---

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SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-Q

|ý | QUARTERLY REPORT PURSUANT TO SECTION 13 OF THE
SECURITIES EXCHANGE ACT OF 1934          
|- | ----------------------------------------------------------------------------------------
|  | For the quarterly period ended September 30, 2003                                       
|o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period
from                             to

Commission file number 000-29335

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WITNESS SYSTEMS, INC.(Exact Name of Registrant as Specified in its Charter)

|Delaware(State or Other Jurisdiction of Incorporation or Organization)               |  | 23-2518693(I.R.S. Employer Identification No.)
|------------------------------------------------------------------------------------ |  | ----------------------------------------------
|300 Colonial Center Parkway
Roswell, Georgia(Address of Principal Executive Offices) |  | 30076(Zip Code)                               

Registrant's
telephone number, including area code770-754-1900

---

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 ý    No o

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

|Class                                  |  | Outstanding at November 7, 2003
|-------------------------------------- |  | -------------------------------
|Common Stock, par value $.01 per share |  | 22,106,243                     

---

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WITNESS SYSTEMS, INC.  FORM 10-Q  INDEX

|                              |  |                                                                                                                 |  | Page
|----------------------------- |  | --------------------------------------------------------------------------------------------------------------- |  | ----
|PART I. FINANCIAL INFORMATION |  |                                                                                                                
|Item 1.                       |  | Financial Statements:                                                                                           |  |     
|                              |  | Condensed Consolidated Balance Sheets at
September 30, 2003 and December 31, 2002                               |  | 3   
|                              |  | Condensed Consolidated Statements of Operations
for the three and nine months ended September 30, 2003 and 2002 |  | 4   
|                              |  | Condensed Consolidated Statements of Cash Flows
for the nine months ended September 30, 2003 and 2002           |  | 5   
|                              |  | Notes to the Condensed Consolidated Financial Statements                                                        |  | 6   
|Item 2.                       |  | Management's Discussion and Analysis of
Financial Condition and Results of Operations                           |  | 16  
|Item 3.                       |  | Quantitative and Qualitative Disclosures About Market Risk                                                      |  | 39  
|Item 4.                       |  | Controls and Procedures                                                                                         |  | 39  
|PART II. OTHER INFORMATION    |  |                                                                                                                
|Item 1.                       |  | Legal Proceedings                                                                                               |  | 40  
|Item 6.                       |  | Exhibits and Reports on Form 8-K                                                                                |  | 40  
|SIGNATURES                    |  | 41                                                                                                             

2

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

WITNESS SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(unaudited)

|                                     |                                                                                                                                                                               | September 30,
2003         |         | December 31,
2002 |       
|------------------------------------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------- | ----------------- | ------
|Assets                               |                                                                                                                                                                              
|Current assets:                      |                                                                                                                                                                               |                            |         |                   |       
|                                     | Cash and cash equivalents                                                                                                                                                     |                            | $       | 38,786            |       
|                                     | Investments                                                                                                                                                                   |                            |         | 310               |       
|                                     | Accounts receivable, net of allowance for doubtful accounts of $3,838 at September 30, 2003 and $1,339 at December 31, 2002                                                   |                            |         | 25,292            |       
|                                     | Other current assets                                                                                                                                                          |                            |         | 5,327             |       
|                                     |                                                                                                                                                                               |                            |         |                   |       
|                                     |                                                                                                                                                                               | Total current assets       |         |                   | 69,715
|Intangible assets, net               |                                                                                                                                                                               |                            | 21,874  |                   |       
|Property and equipment, net          |                                                                                                                                                                               |                            | 6,527   |                   |       
|Other assets, net                    |                                                                                                                                                                               |                            | 1,884   |                   |       
|                                     |                                                                                                                                                                               |                            |         |                   |       
|                                     |                                                                                                                                                                               | $                          | 100,000 |                   | $     
|                                     |                                                                                                                                                                               |                            |         |                   |       
|Liabilities and Stockholders' Equity |                                                                                                                                                                              
|Current liabilities:                 |                                                                                                                                                                               |                            |         |                   |       
|                                     | Accounts payable                                                                                                                                                              |                            | $       | 2,537             |       
|                                     | Accrued expenses                                                                                                                                                              |                            |         | 22,326            |       
|                                     | Deferred revenue                                                                                                                                                              |                            |         | 20,429            |       
|                                     |                                                                                                                                                                               |                            |         |                   |       
|                                     |                                                                                                                                                                               | Total current liabilities  |         |                   | 45,292
|Other long-term liabilities          |                                                                                                                                                                               |                            | 4,025   |                   |       
|Deferred tax liability               |                                                                                                                                                                               |                            | 2,383   |                   |       
|                                     |                                                                                                                                                                               |                            |         |                   |       
|                                     |                                                                                                                                                                               | Total liabilities          |         |                   | 51,700
|                                     |                                                                                                                                                                               |                            |         |                   |       
|Commitments and contingencies        |                                                                                                                                                                               |                            |         |                   |       
|Stockholders' equity:                |                                                                                                                                                                               |                            |         |                   |       
|                                     | Preferred stock, $.01 par value; 10,000,0000 shares authorized, no shares issued or outstanding                                                                               |                            |         |                  |       
|                                     | Common stock, $.01 par value; 50,000,000 shares authorized; 22,056,514 and 22,035,756 shares issued and outstanding at September 30, 2003 and December 31, 2002, respectively |                            |         | 221               |       
|                                     | Additional paid-in capital                                                                                                                                                    |                            |         | 94,266            |       
|                                     | Accumulated deficit                                                                                                                                                           |                            |         | (46,474           | )     
|                                     | Notes receivable for stock                                                                                                                                                    |                            |         | (977              | )     
|                                     | Accumulated other comprehensive income                                                                                                                                        |                            |         | 1,264             |       
|                                     |                                                                                                                                                                               |                            |         |                   |       
|                                     |                                                                                                                                                                               | Total stockholders' equity |         |                   | 48,300
|                                     |                                                                                                                                                                               |                            |         |                   |       
|                                     |                                                                                                                                                                               | $                          | 100,000 |                   | $     
|                                     |                                                                                                                                                                               |                            |         |                   |       

The
accompanying notes are an integral part of these condensed consolidated financial statements.

3

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WITNESS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

|                                            |                                                                  | Three months ended
September 30,                |     | Nine months ended
September 30, |       
|------------------------------------------- | ---------------------------------------------------------------- | ----------------------------------------------- | --- | ------------------------------- | ------
|
|Revenue:                                    |                                                                  |                                                 |     |                                 |       
|                                            | Product                                                          |                                                 | $   | 11,000                          |       
|                                            | Services                                                         |                                                 |     | 16,897                          |       
|                                            |                                                                  |                                                 |     |                                 |       
|                                            |                                                                  | Total revenue                                   |     |                                 | 27,897
|                                            |                                                                  |                                                 |     |                                 |       
|Cost of revenue:                            |                                                                  |                                                 |     |                                 |       
|                                            | Product                                                          |                                                 |     | 2,410                           |       
|                                            | Services                                                         |                                                 |     | 6,524                           |       
|                                            |                                                                  |                                                 |     |                                 |       
|                                            |                                                                  | Total cost of revenue                           |     |                                 | 8,934 
|                                            |                                                                  |                                                 |     |                                 |       
|                                            |                                                                  | Gross profit                                    |     |                                 | 18,963
|Operating expenses:                         |                                                                  |                                                 |     |                                 |       
|                                            | Selling, general and administrative                              |                                                 |     | 15,402                          |       
|                                            | Research and development                                         |                                                 |     | 4,804                           |       
|                                            | Acquired in-process research and development and related charges |                                                 |     |                                |       
|                                            | Merger-related costs                                             |                                                 |     | 1,602                           |       
|                                            |                                                                  |                                                 |     |                                 |       
|                                            |                                                                  | Operating loss                                  |     |                                 | (2,845
|Interest and other income, net              |                                                                  |                                                 | 321 |                                 |       
|                                            |                                                                  |                                                 |     |                                 |       
|                                            |                                                                  | (Loss) income before provision for income taxes |     |                                 | (2,524
|Provision for income taxes                  |                                                                  |                                                 | 8   |                                 |       
|                                            |                                                                  |                                                 |     |                                 |       
|                                            |                                                                  | Net (loss) income                               |     | $                               | (2,532
|                                            |                                                                  |                                                 |     |                                 |       
|Net (loss) income per share:                |                                                                  |                                                 |     |                                 |       
|                                            | Basic                                                            |                                                 | $   | (0.11                           | )     
|                                            |                                                                  |                                                 |     |                                 |       
|                                            | Diluted                                                          |                                                 | $   | (0.11                           | )     
|                                            |                                                                  |                                                 |     |                                 |       
|Weighted-average common shares outstanding: |                                                                  |                                                 |     |                                 |       
|                                            | Basic                                                            |                                                 |     | 22,040                          |       
|                                            | Diluted                                                          |                                                 |     | 22,040                          |       
|                                            |                                                                  |                                                 |     |                                 |       

The
accompanying notes are an integral part of these condensed consolidated financial statements.

4

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WITNESS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

|                                                             |                                                                                                     | Nine months ended
September 30,                                             |                                      
|------------------------------------------------------------ | --------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------- | -------------------------------------
|
|Cash flows from operating activities:                        |                                                                                                     |                                                                             |                                      
|                                                             | Net income (loss)                                                                                   |                                                                             | $                                    
|                                                             | Adjustments to reconcile net income (loss) to net cash provided by (used for) operating activities: |                                                                             |                                      
|                                                             |                                                                                                     | In-process research and development                                         |                                      
|                                                             |                                                                                                     | Depreciation and amortization                                               |                                      
|                                                             |                                                                                                     | Provision for doubtful accounts                                             |                                      
|                                                             |                                                                                                     | Other non-cash items                                                        |                                      
|                                                             |                                                                                                     | Changes in operating assets and liabilities, net of effect of acquisitions: |                                      
|                                                             |                                                                                                     |                                                                             | Accounts receivable                  
|                                                             |                                                                                                     |                                                                             | Other assets                         
|                                                             |                                                                                                     |                                                                             | Accounts payable and accrued expenses
|                                                             |                                                                                                     |                                                                             | Deferred revenue                     
|                                                             |                                                                                                     |                                                                             |                                      
|                                                             |                                                                                                     |                                                                             |                                      
|                                                             |                                                                                                     |                                                                             |                                      
|Cash flows from investing activities:                        |                                                                                                     |                                                                             |                                      
|                                                             | Capital expenditures                                                                                |                                                                             |                                      
|                                                             | Purchases of investments                                                                            |                                                                             |                                      
|                                                             | Sales and maturities of investments                                                                 |                                                                             |                                      
|                                                             | Acquisition of Eyretel plc, net of cash acquired of $38,814                                         |                                                                             |                                      
|                                                             | Purchase of other business' assets                                                                  |                                                                             |                                      
|                                                             | Allocation from restricted cash                                                                     |                                                                             |                                      
|                                                             | Other                                                                                               |                                                                             |                                      
|                                                             |                                                                                                     |                                                                             |                                      
|                                                             |                                                                                                     |                                                                             |                                      
|                                                             |                                                                                                     |                                                                             |                                      
|Cash flows from financing activities:                        |                                                                                                     |                                                                             |                                      
|                                                             | Proceeds from short-term borrowings                                                                 |                                                                             |                                      
|                                                             | Repayment of notes receivable from stockholder                                                      |                                                                             |                                      
|                                                             | Proceeds from exercise of stock options and employee purchase plan                                  |                                                                             |                                      
|                                                             | Stock repurchases                                                                                   |                                                                             |                                      
|                                                             |                                                                                                     |                                                                             |                                      
|                                                             |                                                                                                     |                                                                             |                                      
|                                                             |                                                                                                     |                                                                             |                                      
|Effect of exchange rate changes on cash and cash equivalents |                                                                                                     |                                                                             | 1,526                                
|                                                             |                                                                                                     |                                                                             |                                      
|                                                             |                                                                                                     |                                                                             |                                      
|Cash and cash equivalents at beginning of period             |                                                                                                     |                                                                             | 36,391                               
|                                                             |                                                                                                     |                                                                             |                                      
|Cash and cash equivalents at end of period                   |                                                                                                     | $                                                                           | 38,786                               
|                                                             |                                                                                                     |                                                                             |                                      
|Supplemental disclosure of cash flow information:            |                                                                                                     |                                                                             |                                      
|                                                             | Cash paid for interest                                                                              |                                                                             | $                                    
|                                                             |                                                                                                     |                                                                             |                                      
|                                                             | Cash paid for income taxes                                                                          |                                                                             | $                                    
|                                                             |                                                                                                     |                                                                             |                                      
|Non-cash financing activities:                               |                                                                                                     |                                                                             |                                      
|                                                             | Repayment of notes receivable and interest with stock                                               |                                                                             | $                                    
|                                                             |                                                                                                     |                                                                             |                                      

The
accompanying notes are an integral part of these condensed consolidated financial statements.

