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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-K



(Mark One)

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



For the Fiscal Year Ended December 31, 2003



OR



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



For the Transition Period fromto.



Commission File No. 000-26937



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QUEST SOFTWARE, INC.

(Exact Name of Registrant as Specified in its Charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|California                                                     |  | 33-0231678                          
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|8001 Irvine Center Drive Irvine, California                    |  | 92618 (Zip Code)                    
|(Address of Principal Executive Offices)                       |  |                                     



Registrants
Telephone Number, Including Area Code: (949) 754-8000



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Securities Registered Pursuant to Section 12(b) of the Act: None



Securities Registered Pursuant to Section 12(g) of the Act: Common Stock



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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 period that 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. ̈



Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).    Yes  x    No ̈



The aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $593.9 million as
of June 30, 2003, based upon the closing sale price reported for that date on the NASDAQ National Market. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been
excluded because such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily conclusive for other purposes.



As of March 1, 2004, 93,973,422 shares of the Registrants common stock were outstanding.



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Documents Incorporated by Reference



Portions of the Registrants definitive proxy statement, to be delivered to shareholders in connection with the Registrants 2004 Annual Meeting
of Shareholders, are incorporated by reference into Part III of this Report.



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TABLE OF CONTENTS



|                             |  |                                                                                                                |  |     
|---------------------------- |  | -------------------------------------------------------------------------------------------------------------- |  | ----
|                             |  |                                                                                                                |  | Page
|                             |  | PART I                                                                                                         |  |     
|                             |  |                                                                                                               
|Item 1.                      |  | Business                                                                                                       |  | 3   
|Item 2.                      |  | Properties                                                                                                     |  | 9   
|Item 3.                      |  | Legal Proceedings                                                                                              |  | 10  
|Item 4.                      |  | Submission of Matters to a Vote of Security Holders                                                            |  | 11  
|                             |  |                                                                                                               
|                             |  | PART II                                                                                                        |  |     
|                             |  |                                                                                                               
|Item 5.                      |  | Market for Registrants Common Equity, Related Shareholder Matters and Issuer Repurchases of Equity Securities |  | 12  
|Item 6.                      |  | Selected Financial Data                                                                                        |  | 13  
|Item 7.                      |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                          |  | 14  
|Item 7a.                     |  | Quantitative and Qualitative Disclosures About Market Risk                                                     |  | 35  
|Item 8.                      |  | Financial Statements and Supplementary Data                                                                    |  | 36  
|Item 9.                      |  | Changes in and Disagreements With Accountants on Accounting and Financial Disclosure                           |  | 36  
|Item 9A.                     |  | Controls and Procedures                                                                                        |  | 36  
|                             |  |                                                                                                               
|                             |  | PART III                                                                                                       |  |     
|                             |  |                                                                                                               
|Item 10.                     |  | Directors and Executive Officers of the Registrant                                                             |  | 37  
|Item 11.                     |  | Executive Compensation                                                                                         |  | 37  
|Item 12.                     |  | Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters                 |  | 37  
|Item 13.                     |  | Certain Relationships and Related Transactions                                                                 |  | 37  
|Item 14.                     |  | Principal Accountants Fees and Services                                                                        |  | 37  
|                             |  |                                                                                                               
|                             |  | PART IV                                                                                                        |  |     
|                             |  |                                                                                                               
|Item 15.                     |  | Exhibits, Financial Statement Schedule, and Reports on Form 8-K                                                |  | 38  
|SIGNATURES                   |  | 40                                                                                                            
|FINANCIAL STATEMENTS         |  | F-1                                                                                                           
|FINANCIAL STATEMENT SCHEDULE |  | S-1                                                                                                           



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Forward-Looking Information



Discussions under the captions Business, Risk Factors, and Managements
Discussion and Analysis of Financial Condition and Results of Operations include or may include forward-looking statements within the meaning of the federal securities laws. We have based these forward-looking statements on currently
available information and our current beliefs, expectations and projections about future events. All forward-looking statements contained herein are subject to numerous risks and uncertainties. Our actual results and the timing of certain events
could differ materially from those projected in the forward looking statements due to a number of factors discussed under the heading Risk Factors in this Report and in our other filings with the Securities and Exchange
Commission. Should one or more of these risks or uncertainties materialize, or should the underlying estimates or assumptions prove incorrect, actual results or outcomes may vary significantly from those suggested by forward-looking information. Any
forward-looking statements contained in this document are based on information available at the time of filing and we make no undertaking to update any of these forward-looking statements.



PART I



Item 1.Business



Introduction



Quest
Software develops, sells and supports software products that improve our customers ability to develop, deploy and manage their packaged and custom software applications and associated software infrastructure components such as databases,
application servers and operating systems. Quest fits generally into a category of software companies referred to as Independent Software Vendors, or ISVs, which are companies whose products support other vendors
software or hardware products. We focus on delivering products for widely adopted applications and infrastructure components such as:



|                  |  |                             |  |                          |  |                          
|----------------- |  | --------------------------- |  | ------------------------ |  | -------------------------
|Applications      |  | Database Management Systems |  | Microsoft Infrastructure |  | Application Servers      
|Oracle Financials |  | Oracle                      |  | Active Directory         |  | WebLogic                 
|PeopleSoft        |  | IBM Universal Database      |  | Exchange                 |  | WebSphere                
|SAP               |  | IBM DB2 (Mainframe)         |  |                          |  | Oracle Application Server
|Siebel            |  | Microsoft SQL Server        |  |                          |  |                          



We generate revenues
by licensing our products, principally on a perpetual basis, and by providing support, maintenance and implementation services for these products. Our products improve the quality of service of our customers key software applications and
component infrastructure. Examples of our products benefits include the improvement of application and database code quality, the detection, diagnosis and resolution of hardware and software performance problems, the provision of database
replication and failover capabilities and the simplified administration of large, multi-user Microsoft deployments. Our products can significantly reduce customers capital and operating expenses by minimizing hardware, software and/or
personnel costs.



Our traditional focus has been on the Oracle
database management system, and we are currently recognized as a leading Oracle ISV. Enterprises must contend with the demands of ever increasing data, and much of this data is stored in database management systems such as Oracle, IBMs DB2 and
Microsofts SQL Server. These trends create demand for our database tools that can improve the utilization and reliability of large-scale databases and of the developers and database administrators and other personnel responsible for
maintaining reliability and performance.



Over the last four
years, we have emphasized acquisitions and internal development of products supporting platforms other than the Oracle database. In March 2000, we acquired Foglight Software, Inc., and its Foglight monitoring product has become our primary
Application Performance Management product. In September 2000,



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we acquired FastLane Technologies Inc. and its products for migration and management of Microsoft Active Directory and Exchange environments. In November
2002, we acquired Sitraka and its development tools and Application Performance Management products for J2EE applications. Revenues from these and other acquired and internally developed products have reduced the percentage of total revenues
generated by our Oracle-only products to approximately 50.0% in fiscal 2003 as compared to approximately 60.0% in fiscal 2001.



Over the last three years we have worked to integrate many of our point products into integrated product suites or workbenches aimed at particular IT
functions, such as database administration, application administration or Exchange administration. The first of these integrated product suites were Quest Central for Oracle and Quest Central for UDB.



In addition to integrating point products into a management suite for a given
domain, such as Oracle or Exchange, we have worked to deliver tools for cross-platform management. In the fourth quarter of 2003, for example, we introduced Quest Central for Databases, which we believe is the first database management solution to
combine rich domain-specific functionality and full performance management into a single console (or User Interface) for heterogeneous database environments including Oracle, DB2 (distributed and mainframe) and Microsoft SQL Server. Most
medium-to-large enterprises employ applications, databases and other systems components from multiple vendors, creating the need for a comprehensive heterogeneous database management environment. Employing a common console for database
administrators responsible for managing these disparate systems helps to minimize database differences.



We are likewise pursuing a heterogeneous platform management strategy with our Application Performance Management products. Key enterprise applications
are highly complex and require substantial investment, personnel and expertise in their development, deployment and management. Application Performance Management involves measuring service levels provided by an application, such as application
response times and application outages, and providing the capabilities to diagnose the root causes of performance problems and the means to correct or eliminate them. Because the predominance of enterprise packaged and custom-developed applications
run in multi-vendor environments, the need exists for heterogeneous management tools that have deep monitoring, reporting and diagnostic capabilities for all the components of the application stack. Our Application Performance Management strategy
comprises three integrated product areas that detect, diagnose and resolve application performance issues in the major packaged applications, databases and application servers.



We invest a significant portion of revenues in our product engineering capabilities, and approximately one-third of our
employees work in product development, quality assurance or technical documentation roles. In building our products, we stress technical innovation and depth, ease of deployment, ease of use and tangible, readily articulated customer benefits. We
sell our products primarily via our direct sales channel, supplemented by indirect sales through systems integrators and value added resellers. We operate in North and South America, Europe, Australia and Japan.



We are a California corporation incorporated in 1987. Our principal offices
are located at 8001 Irvine Center Drive, Irvine, California 92618.



Products



We currently market over 50 products, which we have
grouped into three main categories: Database Management; Application Performance Management; and Microsoft Infrastructure Management. Major products in these categories are described as follows.



Database Management



TOAD® and SQL Navigator®.    These tools improve the productivity and capability of application developers working in
the Oracle PL/SQL environment. We provide a complete and integrated development



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environment for coding stored procedures, schemas and SQL scripts from one intuitive graphical user interface. Debugging, SQL tuning, change analysis, and
general administration features improve the quality and performance of database applications before they enter production.



Quest Central for Databases.    Administrating large databases in production involves many tedious, error-prone and repetitive tasks. To
simplify these tasks and increase the accuracy and effectiveness of database administrators (DBAs), we have developed Quest Centralfor Databases. Quest Central for Databases is an integrated workbench for Oracle, DB2 (mainframe and distributed) and Microsoft SQL Server databases that combines four functional
components into one suite: Database Administration, Performance Diagnostics, SQL Tuning, and live or traditional Space. Quest Central for Databases provides a consistent look and feel for the management of Oracle, DB2 and SQL Server
databases, reducing cross training costs and enabling DBAs to manage more databases without adding resources.



SharePlex®.    In many cases, an organizations data can be its most valuable resource. Ensuring that data remains available during
an unplanned outage, disaster, or even planned downtime for maintenance can be imperative to an organizations success. SharePlex provides real-time replication of Oracle databases for customers who need to ensure a current, secondary copy of
their transactional Oracle database is available if the primary database goes down. Many customers use SharePlex to offload management reporting, so the activity no longer compromises the performance of transaction processing. Finally, SharePlex is
also frequently used to eliminate end user disruption by providing access to data during the migration of operating systems, hardware platforms and major application releases.



Application Performance Management



Our Application Performance Management products include our Foglight and Spotlight products, and for custom J2EE
applications, our PerformaSure and JProbe products. We also combine these products into Application Performance Management Suites which pair business-centric views of applications with deep domain expertise to both measure and improve the
performance of packaged and custom applications.



Foglight® and Spotlight®.    Foglight is a 24x7
application monitoring solution that provides a holistic view of an entire application and its related components, including application servers, web servers, databases and operating systems. Foglight offers an array of specialized cartridges
focused on ERP and CRM applications to provide a complete monitoring solution for a distributed IT environment. Foglight will alert appropriate IT personnel of existing or threatened nonconforming operating conditions so that they can take
preventative or corrective actions. Our series of complementary Spotlight diagnostic products allow IT personnel to drill down deeply into the many components of an application, database or other layer of the application stack to identify the root
causes of a problem. With these Application Performance Management solutions, administrators can spend less time in reactive mode and more time focusing on improving and managing their IT infrastructures through notification of potential problems
before end users are affected, monitoring transaction response time, resolving problems through real-time diagnostics and maintaining strict service level agreements.



PerformaSure and JProbe.    Custom-developed J2EE applications require a unique set of performance management solutions to assure performance and
reliability across the entire application lifecycle. We provide an integrated solution designed to help all the stakeholders in J2EE application performance management accelerate the detection, diagnosis and resolution of business-threatening
performance issues. Our PerformaSure and JProbe solutions provide comprehensive coverage, from code optimization in development, through pre-production testing in quality assurance, to 24x7 performance monitoring once the application goes into
production. PerformaSure gives J2EE performance investigators a transaction-centric view of performance so issues may be rapidly identified and repaired before they impact customer experience. A complete performance toolkit for Java code tuning,
JProbe helps developers diagnose and resolve performance bottlenecks, memory leaks, excessive garbage collection, threading issues and coverage deficiencies in their J2EE and J2SE applications.



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Microsoft Infrastructure Management



Microsoft applications and platforms are the global standard for desktop productivity applications. Our
products enable IT personnel to more effectively migrate to, manage and administer Microsoft Windows 2000, Exchange and Active Directory environments. Our Microsoft Infrastructure Management products fall into the following four solution sets:



Quest® Management Suite for Windows®.    An integrated Microsoft Management Console (MMC), the Quest
Management Suite for Windows improves the security, simplifies the delegated administration, and enhances the performance of Windows and Active Directory environments. Designed as a solution that Windows and Active Directory administrators can open
and use all day, the Quest Management Suite for Windows combines Quest ActiveRoles, Quest Reporter and Spotlight on Active Directory to provide a comprehensive delegation model, reporting/auditing system and expert resolution advice for teams
managing complex Microsoft infrastructures.



Quest® Management Suite for
Exchange.    In todays business world, email use is growing at a staggering rate, leading to increased traffic, storage and support issues. The Quest Management Suite for Exchange provides a comprehensive set of tools
to intelligently manage this growth and the related spending for mission critical Exchange infrastructures. The Suites features enable mailbox and public folder management, distribution list management, usage analysis, and diagnostics to
optimize investment and performance in Exchange environments. This allows administrators and managers to better target investments, enforce corporate policy, enhance customer service, reduce administrative costs and improve troubleshooting
efficiency. Additional functionality and integration is available for customers who have chosen Microsoft Operations Manager (MOM) as their unattended monitoring solution.



Quest® Migration Suite.    The Quest Migration Suite provides a complete solution to help organizations rapidly transition
from one platform to another. Whether it is an Exchange migration, a migration from Windows NT4 to Active Directory or NDS to Active Directory, the Quest Migration Suite provides the tools to accomplish migration tasks quickly, accurately and most
importantly, without disruption to end users.



Quest®
Consolidator.    Quest Consolidator helps organizations examine their Windows storage from any angle and take corrective action. This data migration solution contains agentless storage analytics, which help organizations
determine how much data they have, where it is, who owns it and when it was last used. This allows companies to determine where the junk data is, and provides methods to offload unused files, balance data loads or consolidate servers to
make the most of their storage resources.



In
January 2004, we announced a definitive agreement to acquire Aelita Software, a privately held software company, a leading provider of systems management solutions that improve the productivity, system availability and security of Microsoft Active
Directory and Microsoft Exchange environments. With the proposed acquisition of Aelita, we expect to add breadth and depth to our Microsoft expertise and product portfolio and deliver a comprehensive set of product solutions that enable customers to
manage todays complex Microsoft infrastructures throughout their entire lifecycle. The combined product offering will deliver the robust solutions customers require to better administer, migrate, consolidate, recover and audit their Microsoft
Active Directory and Exchange environments.



Sales, Marketing and
Distribution



We market and sell our products and services
worldwide primarily through our direct sales organization. At December 31, 2003, we had approximately 300 direct sales representatives. We reduced the number of sales representatives by over 50 in mid-2003 to reduce our direct sales expenses.
Approximately three-fourths of our sales representatives are field sales persons. We have over 130 pre-sales systems engineers who work with these field sales teams to provide technical assistance and demonstrations to sales prospects. The remaining
one-fourth of our sales representatives are telesales representatives, who sell products such as our Oracle and J2EE development tools that are generally evaluated through internet downloads. We supplement our direct sales



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organization with indirect sales channels such as value added resellers and systems integrators. We also employ local resellers in certain international
territories not covered by our local sales offices.



We have
opened sales offices in the major cities of the United States, Europe and Australia to facilitate close contact between current and potential customers and our field sales organization, which includes sales teams as well as pre- and post-sales
technical consultants. In 2003, we began to expand our direct sales efforts into Asia with the opening of a sales office in Japan.



Our marketing efforts are designed to create awareness and generate demand for our products. To achieve these goals, we participate in industry trade
shows, technical conferences and seminars and publish technical and educational articles in industry journals. Advertising has to date not been a key major part of our marketing programs, other than targeted advertisements in technical magazines and
journals.



Our professional services organization complements
our direct sales organization by providing customers with a full range of support services, including implementations, consulting services and training. We believe that professional services are important to customer satisfaction and the development
of long-term customer relationships.



Customer Service and Support



A high level of customer service and support is critical
to the successful marketing and sale of our products and the development of long-term customer relationships. We have a reputation for providing a high level of customer support and believe this is a competitive differentiator. Enrollment in our
support, maintenance and enhancement program is annual and entitles a customer to:



| |  |  | problem resolution services,
| | - |  | ----------------------------



| |  |  | new functional enhancements of a product, and
| | - |  | ---------------------------------------------



| |  |  | ongoing compatibility with new releases of the database, application or other platform supported by the product.
| | - |  | ----------------------------------------------------------------------------------------------------------------



Annual maintenance, support and enhancement fees generally range from 20% to
25% of the initial purchase cost, depending on the product and the level of problem resolution support purchased. Customer support is provided domestically through our offices in Irvine and internationally through our offices in Europe and Canada.



Research and Development



We believe that strong research and product development capabilities are
essential to enhancing our core technologies and developing additional products. Innovative capabilities, strong product engineering and rich user interfaces are typical Quest attributes. We target ease of implementation and ease of use in designing
our products. Our commitment to ongoing product development is reflected in our investments in research and development, which were $63.3 million, $60.1 million and $67.4 million for the years ended December 31, 2001, 2002 and 2003, respectively. We
have actively recruited key software engineers and developers with expertise in the areas of Oracle technologies, Java, Microsoft infrastructure technologies, ERP and CRM systems, IBM database technologies and document management. Complementing
these individuals, our senior management has extensive background in applications, database management, monitoring, and enterprise and system software industries.



Competition



The market for application management solutions is emerging rapidly, and, as a result, is intensely competitive and characterized by rapidly changing
technology and evolving standards. Pricing pressures have



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increased over the past year, reflecting both competition and IT spending contraction. We expect competition to continue to increase both from existing
competitors and new market entrants. We believe that our ability to compete effectively depends on many factors, including:



| |  |  | the ease of use, performance, features, price and reliability of our products as compared to those of our competitors;
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | the value proposition of our products in terms of return on investment and/or reduced cost of ownership;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | the timing and market acceptance of new products and enhancements to existing products developed by us and our competitors;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | the quality of our customer support; and
| | - |  | ----------------------------------------



| |  |  | the effectiveness of our sales and marketing efforts.
| | - |  | -----------------------------------------------------



We compete in some cases with the vendors of databases, applications and other systems that we manage; for example, Oracle provides various tools for
managing its databases that are competitive with our offerings. Competition from Oracle with certain of our Database Management products including SharePlex and Quest Central for Oracle has increased over the last 24 months and continues to increase
with Oracles introduction of the next version of its database, known as Oracle 10G. Oracle 10G is claimed to have enhanced capabilities in the functions competitive with Quest Central for Oracle and with certain Oracle monitoring capabilities
of Foglight. For the reasons discussed below, if Oracle 10G does provide capabilities closely equivalent to those of Quest Central for Oracle, our revenues from that product line would likely be materially adversely affected.



In some cases these platform vendor-provided tools are bundled with the
platform and in other cases they are separately chargeable products, albeit at significantly lower price points. The inclusion of the functionality of our software as standard features of the underlying database solution or application supported by
our products or sale at much lower cost could erode our revenues, particularly if the competing products and features were of comparable capability to our products. Even if the functionality provided as standard features or lower costs by these
system providers is more limited than that of our software, there can be no assurance that a significant number of customers would not elect to accept more limited functionality in lieu of purchasing our products. Moreover, there is substantial risk
that the mere announcements of competing products or features by large competitors such as Oracle could result in the delay or cancellation of customer orders for our products in anticipation of the introduction of such new products or features.



We also compete with other vendors of database, application
and systems management tools. Public companies with whom we compete include:



| |  |  | the large, well established systems management vendorsIBM/Tivoli, Computer Associates, BMC Software and Veritas Software, which acquired Precise Software in June 2003;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | smaller application and database management vendors such as Mercury Interactive and Embarcadero;
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | providers of Windows NT management and migration tools, such as NetIQ, Aelita and BindView.
| | - |  | -------------------------------------------------------------------------------------------



Some of our competitors and potential competitors have greater name recognition, a larger installed customer base
company-wide and significantly greater financial, technical, marketing, and other resources than we do. Competitors may also be able to respond more quickly to new or emerging technologies and changes in customer requirements or devote greater
resources to the development, promotion and sale of their products than we can.



Because there are relatively low barriers to entry in the software market, we may encounter additional competition as other established and emerging companies enter our field and introduce new products and
technologies. Venture capitalists and others have funded numerous application, database and systems management companies over the last five years. Accordingly, it is likely that new competitors or alliances among current and new competitors will
emerge and rapidly gain acceptance.



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There can be no assurance that we will be able to compete successfully against current and future
competitors. Increased competition could result in price reductions, fewer customer orders, reduced gross margins and loss of market share, any of which could materially affect our business, operating results or financial condition.



Proprietary Rights



Our success and ability to compete depend on our capacity to develop and maintain the proprietary aspects of our technology.
We rely on a combination of trademark, trade secret, copyright, patent law and contractual restrictions to protect the proprietary aspects of our technology. We seek to protect our source code for our software, documentation and other written
materials under trade secret and copyright laws. We license our software pursuant to signed or shrink-wrap license agreements, which impose restrictions on the licensees ability to utilize the software. Finally, we seek to avoid disclosure of
our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements with us and by restricting access to our source code. We currently hold several trademark registrations
and have numerous trademark applications in the United States and certain foreign countries.



Employees



As of
December 31, 2003, we employed 1,735 full-time employees, including 692 in sales and marketing, 54 in professional services, 658 in research and development, 131 in customer service and support and 200 in general and administrative. We believe that
our future success will depend in large part upon our continuing ability to attract and retain highly skilled managerial, sales, marketing, customer support and research and development personnel. Like other software companies, we face intense
competition for such personnel, and we have at times experienced and continue to experience difficulty in recruiting qualified personnel. There can be no assurance that we will be successful in attracting, assimilating and retaining other qualified
personnel in the future. None of our employees are represented by a labor union; we have never experienced any work stoppages and we believe that our relationships with our employees are good.



Website



Our website is located at www.quest.com. We make available, free of charge on or through our website, our annual report on
Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.
Information contained on our website is not part of this annual report on Form 10-K.



Item 2.Properties



Our headquarters and our principal administrative, sales, marketing, support and research and development facilities are currently located in two leased buildings comprising approximately 135,100 square feet of space
in Irvine, California. In addition, we lease facilities in Canada, Australia, Israel and Russia for research and development activities. We also operate in leased facilities throughout North America, including Toronto, Chicago, Atlanta, Ottawa and
Houston. Our international subsidiaries and branches operate in leased facilities worldwide, including Australia, the United Kingdom and Germany.



In February 2004, we entered into an agreement to purchase a building in Aliso Viejo, California comprising approximately 78,000 square feet and an
agreement to lease approximately 57,000 square feet of space in an adjacent building for a ten-year term commencing in December 2005. The lease agreement includes an option, exercisable until November 15, 2004, to purchase this building. We intend
to move all of our Irvine



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operations into these two buildings in stages over the next six quarters. See Liquidity and Capital Resourcesin Item 7
Managements Discussion and Analysis of Financial Condition and Results of Operationsfor additional discussion about costs associated with this move.



Item 3.Legal Proceedings



On July 2, 2002, Computer Associates International, Inc. (CA) filed a complaint against us and four of our employees in the U.S. District
Court for the Northern District of Illinois alleging copyright infringement and trade secret misappropriation in connection with the development of the database administration component of our Quest Central for DB2 product and seeking injunctive
relief and unspecified money damages. The complaint was amended in May 2003 to add another Quest employee as a defendant and to assert breach of contract claims against three of the individual defendants. In October 2003, CA filed a motion for
preliminary injunction. We responded to this motion in January 2004, arguing that CA cannot meet the requirements for injunctive relief. In connection with our response, we sought leave to assert a counterclaim for a declaratory judgment of
invalidity of CAs copyright registrations. Rulings on these motions are not expected until late in the second quarter of 2004. If CAs motion is granted, we would be preliminarily enjoined from licensing Quest Central for DB2. We are
vigorously defending CAs claims and do not believe that this matter will have a material adverse effect on our results of operations or financial condition.



After we announced on July 23, 2003 that we would restate certain financial results as a result of our discovery of a
computational error relating to an error in the method used to translate foreign currency denominated accounts into U.S. Dollars at historical rates, numerous separate complaints purporting to be class actions were filed in the United States
District Court for the Central District of California alleging that we and some of our officers and directors violated provisions of the Securities Exchange Act of 1934. Orders designating a lead plaintiff and consolidating the federal class action
complaints were issued by the U. S. District Court in late October 2003, and an amended consolidated class action complaint was filed in January 2004. The consolidated amended complaint contains varying allegations, including allegations that we
made materially false and misleading statements with respect to our financial results for 2002 and the quarter ended March 31, 2003 included in our filings with the SEC and press releases. In addition, one complaint purporting to be a derivative
action has been filed in California state court against some of our directors and officers. This complaint is based on the same facts and circumstances described in the consolidated amended class action complaints and generally alleges that the
named directors and officers breached their fiduciary duties by failing to oversee adequately our financial reporting. Each of the complaints generally seek an unspecified amount of damages. The cases are in the very preliminary stages and we will
vigorously defend these claims; however, it is not possible for us to quantify the extent of our potential liability, if any. Accordingly, no amounts have been accrued in the accompanying financial statements. Our motions to dismiss the federal
class action complaint and the derivative action are expected to be filed during the second quarter of 2004. An unfavorable outcome in any of these cases could have a material adverse effect on our business, financial condition, results of
operations and cash flow. In addition, defending any litigation may be costly and divert managements attention from the day-to-day operations of our business.



We are a party to other litigation, which we consider to be routine and incidental to our business. Management does not
expect the results of any of these actions to have a material adverse effect on our results of operations or financial condition.



