was $6,877,726,380. For the purposes of the preceding
sentence only, "affiliates" is deemed to consist of executive officers and
directors. At March 31, 2000, there were 90,242,679 shares of the Registrant's
$0.01 par value Common Stock outstanding.

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

   Unless indicated otherwise, all financial information has been restated to
reflect Rational Software Corporation's acquisitions of SQA, Inc., and Pure
Atria Corporation, accounted for as poolings of interests.

   Certain sections of the Registrant's definitive Proxy Statement for the
2000 Annual Meeting of Stockholders to be held on July 20, 2000, 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 51
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   The statements contained in this Annual Report on Form 10-K include
forward-looking information within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended, and are subject to the safe harbor created by those
sections. Such forward-looking statements include without limitation
statements regarding product development plans and schedules, relationships
with strategic partners and other third parties, foreign currency
fluctuations, competition, market conditions, Catapulse operations and
results, year 2000 issues, future acquisitions, trends in overall revenues,
revenue mix, software development costs, tax rates, tax net operating loss
carryforwards, expenses, and other financial statement items. Rational's
actual future results could differ materially from those projected in the
forward-looking information. Factors that could cause actual results to differ
materially include, without limitation, those identified in "Factors That May
Affect Future Results" below.

                                    PART I

ITEM 1--BUSINESS

Overview

   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. Rational's 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 e-business, e-
infrastructure, and e-devices:

  .  e-business 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 Internet e-business
     customers include Charles Schwab & Co., E*Trade, i2 Technologies,
     Merrill Lynch, and Siebel Systems.

  .  e-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 e-infrastructure
     customers include America Online, Cisco, Ericsson, IBM, Lucent,
     Microsoft, and Sun Microsystems.

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

Industry Background

   The rapid growth of the Internet is driving the need for software and
increasing the importance of software development. Software plays a central
role in the development of e-commerce Web sites and related systems and is
embedded in physical devices on which the Internet is built including routers,
hubs, and switches, as well as everyday devices such as mobile phones, hand-
held computing devices, and kitchen appliances.

   The challenge many companies face is that the significant growth in the
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 Internet-centric, 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
"e-software 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 are comprised of
software professionals numbering in the millions and spanning

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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.

  .  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

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     relationship with the software development community as well as 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 ObjecTime extends our capabilities in real-time embedded
     systems development. 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 IBM, Microsoft, Intel, and Hewlett-
     Packard. 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. Rational satisfies 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.

 Rational Integrated Solutions

   Our products span the software development life cycle. Rational products
are available in individual editions that address the unique needs of specific
software engineering disciplines, such as project scheduling, system
definition, software development, content management, and system testing. In
addition, many Rational 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 Suites

   The Rational Suite 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.

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     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 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 PerformanceStudio provides an accurate prediction of an
     application's performance under load by enabling organizations to test
     their e-business, ERP, and client/server applications as their users
     will experience it. Designed for performance engineers and performance
     testers, Rational Suite PerformanceStudio integrates functional and
     system performance testing to deliver the information needed to make
     critical development, deployment, and resource planning decisions.

  .  Rational Suite Enterprise combines all of the tools of Rational Suite
     AnalystStudio, DevelopmentStudio, and TestStudio. Designed for project
     leaders and other practitioners who span multiple functional boundaries,
     Rational Suite Enterprise provides a complete software development
     solution in one easy-to-acquire package.

 Configuration and Change Management Solutions

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

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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 Unified
     Modeling Language (UML).

 Automated Testing Solutions

   Rational's 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, 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.

  .  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.

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 Technical Consulting and Customer Support Services

   Rational offers its customers the benefits of nearly 20 years of experience
in developing and applying tools and proven best practices for software
development. This experience is drawn from hundreds of Rational software
consultants working directly with customers, and from extensive internal use
of Rational tools. Rational's 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
Rational's solution.

   Rational and its partners offer a wide range of professional services.
These include tool and technology training delivered onsite or in public
classes, onsite implementation planning, software-engineering mentoring, and
architecture and process consulting. Rational also offers 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

   Rational works with numerous strategic partners for e-business, e-device,
and e-infrastructure platforms and applications. In this context, Rational
works with vendors such as Microsoft, IBM, Intel, Sun Microsystems,
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. Rational's relationship with Microsoft includes, among other
things, Rational providing certain visual modeling technology to Microsoft
that is included in Microsoft's Visual Studio Products.

   See "Factors That May Affect Future Results: We depend on strategic
relationships and business alliances for continued growth of our business."

 Product Development

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

   Rational's research and development staff, including product development,
product support, and technical writing personnel, consisted of 690 employees
as of March 31, 2000. Rational's total research and development expenses were
approximately $102.8 million, $71.9 million, and $61.6 million in fiscal years
2000, 1999, and 1998, respectively. As a result of our merger with Pure Atria,
accounted for as a pooling of interests, research and development costs are
presented on a combined basis for fiscal 1998.

 Customers and Applications

   More than 617,000 licenses of Rational's software products, exclusive of
Rational Visual Test, have been sold to more than 39,000 customers worldwide.
No single customer accounted for 10% or more of revenues in fiscal 2000.
Rational's comprehensive solution of software-development tools and
professional services is used by major organizations in many industry segments
to design, build, and maintain complex software systems.

 Sales and Marketing

   Rational markets and sells its products and services directly through its
field sales organizations, the World Wide Web, and indirectly through channels
such as value-added resellers (VARs) and distributors.

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

   Rational's sales, marketing, and professional services organization
consisted of 1,701 employees as of March 31, 2000. This organization operated
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. Rational's direct
international operations are staffed almost exclusively by local personnel.
Additionally, Rational also has distributors and resellers in the same
regions.

   In support of its sales efforts, Rational's marketing department conducts
comprehensive programs, which include:

  .  maintenance of an extensive World Wide Web site;

  .  an electronic subscription service for news announcements about
     Rational;

  .  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 its prospects and
     customers informed;

  .  creation of sales brochures, multi-media CD's, and technical papers;

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

  .  internal sales product training.

   International sales accounted for approximately 41%, 40%, and 34% of the
Company's revenues in fiscal 2000, 1999, and 1998, 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;

  .  difficulties in staffing and managing foreign operations;

  .  longer payment cycles;

  .  greater difficulty in accounts receivable collection;

  .  potentially adverse tax consequences;

  .  price controls or other restrictions on foreign currency;

  .  difficulties in obtaining export and import licenses.

   Any material adverse effect on our international business would be likely
to 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. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations:
Overview; Revenue; International Sales."

 Product Pricing

   Rational's 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

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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.

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

   See "Factors That May Affect Future Results: Promotional product versions
may adversely impact our actual product sales."

 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;

  .  quality of support and availability of technical consulting services;

  .  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.

   Rational faces competition from, among others, Aonix, Compaq, Computer
Associates, Compuware, Continuus Software Corporation, Cyrano, GEC-Marconi,
Green Hills Software, Hewlett-Packard, IBM, Merant, plc (formerly Intersolv,
Inc.), Mercury Interactive Corporation, Microsoft, Oracle, Mortice Kern
Systems (MKS), Perforce Software, Platinum Technology, Inc., Princeton
Softech, Inc., Segue Software, Inc., SGI, SQL Software LTD., StarBase
Corporation, Sun Microsystems, Sybase Inc., 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;

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  .  architecture-driven process;

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

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

   We believe that the increased level of competition we observed in fiscal
2000 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.

   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 March 31, 2000, our
employee base is as follows:

  .  product development and support, 690 employees

  .  sales, marketing, and technical consulting, 1,701 employees

  .  finance and administration, 324 employees

  .  total full-time personnel, 2,715 employees

                                      10
<PAGE>

                                  MANAGEMENT

   The following table sets forth certain information with respect to the
executive officers and directors of Rational 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
Timothy A. Brennan...... Senior Vice President, Chief Financial Officer, and Secretary
James P. Cluchey........ Senior Vice President, International Field Operations
Kevin J. Haar........... Senior Vice President, Worldwide Field Operations
Dean Leffingwell........ Senior Vice President, Process and Project Management Products
John R. Lovitt.......... Senior Vice President, Professional Services
Joseph N. Marasco....... Senior Vice President and General Manager
James McGee............. Senior Vice President and General Manager, Modeling and Developer Products
Eric L. Schurr.......... Senior Vice President and General Manager, Marketing and Suite Products
</TABLE>

   Mr. Levy, age 44, cofounded Rational in 1981 and is currently Chairman of
the Board. Before April 1999, Mr. Levy also served as Chief Executive Officer
of Rational. Mr. Levy currently serves as a director of Broadbase
Software Inc.

   Mr. Devlin, age 45, cofounded Rational in 1981 and is currently Chief
Executive Officer and Director. Before September 1996, Mr. Devlin served as
Chairman of the Board of Rational.

   Mr. Bogan, age 48, was named Rational's President and Chief Operating
Officer in April 2000. From April 1999 until April 2000, Mr. Bogan served as
Senior Vice President and Chief Operating Officer. From 1997 to 1999 he served
as Vice President and General Manager, Automated Test. From July 1996 until
February 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 48, 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 as Senior
Vice President and General Manager, Object Technology Products.

   Mr. Brennan, age 44, 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 to 1995, he served as the Company's Controller.

   Mr. Cluchey, age 52, currently serves as Senior Vice President,
International Field Operations. From 1997 to 1999 he served as Vice President,
International Field Operations. From 1995 to February 1997, Mr. Cluchey served
as Vice President and Managing Director of European Operations of SQA, Inc.

   Mr. Haar, age 43, joined the Company in 1986 and currently serves as Senior
Vice President, Worldwide Field Operations. Prior to April 2000, he held
various management positions with the Company, most recently Senior Vice
President, The Americas Field Operations.

   Mr. Leffingwell, age 50, was named Senior Vice President, Process and
Project Management Product in 1999. In 1998, he served as Vice President and
General Manager, Rational University. From 1997 to 1998 he served as Vice
President and General Manager, Requirements Management Business Unit. Prior to
joining Rational, he served as Chief Executive Officer of Requisite, Inc.,
which he cofounded in 1994.

                                      11
<PAGE>

   Mr. Lovitt, age 55, joined the Company in 1986 and currently serves as
Senior Vice President, Professional Services. From 1996 to 1999 he served as
Senior Vice President, Worldwide Field Operations. From 1990 to 1996
Mr. Lovitt served as Vice President, and subsequently Senior Vice President,
North American Field Operations.

   Mr. Marasco, age 54, joined the Company in 1986 and has served as Senior
Vice President and General Manager since 1999. Prior to this, he held various
management positions with the Company, most recently as Senior Vice President,
Operations.

   Mr. McGee, age 48, joined Rational as Senior Vice President and General
Manager, Modeling and Developer Products, in January 2000 when Rational
acquired ObjecTime Ltd. Prior to joining Rational, he served as the President
and Chief Executive Officer of ObjecTime Limited, and had been one of its
founders in 1992.