5

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WITNESS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2003
(unaudited)

1.    General and Basis of Presentation

Witness Systems, Inc. provides an integrated contact center performance optimization software suite that enables global enterprises to capture customer
intelligence and optimize workforce performance. The solution is comprised of business-driven and/or full-time customer interaction recording, performance analysis and
e-learning management applications that are designed to enhance the quality of customer interactions across multiple communications media, including the telephone, e-mail and
the Internet. The Company is headquartered in Roswell, Georgia with other offices in the United States, Australia, Brazil, Canada, China, Germany, Hong Kong, India, Japan, Malaysia, Mexico, the
Netherlands, Singapore and the United Kingdom. The Company was originally incorporated in 1988 in Georgia and was reincorporated in Delaware in 1997.

The
unaudited interim condensed consolidated financial statements include the accounts of Witness Systems, Inc. (the "Company" or "Witness") and subsidiaries. During the first
quarter of 2003, the Company acquired Eyretel plc ("Eyretel"), a U.K.-based provider of compliance and recording solutions for customer contact centers. Their results of operations have, accordingly,
been consolidated in these unaudited interim condensed consolidated financial statements commencing as of March 22, 2003. All significant intercompany accounts and transactions have been
eliminated in the consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation.

The
financial statements herein have been prepared in accordance with the requirements of Form 10-Q and, therefore, do not include all information and footnotes
required by generally accepted accounting principles in the United States. However, in the opinion of management, all adjustments (which, except as disclosed elsewhere herein, consist only of normal
recurring accruals) necessary for a fair presentation of the results of operations for the relevant periods have been made. Results for the interim periods are not necessarily indicative of the
results to be expected for the year. These financial statements should be read in conjunction with the summary of significant accounting policies and the notes to the consolidated financial statements
included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2002, filed with the U.S. Securities and Exchange Commission.

The
preparation of 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 disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses
during the reporting period. Actual results could differ from those estimates.

2.     Significant Accounting Policies

The Company recognizes revenue in accordance with 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. Revenue is primarily derived from licensing software and providing related services including maintenance.

Product
revenue, which includes software and hardware, is recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or
determinable, and collection is probable. The Company recognizes product revenue using the residual method whereby revenue is recognized in a multiple element arrangement when vendor specific
objective evidence of fair value exists for all of the undelivered elements in the arrangement, but does not for one or more of the delivered elements in the arrangement. The Company defers revenue in
an amount equal to the

6

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fair
value of its undelivered elements, normally services (including maintenance), and recognizes the difference between the total arrangement fee and the amount deferred for the undelivered elements
as product revenue.

Services
revenue includes installation, training, consulting, maintenance and reimbursable travel expenses. Revenue from installation, training and consulting services is recognized upon
performance of the related services and is offered and billed as separate elements of contracts. The functionality of the software and any hardware sold is not dependent on installation and training
services. Maintenance is offered as a separate element and the majority of contracts include the right to unspecified upgrades on a when-and-if available basis. Maintenance
revenue, which is generally billed in advance, is deferred and recognized ratably over the term of the related contract. Specified upgrades are not typically offered to customers. Reimbursable travel
expenses revenue is recognized upon incurrence of the related expenses.

Accounts
receivable include amounts due from customers for which revenue has been recognized. The Company performs ongoing evaluations of its customers and continuously monitors
collections and payments and estimates an allowance for doubtful accounts based on the aging of the underlying receivables, its historical experience and any specific customer collection issues that
it has identified.
Account balances are charged off against the allowance after reasonable means of collection have been exhausted and the potential for recovery is considered remote. Deferred revenue consists of
amounts collected from customers for products and services that have not met the criteria for revenue recognition.

3.     Net (Loss) Income Per Share

The following table presents the computation of basic and diluted net (loss) income per share for the three and nine months ended September 30, 2003 and
2002 (in thousands, except per share amounts):

Three months ended
September 30,

Nine months ended
September 30,2003

2002

2003

2002Net (loss) income

$
(2,532
)
$
(1,199
)
$
(18,537
)
$
100Average shares of common stock outstanding:Basic


22,040


22,775


21,947


22,680Effect of stock options











1,079Diluted common shares outstanding


22,040


22,775


21,947


23,759Net (loss) income per share:Basic

$
(0.11
)
$
(0.05
)
$
(0.84
)
$
0.00Diluted

$
(0.11
)
$
(0.05
)
$
(0.84
)
$
0.00


For
the three months ended September 30, 2003 and 2002 and the nine months ended September 30, 2003, the Company has excluded all outstanding stock options from the
calculation of diluted net loss per common share because all such securities were anti-dilutive. The total number of shares excluded from the calculation of diluted net loss per share for
the three and nine months ended September 30, 2003 was 1.3 million and 0.8 million, respectively, calculated using the treasury stock method. The total number of shares excluded
from the calculation of diluted net loss per share for the three months ended September 30, 2002 was 0.5 million calculated using the treasury stock method.

7

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4.     Comprehensive (Loss) Income

The following table presents the components of total comprehensive (loss) income and accumulated other comprehensive loss (in thousands):

Three months ended
September 30,

Nine months ended
September 30,2003

2002

2003

2002Net (loss) income

$
(2,532
)
$
(1,199
)
$
(18,537
)
$
100Other comprehensive (loss) income:Foreign currency translation adjustments


250


(22
)

1,428


(95
)Unrealized net holding gain (loss) on investments





142


(165
)

156Total comprehensive (loss) income

$
(2,282
)
$
(1,079
)
$
(17,274
)
$
161


September 30,
2003

December 31,
2002Cumulative foreign currency translation adjustments

$
1,264

$
(164
)Unrealized net holding gain on investments





165Total accumulated other comprehensive loss

$
1,264

$
1


5.     Eyretel Acquisition

During the first quarter of 2003, the Company acquired a controlling interest in Eyretel and completed the acquisition during the second quarter of 2003. The
Company paid 25 pence per share for a total purchase price of approximately £35.3 million, or $55.3 million, excluding shares owned by Eyretel's employee stock option trust
at the time of acquisition. The acquisition was intended to extend the Company's leadership in the global contact center performance optimization market, offering
customers a comprehensive range of software and services. The Company commenced the consolidation of Eyretel's results on March 22, 2003, the date the Company assumed majority ownership of
Eyretel. The acquisition was accounted for using the purchase method of accounting.

The
following summarizes the total purchase price for Eyretel as of September 30, 2003 (in thousands):

Purchase price (paid in cash)

$
55,269Estimated direct transaction costs


5,041$
60,310


Under
the purchase method of accounting, the total purchase price is allocated to Eyretel's net tangible and intangible assets based upon their estimated fair values as of the date of
the acquisition. The purchase price allocation for this acquisition is based on preliminary estimates and valuations and

8

---

may
be revised at a later date when additional information concerning asset and liability valuations is finalized. The preliminary purchase price allocation is as follows (in thousands):

Current assets and other tangible assets

$
60,318Liabilities assumed


(21,172
)Restructuring accruals


(7,451
)Identifiable intangible assets


22,720Deferred tax liability


(2,383
)Acquired in-process research and development


7,840Goodwill


438$
60,310


The
Company estimated that $7.8 million of the purchase price of Eyretel represented acquired in-process research and development ("IPR&D") that had not yet reached
technological feasibility and had no alternative future use. Accordingly, these amounts were immediately charged to expense upon consummation of the acquisition. An independent third-party appraiser
calculated the value of the IPR&D by utilizing a discounted cash flow methodology, focusing on the income-producing capabilities of the in-process technologies and taking into
consideration: stage of completion; complexity of work to date and to complete; anticipated product development and introduction schedules; forecasted product sales cycles; internal and external risk
factors; revenue and operating expense estimates; contributory asset charges; and costs already incurred and the expected costs to complete.

The
identifiable intangible assets were valued by an independent third-party appraiser using either an income or cost approach taking into consideration the nature, risks, historical
patterns, economic characteristics, and future considerations of the assets. The identifiable intangible assets include acquired technology of $13.6 million, distribution arrangements of
$5.3 million, customer list of $2.6 million and trademarks of $1.3 million. The acquired technology and trademarks are being amortized over three years and the distribution
arrangements and customer list are being amortized over five years.

Supplemental
pro forma information reflecting the acquisition of Eyretel as if it occurred on January 1, 2002 is as follows (in thousands, except per share amounts):

Three months ended
September 30,

Nine months ended
September 30,2003

2002

2003

2002Total revenues

$
27,897

$
31,740

$
88,372

$
93,190Net loss

$
(1,878
)
$
(7,353
)
$
(20,059
)
$
(22,697
)Net loss per share

$
(0.09
)
$
(0.32
)
$
(0.91
)
$
(1.00
)


The
above pro forma results include adjustments for the amortization expense of intangible assets arising from the acquisition and the reversal of interest income. In addition, the pro
forma results for the nine months ended September 30, 2003 exclude the IPR&D charge and certain merger-related and other costs directly attributable to the acquisition.

9

---

6.     Restructuring Accruals and Merger-Related Costs

As a result of the Eyretel acquisition in March 2003, the Company recorded acquisition-related restructuring accruals comprised of Eyretel headcount
reductions, the closing of certain Eyretel facilities, the net accrual of abandoned space and a fair market value rent expense adjustment. The following table summarizes the restructuring accrual
activity (in thousands):

Severance and
Benefits

Facilities

TotalAccrual at December 31, 2002








Initial provision

$
2,445

$
5,006

$
7,451Additional restructuring accruals (reversal of overaccrual)


80


(81
)

(1
)Cash payments


(1,895
)

(524
)

(2,419
)Foreign exchange translation





230


230Total accrual at September 30, 2003


630


4,631


5,261Less: Long-term portion





4,025


4,025Current portion at September 30, 2003

$
630

$
606

$
1,236


In
addition to the above restructuring accruals, the Company incurred merger-related restructuring costs for Witness headcount reductions and the consolidation of certain Witness
facilities. The following table summarizes the merger-related restructuring accrual activity (in thousands):

Severance and
Benefits

Facilities

TotalAccrual at December 31, 2002








Merger-related accruals

$
873

$
742

$
1,615Cash payments


(818
)

(655
)

(1,473
)Accrual at September 30, 2003

$
55

$
87

$
142


The
Company reported total merger-related costs of $6.2 million in the accompanying condensed consolidated statement of operations for the nine months ended September 30,
2003. In addition to the $1.6 million in merger-related restructuring costs outlined in the above chart, merger-related costs included $0.9 million for a sterling-based forward exchange
contract to hedge the dollar cost of the acquisition, $3.3 million of expenses related to integrating Eyretel's software products, training personnel
on products acquired and consolidating the operations of Eyretel with the Company, and $0.4 million relating to the partial accrual of a bonus payable to Eyretel's former Chief Executive
Officer, now the Company's Chief Operating Officer ("COO"). The Company's Board of Directors agreed to pay this bonus totaling £1.0 million to the COO in association with the
Eyretel acquisition and subsequent integration. This bonus is generally payable in two installments due March 2004 and March 2005 but may be payable in advance of these dates under
certain circumstances, such as a change of control. The merger-related restructuring activities should be substantially completed by the end of 2004.