In the normal course of our business, we enter into certain types of agreements that require us to indemnify or guarantee the obligations of other
parties. These commitments include (i) intellectual property indemnities to licensees of our software products, (ii) indemnities to certain lessors under office space leases for certain claims arising from our use or occupancy of the related
premises, or for the obligations of our subsidiaries under leasing arrangements, (iii) indemnities to customers, vendors and service providers for claims based on negligence or willful misconduct of our employees and agents, and (iv) indemnities to
our directors and officers to the maximum extent permitted under applicable law. The terms and duration of these commitments varies and, in



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some cases, may be indefinite, and certain of these commitments do not limit the maximum amount of future payments we could become obligated to make
thereunder; accordingly, our actual aggregate maximum exposure related to these types of commitments cannot be reasonably estimated. Historically, we have not been obligated to make significant payments for obligations of this nature, and no
liabilities have been recorded for these obligations in the accompanying consolidated balance sheets as the fair value of these obligations issued during the twelve months ended December 31, 2003 was not significant to our financial position,
results of operations, or cash flows.



Item 4.Submission of Matters to a Vote of Security Holders



No matters were submitted to a vote of security holders during the fourth quarter of 2003.



11



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##### Table of Contents

PART II



Item 5.Market for the Registrants Common Equity and Related Shareholder Matters



Our common stock is listed on the NASDAQ National Market under the symbol QSFT. The following table sets forth the high and low sale
prices on the NASDAQ National Market for our common stock for the periods indicated.



|               |  |                             |       |     |   |      
|-------------- |  | --------------------------- | ----- | --- | - | -----
|               |  | Price Range of Common Stock
|               |  | High                        |       | Low
|2002:          |  |                             |       |     |   |      
|First Quarter  |  | $                           | 27.68 |     | $ | 14.68
|Second Quarter |  |                             | 15.35 |     |   | 11.01
|Third Quarter  |  |                             | 14.31 |     |   | 8.12 
|Fourth Quarter |  |                             | 13.65 |     |   | 7.30 
|2003:          |  |                             |       |     |   |      
|First Quarter  |  | $                           | 12.79 |     | $ | 8.92 
|Second Quarter |  |                             | 13.56 |     |   | 8.90 
|Third Quarter  |  |                             | 13.50 |     |   | 8.50 
|Fourth Quarter |  |                             | 16.14 |     |   | 12.13



On March 1, 2004, the
closing price of our common stock on the NASDAQ National Market was $16.18 per share. As of March 2, 2004, there were 234 holders of record of our common stock (not including beneficial holders of shares held in street name).



We have never declared or paid any cash dividends on our
common stock and do not expect to do so in the foreseeable future. We currently intend to retain all available funds for use in the operation and expansion of our business. Any future determination to pay dividends will be at the discretion of our
board of directors and will depend on our results of operations, financial conditions, contractual and legal restrictions and other factors the board deems relevant.



12



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Item 6.Selected Financial Data



|                                                    |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|--------------------------------------------------- |  | ------------------------------------- | ------ | ---- | - | ------- | ---- |  | - | ------- | - | ---- | - | ------- |  | - | -------
|                                                    |  | Year Ended December 31,              
|                                                    |  | 1999                                  |        | 2000 |   |         | 2001 |  |   | 2002    |   | 2003
|                                                    |  | (In thousands, except per share data)
|Consolidated Statements of Operations Data:         |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Revenues:                                           |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Licenses                                            |  | $                                     | 54,269 |      | $ | 126,767 |      |  | $ | 174,134 |   |      | $ | 160,636 |  | $ | 179,560
|Services                                            |  |                                       | 16,599 |      |   | 38,820  |      |  |   | 72,389  |   |      |   | 94,946  |  |   | 124,728
|                                                    |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Total revenues                                      |  |                                       | 70,868 |      |   | 165,587 |      |  |   | 246,523 |   |      |   | 255,582 |  |   | 304,288
|Cost of revenues:                                   |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Licenses                                            |  |                                       | 2,998  |      |   | 3,571   |      |  |   | 4,510   |   |      |   | 3,539   |  |   | 4,312  
|Services                                            |  |                                       | 4,197  |      |   | 11,071  |      |  |   | 18,985  |   |      |   | 17,913  |  |   | 21,365 
|Amortization of purchased intangible assets         |  |                                       |       |      |   | 5,038   |      |  |   | 8,003   |   |      |   | 5,744   |  |   | 7,675  
|                                                    |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Total cost of revenues                              |  |                                       | 7,195  |      |   | 19,680  |      |  |   | 31,498  |   |      |   | 27,196  |  |   | 33,352 
|Gross profit                                        |  |                                       | 63,673 |      |   | 145,907 |      |  |   | 215,025 |   |      |   | 228,386 |  |   | 270,936
|Operating expenses:                                 |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Sales and marketing                                 |  |                                       | 32,480 |      |   | 79,763  |      |  |   | 124,079 |   |      |   | 128,570 |  |   | 144,460
|Research and development                            |  |                                       | 16,711 |      |   | 41,984  |      |  |   | 63,334  |   |      |   | 60,051  |  |   | 67,448 
|General and administrative                          |  |                                       | 9,928  |      |   | 18,078  |      |  |   | 24,589  |   |      |   | 24,971  |  |   | 29,656 
|In-process research and development                 |  |                                       |       |      |   |        |      |  |   |        |   |      |   | 2,900   |  |   |       
|Intangible asset and goodwill amortization (1)      |  |                                       | 86     |      |   | 35,958  |      |  |   | 56,724  |   |      |   | 2,037   |  |   | 3,390  
|                                                    |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Total operating expenses                            |  |                                       | 59,205 |      |   | 175,783 |      |  |   | 268,726 |   |      |   | 218,529 |  |   | 244,954
|                                                    |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Income (loss) from operations                       |  |                                       | 4,468  |      |   | (29,876 | )    |  |   | (53,701 | ) |      |   | 9,857   |  |   | 25,982 
|Other income, net                                   |  |                                       | 1,202  |      |   | 11,603  |      |  |   | 3,803   |   |      |   | 8,651   |  |   | 7,637  
|                                                    |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Income (loss) before income tax provision           |  |                                       | 5,670  |      |   | (18,273 | )    |  |   | (49,898 | ) |      |   | 18,508  |  |   | 33,619 
|Income tax provision                                |  |                                       | 2,273  |      |   | 6,805   |      |  |   | 5,861   |   |      |   | 8,124   |  |   | 12,103 
|                                                    |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Net income (loss)                                   |  | $                                     | 3,397  |      | $ | (25,078 | )    |  | $ | (55,759 | ) |      | $ | 10,384  |  | $ | 21,516 
|Preferred stock dividends (2)                       |  |                                       | 590    |      |   |        |      |  |   |        |   |      |   |        |  |   |       
|                                                    |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Net income (loss) applicable to common shareholders |  | $                                     | 2,807  |      | $ | (25,078 | )    |  | $ | (55,759 | ) |      | $ | 10,384  |  | $ | 21,516 
|                                                    |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Basic net income (loss) per share                   |  | $                                     | 0.04   |      | $ | (0.30   | )    |  | $ | (0.64   | ) |      | $ | 0.12    |  | $ | 0.23   
|Diluted net income (loss) per share                 |  | $                                     | 0.03   |      | $ | (0.30   | )    |  | $ | (0.64   | ) |      | $ | 0.11    |  | $ | 0.23   
|Weighted average shares outstanding:                |  |                                       |        |      |   |         |      |  |   |         |   |      |   |         |  |   |        
|Basic                                               |  |                                       | 75,354 |      |   | 84,993  |      |  |   | 87,632  |   |      |   | 90,065  |  |   | 92,081 
|Diluted                                             |  |                                       | 83,600 |      |   | 84,993  |      |  |   | 87,632  |   |      |   | 92,820  |  |   | 94,231 

---

|(1) |  | We adopted SFAS No. 142 and discontinued amortizing goodwill in 2002. See Note 1 of Notes to Consolidated Financial Statements.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------

|(2) |  | Represents cash dividends paid in 1999 to holders of shares of Series B Redeemable Preferred Stock, all of which were redeemed in connection with our initial public offering in
August 1999.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                                                 |  |                |        |      |   |         |  |      |         |      |   |         |  |   |        
|------------------------------------------------ |  | -------------- | ------ | ---- | - | ------- |  | ---- | ------- | ---- | - | ------- |  | - | -------
|                                                 |  | December 31,  
|                                                 |  | 1999           |        | 2000 |   | 2001    |  | 2002 |         | 2003
|                                                 |  | (In thousands)
|Consolidated Balance Sheet Data:                 |  |                |        |      |   |         |  |      |         |      |   |         |  |   |        
|Cash, cash equivalents and marketable securities |  | $              | 55,127 |      | $ | 151,826 |  | $    | 207,156 |      | $ | 207,546 |  | $ | 278,366
|Total assets                                     |  |                | 99,149 |      |   | 534,172 |  |      | 540,125 |      |   | 591,281 |  |   | 667,811
|Long-term obligations                            |  |                | 403    |      |   | 6,422   |  |      | 5,140   |      |   | 5,941   |  |   | 1,677  



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Item 7.Managements Discussion and Analysis of Financial Condition and Results of Operations



The following discussion of our financial condition and results of operations also should be read in conjunction with the
consolidated financial statements and notes to those statements included elsewhere in this Report. Certain statements in this Report, including statements regarding our business strategies, operations, financial conditions and prospects, are
forward-looking statements. Use of the words believe, expect, anticipate, will, contemplate, would and similar expressions that contemplate future events may identify
forward-looking statements.



Numerous important factors, risks
and uncertainties affect our operations and could cause actual results to differ materially from those expressed or implied by these or any other forward-looking statements made by us or on our behalf. Readers are urged to carefully review and
consider the various disclosures made in this Report, including those described under Risk Factors, and in other filings with the SEC, that attempt to advise interested parties of certain risks and factors that may affect our
business. Readers are cautioned not to place undue reliance on these forward-looking statements, which are based on current expectations and reflect managements opinions only as of the date thereof. We do not assume any obligation to revise or
update forward-looking statements. Finally, our historic results should not be viewed as indicative of future performance.



Overview and Business Model



We are an independent software vendor of a broad portfolio of products that improve information technology operations. We focus our efforts on products
for widely adopted software platforms such as the Oracle, IBM DB2 and Microsoft SQL Server database management systems, the packaged applications provided by companies such as SAP, Oracle, PeopleSoft and Siebel and the Microsoft Active Directory and
Exchange systems. Products for the Oracle databases have traditionally been our core product set. Over the last three years, the revenue contribution from Oracle database-only products has declined as a percentage of total revenues because of
reduced revenues from our High Availability products for Oracle and because of our efforts to build and acquire products outside of the Oracle database market, especially in the areas of Application Performance Management and Microsoft
Infrastructure Management. Additional information about our products can be found under the discussion above under the heading Business.



Our revenue consists primarily of software license fees and maintenance fees from customers. Our software-licensing model is primarily based on perpetual
license fees, and our license fees are calculated either on a per-server basis or, for our SQL and J2EE development, report management and Microsoft administration tools, a per user basis. First-year maintenance contracts are typically sold with the
related software license and renewed on an annual basis thereafter. Maintenance services entitle a customer to technical support via telephone and the internet and unspecified maintenance releases, updates and enhancements. Maintenance revenue is
based on vendor-specific objective evidence of fair value and amortized over the term of the maintenance contract, typically 12 months. We also provide consulting and training services, which relate to installation of our products and do not include
significant customization to or development of the underlying software code. Consulting and training service revenues are recognized as the services are performed and represent approximately 10.0% of total services revenues.



Our total revenues increased 19.1% from 2002 to 2003 and increased 3.7% from
2001 to 2002. As discussed below, license revenues increased 11.8% from 2002 to 2003 after decreasing 7.8% from 2001 to 2002. Services revenues increased 31.4% from 2002 to 2003 and increased 31.2% from 2001 to 2002. Total revenues benefited in both
2003 and 2002 from the depreciation of the U.S. Dollar against the Euro and British Pound. Total revenues also benefited in 2003 and, to a lesser extent, in 2002, from the revenue contribution by Sitraka, Inc., which we acquired in November 2002.
Revenue contributions from foreign currency translation benefits and Sitraka are quantified in the discussions headed Revenues below.



Our primary expenses are our personnel costs, which include compensation and benefits and costs of office facilities and travel and entertainment, which
are a function of our world-wide headcount. This is reflected in our gross margins that ranged between 88.0% and 91.0% in 2002 and 2003 and in our estimate that these personnel



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related costs represented approximately 75.0% of total expenses in 2003. We have held our headcount fairly constant throughout 2002 and 2003, with the
exceptions that the Sitraka acquisition in November 2002 added approximately 200 personnel and that we reduced headcount by 6.0% to 7.0% in the June and September quarters of 2003. This reduction in headcount and higher revenues have resulted in
improved operating margins in the second half of 2003. We did not record any restructuring charges in connection with this headcount reduction.



Acquisitions



In January 2004, we signed a definitive agreement to acquire Aelita Software, a privately held software vendor, in a $115 million cash transaction. Aelita
develops, markets and supports products that improve the productivity, system availability and security of Microsoft Active Directory and Microsoft Exchange environments. With the proposed acquisition of Aelita, we expect to add breadth and depth to
our Microsoft expertise and product portfolio and deliver a comprehensive set of product solutions that enable customers to manage todays complex Microsoft infrastructures throughout their entire lifecycle. We expect to complete the
acquisition of Aelita in the first quarter of 2004.



In
November of 2002, we acquired Sitraka, a leading developer of application server performance management products, and broadened our Application Performance Management portfolio of products to enable customers to detect, diagnose and resolve
application bottlenecks within multi-tiered Java application environments. Results of operations from Sitraka and other acquisitions are included in our consolidated statements of operations from the respective dates of acquisition. For more
information concerning our acquisitions during the periods presented herein, see Note 5 of Notes to Consolidated Financial Statements.



Results of Operations



Except as otherwise indicated, the following percentages are percentage of total revenues:



|                                            |  |                         |    |  |       |   |  |       |  
|------------------------------------------- |  | ----------------------- | -- |  | ----- | - |  | ----- | -
|                                            |  | Year Ended December 31, |   
|                                            |  | 2001                    |    |  | 2002  |   |  | 2003  |  
|Revenues:                                   |  |                         |    |  |       |   |  |       |  
|Licenses                                    |  | 70.6                    | %  |  | 62.9  | % |  | 59.0  | %
|Services                                    |  | 29.4                    |    |  | 37.1  |   |  | 41.0  |  
|                                            |  |                         |    |  |       |   |  |       |  
|Total revenues                              |  | 100.0                   |    |  | 100.0 |   |  | 100.0 |  
|                                            |  |                         |    |  |       |   |  |       |  
|Cost of revenues:                           |  |                         |    |  |       |   |  |       |  
|Licenses                                    |  | 1.8                     |    |  | 1.4   |   |  | 1.4   |  
|Services                                    |  | 7.7                     |    |  | 7.0   |   |  | 7.0   |  
|Amortization of purchased intangible assets |  | 3.2                     |    |  | 2.2   |   |  | 2.5   |  
|                                            |  |                         |    |  |       |   |  |       |  
|Total cost of revenues                      |  | 12.7                    |    |  | 10.6  |   |  | 10.9  |  
|                                            |  |                         |    |  |       |   |  |       |  
|Gross profit                                |  | 87.3                    |    |  | 89.4  |   |  | 89.1  |  
|Operating expenses:                         |  |                         |    |  |       |   |  |       |  
|Sales and marketing                         |  | 50.3                    |    |  | 50.3  |   |  | 47.5  |  
|Research and development                    |  | 25.7                    |    |  | 23.5  |   |  | 22.2  |  
|General and administrative                  |  | 10.0                    |    |  | 9.8   |   |  | 9.7   |  
|In-process research and development         |  |                        |    |  | 1.1   |   |  |      |  
|Amortization of purchased intangible assets |  | 23.0                    |    |  | 0.8   |   |  | 1.1   |  
|                                            |  |                         |    |  |       |   |  |       |  
|Total operating expenses                    |  | 109.0                   |    |  | 85.5  |   |  | 80.5  |  
|                                            |  |                         |    |  |       |   |  |       |  
|Income (loss) from operations               |  | (21.7                   | )  |  | 3.9   |   |  | 8.6   |  
|Other income, net                           |  | 1.5                     |    |  | 3.4   |   |  | 2.6   |  
|                                            |  |                         |    |  |       |   |  |       |  
|Income (loss) before income tax provision   |  | (20.2                   | )  |  | 7.3   |   |  | 11.2  |  
|Income tax provision                        |  | 2.4                     |    |  | 3.2   |   |  | 4.0   |  
|                                            |  |                         |    |  |       |   |  |       |  
|Net income (loss)                           |  | (22.6                   | )% |  | 4.1   | % |  | 7.2   | %
|                                            |  |                         |    |  |       |   |  |       |  
|As a percentage of related revenues:        |  |                         |    |  |       |   |  |       |  
|Cost of licenses                            |  | 2.6                     | %  |  | 2.2   | % |  | 2.4   | %
|Cost of services                            |  | 26.2                    | %  |  | 18.9  | % |  | 17.1  | %



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Comparison of Fiscal Years Ended December 31, 2002 and 2003



Revenues



Total revenues and year-over-year changes are as follows (in thousands, except for percentages):



|               |  |      |         |      |   |                   |  |      |  
|-------------- |  | ---- | ------- | ---- | - | ----------------- |  | ---- | -
|               |  | 2002 |         | 2003 |   | Percentage Change | 
|Revenues:      |  |      |         |      |   |                   |  |      |  
|Licenses       |  | $    | 160,636 |      | $ | 179,560           |  | 11.8 | %
|Services       |  |      | 94,946  |      |   | 124,728           |  | 31.4 | %
|               |  |      |         |      |   |                   |  |      |  
|Total revenues |  | $    | 255,582 |      | $ | 304,288           |  | 19.1 | %
|               |  |      |         |      |   |                   |  |      |  



License
RevenuesTotal license revenues growth of 11.8% in 2003 derived from license revenues growth of 11.5% in North America, which increased to $126.2 million in 2003 and license revenues growth of 12.4% outside of North America to $53.4 million
in 2003. The $18.9 million growth in license revenues in 2003 benefited from an $8.0 million contribution by Sitraka, Inc. acquired in November 2002 and an approximately $7.0 million contribution from the impact of the devaluation of the U.S. Dollar
in 2003 relative to certain foreign currencies, primarily the Euro and the British Pound. We saw growth year-over-year primarily in our Application Performance Management products, with Foglight being the main contributor to the growth. License
revenues were reduced by declines in sales of our high availability products for Oracle and our Vista output management products.



Service RevenuesTotal service revenues growth of 31.4% derived from service revenues growth of 22.5% in North America, which increased to
$94.4 million and service revenues growth of 69.5% outside of North America to $30.3 million in 2003. Higher revenues from support renewals primarily contributed to the growth, with an increasing base of products and customers we are supporting and,
we believe, higher support renewal rates. Service revenues also benefited from a contribution of approximately $2.0 million from the impact of the devaluation of the U.S. Dollar in 2003 relative to certain foreign currencies, primarily the Euro and
the British Pound and, to a much lesser extent, support revenues from the acquired base of Sitraka customers. Professional services as a percentage of total service revenues represented 10.0% in 2003 and 9.9% in 2002.



Cost of Revenues



Total cost of revenues and year-over-year changes are as follows (in thousands, except for percentages):



|                                            |  |      |        |      |   |                   |  |      |  
|------------------------------------------- |  | ---- | ------ | ---- | - | ----------------- |  | ---- | -
|                                            |  | 2002 |        | 2003 |   | Percentage Change | 
|Cost of revenues:                           |  |      |        |      |   |                   |  |      |  
|Licenses                                    |  | $    | 3,539  |      | $ | 4,312             |  | 21.8 | %
|Services                                    |  |      | 17,913 |      |   | 21,365            |  | 19.3 | %
|Amortization of purchased intangible assets |  |      | 5,744  |      |   | 7,675             |  | 33.6 | %
|                                            |  |      |        |      |   |                   |  |      |  
|Total cost of revenues                      |  | $    | 27,196 |      | $ | 33,352            |  | 22.6 | %
|                                            |  |      |        |      |   |                   |  |      |  



Cost of
LicensesCost of licenses primarily consists of third-party software royalties, product packaging, documentation, duplication, delivery and personnel. Cost of licenses as a percentage of license revenues was 2.4% for 2003, compared with
2.2% in 2002. We expect that cost of licenses as a percentage of license revenues will remain relatively constant in 2004.



Cost of ServicesCost of services primarily consists of personnel, outside consultants, facilities and systems costs used in providing
support, consulting and training services. Cost of services as a percentage of service revenues declined to 17.1% for 2003, compared to 18.9% for 2002. The increase in the absolute amounts of cost of services is primarily due to an increase in fees
paid to outside professional services consultants in



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support of product deployments, an increase in the number of technical support personnel and consultants, mainly from the acquisition of Sitraka, as well as
the impact from the devaluation of the U.S. Dollar relative to certain foreign currencies, primarily the Euro and the British Pound. The margin improvement is primarily due to our continued increase in customer maintenance and support revenues with
a lower associated increase in headcount.



Amortization of
Purchased Intangible AssetsAmortization of purchased intangible assets includes amortization of the fair value of acquired technology associated with the acquisitions made from 2000 through 2003. The increase is primarily due to
amortization of purchased intangible assets related to the acquisitions of eCritical and Discus in the second quarter of 2003 and Sitraka in 2002, offset slightly by purchased intangible assets from acquisitions made in 2000 that were fully
amortized by the beginning and middle of the year ended December 31, 2003. See Note 4 of the Notes to Consolidated Financial Statements for discussion of estimated future amortization expense. The useful lives of the acquired
technologies range from two to seven years. See Critical Accounting Policies and Estimates for additional discussion regarding accounting for intangible assets.



Operating Expenses



Year-over-year changes in the principal components of our operating expenses are as follows (in thousands, except for percentages):



|                                            |  |      |         |      |   |                   |  |      |  
|------------------------------------------- |  | ---- | ------- | ---- | - | ----------------- |  | ---- | -
|                                            |  | 2002 |         | 2003 |   | Percentage Change | 
|Operating expenses:                         |  |      |         |      |   |                   |  |      |  
|Sales and marketing                         |  | $    | 128,570 |      | $ | 144,460           |  | 12.4 | %
|Research and development                    |  |      | 60,051  |      |   | 67,448            |  | 12.3 | %
|General and administrative                  |  |      | 24,971  |      |   | 29,656            |  | 18.8 | %
|Amortization of purchased intangible assets |  |      | 2,037   |      |   | 3,390             |  | 66.4 | %



Sales and
MarketingSales and marketing expenses consist primarily of the following types of costs related to our sales and marketing activities: compensation and benefits; sales commissions; facilities and systems; recruiting; trade shows; travel
and entertainment; and marketing communications. Sales and marketing expenses as a percentage of total revenues were 47.5% in 2003 compared to 50.3% in 2002. The absolute increase in sales and marketing expenses resulted from increased labor
expenses, primarily due to additional headcount from our acquisition of Sitraka, higher salary and commission rate in 2003 and to the U.S. Dollar devaluation. In addition, employee severance costs contributed approximately $1.4 million to sales and
marketing expenses in 2003. These increases were offset somewhat by lower marketing program costs in 2003, primarily related to advertising and tradeshows. Sales and marketing expenses declined year-over-year on a percentage of revenues basis
because of lower marketing costs in 2003 and reduced sales headcount in the third and fourth quarters of 2003.



Research and DevelopmentResearch and development expenses consist primarily of compensation and benefit costs for software developers,
software product managers, quality assurance and technical documentation personnel, associated facilities and systems costs and payments made to outside software development consultants in connection with our ongoing efforts to enhance our core
technologies and develop additional products. Research and development expenses as a percentage of total revenues were 22.2% in 2003 compared to 23.5% in 2002. Additional headcount from our acquisition of Sitraka was the primary reason for the
absolute increase in research and development expenses. The devaluation of the U.S. Dollar to the Australian and Canadian Dollars also contributed to the expense increase, because we have significant development facilities in Australia and Canada.



General and AdministrativeGeneral and
administrative expenses consist primarily of compensation and benefit costs for our executive, finance, legal, administrative and information services personnel, professional fees, and associated facilities and systems costs. General and
administrative expenses as a percentage of total



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revenues were 9.7% in 2003 and 9.8% in 2002. The absolute increase in general and administrative expenses is primarily attributable to the inclusion of
Sitrakas general and administrative expenses, the currency effect of the U.S. Dollar devaluation, and higher accounting and legal fees. External accounting and legal fees alone increased by approximately $1.0 million in 2003 compared to 2002,
with litigation defense costs and Sarbanes-Oxley compliance costs being the primary components.



Amortization of Purchased Intangible AssetsIntangible asset amortization includes the amortization of customer lists, trademarks and
non-compete agreements associated with acquisitions. The increase in amortization is a result of the recent acquisitions, including Sitraka.



Other Income, Net



Other income, net includes interest income on our investment portfolio and gains and losses from foreign exchange fluctuations, as well as gains or losses
on other financial or physical assets. Interest income decreased 33.7% from $8.9 million in 2002 to $5.9 million in 2003 as a result of lower reinvestment rates and a reduced investment portfolio on average. Foreign currency gains of $6.6 million
were included in other income, net in 2003 as compared to $2.1 million of such gains included in 2002. The 2003 gains were primarily attributable to foreign currency fluctuations on certain non-U.S. Dollar denominated assets, primarily accounts
receivable held in British Pounds and Euros, which appreciated 10.9% and 19.8%, respectively, against the U.S. Dollar in 2003. Other income, net in 2003 also includes an impairment charge of $3.5 million incurred in the fourth quarter of 2003
relating to our aircraft. The impairment charge is equal to the amount by which the carrying amount exceeded the estimated fair value of the aircraft.



Income Tax Provision



Provision for income taxes increased to $12.1 million in 2003 from $8.1 million in 2002, representing an increase of $4.0 million or 49.0%. The effective
income tax rate in 2003 was 36.0% compared to 43.9% in 2002. The decline in the effective tax rate is largely the result of higher profitability of certain of our non-U.S. subsidiaries, which are subject to a lower effective tax rate primarily as a
result of the utilization of historical net operating losses incurred in such jurisdictions.