   Mr. Schurr, age 42, currently serves as Senior Vice President and General
Manager, Marketing and Suite Products. During 1998 he served as Senior Vice
President, Marketing and Windows Suite Products. From 1997 to 1998 Mr. Schurr
served as Vice President, Product Marketing Commercial IS Products. From 1994
to February 1997, Mr. Schurr served as Vice President, Product Management and
Marketing of SQA.

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 price of our Common Stock.

   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, our stock price is likely to decline.

   Factors that may cause quarterly fluctuations in our operating results
include:

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

  .  difficulty predicting the size and timing of customer orders;

  .  long sales cycles;

  .  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;

  .  fluctuations in foreign currency exchange rates;

  .  costs associated with acquisitions; and

  .  global economic conditions.


                                      12
<PAGE>

   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.

   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 price of our Common Stock could decline significantly.

 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 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 is a recent and emerging phenomenon. 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.

                                      13
<PAGE>

 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 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.

 The recent formation of Catapulse, a new Internet company, by our founders
 could divert the attention of our management away from our business and
 affairs, creating potential conflicts of interest.

   On December 3, 1999, we closed a $50,000,000 investment in the Series A
Preferred Stock of Catapulse, founded by Paul Levy and Mike Devlin. As of
March 31, 2000, after taking into account additional investments by third
parties in Catapulse, our Series A Preferred Stock represented approximately
40% of the voting power of the outstanding capital stock of this entity. Paul
Levy serves as its Chief Executive Officer and Mike Devlin serves as the Vice-
Chairman of the board of directors. Catapulse's board of directors is made up
of five directors. Rational has the right to designate two of the members of
its board of directors. As of the date hereof, four of its directors also
serve on our board of directors. Paul Levy and Mike Devlin will continue in
their roles as our Chairman of the Board and Chief Executive Officer,
respectively. Catapulse is a business-to-business application service provider
that will focus on developing a portal to meet the needs of the global
community of software professionals. Catapulse also intends to develop an
electronic marketplace for products and services relating to software
development and intends to develop and deploy a hosted development service for
Internet software development. Rational and Catapulse intend to enter into a
strategic business relationship on terms negotiated at arms-length. This
strategic relationship could give rise to conflicts of interest involving the
two companies and the founders in the future. In addition, Catapulse could
divert the attention of Paul Levy and Mike Devlin away from the business and
affairs of Rational.

 If we are unable to manage our growth, 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.

                                      14
<PAGE>

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

   International sales accounted for approximately 41% of our revenues in
fiscal 2000, 40% in 1999, and 34% in 1998. 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;

  .  greater difficulty in accounts receivable collection;

  .  potentially adverse tax consequences;

  .  price controls or other restrictions on foreign currency;

  .  difficulties in obtaining export and import licenses;

  .  costs of localizing products for 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.

 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

                                      15
<PAGE>

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. Merger activities can be
accompanied or followed by the departure of key personnel, which can compound
the difficulty of integrating the operations of the parties to the business
combination.

 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 acquisition of
ObjecTime Ltd., may disrupt these relationships or activities, and some
companies may reassess the value of their relationship with us as a result of
this merger activity. Divergence in strategy or change in focus by 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.

   Software products as complex as those sold by us 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 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.

                                      16
<PAGE>

   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.

 Year 2000 issues could negatively affect our business.

   Although to date we have not experienced any material problems attributable
to the year 2000 problem with respect to our software products and internal
systems, it is possible that our current products could contain undetected
errors or defects associated with year 2000 date functions that may result in
material costs or liabilities to us in the future. Moreover, our software
directly and indirectly interacts with a large number of third-party hardware
and software systems, each of which may contain or introduce undetected errors
or defects. We are unable to predict to what extent our business may be
affected if our software or the systems that operate in conjunction with our
software experience a material year 2000 related failure. Any year 2000 defect
in our products or the software and hardware systems with which our products
operate, as well as any year 2000 errors caused by older non-current products
that were not upgraded by our customers, could expose us to litigation that
could require us to incur significant costs in defending the litigation or
expose us to the risk of significant damages. The risks of this litigation may
be particularly acute due to the mission-critical applications for which our
products are used.

 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 or other
higher-priced product 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.

                                      17
<PAGE>

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

   We have acquired a number of businesses, technologies, and products, most
recently in January 2000. If we fail to achieve the intended financial or
strategic benefits of past and future acquisitions, 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.

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

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

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

                                      18
<PAGE>

ITEM 2--PROPERTIES

   Rational's headquarters are located in a leased facility, in Cupertino,
California, consisting of approximately 101,000 square feet of office space
occupied under a lease expiring in January 2007. Rational also leases
approximately 95,000 square feet of office space in Santa Clara, California,
under a lease expiring in January 2001, with a renewal option for an
additional five years, and approximately 178,000 square feet of office space
in Lexington, Massachusetts, under a multiple leases expiring through December
2004. The Company has additional field sales and software development offices
in the Americas, Europe, and Asia/Pacific regions.

ITEM 3--LEGAL PROCEEDINGS

   The following actions have been filed against the Company, officer Paul D.
Levy, Cowen & Company and an individual Cowen employee, analyst Rehan Syed.
The action, In re Rational Software Securities Litigation, No. 21001-JF (N.D.
Cal. May 26, 1998) is a consolidated action supplanting prior complaints filed
against defendants. The actions are putative shareholder class action
lawsuits. The complaint alleges that defendants violated Sections 10(b) and
20A of the Securities Exchange Act of 1934 through the selective disclosure of
material inside information regarding the Company's prospects and seek damages
on behalf of a class of shareholders who purchased the Company's Common Stock
on October 8, 1997. Plaintiffs have dismissed the Complaint as against the
Company and Mr. Levy.

   In December 1996, the Company filed suit against Silicon Graphics, Inc.
("SGI") seeking to recover royalties due to the Company under a license
agreement between SGI and the Company's predecessor in interest, Verdix
Corporation. SGI answered the complaint, denying any liability, and filed a
cross complaint seeking unspecified damages for alleged violations of the same
license agreement. Effective August 12, 1999, the Company and SGI entered an
agreement under which this litigation was settled in its entirety. The terms
of this agreement are confidential. The arrangement, however, will not have
any material impact on the Company's financial statements.

   Any adverse outcome to these or future lawsuits against the Company may
result in a material adverse effect on the Company's financial condition.

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

   Not applicable.

                                      19
<PAGE>

                                    PART II

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

   The Company's Common Stock is traded on the NASDAQ national market under
the symbol RATL. As of March 31, 2000, there were approximately 1,047
stockholders of record of the Company's Common Stock. The Company has not,
since its formation, declared or paid any cash dividends on its Common Stock.
The Company intends to employ all available funds for the development of its
business and, accordingly, does not intend to declare or pay any cash
dividends in the foreseeable future.

   The following table sets forth the range of high and low bids for the
Company's Common Stock as quoted on the NASDAQ national market for Rational
Common Stock for the periods indicated:

<TABLE>
<CAPTION>
                                                                  High    Low
                                                                 ------- ------
   <S>                                                           <C>     <C>
   Fiscal year ended March 31, 2000:
   Fourth Quarter............................................... $105.00 $42.31
   Third Quarter................................................   53.69  27.88
   Second Quarter...............................................   40.00  26.38
   First Quarter................................................   37.50  21.88

   Fiscal year ended March 31, 1999:
   Fourth Quarter............................................... $ 35.63 $22.88
   Third Quarter................................................   27.36  10.88
   Second Quarter...............................................   18.94  10.50
   First Quarter................................................   18.13  12.25
</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,
                             -------------------------------------------------
                                2000      1999      1998      1997      1996
                             ---------- --------  --------  --------  --------
                                 (in thousands, except per share data)
<S>                          <C>        <C>       <C>       <C>       <C>
Consolidated Statements of
 Operations Data:
Net product revenues.......  $  354,497 $259,335  $184,953  $185,133  $126,876
Consulting and support
 revenues..................     217,693  152,481   125,717    92,735    61,261
                             ---------- --------  --------  --------  --------
    Total revenues.........     572,190  411,816   310,670   277,868   188,137
Cost of product revenues...      27,297   22,020    19,709    11,777     9,735
Cost of consulting and
 support revenues..........      59,607   40,848    43,356    38,305    26,779
                             ---------- --------  --------  --------  --------
    Total cost of
     revenues..............      86,904   62,868    63,065    50,082    36,514
                             ---------- --------  --------  --------  --------
Gross margin...............     485,286  348,948   247,605   227,786   151,623
Operating expenses:
  Research and
   development.............     102,846   71,869    61,560    47,239    33,773
  Sales and marketing......     220,529  172,448   138,709   108,403    80,063
  General and
   administrative..........      50,244   33,910    29,092    27,267    19,481
  Charges for acquired in-
   process research and
   development.............       3,529       --        --    56,798    20,300
  Merger and integration
   costs...................          --   (1,200)   63,759    42,456     2,961
                             ---------- --------  --------  --------  --------
    Total operating
     expenses..............     377,148  277,027   293,120   282,163   156,578
                             ---------- --------  --------  --------  --------
Operating income (loss)....     108,138   71,921   (45,515)  (54,377)   (4,955)
Other income, net..........      12,857   12,721    16,689    11,586     4,234
                             ---------- --------  --------  --------  --------
Income (loss) from
 continuing operations
 before income taxes.......     120,995   84,642   (28,826)  (42,791)     (721)
Provision for income
 taxes.....................      36,765   25,393     9,447     6,820     7,115
Minority interest..........       1,084       --        --        --        --
                             ---------- --------  --------  --------  --------
    Net income (loss)......  $   85,314 $ 59,249  $(38,273) $(49,611) $ (7,836)
                             ========== ========  ========  ========  ========
Net income (loss) per
 common share (pro forma
 for fiscal 1996):
  Basic....................  $     0.97 $   0.69  $  (0.44) $  (0.62) $  (0.11)
  Diluted..................  $     0.89 $   0.65  $  (0.44) $  (0.62) $  (0.11)
Shares used in computing
 per share amounts:
  Basic....................      87,729   85,697    87,575    79,631    69,778
  Diluted..................      95,637   91,849    87,575    79,631    69,778
Consolidated Balance Sheet
 Data:
Cash, cash equivalents, and
 short-term investments....  $  906,311 $259,830  $289,470  $327,395  $167,623
Working capital............     831,858  228,366   228,397   282,974   145,383
Total assets...............   1,225,776  453,956   445,205   456,740   236,213
Long-term obligations......     501,668    3,696     6,492     3,192     2,189
Stockholders' equity.......     456,307  294,372   287,176   330,109   162,482
</TABLE>

                                       21
<PAGE>

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

   The statements contained in "Management's Discussion and Analysis of
Financial Condition and Results of Operations" include forward-looking
information within the meaning of Section 27A of the Securities Act of 1933,
as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended, and are subject to the safe harbor created by those sections. Such
forward-looking statements include without limitation statements regarding
trends in overall revenues, revenue mix, software development costs, tax
rates, tax net operating loss carryforwards, and liquidity and capital
resources. Rational's actual future results could differ materially from those
projected in the forward-looking information. Factors that could cause actual
results to differ materially include, without limitation, those identified in
"Factors That May Affect Future Results." Rational assumes no obligation to
update the forward-looking information or such factors.