7.     Purchase of Other Business' Assets

In February 2003, the Company purchased the assets of a software and services company focused on the business intelligence marketplace for
$2.4 million, including direct costs of $0.3 million. At the time of purchase, the Company paid $1.1 million and executed a $1.0 million note payable, which was paid in
full in June 2003. As a result of the purchase, the Company recorded an intangible asset of $2.5 million for acquired technology.

10

---

8.     Intangible Assets

The following tables present the components of intangible assets (in thousands):

September 30, 2003Gross Amount

Accumulated
Amortization

Net AmountAcquired technology

$
16,135

$
2,904

$
13,231Distribution arrangements


5,280


560


4,720Customer list


2,560


272


2,288Trademarks and patents


1,461


264


1,197Goodwill


438





438$
25,874

$
4,000

$
21,874


December 31, 2002Gross Amount

Accumulated
Amortization

Net AmountAcquired technology

$
150

$
100

$
50Patents


148


13


135$
298

$
113

$
185


The
Company's intangible assets with definite lives are amortized over the assets' estimated useful lives using the straight-line method. Estimated useful lives range from
three to five years. Amortization of intangible assets included in the accompanying condensed consolidated statements of operations is as follows (in thousands):

Three months ended
September 30,

Nine months ended
September 30,2003

2002

2003

2002Cost of product revenue

$
1,301

$
13

$
2,666

$
50Selling, general and administrative


507


6


1,221


6Research and development





84





254$
1,808

$
103

$
3,887

$
310


Estimated
amortization expense for the following years ended December 31 are as follows: 2003$5.7 million; 2004$7.1 million;
2005$7.1 million; 2006$3.3 million; and 2007 and thereafter$2.0 million. In accordance with SFAS No. 142, Goodwill and Other Intangibles, goodwill is not being
amortized but is subject to annual impairment tests. To date no impairments have been identified.

9.     Line of Credit

The Company maintains various borrowing and credit arrangements, primarily consisting of a line of credit of $15.0 million maturing in January 2004.
At the Company's election, borrowings under the line of credit bear interest at the bank's prime rate or LIBOR plus 300 basis points. Borrowings under the revolving line of credit are limited to 85%
of eligible accounts receivable, as defined by the agreement.
The revolving line of credit is secured by all assets of the Company and requires compliance with various covenants, including liquidity ratios and tangible net worth requirements, among others.

The
amount available for borrowing under the line of credit at September 30, 2003 was $11.7 million, which was net of outstanding letters of credit of $3.3 million.
The letters of credit secure

11

---

the
leases on the corporate headquarters facility and have decreasing schedules that ultimately expire in 2007.

10.   Stock Incentive Plans

The Company has three stock incentive plans: (i) the 1999 Stock Incentive Plan (the "1999 Plan"); (ii) the 2003 Broad Based Option Plan (the "2003
Plan"); and (iii) the 2003 Non-employee Director Stock Option Global Plan (the "Director Plan").

Under
the 1999 Plan, the Company may grant shares of common stock in the form of stock options, restricted stock awards, or stock appreciation rights to employees and key persons
affiliated with the Company, as defined. In 2001, the Company's stockholders modified a provision to increase, without further approval required, the number of shares authorized each year beginning on
January 1, 2002 by a number equal to the lesser of 10% of the total number of shares of common stock then outstanding or 3,000,000 shares. During the nine months ended September 30,
2003, 2,543,756 stock options were granted under the 1999 Plan. As of September 30, 2003, there were 10,962,179 shares authorized for issuance, of which 540,336 shares remain available for
future grant.

In
connection with the Eyretel acquisition, the Company established the 2003 Plan in order to replace the stock incentive plan maintained by Eyretel. The 2003 Plan became effective in
June 2003, and the Company may grant shares of common stock in the form of stock options. During the nine months ended September 30, 2003, 1,451,044 stock options were granted under the
2003 Plan. At September 30, 2003, there were 1,600,000 shares authorized for issuance, of which 148,956 shares remain available for future grant under the 2003 Plan. Initial grants were made to
former Eyretel employees and the Company does not anticipate increasing the number of shares available for issuance.

Under
the Director Plan, which became effective in May 2003, continuing non-employee members of the Board of Directors are granted non-qualified options to
purchase shares of common stock, pursuant to a formula award. During the nine months ended September 30, 2003, 24,000 stock options were granted under the Director Plan. At September 30,
2003, there were 500,000 shares authorized for issuance, of which 476,000 shares remain available for future grant under the Director Plan.

Each
plan remains in effect until the earlier of the tenth anniversary of its effective date or the date on which all reserved shares have been issued or are no longer available for use.
Options granted under these plans in 2003 were non-qualified stock options that were granted at a price greater than or equal to the fair value of the stock on the grant date. Option
vesting terms typically range from two to four years and expire no more than ten years from the date of the grant. These plans provide for accelerated option vesting terms in connection with a change
in control of the Company. To the extent that this occurs, the Company may have a future charge.

11.   Stock-Based Compensation

The Company applies the intrinsic value-based method of accounting prescribed by Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock
Issued to Employees,and related interpretations, in accounting for its fixed plan stock options. As such, compensation expense is
recorded on the date of grant only if the current estimated fair value of the underlying stock exceeds the exercise price. Had the Company determined compensation cost based on the fair value at the
grant date for its stock options and purchase rights under SFAS No. 123,Accounting for Stock Based

12

---

Compensation, the Company's net income (loss) would have been the pro forma amounts indicated below (in thousands, except per share data):

Three months ended
September 30,

Nine months ended
September 30,2003

2002

2003

2002Reported net (loss) income

$
(2,532
)
$
(1,199
)
$
(18,537
)
$
100Add: Stock-based employee compensation


23


28


69


88Add: Stock-based employee compensation:Deduct: Total stock-based compensation expense determined under fair value based method for all awards


(1,862
)

(2,693
)

(5,689
)

(9,057
)Pro forma net loss

$
(4,371
)
$
(3,864
)
$
(24,157
)
$
(8,869
)Basic and diluted net (loss) income per share:Reported net loss per share

$
(0.11
)
$
(0.05
)
$
(0.84
)
$
0.00Pro forma net loss per share

$
(0.20
)
$
(0.17
)
$
(1.10
)
$
(0.39
)


12.   Notes Receivable for Stock

In 1999, the Company received notes totaling $1.8 million from the Company's Chief Executive Officer ("CEO") in exchange for 991,993 shares of the
Company's common stock. In February 2002, the notes receivable were refinanced in part with a full recourse note (the "2002 Note") for approximately $1.5 million with floating monthly
interest of 325 basis points over the Federal Funds Rate. The 2002 Note is payable in three equal payments of principal and interest due annually through February 2005. During the first quarter
of 2003, the CEO made the first principal payment of approximately $0.5 million and the related interest. At September 30, 2003, the 2002 Note was fully secured in accordance with its
terms.

13.   Geographic Information

The Company considers itself to be in a single industry segment, specifically the license, installation, training and maintenance of its software applications to
the customer interaction recording and analysis market. The Company markets its products through its direct sales force and indirect distribution channels. Certain enterprise-wide
information is presented in the tables below.

Revenue
by geographic region based on customer location is as follows (in thousands):

Three months ended
September 30,

Nine months ended
September 30,2003

2002

2003

2002United States

$
14,902

$
11,233

$
41,574

$
39,085United Kingdom


6,418


599


15,107


1,907Rest of World


6,577


3,219


17,771


9,288$
27,897

$
15,051

$
74,451

$
50,280


Rest
of world revenue was derived primarily from customers located in Australia, Brazil, Canada, China, Continental Europe, India, Japan and Mexico. For the three and nine months ended
September 30, 2003 and 2002, no individual customer accounted for more than 10% of consolidated revenue.

13

---

Long-lived
assets, including intangible assets, by geographic region are as follows (in thousands):

September 30,
2003

December 30,
2002United States

$
6,294

$
4,934United Kingdom


20,941


85Rest of World


728


223$
27,963

$
5,242


14.   Recent Accounting Pronouncements

The Emerging Issues Task Force (EITF) recently reached a consensus on two issues relating to the accounting for multiple element arrangements: Issue
No. 00-21,Accounting for Revenue Arrangements with Multiple Deliverables, and Issue No. 03-05, Applicability of AICPA SOP 97-2 to Non Software Deliverables in an
Arrangement Containing More Than Incidental Software. The consensus
opinion in EITF No. 03-05 clarifies the guidance in EITF 00-21 and was reached on July 31, 2003. The transition provisions allow either prospective application or
a cumulative effect adjustment upon adoption. The Company adopted the consensus prospectively as of July 1, 2003. EITF Nos. 00-21 and 03-05 did not have a material
impact on the Company's financial statements.

In
May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 (SFAS 150),Accounting for Certain Financial Instruments
with Characteristics of both Liabilities and Equity. SFAS 150 modifies the accounting for certain financial instruments that, under previous guidance, issuers could
account for as equity. The Statement requires that those instruments be classified as liabilities in statements of financial position. The provisions of SFAS 150 are effective for instruments
entered into or modified after May 31, 2003 and pre-existing instruments as of July 1, 2003. On October 29, 2003, the FASB voted to indefinitely defer the effective
date of SFAS 150 for mandatorily
redeemable instruments as they relate to minority interests in consolidated finite-lived entities through the issuance of FASB Staff Position (FSP) 150-3. The adoption of SFAS 150,
as modified by FSP 150-3, did not have a material effect on the Company's financial statements.

In
April 2003, the FASB issued Statement of Financial Accounting Standards No. 149 (SFAS 149),Amendment of Statement 133 on Derivative
Instruments and Hedging Activities. This statement amends SFAS 133 to provide clarification on the financial accounting and reporting of derivative instruments and
hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. SFAS 149 is effective for contracts entered into or modified after
June 30, 2003, and for hedging relationships designated after June 30, 2003. In addition, most provisions of SFAS 149 are to be applied prospectively. The adoption of
SFAS 149 did not have a material impact on the Company's financial statements.

In
January 2003, the FASB issued FASB Interpretation No. (FIN) 46,Consolidation of Variable Interest Entities.FIN 46 provides
guidance on identifying variable interest entities and assessing whether or not a variable interest entity should be consolidated. The provisions of FIN 46 are to be applied immediately to variable
interest entities created after January 31, 2003. For variable interest entities created prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or
annual period beginning after June 15, 2003. The adoption of FIN 46 did not have a material impact on the Company's financial statements.

14

---

Effective
January 1, 2003, the Company adopted FIN 45,Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others, which clarifies disclosure and recognition/measurement requirements related to certain guarantees. The Company typically grants its customers a
warranty, which guarantees that its products will substantially conform to its current specifications for 90 days from the delivery date. The Company may also indemnify its customers from
third-party claims of intellectual property infringement relating to the use of its products. Costs related to these guarantees have not been significant. The adoption of FIN 45 did not have a
material impact on the Company's financial statements.

Effective
January 1, 2003, the Company adopted SFAS No. 146,Accounting for Costs Associated with Exit or Disposal
Activities. Under the new rules, a liability for a cost associated with an exit or disposal activity must only be recognized when the liability is incurred. Under the previous
guidance of EITF No. 94-3, a liability for an exit cost was recognized at the date of an entity's commitment to an exit plan. The Company's financial statements presented herein
reflect the adoption of this SFAS.