Comparison of Fiscal Years Ended December 31, 2001 and 2002



Revenues



Total
revenues and year-over-year changes are as follows (in thousands, except for percentages):



|               |  |      |         |      |   |                   |  |      |   
|-------------- |  | ---- | ------- | ---- | - | ----------------- |  | ---- | --
|               |  | 2001 |         | 2002 |   | Percentage Change | 
|Revenues:      |  |      |         |      |   |                   |  |      |   
|Licenses       |  | $    | 174,134 |      | $ | 160,636           |  | (7.8 | )%
|Services       |  |      | 72,389  |      |   | 94,946            |  | 31.2 | % 
|               |  |      |         |      |   |                   |  |      |   
|Total revenues |  | $    | 246,523 |      | $ | 255,582           |  | 3.7  | % 
|               |  |      |         |      |   |                   |  |      |   



License
RevenuesWe believe customer efforts to reduce IT spending in response to general economic conditions contributed to the decrease in license revenues in 2002. In addition, we experienced increased competition related to our high
availability and production support products for Oracle and our Vista output management products, which also contributed to the decline in license revenues. The decline in license revenues for these products was offset by growth in other product
areas, primarily our Microsoft administration products and our monitoring products. License revenues in North America decreased to $113.1 million in 2002 from $136.1 million in 2001, a decline of 16.9%. License revenues outside of North America
increased 24.8% to $47.5 million in 2002 from $38.1 million in 2001, and accounted for 29.6% of total license revenues, compared to



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21.9% in 2001. The increase in license revenues outside of North America is primarily due to strengthening operations in Europe as a result of continued
investment in our foreign operations. License revenues attributable to our European operations represented $42.7 million in 2002, compared to $33.1 million in 2001, representing growth of 29.0%.



Service RevenuesThe increase in service revenues was derived
primarily from higher renewal maintenance fees. Higher renewal maintenance fees derived from growth in the base of installed products and, we believe, from improved support renewal billing processes and improved maintenance renewal rates. To a much
lesser extent, support revenues from the acquired base of Sitraka customers also contributed to year-over-year increase in service revenues. Professional services as a percentage of total service revenues represented 9.9% in 2002 and 15.4% in 2001.



Cost of Revenues



Total cost of revenues and year-over-year changes are as follows (in
thousands, except for percentages):



|                                            |  |      |        |      |   |                   |  |       |   
|------------------------------------------- |  | ---- | ------ | ---- | - | ----------------- |  | ----- | --
|                                            |  | 2001 |        | 2002 |   | Percentage Change | 
|Cost of revenues:                           |  |      |        |      |   |                   |  |       |   
|Licenses                                    |  | $    | 4,510  |      | $ | 3,539             |  | (21.5 | )%
|Services                                    |  |      | 18,985 |      |   | 17,913            |  | (5.6  | )%
|Amortization of purchased intangible assets |  |      | 8,003  |      |   | 5,744             |  | (28.2 | )%
|                                            |  |      |        |      |   |                   |  |       |   
|Total cost of revenues                      |  | $    | 31,498 |      | $ | 27,196            |  | (13.7 | )%
|                                            |  |      |        |      |   |                   |  |       |   



Cost of
LicensesCost of licenses as a percentage of license revenues was 2.2% for 2002, compared with 2.6% in 2001. The decrease in cost of licenses for 2002 was primarily due to a decrease in third-party royalty obligations associated with our
acquisition of RevealNet in the third quarter of 2001, whose products we distributed, and a decrease in amortization expense related to rights in purchased software rights.



Cost of ServicesCost of services as a percentage of service revenues declined to 18.9% for 2002, compared to
26.2% for 2001. The decrease in cost of services for 2002 is primarily attributable to a reduction in the amount of fees paid to outside consultants who provided specialized professional services.



Amortization of Purchased Intangible AssetsThe decrease in
amortization of purchased intangible assets is primarily due to the completion of amortization of purchased intangible assets related to certain acquisitions made in 2000, offset slightly by amortization related to acquisitions made in 2002.
Intangible assets purchased as part of acquisitions were $3.2 million and $30.6 million in 2001 and 2002, respectively.



Operating Expenses



Year-over-year changes in the principal components of our operating expenses are as follows (in thousands, except for percentages):



|                                            |  |      |         |      |   |                   |  |       |   
|------------------------------------------- |  | ---- | ------- | ---- | - | ----------------- |  | ----- | --
|                                            |  | 2001 |         | 2002 |   | Percentage Change | 
|Operating expenses:                         |  |      |         |      |   |                   |  |       |   
|Sales and marketing                         |  | $    | 124,079 |      | $ | 128,570           |  | 3.6   | % 
|Research and development                    |  |      | 63,334  |      |   | 60,051            |  | (5.2  | )%
|General and administrative                  |  |      | 24,589  |      |   | 24,971            |  | 1.6   | % 
|Amortization of purchased intangible assets |  |      | 56,724  |      |   | 2,037             |  | (96.4 | )%



Sales and
MarketingAs a percentage of total revenues, sales and marketing remained flat at 50.3% from 2001 to 2002. The increase in sales and marketing expenses in 2002 resulted from increased labor expenses,



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primarily due to additional headcount from our acquisition of Sitraka, higher sales commission expenses and increased depreciation of sales and marketing
information technology assets.



Research and
DevelopmentResearch and development expenses declined as a percentage of total revenues to 23.5% in 2002 from 25.7% in 2001. In 2002, we implemented cost-control measures that resulted in decreases in travel expenses and fees paid to
outside software development consultants. These savings were offset by increased labor costs primarily attributable to the additional headcount resulting from the Sitraka acquisition.



General and AdministrativeThe increase in general and administrative expenses in 2002 was primarily
attributable to increased legal expenses and premiums for directors and officers liability insurance coverage. General and administrative expenses as a percentage of total revenues remained relatively flat from 2001 to 2002.



Intangible Asset and Goodwill AmortizationThe decrease in
intangible asset and goodwill amortization was principally due to our adoption of SFAS No. 142 Previously recognized workforce-in-place intangible assets were reclassified to goodwill effective January 1, 2002. See Note 1 of Notes to
Consolidated Financial Statements.



Other Income, Net



Interest income decreased 13.5% from $10.3 million in
2002 to $8.9 million in 2003 as a result of lower reinvestment rates and a reduced investment portfolio on average. Foreign currency gains of $2.1 million were included in other income, net in 2002 as compared to a nominal amount in 2002. The 2002
gains were primarily attributable to foreign currency fluctuations on certain non-U.S. Dollar denominated assets, primarily accounts receivable held in British Pounds and Euros, which appreciated 10.5% and 18.3%, respectively, against the U.S.
Dollar in 2002. Other income, net in 2002 also included a net gain on equity investments of $1.9 million arising from the sale of an equity investment and a loss of $1.6 million from an adjustment for other than temporary impairment of another
equity investment. The gain is also attributable to a $4.4 million loss on equity investments recorded in 2001.



Income Tax Provision



Provision for income taxes increased to $8.1 million in 2002 from $5.9 million in 2001, representing an increase of $2.2 million or 38.6%. The effective
income tax rate in 2002 was 43.9% compared to (11.7)% in 2001. The change in the effective tax rate from 2001 to 2002 results primarily from the elimination of goodwill amortization associated with the implementation of SFAS No. 142. See Note 9 of
Notes to Consolidated Financial Statements.



Inflation



Inflation has not had a significant effect on our results
of operations or financial position for the years ended December 31, 2001, 2002 and 2003.



Liquidity and Capital Resources



As of December 31, 2003, cash and cash equivalents and short-term marketable securities were $94.2 million and we held $184.2 million of long-term investment grade corporate and government securities.



Operating Activities



Net cash provided by operating activities increased to $76.7 million in 2003, compared with $53.2 million in 2002. The
increase in cash from operating activities in 2003 was driven primarily by higher net income and



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deferred revenue with a reduction to deferred taxes. These increases were partially offset by an increase to accounts receivable and a reduction to income
taxes payable.



Investing Activities



We used $80.2 million in investing activities in 2003, consisting primarily
of $68.7 million net cash paid for purchases of marketable securities, $4.8 million net cash paid for acquisitions and $6.7 million in capital expenditures. We used $21.9 million in investing activities in 2002, consisting primarily of $56.8 million
net cash paid for acquisitions and $3.0 million in capital expenditures, offset by net sales and maturities of marketable securities of $35.2 million and $2.8 million from the sale of an aircraft and equity investments. Capital expenditures
primarily consisted of information technology hardware and software purchases.



In February 2004, we entered into an agreement to purchase a building in Aliso Viejo, California comprising approximately 78,000 square feet for approximately $14.0 million, and an agreement to lease approximately
57,000 square feet of space in an adjacent building for a ten-year term commencing in December 2005. The purchase of this building is expected to close at the end of the first quarter of 2004. The lease agreement includes an option, exercisable
until November 15, 2004, to purchase this building. If we exercise this option, the purchase price would be approximately $18.6 million. We intend to move all of our Irvine operations into these two buildings in stages over the next six quarters.
The cost of improvements and moving to a new location is expected to be approximately $9.0 million for each building.



On January 28, 2004, we signed a definitive agreement to acquire Aelita Software Corporation in a transaction valued at approximately $115.0 million, of
which approximately $101.0 million is expected to be paid to Aelitas stockholders in cash upon closing of this transaction (assuming no unanticipated exercise of existing Aelita stock options prior to closing). This transaction is expected to
close by the end of the first quarter of 2004.



In the future,
we expect cash will continue to be generated from our operations. We plan to reinvest our cash generated from operations in new short and long-term marketable securities consistent with past investment practices and continue to evaluate a variety of
other strategic investment and acquisition opportunities.



Financing
Activities



Financing activities generated $9.6 million in
2003, primarily from net proceeds of $14.1 million from issuances of our common stock under employee stock option and stock purchase plans, offset by the use of $4.6 million to repay debt. Financing activities generated $4.0 million in 2002, of
which $6.2 million was generated from issuances of our common stock under employee stock option and stock purchase plans, offset by the use of $2.3 million to repay debt.



In December 2000, our Board of Directors authorized a stock repurchase program under which we may purchase up to two million
shares of our common stock. Under the repurchase program, we may purchase shares from time to time at varying prices in open market or private transactions. In October 2001, our Board of Directors increased the total number of shares authorized for
repurchase under the stock repurchase program from two million shares to five million. As of December 31, 2003, we had repurchased approximately 1.7 million shares of our common stock under this program for an aggregate cost of approximately $58.0
million. Repurchases help offset dilution from stock issued under our employee stock option and employee stock purchase plans. No shares of common stock were repurchased under this plan during 2002 or 2003.



Contractual Obligations



As of December 31, 2003, our contractual obligations or commercial commitments include our facility lease commitments and
operating leases for office facilities and certain items of equipment as well as the remaining



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balance of $0.9 million for certain indebtedness assumed in connection with our acquisition of FastLane in September 2000, which is due in July of 2004. In
addition, we are committed to pay additional capital contributions to a private equity fund totaling $1.7 million as capital calls are made. We do not have any off-balance sheet arrangements that could reduce our liquidity.



The following table summarizes our obligations as of December 31, 2003 and
the effect we expect such obligations to have on our liquidity and cash flows in future periods (in thousands):



|                            |  |                        |        |                  |   |           |  |           |        |                   |   |       |  |   |  
|--------------------------- |  | ---------------------- | ------ | ---------------- | - | --------- |  | --------- | ------ | ----------------- | - | ----- |  | - | -
|                            |  | Payments due by period
|                            |  | Total                  |        | Less Than 1 Year |   | 1-3 Years |  | 3-5 Years |        | More Than 5 Years
|Operating Lease Obligations |  | $                      | 32,004 |                  | $ | 11,082    |  | $         | 14,846 |                   | $ | 6,076 |  | $ | 
|Capital Lease Obligations   |  |                        | 194    |                  |   | 132       |  |           | 62     |                   |   |      |  |   | 
|Acquisition Obligations(1)  |  |                        | 3,774  |                  |   | 2,534     |  |           | 1,240  |                   |   |      |  |   | 
|                            |  |                        |        |                  |   |           |  |           |        |                   |   |       |  |   |  
|Total                       |  | $                      | 35,972 |                  | $ | 13,748    |  | $         | 16,148 |                   | $ | 6,076 |  | $ | 
|                            |  |                        |        |                  |   |           |  |           |        |                   |   |       |  |   |  

---

|(1) |  | $1.0 million of the contractual obligation in the 1-3 year period may become due in less than one year if certain earn-out requirements are met.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------



Based on our current operating plan, we believe that our existing cash, cash
equivalents and investment balances and cash flows from operations will be sufficient to finance our working capital and capital expenditure requirements through at least the next 12 months. If we are not able to generate or sustain positive cash
flow from operations, we would be required to use existing cash, cash equivalents and investment balances to support our working capital. Our ability to generate cash from operations is subject to substantial risks described below under the caption
Risk Factors.



Critical Accounting Policies and Estimates



The discussion and analysis of our financial condition
and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements
requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, accounts receivable, intangible assets,
income taxes and stock based compensation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. This forms the basis of judgments about the carrying values of
assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.



We believe the following critical accounting policies and the related judgments and estimates affect the preparation of our
consolidated financial statements.



Revenue Recognition



We derive revenues from two primary sources: (1) software
licenses and (2) services, which include post-contract customer support, consulting and education. We utilize written contracts as the means to establish the terms and conditions by which our products and services are sold to our customers. We
license our products primarily through our direct sales force and indirectly through resellers.



We recognize revenue in accordance with the American Institute of Certified Public Accountants (AICPA) Statement of Position
(SOP) 97-2, Software Revenue Recognition, and related interpretations, SOP 98-9 Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions, Securities
and Exchange Commission (SEC) Staff Accounting Bulletin No. 101 (SAB 101), Revenue



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Recognition in Financial Statements, and other related pronouncements. Based on our reading and interpretation of SOP 97-2, SOP 98-9, SAB 101
and other related pronouncements, we believe that our current sales contract terms and business arrangements have been properly reported. The AICPA and its Software Revenue Recognition Task Force continue to issue interpretations and guidance for
applying the relevant standards to a wide range of sales contract terms and business arrangements that are prevalent in the software industry. Future interpretations of existing accounting standards or changes in our business practices could result
in future changes in our revenue accounting policies that could have a material adverse effect on our business, financial condition and results of operations.



Our software products are off-the-shelf products that do not require modification or customization. Revenues from sales to of software
licenses to customers are recognized when:



| | (1) |  | Persuasive evidence of an arrangement existsWe consider a written contract, signed by both the customer and us, to be persuasive evidence of an arrangement;
| | --- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (2) |  | Delivery has occurredWe deem delivery to have occurred when all products or services that are essential to the functionality are delivered to the customer;
| | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (3) |  | The fee is fixed or determinableWe deem our fee to be fixed or determinable when we have a signed contract that states the agreed upon fee for our software and/or services. We
consider arrangements with 80% or more of the payments due within six months and the balance due within the next six months to be fixed and determinable. Arrangements with payment terms extending beyond these customary payment terms are considered
neither to be fixed nor determinable, and revenue from such arrangements is recognized as payments are received. We do not grant customers a right of return; and
| | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (4) |  | Collection is probableWe assess the probability of collection on a customer-by-customer basis, based on the customers payment history and our evaluation of the
customers financial position. If we determine that collection is not probable, we recognize revenue upon receipt of payment.
| | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Our software license sales include an implicit first year annual customer support fee, which is recognized ratably over the one-year term of the
arrangement. A customers renewal of annual customer support is priced as a percentage of the net software license fees, generally 20% to 25% of the initial purchase price.



We also offer product implementation and training services, which are sold separately under consulting engagement contracts.
Revenues from these arrangements are accounted for separately from new software license revenues because the arrangements qualify as service transactions as defined in SOP 97-2 and are recognized as the services are performed.



For arrangements with multiple elements, we allocate revenue to each element
of a transaction based upon its fair value as determined in reliance on vendor-specific objective evidence, or VSOE. VSOE of fair value for all elements of an arrangement is based upon the normal pricing and discounting
practices for those products and services when sold separately. When multiple elements are sold to a customer in a single contract, the revenues from such multiple-element arrangements are allocated to each element based upon the residual method.
Under the residual method, revenue is recognized for all delivered elements when (1) there is VSOE of the fair values of all undelivered elements and (2) all revenue recognition criteria of SOP 97-2, as amended, are satisfied. Under the residual
method of accounting, any discount in the arrangement is allocated to the delivered elements. If we cannot objectively determine the fair value of any undelivered element included in bundled software and service arrangements, we defer revenue until
all elements are delivered, services have been performed or until fair value can objectively be determined.



We sell our products primarily through direct sales. For indirect sales transactions sold through distributors or resellers, we recognize revenue using
the sell-through method, meaning revenues are associated with specific customer orders. In addition, we defer recognition on indirect sales until receipt of payment unless we have a payment history with the reseller or distributor with no late
payment experiences.



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Accounts Receivable



We maintain allowances for sales returns and doubtful accounts for estimated losses resulting from the unwillingness or
inability of our customers to make required payments. This requires us to make estimates of future product returns, annual support cancellations and write-offs of bad debt accounts related to current period revenues. The amount of our reserves is
based on historical experience and our analysis of the accounts receivable. As a percentage of current period revenues, charges against sales allowances for bad debt, sales returns and annual support cancellations were insignificant in both of the
years ended December 31, 2003 and 2002.



If the financial
condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required which would result in an additional general and administrative expense in the period such
determination was made. Additionally, if significant product performance issues were to arise resulting in our accepting sales returns, additional allowances may be required which would result in a reduction of revenue in the period such
determination was made. Our standard licensing agreement does not permit customers to return products unless we have breached the product warranty and are unable to cure the breach. Our product warranties are typical industry warranties that a
product will perform in accordance with established product requirements. While such amounts have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss
rates that we have in the past.



Intangible Assets



In July 2001, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires all business
combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting. SFAS No. 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. We adopted SFAS No. 141 at the
beginning of the third quarter of 2001 and adopted SFAS No. 142 at the beginning of the first quarter of 2002. As required by SFAS No. 142, we discontinued amortizing the remaining balances of goodwill as of the beginning of fiscal 2002. As a
result, our annual amortization expense decreased approximately $56.0 million. All remaining and future acquired goodwill will be subject to impairment tests annually, or earlier if indicators of potential impairment exist, using a fair-value-based
approach. All other intangible assets will continue to be amortized over their estimated useful lives and assessed for impairment under SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.



Under SFAS No. 142, goodwill impairment is deemed to exist if the net book
value of a reporting unit exceeds its estimated fair value. We performed our annual impairment review and as a result determined that the carrying value of goodwill was less than the estimated fair value. In calculating the fair value of the
reporting units (licenses and services), the Market Approach (Guideline Company Method) was the methodology deemed the most reliable and used for impairment analysis. We will perform subsequent annual impairment reviews during the fourth quarter of
each year, or earlier if indicators of potential impairment exist. Future impairment reviews may result in charges against earnings to write down the value of goodwill.



Purchased intangible assets are recorded at the appraised value and amortized using the straight-line method over estimated
useful lives of two years to seven years. The net carrying amount of purchased intangible assets was considered recoverable at December 31, 2003. In accordance with SFAS No. 144, purchased intangible assets are reviewed for events or changes in
circumstances, which indicate that their carrying value may not be recoverable. We periodically review the carrying value of these assets to determine whether or not impairment to such value has occurred. In the event that in the future it is
determined that the purchased intangible assets value has been impaired, an adjustment will be made resulting in a charge for the write-down in the period in which the determination is made.



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Income Taxes



We are required to estimate income taxes in each of the jurisdictions in which we operate as part of the process of
preparing the consolidated financial statements. We recognize deferred income tax assets and liabilities based upon the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. Such deferred income
taxes primarily relate to the timing of the recognition of certain revenue items and the timing of the deductibility of certain reserves and accruals for income tax purposes. We regularly review the deferred tax assets for recoverability and
establish a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. If we are unable to generate sufficient future taxable income, or if there is a material change in the actual
effective tax rates or time periods within which the underlying timing differences become taxable or deductible, we could be required to establish an additional valuation allowance against the deferred tax assets, which could result in a substantial
increase in our effective tax rate and have a materially adverse impact on our operating results. U.S. income taxes were not provided for on undistributed earnings from certain non-U.S. subsidiaries. Those earnings are considered to be permanently
reinvested.



Accounting for Stock-Based Compensation



Our stock-based employee compensation plans are described
more fully in Note 11 of Notes to Consolidated Financial Statements. We account for those plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25 and related
interpretations. Certain options granted under those plans had an exercise price less than the fair value of the underlying common stock on the date of grant, which is described more fully in Note 11. Unearned stock-based employee compensation costs
associated with these options are reflected in net income. The expense equals the difference between the fair market value of our common stock on the grant date and the exercise price of the stock options and is recognized ratably over the vesting
period of the stock options, currently four to five years.



We
amortize stock-based compensation using the straight-line method over the remaining vesting periods of the related options, which is generally four to five years. Pro forma information regarding net income and earnings per share is required by SFAS
No. 123. This information is required to be determined as if we had accounted for employee stock options and stock purchase plans under the fair value method of SFAS No. 123, as amended by SFAS No. 148.



Had employee stock based compensation cost been determined using the fair
value method our net income (loss) would have been adjusted to the pro forma amounts indicated below (in thousands, except per share data):



|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                                           |  | December 31, |        
|                                                                                                                           |  | 2001         |         |   | 2002 |   |         | 2003 | 
|Net income (loss):                                                                                                         |  |              |         |   |      |   |         |      |  |   |         |  
|As reported                                                                                                                |  | $            | (55,759 | ) |      | $ | 10,384  |      |  | $ | 21,516  |  
|Add: Stock-based compensation expense included in reported net income (loss), net of related tax effects                   |  |              | 2,930   |   |      |   | 891     |      |  |   | 529     |  
|Deduct: Total stock-based compensation determined under fair value based method for all awards, net of related tax effects |  |              | (21,335 | ) |      |   | (23,970 | )    |  |   | (27,746 | )
|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  
|Pro forma                                                                                                                  |  | $            | (74,164 | ) |      | $ | (12,695 | )    |  | $ | (5,701  | )
|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  
|Basic net income (loss) per share:                                                                                         |  |              |         |   |      |   |         |      |  |   |         |  
|As reported                                                                                                                |  | $            | (0.64   | ) |      | $ | 0.12    |      |  | $ | 0.23    |  
|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  
|Pro forma                                                                                                                  |  | $            | (0.85   | ) |      | $ | (0.14   | )    |  | $ | (0.06   | )
|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  
|Diluted net income (loss) per share:                                                                                       |  |              |         |   |      |   |         |      |  |   |         |  
|As reported                                                                                                                |  | $            | (0.64   | ) |      | $ | 0.11    |      |  | $ | 0.23    |  
|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  
|Pro forma                                                                                                                  |  | $            | (0.85   | ) |      | $ | (0.14   | )    |  | $ | (0.06   | )
|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  



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The fair value of options and shares issued pursuant to the Employee Stock Purchase Plan at the grant
date was estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing
models require the input of highly subjective assumptions including the expected stock price volatility. We use projected volatility rates, which are based upon historical volatility rates trended into future years. Because our employee stock
options 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 our options.



The effects of applying pro forma disclosures of net income and earnings per share are not likely to be representative of the pro forma effects on net income and earnings per share in the future years, because the
number of future shares to be issued under these plans is not known and the assumptions used to determine the fair value can vary significantly.



Recently Issued Accounting Pronouncements



In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has
issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. We adopted the disclosure provisions of FIN 45 during the fourth quarter of
fiscal 2002 and we provided the required disclosures in Note 13 Commitments and Contingencies. We adopted the recognition provisions of FIN 45 effective January 1, 2003 and such adoption did not have an impact on our consolidated
results of operations or financial position.



In December 2002,
the FASB issued SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure effective for fiscal years ending after December 15, 2002. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based
Compensation, to provide alternative methods of transition to the fair value method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure provisions of SFAS No. 123 to require disclosure in the
summary of significant accounting policies of the effects of an entitys accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. SFAS No. 148
does not amend SFAS No. 123 to require companies to account for their employee stock-based awards using the fair value method. The disclosure provisions are required, however, for all companies with stock-based employee compensation, regardless of
whether they utilize the fair value method of accounting described in SFAS No. 123 or the intrinsic value method described in APB Opinion No. 25, Accounting for Stock Issued to Employees. We adopted the disclosure requirements of
SFAS No. 148 effective January 1, 2003. The adoption of this standard did not have a significant impact on our financial condition or operating results.



In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities.
In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide
sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors do not have the characteristics of a controlling
financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. We adopted the provisions of FIN 46 effective January 1, 2003. We do not have
any variable interest entities; thus adoption of FIN 46 did not have an impact on our consolidated results of operations or financial position.



In January 2003, the Emerging Issues Task Force (EITF) issued EITF 00-21, Revenue Arrangements with Multiple Deliverables,
which requires companies to allocate the consideration received on arrangements



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involving multiple arrangements based on their relative fair values. Further, this EITF requires that the companies consider the revenue recognition criteria
separately for each of the deliverables. This EITF is applicable for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Early adoption is permitted. We adopted EITF 00-21 on January 1, 2003 and it did not have a
material impact on our consolidated results of operations or financial position.



In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies accounting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging. The statement requires that contracts with comparable
characteristics be accounted for similarly and clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 is effective for contracts entered into or modified after June 30,
2003, except in certain circumstances, and for hedging relationships designated after June 30, 2003. We adopted SFAS No. 149 effective July 1, 2003 and such adoption did not have an impact on our consolidated results of operations or financial
position.



In May 2003, the FASB issued SFAS No. 150,
Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for how an issuer classifies and measures in its statement of financial position certain
financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument
embodies an obligation of the issuer. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. We adopted
SFAS No. 150 effective July 1, 2003 and such adoption did not have an impact on our consolidated results of operations or financial position because we have not issued any of these types of financial instruments.



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RISK FACTORS



An investment in our shares involves risks and uncertainties. You should carefully consider the factors described below
before making an investment decision in our securities. The risks described below are the risks that we currently believe are material risks of business and the industry in which we compete.



Our business, financial condition and results of operations could be
adversely affected by any of the following risks. If we are adversely affected by such risks, then the trading price of our common stock could decline, and you could lose all or part of your investment.