Overview

 General

   Rational's 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, Rational 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 and
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. Rational's 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%, 40%, and 34% of Rational's revenues
in fiscal 2000, 1999, and 1998, respectively. Rational expects that
international sales will continue to account for a significant portion of
Rational's revenues in future periods. See "Factors That May Affect Future
Results: Our international operations expose us to greater management,
collections, currency, intellectual property, regulatory, and other risks."

   In the fiscal year ended March 31, 2000, Rational's revenues from product
sales grew 37% while revenues from consulting and support grew 43%, resulting
in a net overall increase in revenues of 39%. There can be no assurance that
this revenue mix trend will continue in future periods. See "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 price of our
Common Stock and the Notes; If market acceptance of our sophisticated software
development tools fails to grow adequately, our business may suffer; If we do
not develop and enhance new and existing products to keep pace with
technological, market, and industry changes, our revenues may decline."

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

   As a result of the Company's acquisition of Pure Atria Corporation in July
1997, accounted for as a pooling of interests, the information herein and the
accompanying consolidated financial statements and selected financial data are
presented on a combined basis for fiscal 1998 and all applicable periods, as
described in more detail below.

                                      22
<PAGE>

 Acquisitions

   The Company completed a business combination, accounted for as a pooling of
interests, with Pure Atria Corporation in July 1997. Additionally, the Company
completed a business combination, accounted for as a purchase, with ObjecTime,
Limited, in January, 2000. See Note 3 of Notes to Consolidated Financial
Statements for details of these combinations. See "Factors That May Affect
Future Results: If we cannot successfully integrate our past and future
acquisitions and achieve intended financial or strategic benefits, our
revenues may decline and our expenses increase."

Results of Operations

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

<TABLE>
<CAPTION>
                                                              Fiscal Year
                                                                 Ended
                                                               March 31,
                                                             ----------------
                                                             2000  1999  1998
                                                             ----  ----  ----
   <S>                                                       <C>   <C>   <C>
   Net product revenues.....................................  62%   63%   60%
   Consulting and support revenues..........................  38    37    40
                                                             ---   ---   ---
       Total revenues....................................... 100   100   100
   Cost of product revenues.................................   5     5     6
   Cost of consulting and support revenues..................  10    10    14
                                                             ---   ---   ---
       Total cost of revenues...............................  15    15    20
                                                             ---   ---   ---
   Gross margin.............................................  85    85    80
   Operating expenses:
     Research and development...............................  18    18    20
     Sales and marketing....................................  38    42    45
     General and administrative.............................   9     8     9
     Charges for acquired in-process research and
      development...........................................   1    --    --
     Merger and integration costs...........................  --    --    20
                                                             ---   ---   ---
       Total operating expenses.............................  66    68    94
                                                             ---   ---   ---
   Income (loss) from continuing operations.................  19    17   (14)
   Other income, net........................................   2     3     5
                                                             ---   ---   ---
   Income (loss) before provision for income taxes..........  21    20    (9)
   Provision for income taxes...............................   6     6     3
                                                             ---   ---   ---
       Net income (loss)....................................  15%   14%  (12)%
                                                             ===   ===   ===
</TABLE>

   See "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 price of our Common Stock and the Notes."

 Fiscal Years Ended March 31, 2000, 1999, and 1998

  Revenues

   Total revenues increased 39% in fiscal 2000 compared with fiscal 1999 and
33% in fiscal 1999 compared with fiscal 1998.

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

                                      23
<PAGE>

continued strong customer acceptance of the Company's 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 the Company's
products. Net product revenues increased $74 million or 40% in fiscal 1999
compared with fiscal 1998. This increase is a result of continued strong
customer acceptance of the Company's existing products, including products for
requirements management, modeling, testing, change and configuration
management, the introduction of the Rational Suite family of products, and the
year-to-year increase in sales capacity. See "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 price of our Common Stock and
the Notes; If market acceptance of our sophisticated software development
tools fails to grow adequately, our business may suffer; If we do not develop
and enhance new and existing products to keep pace with technological, market,
and industry changes, our revenues may decline; If we do not effectively
compete with new and existing competitors, our revenues and operating margins
will decline; If we cannot successfully integrate our past and future
acquisitions and achieve intended financial or strategic benefits, our
revenues may decline and our expenses increase; Promotional product versions
may adversely impact our actual product sales."

   Consulting and support revenues. Consulting and support revenues increased
$65.2 million or 43% in fiscal 2000 compared with fiscal 1999 and $27 million
or 21% in fiscal 1999 compared with fiscal 1998. These increases reflected
increased revenues related to maintenance contracts, higher demand for
Rational's consulting expertise in advanced software development practices
and, to a lesser extent, increased training and customer-support revenues. See
"Factors That May Affect Future Results: If we fail to maintain and expand our
distribution channels, our business will suffer."

   International sales. During fiscal 2000, 1999, and 1998, international
revenues from product sales and related consulting and customer support were
$233.0 million, $165.2 million, and $106.9 million, representing 41%, 40%, and
34% of total revenues, respectively. The growth in international sales during
2000 was due principally to increased sales and marketing activities in
international markets. The Company's international sales are principally
priced in local currencies. The Company enters 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 the Company or its subsidiaries.
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 the Company's results of operations in any period
presented. See "Factors That May Affect Future Results: Our international
operations expose us to greater management, collections, currency,
intellectual property, regulatory, and other risks; We are subject to risks
associated with the European monetary conversion; 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."

  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 and 12% in fiscal 1999 compared with fiscal 1998. These costs
represented 8%, 8%, and 11% of net product revenues in fiscal 2000, 1999, and
1998, respectively. 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. In fiscal 1999, the decrease in product cost as a
percentage of product revenues was due primarily to better economies of scale
on materials and packaging and freight with respect to certain products as a
result of increased volume.

   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 and decreased 6% in fiscal 1999 compared
with fiscal 1998. These costs represented 27%, 27%, and 34% of consulting and
support revenues in fiscal 2000, 1999, and 1998,

                                      24
<PAGE>

respectively. In fiscal 2000, the increase in cost is primarily due to
increased headcount commensurate to the demand of growing support activities.
In fiscal 1999, the decrease in cost and cost as a percentage of related
revenues is primarily due to changes to the Company's customer support
business model as a result of combining the Pure Atria and Rational service
organizations following the fiscal 1998 merger, combined with the impact of a
relatively fixed support cost base servicing increased revenues. Additionally,
the cost decreases as a percentage of consulting and support revenues resulted
from an overall higher mix of customer support services, which generally have
a higher gross margin than consulting services.

  Operating Expenses

   Research and development. Total expenditures for research and development
increased 43% in fiscal 2000 compared with fiscal 1999 and 17% in fiscal 1999
compared with fiscal 1998. Research and development costs represented 18%,
18%, and 20% of total revenues in fiscal 2000, 1999, and 1998, respectively.
The increases in fiscal 2000 as compared with fiscal 1999, and in fiscal 1999
as compared with fiscal 1998, were 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 include
$4.2 million of costs incurred by Catapulse, the recently formed Internet
venture in which Rational invested $50.0 million in December, 1999. See
"Factors That May Affect Future Results: 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; 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 recent formation
of Catapulse, a new Internet company, by our founders could divert the
attention of our management away from our business and affairs and create
potential conflicts of interest."

   Rational did not capitalize any software development costs in fiscal 2000,
1999, and 1998 because eligible costs were not material. Rational expects that
the amount of software development costs capitalized in future periods will be
immaterial to Rational's results of operations and financial position because
the time period and the engineering effort required between demonstration of a
product's economic and technological feasibility and the date of product
release has been very short. See "Factors That May Affect Future Results: 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; If
we fail to maintain and expand our distribution channels, our business will
suffer."

   Sales and marketing. Sales and marketing expenses increased 28% in fiscal
2000 compared with fiscal 1999 and 24% in fiscal 1999 compared with fiscal
1998. These expenses represented 38%, 42%, and 45% of total revenues in fiscal
2000, 1999, and 1998, respectively. The fiscal 2000 and 1999 increases in
sales and marketing expenses reflect the additional personnel, commissions,
and related costs required in sales and marketing departments to expand
Rational's sales channels, to penetrate new markets, and to increase its
market share in core markets. The fiscal 2000 and 1999 decreases in sales and
marketing expenses as a percentage of total revenues reflect improved
economies of scale. See "Factors That May Affect Future Results: If we fail to
maintain and expand our distribution channels, our business will suffer."

   General and administrative. General and administrative expenses increased
48% in fiscal 2000 compared with fiscal 1999 and 17% in fiscal 1999 compared
with fiscal 1998. General and administrative expenses represented 9%, 8%, and
9% of total revenues in fiscal 2000, 1999, and 1998, respectively. The fiscal
2000 increase in general and administrative expenses resulted from increased
employee-related expenses associated with staffing requirements needed to
support the Company's expanding business as well as additional amortization of
goodwill associated with the January 2000 acquisition of ObjecTime Limited.
See "Factors That May Affect Future Results: If we are unable to manage our
growth, our business will suffer; 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."

   Charges for acquired in-process research and development. In-process
research and development represents the present value of the estimated cash
flow expected to be generated by acquired technology that at the acquisition
date has not yet reached the point of technological feasibility and does not
have an alternative

                                      25
<PAGE>

future use. In fiscal 2000, write-offs associated with acquired in-process
research and development included $3.5 million related to the acquisition of
ObjecTime Limited. See "Factors That May Affect Future Results: If we cannot
successfully integrate our past and future acquisitions and achieve intended
financial or strategic benefits, our revenues may decline and our expenses
increase."

   Merger and integration costs. In fiscal 1999, the Company substantially
completed certain elements of the organizational integrations following the
July 1997 Pure Atria merger. This consisted primarily of exiting certain
nonstrategic 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.
In fiscal 1998, merger-related expenses of $63.8 million were recorded related
to the merger of Rational and Pure Atria to accrue transaction costs,
severance costs associated with employee terminations, costs associated with
conforming employee benefits plans, charges associated with the closure of
duplicate facilities, and asset writedowns related to duplicate business
systems. The actions related to severance and administrative costs are
substantially complete. See "Factors That May Affect Future Results: If we are
unable to manage our growth, our business will suffer; If we cannot
successfully integrate our past and future acquisitions and achieve intended
financial or strategic benefits, our revenues may decline and our expenses
increase."