Effective
January 1, 2003, the Company adopted SFAS No. 145,Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement
No. 13, and Technical Corrections. Prior to the issuance of SFAS
No. 145, SFAS No. 4 had required that all gains and losses from extinguishment of debt were to be aggregated and, if material, classified as an extraordinary item, net of related income
tax effect. SFAS No. 145 rescinds SFAS No. 4 and the related required classification of extraordinary items. The adoption of this SFAS did not have a material impact on the Company's
financial statements.

Effective
January 1, 2003, the Company adopted SFAS No. 143,Accounting for Asset Retirement Obligations, which addresses
financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The adoption of this SFAS did not
have a material impact on the Company's financial statements.

15

---



Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

This quarterly report on Form 10-Q contains forward-looking statements that are not historical facts but rather are based on current
expectations, estimates and projections about our business and industry, and our beliefs and assumptions. Words such as"anticipates","expects","intends","plans","believes","seeks","estimates" and
variations of these words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties
and other factors, some of which are beyond our control, are difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking
statements. Forward-looking statements that were true at the time made may ultimately prove to be incorrect or false. Readers are cautioned not to place undue reliance on forward-looking statements,
which reflect our management's view only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new
information, future events or otherwise.

The
following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Condensed Consolidated Financial Statements and
Notes thereto included elsewhere in this report. Investors should carefully review the information contained in this report under the caption "Factors That May Affect Our Future Results and Market
Price of Our Stock" beginning on page 25.

Overview

We provide the contact center market an integrated performance optimization software suite that enables global enterprises to capture customer intelligence and
optimize workforce performance. Our solution is comprised of business-driven and/or full-time customer interaction recording, performance analysis and e-learning management
applications that are designed to enhance the quality of customer interactions across multiple communications media, including the telephone, e-mail and the Internet. Our software suite
allows contact center management to share information gathered in the contact center with departments that touch the customer, as well as executives throughout the organization. Using an integrated
business consulting, installation and training methodology, we provide services to support an effective and rapid deployment of our software that enables organizations to maximize their return on an
investment in our products and services. Our software is designed to integrate with a variety of third-party software applications, such as customer relationship management and enterprise resource
planning applications, and with existing telephony and computer network hardware and software. The majority of our customers are
companies with one or more contact centers that handle voice and data customer interactions for outbound sales and marketing operations, inbound service/support lines, or both.

Since
our inception in 1988, we have incurred substantial costs to develop our technology and products; market, sell and service these products; recruit and train personnel; and build a
corporate infrastructure. As a result, we have incurred significant losses since our inception and, as of September 30, 2003, we had an accumulated deficit of approximately
$46.5 million. We believe our success depends on the continued development and acceptance of our products and services, the growth of our customer base and the overall growth in the customer
relationship management market. However, corporate spending for information technology and customer relationship management applications has sharply decreased over the past two years and information
technology budgets have been constrained. These declines have had and may continue to have an adverse effect on our financial condition and results of operations. In addition, the length of our
collections cycle has been adversely affected by the increase in our international revenue as well as by the weakened economy, resulting in our customers deferring payments to us or requiring payment
terms longer than those normally provided by us. As a result of these economic conditions, our ability to forecast future product and services revenue has become more difficult.

16

---

Eyretel Acquisition

During the first quarter of 2003, we acquired a controlling interest in Eyretel plc ("Eyretel"), a U.K.-based provider of compliance and recording solutions for
customer contact centers, and completed the acquisition during the second quarter of 2003. We paid 25 pence per share for a total purchase price of approximately £35.3 million, or
$55.3 million, which excludes shares owned by Eyretel's employee stock option trust at the time of acquisition. The acquisition was intended to extend our leadership in the global contact
center performance optimization market, offering customers a comprehensive range of software and services. We commenced the consolidation of Eyretel's results on March 22, 2003, the date we
assumed majority ownership of Eyretel. The acquisition was accounted for using the purchase method of accounting.

The
acquisition extends our performance optimization suite to include advanced compliance and high volume 100% recording applications and related services, and strengthens our
international presence. The following are updates to our business offerings as a result of the Eyretel acquisition:

eQuality ContactStore.eQuality ContactStore records 100% of voice conversations between customer service representatives
("CSRs") and their customers, along with the corresponding computer desktop activity, such as the CSR keystrokes and data input. This application is designed for organizations with
high-volume recording requirements, including compliance recording and/or sales verification, in either traditional or Internet protocol (IP) telephony environments.

eQuality Vision.eQuality Vision enables the rapid search and retrieval of recorded customer interactions. With the
solution's powerful data visualization capabilities, contact center management can pinpoint and view contacts of interest. Through its color-coding classification of calls based on nature and outcome,
patterns and trends, key areas of interest are identifiable, providing unique visualization that allows users to search through contact recordings and focus on those of interest.

eQuality Focus.eQuality Focus monitors desktop activities and provides graphical reports to illustrate which applications
employees use, including how they use them, when and for how long. With this information, contact center management can gain an analytical view of desktop workflow, as well as whether business
applications and productivity tools are correctly configured for optimum use.

Sources of Revenue and Revenue Recognition Policy

We primarily derive our revenue from licensing our software products and providing related services. We use a direct sales organization and an indirect sales
channel that consists of select resellers and a variety of strategic marketing relationships to reach our target customer base. For the nine months ended September 30, 2003 and 2002,
approximately 32% and 23%, respectively, of our license revenue was derived from our indirect sales channel. We expect the proportion of product revenue derived from our indirect sales channel to
increase in the near future as international revenue increases and as we execute new original equipment manufacturer ("OEM") agreements. OEM agreements are enabling us to embed our products into the
OEM's equipment, which can then be offered to the OEM's indirect sales channel, further broadening our target customer base.

During
the nine months ended September 30, 2003 and 2002, 44% and 22%, respectively, of our revenue was derived from customers outside the United States. We expect the proportion
of future international revenue will continue to increase due to the Eyretel acquisition and that the revenue may be denominated in the currency of the applicable market.

Product
revenue, which includes hardware and software revenue, is recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or
determinable and collection is probable. We recognize product revenue using the residual method whereby revenue is recognized in a multiple element arrangement when

17

---

vendor
specific objective evidence of fair value exists for all of the undelivered elements in the arrangement, but does not for one of the delivered elements in the arrangement. We defer revenue for
the fair value of its undelivered elements, normally services including maintenance, and recognize product revenue for the remainder of the total arrangement fee. Our license agreements generally
provide that customers pay a software license fee for one or more software products for a specified number of users. The amount of the license fee varies based on which product is licensed, the number
of software products licensed, the number of installation sites, the geographic region of the site and the number of users licensed. Customers can subsequently pay additional license fees to allow
additional users to use previously licensed software products or to license additional software products. Each software product contains common components, allowing for easy integration of additional
software products as they are licensed from us. Customers that license our software products usually receive the software on compact disc.

Services
revenue includes installation, training, consulting, maintenance and reimbursable travel expenses. Revenue from installation, training and consulting services is recognized upon
performance of the related services. Services are traditionally offered and billed as separate elements of contracts on either a fixed service fee plus travel expenses or on a
time-and-materials basis. The functionality of the software is not dependent on these services. Maintenance is offered as a separate element and the majority of contracts
include the right to unspecified upgrades on a when-and-if available basis. Maintenance revenue, which is generally billed annually in advance, is deferred and recognized
ratably over the term of the related contract. Specified upgrades are not typically offered to customers. Reimbursable travel expenses revenue is recognized upon incurrence of the related expenses.

Cost of Revenue and Operating Expenses

Cost of product revenue primarily consists of royalties due to third parties, amortization of acquired technology, hardware and packaging costs. Cost of services
revenue for installation, training, consulting and maintenance services includes personnel costs and related expenses and allocated overhead. Personnel costs include salaries, bonuses and benefits.

Selling,
general and administrative expenses consist primarily of personnel costs for sales, marketing, finance, information technology, human resources, legal and facilities, as well as
sales commissions, promotional expenses, public relations, tradeshows, travel expenses, provisions for allowance for doubtful accounts, amortization of certain intangible assets and allocated
overhead. Research and development expenses consist primarily of personnel and consulting costs to support product development, and allocated overhead. Research and development costs are expensed as
incurred. Costs incurred subsequent to establishing technological feasibility would be capitalized and amortized over their estimated useful lives. Historically, software development costs incurred
after technological feasibility has been established have not been material and, therefore, have been charged to expense.

We
had 517 full-time employees at September 30, 2003, up from 320 at September 30, 2002. The increase was due to the acquisition of Eyretel. During the second
quarter of 2003, we significantly reduced the number of full-time employees in order to realign the resources of the combined organization.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect our reported
assets, liabilities, revenues and expenses, and our related disclosure of contingent assets and liabilities. On an on-going basis, we

18

---

evaluate our estimates, including
those related to revenue recognition, allowance for doubtful accounts, impairment of long-lived assets and intangible assets,
restructuring, merger-related and contingency costs, allowance for deferred tax assets and stock-based compensation. We base our estimates on historical experience and on various assumptions that we
believe 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.

Factors
that could affect our future operating results and cause actual results to vary materially from expectations include, but are not limited to, lower than anticipated growth from
existing customers, our ability to attract new customers, our ability to grow through acquisitions and to successfully integrate acquisitions, the availability and cost of debt and equity financing,
technology changes, or a decline in the financial stability of our customers. Negative developments in these or other risk factors could have a material adverse effect on our financial position and
results of operations. A summary of our critical accounting policies follows.

Revenue Recognition.Our revenue recognition policy is significant because our revenues are a key component of our results of
operations. We follow very specific and detailed guidelines, discussed above, in measuring revenues; however, certain judgments affect the application of our revenue policy. Further, assessment of
collectibility is particularly critical in determining whether or not revenues should be recognized in the current market environment. We also record provisions for estimated sales allowances on
product and service related revenues at the time the related revenues are recorded. These estimates are based on historical sales and services allowances, analysis of credit memo data and other known
factors. If future sales credits prove to be greater than the historical data and management estimates we used to calculate these estimates, revenues could be overstated.

Allowance for Doubtful Accounts.We perform ongoing evaluations of our customers and continuously monitor collections and
payments and estimate an allowance for doubtful accounts based on the aging of the underlying receivables, our historical experience and any specific customer collection issues that we have
identified. While such credit losses have historically been within our expectations and we believe appropriate reserves have been established, we cannot assure that we will continue to experience the
same credit loss rates that we have experienced in the past or adequately predict future credit losses. 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 selling, general and administrative expense in the period such determination is made.

Impairment of Long-lived Assets and Intangible Assets.Long-lived assets, such as property, plant,
and equipment, and purchased intangible assets subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be
recoverable. All of the intangible assets are being amortized on a straight-line basis. Useful lives of amortizable intangible assets are reviewed annually with any changes in estimated
useful lives being accounted for prospectively over the revised remaining useful life. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to
the estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in
the amount by which the carrying amount of the asset exceeds the fair value of the asset. Goodwill, which is not subject to amortization, is tested annually for impairment, and is tested for
impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset's fair
value. The determination of estimated future cash flows requires management to make estimates. Future events and changes in circumstances may require us to record a significant impairment charge in
any given period. Impairment testing requires considerable analysis and judgment in determining the results. If other assumptions and estimates were used in our evaluations, the results could differ
significantly.

19

---

Restructuring, merger-related and contingency costs.During 2003, we recorded acquisition accruals and merger-related
restructuring accruals in connection with the acquisition of Eyretel. See further discussion of the nature of these accruals in the Notes to the accompanying condensed consolidated financial
statements. Acquisition restructuring accrual estimates are recorded when an approved restructuring plan is in place. At that time, and thereafter until the plan activities are complete, the actual
costs associated with the plan may differ from our estimates. We use our judgment and information available to us at the date of the financial statements to reevaluate our initial estimates of the
plan costs. Merger-related restructuring accruals are recognized once the expense has been incurred. The merger-related restructuring activities and costs should be substantially completed by the end
of 2004.