Our quarterly operating results may fluctuate in future periods and, as a result, we may
fail to meet expectations of investors and analysts, causing our stock price to fluctuate or decline



Our revenues and operating results may vary significantly from quarter to quarter due to a number of factors. These factors include the following:



| |  |  | the size and timing of customer orders. See The size and timing of our customer orders may vary significantly from quarter to quarter which could cause fluctuations in
our revenues.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the discretionary nature of our customers purchasing decisions and budget cycles;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | the timing of revenue recognition for sales of software products and services;
| | - |  | ------------------------------------------------------------------------------



| |  |  | the extent to which our customers renew their maintenance contracts with us;
| | - |  | ----------------------------------------------------------------------------



| |  |  | exposure to general economic conditions and reductions in corporate IT spending;
| | - |  | --------------------------------------------------------------------------------



| |  |  | changes in our level of operating expenses and our ability to control costs;
| | - |  | ----------------------------------------------------------------------------



| |  |  | our ability to attain market acceptance of new products and services and enhancements to our existing products;
| | - |  | ---------------------------------------------------------------------------------------------------------------



| |  |  | changes in our pricing policies or the pricing policies of our competitors;
| | - |  | ---------------------------------------------------------------------------



| |  |  | the relative growth rates of competing operating system, database and application platforms;
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | the unpredictability of the timing and level of sales through our indirect sales channels;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | costs related to acquisitions of technologies or businesses, including amortization costs for intangible assets with indefinite lives; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the timing of releases of new versions of third-party software products that our products support or with which our products compete.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------



Fluctuations in our results of operations are likely to affect the market
price of our common stock and may not be related to or indicative of our long-term performance.



The size and timing of our customer orders may vary significantly from quarter to quarter which could cause fluctuations in our revenues and operating results



Our license revenues in any quarter are substantially dependent on orders
booked and delivered in that quarter. Our revenues in a given quarter could be adversely affected if we are unable to complete one or more large license agreements, or if the contract terms were to prevent us from recognizing revenue during that
quarter. The sales cycles for certain of our software products, such as Vista Plus and SharePlex, can last from three to nine months and often require pre-purchase evaluation periods and customer education. Also, we have often booked a large amount
of our sales in the last month, weeks or days of each quarter and delays in the closing of sales near the end of a quarter could cause quarterly revenue to fall short of anticipated levels. Finally, while a portion of our revenues each quarter is
recognized from previously deferred revenue, our quarterly



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performance will depend primarily upon entering into new contracts to generate revenues for that quarter. These factors may cause significant periodic
variation in our license revenues. In addition, we incur or commit to operating expenses based on anticipated revenue levels, and generally do not know whether revenues in any quarter will meet expectations until the end of that quarter.
Accordingly, if our revenue growth rates slow or our revenues decline, our operating results could be seriously impaired because many of our expenses are relatively fixed in nature and cannot be easily or quickly changed.



General economic conditions and reduced levels of corporate IT spending may continue to
affect revenue growth rates and impact our business



Our
business and operating results are subject to the effects of changes in general economic conditions. Recent unfavorable economic conditions have resulted in continued reduced corporate IT spending in the industries that we serve and a softening of
demand for computer software, not only in the database and application market segments we support but also in the product segment in which we compete. If these economic conditions do not improve, or we experience continued deterioration in general
economic conditions or further reduced corporate IT spending, our business and operating results could continue to be adversely impacted.



Many of our products are vulnerable to direct competition from Oracle



We compete with Oracle in the market for database management solutions and the competitive pressure continues to increase. We expect that Oracles
commitment to and presence in the database management product market will increase in the future and therefore substantially increase competitive pressures. We believe that Oracle will continue to incorporate database management technology into its
server software offerings, possibly at no additional cost to its users. Competition from Oracle with certain of our Database Management products including SharePlex and Quest Central for Oracle has increased over the last two years and continues to
increase with Oracles introduction of the next version of its database, known as Oracle 10G. Oracle 10G is claimed to have enhanced capabilities in the functions competitive with Quest Central for Oracle and with the Oracle monitoring
capabilities of Foglight. If Oracle 10G does provide capabilities closely equivalent to those of Quest Central for Oracle, our revenues from that product line would likely be materially adversely affected.



In some cases these platform vendor-provided tools are bundled with the
platform and in other cases they are separately chargeable products, albeit at significantly lower price points. The inclusion of the functionality of our software as standard features of the underlying database solution or application supported by
our products or sale at much lower cost could erode our revenues, particularly if the competing products and features were of comparable capability to our products. Even if the functionality provided as standard features or lower costs by these
system providers is more limited than that of our software, there can be no assurance that a significant number of customers would not elect to accept more limited functionality in lieu of purchasing our products. Moreover, there is substantial risk
that the mere announcements of competing products or features by large competitors such as Oracle could result in the delay or cancellation of customer orders for our products in anticipation of the introduction of such new products or features.



Many of our products are dependent on database or application technologies
of others; if these technologies lose market share or become incompatible with our products, or if these vendors acquire or form strategic relationships with our competitors, the demand for our products could suffer



We believe that our success has depended in part, and will continue to
depend in part for the foreseeable future, upon our relationships with providers of major database and enterprise software programs, including Oracle, IBM, Microsoft, SAP, Siebel and PeopleSoft. Our competitive advantage consists in substantial part
on the integration between our products and products provided by these major software providers, and our extensive knowledge of their products and technologies. If these companies for any reason decide to promote technologies and standards that are
not compatible with our technologies, or if they lose market share for their database or application products, our business, operating results and financial condition would be materially adversely



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affected. Furthermore, these major software vendors could attempt to increase their presence in the markets we serve by acquiring or forming strategic
alliances with our competitors, and may be in better position to withstand and respond to the current factors impacting this industry. These companies have longer operating histories, larger installed bases of customers and substantially greater
financial, distribution, marketing and technical resources than we do, as well as well-established relationships with many of our present and potential customers. As a result, we may not be able to compete effectively with these companies in the
future, which could materially adversely affect our business, operating results and financial condition.



Our success depends on our ability to develop new and enhanced products that achieve widespread market acceptance



Our future success depends on our ability to address the rapidly changing needs of our customers by developing and introducing new products, product
updates and services on a timely basis, by extending the operation of our products on new platforms and by keeping pace with technological developments and emerging industry standards. In order to grow our business, we are committing substantial
resources to developing software products and services for the applications management market. If this market does not continue to develop as anticipated, or demand for our products in this market does not materialize or occurs more slowly than we
expect, or if our development efforts are delayed or unsuccessful, we will have expended substantial resources and capital without realizing sufficient revenues, and our business and operating results could be adversely affected.



Our operating results may be negatively impacted by fluctuations in foreign currency
exchange rates



Our international operations are generally
conducted through our international subsidiaries, with the associated revenues and related expenses, and balance sheets, denominated in the currency of the country in which the international subsidiaries operate. As a result, our operating results
may be harmed by fluctuations in exchange rates between the U.S. Dollar and other foreign currencies. The foreign currencies to which we currently have the most significant exposure are the Canadian Dollar, the British Pound, the Euro and the
Australian Dollar. To date, we have not used derivative financial instruments to hedge our exposure to fluctuations in foreign currency exchange rates.



Our international operations and our planned expansion of our international operations expose us to certain risks



We maintain research and development operations in Canada, Australia, Israel
and Russia, and continue to expand our international sales activities as part of our business strategy. As a result, we face increasing risks from our international operations, including, among others:



| |  |  | difficulties in staffing and managing foreign operations;
| | - |  | ---------------------------------------------------------



| |  |  | longer payment cycles;
| | - |  | ----------------------



| |  |  | seasonal reductions in business activity in Europe;
| | - |  | ---------------------------------------------------



| |  |  | increased financial accounting and reporting burdens and complexities;
| | - |  | ----------------------------------------------------------------------



| |  |  | potentially adverse tax consequences;
| | - |  | -------------------------------------



| |  |  | potential loss of proprietary information due to piracy, misappropriation or weaker laws regarding intellectual property protection;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------



| |  |  | delays in localizing our products;
| | - |  | ----------------------------------



| |  |  | political unrest or terrorism, particularly in areas in which we have facilities;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | compliance with a wide variety of complex foreign laws and treaties; and
| | - |  | ------------------------------------------------------------------------



| |  |  | licenses, tariffs and other trade barriers.
| | - |  | -------------------------------------------



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Operating in international markets also requires significant management attention and financial resources
and will place additional burdens on our management, administrative, operational and financial infrastructure. We cannot be certain that our investments in establishing facilities in other countries will produce desired levels of revenue or
profitability. In addition, we have limited experience in developing localized versions of our products and marketing and distributing them internationally.



Acquisitions of companies or technologies may result in disruptions to our business and diversion of management attention



We have in the past made and we expect to continue to make acquisitions of
complementary companies, products or technologies, including Sitraka and our recently announced acquisition of Aelita. Any additional acquisitions will require us to assimilate the operations, products and personnel of the acquired businesses and
train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may subject us to liabilities and risks
that are not known or identifiable at the time of the acquisition or may cause disruptions in our operations and divert managements attention from day-to-day operations, which could impair our relationships with our current employees,
customers and strategic partners. We may have to use cash, incur debt or issue equity securities to pay for any future acquisitions. Use of cash or debt may affect our liquidity and use of cash would reduce our cash reserves. The issuance of equity
securities for any acquisition could be substantially dilutive to our shareholders. In addition, our profitability may suffer because of acquisition-related costs or amortization costs for intangible assets with indefinite useful lives. In
consummating acquisitions, we are also subject to risks of entering geographic and business markets in which we have no or limited prior experience. If we are unable to fully integrate acquired businesses, products or technologies with our existing
operations, we may not receive the intended benefits of an acquisition.



We
Face Risks Associated With Governmental Contracting



We
derive a portion of our revenues from contracts with the United States government and its agencies and from contracts with state and local governments or agencies. Demand and payment for our products and services are impacted by public sector
budgetary cycles and funding availability, with funding reductions or delays adversely impacting public sector demand for our products and services. Public sector customers may also change the way they procure new contracts and may adopt new rules
or regulations governing contract procurement, including required competitive bidding or use of open source products, where available. These factors may limit the growth of or reduce the amount of revenues we derive from the public
sector, which could negatively affect our results of operations.



Our
efforts to constrain costs may strain our management, administrative, operational and financial infrastructure



We are experiencing slower growth and are focused on increasing our operating margins. These efforts place a strain on our management, administrative,
operational and financial infrastructure. Our ability to manage our operations while reducing operating costs requires us to continue to improve our operational, financial and management controls and reporting systems and procedures. Although we
achieved a year over year increase in our margins from fiscal 2002 to 2003, there can be no guarantees that we will be successful in achieving our profitability targets in any future quarterly or annual period.



We may not generate increased business from our current customers, which could slow our
revenue growth in the future



Most of our customers
initially make a purchase of our products for a single department or location. Many of these customers may choose not to expand their use of our products. If we fail to generate expanded business from our current customers, our business, operating
results and financial condition could be materially adversely



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affected. In addition, as we deploy new modules and features for our existing products or introduce new products, our current customers may choose not to
purchase this new functionality or these new products. Moreover, if customers elect not to renew their maintenance agreements, our service revenues would be materially adversely affected.



Our operating results may be affected if we are required to change our accounting for employee stock options



We currently account for the issuance of stock options under Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Under APB No. 25, no compensation expense is recognized for options granted to employees where the exercise price equals the market price
of the underlying stock on the date of grant. Certain proposals related to treating the grant of an employee stock option as an expense are currently under consideration by accounting standards organizations and governmental authorities. If such
proposals are adopted and we are required to change the way we account for stock options, our operating results could be negatively impacted as a result of the additional expenses associated with stock options. See Note 1 of the Notes to
Consolidated Financial Statements for a more detailed presentation of our accounting for stock-based compensation plans.



Failure to develop strategic relationships could harm our business by denying us selling opportunities and other benefits



Our current collaborative relationships may not prove to be beneficial to
us, and they may not be sustained. We also may not be able to enter into successful new strategic relationships in the future, which could have a material adverse effect on our business, operating results and financial condition. We could lose sales
opportunities if we fail to work effectively with these parties. Moreover, we expect that maintaining and enhancing these and other relationships will become a more meaningful part of our business strategy in the future. However, many of our current
partners are either actual or potential competitors with us. In addition, many of these third parties also work with competing software companies and we may not be able to maintain these existing relationships, due to the fact that these
relationships are informal or, if written, are terminable with little or no notice.



Failure to adequately protect our intellectual property rights could harm our competitive position



Our success and ability to compete are dependent on our ability to develop and maintain the proprietary aspects of our technology. We generally rely on a
combination of trademark, trade secret, patent, copyright law and contractual restrictions to protect the proprietary aspects of our technology.



Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information
that we regard as proprietary. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, and to determine the validity and scope of the proprietary rights of others. Any such resulting
litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management and financial resources, which could harm our business.



Our means of protecting our proprietary rights may prove to be inadequate and competitors may independently develop similar
or superior technology. Policing unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect
our proprietary rights as fully as in the United States. We also believe that, because of the rapid rate of technological change in the software industry, trade secret and copyright protection are less significant than factors such as the knowledge,
ability and experience of our employees, frequent product enhancements and the timeliness and quality of customer support services.



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Third parties may claim that our software products or services infringe on their intellectual property rights,
exposing us to litigation that, regardless of merit, may be costly to defend



Our success and ability to compete are also dependent on our ability to operate without infringing upon the proprietary rights of others. Third parties may claim that our current or future products infringe their
intellectual property rights. Any such claim, with or without merit, could have a significant effect on our business and financial results. SeeLegal Proceedings in Part I, Item 3, of this report, for information concerning
copyright infringement and trade secret misappropriation claims initiated against Quest by Computer Associates International, Inc. This and any future third party claim could be time consuming, divert managements attention from our business
operations and result in substantial litigation costs, including any monetary damages and customer indemnification obligations, which may result from such claims. In addition, parties making these claims may be able to obtain injunctive or other
equitable relief affecting our ability to license the products that incorporate the challenged intellectual property. As a result of such claims, we may be required to obtain licenses from third parties, develop alternative technology or redesign
our products. We cannot be sure that such licenses would be available on terms acceptable to us, if at all. If a successful claim is made against us and we are unable to develop or license alternative technology, our business and financial results
and position could be materially adversely affected.



Our business will
suffer if our software contains errors



The software
products we offer are inherently complex. Despite testing and quality control, we cannot be certain that errors will not be found in current versions, new versions or enhancements of our products after commencement of commercial shipments.
Significant technical challenges also arise with our products because our customers purchase and deploy our products across a variety of computer platforms and integrate it with a number of third-party software applications and databases. If new or
existing customers have difficulty deploying our products or require significant amounts of customer support, our operating margins could be harmed. Moreover, we could face possible claims and higher development costs if our software contains
undetected errors or if we fail to meet our customers expectations. As a result of the foregoing, we could experience:



| |  |  | loss of or delay in revenues and loss of market share;
| | - |  | ------------------------------------------------------



| |  |  | loss of customers;
| | - |  | ------------------



| |  |  | damage to our reputation;
| | - |  | -------------------------



| |  |  | failure to achieve market acceptance;
| | - |  | -------------------------------------



| |  |  | diversion of development resources;
| | - |  | -----------------------------------



| |  |  | increased service and warranty costs;
| | - |  | -------------------------------------



| |  |  | legal actions by customers against us which could, whether or not successful, increase costs and distract our management; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------



| |  |  | increased insurance costs.
| | - |  | --------------------------



In addition, a product liability claim, whether or not successful, could harm our business by increasing our costs and distracting our management.



We incorporate software licensed from third parties into some of our
products and any significant interruption in the availability of these third-party software products or defects in these products could reduce the demand for, or prevent the shipping of, our products



Certain of our software products contain components developed and maintained
by third-party software vendors. We expect that we may have to incorporate software from third-party vendors in our future products. We may not be able to replace the functionality provided by the third-party software currently offered with our



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products if that software becomes obsolete, defective or incompatible with future versions of our products or is not adequately maintained or updated. Any
significant interruption in the availability of these third-party software products or defects in these products could harm our sales unless and until we can secure an alternative source. Although we believe there are adequate alternate sources for
the technology licensed to us, such alternate sources may not provide us with the same functionality as that currently provided to us.



Natural disasters or power outages could disrupt our business



A substantial portion of our operations is located in California, and we are subject to risks of damage and business disruptions resulting from
earthquakes, floods, fires and similar events, as well as from power outages. We have in the past experienced limited and temporary power losses in our California facilities due to power shortages, and we expect in the future to experience
additional power losses. While the impact to our business and operating results has not been material, we cannot assure you that power losses will not adversely affect our business in the future, or that the cost of acquiring sufficient power to run
our business will not increase significantly. Since we do not have sufficient redundancy in our networking infrastructure, a natural disaster or other unanticipated problem could have an adverse effect on our business, including both our internal
operations and our ability to communicate with our customers or sell and deliver our products.



The demand for our products will depend on our ability to adapt to rapid technological change



Our future success will depend on our ability to continue to enhance our current products and to develop and introduce new products on a timely basis that
keep pace with technological developments and satisfy increasingly sophisticated customer requirements. Rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles, changes in customer demands and
evolving industry standards characterize the market for our products and services. The introduction of products embodying new technologies and the emergence of new industry standards can render our existing products obsolete and unmarketable. As a
result of the complexities inherent in todays computing environments and the performance demanded by customers for embedded databases and Web-based products, new products and product enhancements can require long development and testing
periods. As a result, significant delays in the general availability of such new releases or significant problems in the installation or implementation of such new releases could have a material adverse effect on our business, operating results and
financial condition. We may not be successful in:



| |  |  | developing and marketing, on a timely and cost-effective basis, new products or new product enhancements that respond to technological change, evolving industry standards or
customer requirements;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | avoiding difficulties that could delay or prevent the successful development, introduction or marketing of these products; or
| | - |  | -----------------------------------------------------------------------------------------------------------------------------



| |  |  | achieving market acceptance for our new products and product enhancements.
| | - |  | --------------------------------------------------------------------------



We may not be able to attract and retain personnel



Our future success depends on the continued service of our executive officers and other key administrative, sales and marketing and support personnel,
many of whom have recently joined our company. In addition, the success of our business is substantially dependent on the services of our Chief Executive Officer and other executive officers. There has in the past been and there may in the future be
a shortage of personnel that possess the technical background necessary to sell, support and develop our products effectively. Competition for skilled personnel is intense, and we may not be able to attract, assimilate or retain highly qualified
personnel in the future. Our business may not be able to grow if we cannot attract qualified personnel. Hiring qualified sales, marketing, administrative, research and development and customer support personnel is very competitive in our industry,
particularly in Southern California where Quest is headquartered.



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Item 7a.Quantitative and Qualitative Disclosures About Market Risks



We transact business in a number of different foreign countries around the world. In most instances, revenues are collected and operating expenses are
paid in the local currency of the country in which we are transacting. Accordingly, we are exposed to incremental volatility in sales and earnings within these countries due to fluctuations in foreign exchange rates.



Our exposure to foreign exchange risk is directly proportional to the
magnitude of foreign net profits and losses denominated in currencies other than the U.S. Dollar, as well as our net foreign investment in non-U.S. Dollar assets. These exposures have the potential to produce either gains or losses. Our cumulative
currency gains or losses in any given period are typically lessened by the economic benefits of diversification and low correlation between different currencies, but there can be no assurance that this pattern will continue to be true in future
periods.



The foreign currencies to which we currently have the
most significant exposure are the Canadian Dollar, the British Pound, the Euro and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our foreign exchange exposures, nor do we use such instruments for
speculative trading purposes. We regularly monitor the potential cost and benefits of hedging foreign exchange exposures with derivatives and there remains the possibility that our foreign exchange hedging practices could change accordingly in time.



Interest Rate Risk



Our exposure to market interest-rate risk relates primarily to our
investment portfolio. We have not used derivative financial instruments to hedge the market risks of our investments. We place our investments with high-quality issuers and, by policy, limit the amount of credit exposure to any one issuer other than
the United States government and its agencies. Our investments in marketable securities consist primarily of investment-grade bonds and United States government and agency securities. Investments purchased with an original maturity of three months
or less are considered to be cash equivalents. We classify all of our investments as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of
shareholders equity.



Information about our investment
portfolio is presented in the table below, which states the amortized book value and related weighted-average interest rates by year of maturity (in thousands):



|                                     |  |                     |         |                      |      |  
|------------------------------------ |  | ------------------- | ------- | -------------------- | ---- | -
|                                     |  | AmortizedBook Value |         | WeightedAverage Rate |     
|Investments maturing by December 31, |  |                     |         |                      |      |  
|2004                                 |  | $                   | 95,821  |                      | 1.87 | %
|2005                                 |  |                     | 21,871  |                      | 2.30 | %
|2006                                 |  |                     | 84,511  |                      | 2.49 | %
|2007                                 |  |                     | 22,000  |                      | 3.09 | %
|Thereafter                           |  |                     | 53,903  |                      | 4.48 | %
|                                     |  |                     |         |                      |      |  
|Total portfolio                      |  | $                   | 278,106 |                      | 2.69 | %
|                                     |  |                     |         |                      |      |  



We maintain a level of cash and cash
equivalents such that we have generally been able to hold our investments to maturity. Accordingly, changes in the market interest rate would not have a material effect on the fair value of such investments.



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Item 8.Financial Statements and Supplementary Data



The financial statements required by this item are included in Part IV, Item 15 (a) of this Form 10-K and are presented beginning on page F-1.



The following table sets forth selected unaudited consolidated quarterly
financial data for the eight quarters ended December 31, 2003:



|                                   |  |                                       |        |               |   |                |  |               |        |                |   |               |  |                |        |               |   |        |  |   |        |  |   |       
|---------------------------------- |  | ------------------------------------- | ------ | ------------- | - | -------------- |  | ------------- | ------ | -------------- | - | ------------- |  | -------------- | ------ | ------------- | - | ------ |  | - | ------ |  | - | ------
|                                   |  | Quarters Ended                       
|                                   |  | March 31, 2002                        |        | June 30, 2002 |   | Sept. 30, 2002 |  | Dec. 31, 2002 |        | March 31, 2003 |   | June 30, 2003 |  | Sept. 30, 2003 |        | Dec. 31, 2003
|                                   |  | (in thousands, except per share data)
|Revenues                           |  | $                                     | 59,591 |               | $ | 61,890         |  | $             | 62,902 |                | $ | 71,199        |  | $              | 71,199 |               | $ | 70,835 |  | $ | 73,264 |  | $ | 88,990
|Gross profit                       |  |                                       | 52,898 |               |   | 55,006         |  |               | 56,389 |                |   | 64,093        |  |                | 62,941 |               |   | 61,991 |  |   | 65,072 |  |   | 80,932
|Income before income tax provision |  |                                       | 3,219  |               |   | 4,133          |  |               | 4,359  |                |   | 6,797         |  |                | 4,069  |               |   | 4,897  |  |   | 7,220  |  |   | 17,433
|Net income                         |  | $                                     | 1,889  |               | $ | 2,415          |  | $             | 2,270  |                | $ | 3,810         |  | $              | 2,534  |               | $ | 3,066  |  | $ | 4,438  |  | $ | 11,478
|                                   |  |                                       |        |               |   |                |  |               |        |                |   |               |  |                |        |               |   |        |  |   |        |  |   |       
|Basic net income per share         |  | $                                     | 0.02   |               | $ | 0.03           |  | $             | 0.03   |                | $ | 0.04          |  | $              | 0.03   |               | $ | 0.03   |  | $ | 0.05   |  | $ | 0.12  
|                                   |  |                                       |        |               |   |                |  |               |        |                |   |               |  |                |        |               |   |        |  |   |        |  |   |       
|Diluted net income per share       |  | $                                     | 0.02   |               | $ | 0.03           |  | $             | 0.02   |                | $ | 0.04          |  | $              | 0.03   |               | $ | 0.03   |  | $ | 0.05   |  | $ | 0.12  
|                                   |  |                                       |        |               |   |                |  |               |        |                |   |               |  |                |        |               |   |        |  |   |        |  |   |       



Item 9.Changes In and Disagreements With Accountants on Accounting and Financial Disclosure.



Not applicable.



Item 9A.Controls and Procedures.



Our management, with the participation of the chief executive officer and chief financial officer, has performed an evaluation of our disclosure controls
and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934). Based on such evaluation, our chief executive officer and chief financial officer concluded that, as of December 31, 2003, our disclosure controls
and procedures were effective to ensure that information required to be disclosed by us in the reports that we file under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the
SECs rules and forms and that such information is accumulated and communicated to our management as appropriate to allow timely decisions regarding required disclosure.



No changes in our internal control over financial reporting have come to our managements attention that have
materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



36



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##### Table of Contents

PART III



Item 10.Directors and Executive Officers of the Registrant



Information required by this item will be included in the sections captioned Directors, Executive Officers, Code of
Ethics and Section 16(a) of the Securities Exchange Act of 1934 in our definitive proxy statement, to be delivered to shareholders in connection with our 2004 annual meeting. Such information is incorporated herein by
reference.



Item 11.Executive Compensation



Information regarding compensation of certain named executive officers will be included in the section captioned Executive Compensation
appearing in our definitive proxy statement, to be delivered to shareholders in connection with our 2004 annual meeting of shareholders. Such information is incorporated herein by reference.



Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters



Information required by this item will be included in the section captioned Security Ownership of Certain
Beneficial Owners and Management appearing in our definitive proxy statement, to be delivered to shareholders in connection with our 2004 annual meeting of shareholders. The information regarding securities authorized for issuance under
equity compensation plans will be included in the section captioned Equity Compensation Plan Information appearing in our definitive proxy statement, to be delivered to shareholders in connection with our 2004 annual meeting of
shareholders. Such information is incorporated herein by reference.



Item 13.Certain Relationships and Related Transactions



Information required by this item will be included in the section captioned Related Party Transactionsappearing in our definitive
proxy statement, to be delivered to shareholders in connection with our 2004 annual meeting of shareholders. Such information is incorporated herein by reference.



Item 14.Principal Accountant Fees and Services



The information contained in the section captioned Fees Paid to the Independent Auditors in our definitive proxy statement for our 2004
annual meeting of shareholders is incorporated herein by reference.