Interest Expense

   The increase in interest expense in fiscal 2000 is a result of the
Convertible Subordinated Notes which the Company sold and began incurring
interest expense for in last quarter of fiscal 2000. Interest expense incurred
in fiscal 1999 and 1998 relates to interest on capital leases which have since
expired.

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 $4.2 million to $17.0 million in fiscal 2000 and decreased $4
million to $12.8 million in fiscal 1999. The increase in other income in
fiscal 2000 is 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, Inc., 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. The decrease in
fiscal 1999 is due primarily to a lower average amount of invested cash
resulting from repurchase of Company Common Stock and to declining interest
rates. See "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 price of our Common Stock."

Income Taxes

   The income tax provisions for fiscal 2000, 1999, and 1998 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. The Company's
effective tax rate is expected to increase to 30% in fiscal 2001.

   Net undistributed earnings of the foreign subsidiaries considered
permanently reinvested amounted to approximately $24 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, the

                                      26
<PAGE>

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.

   As of March 31, 2000, Rational had net operating loss carryforwards for
federal income tax purposes of approximately $83 million that expire in years
2001 through 2020. The Company 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, 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.

   Under Statement of Financial Accounting Standards No. 109 (FAS 109),
deferred tax assets and liabilities are determined based on differences
between financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse. FAS 109 provides for the recognition of
deferred tax assets if realization of such assets is more likely than not.
Based on the weight of available evidence, the Company has provided a
valuation allowance against certain foreign tax credit carryforwards and the
future amortization of certain intangible assets. The Company will continue to
evaluate the realizability of the deferred tax assets on a quarterly basis.

Minority Interest

   In fiscal 2000 the Company's subsidiary, Catapulse, Inc., incurred $4.2
million of research and development costs and earned $1.2 million of interest
income on cash balances. Minority interest, net of tax, for fiscal 2000 was
$1.1 million.

Liquidity and Capital Resources at March 31, 2000

   As of March 31, 2000, Rational had cash, cash equivalents, and short-term
investments of $906 million and working capital of $832 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 in-process research and development,
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. Total cash, cash equivalents,
and short-term investments for the period ended March 31, 1999, was $260
million and working capital was $228 million. Net cash provided by operating
activities for the period ended March 31, 1999, was composed primarily of net
income plus noncash charges for depreciation and amortization, tax benefits
from employee stock plans, increases in income taxes payable and deferred
revenues, and a decrease in noncash merger and integration liabilities. These
were offset primarily by a decrease in accrued merger and integration expenses
and increases in accounts receivable, deferred tax assets, and prepaid
expenses.

   Net cash used in investing activities resulted primarily from net purchases
and maturities and sales of short-term investments of $293 million in fiscal
2000, $36.6 million in fiscal 1999, and $80.7 million in fiscal 1998 and
expenditures for fixed assets and net changes in other assets of $44.2 million
in fiscal 2000, $23.2 million in fiscal 1999, and $38.6 million in fiscal
1998. Net cash used for business and product acquisitions totaled
$13.2 million in fiscal 2000 and $15.5 million in 1998 (see Notes 3 and 4 of
Notes to Consolidated Financial Statements).

   Net cash provided in 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, Inc. of
$24.5 million. This is 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 million used to
decrease long-term debt, offset by $36 million received from issuance of
Common Stock under the employee stock plans.

                                      27
<PAGE>

   In April 1998, the Board of Directors authorized the Company to repurchase
up to 6 million shares of its Common Stock in the open market to be used for
general corporate purposes. The Company completed that repurchase program
during the September 1998 quarter. In October 1998, the Board of Directors
authorized the Company to repurchase an additional 6 million shares of its
Common Stock in the open market to be used for general corporate purposes.
Through March 31, 2000, the Company had repurchased a total of 2.1 million
shares of its Common Stock, including repurchases authorized in April 1998 and
October 1998, for a total cash outlay of approximately $61.4 million.
Repurchases helped offset dilution from stock issued under the company's stock
option and stock purchase plans.

   The Company believes that expected cash flow from operations combined with
existing cash, cash equivalents, and short-term investments will be sufficient
to meet its cash requirements for the foreseeable future. See "Factors That
May Affect Future Results: 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 price
of our Common Stock; If we cannot successfully integrate our past and future
acquisitions and achieve intended financial or strategic benefits, our
revenues may decline and our expenses increase."

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

   The Company is exposed to market risk, including changes in interest rates
and currency exchange rates. To manage the volatility relating to these
exposures, the Company employs established policies and procedures to manage
its exposure to fluctuations in interest rates and changes in known or
forecasted currency exchange rates.

Foreign Currency Risk

   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 with realized and unrealized gains or losses
recognized in the period in which they are incurred. Such contracts meet the
criteria established in FAS 52 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.

   At March 31, 2000 and 1999, 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 amounts
(U.S. dollar equivalent) of $47.1 million and $34.3 million, respectively. The
net gains and losses associated with all forward exchange contracts in fiscal
2000, 1999, and 1998 are not material to the Company's results of operations.

Interest Rate Risk

   The Company's exposure to market rate risk for changes in interest rates
relates primarily to the Company's investment portfolio. All the Company's
cash equivalents and 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, 2000 and 1999. Unrecognized gains and losses and
declines in value judged to be other than temporary on available-for-sale
securities are included in other 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,
2000 and 1999. There were no significant unrealized holding gains or losses on
such

                                      28
<PAGE>

securities at March 31, 2000 and 1999. 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, 2000:

<TABLE>
<CAPTION>
                           2000      2001      2002    2003 2004 Thereafter  Total    Fair value
                         --------  --------  --------  ---- ---- ---------- --------  ----------
<S>                      <C>       <C>       <C>       <C>  <C>  <C>        <C>       <C>
Cash equivalents
  Fixed rate............ $163,108        --        --   --   --         --  $163,108   $163,108
  Average rate..........     5.89%       --        --   --   --         --      5.89%
  Variable rate......... $157,621        --        --   --   --         --  $157,621   $157,621
  Average rate..........     5.06%       --        --   --   --         --      5.06%
Short term investments
  Fixed rate............ $ 90,765  $244,555  $104,284   --   --         --  $439,604   $439,604
  Average rate..........     5.96%     5.88%     6.80%  --   --         --      6.11%
  Auction rate preferrds
  Fixed rate............ $ 53,566        --        --   --   --         --  $ 53,566   $ 53,566
  Average rate..........     5.83%       --        --   --   --         --      5.83%
                         --------  --------  --------  ---  ---   --------  --------   --------
Total investments
 securities............. $465,060  $244,555  $104,284   --   --         --  $813,899   $813,899
                         --------  --------  --------  ---  ---   --------  --------   --------
Average rates...........     5.62%     5.88%     6.80%  --   --         --      5.85%
                         --------  --------  --------  ---  ---   --------  --------   --------
Long-term debt
  Fixed rate............       --        --        --   --   --   $500,000  $500,000   $500,000
  Average rate..........       --        --        --   --   --       5.00%     5.00%
                         --------  --------  --------  ---  ---   --------  --------   --------
</TABLE>

                                      29
<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, 2000 and 1999, and the related
consolidated statements of operations, stockholders' equity, comprehensive
income (loss) and cash flows for each of the three years in the period ended
March 31, 2000. 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, 2000 and 1999, and the consolidated results
of its operations, comprehensive income (loss) and its cash flows for each of
the three years in the period ended March 31, 2000, in conformity with
accounting principles generally accepted in the United States.

                                          /s/ Ernst & Young LLP

Palo Alto, California
April 18, 2000

                                      30
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

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

<TABLE>
<CAPTION>
                                                              March 31,
                                                         ---------------------
                                                            2000       1999
                                                         ----------  ---------
<S>                                                      <C>         <C>
Assets
Current assets:
  Cash and cash equivalents............................. $  413,230  $  59,965
  Short-term investments................................    493,081    199,865
  Accounts receivable, net of allowance for doubtful
   accounts of $3,259 and $3,226 in 2000 and 1999,
   respectively.........................................    148,818     92,367
  Deferred tax assets...................................      9,384     22,881
  Prepaid expenses and other assets.....................     10,671      9,176
                                                         ----------  ---------
    Total current assets................................  1,075,184    384,254
Property and equipment, net.............................     52,440     45,445
Other assets, net.......................................     98,152     24,257
                                                         ----------  ---------
    Total assets........................................ $1,225,776  $ 453,956
                                                         ==========  =========
Liabilities and stockholders' equity
Current liabilities:
  Accounts payable...................................... $    8,496  $  13,848
  Accrued employee benefits.............................     49,290     27,212
  Income taxes payable..................................     24,323     19,652
  Other accrued expenses................................     33,257     16,334
  Current portion of accrued merger and integration
   expenses.............................................      5,147      2,619
  Deferred revenues.....................................    122,813     76,223
                                                         ----------  ---------
    Total current liabilities...........................    243,326    155,888
Accrued rent............................................        968        896
Long-term accrued merger and integration expenses.......        700      2,800
Convertible subordinated notes..........................    500,000         --
                                                         ----------  ---------
    Total liabilities...................................    744,994    159,584
                                                         ----------  ---------
Minority interest.......................................     24,475         --
Stockholders' equity:
  Common stock, $0.01 par value, 150,000 shares
   authorized, 99,622 and 93,381 shares issued and
   outstanding in 2000 and 1999, respectively...........        996        933
  Additional paid-in capital............................    709,488    562,742
  Deferred stock compensation...........................     (2,763)        --
  Treasury stock, 9,379 and 7,306 shares in 2000 and
   1999, respectively...................................   (180,851)  (119,488)
  Accumulated deficit...................................    (60,699)  (146,013)
  Accumulated other comprehensive loss..................     (9,864)    (3,802)
                                                         ----------  ---------
    Total stockholders' equity..........................    456,307    294,372
                                                         ----------  ---------
    Total liabilities and stockholders' equity.......... $1,225,776  $ 453,956
                                                         ==========  =========
</TABLE>