In
connection with the acquisition of Eyretel, we recorded liabilities, or reserves for certain Eyretel contingencies that existed at the date of acquisition. At that time, we believed
that the resolution of the
contingencies would result in future cash expenditures that we estimated based on the information available at the date of acquisition. As those contingencies are resolved, we reduce the related
liabilities for any related cash disbursements or if we determine that the contingency is no longer likely to result in a loss.

Allowance for Deferred Tax Assets.We record a valuation allowance to reduce our deferred tax assets to an amount that is
more likely than not to be realized. To the extent that future taxable income is generated and considered more likely than not to continue in the future an adjustment to reduce the valuation allowance
would be made, increasing net income in the period in which such determination is made.

Stock-Based Compensation.With the exception of the deferred stock compensation that we recorded at our initial public
offering ("IPO"), we generally do not record compensation expense for options granted to our employees because all options granted under our stock option plans have an exercise price equal to the
market value of the underlying common stock on the date of grant. As permitted under SFAS No. 148,Accounting for Stock-Based CompensationTransition and
Disclosure, and SFAS No. 123,Accounting for Stock-Based Compensation, we have elected to continue to apply the
provisions of Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees,and have adopted only the disclosure
requirements of SFAS No. 123. SFAS 123 included the use of certain input factors in calculating the fair value of stock option grants, some of which require management to make estimates
and use judgment.

20

---

Results of Operations

The following table sets forth the results of operations for the three and nine months ended September 30, 2003 and 2002 expressed as a percentage of total
revenue.

Three months ended
September 30,

Nine months ended
September 30,2003

2002

2003

2002Revenue:Product

39
%
44
%
43
%
51
%Services

61

56

57

49Total revenue

100

100

100

100Cost of revenue:Product

9

2

10

1Services

23

20

22

18Total cost of revenue

32

22

32

19Gross profit

68

78

68

81Operating expenses:Selling, general and administrative

55

64

57

61Research and development

17

25

18

22Acquired in-process research and development and related charges





11

Merger-related costs

6



8

Operating loss

(10
)
(11
)
(26
)
(2
)Interest and other income, net

1

3

1

2(Loss) income before provision for income taxes

(9
)
(8
)
(25
)
Provision for income taxes







Net (loss) income

(9
%)
(8
%)
(25
%)

%


Revenue

Total revenue increased 85% to $27.9 million in the third quarter of 2003 from $15.1 million in the third quarter of 2002. For the nine months ended
September 30, 2003, total revenue increased 48% to $74.5 million from $50.3 million in the same year ago period. These increases were largely attributable to an increase in
international revenues due to the Eyretel acquisition, an increase in the number of customer site installations, and increased maintenance revenue from our expanded customer base.

Product
revenue increased 67% to $11.0 million in the third quarter of 2003 from $6.6 million in the third quarter of 2002, representing 39% and 44% of total revenue,
respectively. For the nine months ended September 30, 2003, product revenue increased 25% to $32.0 million from $25.5 million in the same year ago period, representing 43% and 51%
of total revenue, respectively. The increases largely reflect increased international revenue resulting from our acquisition of Eyretel, which we began consolidating effective March 22, 2003.
Product revenue included $1.0 million and $4.3 million of hardware sales for the three and nine months ended September 30, 2003, respectively. There were no
hardware sales in 2002. We intend to continue to transition our customers to third-party hardware suppliers and thus expect hardware revenue to decline over time.

21

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Services
revenue, consisting of installation, training, consulting and maintenance services revenue, as well as reimbursable travel expense revenue, increased 100% to
$16.9 million in the third quarter of 2003 from $8.5 million in the third quarter of 2002, representing 61% and 56% of total revenue, respectively. For the nine months ended
September 30, 2003, services revenue increased 72% to $42.5 million from $24.7 million in the same year ago period, representing 57% and 49% of total revenue, respectively.
Services revenue increased in 2003 due to growth in all types of services revenue primarily due to the Eyretel acquisition. Maintenance revenue increased due to additional customer sites and higher
renewal rates charged for annual maintenance contracts from existing customer sites. Maintenance revenue in 2003 reflects the write-down of Eyretel's opening deferred maintenance revenue
to fair value as required by purchase accounting. The fair value of the maintenance contracts is less than the contract value of the underlying maintenance contract. Our customers have paid, and upon
renewing their maintenance contracts will continue to pay, an amount that is higher than the fair value as determined under purchase accounting. This will result in an increase in maintenance revenue
as these contracts renew. Installation, training and consulting revenue increased due to a related increase in the number of customer sites installed during 2003 compared to 2002 and growth in
consulting services offerings. We expect services revenue to continue to increase throughout the remainder of 2003.

Cost of Revenue

Total cost of revenue increased 171% to $8.9 million in the third quarter of 2003 from $3.3 million in the third quarter of 2002. For the nine
months ended September 30, 2003, total cost of revenue increased 157% to $24.3 million from $9.4 million in the same year ago period. The increase in cost of revenue is mainly due
to an increase in cost of product, which includes the cost of software and hardware. The cost of hardware is significantly higher than the cost of software. Prior to the Eyretel acquisition, we did
not sell hardware, resulting in a significantly higher product margin.

Cost
of services revenue increased 115% to $6.5 million in the third quarter of 2003 from $3.0 million in the third quarter of 2002. For the nine months ended
September 30, 2003, cost of services revenue increased 89% to $16.7 million from $8.9 million in the same year ago period. These increases were the result of an increase in the
number of employees engaged in installation, training, consulting and customer maintenance services due to the Eyretel acquisition. Cost of services revenue as a percentage of services revenue
increased to 39% in the three and nine months ended September 30, 2003 from 36% in the same year ago periods. These percentage increases were primarily due to the impact of the fair value
recorded to Eyretel's deferred services revenue balances recorded at the purchase date. We expect that the cost of services revenue, as a percentage of services revenue, will decrease over the next
two quarters as the impact of Eyretel's fair market adjustment decreases and as renewal maintenance
revenue is reflected in income at their actual invoice amount, rather than the lower amount recorded due to purchase accounting requirements. In addition, we anticipate that services margin will
improve as we implement an improved services methodology throughout our entire organization during the fourth quarter of 2003. We expect our customer service organization to continue to grow over time
and, therefore, we anticipate that services revenue, in absolute dollars, will increase as we grow our customer base.

Gross
profit margins decreased to 68% in the three and nine months ended September 30, 2003 from 78% and 81% in the same periods of 2002, respectively. The declines in gross
profit margins were mainly attributable to hardware sales in 2003, which have a relatively low margin, and to amortization of intangible assets. We expect our product gross profit margin to improve as
hardware sales decline. We also expect services margin to increase as we roll out an improved services methodology around the globe and as the impact of the fair value adjustment to Eyretel's deferred
services balance, recorded at the purchase date, decreases over the next two quarters.

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Operating Expenses

Selling, General and Administrative.Selling, general and administrative expense increased 60% to $15.4 million in the
third quarter of 2003 from $9.6 million in the third quarter of 2002, representing 55% and 64% of total revenue, respectively. For the nine months ended September 30, 2003, selling,
general and administrative expense increased 39% to $42.4 million from $30.6 million in the same year ago period, representing 57% and 61% of total revenue, respectively. The increases
in absolute dollars were primarily due to the increased size of our company after the Eyretel acquisition and due to amortization of intangible assets. Bad debt expense also increased by
$0.5 million and $2.3 million for the three and nine months ended September 30, 2003, respectively, as compared to the same year ago periods primarily due to increased
international receivables. As the percentage of our international revenue increases, we would expect our bad debt expense to also increase. We expect selling, general and administrative expense to
continue at this higher dollar level, but slightly decrease as a percentage of total revenue throughout the remainder of 2003.

Research and Development.Research and development expense increased 30% to $4.8 million in the third quarter of 2003
from $3.7 million in the third quarter of 2002, representing 17% and 25% of total revenue, respectively. For the nine months ended September 30, 2003, research and development expense
increased 19% to $13.3 million from $11.2 million in the same year ago period, representing 18% and 22% of total revenue, respectively. These increases were due primarily to an increased
number of employees and consultants engaged in research and development activities. We expect research and development expense to continue at this higher dollar level, but remain fairly constant as a
percentage of total revenue throughout the remainder of 2003.

In-Process Research and Development.We estimated that $7.8 million of the purchase price of Eyretel
represented acquired in-process research and development ("IPR&D") that had not yet reached technological feasibility and had no alternative future use. Accordingly, these amounts were
immediately charged to expense upon consummation of the acquisition. An independent third-party appraiser calculated the value of IPR&D by utilizing a discounted cash flow methodology, focusing on the
income-producing capabilities of the in-process technologies and taking into consideration: stage of completion; complexity of work to date and to complete; anticipated product development
and introduction schedules; forecasted product sales cycles; internal and external risk factors; revenue and operating expense estimates; contributory asset charges, and costs already incurred and the
expected costs to complete.

Merger-related Costs.We incurred merger-related costs of $6.2 million for the nine months ended September 30,
2003. These merger-related costs included $0.9 million for a sterling-based forward exchange contract to hedge the dollar cost of the acquisition, $3.3 million of expenses related to
integrating Eyretel's software products, training personnel on products acquired and consolidating the operations of Eyretel with the Company, $0.7 million of facilities costs to consolidate
Witness' facilities, $0.9 million of expenses related to employee severance and benefits, and $0.4 million relating to the partial accrual of a bonus payable to Eyretel's former Chief
Executive Officer, now our Chief Operating Officer ("COO"). Our Board of Directors agreed to pay this bonus of £1.0 million to our COO in connection with the Eyretel acquisition and
subsequent integration. This bonus is generally payable in two installments due March 2004 and March 2005 but may be payable in advance of these dates under certain circumstances, such
as a change of control.

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Interest and Other Income, Net

Interest and other income, net consists primarily of interest earned on funds available for investment, net of foreign currency exchange gains and losses.
Interest and other income, net decreased 15% to $321,000 in the third quarter of 2003 from $379,000 in the third quarter of 2002. These decreases were primarily due to lower yields earned on our
investments and the reduction in cash as a result of the Eyretel acquisition offset partially by net foreign currency exchange gains in 2003. For the nine months ended September 30, 2003 and
2002, interest and other income, net was $1.2 million as lower interest income in the 2003 period was offset by net foreign currency exchange gains. We expect that interest income in 2003 will
be materially less than in 2002 due to lower rates and invested balances.

Provision for Income Taxes

We recorded a provision for foreign income taxes in the third quarter of 2003. We did not record a provision for state and federal alternative minimum tax in the
third quarter of 2003. For each of the nine months ended September 30, 2003 and 2002, we recorded a provision of $0.2 million for foreign income tax and federal alternative minimum tax.
We have recorded a full valuation allowance against deferred tax assets, including those generated as a result of net operating loss carryforwards for U.S. and foreign tax purposes at
September 30, 2003, as the future realization of the tax benefits is not currently considered more likely than not.

Liquidity and Capital Resources

During the nine months ended September 30, 2003, cash used for operating activities was $3.3 million, compared to $1.8 million of cash
provided by operating activities during the same year ago period. The cash flow from operations in 2003 was adversely affected by merger-related costs.

Net
cash provided by investing activities during the nine months ended September 30, 2003 was $3.9 million compared to $6.6 million during the same year ago period.
Investing activities for 2003 included the acquisition of Eyretel and the assets purchased from a software and services company focused on the business intelligence marketplace, net of cash
equivalents acquired, for $23.6 million. In addition, in 2003 cash was provided by the sale of investments securities of $31.8 million to initially fund the Eyretel acquisition.

Net
cash provided by financing activities during the nine months ended September 30, 2003 was $0.3 million as compared to $1.1 million during the same year ago
period. This decrease was due to $0.7 million in stock repurchases and a decrease in proceeds received from the exercise of stock options and the employee purchase plan, which was offset by the
repayment of notes receivable in 2003.