37



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##### Table of Contents

PART IV



Item 15.Exhibits, Financial Statement Schedules And Reports On Form 8-K



(a) The following documents are filed as part of this Form 10-K.



|1. |  | Financial Statements
|-- |  | --------------------



|                                                                                                     |  |     
|---------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                     |  | Page
|Independent Auditors Report                                                                         |  | F-1 
|Consolidated Balance Sheets as of December 31, 2002 and 2003                                         |  | F-2 
|Consolidated Statements of Operations for the Years Ended December 31, 2001, 2002 and 2003           |  | F-3 
|Consolidated Statements of Shareholders Equity for the Years Ended December 31, 2001, 2002 and 2003 |  | F-4 
|Consolidated Statements of Cash Flows for the Years Ended December 31, 2001, 2002 and 2003           |  | F-5 
|Notes to Consolidated Financial Statements                                                           |  | F-7 



|2. |  | Financial Statement Schedules
|-- |  | -----------------------------



The following financial statement schedule should be read in conjunction with the consolidated financial statements of Quest Software, Inc. filed as part
of this Report:



| |  |  | Schedule II  Valuation and Qualifying Accounts
| | - |  | -----------------------------------------------



Schedules other than that listed above have been omitted since they are either not required or not applicable or because the information required is
included in the consolidated financial statements included elsewhere herein or the notes thereto.



|3. |  | Exhibits
|-- |  | --------



|               |    |  |                                                                                                                                                    
|-------------- | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |    |  | Exhibit Title                                                                                                                                      
|               |   
|3.1            |    |  | Second Amended and Restated Articles of Incorporation.(1)                                                                                          
|               |   
|3.2            |    |  | Second Amended and Restated Bylaws, as amended.(2)                                                                                                 
|               |   
|3.3            |    |  | Certificate of Amendment of Second Amended and Restated Articles of Incorporation.(3)                                                              
|               |   
|3.4            |    |  | Certificate of Amendment of Bylaws.(4)                                                                                                             
|               |   
|4.1            |    |  | Form of Registrants Specimen Common Stock Certificate.(1)                                                                                         
|               |   
|10.1           | ++ |  | Registrants 1999 Stock Incentive Plan, as amended.                                                                                                
|               |   
|10.2           | ++ |  | Registrants 1999 Employee Stock Purchase Plan.(7)                                                                                                 
|               |   
|10.3           |    |  | Form of Directors and Officers Indemnification Agreement.(1)                                                                                     
|               |   
|10.4           |    |  | Office Space Lease dated as of June 17, 1999 between The Irvine Company and Quest Software, Inc.(1)                                                
|               |   
|10.5           |    |  | Office Lease between The Northwestern Mutual Life Insurance Company (Landlord) and Quest Software, Inc. (Tenant) dated as of September 30,
1999.(2)
|               |   
|10.6           |    |  | Office Lease, dated June 2000, between Fund VIII and Fund IX Associates and Quest Software, Inc.(5)                                                
|               |   
|10.7           | ++ |  | Registrants 2001 Stock Incentive Plan.(6)                                                                                                         
|               |   
|10.8           |    |  | First Amendment to Lease dated as of January 2, 2003 between The Irvine Company and Quest Software, Inc.(8)                                        



38



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##### Table of Contents

|               |  |                                                                                                                                                   
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Exhibit Title                                                                                                                                     
|               | 
|10.9           |  | Office Building Lease, dated as of February 13, 2004, between Fluor Enterprises, Inc. and Quest Software, Inc.                                    
|               | 
|14.1           |  | Code of Ethics                                                                                                                                    
|               | 
|21.1           |  | Subsidiaries of the Company.                                                                                                                      
|               | 
|23.1           |  | Consent of Deloitte & Touche LLP.                                                                                                                 
|               | 
|31.1           |  | Certification of the Chief Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as
amended.                       
|               | 
|31.2           |  | Certification of the Chief Financial Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as
amended.                       
|               | 
|32.1           |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
|               | 
|32.2           |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.

---

|(1) |  | Incorporated herein by reference to our Registration Statement on Form S-1 and all amendments thereto (File No. 333-80543).
|--- |  | ---------------------------------------------------------------------------------------------------------------------------

|(2) |  | Incorporated herein by reference to our Registration Statement on Form S-1 and all amendments thereto (File No. 333-30816).
|--- |  | ---------------------------------------------------------------------------------------------------------------------------

|(3) |  | Incorporated herein by reference to our Quarterly Report on Form 10-Q for the period ended June 30, 2000.
|--- |  | ---------------------------------------------------------------------------------------------------------

|(4) |  | Incorporated herein by reference to our Quarterly Report on Form 10-Q for the period ended June 30, 2001
|--- |  | --------------------------------------------------------------------------------------------------------

|(5) |  | Incorporated herein by reference to our Annual Report on Form 10-K for the year ended December 30, 2000
|--- |  | -------------------------------------------------------------------------------------------------------

|(6) |  | Incorporated herein by reference to our Registration Statement on Form S-8 (File No. 333-82784) filed on February 14, 2002
|--- |  | --------------------------------------------------------------------------------------------------------------------------

|(7) |  | Incorporated herein by reference to our Registration Statement on Form S-8 (File No. 333-107045) filed on July 15, 2003
|--- |  | -----------------------------------------------------------------------------------------------------------------------

|(8) |  | Incorporated herein by reference to our Annual Report on Form 10-K for the year ended December 31, 2002
|--- |  | -------------------------------------------------------------------------------------------------------

|++ |  | Indicates a management contract or compensatory arrangement.
|-- |  | ------------------------------------------------------------



(b) Reports on Form 8-K



On October 22, 2003, we filed a Current Report on Form 8-K furnishing the press release announcing our operating results for the quarter ended September
30, 2003.



39



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##### Table of Contents

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.



|                       |  |                      |  |                                         
|---------------------- |  | -------------------- |  | ----------------------------------------
|                       |  | QUEST SOFTWARE, INC.
|                       |  |                     
|Dated:  March 15, 2004 |  | By:                  |  | /S/    VINCENT C.
SMITH                 
|                       |  |                      |  | Vincent C. Smith Chief Executive Officer



Pursuant to the
requirements of the Securities 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.



|                                                  |  |                                                                                                  |  |               
|------------------------------------------------- |  | ------------------------------------------------------------------------------------------------ |  | --------------
|Signature                                         |  | Title                                                                                            |  | Date          
|                                                  |  |                                                                                                 
|/S/    VINCENT C.
SMITHVincent C.
Smith           |  | Chief Executive Officer (principal executive officer) and Chairman of the Board                  |  | March 15, 2004
|                                                  |  |                                                                                                 
|/S/    M. BRINKLEY
MORSEM. Brinkley
Morse         |  | Vice President, Finance and Operations and Chief Financial Officer (principal financial officer) |  | March 15, 2004
|                                                  |  |                                                                                                 
|/S/    KEVIN E.
BROOKSKevin E.
Brooks             |  | Vice President and Corporate Controller (principal accounting officer)                           |  | March 15, 2004
|                                                  |  |                                                                                                 
|/S/    DAVID M.
DOYLEDavid M.
Doyle               |  | Director                                                                                         |  | March 15, 2004
|                                                  |  |                                                                                                 
|/S/    KEVIN
KLAUSMEYERKevin
Klausmeyer           |  | Director                                                                                         |  | March 15, 2004
|                                                  |  |                                                                                                 
|/S/    RAYMOND J.
LANERaymond J.
Lane             |  | Director                                                                                         |  | March 15, 2004
|                                                  |  |                                                                                                 
|/S/    DORAN G.
MACHINDoran G.
Machin             |  | Director                                                                                         |  | March 15, 2004
|                                                  |  |                                                                                                 
|/S/    JERRY MURDOCK,
JR.Jerry Murdock,
Jr.       |  | Director                                                                                         |  | March 15, 2004
|                                                  |  |                                                                                                 
|/S/    AUGUSTINE L. NIETO
IIAugustine L. Nieto II |  | Director                                                                                         |  | March 15, 2004



40



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##### Table of Contents

INDEPENDENT AUDITORS REPORT



The
Shareholders and Board of Directors

Quest Software, Inc.



We have audited the accompanying consolidated balance sheets of Quest Software, Inc. and subsidiaries (the Company) as of December 31, 2002 and 2003, and
the related consolidated statements of operations, shareholders equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2003. These consolidated financial statements are the
responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.



We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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, such consolidated financial statements present
fairly, in all material respects, the financial position of Quest Software, Inc. and subsidiaries at December 31, 2002 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31,
2003 in conformity with accounting principles generally accepted in the United States of America.



As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets
during 2002 as a result of adopting Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets.



/s/    DELOITTE & TOUCHE LLP



Costa Mesa, California

March 9, 2004



F-1



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##### Table of Contents

QUEST SOFTWARE, INC.



CONSOLIDATED BALANCE SHEETS

(In thousands)



|                                                                                                                                                   |  |                   |         |   |                   |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                                                                                   |  | December 31, 2002 |         |   | December 31, 2003 |  
|ASSETS                                                                                                                                             |  |                   |         |   |                   |   |         |  
|Current assets:                                                                                                                                    |  |                   |         |   |                   |   |         |  
|Cash and cash equivalents                                                                                                                          |  | $                 | 64,283  |   |                   | $ | 67,470  |  
|Short-term marketable securities                                                                                                                   |  |                   | 27,841  |   |                   |   | 26,736  |  
|Accounts receivable, net                                                                                                                           |  |                   | 39,898  |   |                   |   | 58,535  |  
|Prepaid expenses and other current assets                                                                                                          |  |                   | 9,653   |   |                   |   | 6,846   |  
|Deferred income taxes                                                                                                                              |  |                   | 9,491   |   |                   |   | 15,074  |  
|                                                                                                                                                   |  |                   |         |   |                   |   |         |  
|Total current assets                                                                                                                               |  |                   | 151,166 |   |                   |   | 174,661 |  
|Property and equipment, net                                                                                                                        |  |                   | 44,505  |   |                   |   | 31,950  |  
|Long-term marketable securities                                                                                                                    |  |                   | 115,422 |   |                   |   | 184,160 |  
|Goodwill                                                                                                                                           |  |                   | 231,717 |   |                   |   | 239,840 |  
|Amortizing intangible assets, net                                                                                                                  |  |                   | 31,116  |   |                   |   | 25,159  |  
|Deferred income taxes                                                                                                                              |  |                   | 15,014  |   |                   |   | 10,126  |  
|Other assets                                                                                                                                       |  |                   | 2,341   |   |                   |   | 1,915   |  
|                                                                                                                                                   |  |                   |         |   |                   |   |         |  
|Total assets                                                                                                                                       |  | $                 | 591,281 |   |                   | $ | 667,811 |  
|                                                                                                                                                   |  |                   |         |   |                   |   |         |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                               |  |                   |         |   |                   |   |         |  
|Current liabilities:                                                                                                                               |  |                   |         |   |                   |   |         |  
|Accounts payable                                                                                                                                   |  | $                 | 5,308   |   |                   | $ | 4,180   |  
|Accrued compensation                                                                                                                               |  |                   | 13,900  |   |                   |   | 17,384  |  
|Other accrued expenses                                                                                                                             |  |                   | 23,678  |   |                   |   | 27,939  |  
|Income taxes payable                                                                                                                               |  |                   | 1,262   |   |                   |   | 9,082   |  
|Current portion of deferred revenue                                                                                                                |  |                   | 59,209  |   |                   |   | 73,957  |  
|                                                                                                                                                   |  |                   |         |   |                   |   |         |  
|Total current liabilities                                                                                                                          |  |                   | 103,357 |   |                   |   | 132,542 |  
|Long-term liabilities:                                                                                                                             |  |                   |         |   |                   |   |         |  
|Long-term portion of deferred revenue                                                                                                              |  |                   | 4,001   |   |                   |   | 9,416   |  
|Other long-term liabilities                                                                                                                        |  |                   | 5,941   |   |                   |   | 1,677   |  
|                                                                                                                                                   |  |                   |         |   |                   |   |         |  
|Total long-term liabilities                                                                                                                        |  |                   | 9,942   |   |                   |   | 11,093  |  
|                                                                                                                                                   |  |                  
|Commitments and contingencies (Notes 3, 5 and 13)                                                                                                  |  |                   |         |   |                   |   |         |  
|                                                                                                                                                   |  |                  
|Shareholders equity:                                                                                                                              |  |                   |         |   |                   |   |         |  
|Preferred stock, no par value, 10,000 shares authorized; no shares issued or outstanding                                                           |  |                   |        |   |                   |   |        |  
|Common stock, no par value, 150,000 shares authorized; 90,715 and 93,309 shares issued and outstanding at December 31, 2002 and 2003,
respectively |  |                   | 562,476 |   |                   |   | 588,203 |  
|Accumulated deficit                                                                                                                                |  |                   | (68,589 | ) |                   |   | (47,073 | )
|Accumulated other comprehensive income                                                                                                             |  |                   | 1,309   |   |                   |   | 260     |  
|Notes receivable from sale of common stock                                                                                                         |  |                   | (17,214 | ) |                   |   | (17,214 | )
|                                                                                                                                                   |  |                   |         |   |                   |   |         |  
|Net shareholders equity                                                                                                                           |  |                   | 477,982 |   |                   |   | 524,176 |  
|                                                                                                                                                   |  |                   |         |   |                   |   |         |  
|Total liabilities and shareholders equity                                                                                                         |  | $                 | 591,281 |   |                   | $ | 667,811 |  
|                                                                                                                                                   |  |                   |         |   |                   |   |         |  



See accompanying notes
to consolidated financial statements.



F-2



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##### Table of Contents

QUEST SOFTWARE, INC.



CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)



|                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                            |  | Year Ended December 31, |        
|                                            |  | 2001                    |         |   | 2002 |   |         | 2003 | 
|Revenues:                                   |  |                         |         |   |      |   |         |      |  |   |         |  
|Licenses                                    |  | $                       | 174,134 |   |      | $ | 160,636 |      |  | $ | 179,560 |  
|Services                                    |  |                         | 72,389  |   |      |   | 94,946  |      |  |   | 124,728 |  
|                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Total revenues                              |  |                         | 246,523 |   |      |   | 255,582 |      |  |   | 304,288 |  
|Cost of revenues:                           |  |                         |         |   |      |   |         |      |  |   |         |  
|Licenses                                    |  |                         | 4,510   |   |      |   | 3,539   |      |  |   | 4,312   |  
|Services                                    |  |                         | 18,985  |   |      |   | 17,913  |      |  |   | 21,365  |  
|Amortization of purchased intangible assets |  |                         | 8,003   |   |      |   | 5,744   |      |  |   | 7,675   |  
|                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Total cost of revenues                      |  |                         | 31,498  |   |      |   | 27,196  |      |  |   | 33,352  |  
|                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Gross profit                                |  |                         | 215,025 |   |      |   | 228,386 |      |  |   | 270,936 |  
|Operating expenses:                         |  |                         |         |   |      |   |         |      |  |   |         |  
|Sales and marketing                         |  |                         | 124,079 |   |      |   | 128,570 |      |  |   | 144,460 |  
|Research and development                    |  |                         | 63,334  |   |      |   | 60,051  |      |  |   | 67,448  |  
|General and administrative                  |  |                         | 24,589  |   |      |   | 24,971  |      |  |   | 29,656  |  
|In-process research and development         |  |                         |        |   |      |   | 2,900   |      |  |   |        |  
|Intangible asset and goodwill amortization  |  |                         | 56,724  |   |      |   | 2,037   |      |  |   | 3,390   |  
|                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Total operating expenses                    |  |                         | 268,726 |   |      |   | 218,529 |      |  |   | 244,954 |  
|                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Income (loss) from operations               |  |                         | (53,701 | ) |      |   | 9,857   |      |  |   | 25,982  |  
|Other income, net                           |  |                         | 8,208   |   |      |   | 9,131   |      |  |   | 11,132  |  
|Loss on impairment/sale of aircraft         |  |                         |        |   |      |   | (790    | )    |  |   | (3,495  | )
|Gain (loss) on equity investments           |  |                         | (4,405  | ) |      |   | 310     |      |  |   |        |  
|                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Income (loss) before income tax provision   |  |                         | (49,898 | ) |      |   | 18,508  |      |  |   | 33,619  |  
|Income tax provision                        |  |                         | 5,861   |   |      |   | 8,124   |      |  |   | 12,103  |  
|                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Net income (loss)                           |  | $                       | (55,759 | ) |      | $ | 10,384  |      |  | $ | 21,516  |  
|                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Net income (loss) per share:                |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic                                       |  | $                       | (0.64   | ) |      | $ | 0.12    |      |  | $ | 0.23    |  
|                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Diluted                                     |  | $                       | (0.64   | ) |      | $ | 0.11    |      |  | $ | 0.23    |  
|                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Weighted-average shares:                    |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic                                       |  |                         | 87,632  |   |      |   | 90,065  |      |  |   | 92,081  |  
|Diluted                                     |  |                         | 87,632  |   |      |   | 92,820  |      |  |   | 94,231  |  



See accompanying notes
to consolidated financial statements.



F-3



---

##### Table of Contents

QUEST SOFTWARE, INC.



CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY

AND COMPREHENSIVE INCOME (LOSS)

(In thousands)



|                                                                                     |        |              |        |   |         |                     |   |         |                                        |  |   |                                            |   |  |                            |         |   |                                   |   |         |   |  |   |         |  
|------------------------------------------------------------------------------------ | ------ | ------------ | ------ | - | ------- | ------------------- | - | ------- | -------------------------------------- |  | - | ------------------------------------------ | - |  | -------------------------- | ------- | - | --------------------------------- | - | ------- | - |  | - | ------- | -
|                                                                                     |        |              |        |   |         | Accumulated Deficit |   |         | Accumulated Other Comprehensive Income |  |   | Notes Receivable From Sale of Common Stock |   |  | Total Shareholders Equity |         |   | Total Comprehensive Income (Loss) |  
|                                                                                     |        |              |        |   |         |                     |   |         |                                       
|                                                                                     |        | Common Stock |        |   |         |                     |  
|                                                                                     | Shares |              | Amount |   |         |                     |   |        
|BALANCE, January 1, 2001                                                             |        | 86,371       |        | $ | 500,324 |                     | $ | (23,214 | )                                      |  | $ | 132                                        |   |  | $                          | (18,888 | ) |                                   | $ | 458,354 |   |  | $ |        |  
|Exercise of stock options, including tax benefit of $10,370                          |        | 1,716        |        |   | 16,296  |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 16,296  |   |  |   |        |  
|Accrued interest from shareholders for purchase of common stock                      |        |             |        |   |        |                     |   |        |                                        |  |   |                                           |   |  |                            | (1,221  | ) |                                   |   | (1,221  | ) |  |   |        |  
|Payments on notes receivable from shareholders for purchase of common stock          |        |             |        |   |        |                     |   |        |                                        |  |   |                                           |   |  |                            | 2,847   |   |                                   |   | 2,847   |   |  |   |        |  
|Common stock issued for employee stock purchase plan                                 |        | 203          |        |   | 5,593   |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 5,593   |   |  |   |        |  
|Compensation expense associated with stock option grants                             |        |             |        |   | 4,508   |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 4,508   |   |  |   |        |  
|Common stock issued for acquisitions                                                 |        | 597          |        |   | 10,360  |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 10,360  |   |  |   |        |  
|Unrealized gain on available-for-sale securities                                     |        |             |        |   |        |                     |   |        |                                        |  |   | 390                                        |   |  |                            |        |   |                                   |   | 390     |   |  |   | 390     |  
|Net loss                                                                             |        |             |        |   |        |                     |   | (55,759 | )                                      |  |   |                                           |   |  |                            |        |   |                                   |   | (55,759 | ) |  |   | (55,759 | )
|                                                                                     |        |              |        |   |         |                     |   |         |                                        |  |   |                                            |   |  |                            |         |   |                                   |   |         |   |  |   |         |  
|Comprehensive loss                                                                   |        |             |        |   |        |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   |        |   |  | $ | (55,369 | )
|                                                                                     |        |              |        |   |         |                     |   |         |                                        |  |   |                                            |   |  |                            |         |   |                                   |   |         |   |  |   |         |  
|BALANCE, December 31, 2001                                                           |        | 88,887       |        |   | 537,081 |                     |   | (78,973 | )                                      |  |   | 522                                        |   |  |                            | (17,262 | ) |                                   |   | 441,368 |   |  |   |        |  
|Exercise of stock options, including tax benefit of $17,743                          |        | 1,466        |        |   | 19,500  |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 19,500  |   |  |   |        |  
|Notes receivable and accrued interest from shareholders for purchase of common stock |        |             |        |   |        |                     |   |        |                                        |  |   |                                           |   |  |                            | (26     | ) |                                   |   | (26     | ) |  |   |        |  
|Payments on notes receivable from shareholders for purchase of common stock          |        |             |        |   |        |                     |   |        |                                        |  |   |                                           |   |  |                            | 74      |   |                                   |   | 74      |   |  |   |        |  
|Common stock issued for employee stock purchase plan                                 |        | 362          |        |   | 4,480   |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 4,480   |   |  |   |        |  
|Compensation expense associated with stock option grants                             |        |             |        |   | 1,415   |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 1,415   |   |  |   |        |  
|Unrealized gain on available-for-sale securities                                     |        |             |        |   |        |                     |   |         |                                        |  |   | 787                                        |   |  |                            |        |   |                                   |   | 787     |   |  |   | 787     |  
|Net income                                                                           |        |             |        |   |        |                     |   | 10,384  |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 10,384  |   |  |   | 10,384  |  
|                                                                                     |        |              |        |   |         |                     |   |         |                                        |  |   |                                            |   |  |                            |         |   |                                   |   |         |   |  |   |         |  
|Comprehensive income                                                                 |        |             |        |   |        |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   |        |   |  | $ | 11,171  |  
|                                                                                     |        |              |        |   |         |                     |   |         |                                        |  |   |                                            |   |  |                            |         |   |                                   |   |         |   |  |   |         |  
|BALANCE, December 31, 2002                                                           |        | 90,715       |        |   | 562,476 |                     |   | (68,589 | )                                      |  |   | 1,309                                      |   |  |                            | (17,214 | ) |                                   |   | 477,982 |   |  |   |        |  
|Exercise of stock options, including tax benefit of $8,864                           |        | 1,800        |        |   | 18,363  |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 18,363  |   |  |   |        |  
|Common stock issued for employee stock purchase plan                                 |        | 599          |        |   | 4,631   |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 4,631   |   |  |   |        |  
|Compensation expense associated with stock option grants                             |        |             |        |   | 890     |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 890     |   |  |   |        |  
|Common stock issued for acquisitions                                                 |        | 195          |        |   | 1,843   |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 1,843   |   |  |   |        |  
|Unrealized loss on available-for-sale securities                                     |        |             |        |   |        |                     |   |        |                                        |  |   | (1,049                                     | ) |  |                            |        |   |                                   |   | (1,049  | ) |  |   | (1,049  | )
|Net income                                                                           |        |             |        |   |        |                     |   | 21,516  |                                        |  |   |                                           |   |  |                            |        |   |                                   |   | 21,516  |   |  |   | 21,516  |  
|                                                                                     |        |              |        |   |         |                     |   |         |                                        |  |   |                                            |   |  |                            |         |   |                                   |   |         |   |  |   |         |  
|Comprehensive income                                                                 |        |             |        |   |        |                     |   |        |                                        |  |   |                                           |   |  |                            |        |   |                                   |   |        |   |  | $ | 20,467  |  
|                                                                                     |        |              |        |   |         |                     |   |         |                                        |  |   |                                            |   |  |                            |         |   |                                   |   |         |   |  |   |         |  
|BALANCE, December 31, 2003                                                           |        | 93,309       |        | $ | 588,203 |                     | $ | (47,073 | )                                      |  | $ | 260                                        |   |  | $                          | (17,214 | ) |                                   | $ | 524,176 |   |  |   |         |  
|                                                                                     |        |              |        |   |         |                     |   |         |                                        |  |   |                                            |   |  |                            |         |   |                                   |   |         |   |  |   |         |  



See accompanying notes
to consolidated financial statements.



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##### Table of Contents

QUEST SOFTWARE, INC.



CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|---------------------------------------------------------------------------------------- |  | ----------------------- | -------- | - | ---- | - | ------- | ---- |  | - | -------- | -
|                                                                                         |  | Year Ended December 31, |         
|                                                                                         |  | 2001                    |          |   | 2002 |   |         | 2003 | 
|Cash flows from operating activities:                                                    |  |                         |          |   |      |   |         |      |  |   |          |  
|Net income (loss)                                                                        |  | $                       | (55,759  | ) |      | $ | 10,384  |      |  | $ | 21,516   |  
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |  |                         |          |   |      |   |         |      |  |   |          |  
|Depreciation and amortization                                                            |  |                         | 75,659   |   |      |   | 23,358  |      |  |   | 26,584   |  
|Compensation expense associated with stock option grants                                 |  |                         | 4,508    |   |      |   | 1,415   |      |  |   | 890      |  
|Accrued interest receivable from shareholders                                            |  |                         | (1,221   | ) |      |   | (26     | )    |  |   |         |  
|Deferred income taxes                                                                    |  |                         | (5,653   | ) |      |   | (12,334 | )    |  |   | (3,234   | )
|Provision for bad debts                                                                  |  |                         | 789      |   |      |   | 903     |      |  |   | 291      |  
|(Gain) loss on equity investments                                                        |  |                         | 4,405    |   |      |   | (310    | )    |  |   |         |  
|Loss on impairment/sale of aircraft                                                      |  |                         |         |   |      |   | 790     |      |  |   | 3,495    |  
|In-process research and development                                                      |  |                         |         |   |      |   | 2,900   |      |  |   |         |  
|Changes in operating assets and liabilities, net of effects of acquisitions:             |  |                         |          |   |      |   |         |      |  |   |          |  
|Accounts receivable                                                                      |  |                         | 2,056    |   |      |   | 698     |      |  |   | (14,622  | )
|Prepaid expenses and other current assets                                                |  |                         | 3,186    |   |      |   | 1,651   |      |  |   | 4,074    |  
|Other assets                                                                             |  |                         | (34      | ) |      |   | 1,478   |      |  |   | (92      | )
|Accounts payable                                                                         |  |                         | 18       |   |      |   | (677    | )    |  |   | (1,329   | )
|Accrued compensation                                                                     |  |                         | 3,397    |   |      |   | 151     |      |  |   | 2,276    |  
|Other accrued expenses                                                                   |  |                         | (752     | ) |      |   | (2,970  | )    |  |   | 869      |  
|Income taxes payable                                                                     |  |                         | 15,104   |   |      |   | 20,961  |      |  |   | 16,705   |  
|Deferred revenue                                                                         |  |                         | 18,457   |   |      |   | 9,394   |      |  |   | 19,557   |  
|Other liabilities                                                                        |  |                         | 349      |   |      |   | (4,536  | )    |  |   | (329     | )
|                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Net cash provided by operating activities                                                |  |                         | 64,509   |   |      |   | 53,230  |      |  |   | 76,651   |  
|Cash flows from investing activities:                                                    |  |                         |          |   |      |   |         |      |  |   |          |  
|Purchases of property and equipment                                                      |  |                         | (22,079  | ) |      |   | (3,006  | )    |  |   | (6,664   | )
|Proceeds from sale of aircraft                                                           |  |                         |         |   |      |   | 1,932   |      |  |   |         |  
|Cash paid for acquisitions, net of cash acquired                                         |  |                         | (330     | ) |      |   | (56,841 | )    |  |   | (4,796   | )
|Proceeds from sale of equity investments                                                 |  |                         |         |   |      |   | 875     |      |  |   |         |  
|Purchases of marketable securities                                                       |  |                         | (187,233 | ) |      |   | (57,640 | )    |  |   | (175,079 | )
|Sales and maturities of marketable securities                                            |  |                         | 137,431  |   |      |   | 92,795  |      |  |   | 106,348  |  
|                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Net cash used in investing activities                                                    |  |                         | (72,211  | ) |      |   | (21,885 | )    |  |   | (80,191  | )
|Cash flows from financing activities:                                                    |  |                         |          |   |      |   |         |      |  |   |          |  
|Repayment of notes payable                                                               |  |                         | (1,163   | ) |      |   | (1,884  | )    |  |   | (4,249   | )
|Collections of note receivable from shareholder                                          |  |                         | 2,847    |   |      |   | 74      |      |  |   |         |  
|Repayment of capital lease obligations                                                   |  |                         | (312     | ) |      |   | (414    | )    |  |   | (315     | )
|Proceeds from the exercise of stock options                                              |  |                         | 5,926    |   |      |   | 1,757   |      |  |   | 9,499    |  
|Proceeds from employee stock purchase plan                                               |  |                         | 5,593    |   |      |   | 4,480   |      |  |   | 4,631    |  
|                                                                                         |  |                         |          |   |      |   |         |      |  |   |          |  
|Net cash provided by financing activities                                                |  |                         | 12,891   |   |      |   | 4,013   |      |  |   | 9,566    |  



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##### Table of Contents

QUEST SOFTWARE, INC.



CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)



|                                                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|--------------------------------------------------------------------- |  | ----------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                      |  | Year Ended December 31, |       
|                                                                      |  | 2001                    |        |   | 2002 |   |        | 2003 | 
|Effect of exchange rate changes on cash and cash equivalents          |  |                         | (65    | ) |      |   | (1,354 | )    |  |   | (2,839 | )
|                                                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|Net increase in cash and cash equivalents                             |  | $                       | 5,124  |   |      | $ | 34,004 |      |  | $ | 3,187  |  
|Cash and cash equivalents, beginning of period                        |  |                         | 25,155 |   |      |   | 30,279 |      |  |   | 64,283 |  
|                                                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|Cash and cash equivalents, end of period                              |  | $                       | 30,279 |   |      | $ | 64,283 |      |  | $ | 67,470 |  
|                                                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|Supplemental disclosures of consolidated cash flow information:       |  |                         |        |   |      |   |        |      |  |   |        |  
|Cash paid for interest                                                |  | $                       | 103    |   |      | $ | 54     |      |  | $ | 51     |  
|                                                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|Cash paid (refunded) for income taxes                                 |  | $                       | (3,642 | ) |      | $ | 693    |      |  | $ | 380    |  
|                                                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|Supplemental schedule of non-cash investing and financing activities: |  |                         |        |   |      |   |        |      |  |   |        |  
|Tax benefit related to stock option exercises                         |  | $                       | 10,370 |   |      | $ | 17,743 |      |  | $ | 8,864  |  
|                                                                      |  |                         |        |   |      |   |        |      |  |   |        |  
|Unrealized (loss) gain on available-for-sale securities               |  | $                       | 390    |   |      | $ | 787    |      |  | $ | (1,049 | )
|                                                                      |  |                         |        |   |      |   |        |      |  |   |        |  



See Note 5 for details
of assets acquired and liabilities assumed in purchase transactions.







See accompanying notes to consolidated financial statements.



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##### Table of Contents

QUEST SOFTWARE, INC.



NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS



1.    Description
of Business and Summary of Significant Accounting Policies



Nature of Operations and Basis of PresentationQuest Software, Inc., was incorporated in California in 1987 and is a leading developer and vendor of application and database management software products. We also provide
consulting, training, and support services to our customers. We have wholly-owned research and development subsidiaries in Russia, Israel and Canada and sales subsidiaries in Europe, Canada, Australia, Japan and Latin America for marketing,
distribution, and support of our products and services. The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and include our accounts and
those of our wholly owned subsidiaries. All inter-company transactions and balances have been eliminated in consolidation.



Foreign Currency TranslationIn accordance with Statement of Financial Accounting Standards (SFAS) No. 52, Foreign
Currency Translation, the United States Dollar is considered to be the functional currency for our foreign subsidiaries, as such subsidiaries act primarily as an extension of our parent companys operations. Assets and liabilities in
these subsidiaries are re-measured at current exchange rates, except for property and equipment, deferred revenue, depreciation and investments, which are translated at historical exchange rates. Revenues and expenses are translated at weighted
average exchange rates in effect during the year, except for costs related to those balance sheet items, which are translated at historical rates. Foreign currency translation gains and losses are included in other income, net in the
consolidated statements of operations. The net foreign currency translation gain was nominal, $2.1 million and $6.6 million for the years ended December 31, 2001, 2002 and 2003, respectively.



Fair Value of Financial InstrumentsThe carrying amounts of our
financial instruments including cash and cash equivalents, marketable securities, accounts receivable, investments, accounts payable and accrued liabilities approximate their respective fair values because of the relatively short period of time
between origination of the instruments and their expected realization, or because they are carried at fair value.



Cash and Cash EquivalentsWe consider all highly liquid investments purchased with original maturities of three months or less to be cash
equivalents.



Concentration of Credit
RiskFinancial instruments that potentially subject us to credit risk include cash and cash equivalents, marketable securities and accounts receivable. Trade receivables potentially subject us to concentrations of credit risk. We believe
that credit risks related to our investment portfolio are moderated by limitations we place on our exposure to any one issuer and credit risks on trade accounts receivable are moderated by the diversity of our products, customers and geographic
sales areas. We closely monitor extensions of credit and have not experienced significant credit losses in the past. We maintain reserves for estimated credit losses and sales returns, and such losses and returns have historically been within
managements expectations. No single customer accounted for 10% or more of our total revenues or accounts receivable for the years ended December 31, 2001, 2002 or 2003.



Marketable SecuritiesWe have classified all debt securities with original maturities of greater than three
months as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of shareholders equity net of applicable income taxes. Realized 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 basis for realized gains and losses on available-for-sale securities is determined on a specific identification basis. We
have classified available-for-sale securities as current or long-term based primarily on the maturity date of the related securities.



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##### Table of Contents

QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Investments in Non-consolidated CompaniesWe have made venture capital investments in
early stage private companies and a private equity fund for business and strategic purposes, and may make additional investments of this nature in the future. These investments are accounted for under the cost method, as we do not have the ability
to exercise significant influence over these companies operations. We periodically monitor our investments for impairment and will record reductions in carrying values if and when necessary. The evaluation process is based on information that
we request from these privately-held companies. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received
from these companies. As part of this evaluation process, our review includes, but is not limited to, a review of each companys cash position, recent financing activities, financing needs, earnings and revenue outlook, operational performance,
management or ownership changes, and competition. If we determine that the carrying value of our investment in a company is at an amount below fair value, we write down the investment and record a loss in the consolidated statements of operations.
Estimating the fair value of non-marketable equity investments in early-stage technology companies is inherently subjective and may contribute to volatility in our reported results of operations. Investments in non-consolidated companies are
included in other assets on our consolidated balance sheet at December 31, 2002 and 2003.



Long-Lived AssetsWe account for the impairment and disposition of long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. In
accordance with SFAS No. 144, long-lived assets to be held are reviewed for events or changes in circumstances which indicate that their carrying value may not be recoverable. We periodically review the carrying value of long-lived assets to
determine whether or not impairment to such value has occurred.



Property and EquipmentProperty and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are provided using the straight-line method over the following estimated useful
lives:



|                        |  |      
|----------------------- |  | -----
|                        |  | Years
|Furniture and fixtures  |  | 7    
|Machinery and equipment |  | 7    
|Computer equipment      |  | 3    
|Computer software       |  | 3    



Leasehold improvements
are amortized over the shorter of the estimated useful lives of the improvements or the term of the related lease. Repair and maintenance costs associated with property, equipment and leasehold improvements are expensed as incurred. Software
licenses are recorded at cost and are amortized over the shorter of the estimated useful lives of the related products or the term of the license, generally three years.



Goodwill and Amortizing Intangible AssetsGoodwill arising from acquisitions (see Notes 4 and 5) is recorded as
the excess of the purchase price over the fair value of assets acquired and, prior to 2002, was amortized over a useful life of five years. Accumulated goodwill amortization was $89.5 million in 2001. Purchased intangible assets are recorded at the
appraised value of technology, customer lists, trademarks and non-compete agreements acquired and amortized using the straight-line method over estimated useful lives ranging from two to seven years. Accumulated amortization of purchased intangible
assets was $16.4 million, $23.9 million and $35.0 million at December 31, 2001, 2002 and 2003, respectively. The net carrying amount of purchased intangible assets was considered recoverable at December 31, 2003, based on the undiscounted future
cash flows expected to be realized from continued sales of the related software products. The carrying amount of goodwill was considered recoverable at December 31, 2003. As a result of adopting SFAS No. 142 in 2002, goodwill is no longer amortized
but is evaluated for impairment at least annually.



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##### Table of Contents

QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Other AssetsOther assets primarily include lease security deposits and cost basis
investments, which are accounted for on the cost basis as we do not have the ability to exercise significant influence. Cost basis investments are adjusted only for other-than-temporary impairments, additional investments or the sale of an
investment.



Revenue RecognitionWe record revenue
in accordance with the American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software Revenue Recognition, and SOP 98-9, Modification of SOP 97-2, Software
Revenue Recognition, With Respect to Certain Transactions. The AICPA and its Software Revenue Recognition Task Force continue to issue interpretations and guidance for applying the relevant standards to a wide range of sales contract terms
and business arrangements that are prevalent in the software industry. Also, the Securities and Exchange Commission (SEC) has issued Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial
Statements,which provides guidance related to revenue recognition based on interpretations and practices followed by the SEC.



Software Licenses, Services, and Post-Contract Customer SupportWe market our software licenses primarily through our direct sales force and
indirectly through resellers. Revenues from sales of software licenses, which generally do not contain multiple elements, are recognized when: (1) we enter into a legally binding arrangement with a customer; (2) we deliver the products; (3) customer
payment is deemed fixed or determinable and free of contingencies or significant uncertainties; and (4) collection is probable. If all the requirements of revenue recognition have not been met, revenue recognition is deferred until such items are
known or resolved. Revenue from post-sale customer support is deferred and recognized ratably over the term of the support contract. Revenue from consulting and training services is recognized as the services are performed. We provide a limited
warranty on all sales of software licenses, which states that for a period of 30 days from delivery the media on which the software is recorded will be free from material defects in materials and workmanship under normal use, and that the operation
of our software will substantially conform to the applicable product documentation. We do not maintain a warranty reserve as costs incurred in association with the warranty are not material.



For arrangements with multiple elements, we allocate revenue to each element
of a transaction based upon its fair value as determined in reliance on vendor-specific objective evidence, or VSOE. VSOE of fair value for all elements of an arrangement is based upon the normal pricing and discounting
practices for those products and services when sold separately. When multiple elements are sold to a customer in a single contract, the revenues from such multiple-element arrangements are allocated to each element based upon the residual method.
Under the residual method, revenue is recognized for all delivered elements when (1) there is VSOE of the fair values of all undelivered elements and (2) all revenue recognition criteria of SOP 97-2, as amended, are satisfied. Under the residual
method of accounting, any discount in the arrangement is allocated to the delivered elements. If we cannot objectively determine the fair value of any undelivered element included in bundled software and service arrangements, we defer revenue until
all elements are delivered, services have been performed or until fair value can objectively be determined.



Software Development CostsCosts incurred in the research and development of new software products and enhancements to existing software
products are expensed as incurred until technological feasibility has been established. After technological feasibility is established, any additional costs are capitalized in accordance with SFAS No. 86, Accounting for the Costs of
Computer Software to Be Sold, Leased or Otherwise Marketed. Because we believe that our current process for developing software is essentially completed concurrently with the establishment of technical feasibility, no software development
costs have been capitalized as of December 31, 2002 and 2003.



Other Compensation CostsWe record compensation expense for options granted to purchase common stock if the related exercise price of the option is below fair market value. The expense equals the difference



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##### Table of Contents

QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



between the fair market value of our common stock on the grant or assumption date and the exercise price of the stock options. We assumed certain stock
options in connection with various acquisitions. We also record compensation costs from additional payroll taxes incurred when employees exercise stock options based on the difference between the exercise price and the market price on the date of
exercise.



The following table shows the allocation of such
costs to cost of licenses and services revenues and operating expenses based on the related headcount (in thousands):



|                               |  |              |       |      |   |       |  |   |      
|------------------------------ |  | ------------ | ----- | ---- | - | ----- |  | - | -----
|                               |  | December 31,
|                               |  | 2001         |       | 2002 |   | 2003 
|Cost of licenses revenues      |  | $            |      |      | $ |      |  | $ | 2    
|Cost of services revenues      |  |              | 443   |      |   | 110   |  |   | 71   
|Sales and marketing            |  |              | 2,178 |      |   | 1,083 |  |   | 634  
|Research and development       |  |              | 3,786 |      |   | 621   |  |   | 458  
|General and administrative     |  |              | 596   |      |   | 175   |  |   | 100  
|                               |  |              |       |      |   |       |  |   |      
|Total other compensation costs |  | $            | 7,003 |      | $ | 1,989 |  | $ | 1,265
|                               |  |              |       |      |   |       |  |   |      



We expect amortization
expense for other compensation costs to be insignificant throughout 2004, which corresponds to the remaining vesting periods of the related options.



Advertising ExpensesWe expense all advertising costs as incurred, and such costs were $2.8 million, $3.4 million, and $2.9 million for the
years ended December 31, 2001, 2002 and 2003, respectively.



Income TaxesWe account for income taxes under the provisions of SFAS No. 109, Accounting for Income Taxes. Deferred taxes on income result from temporary differences between the reporting of income for
financial statements and tax reporting purposes. Measurement of the deferred items is based on enacted tax laws. In the event the future consequences of differences between financial reporting bases and tax bases of our assets and liabilities result
in a deferred tax asset, SFAS No. 109 requires an evaluation of the probability of being able to realize the future benefits indicated by such asset. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not
that some portion or all of the deferred tax asset will not be realized.



Stock-Based CompensationIn December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure effective for fiscal years ending after December
15, 2002. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition to the fair value method of accounting for stock-based employee compensation. SFAS No. 148 also
amends the disclosure provisions of SFAS No. 123 to require disclosure in the summary of significant accounting policies of the effects of an entitys accounting policy with respect to stock-based employee compensation on reported net income
and earnings per share in annual and interim financial statements. SFAS No. 148 does not amend SFAS No. 123 to require companies to account for their employee stock-based awards using the fair value method. The disclosure provisions are required,
however, for all companies with stock-based employee compensation, regardless of whether they utilize the fair value method of accounting described in SFAS No. 123 or the intrinsic value method described in Accounting Principles Board
(APB) Opinion No. 25, Accounting for Stock Issued to Employees. We adopted the disclosure requirements of SFAS No. 148 effective January 1, 2003. The adoption of this standard did not have a significant impact on our
financial condition or operating results.



We account for
stock-based awards to employees using the intrinsic value method in accordance with APB Opinion No. 25. As permitted by SFAS No. 123, as amended by SFAS No. 148, we have chosen to continue to



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QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



account for our employee stock-based compensation plans under APB Opinion No. 25 and provide the expanded disclosures specified in SFAS No. 123, as amended
by SFAS No. 148. Had employee stock based compensation cost been determined using the fair value method our net income (loss) would have been adjusted to the pro forma amounts indicated below (in thousands, except per share data):



|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                                           |  | December 31, |        
|                                                                                                                           |  | 2001         |         |   | 2002 |   |         | 2003 | 
|Net income (loss):                                                                                                         |  |              |         |   |      |   |         |      |  |   |         |  
|As reported                                                                                                                |  | $            | (55,759 | ) |      | $ | 10,384  |      |  | $ | 21,516  |  
|Add: Stock-based compensation expense included in reported net income (loss), net of related tax effects                   |  |              | 2,930   |   |      |   | 891     |      |  |   | 529     |  
|Deduct: Total stock-based compensation determined under fair value based method for all awards, net of related tax effects |  |              | (21,335 | ) |      |   | (23,970 | )    |  |   | (27,746 | )
|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  
|Pro forma                                                                                                                  |  | $            | (74,164 | ) |      | $ | (12,695 | )    |  | $ | (5,701  | )
|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  
|Basic net income (loss) per share:                                                                                         |  |              |         |   |      |   |         |      |  |   |         |  
|As reported                                                                                                                |  | $            | (0.64   | ) |      | $ | 0.12    |      |  | $ | 0.23    |  
|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  
|Pro forma                                                                                                                  |  | $            | (0.85   | ) |      | $ | (0.14   | )    |  | $ | (0.06   | )
|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  
|Diluted net income (loss) per share:                                                                                       |  |              |         |   |      |   |         |      |  |   |         |  
|As reported                                                                                                                |  | $            | (0.64   | ) |      | $ | 0.11    |      |  | $ | 0.23    |  
|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  
|Pro forma                                                                                                                  |  | $            | (0.85   | ) |      | $ | (0.14   | )    |  | $ | (0.06   | )
|                                                                                                                           |  |              |         |   |      |   |         |      |  |   |         |  



For purposes of
estimating the compensation cost of our option grants in accordance with SFAS No. 123, as amended by SFAS No. 148, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. Weighted-average
assumptions used for 2001, 2002 and 2003 were as follows:



|                          |  |              |   |  |      |   |  |      |  
|------------------------- |  | ------------ | - |  | ---- | - |  | ---- | -
|                          |  | December 31, |  
|                          |  | 2001         |   |  | 2002 |   |  | 2003 |  
|Risk-free interest rates  |  | 5.00         | % |  | 4.00 | % |  | 3.97 | %
|Expected life (in years)  |  | 5            |   |  | 5    |   |  | 5    |  
|Expected stock volatility |  | 103          | % |  | 86   | % |  | 61   | %



Net Income (Loss)
Per ShareWe compute net income (loss) per share in accordance with SFAS No. 128, Earnings per Share. Basic earnings (loss) per share is computed by dividing net income (loss) available to common shareholders by the
weighted-average number of common shares outstanding for the period. Diluted earnings (loss) per share reflects the potential dilution of securities by including other common stock equivalents, including stock options, in the weighted-average number
of common shares outstanding for a period, if dilutive. For the year ended December 31, 2001, all potential common stock equivalents have been excluded from the computation of diluted net loss per share because the effect would be antidilutive.



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QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



The table below sets forth the reconciliation of the denominator of the earnings (loss) per share
calculation (in thousands):



|                                                             |  |        |     |  |        |     |  |        |    
|------------------------------------------------------------ |  | ------ | --- |  | ------ | --- |  | ------ | ---
|                                                             |  | 2001   |     |  | 2002   |     |  | 2003   |    
|Shares used in computing basic net income (loss) per share   |  | 87,632 |     |  | 90,065 |     |  | 92,081 |    
|Dilutive effect of stock options                             |  |       | (1) |  | 2,755  | (1) |  | 2,150  | (1)
|                                                             |  |        |     |  |        |     |  |        |    
|Shares used in computing diluted net income (loss) per share |  | 87,632 |     |  | 92,820 |     |  | 94,231 |    
|                                                             |  |        |     |  |        |     |  |        |    

---

|(1) |  | Options to purchase 15,568, 7,755 and 7,703 shares of common stock were outstanding during 2001, 2002 and 2003, respectively, but were not included in the computation of diluted net
income per share as inclusion would have been anti-dilutive.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Comprehensive Income (Loss)The difference between net income (loss) and comprehensive net income (loss) was an unrealized gain on available-for-sale securities of $0.4 million and $0.8 million for the
years ended December 31, 2001 and 2002, respectively, and an unrealized loss on available-for-sale securities of $1.0 million for the year ended December 31, 2003.



Use of EstimatesThe preparation of the consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the
consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.



Risks and UncertaintiesWe are subject to risks and uncertainties in the normal course of business, including
customer acceptance of our products, rapid technological changes, delays in introducing and market acceptance of new products, competition, e-business developments, international expansion, ability to attract and retain qualified personnel, ability
to protect our intellectual property, and other matters inherent in the software industry.



ReclassificationsCertain reclassifications have been made to the prior-years balances to conform to the current years presentation.



New Accounting Pronouncements:



In November 2002, the FASB issued FASB Interpretation No. 45 (FIN
45), Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 elaborates on the disclosures to be made by the guarantor in its interim and annual
financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the
guarantee. We adopted the disclosure provisions of FIN 45 during the fourth quarter of fiscal 2002 and we provided the required disclosures in Note 13 Commitments and Contingencies. We adopted the recognition provisions of FIN 45
effective January 1, 2003 and such adoption did not have an impact on our consolidated results of operations or financial position.



In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities.
In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide
sufficient financial resources for the entity to support its activities. FIN 46



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QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. We adopted the provisions of FIN 46 effective January 1, 2003. We
do not have any variable interest entities; thus adoption of FIN 46 did not have an impact on our consolidated results of operations or financial position.



In January 2003, the Emerging Issues Task Force (EITF) issued EITF 00-21, Revenue Arrangements with Multiple Deliverables,
which requires companies to allocate the consideration received on arrangements involving multiple arrangements based on their relative fair values. Further, this EITF requires that the companies consider the revenue recognition criteria separately
for each of the deliverables. This EITF is applicable for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Early adoption is permitted. We adopted EITF 00-21 on January 1, 2003 and it did not have a material impact
on our consolidated results of operations or financial position.



In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging. The statement requires that contracts with comparable characteristics be
accounted for similarly and clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, except in
certain circumstances, and for hedging relationships designated after June 30, 2003. We adopted SFAS No. 149 effective July 1, 2003 and such adoption did not have an impact on our consolidated results of operations or financial position.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with
characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the
issuer. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. We adopted SFAS No. 150 effective July 1,
2003 and such adoption did not have an impact on our consolidated results of operations or financial position because we have not issued any of these types of financial instruments.



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QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



2.    Marketable Securities



The following table summarizes our portfolio of marketable securities (in thousands):



|                                 |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|-------------------------------- |  | -------------- | ------- | ---------------- | - | ----------------- |  | - | ---------- | - |  | - | -------
|December 31, 2002                |  | Amortized Cost |         | Unrealized Gains |   | Unrealized Losses |  |   | Fair Value
|Due in one year or less:         |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|U.S. government agencies         |  | $              | 11,994  |                  | $ | 94                |  | $ |           |   |  | $ | 12,088 
|Corporate bonds                  |  |                | 8,972   |                  |   | 71                |  |   |           |   |  |   | 9,043  
|Mortgage-backed securities       |  |                | 5,839   |                  |   | 17                |  |   | (27        | ) |  |   | 5,829  
|Corporate stock                  |  |                | 828     |                  |   |                  |  |   |           |   |  |   | 828    
|Other                            |  |                | 53      |                  |   |                  |  |   |           |   |  |   | 53     
|Due in one to five years:        |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|U.S. government agencies         |  |                | 34,956  |                  |   | 437               |  |   |           |   |  |   | 35,393 
|Mortgage-backed securities       |  |                | 79,312  |                  |   | 771               |  |   | (54        | ) |  |   | 80,029 
|                                 |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|Total                            |  | $              | 141,954 |                  | $ | 1,390             |  | $ | (81        | ) |  | $ | 143,263
|                                 |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|Reported As:                     |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|Short-term marketable securities |  |                |         |                  |   |                   |  |   |            |   |  | $ | 27,841 
|Long-term marketable securities  |  |                |         |                  |   |                   |  |   |            |   |  |   | 115,422
|                                 |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|Total                            |  |                |         |                  |   |                   |  |   |            |   |  | $ | 143,263
|                                 |  |                |         |                  |   |                   |  |   |            |   |  |   |        



|                                 |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|-------------------------------- |  | -------------- | ------- | ---------------- | - | ----------------- |  | - | ---------- | - |  | - | -------
|December 31, 2003                |  | Amortized Cost |         | Unrealized Gains |   | Unrealized Losses |  |   | Fair Value
|Due in one year or less:         |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|U.S. government agencies         |  | $              | 24,978  |                  | $ | 178               |  | $ |           |   |  | $ | 25,156 
|Mortgage-backed securities       |  |                | 1,454   |                  |   | 18                |  |   | (28        | ) |  |   | 1,444  
|Corporate stock                  |  |                | 89      |                  |   |                  |  |   |           |   |  |   | 89     
|Other                            |  |                | 48      |                  |   |                  |  |   |           |   |  |   | 48     
|Due in one to five years:        |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|U.S. government agencies         |  |                | 117,527 |                  |   | 393               |  |   | (168       | ) |  |   | 117,752
|Mortgage-backed securities       |  |                | 37,162  |                  |   | 282               |  |   | (166       | ) |  |   | 37,278 
|Due in five to ten years:        |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|Mortgage-backed securities       |  |                | 29,378  |                  |   | 22                |  |   | (271       | ) |  |   | 29,129 
|                                 |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|Total                            |  | $              | 210,636 |                  | $ | 893               |  | $ | (633       | ) |  | $ | 210,896
|                                 |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|Reported As:                     |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|Short-term marketable securities |  |                |         |                  |   |                   |  |   |            |   |  | $ | 26,736 
|Long-term marketable securities  |  |                |         |                  |   |                   |  |   |            |   |  |   | 184,160
|                                 |  |                |         |                  |   |                   |  |   |            |   |  |   |        
|Total                            |  |                |         |                  |   |                   |  |   |            |   |  | $ | 210,896
|                                 |  |                |         |                  |   |                   |  |   |            |   |  |   |        



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QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



The following table summarizes gross unrealized losses and fair value for our portfolio of marketable
securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2003 (in thousands):



|                           |  |                     |        |                  |                     |        |            |  |                  |   |            |   |                  |  |   |        |  |   |        |  
|-------------------------- |  | ------------------- | ------ | ---------------- | ------------------- | ------ | ---------- |  | ---------------- | - | ---------- | - | ---------------- |  | - | ------ |  | - | ------ | -
|                           |  | Less than 12 months |        |                  | 12 months or longer |        | Total      | 
|                           |  | Fair Value          |        | UnrealizedLosses |                     |        | Fair Value |  | UnrealizedLosses |   | Fair Value |   | UnrealizedLosses | 
|U.S. government agencies   |  | $                   | 14,720 |                  | $                   | (279   | )          |  | $                |  |            | $ |                 |  | $ | 14,720 |  | $ | (279   | )
|Mortgage-backed securities |  |                     | 38,397 |                  |                     | (770   | )          |  |                  |  |            |   |                 |  |   | 38,397 |  |   | (770   | )
|                           |  |                     |        |                  |                     |        |            |  |                  |   |            |   |                  |  |   |        |  |   |        |  
|Total                      |  | $                   | 53,117 |                  | $                   | (1,049 | )          |  | $                |  |            | $ |                 |  | $ | 53,117 |  | $ | (1,049 | )
|                           |  |                     |        |                  |                     |        |            |  |                  |   |            |   |                  |  |   |        |  |   |        |  



Interest income,
included in other income (expense), net in the accompanying consolidated statements of operations, was $10.8 million, $9.3 million and $6.1 million for the years ended December 31, 2001, 2002 and 2003, respectively.