                 See Notes to Consolidated Financial Statements

                                       31
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

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

<TABLE>
<CAPTION>
                                                     Year Ended March 31,
                                                  ---------------------------
                                                    2000     1999      1998
                                                  -------- --------  --------
<S>                                               <C>      <C>       <C>
Net product revenues............................. $354,497 $259,335  $184,953
Consulting and support revenues..................  217,693  152,481   125,717
                                                  -------- --------  --------
  Total revenues.................................  572,190  411,816   310,670
Cost of product revenues.........................   27,297   22,020    19,709
Cost of consulting and support revenues..........   59,607   40,848    43,356
                                                  -------- --------  --------
  Total cost of revenues.........................   86,904   62,868    63,065
                                                  -------- --------  --------
Gross margin.....................................  485,286  348,948   247,605
Operating expenses:
  Research and development expenses..............  102,846   71,869    61,560
  Sales and marketing expenses...................  220,529  172,448   138,709
  General and administrative expenses............   50,244   33,910    29,092
  Charges for acquired in-process research and
   development...................................    3,529       --        --
  Merger and integration costs...................       --   (1,200)   63,759
                                                  -------- --------  --------
    Total operating expenses.....................  377,148  277,027   293,120
                                                  -------- --------  --------
Operating income (loss)..........................  108,138   71,921   (45,515)
Interest expense.................................    4,132       37        70
Interest income..................................   16,989   12,758    16,759
                                                  -------- --------  --------
  Income (loss) before income taxes..............  120,995   84,642   (28,826)
Provision for income taxes.......................   36,765   25,393     9,447
Minority interest................................    1,084       --        --
                                                  -------- --------  --------
Net income (loss)................................ $ 85,314 $ 59,249  $(38,273)
                                                  ======== ========  ========
Net income (loss) per share--basic............... $   0.97 $   0.69  $  (0.44)
                                                  ======== ========  ========
Shares used in computing net income (loss) per
 share--basic....................................   87,729   85,697    87,575
                                                  ======== ========  ========
Net income (loss) per share--diluted............. $   0.89 $   0.65  $  (0.44)
                                                  ======== ========  ========
Shares used in computing net income (loss) per
 share--diluted..................................   95,637   91,849    87,575
                                                  ======== ========  ========
</TABLE>

                 See Notes to Consolidated Financial Statements

                                       32
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                                        Accumulated
                          Common Stock  Additional   Deferred                              Other         Total
                          -------------  Paid-In      Stock     Treasury   Accumulated Comprehensive Stockholders'
                          Shares Amount  Capital   Compensation   Stock      Deficit       Loss         Equity
                          ------ ------ ---------- ------------ ---------  ----------- ------------- -------------
<S>                       <C>    <C>    <C>        <C>          <C>        <C>         <C>           <C>
Balance at March 31,
 1997...................  84,502  $845   $455,753         --    $  (1,340)  $(123,828)    $(1,321)     $ 330,109
Exercise of common stock
 options................   2,057    22      5,141         --           --          --          --          5,163
Issuance of common stock
 under Employee Stock
 Purchase Plan..........     698     6      6,178         --           --          --          --          6,184
Cumulative translation
 adjustment.............      --    --         --         --           --          --         (53)           (53)
Net loss................      --    --         --         --           --     (38,273)         --        (38,273)
Net transactions of Pure
 Atria from January 1,
 1997, to March 31,
 1997...................   1,718    17     27,646         --           --     (43,161)       (456)       (15,954)
                          ------  ----   --------    -------    ---------   ---------     -------      ---------
Balance at March 31,
 1998...................  88,975  $890   $494,718         --    $  (1,340)  $(205,262)    $(1,830)     $ 287,176
Exercise of common stock
 options................   3,553    34     27,745         --           --          --          --         27,779
Issuance of common stock
 under Employee Stock
 Purchase Plans.........     853     9      8,258         --           --          --          --          8,267
Tax benefit from
 employee stock plans...      --    --     32,021         --           --          --          --         32,021
Treasury stock
 repurchases............      --    --         --         --     (118,148)         --          --       (118,148)
Cumulative translation
 adjustment.............      --    --         --         --           --          --      (1,972)        (1,972)
Net income..............      --    --         --         --           --      59,249          --         59,249
                          ------  ----   --------    -------    ---------   ---------     -------      ---------
Balance at March 31,
 1999...................  93,381  $933   $562,742         --    $(119,488)  $(146,013)    $(3,802)     $ 294,372
Exercise of common stock
 options................   5,244    53     64,579         --           --          --          --         64,632
Issuance of common stock
 under Employee Stock
 Purchase Plans.........     626     6      9,930         --           --          --          --          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
 for acquisition........     371     4     31,884         --           --          --          --         31,888
Treasury stock
 repurchases............      --    --         --         --      (61,363)         --          --        (61,363)
Cumulative translation
 adjustment.............      --    --         --         --           --          --      (6,062)        (6,062)
Net income..............      --    --         --         --           --      85,314          --         85,314
                          ------  ----   --------    -------    ---------   ---------     -------      ---------
Balance at March 31,
 2000...................  99,622  $996   $709,488    $(2,763)   $(180,851)  $ (60,699)    $(9,864)     $ 456,307
                          ======  ====   ========    =======    =========   =========     =======      =========
</TABLE>

                 See Notes to Consolidated Financial Statements

                                       33
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

             CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
                                 (in thousands)

<TABLE>
<CAPTION>
                                                       Year Ended March 31,
                                                     --------------------------
                                                      2000     1999      1998
                                                     -------  -------  --------
<S>                                                  <C>      <C>      <C>
Net income (loss)................................... $85,314  $59,249  $(38,273)
Other comprehensive income:
  Foreign currency translation adjustments, net of
   tax of $(1,819), $(592), and $(153)..............  (4,243)  (1,380)     (356)
                                                     -------  -------  --------
Comprehensive income (loss)......................... $81,071  $57,869  $(38,629)
                                                     =======  =======  ========
</TABLE>



                 See Notes to Consolidated Financial Statements

                                       34
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)

<TABLE>
<CAPTION>
                                                   Year Ended March 31,
                                               -------------------------------
                                                 2000       1999       1998
                                               ---------  ---------  ---------
<S>                                            <C>        <C>        <C>
Operating activities:
Net income (loss)............................  $  85,314  $  59,249  $ (38,273)
Adjustments to reconcile net income (loss) to
 net cash provided by operating activities:
 Charges for acquired in-process research and
  development................................      3,529         --         --
 Depreciation................................     18,860     14,285     13,387
 Amortization................................      7,570      4,480      7,496
 Compensation expense related to stock
  options....................................        765         --         --
 Tax benefits from employee stock plans......     36,825     32,021         --
 Noncash merger and integration costs........      2,338      5,699      7,625
 Changes in operating assets and liabilities:
  Accounts receivable........................    (54,806)   (20,988)    (8,336)
  Prepaid expenses and other, net............     (1,040)    (1,937)      (318)
  Deferred tax assets........................     13,497    (11,035)    (4,851)
  Accounts payable...........................     (5,641)       586       (521)
  Accrued employee benefits and other accrued
   expenses..................................     31,209      1,418      5,671
  Income taxes payable.......................      4,671      4,393     11,225
  Accrued merger and integration expenses....        428    (32,106)    (1,322)
  Deferred revenues..........................     44,164     23,516     10,490
                                               ---------  ---------  ---------
Net cash provided by operating activities....    187,683     79,581      2,273
Investing activities:
Purchase of short-term investments...........   (524,642)  (327,012)  (486,710)
Maturities and sales of short-term
 investments.................................    231,426    290,388    406,008
Purchases of property and equipment..........    (24,474)   (21,742)   (29,961)
Proceeds from sale of fixed assets...........         --         --      4,850
Net changes in other assets..................    (19,738)    (1,454)    (8,657)
Business combinations, net of cash acquired..    (13,208)        --    (15,498)
                                               ---------  ---------  ---------
Net cash used in investing activities........   (350,636)   (59,820)  (129,968)
Financing activities:
Principal payments under long-term debt and
 capital lease obligations...................         --     (1,951)    (1,770)
Net proceeds from sale of convertible notes..    484,600         --         --
Net proceeds from issuances of common stock..     74,568     36,046     11,347
Purchase of treasury stock...................    (61,363)  (118,148)        --
Proceeds from minority investors in
 Catapulse, Inc..............................     24,475         --         --
                                               ---------  ---------  ---------
Net cash (used in) provided by financing
 activities..................................    522,280    (84,053)     9,577
Effect of changes in foreign currency
 exchange rate on cash.......................     (6,062)    (1,972)      (509)
                                               ---------  ---------  ---------
Net (decrease) increase in cash and cash
 equivalents.................................    353,265    (66,264)  (118,627)
Cash and cash equivalents at beginning of
 year........................................     59,965    126,229    244,856
                                               ---------  ---------  ---------
Cash and cash equivalents at end of year.....  $ 413,230  $  59,965  $ 126,229
                                               =========  =========  =========
Supplemental disclosure of cash flow
 information:
Cash paid for income taxes...................  $   4,077  $   4,100  $   2,577
</TABLE>

                 See Notes to Consolidated Financial Statements

                                       35
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                March 31, 2000

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 its 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, including Pure Atria Corporation which
merged with the Company effective July 30, 1997. The historical consolidated
financial statements of the Company for the period prior to this merger date
have been restated to reflect the merger, which has been accounted for as a
pooling of interests. Consolidated results include the Company's share of
operating results of Catapulse, Inc. 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 generally recognizes software license
revenues 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 and determinable, and collection is
considered probable. For customer license agreements, which 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 software royalties, whether they are advance payments that are
nonrefundable or minimum royalty guarantee payable over a fixed period, are
recorded when the earnings process is complete and collection is considered
probable. Revenues from consulting services are recognized when earned.
Customer support revenues are deferred and recognized on a straight-line basis
over the period covered by the customer support agreements. Contract revenues,
which generally represent special or custom engineering development with
milestone payments, are recognized under the percentage of completion method
in conformity with Accounting Research Bulletin No. 45, "Long-Term
Construction-Type Contracts," using the relevant guidance in Statement of
Position 81-1, "Accounting for Performance of Construction-Type and Certain
Production-Type Contracts." The Company considers all arrangements with
payment terms extending beyond twelve months and other arrangements with
payment terms longer than normal not to be fixed or determinable.

   The Company adopted Statement of Position (SOP) 97-2 "Software Revenue
Recognition," as amended by SOP 98-4, in fiscal 1999. SOP 97-2 was further
amended by SOP 98-9 which the Company adopted in fiscal 2000. This Statement
supersedes Statement of Position 91-1 on software revenue recognition. This
Statement establishes revenue recognition criteria for arrangements to deliver
software that do not require significant production, modifications, or
customization of the software. This Statement also establishes guidelines for
recognizing revenues when multiple elements exist in a software arrangement.
The Company believes that the adoption of this Statement did not have a
material effect on its financial statements for fiscal 1999 or 2000.

   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.