At
September 30, 2003, we had $39.1 million in total cash and cash equivalents and short-term investments and $24.4 million in working capital. In
addition, we had $11.7 million available under a line of credit, which was net of outstanding letters of credit of $3.3 million. The letters of credit secure the lease on the corporate
headquarters facility and have decreasing schedules that ultimately expire in 2007. At the Company's election, borrowings under the line of credit bear interest at the bank's prime rate, or LIBOR plus
300 basis points and are limited to 85% of eligible accounts receivable, as defined by the agreement. The revolving line of credit is secured by all of our assets and requires compliance with various
covenants, including liquidity ratios and tangible net worth requirements, among others. In May 2003, we amended the amount of our tangible net worth requirement due to the effect of the
Eyretel acquisition.

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We
expect to have total capital expenditures of approximately $2.0 million in 2003. We anticipate that our capital expenditures will increase over the next several years as we
expand our facilities and acquire equipment to support the expansion of our research and development activities and internal management information systems.

We
anticipate that operating expenses and planned capital expenditures will continue to be a material use of our cash resources. We believe that our existing cash and cash equivalents
are sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. If cash generated from operations is insufficient to satisfy our
liquidity requirements, we may seek to sell additional equity or debt securities or establish new financing arrangements. The sale of additional equity or convertible debt securities could result in
additional dilution to our stockholders. We cannot assure that any financing arrangements will be available in sufficient amounts or on acceptable terms.

Our
accounts receivable days sales outstanding ("DSO") increased from 79 days at September 30, 2002 to 80 days at September 30, 2003. We expect our DSO to be
in the mid-80s range in the future as we derive a greater proportion of our revenue from international operations, where payment is typically slower than in the United States, and due to
an increase in the number of customers with extended payment terms or deferred payments, which we believe can be attributed to a weakened economy.

Our
interest income is sensitive to changes in interest rates. Our investments are made with capital preservation and liquidity as our primary objectives. We generally hold only
high-grade investments such as commercial paper, corporate bonds and U.S. government agency securities to maturity. In order to acquire the shares of Eyretel, we converted our investment
portfolio to cash in February 2003, realizing a gain of $0.2 million.

The
majority of our operations have historically been in the United States and, accordingly, the majority of our transactions are denominated in U.S. dollars. However, with the
acquisition of Eyretel and along with our existing foreign-based operations, where transactions may be denominated in foreign currencies, we are subject to market risk with respect to fluctuations in
the relative value of currencies. Currently, we have offices in Australia, Brazil, Canada, China, Germany, Hong Kong, India, Japan, Malaysia, Mexico, the Netherlands, Singapore and the United Kingdom
and conduct transactions in either the local currency of the location or U.S. dollars. We are exposed to adverse movements in foreign currency exchange rates because we translate foreign currencies
into U.S. dollars for reporting purposes. Historically, these risks have been minimal, but as our international operations continue to grow, adverse currency fluctuations could have a material adverse
impact on our financial results. Net foreign exchange gains and (losses) were $160,000 and ($1,000) in the third quarter of 2003 and 2002, respectively. Net foreign exchange gains were $407,000 and
$8,000 for the nine months ended September 30, 2003 and 2002, respectively.

Factors That May Affect Our Future Results and Market Price of Our Stock

Our future operating results may vary substantially from period to period. The price of our common stock will fluctuate in the future, and an investment in our
common stock is subject to a variety of risks, including, but not limited to, the specific risks identified below. Inevitably, some investors in our securities will experience gains while others will
experience losses depending on the prices at which they purchase and sell our securities. Prospective and existing investors are strongly urged to carefully consider the various cautionary statements
and risks set forth in this report and the other documents we file with the SEC.

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Important
factors currently known to our management that could cause actual results to differ materially from those in forward-looking statements include disclosures contained in this
report and the other documents we file with the SEC, as well as the following risks:

Our products have a long sales cycle that makes it difficult to plan our expenses and forecast our results

Although it typically takes three to nine months from the time we qualify a sales lead until we sign a contract with the customer, we occasionally experience a
longer sales cycle. We expect that this will be the case in future periods. It is therefore difficult to predict the quarter in which a particular sale will occur. If our sales cycle unexpectedly
lengthens for one or more large orders or a significant number of small orders, it would delay the timing of our revenue, but not the timing of our corresponding expenditures. Lengthening our sales
cycle could also increase the total cost of a sale. This could harm our ability to meet our financial forecasts for a given quarter. Our customers' decisions regarding their purchase of our products
and services is relatively long due to several factors, including:



If the market in which we sell our products and services deteriorates further as a result of adverse economic conditions, it will have a material adverse effect on our business
and results of operations

The market for customer relationship management software, including software that records and analyzes customer interactions, is still emerging. Our success
depends on the use and acceptance of our software and services by existing and prospective customers. However, many of our current and prospective customers have postponed their capital expenditures
and experienced financial difficulties due to recent economic conditions and uncertainties. These conditions have had an adverse effect on our business and results of operations in recent quarters,
and we anticipate that the relatively slow and uneven economic recovery and the related uncertainty may adversely affect our business and results of operations in the future.

In
addition, demand for our software remains uncertain because our existing and potential customers may:



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We may continue to experience quarterly losses from operations in the future

With the exception of the first and second quarters of 2002, in which we achieved a quarterly operating profit, we have experienced quarterly losses from
operations. We incurred losses in 2003, the third and fourth quarters of 2002 and substantial losses before 2002. We may continue to suffer losses in the future. As a result of our operating losses,
we had an accumulated deficit of $46.5 million as of September 30, 2003. In addition, we expect to continue to devote substantial resources to research and development, professional
services, and sales and marketing activities. As a result, we will need to generate significant revenue to achieve profitability in any future period. If we do not achieve profitability from
operations, or if we do not remain profitable, we may need to obtain additional financing. In such event, the financing from sources upon which we have historically relied may not be available to us
on acceptable terms, if at all. Once profitability is achieved, if we fail to remain profitable, it will materially and adversely affect the market price of our stock.

Our quarterly revenue, expenses and operating results have fluctuated and are likely to continue to fluctuate, which may cause our stock price to decline

Our quarterly revenue, expenses and operating results are difficult to predict and could vary significantly from period to period. In particular, we typically
derive a significant portion of our software product revenue in each quarter from a small number of relatively large orders. A delay in the recognition of revenue from one of these orders may cause
our results of operations during a quarter to be lower than investors or securities analysts expect. The delay or failure to close anticipated sales in a particular quarter could reduce our revenue in
that quarter and subsequent quarters over which revenue for the sale could be recognized. In addition, because our revenue from installation, maintenance and training services largely correlates with
our product revenue, a decline in product revenue could also cause a decline in our services revenue in the same quarter or in subsequent quarters. Our revenue, expenses and operating results may vary
significantly in response to the risk factors described in this section, as well as the following factors, some of which are beyond our control:



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Due
to the foregoing factors, we believe that quarter-to-quarter comparisons of our operating results may not be a good indication of our future performance, and
you should not rely on them to predict our future performance or the future performance of our stock price. If our future revenue or operating results fall below the expectations of investors or
securities analysts, the price of our common stock would likely decline.

If we fail to manage and expand our international operations, we may be unable to reach or maintain our desired levels of revenue or profitability

Our revenue derived from customers outside the United States, principally in the United Kingdom, Continental Europe, Hong Kong/Greater China, Canada, Singapore,
Japan, Australia, Brazil, India and Mexico was $13.0 million and $32.9 million for the three and nine month periods ended September 30, 2003, respectively; and $3.8 million
and $11.2 million for the three and nine month periods ended September 30, 2002, respectively. In May 2003, we completed the purchase of Eyretel. Through this acquisition, we
significantly expanded our operations outside of North America. We intend to continue to expand our international operations through additional acquisitions, internal business expansion and strategic
business relationships. Our operations outside of the United States at September 30, 2003 consisted of 208 dedicated employees located in Australia, Brazil, Canada, China, Germany, Hong Kong,
India, Japan, Malaysia, Mexico, the Netherlands, Singapore and the United Kingdom. We have also established relationships with a number of international resellers.

We
intend to continue to analyze opportunities to expand our operations into other international markets. Our plans to expand internationally and our operations in new markets may be
adversely affected by a number of risks, including:



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As
we further expand our operations outside the United States, we will also face new competitors and competitive environments. In addition to the risks associated with our domestic
competitors, foreign competitors may pose an even greater risk, as they may possess a better understanding of their local markets and better working relationships with local infrastructure providers
and others. In particular, because telephone protocols and standards are unique to each country, local competitors will have more experience with, and may have a competitive advantage in, these
markets. We may not be able to obtain similar levels of local knowledge or similar relationships in foreign markets, which could place us at a significant competitive disadvantage. In addition, we
have limited experience in developing local language versions of our products or in marketing our products to international customers. We may not be able to successfully translate, market, sell, and
deliver our products internationally.

Fluctuations in foreign currency exchange rates could affect our financial results

We may experience gains and losses resulting from fluctuations in currency exchange rates for which hedging activities may not adequately protect us. Moreover,
exchange rate risks can have an adverse effect on our ability to sell our products in foreign markets. Where we sell our products in U.S. dollars, our sales could be affected adversely by declines in
foreign currencies relative to the dollar, thereby making our products more expensive in local currencies. Where we sell our products in local currencies, we could be competitively unable to increase
our prices to reflect fluctuations in the exchange rates. We cannot predict accurately the impact that future exchange rate fluctuations may have on our results.

We face intense competition that could adversely affect our revenue, profitability and market share

The market for products that record customer interactions, analyze performance and/or provide electronic learning is intensely competitive, evolving and is
subject to rapid changes in technology. We believe our principal competitors include, but are not limited to:



Many
of our current and potential competitors have longer operating histories, more established business relationships, larger customer bases, a broader range of products and services,
greater name recognition and substantially greater financial, technical, marketing, personnel, management, service, support and other resources than we do. As a result, our current and potential
competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, take better advantage of acquisitions and other opportunities, devote greater
resources to marketing and

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selling
their products and services and adopt more aggressive pricing policies. These competitors may distinguish themselves from us on the basis of their longer operating histories and ability to
withstand difficult economic conditions. Our competitors may also be able to offer products at lower prices or with other incentives that we cannot match. Additionally, the scope of our products and
services may be viewed as too narrow because some of our competitors offer a broader range of products and services.

In
addition, many of our competitors market their products through resellers and companies that integrate their technology and products with those of the competitor. These resellers and
technology partners of our competitors often have strong business relationships with our customers and potential customers. For example, some of our competitors have better and more long standing
relationships with telephone switch vendors. Our competitors may use these business relationships to market and sell their products and compete for customers with us. In addition, our competitors may
offer or develop products and services that are superior to ours. It is also possible that resellers or technology partners,
such as certain telephone switch vendors, may acquire one or more of our competitors, which would further solidify their business relationships.

We
have developed, and intend to continue to develop, relationships with companies that resell our software and companies that provide us with customer referrals or leads, some of which
may become competitors. We engage in joint marketing and sales efforts with our resellers, and rely on them for recommendations of our software during the evaluation stage of the purchase process.
When we enter into agreements with resellers, the agreements are not exclusive and may ordinarily be terminated by either party. Some of the resellers have similar, and often more established,
relationships with our competitors, and may recommend the products and services of our competitors to customers instead of our software and services. In addition, through their relationships with us,
the resellers could learn about our software and the market for our software and services and could develop and sell competing products and services. As a result, our relationships with resellers
could lead to increased competition for us.

We
expect that competition will increase as other established and emerging companies enter our market and as new products, services and technologies are introduced. Increased competition
may result in price reductions, lower gross margins and loss of our market share, which could materially and adversely affect our business, financial condition and results of operations.