3.    Cost Basis Investments



At December 31, 2003, we valued our cost basis investments in private
companies at $1.0 million. In addition, we have committed to make additional capital contributions to a private equity fund totaling $1.7 million. If the companies in which we have made direct or indirect investments do not complete initial public
offerings or are not acquired by publicly traded companies or for cash, we may not be able to sell these investments. In addition, even if we are able to sell these investments we cannot assure that we will be able to sell them at a gain or even
recover our investment. For the year ended December 31, 2002, we recorded a loss in other income, net, of $1.6 million associated with an other-than-temporary impairment and realized a gain of $1.9 million on the sale of one of our investments
in an early stage private company.



4.    Goodwill and
Amortizable Intangible Assets



Amortizing intangible
assets as of December 31, 2002 and 2003, respectively, are comprised of the following:



|                      |  |                       |        |                          |   |         |     |  |                                      |        |                       |     |                          |   |        |     |   |                                      |   |  |   |        |  |    
|--------------------- |  | --------------------- | ------ | ------------------------ | - | ------- | --- |  | ------------------------------------ | ------ | --------------------- | --- | ------------------------ | - | ------ | --- | - | ------------------------------------ | - |  | - | ------ |  | ---
|                      |  | 2002                  |        | 2003                    
|                      |  | Gross Carrying Amount |        | Accumulated Amortization |   |         | Net |  | Weighted Average Amortization Period |        | Gross Carrying Amount |     | Accumulated Amortization |   |        | Net |   | Weighted Average Amortization Period
|Acquired technology   |  | $                     | 44,017 |                          | $ | (18,785 | )   |  | $                                    | 25,232 |                       | 4.4 |                          | $ | 47,617 |     | $ | (26,460                              | ) |  | $ | 21,157 |  | 4.5
|Customer list         |  |                       | 5,101  |                          |   | (1,945  | )   |  |                                      | 3,156  |                       | 2.7 |                          |   | 6,351  |     |   | (3,944                               | ) |  |   | 2,407  |  | 3.2
|Non-compete agreement |  |                       | 2,200  |                          |   | (1,008  | )   |  |                                      | 1,192  |                       | 2.0 |                          |   | 2,325  |     |   | (2,108                               | ) |  |   | 217    |  | 2.2
|Trademark             |  |                       | 1,450  |                          |   | (48     | )   |  |                                      | 1,402  |                       | 5.0 |                          |   | 1,450  |     |   | (338                                 | ) |  |   | 1,112  |  | 5.0
|Other                 |  |                       | 2,264  |                          |   | (2,130  | )   |  |                                      | 134    |                       | 2.3 |                          |   | 2,445  |     |   | (2,179                               | ) |  |   | 266    |  | 2.3
|                      |  |                       |        |                          |   |         |     |  |                                      |        |                       |     |                          |   |        |     |   |                                      |   |  |   |        |  |    
|                      |  | $                     | 55,032 |                          | $ | (23,916 | )   |  | $                                    | 31,116 |                       |     |                          | $ | 60,188 |     | $ | (35,029                              | ) |  | $ | 25,159 |  |    
|                      |  |                       |        |                          |   |         |     |  |                                      |        |                       |     |                          |   |        |     |   |                                      |   |  |   |        |  |    



Amortization expense
for amortizing intangible assets was $9.6 million, $8.1 million and $11.1 million for years ended December 31, 2001, 2002 and 2003, respectively. Estimated annual amortization expense by fiscal year is as follows: 2004$6.9 million;
2005$5.1 million; 2006$4.8 million; 2007$4.0 million; 2008$3.2 million; thereafter$1.2 million. All intangible assets currently recorded will be fully amortized by the end of 2009.



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QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



The changes in the carrying amount of goodwill by reportable operating segment for the year ended
December 31, 2003 are as follows (in thousands):



|                                                           |  |          |         |          |   |        |  |   |        
|---------------------------------------------------------- |  | -------- | ------- | -------- | - | ------ |  | - | -------
|                                                           |  | Licenses |         | Services |   | Total 
|Balance as of December 31, 2002                            |  | $        | 176,104 |          | $ | 55,613 |  | $ | 231,717
|Goodwill acquired during the year ended December 31, 2003: |  |          |         |          |   |        |  |   |        
|ECritical                                                  |  |          | 1,562   |          |   |       |  |   | 1,562  
|Discus Data                                                |  |          | 4,427   |          |   | 1,398  |  |   | 5,825  
|Other                                                      |  |          | 80      |          |   | 64     |  |   | 144    
|Goodwill adjustment for Sitraka severance costs            |  |          | 450     |          |   | 142    |  |   | 592    
|                                                           |  |          |         |          |   |        |  |   |        
|Balance as of December 31, 2003                            |  | $        | 182,623 |          | $ | 57,217 |  | $ | 239,840
|                                                           |  |          |         |          |   |        |  |   |        



5.    Acquisitions



2003 Acquisitions



On April 3, 2003, we
acquired the outstanding shares of eCritical Inc. (eCritical), a provider of performance management solutions for network-enabled applications. eCriticals products extend our software monitoring solutions beyond the internal
firewall to enable information technology (IT) administrators to monitor end user application response times and serve as an additional complement to our end-to-end response time management solution. The purchase price for eCritical was
$2.1 million, consisting of stock of $1.8 million, of which $0.2 million was withheld in escrow for certain indemnification obligations of the selling shareholders, guaranteed future payments of $0.2 million related to employment agreements with
certain key employees, and direct acquisition costs of $0.1 million. Goodwill in the amount of $1.6 million was assigned to the license segment of our business and is not expected to be deductible for tax purposes. As of December 31, 2003, none of
the $0.2 million guaranteed future payments had been made.



An
additional non-guaranteed amount of up to $0.2 million may be earned in the two years following the acquisition if certain sales of eCritical products, based on a formula, exceed $1.0 million following the close of the acquisition. These
non-guaranteed payments will be recorded as compensation expense when and if such amounts are earned. As of December 31, 2003, none of the non-guaranteed future consideration had been earned or paid.



We acquired the outstanding shares of Discus Data Solutions, Inc.
(Discus Data), a provider of infrastructure management solutions for the Microsoft environment, on May 30, 2003 in exchange for cash paid of $5.9 million, guaranteed future consideration of $2.0 million and direct acquisition costs of
$0.1 million. Discus Datas products broaden our core products for the Microsoft environment, specifically enabling Microsoft IT administrators with complementary functionality to manage user populations within Active Directory and Exchange
environments. Of the cash paid, $0.6 million was withheld in escrow for certain indemnification obligations of the selling shareholders. Goodwill in the amount of $5.8 million is not expected to be deductible for tax purposes and was assigned as
follows: $4.4 million to the license segment and $1.4 million to the services segment of our business.



We are required to pay guaranteed future consideration of $2.0 million no later than May 30, 2005. Payment of $1.0 million of the future consideration is
required to be paid earlier if the completion of certain deliverables is achieved and the remaining $1.0 million is required to be paid earlier if certain earn-out requirements are met. As of December 31, 2003, deliverable consideration of $0.3
million had been paid.



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QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



An additional non-guaranteed amount of up to $1.0 million may be earned over the two year period
following the acquisition if certain sales of Discus Data products, based on a formula, exceed $5.0 million and $9.0 million in the first and second year, respectively, following the close of the acquisition. Such payments will be recorded as
compensation expense when and if such amounts are earned. As of December 31, 2003, none of the non-guaranteed future consideration had been earned or paid.



On December 5, 2003 we purchased the technology and intellectual property rights to TOra in exchange for cash paid of $50,000 and guaranteed future
consideration of $450,000 related to an employment agreement with the former owner. Future consideration of $210,000 will be paid during the first year following the date of acquisition with the remainder ratably over the second and third year
following the acquisition. Goodwill in the amount of $140,000 is not expected to be deductible for tax purposes and was assigned as follows: $77,000 to the license segment and $63,000 to the services segment of our business.



2002 Acquisitions



In February of 2002, we acquired the outstanding shares of BB4 Technologies,
Inc. (BB4), a provider of systems availability monitoring solutions. The purchase price for BB4 was $6.6 million, consisting of $4.2 million cash, direct acquisition costs of $0.2 million and future payments of $2.2 million related to
non-compete agreements with certain key employees who are former shareholders. Goodwill in the amount of $4.8 million is not expected to be deductible for tax purposes and was assigned as follows: $3.7 million to the license segment and $1.1 million
to the services segment of our business. As of December 31, 2003, $0.8 million of the future consideration had been paid.



In November of 2002, we acquired the outstanding shares of Sitraka, Inc. (Sitraka) a leading developer of application server performance
management products in November 2002. The acquisition of Sitraka was made to broaden our application management portfolio of products to enable customers to detect, diagnose and resolve application bottlenecks within multi-tiered Java application
environments. We acquired Sitraka in exchange for cash payments of $53.4 million, up to $3.6 million in additional contingent consideration, direct acquisition costs of $1.1 million and during 2003 an additional $0.6 million was recorded to goodwill
for severance charges directly related to the acquisition. Goodwill in the amount of $36.5 million is not expected to be deductible for tax purposes and was assigned as follows: $27.7 million to the license segment and $8.8 million to the services
segment of our business. Of the cash paid, $5.2 million was deposited to an escrow account to secure certain indemnification obligations of the selling shareholders. The obligation to pay the contingent consideration is dependent upon receipt of
certain tax credits due to Sitraka. As of December 31, 2003, $3.0 million of the contingent consideration had been paid.



In connection with the Sitraka acquisition, we identified and valued two In-Process Research and Development (IPR&D) projects. Related to these
IPR&D projects, $2.9 million was allocated to IPR&D and expensed immediately upon completion of the acquisition (as a charge not deductible for tax purposes), because the technological feasibility of products under development had not been
established and no future alternative uses existed. Both projects were approximately 50% complete at the date of acquisition and the estimated cost to complete the projects was $1.3 million and were completed as anticipated and made generally
available for sale in March 2003.



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QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



The acquisitions were all accounted for as purchase business combinations, and the results of each
acquisitions operations are included in our consolidated statements of operations from the respective dates of acquisition. The purchase prices of these acquisitions were allocated as follows (in thousands):



|                             |  |                |        |                                 |   |          |  |                   |        |       |   |                     |  |   |                |  |   |                      |   |  |   |         |   |  |   |       
|---------------------------- |  | -------------- | ------ | ------------------------------- | - | -------- |  | ----------------- | ------ | ----- | - | ------------------- |  | - | -------------- |  | - | -------------------- | - |  | - | ------- | - |  | - | ------
|                             |  | Current Assets |        | Property andEquipment and Other |   | Goodwill |  | Other Intangibles |        | IPR&D |   | Assumed Liabilities |  |   | Deferred Taxes |  |   | Total Purchase Price
|YEAR ENDED DECEMBER 31, 2002 |  |                |        |                                 |   |          |  |                   |        |       |   |                     |  |   |                |  |   |                      |   |  |   |         |   |  |   |       
|BB4 Technologies, Inc.       |  | $              | 123    |                                 | $ |         |  | $                 | 4,846  |       | $ | 2,743               |  | $ |               |  | $ | (60                  | ) |  | $ | (1,097  | ) |  | $ | 6,555 
|Sitraka, Inc.                |  |                | 12,685 |                                 |   | 968      |  |                   | 36,524 |       |   | 24,950              |  |   | 2,900          |  |   | (9,584               | ) |  |   | (9,723  | ) |  |   | 58,720
|                             |  |                |        |                                 |   |          |  |                   |        |       |   |                     |  |   |                |  |   |                      |   |  |   |         |   |  |   |       
|                             |  | $              | 12,808 |                                 | $ | 968      |  | $                 | 41,370 |       | $ | 27,693              |  | $ | 2,900          |  | $ | (9,644               | ) |  | $ | (10,820 | ) |  | $ | 65,275
|                             |  |                |        |                                 |   |          |  |                   |        |       |   |                     |  |   |                |  |   |                      |   |  |   |         |   |  |   |       
|YEAR ENDED DECEMBER 31, 2003 |  |                |        |                                 |   |          |  |                   |        |       |   |                     |  |   |                |  |   |                      |   |  |   |         |   |  |   |       
|eCritical, Inc.              |  | $              | 21     |                                 | $ | 12       |  | $                 | 1,562  |       | $ | 1,200               |  | $ |               |  | $ | (270                 | ) |  | $ | (382    | ) |  | $ | 2,143 
|Discus Data Solutions, Inc.  |  |                | 705    |                                 |   | 41       |  |                   | 5,825  |       |   | 3,400               |  |   |               |  |   | (716                 | ) |  |   | (1,229  | ) |  |   | 8,026 
|Other.                       |  |                |       |                                 |   |         |  |                   | 151    |       |   | 375                 |  |   |               |  |   |                     |   |  |   |        |   |  |   | 526   
|                             |  |                |        |                                 |   |          |  |                   |        |       |   |                     |  |   |                |  |   |                      |   |  |   |         |   |  |   |       
|                             |  | $              | 726    |                                 | $ | 53       |  | $                 | 7,538  |       | $ | 4,975               |  | $ |               |  | $ | (986                 | ) |  | $ | (1,611  | ) |  | $ | 10,695
|                             |  |                |        |                                 |   |          |  |                   |        |       |   |                     |  |   |                |  |   |                      |   |  |   |         |   |  |   |       



Goodwill by reportable
segment, related to acquisitions in 2002 and 2003, is as follows:



|                             |  |          |        |          |   |       |  |   |       
|---------------------------- |  | -------- | ------ | -------- | - | ----- |  | - | ------
|                             |  | Licenses |        | Services |   | Total
|YEAR ENDED DECEMBER 31, 2002 |  |          |        |          |   |       |  |   |       
|BB4 Technologies, Inc.       |  | $        | 3,683  |          | $ | 1,163 |  | $ | 4,846 
|Sitraka, Inc.                |  |          | 27,764 |          |   | 8,760 |  |   | 36,524
|                             |  |          |        |          |   |       |  |   |       
|                             |  | $        | 31,447 |          | $ | 9,923 |  | $ | 41,370
|                             |  |          |        |          |   |       |  |   |       
|YEAR ENDED DECEMBER 31, 2003 |  |          |        |          |   |       |  |   |       
|ECritical, Inc.              |  | $        | 1,562  |          | $ |      |  | $ | 1,562 
|Discus Data Solutions, Inc.  |  |          | 4,427  |          |   | 1,398 |  |   | 5,825 
|Other                        |  |          | 80     |          |   | 71    |  |   | 151   
|                             |  |          |        |          |   |       |  |   |       
|                             |  | $        | 6,069  |          | $ | 1,469 |  | $ | 7,538 
|                             |  |          |        |          |   |       |  |   |       



Our financial results
for the years ended December 31, 2002 and 2003 include actual results of these acquisitions from the dates on which the acquisitions were completed. The pro forma results of operations data for 2002 and 2003 presented below assume that the
acquisitions had been made at the beginning of each fiscal year and include amortization of identified intangibles from that date. The pro forma data is presented for informational purposes only and is not necessarily indicative of the results of
future operations nor of the actual results that would have been achieved had the acquisitions taken place at the beginning of the fiscal year (in thousands):



|                                       |  |                                  |         |      |   |        
|-------------------------------------- |  | -------------------------------- | ------- | ---- | - | -------
|                                       |  | Twelve Months Ended December 31,
|                                       |  | 2002                             |         | 2003
|Revenues                               |  | $                                | 270,158 |      | $ | 305,713
|Net income                             |  |                                  | 4,361   |      |   | 20,568 
|Basic and diluted net income per share |  |                                  | 0.05    |      |   | 0.22   



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QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



6.    Property and Equipment



Net property and equipment consist of the following at December 31 (in
thousands):



|                                               |  |      |         |   |      |   |         |  
|---------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                               |  | 2002 |         |   | 2003 |  
|Furniture and fixtures                         |  | $    | 8,438   |   |      | $ | 9,114   |  
|Machinery and equipment                        |  |      | 24,384  |   |      |   | 21,003  |  
|Computer equipment                             |  |      | 22,481  |   |      |   | 25,563  |  
|Computer software                              |  |      | 20,237  |   |      |   | 21,594  |  
|Leasehold improvements                         |  |      | 4,251   |   |      |   | 4,910   |  
|                                               |  |      |         |   |      |   |         |  
|                                               |  |      | 79,791  |   |      |   | 82,184  |  
|Less accumulated depreciation and amortization |  |      | (35,286 | ) |      |   | (50,234 | )
|                                               |  |      |         |   |      |   |         |  
|Property and equipment, net                    |  | $    | 44,505  |   |      | $ | 31,950  |  
|                                               |  |      |         |   |      |   |         |  



7.    Related-Party Transactions



In August 2000, we received a note receivable from one of our executive officers, for the purchase of 339,000 shares of our common stock at a purchase price of $46.50 per share. The former officer remains employed by us. The note
receivable, plus accrued interest, is due August 2007, bears interest at 6.33% per annum, and is secured by the common stock. The note receivable is deemed to be a non-recourse obligation of the former officer for financial reporting purposes.



A related party provides us with investment advisory services
and receives no compensation.



8.    Notes Payable



In conjunction with an acquisition in 2000, we assumed a
$4.4 million zero-interest loan related to a research and development funding arrangement with the Province of Nova Scotia. We have imputed interest on the loan of $1.2 million, which is being amortized to interest expense over the term of the loan.
The repayments were fixed at $1.2 million each July of 2001, 2002 and 2003. As of December 31, 2003, the remaining amount payable is $0.9 million, which is due in July of 2004.



9.    Income Taxes



The provision for income taxes consists of the following for the years ended December 31 (in thousands):



|                              |  |      |        |   |      |   |         |      |  |   |        |  
|----------------------------- |  | ---- | ------ | - | ---- | - | ------- | ---- |  | - | ------ | -
|                              |  | 2001 |        |   | 2002 |   |         | 2003 | 
|Current:                      |  |      |        |   |      |   |         |      |  |   |        |  
|Federal                       |  | $    | 9,743  |   |      | $ | 16,358  |      |  | $ | 9,457  |  
|State                         |  |      | 1,557  |   |      |   | 3,715   |      |  |   | 3,933  |  
|Foreign                       |  |      | 149    |   |      |   | 391     |      |  |   | 1,353  |  
|                              |  |      |        |   |      |   |         |      |  |   |        |  
|                              |  |      | 11,449 |   |      |   | 20,464  |      |  |   | 14,743 |  
|Deferred:                     |  |      |        |   |      |   |         |      |  |   |        |  
|Federal                       |  |      | (4,083 | ) |      |   | (2,176  | )    |  |   | 906    |  
|State                         |  |      | (3,352 | ) |      |   | (1,630  | )    |  |   | 801    |  
|Foreign                       |  |      | (4,646 | ) |      |   | 1,971   |      |  |   | 217    |  
|Change in valuation allowance |  |      | 6,493  |   |      |   | (10,505 | )    |  |   | (4,564 | )
|                              |  |      |        |   |      |   |         |      |  |   |        |  
|                              |  |      | (5,588 | ) |      |   | (12,340 | )    |  |   | (2,640 | )
|                              |  |      |        |   |      |   |         |      |  |   |        |  
|Total income tax provision    |  | $    | 5,861  |   |      | $ | 8,124   |      |  | $ | 12,103 |  
|                              |  |      |        |   |      |   |         |      |  |   |        |  



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QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



The reconciliation of the U.S. federal statutory rate to the effective income tax rate for the years
ended December 31, 2001, 2002 and 2003, is as follows:



|                                                            |  |       |    |  |       |   |  |      |  
|----------------------------------------------------------- |  | ----- | -- |  | ----- | - |  | ---- | -
|                                                            |  | 2001  |    |  | 2002  |   |  | 2003 |  
|Tax provision (benefit) at U.S. federal statutory rates     |  | (35.0 | )% |  | 35.0  | % |  | 35.0 | %
|State taxes                                                 |  | (1.9  | )  |  | 1.3   |   |  | 3.7  |  
|Goodwill amortization                                       |  | 38.1  |    |  |      |   |  |     |  
|Foreign taxes and foreign losses (with) without tax benefit |  | 13.5  |    |  | 9.6   |   |  | (1.6 | )
|Research and development credits                            |  | (5.8  | )  |  | (10.4 | ) |  | (3.2 | )
|In-process research and development                         |  |      |    |  | 5.5   |   |  |     |  
|Other                                                       |  | 2.9   |    |  | 2.9   |   |  | 2.1  |  
|                                                            |  |       |    |  |       |   |  |      |  
|                                                            |  | 11.8  | %  |  | 43.9  | % |  | 36.0 | %
|                                                            |  |       |    |  |       |   |  |      |  



Deferred income taxes
reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred taxes as of December 31,
2002 and 2003 are as follows (in thousands):



|                                               |  |      |         |   |      |   |         |  
|---------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                               |  | 2002 |         |   | 2003 |  
|Deferred tax assets:                           |  |      |         |   |      |   |         |  
|Accounts receivable and sales returns reserves |  | $    | 1,390   |   |      | $ | 1,775   |  
|Accrued liabilities                            |  |      | 1,962   |   |      |   | 2,234   |  
|Foreign net operating loss carryforwards       |  |      | 13,080  |   |      |   | 12,862  |  
|U.S. net operating loss carryforwards          |  |      | 11,780  |   |      |   | 4,954   |  
|Stock compensation                             |  |      | 1,452   |   |      |   | 1,652   |  
|Tax credits                                    |  |      | 14,429  |   |      |   | 15,777  |  
|Deferred revenue                               |  |      | 14,979  |   |      |   | 11,963  |  
|Other                                          |  |      | 3,300   |   |      |   | 3,497   |  
|                                               |  |      |         |   |      |   |         |  
|Total gross deferred assets                    |  |      | 62,372  |   |      |   | 54,714  |  
|                                               |  |     
|Deferred tax liabilities:                      |  |      |         |   |      |   |         |  
|Intangibles                                    |  |      | (11,839 | ) |      |   | (9,057  | )
|State taxes                                    |  |      | (3,718  | ) |      |   | (3,241  | )
|Fixed assets                                   |  |      | (3,082  | ) |      |   | (2,554  | )
|                                               |  |      |         |   |      |   |         |  
|Total gross deferred liabilities               |  |      | (18,639 | ) |      |   | (14,852 | )
|Valuation allowance                            |  |      | (19,228 | ) |      |   | (14,662 | )
|                                               |  |      |         |   |      |   |         |  
|Net deferred income taxes                      |  |      | 24,505  |   |      |   | 25,200  |  
|                                               |  |      |         |   |      |   |         |  
|Less current portion                           |  |      | (9,491  | ) |      |   | (15,074 | )
|                                               |  |      |         |   |      |   |         |  
|                                               |  | $    | 15,014  |   |      | $ | 10,126  |  
|                                               |  |      |         |   |      |   |         |  



At December 31, 2003,
we had recorded a valuation allowance of $14.7 million on our deferred tax assets. Based on the weight of available evidence, we believe that it is more likely than not that these deferred tax assets will not be realized. Approximately $4.6 million
of the valuation allowance was reduced in the current year as we believe that these deferred tax assets will more likely than not be realized. Approximately $4.4 million of these deferred tax assets relate to net operating losses resulting from
stock option exercises and therefore the tax benefit of these stock options was credited to shareholders equity in the current year.



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QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



At December 31, 2003, we had federal, state and foreign net operating loss carryforwards of $8.3
million, $26.4 million and $36.9 million, respectively, which begin to expire in 2018, 2005 and 2004, respectively. Approximately $19.8 million of the foreign net operating loss carryforwards were incurred by a subsidiary prior to the date of our
acquisition of such subsidiary. Accordingly, the tax benefits associated with the realization of such net operating losses will be credited to goodwill if realized.



At December 31, 2003 we had federal and state tax credit carryforwards of $9.8 million and $5.9 million, respectively, which
begin to expire in 2018.



Tax benefits associated with the
exercise of stock options of $17.7 million and $8.9 million in 2002 and 2003, respectively, were credited to shareholders equity.



Income (loss) before income taxes consists of the following components (in thousands):



|              |  |      |         |   |      |   |        |      |  |   |       
|------------- |  | ---- | ------- | - | ---- | - | ------ | ---- |  | - | ------
|              |  | 2001 |         |   | 2002 |   |        | 2003
|United States |  | $    | (4,039  | ) |      | $ | 27,057 |      |  | $ | 18,762
|Foreign       |  |      | (45,859 | ) |      |   | (8,549 | )    |  |   | 14,857
|              |  |      |         |   |      |   |        |      |  |   |       
|Total         |  | $    | (49,898 | ) |      | $ | 18,508 |      |  | $ | 33,619
|              |  |      |         |   |      |   |        |      |  |   |       



Undistributed earnings
of our foreign subsidiaries were immaterial as of December 31, 2003. Those earnings are considered to be permanently reinvested. Accordingly, no provision for U.S. federal or state income tax has been provided thereon.