                                      36
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000


   Earnings (loss) per share. Calculation of earnings (loss) per share is as
follows (in thousands, except per share amounts):

<TABLE>
<CAPTION>
                                                         Year Ended March 31,
                                                       ------------------------
                                                        2000    1999     1998
                                                       ------- ------- --------
<S>                                                    <C>     <C>     <C>
Numerator:
Net income (loss)....................................  $85,314 $59,249 $(38,273)
                                                       ======= ======= ========
Denominator:
Denominator for basic net income (loss) per share--
 weighted average shares.............................   87,729  85,697   87,575
Incremental common shares attributable to shares
 issuable under employee stock plans (Treasury Stock
 Method).............................................    7,908   6,152       --
                                                       ------- ------- --------
Denominator for diluted net income (loss) per share--
 weighted average shares and assumed conversions.....   95,637  91,849   87,575
                                                       ======= ======= ========
Net income (loss) per share--basic...................  $  0.97 $  0.69 $  (0.44)
                                                       ======= ======= ========
Net income (loss) per share--diluted.................  $  0.89 $  0.65 $  (0.44)
                                                       ======= ======= ========
</TABLE>

   The effect of options to purchase 151,018 and 185,112 shares of Common
Stock was not included in the computation of the 2000 and 1999, respectively,
diluted earnings per share because the options' exercise price was greater
than the average market price of common shares. The effect of converting
6,998,880 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 antidilutive.

   Cash, cash equivalents, and short-term investments. Cash equivalents are
highly liquid investments with original maturity dates of three months or less
at the date of acquisition. Investments with maturity dates of greater than
three months are considered to be short-term investments.

   All the Company's cash equivalents and short-term investments are
classified as available-for-sale and are recorded at amounts that approximate
fair value based on quoted market prices at March 31, 2000 and 1999.
Unrecognized gains and losses and declines in value judged to be other than
temporary on available-for-sale securities are included in interest income.
The cost of securities sold is based on the specific identification method.

   Property and equipment. The Company's property and equipment are recorded
at cost and are generally depreciated over three- to five-year periods using
the straight-line method. The cost of furniture and equipment under capital
leases is recorded at the lower of the present value of the minimum lease
payments or the fair value of the asset and is amortized over the shorter of
the term of the related lease or the estimated useful life of the asset.
Leasehold improvements are depreciated over the remaining life of the lease.

   In accordance with Statement of Financial Accounting Standards No. 121 (FAS
121), "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed of," 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. In certain situations,
an impairment loss has been recognized.

   Goodwill and other intangibles. Goodwill represents the excess purchase
price of net tangible and intangible assets acquired in business combinations
over their estimated fair value. Other intangibles mainly

                                      37
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000

represent developed and core technology, and assembled workforce. Goodwill and
other intangibles are being amortized on a straight-line basis over their
estimated useful lives which range from 1 to 4 years. The Company reviews
goodwill and other intangibles to assess recoverability from future operations
using undiscounted cash flows. In management's opinion, no material impairment
exists at March 31, 2000. Accumulated amortization of goodwill and other
intangibles was $65.8 million and $58.2 million as of March 31, 2000 and 1999,
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 FASB
Statement No. 123 (FAS 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, short-term investments, and long-
term debt approximate fair value. The fair value of short-term investments is
based on quoted market prices.

   Advertising costs. The Company expenses advertising costs as incurred.
Advertising costs totaled $10.1 million, $6.6 million, and $6.5 million for
the years ended March 31, 2000, 1999, and 1998, respectively.

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

   Recent pronouncements. In June 1998, the Financial Accounting Standards
Board (FASB) issued Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities" (FAS 133). FAS
133 is effective for all fiscal quarters of all fiscal years beginning after
June 15, 2000. FAS 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 FAS 133 in fiscal
2002. Adoption of FAS 133 is not expected to have a material impact on the
Company's consolidated financial statements.

   In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101, Revenue Recognition in Financial Statements,
referred to as SAB 101, SAB 101 summarizes certain of the SEC staffs views in
applying generally accepted accounting principles to revenue recognition. The
Company has

                                      38
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000

evaluated SAB 101 and believes it will not have a material impact on our
financial position or results of operations.

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 currently account for
approximately 41% of the Company's revenues, and the Company expects that
international sales will continue to account for a significant portion of the
Company's revenues in future periods. Any material adverse effect on the
Company's international business would have a material adverse effect on the
Company's financial statements. Also, the Company's international sales are
generally denominated in foreign currencies. Losses on the conversion of
foreign-denominated receivables into U.S. dollars may have a material adverse
effect on the Company's financial statements.

   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 with realized and unrealized gains or losses
recognized in the period in which they are incurred. Such contracts meet the
criteria established in FAS 52 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.

   At March 31, 2000 and 1999, the Company had outstanding forward exchange
contracts, all having maturities of less than 90 days, to exchange various
nonfunctional currencies for U.S. dollars, Dutch guilders, or Euros in the
aggregate amounts (U.S. dollar equivalent) of $47.1 million and $34.3 million,
respectively. Two 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 2000, 1999, and 1998 were not material to the Company's results of
operations.

3. Acquisitions

   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 $9,045,000 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

                                      39
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000

purchase 358,546 shares of the Company's Common Stock. Prior to the
consummation of this deal, the Company held a 19.9 percent ownership in OTL
from an initial investment of approximately $9,000,000 made in December 1997.

   Total purchase price of OTL, including the prior investment and
acquisition-related costs of approximately $6,028,000, was approximately
$58,832,000. The acquisition was accounted for as a purchase 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 in-process research and development.....................   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 $3,529,000 charge related to
the value of acquired in-process research and development in the fourth
quarter of fiscal 2000. The value of acquired in-process research and
development 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 developed technology, core technology,
goodwill, and other intangibles are being amortized on a straight-line basis
over periods from one to four years, 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 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 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
has been initiated as of March 31, 2000, and will be completed in fiscal 2001.
Total severance pay and relocation costs of the plan, expected to be
approximately $1,311,000, have been included in the purchase price allocation.

   The unaudited pro forma consolidated results for the Company had the
acquisition been consummated April 1, 1998, excluding the charge for acquired
in-process research and development 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>

   Merger with Pure Atria Corporation. On July 30, 1997, the Company acquired
Pure Atria Corporation (Pure Atria) pursuant to which the Company issued
approximately 39.082 million shares of Common Stock. In addition, each
outstanding option or right to purchase Pure Atria Common Stock under various
stock option and purchase plans was assumed by the Company. Pure Atria was
primarily involved in developing, marketing, and supporting a comprehensive,
integrated suite of software products that enabled the production of reliable,
high-

                                      40
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000

quality software and improved the development process. This acquisition was
accounted for as a pooling of interests, and accordingly, the Company's
consolidated financial statements and notes thereto have been restated to
include the financial position and results of this merger for the three-month
period ended June 30, 1997. For the three-month period ended June 30, 1997,
preceding the combination, Rational and Pure Atria unaudited, pro forma
revenues were $42,928,000 and $23,220,000, respectively, and Rational and Pure
Atria unaudited, pro forma net income (loss) was $7,814,000 and $(2,686,000),
respectively.

4. Cash Equivalents and Short-Term Investments

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

<TABLE>
<CAPTION>
                                                                  March 31,
                                                              -----------------
                                                                2000     1999
                                                              -------- --------
     <S>                                                      <C>      <C>
     Bank certificates of deposit............................ $ 50,077 $     --
     U.S. treasury and agency obligations....................  169,755    5,060
     Municipal obligations...................................  126,376   48,149
     Corporate securities....................................  146,873  146,656
                                                              -------- --------
       Total................................................. $493,081 $199,865
                                                              ======== ========
</TABLE>

   Realized gains and losses on sales of available-for-sale securities were
immaterial for the years ended March 31, 2000 and 1999. There were no
significant unrealized holding gains or losses on such securities at March 31,
2000 and 1999.

   Debt securities at March 31, 2000 and 1999, 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,
                                                               -----------------
                                                                 2000     1999
                                                               -------- --------
     <S>                                                       <C>      <C>
     Short-term investments:
       Due in one year or less................................ $243,357 $140,031
       Due after one year.....................................  249,724   59,834
                                                               -------- --------
         Total................................................ $493,081 $199,865
                                                               ======== ========
</TABLE>

5. Property and Equipment

   Property and equipment is as follows (in thousands):

<TABLE>
<CAPTION>
                                                                 March 31,
                                                             ------------------
                                                               2000      1999
                                                             --------  --------
     <S>                                                     <C>       <C>
     Computer, office, and manufacturing equipment.......... $ 82,838  $ 71,754
     Office furniture.......................................   13,957    10,535
     Leasehold improvements.................................   13,850    10,905
     Construction in progress...............................    5,687     3,113
                                                             --------  --------
                                                              116,332    96,307
     Accumulated depreciation and amortization..............  (63,892)  (50,862)
                                                             --------  --------
     Net property and equipment............................. $ 52,440  $ 45,445
                                                             ========  ========
</TABLE>

                                      41
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000


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 3 years are as
follows (in thousands):

<TABLE>
<CAPTION>
                                        Severance         Asset
                                        and Other      Write-Offs
                         Transaction Employee-Related   and Lease
                            Costs        Charges      Cancellations  Other    Total
                         ----------- ---------------- ------------- -------  --------
<S>                      <C>         <C>              <C>           <C>      <C>
Accrued as of March 31,
 1997...................  $  1,134       $ 11,778        $ 3,021    $ 2,797  $ 18,730
Provision recorded at
 acquisition of Pure
 Atria..................    15,629         18,339         19,352     10,439    63,759
Noncash charges.........        --             --         (6,469)    (1,156)   (7,625)
Cash payments...........   (15,556)       (21,773)        (2,006)    (7,635)  (46,970)
                          --------       --------        -------    -------  --------
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
                          ========       ========        =======    =======  ========
</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 29, 26,
and 37 employees were terminated in fiscal 2000, 1999, and 1998, respectively,
as a result of this activity. The Company also committed to pay noncontingent
retention bonuses, commissions, and relocation costs to other employees, and
these costs have been included in the accrual.

   Asset write-offs and lease cancellations. The Company has consolidated
duplicate offices in North America and Europe and has relocated the North
American headquarters to a larger facility. The accrual 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 OTL acquisition included costs
associated with, communication of the merger to employees' and costs accrued
to provide future support and maintenance for former OTL customers. Expenses
specific to the Pure Atria acquisition included costs associated with
communication of the merger to employees, with discontinuance of the Pure
Vision product line, and termination of European and Asian distributors.

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.

                                      42
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000

Interest on the five percent 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 $71.44 per share, subject to anti-dilution
adjustments. This is equivalent to a conversion rate of 13.9983 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, 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
6,998,880 shares of Common Stock for conversion of the Notes.

8. Commitments and Contingencies

   The Company leases its primary office space under operating leases. Rental
expense for facilities was approximately $15.1 million, $12.3 million, and
$13.4 million for the fiscal years ended March 31, 2000, 1999, and 1998,
respectively. Estimated future rents from sublease agreements are $2.1 million
and $198,000 in fiscal 2001, and 2002, respectively. 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>
            2001................................. $21,716
            2002.................................  18,737
            2003.................................  16,648
            2004.................................  14,462
            2005.................................  10,337
            Thereafter...........................  17,442
                                                  -------
                                                  $99,342
                                                  =======
</TABLE>

   As of March 31, 2000, the Company had three letters of credit outstanding
in the amount of $62,500, $3 million, and $1 million guaranteeing certain
rental payments at its office locations in Lexington, Massachusetts, and
Cupertino, California.