We rely heavily on sales of our eQuality Balance, eQuality Evaluation and eQualityContactStore products

Our financial performance has depended, and will continue to depend, on our ability to develop and maintain market acceptance of our eQuality Balance, eQuality
Evaluation and eQuality ContactStore products and new and enhanced versions of them. Historically, nearly all of our product revenue has been derived from the sale of our eQuality Balance and eQuality
Evaluation software, and nearly all of Eyretel's product revenue was derived from the sale of eQuality ContactStore. We expect revenue from these products to continue to account for most of our
revenue for the foreseeable future. As a result, factors that adversely affect the pricing of or demand for these products, such as competitive pressures, technological change or evolution in customer
preferences, could materially and adversely affect our business, financial condition and results of operations. Many of these factors are beyond our control and difficult to predict.

If we fail to develop new software or improve our existing software to meet or adapt to the changing needs and standards of our target market, sales of our software and
services may decline

The markets for our products are characterized by rapidly changing technology and evolving industry standards. Our future success depends upon our ability to
develop and introduce new software and software enhancements which meet the

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needs
of companies seeking to record and analyze their interactions with customers and/or deliver electronic learning to their employees. To achieve increased market acceptance of our software and
services, we must, among other things, continue to:



We
may require substantial product development expenditures and lead-time to keep pace and ensure compatibility with new technology in our industry. If we fail to develop and
introduce new software and enhancements for our existing software, our software and services may not achieve market acceptance and we may be unable to attract new customers.

Our products may fail to perform properly and contain defects, which may cause us to incur additional expenses or result in the loss of customers

Our software is used in a complex operating environment that requires its integration with computer and telephone networks and other business software
applications. Furthermore, the hardware, software and network systems generally used in conjunction with our software, particularly telephone standards and protocols, change rapidly. The evolution of
these standards may cause our products to function slowly or improperly. Poor product performance may necessitate redevelopment of our product or other costly reengineering measures which may divert
our management and product development resources and funds. Due to the large number of, and variations in, computer and telephone network systems and applications, as well as the rapid changes in
these products, our testing process may be unable to duplicate all possible environments in which our software is expected to perform. Any errors or defects that are discovered after we release new or
enhanced software could cause us to lose revenue and customers, delay the market acceptance of our software, damage our customer relationships and reputation and increase our service and warranty
costs. All of these problems could be exacerbated as we move our products to the latest software technologies and platforms.

If our advanced compliance recording applications fail to record 100% of our customers' interactions, we may be subject to liability and our reputation may be harmed

Through our acquisition of Eyretel, we have extended our performance optimization suite to include advanced compliance recording applications and related
services. Many of our customers acquired through the Eyretel acquisition use these applications to record and store recordings of interactions to provide back-up and verification of
transactions and to guard against risks posed by lost or misinterpreted voice communications. These customers rely on our applications to record, store and retrieve voice data in a timely, reliable
and efficient manner. If our applications fail to record 100% of our

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customers'
interactions or our customers are unable to retrieve the recordings when necessary, we may be subject to liability and our reputation may be harmed. Although we attempt to limit any
potential exposure through our license agreements for these applications, we cannot guarantee that we will eliminate or successfully limit our liability for any failure of our applications.

If we are unable to maintain the security of our systems, our business, financial condition and operating results could be harmed

The occurrence or perception of security breaches in the operation of our business or by third parties using our products could harm our business, financial
condition and operating results. Our customers use our products to compile and analyze highly sensitive or confidential information. We may come into contact with such information or data when we
perform support or maintenance functions for our customers. While we have internal policies and procedures for employees in connection with performing these functions, the perception that any of our
employees has improperly handled sensitive information of a customer or a customer's customer could negatively impact our business. If, in handling this information, we fail to comply with our privacy
policies or privacy and security laws, we could incur civil liability to government agencies, customers and individuals whose privacy is compromised. If personal information is received or used from
sources outside the U.S., we could be subject to civil, administrative or criminal liability under the laws of other countries. In addition, while we implement sophisticated security measures, third
parties may attempt to breach our security or inappropriately use our products through computer viruses, electronic break-ins and other disruptions. If successful, confidential
information, including passwords, financial information, or other personal information may be improperly obtained and we may be subject to lawsuits and other liability. Any internal or external
security breaches could harm our reputation, and even the perception of security risks, whether or not valid, could inhibit market acceptance of our products.

Certain of our contracts contain provisions that are unfavorable to us

Certain of our contracts contain provisions that expose us to risks of loss that, in some cases, are not limited to amounts received under those contracts. If we
fail to perform to the standards required by these contracts, we could be subject to liability and our business, financial condition and results of operations could be materially and adversely
affected.

If we fail to protect our intellectual property, third parties may use our technology for their own benefit

Our success depends to a significant degree upon the legal protection of our software and other proprietary technology rights. We rely on a combination of patent,
trade secret, copyright and trademark laws and confidentiality and non-disclosure agreements with employees and third parties to establish and protect our proprietary rights. These
measures may not be sufficient to protect our proprietary rights, and we cannot be certain that third parties will not misappropriate our technology and use it for their own benefit. Also, most of
these protections do not preclude our competitors from independently developing products with functionality or features substantially equivalent or superior to our software. Any failure to protect our
intellectual property could have a material adverse effect on our business.

As
of September 30, 2003, we had ten registered trademarks, four patents and 19 patent applications pending. There is no guarantee that our pending applications will result in
issued patents or, if issued,
that they will provide us with any competitive advantages. We cannot assure you that we will file further patent or trademark applications, that any future applications will be approved, that any
existing or future patents, trademarks or copyrights will adequately protect our intellectual property or that any existing or future patents, trademarks or copyrights will not be challenged by third
parties. Furthermore, one or more of our existing or future patents, trademarks or copyrights may be found to be invalid or unenforceable.

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We
are aware of certain uses, U.S. trademark registrations, and U.S. trademark applications for our "eQuality" trademark and its variations that predate our use, and the
April 2002 issuance of the U.S. registration for our trademark eQuality®. It is possible that the owner of legal rights resulting from one or more of these prior uses, U.S.
trademark registrations, or U.S. trademark applications will bring legal action to challenge our registration of and/or our continued use of the trademark eQuality®, and may also seek
compensation for damages resulting from our use of our registered trademark if such challenging party prevails on such a claim. As a result, we cannot assure you that our registration of this
trademark will be undisturbed, or that this use will not result in liability for trademark infringement, trademark dilution, and/or unfair competition.

Moreover,
the laws of other countries in which we market our products may afford little or no effective protection of our proprietary technology as compared to the laws of the United
States. If we resort to litigation to enforce our intellectual property rights, the proceedings could be burdensome and expensive, would likely divert valuable management and product development
resources and could involve a high degree of risk, regardless of whether we win or lose the litigation.

Claims by other companies that our software infringes their intellectual property could require us to incur substantial expenses or prevent us from selling our software or
services

If any of our software violates the intellectual property rights of others, we may be required to reengineer or redevelop our software, seek to obtain licenses
from third parties to continue offering our software without substantial reengineering, or conduct studies of such intellectual property rights so as to evaluate whether such intellectual property
rights are valid or enforceable. Any efforts to reengineer our software or obtain licenses from third parties may not be successful, could be extremely costly and would likely divert valuable
management and product development resources. Our efforts to study the intellectual property rights of third parties may not be successful and could reveal that such intellectual property rights are
valid and enforceable, could be extremely costly and would likely divert valuable management and product development resources. For example, depending on the outcome of our lawsuit against Knowlagent
(as described under the heading "Legal Proceedings"), we may be required to enter into royalty and licensing agreements on unfavorable terms, to stop selling or redesign our eQuality® NOW
application, or to pay damages or satisfy indemnification commitments with our customers.

In
addition, in the rapidly developing technological environment in which we operate, third parties may have filed a number of patent applications, many of which are confidential when
filed. If our software is found to violate these patents when they are issued or any other intellectual property of others, we may become subject to claims for infringement. An infringement claim
against us could result in the loss of our proprietary rights and, whether meritorious or not, could be time-consuming, result in costly litigation or require us to pay damages or enter
into royalty or licensing agreements on terms that are unfavorable to us, if such agreements are available at all. In addition, our customers and other users of our software may become subject to
claims if the software they license from us is alleged to infringe the intellectual property of others. Our customers and these other users of our software would likely attempt to hold us responsible
for these claims and any resulting harm they suffer.

If
we decide to, or are forced to, litigate any of these claims, the litigation could be expensive and time-consuming, could divert our management's attention from other
matters, and could otherwise materially and adversely affect our business, financial condition and results of operations, regardless of the outcome of the litigation. Litigation and intellectual
property claims against us could also disrupt our sale of software.

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We expect that we and other participants in our industry and related industries will be increasingly subject to infringement claims as the number of competitors with patent and other
intellectual property portfolios in these industries grows. Although patent and intellectual property disputes may be settled through licensing or similar arrangements, costs associated with these
arrangements may be substantial and we cannot assure you that necessary licenses or similar arrangements will be made available to us on a reasonable basis or at all. Consequently, if we become
subject to an adverse determination in a judicial or administrative proceeding or we fail to obtain necessary licenses, we could be prevented from producing and selling some or potentially all of the
components of our software. Such a result would have a material adverse effect on our business, financial condition and results of operations.

We believe that our future success also depends upon the continued compatibility of our software with the products and other technologies offered by other
software and hardware companies

Our
software must integrate with software and hardware solutions provided by a number of our existing and potential competitors. These competitors or their business partners could alter
their products so that our software no longer integrates well with them, or they could delay or deny our access to software releases that allow us to timely adapt our software to integrate with their
products. They could thus effectively prevent us from modifying our software to keep pace with the changing technology of their products. If we cannot adapt our software to changes in our competitors'
technology, it may significantly impair our ability to compete effectively, particularly if our software must integrate with the software and hardware solutions of our competitors.

New
products may not be compatible with our software, but may be compatible with the products of our competitors. For example, our products must integrate with phone switches made by the
telephone switch vendors and computer telephony software applications offered by other software providers. If our products are not compatible with the new technologies offered by other software and
hardware companies, it would have a material adverse effect on our business and results of operations.

If we do not continue to expand the distribution of our products through direct and indirect sales channels, we may be unable to expand our market share or increase our revenue

To expand our market share and revenue, attract new customers and increase sales to existing customers, we may need to expand our direct and indirect sales
channels. We may need to expand our direct sales force by hiring additional sales personnel and management, and increase the number of relationships we have with companies that provide us with
customer referrals or leads for new business. Historically, it has taken us up to six months to train new sales personnel before they reach an
acceptable level of productivity. We have also experienced difficulty in finding new sales personnel with experience in computer and telephone integration technologies. We cannot assure you that we
will be able to continue to find an adequate number of new sales personnel meeting our specific needs. If the personnel we hire are less qualified, it may take us more time to train them before they
reach an acceptable level of productivity.

We
also intend to derive revenue from our indirect sales channel through relationships with companies that resell our software. Product revenue from our indirect sales channel, which
consists of select resellers and a variety of strategic marketing alliances, accounted for approximately 32% and 23% of total product revenue for the nine months ended September 30, 2003 and
2002, respectively. We expect revenue from our indirect sales channel and, accordingly, our dependence on resellers to continue to increase as we establish more relationships with companies to resell
our software worldwide. We intend to use resellers to increase our sales internationally and to market our software to small and medium contact centers. We cannot assure you that we will be able to
maintain productive relationships or that we will be able to establish similar relationships with additional resellers on a timely basis, or at all. In addition, we cannot be certain that these
distribution partners will devote adequate resources to selling our software and services. If we are unable to maintain and expand our direct sales force and indirect distribution channels, we will
not be able to increase our revenue and our business will suffer.