Our federal income tax returns for the years ended December 31, 2000 and 2001
are currently under examination by the Internal Revenue Service. We believe that resolution of this examination will not have a material effect on our results of operations or financial position.



10.    Shareholders Equity



In December 2000, our Board of Directors authorized a stock repurchase
program under which we may repurchase up to 2.0 million shares of our common stock. In October 2001, our Board of Directors increased the total number of shares authorized for repurchase under this program to 5.0 million shares. Under the repurchase
program, we may repurchase shares from time to time at varying prices in open market or private transactions. We did not set any timeline within which repurchases would be made and have not committed to repurchase any specific amount of shares. As
of December 31, 2000, we had repurchased 1.7 million shares for approximately $57.4 million under this program. No additional shares were repurchased under this program in 2001, 2002 or 2003.



11.    Employee Benefit Plans



Stock Option Plans



Our stock option plans provide for the issuance of stock options to our employees, directors and consultants. The options
are generally granted with exercise prices equal to the fair market value of our common stock as of the grant date, expire ten years from the date of grant, and ratably vest over a four- to five-year period. As of December 31, 2003, we have
authorized 26.5 million shares for issuance under the plans, of which 3.6 million shares are available for future grant.



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QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



A summary of the status of our stock option plans as of December 31, 2001, 2002 and 2003 and changes
during the years ending on those dates is presented below (in thousands, except per share data):



|                                 |  |        |   |      |                                  |       |        |        |   |                                  |   |        |  |        |                                  |  |   |      
|-------------------------------- |  | ------ | - | ---- | -------------------------------- | ----- | ------ | ------ | - | -------------------------------- | - | ------ |  | ------ | -------------------------------- |  | - | -----
|                                 |  | 2001   |   | 2002 |                                  | 2003 
|                                 |  | Shares |   |      | Weighted- Average Exercise Price |       | Shares |        |   | Weighted- Average Exercise Price |   | Shares |  |        | Weighted- Average Exercise Price
|Outstanding, beginning of period |  | 10,641 |   |      | $                                | 12.56 |        | 15,568 |   |                                  | $ | 13.56  |  | 19,710 |                                  |  | $ | 13.28
|Granted                          |  | 8,895  |   |      | $                                | 14.16 |        | 6,904  |   |                                  | $ | 9.46   |  | 6,947  |                                  |  | $ | 11.49
|Exercised                        |  | (1,716 | ) |      | $                                | 3.76  |        | (1,466 | ) |                                  | $ | 1.21   |  | (1,799 | )                                |  | $ | 5.28 
|Canceled                         |  | (2,252 | ) |      | $                                | 19.08 |        | (1,296 | ) |                                  | $ | 20.78  |  | (1,939 | )                                |  | $ | 14.44
|                                 |  |        |   |      |                                  |       |        |        |   |                                  |   |        |  |        |                                  |  |   |      
|Balance, end of period           |  | 15,568 |   |      | $                                | 13.56 |        | 19,710 |   |                                  | $ | 13.28  |  | 22,919 |                                  |  | $ | 13.27
|                                 |  |        |   |      |                                  |       |        |        |   |                                  |   |        |  |        |                                  |  |   |      
|Exercisable, end of period       |  | 2,922  |   |      | $                                | 8.82  |        | 4,992  |   |                                  | $ | 12.36  |  | 6,935  |                                  |  | $ | 14.05
|                                 |  |        |   |      |                                  |       |        |        |   |                                  |   |        |  |        |                                  |  |   |      



The weighted-average
fair value of options granted during the years ended December 31, 2001, 2002 and 2003 was $14.16, $9.46 and $11.49, respectively.



During 2000, options to purchase an aggregate of 594,000 shares, with a weighted-average exercise price of $26.84 per share, were granted with below
market exercise prices. No options were granted during 2001, 2002 or 2003 with below market exercise prices. Included in the accompanying consolidated financial statements is $4.5 million, $1.5 million and $0.9 million of expense recorded during the
years ended December 31, 2001, 2002 and 2003, respectively, associated with such option grants. The expense equals the difference between the fair market value of our common stock on the grant date and the exercise price of the stock options and is
recognized ratably over the vesting period of the stock options, currently four to five years.



The following table summarizes information about stock options outstanding at December 31, 2003 (numbers of shares in thousands):



|                         |  |                     |  |                                                      |  |                                  |       |                    |       |                                  |   |      
|------------------------ |  | ------------------- |  | ---------------------------------------------------- |  | -------------------------------- | ----- | ------------------ | ----- | -------------------------------- | - | -----
|                         |  | Options Outstanding |  | Options Exercisable                                 
|Range of Exercise Prices |  | Number Outstanding  |  | Weighted- Average Remaining Contractual Life (Years) |  | Weighted- Average Exercise Price |       | Number Exercisable |       | Weighted- Average Exercise Price
|$  0.50  8.30           |  | 3,316               |  | 6.90                                                 |  | $                                | 5.11  |                    | 1,781 |                                  | $ | 2.41 
|$  8.40  9.98           |  | 2,599               |  | 8.77                                                 |  | $                                | 8.60  |                    | 308   |                                  | $ | 8.40 
|$10.1510.55             |  | 574                 |  | 8.46                                                 |  | $                                | 10.36 |                    | 139   |                                  | $ | 10.21
|$10.7410.74             |  | 2,781               |  | 7.75                                                 |  | $                                | 10.74 |                    | 908   |                                  | $ | 10.74
|$10.8210.82             |  | 714                 |  | 8.84                                                 |  | $                                | 10.82 |                    | 124   |                                  | $ | 10.82
|$10.9911.56             |  | 5,116               |  | 9.69                                                 |  | $                                | 11.56 |                    |      |                                  | $ |     
|$11.6014.81             |  | 2,461               |  | 8.35                                                 |  | $                                | 13.82 |                    | 910   |                                  | $ | 14.26
|$14.9118.72             |  | 2,292               |  | 7.29                                                 |  | $                                | 15.33 |                    | 1,017 |                                  | $ | 15.44
|$19.3820.67             |  | 55                  |  | 0.83                                                 |  | $                                | 20.37 |                    | 54    |                                  | $ | 20.36
|$20.6935.06             |  | 2,332               |  | 6.47                                                 |  | $                                | 26.07 |                    | 1,456 |                                  | $ | 26.30
|$35.1753.41             |  | 679                 |  | 6.50                                                 |  | $                                | 44.63 |                    | 238   |                                  | $ | 41.93
|                         |  |                     |  |                                                      |  |                                  |       |                    |       |                                  |   |      
|                         |  | 22,919              |  |                                                      |  | $                                | 13.27 |                    | 6,935 |                                  | $ | 14.05
|                         |  |                     |  |                                                      |  |                                  |       |                    |       |                                  |   |      



F-22



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##### Table of Contents

QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Employee Stock Purchase Plan



Under our 1999 Employee Stock Purchase Plan, we are authorized to issue up to 1.2 million shares of our common stock to
eligible employees and the employees of participating subsidiaries. Individuals who are scheduled to work more than 20 hours per week for more than five calendar months per year are eligible to participate in the plan. A participant may contribute
up to 15% of their cash earnings, and the accumulated payroll deductions will be applied to the purchase of shares on semi-annual purchase dates. The purchase price per share will be equal to 85% of the lower of the fair market value of the common
stock on the start date of the purchase period or the fair market value of the common stock on the semi-annual purchase date. Semi-annual purchase dates will occur on the last business day of January and July each year.



At December 31, 2003, 547,762 shares of common stock were reserved for
issuance under this plan. In January 2003, 286,815 shares of common stock were purchased under this plan at a price of $7.97 per share. In July 2003, 311,884 shares of common stock were purchased under this plan at a price of $7.52 per share. At
December 31, 2003, $2.7 million was recorded in accrued liabilities that employees had deposited for purchases of common stock under the plan for the current offering period, which expired on January 31, 2004.



Employee 401(k) Plan



We sponsor the Quest Software, Inc. 401(k) Plan (401(k) Plan) covering substantially all of our employees. As
allowed under Section 401(k) of the Internal Revenue Code, the 401(k) Plan provides tax-deferred salary deductions for eligible employees. Employees may contribute from 1% to 100% of their annual compensation to the 401(k) Plan, limited to a maximum
annual amount as set periodically by the Internal Revenue Service. The 401(k) Plan provides for discretionary contributions, as determined by the Board of Directors. Such contributions to the 401(k) Plan are allocated among eligible participants in
the proportion of their salaries to the total salaries of all participants. Participant contributions vest immediately, while discretionary contributions we make vest over a three-year period. Our discretionary contributions to the 401(k) Plan
totaled $1.0 million for the years ended December 31, 2001, 2002 and 2003.



12.    Impairment/Sale of Aircraft



In August 2002, we sold our interest in an aircraft and received proceeds of approximately $1.9 million. The sale resulted in a loss of $0.8 million. In December 2003, we performed an evaluation of the carrying value of our remaining
aircraft. The evaluation was performed because revenues from outsourcing our aircraft was expected to decrease and the market value of the aircraft was expected to be lower than the carrying value. We evaluated the carrying amount of our aircraft
under the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. As part of our evaluation we estimated the undiscounted future cash flows to be generated (used) from outsourcing and corporate
use of the aircraft along with expected cash from a potential sale of the aircraft, which was less than the carrying amount. The impairment charge of $3.5 million reflects the amounts by which the carrying value exceeds the estimated fair value of
the aircraft as determined by an independent appraisal.



13.    Commitments and Contingencies



We lease office facilities and certain equipment under various operating leases. A majority of these leases are non-cancelable and obligate us to pay costs of maintenance, utilities, and applicable taxes. The leases
on most of the office facilities contain escalation clauses and renewal options. Total rent expense was $12.2 million, $12.9 million and $13.3 million for the years ended December 31, 2001, 2002 and 2003, respectively.



F-23



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##### Table of Contents

QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Minimum lease commitments under non-cancelable operating leases as of December 31, 2003 are as
follows (in thousands):



|                         |  |   |       
|------------------------ |  | - | ------
|Year ending December 31: |  |  
|2004                     |  | $ | 11,082
|2005                     |  |   | 9,321 
|2006                     |  |   | 5,525 
|2007                     |  |   | 3,406 
|2008                     |  |   | 2,372 
|Thereafter               |  |   | 298   
|                         |  |   |       
|                         |  | $ | 32,004
|                         |  |   |       



On July 2, 2002,
Computer Associates International, Inc. (CA) filed a complaint against us and four of our employees in the U.S. District Court for the Northern District of Illinois alleging copyright infringement and trade secret misappropriation in
connection with the development of the database administration component of our Quest Central for DB2 product and seeking injunctive relief and unspecified money damages. The complaint was amended in May 2003 to add another Quest employee as a
defendant and to assert breach of contract claims against three of the individual defendants. In October 2003, CA filed a motion for preliminary injunction. We responded to this motion in January 2004, arguing that CA cannot meet the requirements
for injunctive relief. In connection with our response, we sought leave to assert a counterclaim for a declaratory judgment of invalidity of CAs copyright registrations. Rulings on these motions are not expected until late in the second
quarter of 2004. If CAs motion is granted, we would be preliminarily enjoined from licensing Quest Central for DB2. We are vigorously defending CAs claims and do not believe that this matter will have a material adverse effect on our
results of operations or financial condition.



After we
announced on July 23, 2003 that we would restate certain financial results as a result of our discovery of a computational error relating to an error in the method used to translate foreign currency denominated accounts into U.S. Dollars at
historical rates, numerous separate complaints purporting to be class actions were filed in the United States District Court for the Central District of California alleging that we and some of our officers and directors violated provisions of the
Securities Exchange Act of 1934. Orders designating a lead plaintiff and consolidating the federal class action complaints were issued by the U. S. District Court in late October 2003, and an amended consolidated class action complaint was filed in
January 2004. The consolidated amended complaint contains varying allegations, including allegations that we made materially false and misleading statements with respect to our financial results for 2002 and the quarter ended March 31, 2003 included
in our filings with the SEC and press releases. In addition, one complaint purporting to be a derivative action has been filed in California state court against some of our directors and officers. This complaint is based on the same facts and
circumstances described in the consolidated amended class action complaints and generally alleges that the named directors and officers breached their fiduciary duties by failing to oversee adequately our financial reporting. Each of the complaints
generally seeks an unspecified amount of damages. The cases are in the very preliminary stages and we will vigorously defend these claims; however, it is not possible for us to quantify the extent of our potential liability, if any. Accordingly, no
amounts have been accrued in the accompanying financial statements. Our motions to dismiss the federal class action complaint and the derivative action are expected to be filed during the second quarter of 2004. An unfavorable outcome in any of
these cases could have a material adverse effect on our business, financial condition, results of operations and cash flow. In addition, defending any litigation may be costly and divert managements attention from the day-to-day operations of
our business.



We are a party to other litigation, which we
consider to be routine and incidental to our business. Management does not expect the results of any of these actions to have a material adverse effect on our results of operations or financial condition.



F-24



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##### Table of Contents

QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



In the normal course of our business, we enter into certain types of agreements that require us to
indemnify or guarantee the obligations of other parties. These commitments include (i) intellectual property indemnities to licensees of our software products, (ii) indemnities to certain lessors under office space leases for certain claims arising
from our use or occupancy of the related premises, or for the obligations of our subsidiaries under leasing arrangements, (iii) indemnities to customers, vendors and service providers for claims based on negligence or willful misconduct of our
employees and agents, and (iv) indemnities to our directors and officers to the maximum extent permitted under applicable law. The terms and duration of these commitments varies and, in some cases, may be indefinite, and certain of these commitments
do not limit the maximum amount of future payments we could become obligated to make thereunder; accordingly, our actual aggregate maximum exposure related to these types of commitments cannot be reasonably estimated. Historically, we have not been
obligated to make significant payments for obligations of this nature, and no liabilities have been recorded for these obligations in the accompanying consolidated balance sheets as the fair value of these obligations issued during the three and
twelve months ended December 31, 2003 was not significant to our financial position, results of operations, or cash flows.



14.    Geographic and Segment Information



Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by our
chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. Our operating segments are managed separately because each segment represents a strategic business unit that offers
different products or services.



Our reportable operating
segments are Licenses and Services. The Licenses segment develops and markets licenses to use our software products. The Services segment provides after-sale support for software products and fee-based training and consulting services related to our
software products.



We do not separately allocate operating
expenses to these segments, nor do we allocate specific assets to these segments. Therefore, segment information reported includes only revenues, cost of revenues, and gross profit, as this information and the geographic information described below
are the only information provided to the chief operating decision maker on a segment basis.



Reportable segment data for the three years in the period ended December 31, 2003, is as follows (in thousands):



|                              |  |          |         |          |   |         |  |   |        
|----------------------------- |  | -------- | ------- | -------- | - | ------- |  | - | -------
|                              |  | Licenses |         | Services |   | Total  
|Year ended December 31, 2001: |  |          |         |          |   |         |  |   |        
|Revenues                      |  | $        | 174,134 |          | $ | 72,389  |  | $ | 246,523
|Cost of revenues              |  |          | 12,513  |          |   | 18,985  |  |   | 31,498 
|                              |  |          |         |          |   |         |  |   |        
|Gross profit                  |  | $        | 161,621 |          | $ | 53,404  |  | $ | 215,025
|                              |  |          |         |          |   |         |  |   |        
|Year ended December 31, 2002: |  |          |         |          |   |         |  |   |        
|Revenues                      |  | $        | 160,636 |          | $ | 94,946  |  | $ | 255,582
|Cost of revenues              |  |          | 9,283   |          |   | 17,913  |  |   | 27,196 
|                              |  |          |         |          |   |         |  |   |        
|Gross profit                  |  | $        | 151,353 |          | $ | 77,033  |  | $ | 228,386
|                              |  |          |         |          |   |         |  |   |        
|Year ended December 31, 2003: |  |          |         |          |   |         |  |   |        
|Revenues                      |  | $        | 179,560 |          | $ | 124,728 |  | $ | 304,288
|Cost of revenues              |  |          | 11,987  |          |   | 21,365  |  |   | 33,352 
|                              |  |          |         |          |   |         |  |   |        
|Gross profit                  |  | $        | 167,573 |          | $ | 103,363 |  | $ | 270,936
|                              |  |          |         |          |   |         |  |   |        



F-25



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##### Table of Contents

QUEST SOFTWARE, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Revenues are attributed to geographic areas primarily based on the location of the entity to which
the products or services were delivered. Revenues, gross profit, income (loss) from operations and long-lived assets concerning principal geographic areas in which we operate are as follows (in thousands):



|                              |  |                   |         |   |            |   |        |                     |  |   |        |   |  |   |         |  
|----------------------------- |  | ----------------- | ------- | - | ---------- | - | ------ | ------------------- |  | - | ------ | - |  | - | ------- | -
|                              |  | North America (1) |         |   | Europe (2) |   |        | Other International |  |   | Total  |  
|Year ended December 31, 2001: |  |                   |         |   |            |   |        |                     |  |   |        |   |  |   |         |  
|Revenues                      |  | $                 | 198,154 |   |            | $ | 42,534 |                     |  | $ | 5,835  |   |  | $ | 246,523 |  
|Gross profit                  |  |                   | 185,141 |   |            |   | 27,042 |                     |  |   | 2,842  |   |  |   | 215,025 |  
|Loss from operations          |  |                   | (43,395 | ) |            |   | (8,695 | )                   |  |   | (1,611 | ) |  |   | (53,701 | )
|Long-lived assets             |  |                   | 419,681 |   |            |   | 2,013  |                     |  |   | 9,015  |   |  |   | 430,709 |  
|                              |  |                   |         |  
|Year ended December 31, 2002: |  |                   |         |   |            |   |        |                     |  |   |        |   |  |   |         |  
|Revenues                      |  | $                 | 190,231 |   |            | $ | 58,566 |                     |  | $ | 6,785  |   |  | $ | 255,582 |  
|Gross profit                  |  |                   | 187,101 |   |            |   | 37,658 |                     |  |   | 3,627  |   |  |   | 228,386 |  
|Income from operations        |  |                   | 15,158  |   |            |   | (5,380 | )                   |  |   | 79     |   |  |   | 9,857   |  
|Long-lived assets             |  |                   | 429,289 |   |            |   | 2,888  |                     |  |   | 7,938  |   |  |   | 440,115 |  
|                              |  |                   |         |  
|Year ended December 31, 2003: |  |                   |         |   |            |   |        |                     |  |   |        |   |  |   |         |  
|Revenues                      |  | $                 | 220,549 |   |            | $ | 74,497 |                     |  | $ | 9,242  |   |  | $ | 304,288 |  
|Gross profit                  |  |                   | 203,230 |   |            |   | 62,072 |                     |  |   | 5,634  |   |  |   | 270,936 |  
|Income from operations        |  |                   | 21,868  |   |            |   | 1,632  |                     |  |   | 2,481  |   |  |   | 25,982  |  
|Long-lived assets             |  |                   | 484,139 |   |            |   | 1,919  |                     |  |   | 7,093  |   |  |   | 493,150 |  

---

|(1) |  | Principally represents operations in the United States
|--- |  | ------------------------------------------------------

|(2) |  | Our subsidiary located in the United Kingdom accounted for $23.9 million, $29.0 million and $33.2 million of total European revenues during the years ended December 31, 2001, 2002
and 2003, respectively.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



15.    Subsequent
Event



On January 28, 2004, we signed a definitive
agreement to acquire Aelita Software Corporation in a transaction valued at approximately $115.0 million, of which approximately $101.0 million is expected to be paid to Aelitas stockholders in cash (assuming no unanticipated exercise of
existing Aelita stock options prior to closing and assuming no valid claims are made against the indemnity escrow fund to be established in connection with the contemplated transaction). The balance of the transaction value represents amounts
allocable to Aelita stock options that are to be assumed by Quest and converted into Quest stock options, and amounts allocable to Aelitas transaction-related expenses. Closing of the contemplated transaction is subject to customary closing
conditions, including expiration of the applicable Hart-Scott-Rodino waiting period, and is expected to be completed by the end of the first quarter of 2004. The acquisition will be accounted for as a purchase and the purchase price is expected to
be allocated primarily to goodwill and other intangible assets.



F-26



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##### Table of Contents

QUEST SOFTWARE INC.



FINANCIAL
STATEMENT SCHEDULE



SCHEDULE IIVALUATION AND
QUALIFYING ACCOUNT



|                                              |  |                                |       |                             |   |                       |  |   |                          |   |  |   |       
|--------------------------------------------- |  | ------------------------------ | ----- | --------------------------- | - | --------------------- |  | - | ------------------------ | - |  | - | ------
|Description                                   |  | Balance at Beginning of Period |       | Charges, Costs and Expenses |   | Additions/ Deductions |  |   | Balance at End of Period
|                                              |  | (In Thousands)                
|Year ended December 31, 2001:                 |  |                                |       |                             |   |                       |  |   |                          |   |  |   |       
|Allowance for bad debt                        |  | $                              | 1,372 |                             | $ | 789                   |  | $ | (1,267                   | ) |  | $ | 895   
|Allowance for sales returns and cancellations |  | $                              | 8,604 |                             | $ | 7,935                 |  | $ | (7,483                   | ) |  | $ | 9,056 
|Year ended December 31, 2002:                 |  |                                |       |                             |   |                       |  |   |                          |   |  |   |       
|Allowance for bad debt                        |  | $                              | 895   |                             | $ | 580                   |  | $ | (634                     | ) |  | $ | 841   
|Allowance for sales returns and cancellations |  | $                              | 9,056 |                             | $ | 4,848                 |  | $ | (5,152                   | ) |  | $ | 8,752 
|Year ended December 31, 2003:                 |  |                                |       |                             |   |                       |  |   |                          |   |  |   |       
|Allowance for bad debt                        |  | $                              | 841   |                             | $ | 291                   |  | $ | (44                      | ) |  | $ | 1,088 
|Allowance for sales returns and cancellations |  | $                              | 8,752 |                             | $ | 4,493                 |  | $ | (1,500                   | ) |  | $ | 11,745



S-1



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##### Table of Contents

EXHIBIT INDEX



|              |    |  |                                                                                                                                                    
|------------- | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |    |  | Exhibit Title                                                                                                                                      
|              |   
|3.1           |    |  | Second Amended and Restated Articles of Incorporation.(1)                                                                                          
|              |   
|3.2           |    |  | Second Amended and Restated Bylaws, as amended.(2)                                                                                                 
|              |   
|3.3           |    |  | Certificate of Amendment of Second Amended and Restated Articles of Incorporation.(3)                                                              
|              |   
|3.4           |    |  | Certificate of Amendment of Bylaws.(4)                                                                                                             
|              |   
|4.1           |    |  | Form of Registrants Specimen Common Stock Certificate.(1)                                                                                         
|              |   
|10.1          | ++ |  | Registrants 1999 Stock Incentive Plan, as amended.                                                                                                
|              |   
|10.2          | ++ |  | Registrants 1999 Employee Stock Purchase Plan.(7)                                                                                                 
|              |   
|10.3          |    |  | Form of Directors and Officers Indemnification Agreement.(1)                                                                                     
|              |   
|10.4          |    |  | Office Space Lease dated as of June 17, 1999 between The Irvine Company and Quest Software, Inc.(1)                                                
|              |   
|10.5          |    |  | Office Lease between The Northwestern Mutual Life Insurance Company (Landlord) and Quest Software, Inc. (Tenant) dated as of September 30,
1999.(2)
|              |   
|10.6          |    |  | Office Lease, dated June 2000, between Fund VIII and Fund IX Associates and Quest Software, Inc.(5)                                                
|              |   
|10.7          | ++ |  | Registrants 2001 Stock Incentive Plan.(6)                                                                                                         
|              |   
|10.8          |    |  | First Amendment to Lease dated as of January 2, 2003 between The Irvine Company and Quest Software, Inc.(8)                                        
|              |   
|10.9          |    |  | Office Building Lease, dated as of February 13, 2004, between Fluor Enterprises, Inc. and Quest Software, Inc.                                     
|              |   
|14.1          |    |  | Code of Ethics                                                                                                                                     
|              |   
|21.1          |    |  | Subsidiaries of the Company.                                                                                                                       
|              |   
|23.1          |    |  | Consent of Deloitte & Touche LLP.                                                                                                                  
|              |   
|31.1          |    |  | Certification of the Chief Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as
amended.                        
|              |   
|31.2          |    |  | Certification of the Chief Financial Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as
amended.                        
|              |   
|32.1          |    |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002. 
|              |   
|32.2          |    |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002. 

---

|(1) |  | Incorporated herein by reference to our Registration Statement on Form S-1 and all amendments thereto (File No. 333-80543).
|--- |  | ---------------------------------------------------------------------------------------------------------------------------

|(2) |  | Incorporated herein by reference to our Registration Statement on Form S-1 and all amendments thereto (File No. 333-30816).
|--- |  | ---------------------------------------------------------------------------------------------------------------------------

|(3) |  | Incorporated herein by reference to our Quarterly Report on Form 10-Q for the period ended June 30, 2000.
|--- |  | ---------------------------------------------------------------------------------------------------------

|(4) |  | Incorporated herein by reference to our Quarterly Report on Form 10-Q for the period ended June 30, 2001.
|--- |  | ---------------------------------------------------------------------------------------------------------

|(5) |  | Incorporated herein by reference to our Annual Report on Form 10-K for the year ended December 30, 2000.
|--- |  | --------------------------------------------------------------------------------------------------------

|(6) |  | Incorporated herein by reference to our Registration Statement on Form S-8 (File No. 333-82784) filed on February 14, 2002.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------

|(7) |  | Incorporated herein by reference to our Registration Statement on Form S-8 (File No. 333-107045) filed on July 15, 2003
|--- |  | -----------------------------------------------------------------------------------------------------------------------

|(8) |  | Incorporated herein by reference to our Annual Report on Form 10-K for the year ended December 31, 2002
|--- |  | -------------------------------------------------------------------------------------------------------

|++ |  | Indicates a management contract or compensatory arrangement.
|-- |  | ------------------------------------------------------------