   Legal matters. The following actions have been filed against the Company,
officer Paul D. Levy, Cowen & Company and an individual Cowen employee,
analyst Rehan Syed. The action, In re Rational Software Securities Litigation,
No. 21001-JF (N.D. Cal. May 26, 1998) is a consolidated action supplanting
prior complaints filed against defendants. The actions are putative
shareholder class action lawsuits. The complaint

                                      43
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000

alleges that defendants violated Sections 10(b) and 20A of the Securities
Exchange Act of 1934 through the selective disclosure of material inside
information regarding the Company's prospects and seek damages on behalf of a
class of shareholders who purchased the Company's Common Stock on October 8,
1997. Plaintiffs have dismissed the Complaint as against the Company and Mr.
Levy.

   In December 1996, the Company filed suit against Silicon Graphics, Inc.
("SGI") seeking to recover royalties due to the Company under a license
agreement between SGI and the Company's predecessor in interest, Verdix
Corporation. SGI answered the complaint, denying any liability, and filed a
cross complaint seeking unspecified damages for alleged violations of the same
license agreement. Effective August 12, 1999, the Company and SGI entered an
agreement under which this litigation was settled in its entirety. The terms
of this agreement are confidential. The arrangement, however, will not have
any material impact on the Company's financial statements.

   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 these or future lawsuits against the Company may result in
a material adverse effect on the Company's financial condition.

9. Stockholders' Equity

   Stock repurchase program. In April 1998, the Company's Board of Directors
authorized the purchase of up to 6 million shares of the Company's Common
Stock from time to time in the open market. The Company completed the
repurchase of these 6 million shares by August 1998 for an aggregate cost of
$98.4 million. In October 1998, the Company's Board of Directors authorized
the purchase of an additional 6 million shares. As of March 31, 2000, the
Company had repurchased approximately 2.1 million shares of its Common Stock
under this program for an aggregate cost of $61.4 million.

   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 going forward.

   Stock options. The Company provides equity incentives to employees and
directors by means of incentive stock options and nonstatutory options which
historically have been provided under various stock option plans. The Company
now issues options from the Stock Option Plan for Directors, 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 20,169,442
shares for issuance at March 31, 2000. Options generally expire 10 years from
the date of grant.

                                      44
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000


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

<TABLE>
<CAPTION>
                                                          Options Outstanding
                                                          ---------------------
                                                                      Weighted-
                                                Shares                 Average
                                              Available               Exercise
                                              for Grant    Options      Price
                                              ----------  ----------  ---------
<S>                                           <C>         <C>         <C>
Balance at March 31, 1997....................    570,574  15,428,269   $17.08
 Net transactions of Pure Atria during the
  period from January 1, 1997, to March 31,
  1997.......................................  1,611,351    (416,912)   25.65
 Additional shares authorized................  4,350,000          --       --
 Granted..................................... (6,523,621)  6,523,621    13.71
 Exercised...................................         --  (2,056,891)   10.52
 Canceled....................................  1,910,661  (1,910,661)   20.41
 Expired or retired.......................... (1,204,801)         --       --
                                              ----------  ----------   ------
Balance at March 31, 1998....................    714,164  17,567,426   $12.57
 Additional shares authorized................  4,450,000          --       --
 Granted..................................... (6,138,937)  6,138,937    15.32
 Exercised...................................         --  (3,552,847)    7.95
 Canceled....................................  3,983,241  (3,983,241)   20.39
 Expired or retired.......................... (1,321,043)         --       --
                                              ----------  ----------   ------
Balance at March 31, 1999....................  1,687,425  16,170,275   $12.63
 Additional shares authorized................ 18,364,132          --       --
 Granted..................................... (8,806,677)  8,806,677    40.52
 Exercised...................................         --  (5,248,301)   12.42
 Canceled....................................  1,079,773  (1,079,773)   18.92
 Expired or retired..........................   (404,089)         --       --
                                              ----------  ----------   ------
Balance at March 31, 2000.................... 11,920,564  18,648,878   $25.09
                                              ==========  ==========   ======
</TABLE>

   In November 1997, the Company entered into agreements with most of its
employees to reprice (at the closing price for the Company's Common Stock on
November 14, 1997, of $10.00) employees' stock options for an aggregate of
approximately 6.9 million shares of Common Stock. 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 $13.38)
employee stock options for an aggregate of approximately 1.7 million shares of
Common Stock. All employees participating in the repricing agreed to certain
limitations on the disposition of repriced options. The foregoing table has
not been adjusted for such repriced options.

                                      45
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000


   In fiscal 2000 the Company recorded deferred stock compensation of
$3,044,000 representing the difference between the exercise price and the
deemed fair value of Catapulse, which results are consolidated with Rational,
Common Stock on the date such stock options were granted. The Company also
recorded amortization of deferred stock compensation of $281,000 in fiscal
2000. At March 31, 2000 the Company had $2,763,000 of remaining unamortized
deferred compensation. Additionally, as a result of accelerating the vesting
period of certain stock options, the Company recorded compensation expense of
$484,000.

   At March 31, 2000, options to purchase 5,504,938 shares of Common Stock
were exercisable and unrestricted at a weighted-average exercise price of
$13.26. At March 31, 2000, the range of options outstanding and exercisable is
as follows:

<TABLE>
<CAPTION>
                                                          Options Exercisable
                              Options Outstanding          and Unrestricted
                       --------------------------------- ---------------------
                                    Weighted-
                                     Average
                                    Remaining  Weighted-             Weighted-
                                   Contractual  Average               Average
        Range of         Shares       Life     Exercise    Number    Exercise
     Exercise Prices   Outstanding   (years)     Price   Exercisable   Price
     ---------------   ----------- ----------- --------- ----------- ---------
     <S>               <C>         <C>         <C>       <C>         <C>
     $0.0018-$ 3.47       428,462     4.35      $ 1.68      411,132   $ 1.73
     $  3.75-$10.00     3,277,519     6.66        9.76    2,165,142     9.69
     $ 10.06-$11.13     2,172,017     8.06       10.85      466,559    10.87
     $ 11.18-$13.38     2,519,810     7.11       12.65    1,266,897    12.88
     $ 13.56-$23.94     2,200,971     8.33       19.58      657,070    18.53
     $ 24.00-$30.50     1,000,667     8.63       27.48      215,699    27.29
     $ 30.75-$30.75     2,070,126     9.53       30.75      184,915    30.75
     $ 31.13-$51.56     1,692,214     9.56       42.25       90,494    40.97
     $ 52.31-$52.31     3,192,762     9.84       52.31       47,030    52.31
     $ 71.75-$71.75        94,330     9.92       71.75            0     0.00
                       ----------     ----      ------    ---------   ------
                       18,648,878     8.28      $25.09    5,504,938   $13.26
                       ==========     ====      ======    =========   ======
</TABLE>

   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, the "1998 Employee Stock Purchase Plan" was
approved by the shareholders with an initial 2 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 2000, approximately 626,138 shares were issued
under the plans.

                                      46
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000


   Stock-based compensation. Pro forma information regarding net income (loss)
and earnings (loss) per share is required by FAS 123 for awards granted or
modified after December 31, 1994, as if the Company had accounted for its
stock-based awards to employees under the fair value method of FAS 123. The
fair value of the Company's stock-based awards to employees was estimated
using a Black-Scholes option pricing model. The Black-Scholes model requires
the input of highly subjective assumptions, including the expected stock price
volatility. Because the Company's stock-based awards to employees have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its stock-
based awards to employees. The fair value of the Company's stock-based awards
to employees was estimated assuming no expected dividends and the following
weighted-average assumptions:

<TABLE>
<CAPTION>
                                                       Year Ended March 31,
                                                   -----------------------------
                                                   2000 1999 1998 2000 1999 1998
                                                   ---- ---- ---- ---- ---- ----
                                                   Stock Options       ESPP
                                                   -------------- --------------
<S>                                                <C>  <C>  <C>  <C>  <C>  <C>
Expected life (in years).......................... 3.60 3.35 3.02 0.62 0.60 0.50
Expected volatility............................... 0.76 0.72 0.60 0.74 0.67 0.60
Risk-free interest rate........................... 6.10 5.21 5.80 5.61 5.15 5.54
</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,
                                                      ------------------------
                                                       2000    1999     1998
                                                      ------- ------- --------
     <S>                                              <C>     <C>     <C>
     Net income (loss):
       As reported................................... $85,314 $59,249 $(38,273)
       Pro forma.....................................  20,089  13,635  (90,277)
     Basic net income (loss) per share:
       As reported................................... $  0.97 $  0.69 $  (0.44)
       Pro forma.....................................    0.23    0.16    (1.03)
     Diluted net income (loss) per share:
       As reported................................... $  0.89 $  0.65 $  (0.44)
       Pro forma.....................................    0.21    0.15    (1.03)
</TABLE>

   The effects of applying FAS 123 in this pro forma disclosure are not
indicative of future amounts. FAS 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 2000, 1999, and 1998 was $24.03, $7.76, and $5.63 per share,
respectively. The weighted-average fair value of employee stock purchase
rights during fiscal 2000, 1999, and 1998 was $10.39, $4.82, and $4.17 per
share, respectively.