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If our professional services employees do not provide installation services effectively and according to schedule, our customers may not use our installation
services or may stop using our software

Our
customers ordinarily purchase installation, training and maintenance services, which they typically obtain from our professional services organization. Because our software must be
installed to work with a number of computer and telephone network systems, installation of our software can be complex. These systems vary greatly from one customer site to another, and the versions
and integration requirements of these third-party systems change frequently. We believe that the speed and quality of installation services are competitive factors in our industry. If our installation
services are not satisfactory to our customers, the customers may choose not to use our installation services to install our software. In addition, these customers may determine that they will not
license our software and instead will use the products and services of one of our competitors. If this happens, we would lose licensing and services revenue from these customers, and it would likely
harm our reputation in the industry in which we compete. This could materially and adversely affect our business, financial condition and results of operations.

We may make acquisitions or investments that are not successful and that adversely affect our ongoing operations

We may acquire or make investments in companies, products, services and technologies which we believe complement our software and services. Because of the
increasing use of new customer interaction media such as the Internet and e-mail, we believe that it may be important for us to acquire complementary technology to quickly bring new
products to market. We have limited experience in making acquisitions and investments. As a result, our ability to identify prospects, conduct acquisitions and properly manage the integration of
acquisitions is unproven. If we fail to properly evaluate and execute acquisitions or investments, it may have a material adverse effect on our business and operating results. In making or attempting
to make acquisitions or investments, we face a number of risks, including:



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In
May 2003, completed the acquisition of Eyretel. We bought Eyretel for $55.3 million using our existing cash balance, and following the acquisition, our cash balance was
$39.1 million at September 30, 2003. Our senior management is currently focused on integrating the operations, product sets and personnel of Eyretel into our business and product
offerings. The acquisition of Eyretel significantly expands our operations into new geographic markets and, as a result, the integration process could divert the attention of our senior management
from our existing operations and other potential business opportunities.

Our
senior management is focusing on retaining key employees and maintaining relationships with Eyretel's customers and suppliers. We cannot assure you, however, that we will be able to
retain key employees or preserve Eyretel's customer and supplier relationships. For example, because the combined company will not offer hardware products going forward, customers who purchased
products from Eyretel because of its complete compliance recording solution may decide to purchase products from other companies. Certain customers simply may not want to continue their relationship
with the larger combined enterprise.

If
we are not successful in integrating Eyretel into our operations or are otherwise unable to realize the anticipated synergies of the combined companies, our business may suffer.

If we need additional financing to maintain or expand our business, it may not be available on favorable terms, or at all

Although we believe our current cash and borrowing capacity will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for
at least the next 12 months and the foreseeable future, we may need additional funds to expand or meet all of our operating needs. If we need additional financing, we cannot be certain that it
will be available to us on favorable terms, or at all. If we raise additional funds by issuing equity securities or convertible debt, the ownership interest of our stockholders could be significantly
diluted, and any additional equity securities we issue may have rights, preferences or privileges senior to the rights of our stockholders. Also, the terms of any additional financing we obtain may
significantly limit our future financing and operating activities. If we need funds and cannot raise them on acceptable terms, we may be forced to sell assets or seek to refinance our outstanding
obligations. We may also be unable to:



Any
of these events could significantly harm our business and financial condition and limit our growth.

The loss of our third-party hardware distributor and its suppliers could harm our business

We intend to discontinue selling hardware and are transferring the fulfillment of all hardware orders to one or more third-party distributors. We are therefore
largely dependent on third parties for the supply of hardware components, the assembly of hardware, and the distribution of hardware to our customers. For most customer orders, we rely on a
third-party hardware distributor to obtain, assemble (if required) and deliver the hardware portion of the order. Our hardware distributor and, for the declining portion of hardware orders that we
continue to fulfill directly, we in turn rely on a third-party hardware supplier for certain key materials and components. If our current hardware distributor experiences financial, operational or
quality assurance difficulties, or if there is any other disruption in our relationship with our current hardware distributor, we

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will be required to locate another hardware distributor. Similarly,
if our current hardware supplier experiences financial, operational or
quality assurance difficulties, or if there is any other disruption in our relationship with our current hardware supplier or our current hardware distributor's relationship with this supplier, we
and/or our hardware distributor will be required to locate alternative sources of supply. If we or our distributor are unable to obtain sufficient quantities of materials and components, we will be
subject to the following risks:



Even
if we and/or our distributor are successful in locating alternative sources of supply, alternative suppliers could increase prices significantly and with immediate effect. In
addition, alternative components may not be identical to previous components and may malfunction or interact with other components in unexpected ways. The use of new suppliers and the modification of
our products will require testing and may require further modifications or other remedial action, which may result in additional expense to us, diversion of management attention and other resources,
inability to fulfill customer orders or delay in fulfillment, reduction in quality and reliability, customer dissatisfaction, and other adverse effects on our reputation, business and operating
results. In addition, if for any reason our proprietary hardware becomes unavailable from our current distributor, it may be difficult for us to
source our proprietary hardware elsewhere. This may adversely affect our business and relationship with customers who require or expect us to provide a complete hardware-software solution that
includes this proprietary hardware.

Our stock price has been volatile

The market price of our common stock has been subject to significant fluctuations in response to variations in quarterly operating results and other factors. In
addition, the securities markets have experienced significant price and volume fluctuations from time to time that have often been unrelated or disproportionate to the operating performance of
particular companies. Any announcement with respect to any adverse variance in revenue or earnings from levels generally expected by securities analysts or investors for a given period could have an
immediate and significant adverse effect on the trading price of our common stock. In addition, factors such as announcements of technological innovations or new products by us, our competitors or
third parties, changing conditions in the market for products that record and analyze customer interactions, changes in the market valuations of similar companies, loss of a major customer, additions
or departures of key personnel, changes in estimates by securities analysts, announcements of extraordinary events, such as acquisitions or litigation, or general economic conditions may have an
adverse effect on the market price of our common stock.

Terrorist attacks and other acts of war may adversely affect the markets in which we operate, our operations and our stock price

Terrorist attacks and other acts of war, and any response to them, may cause instability in financial markets. Armed hostilities and terrorism may also directly
impact our facilities, personnel and operations, as well as those of our clients. Furthermore, terrorist attacks or acts of war may result in temporary halts of commercial activity in the affected
regions, and may result in reduced demand for our products. These developments could have a material adverse effect on our business and the trading price of our common stock.

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Government regulation of telephone and Internet monitoring could cause a decline in the use of our software, result in increased expenses for us or subject us and our customers
to liability

As the telecommunications industry continues to evolve, state, federal and foreign governments (including supranational governmental organizations such as the
European Union) may increasingly regulate the monitoring of telecommunications and telephone and Internet monitoring and recording products, such as our software. We believe that increases in
regulation could come in the form of a
number of different kinds of regulations, including regulations regarding privacy, protection of personal information and employment. For example, the State of California recently enacted the Database
Security Breach Act, which requires any business that suffers a computer security breach to immediately notify customers in California if personal information has been compromised. The adoption of any
new regulations or changes made to existing regulations could cause a decline in the use of our software and could result in increased expenses for us, particularly if we are required to modify our
software to accommodate these new or changing regulations. Moreover, new regulations or changes to existing regulations could subject us and our customers to liability. In addition, whether or not
these regulations are adopted, if we do not adequately address the privacy concerns of consumers, companies may be hesitant to use our software. If any of these events occur, it could materially and
adversely affect our business.

We may face difficulty in attracting and retaining key personnel, which are necessary to effectively manage and expand our business

Our future success will depend in large part on our ability to hire, train, retain and motivate a sufficient number of qualified personnel, particularly in sales,
marketing, research and development, service and support. Competition for experienced research and development personnel with software and telephone integration skills remains strong, but turnover of
technical personnel has decreased from prior years. We expect to face additional difficulties retaining personnel who have stock options with exercise prices above the fair market value of our stock.
In order to retain these employees, we may need to grant additional options to purchase common stock with exercise prices equal to the fair market value of our stock, which will cause dilution to our
stockholders. If we are unable to attract and retain qualified personnel or if we experience high personnel turnover, it would increase our costs of operations and could prevent us from effectively
managing and expanding our business.

Our
future success also depends upon the continued service of our executive officers, particularly our Chairman and Chief Executive Officer, David Gould, and our President and Chief
Operating Officer, Nick Discombe. We have employment agreements with Mr. Gould and Mr. Discombe and limited non-compete agreements with most of our other executive officers.
However, any of our executive officers and other employees could terminate his or her relationship with us at any time. The loss of the services of our executive officers or other key personnel could
materially and adversely affect our business. In addition, if one or more of our executive officers or key employees were to join one of our competitors or otherwise compete with us, it could harm our
business.

Our management and affiliates control a large percentage of our voting stock and could exert significant influence over matters requiring stockholder approval

At September 30, 2003, our executive officers and directors and their affiliates together controlled approximately 24% of our outstanding common stock. As
a result, these stockholders, if they act together, will be able to exert significant influence over all matters requiring stockholder approval, including the election of our directors and the
approval of significant corporate transactions.

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Our certificate of incorporation and bylaws, as well as Delaware law, may prevent or delay a future takeover

Our amended and restated certificate of incorporation and bylaws contain provisions which could make it difficult for a third party to acquire us without consent
of our board of directors. For example, if a potential acquirer were to make a hostile bid for us, the acquirer would not be able to call a special meeting of stockholders to remove our board of
directors or act by written consent without a meeting. In addition, our board of directors has staggered terms which makes it difficult to remove all our
directors at once. A potential acquirer would also be required to provide advance notice of its proposal to remove directors at an annual meeting.

Our
board of directors has the ability to issue preferred stock which would significantly dilute the ownership of a hostile acquirer. In addition, Delaware law limits business
combination transactions with 15% stockholders that have not been approved by the board of directors. In October 2002, our board of directors approved, and we have implemented, a stockholder
rights plan which has the effect of causing substantial dilution to a person or group that attempts to acquire us on terms not approved by the board of directors.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

None.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The Company conducted an evaluation of the effectiveness of the Company's disclosure controls and procedures (as defined in Rules 13a-14 and
15d-14 under the Securities Exchange Act of 1934), as of the end of the period covered by this quarterly report. This evaluation was conducted under the supervision and with the
participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer. Based on this evaluation, as of the quarter ended September 30, 2003, the Company's
Chief Executive Officer and Chief Financial Officer have concluded the Company's disclosure controls and procedures are effective. There were no changes in internal controls over financial reporting
that occurred during the period covered by this quarterly report that have materially affected, or that are reasonably likely to materially affect, our internal controls over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

From time to time we may be involved in legal proceedings and/or litigation arising in the ordinary course of our business.

On
December 11, 2002, we filed in the United States District Court for the Northern District of Georgia, Atlanta Division, a lawsuit against Knowlagent, Inc.
("Knowlagent"), which is the assignee of the United States Patent Nos. 6,324,282 B1 and 6,459,787 B2. Knowlagent has accused our eQuality Now software suite of infringing the above patents. We filed
suit seeking a declaration that we did not and do not infringe either of the two patents listed above, as well as a declaration that the above patents are invalid and unenforceable. We also filed a
claim requesting that if the patents are found to be valid, that one of our own employees be named the rightful inventor of the patents. We also requested that monetary damages in an amount equal to
the amount that Knowlagent has received from its use of the above patents. On December 31, 2002, Knowlagent filed its answer to our complaint as well as two counterclaims, alleging that we
infringe and contribute to the infringement by others of the above patents; Knowlagent seeks both monetary damages and an injunction in connection with its counterclaim. We are currently in the
discovery phase of the lawsuit.

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

Item 6. Exhibits and Reports on Form 8-K

31.1*

Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2*

Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1*

Certification of David B. Gould 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 William F. Evans pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002.


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We
filed the following report on Form 8-K filed during the third quarter of 2003:



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SIGNATURES

Pursuant to the requirements 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.

|Dated: November 13, 2003 |  | Witness Systems, Inc.
|------------------------ |  | ---------------------
|                         |  | By:                  
|                         |  | By:                  

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