                                      47
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000


10. Income Taxes

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

<TABLE>
<CAPTION>
                                                          March 31,
                                                  ----------------------------
                                                    2000      1999      1998
                                                  --------  --------  --------
     <S>                                          <C>       <C>       <C>
     Income (loss) before income taxes:
       United States............................. $ 68,072  $ 51,372  $    424
       Foreign...................................   52,923    33,270   (29,250)
                                                  --------  --------  --------
         Total................................... $120,995  $ 84,642  $(28,826)
                                                  --------  --------  --------
     Provision for income taxes:
       Current:
         Federal................................. $     --  $  1,469  $  9,908
         State...................................       56     3,120     2,220
         Foreign.................................    8,656     3,904     2,170
                                                  --------  --------  --------
           Total................................. $  8,712  $  8,493  $ 14,298
                                                  --------  --------  --------
       Deferred:
         Federal................................. $ (8,498) $(13,858) $ (5,988)
         State...................................     (274)   (1,263)     (375)
                                                  --------  --------  --------
           Total................................. $ (8,772) $(15,121) $ (6,363)
                                                  --------  --------  --------
     Charge in lieu of taxes attributable to
      employee stock plans....................... $ 36,825  $ 32,021  $     --
     Charge in lieu of taxes resulting from
      initial recognition of acquired tax
      benefits that were allocated to reduce
      intangible assets related to the acquired
      entity.....................................       --        --     1,512
                                                  --------  --------  --------
         Total................................... $ 36,765  $ 25,393  $  9,447
                                                  ========  ========  ========
</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,
                                                    --------------------------
                                                     2000     1999      1998
                                                    -------  -------  --------
<S>                                                 <C>      <C>      <C>
Income tax provision (benefit) at the federal
 statutory rate...................................  $42,348  $29,625  $(10,089)
State income taxes (net of federal benefit).......    4,781    5,502     1,845
Tax benefit of net operating loss carryforwards...       --   (7,027)  (19,260)
Tax benefit of research credit carryforwards......   (6,336)  (3,000)       --
Nondeductible charges for acquired in-process
 research and development, and goodwill...........    2,285       --        --
Foreign taxes in excess of U.S. statutory rates...      603    1,333       651
Foreign earnings permanently reinvested in foreign
 operations.......................................   (8,400)      --        --
Nondeductible losses attributable to Catapulse....    1,047       --        --
Nondeductible merger-related costs................       --       --     6,075
Foreign losses not resulting in a U.S. tax
 benefit..........................................    1,077       --    21,297
Change in valuation allowance.....................       --   (1,474)    7,562
Other.............................................     (640)     434     1,366
                                                    -------  -------  --------
  Total...........................................  $36,765  $25,393  $  9,447
                                                    =======  =======  ========
</TABLE>

                                      48
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000


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

<TABLE>
<CAPTION>
                                                                 March 31,
                                                             ------------------
                                                               2000      1999
                                                             --------  --------
<S>                                                          <C>       <C>
Deferred tax assets:
  Net operating loss carryforwards.......................... $ 31,939  $ 22,218
  Tax credit carryforwards..................................   10,052     6,865
  Allowances, reserves, and accrued expenses................   10,943     9,240
  Property, equipment, and intangibles......................    2,640     6,058
  Other.....................................................    1,466     1,928
                                                             --------  --------
    Gross deferred tax assets...............................   57,040    46,309
    Less valuation allowance................................   (8,517)  (11,100)
                                                             --------  --------
    Total deferred tax assets...............................   48,523    35,209
Deferred tax liabilities:
  Unremitted earnings of foreign subsidiaries...............  (12,848)   (5,337)
                                                             --------  --------
    Total deferred tax liabilities..........................  (12,848)   (5,337)
                                                             --------  --------
Net deferred tax assets..................................... $ 35,675  $ 29,872
                                                             ========  ========
</TABLE>

   The valuation allowance decreased by $2.6 million and $19.9 million in 2000
and 1999, respectively. In 2000, the $2.6 million decrease was primarily
attributable to previously unbenefitted research and development tax credits.
In 1999, approximately $18.4 million of such decrease was attributable to the
tax benefit associated with employee stock plans and was credited to
additional paid-in capital.

   Net undistributed earnings of the foreign subsidiaries considered
permanently reinvested amounted to approximately $24 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, 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.

   FASB Statement 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
certain foreign tax credit carryforwards and the future amortization of
certain intangible assets. The Company will continue to evaluate the
realizability of the deferred tax asset on a quarterly basis.

   At March 31, 2000, the Company had net operating loss carryforwards for
federal income tax purposes of approximately $83 million that expire in 2001
through 2020. The Company also had tax credit carryforwards for federal and
state purposes of approximately $7.5 million and $4.0 million, respectively,
that expire in 2001 through 2020, 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.

11. Segment Information

   The Company has adopted FAS 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

                                      49
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                                March 31, 2000

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,
                                                      --------------------------
                                                        2000     1999     1998
                                                      -------- -------- --------
     <S>                                              <C>      <C>      <C>
     Revenues:
       United States................................. $339,116 $246,650 $203,810
       Europe........................................  167,507  121,848   82,202
       Other.........................................   65,567   43,318   24,658
                                                      -------- -------- --------
         Consolidated................................ $572,190 $411,816 $310,670
                                                      ======== ======== ========
     Long-lived assets:
       United States................................. $ 87,272 $ 60,178 $391,951
       Europe........................................    6,816    6,117   38,011
       Other.........................................   56,504    3,407   15,243
                                                      -------- -------- --------
         Consolidated................................ $150,592 $ 69,702 $445,205
                                                      ======== ======== ========
</TABLE>

   "Other" represents Canada, Latin America, and the Asia/Pacific region.
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. 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, 2000
(in thousands, except per share amounts).

<TABLE>
<CAPTION>
                                                      Quarter Ended
                                           ------------------------------------
                                                    September December
                                           June 30     30        31    March 31
                                           -------- --------- -------- --------
<S>                                        <C>      <C>       <C>      <C>
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.............     0.17     0.22      0.29     0.29
  Net income per share--diluted...........     0.16     0.21      0.27     0.26
Fiscal 1999:
  Total revenues.......................... $ 82,971 $ 94,656  $109,133 $125,056
  Gross margin............................   67,208   79,759    93,674  108,307
  Operating income........................    8,321   14,194    22,525   26,881
  Net income..............................    8,005   12,200    17,954   21,090
  Net income per share--basic.............     0.09     0.14      0.21     0.25
  Net income per share--diluted...........     0.09     0.14      0.20     0.23
</TABLE>

                                      50
<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

   Reference is made to "election of directors" in the Company's proxy
statement for the 2000 annual meeting of stockholders, incorporated by
reference herein.

ITEM 11--EXECUTIVE COMPENSATION

   Reference is made to "executive compensation" and "performance graph" in
the Company's proxy statement for the 2000 annual meeting of stockholders,
incorporated by reference herein.

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

   Reference is made to "beneficial ownership of Common Stock" in the
Company's proxy statement for the 2000 annual meeting of stockholders,
incorporated by reference herein.

ITEM 13--CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

   Reference is made to "certain transactions" in the Company's proxy
statement for the 2000 annual meeting of stockholders, incorporated by
reference herein.

                                    PART IV

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

(a) 1. FINANCIAL STATEMENTS

   See Item 8 of this Form 10-K.

    2. FINANCIAL STATEMENT SCHEDULES

   The following financial statement schedule of the Company for each of the
years ended March 31, 2000, 1999, and 1998, 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.

<TABLE>
<CAPTION>
                                                                           Page
                                                                          Number
                                                                          ------
       <S>                                                                <C>
       Schedule II--Valuation and Qualifying Accounts....................  S-1
</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.

                                      51
<PAGE>

    3. EXHIBITS

<TABLE>
<CAPTION>
   Exhibit
   -------
   <C>     <S>
     3.01  Certificate of Incorporation as amended through July 30, 1997, is
           incorporated herein by reference to Exhibit 3.1 filed with the
           Registrant's Form 10-Q dated November 14, 1997.

     3.02  Bylaws as amended through October 1999.

     4.01  Reference is made to Exhibits 3.01 and 3.02.

     4.02  Specimen of Common Stock Certificate is incorporated by reference to
           Exhibit 4.06 filed with the Registrant's Amendment No. 1 to Form S-3
           Registration Statement on May 31, 1995 (File No. 33-91740).

     4.03  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.

     4.04  Registration Rights Agreement of the Registrant, dated as of
           February 2, 2000, with respect to 5% Convertible Subordinated Notes
           due February 1, 2007.

    10.01  Relocation Agreement with David Bernstein is incorporated herein by
           reference to Exhibit 10 filed with the Registrant's Form 10-Q dated
           November 14, 1997.

    10.02  *Form of Employment Agreement is incorporated by reference to
           Exhibit 10.03 filed with the Registrant's Form 10-K dated June 1,
           1998.

    10.03  *Form of Employment Agreement. is incorporated by reference to
           Exhibit 10.04 filed with the Registrant's Form 10-K dated June 1,
           1998.

    10.04  Form of Stock Option Repricing Agreement is incorporated by
           reference to Exhibit 10.05 filed with the Registrant's Form 10-K
           dated June 1, 1998.

    10.05  Form of Director and Officer Indemnification Agreement incorporated
           herein by reference to Exhibit 10.1 filed with the Registrant's
           Registration Statement on Form S-4, dated January 17, 1997, as
           amended on January 17, 1997.

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

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

    21.01  Subsidiaries of the Registrant.

    23.01  Consent of Ernst & Young LLP, independent auditors.

    24.01  Power of attorney is contained on the signature pages of this
           registration statement.

    27.1   Annual financial data schedule.
</TABLE>
--------
* Indicates those exhibits that are management contracts or compensatory plans
  or arrangements required to be filed as an exhibit to this form.

                                       52
<PAGE>

(b) REPORTS ON FORM 8-K

   Item 2: On January 21, 2000, the Company filed Form 8-K regarding the
closing of the acquisition of ObjecTime Limited

   Item 5: On January 24, 2000, the Company filed Form 8-K announcing a
proposed private offering of Convertible Subordinated Notes.

   Item 5: On January 31, 2000, the Company filed Form 8-K announcing that the
Company had entered into an agreement to sell Convertible Subordinated Notes.

   Item 5: On February 16, 2000, the Company filed Form 8-K regarding the
completion of the agreement to sell Convertible Subordinated Notes.

                                      53
<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: May 1, 2000           /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      May 1, 2000
____________________________________ Board
             Paul D. Levy

      /s/ Michael T. Devlin          Founder, Chief Executive         May 1, 2000
____________________________________ Officer, and Director
          Michael T. Devlin

       /s/ Thomas F. Bogan           President and Chief              May 1, 2000
____________________________________ Operating Officer
           Thomas F. Bogan

      /s/ Timothy A. Brennan         Senior Vice President, Chief     May 1, 2000
____________________________________ Financial Officer, and
          Timothy A. Brennan          Secretary (principal
                                      financial officer and
                                      principal accounting
                                      officer)

       /s/ Leslie G. Denend          Director                         May 1, 2000
____________________________________
           Leslie G. Denend

       /s/ John E. Montague          Director                         May 1, 2000
____________________________________
           John E. Montague

    /s/ Allison R. Schleicher        Director                         May 1, 2000
____________________________________
        Allison R. Schleicher
</TABLE>

                                      54
<PAGE>

                         RATIONAL SOFTWARE CORPORATION

                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
                   Years Ended March 31, 2000, 1999, and 1998
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                         Balance
                                           Balance                         at
                                             at                          Ending
                                          Beginning                        of
                                          of Period Additions Deductions Period
                                          --------- --------- ---------- -------
<S>                                       <C>       <C>       <C>        <C>
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
March 31, 1998
  Allowance for doubtful accounts........  $4,001     $664     $(1,027)  $3,638
</TABLE>

                           INDEX OF ATTACHED EXHIBITS

<TABLE>
 <C>   <S>
  3.02 Bylaws as amended through October 1999.

  4.03 Indenture by and between Registrant and State Street Bank and Trust
       Company of California, N.A.

  4.04 Registration Rights Agreement of the Registrant

 21.01 Subsidiaries of Registrant

 23.01 Consent of Ernst & Young LLP, Independent Auditors

 27.1  Annual financial data schedule
</TABLE>

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

                                       55