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, 2004                                       
|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

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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the
past 90 days. Yes 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 October 29, 2004Common Stock, par value $.01 per share

24,301,304




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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, 2004 and December 31, 2003                               |  | 3   
|                                 |  | Condensed Consolidated Statements of Operations
for the three and nine months ended September 30, 2004 and 2003 |  | 4   
|                                 |  | Condensed Consolidated Statements of Cash Flows
for the nine months ended September 30, 2004 and 2003           |  | 5   
|                                 |  | Notes to the Condensed Consolidated Financial Statements                                                        |  | 6   
|Item 2.                          |  | Management's Discussion and Analysis of
Financial Condition and Results of Operations                           |  | 17  
|Item 3.                          |  | Quantitative and Qualitative Disclosures About Market Risk                                                      |  | 40  
|Item 4.                          |  | Controls and Procedures                                                                                         |  | 40  
|PART II.    OTHER INFORMATION    |  |                                                                                                                
|Item 1.                          |  | Legal Proceedings                                                                                               |  | 41  
|Item 2.                          |  | Changes in Securities and Use of Proceeds                                                                       |  | 41  
|Item 6.                          |  | Exhibits                                                                                                        |  | 41  
|SIGNATURES                       |  | 42                                                                                                             

2

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PART 1. FINANCIAL INFORMATION

Item 1. Financial Statements

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

|                                                                                                                         |                                                                                                                                                                                                | September 30,
2004         |         | December 31,
2003 |       
|------------------------------------------------------------------------------------------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------- | ----------------- | ------
|ASSETS                                                                                                                   |                                                                                                                                                                                                |                            |         |                   |       
|Current assets:                                                                                                          |                                                                                                                                                                                                |                            |         |                   |       
|                                                                                                                         | Cash and cash equivalents                                                                                                                                                                      |                            | $       | 36,417            |       
|                                                                                                                         | Investments                                                                                                                                                                                    |                            |         | 26,530            |       
|                                                                                                                         | Accounts receivable, net of allowance for doubtful accounts of $2,677 at September 30, 2004 and $2,584 at December 31, 2003                                                                    |                            |         | 27,694            |       
|                                                                                                                         | Prepaid and other current assets                                                                                                                                                               |                            |         | 4,906             |       
|                                                                                                                         |                                                                                                                                                                                                |                            |         |                   |       
|                                                                                                                         |                                                                                                                                                                                                | Total current assets       |         |                   | 95,547
|Intangible assets, net                                                                                                   |                                                                                                                                                                                                |                            | 11,907  |                   |       
|Property and equipment, net of accumulated depreciation of $10,931 at September 30, 2004 and $7,556 at December 31, 2003 |                                                                                                                                                                                                |                            | 6,057   |                   |       
|Other assets                                                                                                             |                                                                                                                                                                                                |                            | 1,399   |                   |       
|                                                                                                                         |                                                                                                                                                                                                |                            |         |                   |       
|                                                                                                                         |                                                                                                                                                                                                | $                          | 114,910 |                   | $     
|                                                                                                                         |                                                                                                                                                                                                |                            |         |                   |       
|LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                     |                                                                                                                                                                                                |                            |         |                   |       
|Current liabilities:                                                                                                     |                                                                                                                                                                                                |                            |         |                   |       
|                                                                                                                         | Accounts payable                                                                                                                                                                               |                            | $       | 4,601             |       
|                                                                                                                         | Accrued expenses                                                                                                                                                                               |                            |         | 15,942            |       
|                                                                                                                         | Deferred revenue                                                                                                                                                                               |                            |         | 23,179            |       
|                                                                                                                         |                                                                                                                                                                                                |                            |         |                   |       
|                                                                                                                         |                                                                                                                                                                                                | Total current liabilities  |         |                   | 43,722
|Other long-term liabilities                                                                                              |                                                                                                                                                                                                |                            | 4,129   |                   |       
|Deferred income taxes                                                                                                    |                                                                                                                                                                                                |                            | 119     |                   |       
|                                                                                                                         |                                                                                                                                                                                                |                            |         |                   |       
|                                                                                                                         |                                                                                                                                                                                                | Total liabilities          |         |                   | 47,970
|                                                                                                                         |                                                                                                                                                                                                |                            |         |                   |       
|Stockholders' equity:                                                                                                    |                                                                                                                                                                                                |                            |         |                   |       
|                                                                                                                         | Preferred stock, $.01 par value; 10,000,000 shares authorized; (50,000 shares of which have been designated as Series A Junior Participating Preferred Stock), no shares issued or outstanding |                            |         |                  |       
|                                                                                                                         | Common stock, $.01 par value; 50,000,000 shares authorized; 24,160,563 and 22,169,672 shares issued and outstanding at September 30, 2004 and December 31, 2003, respectively                  |                            |         | 242               |       
|                                                                                                                         | Additional paid-in capital                                                                                                                                                                     |                            |         | 106,109           |       
|                                                                                                                         | Accumulated deficit                                                                                                                                                                            |                            |         | (43,579           | )     
|                                                                                                                         | Accumulated other comprehensive income                                                                                                                                                         |                            |         | 4,168             |       
|                                                                                                                         |                                                                                                                                                                                                |                            |         |                   |       
|                                                                                                                         |                                                                                                                                                                                                | Total stockholders' equity |         |                   | 66,940
|Commitments and contingencies                                                                                            |                                                                                                                                                                                                |                            |         |                   |       
|                                                                                                                         |                                                                                                                                                                                                |                            |         |                   |       
|                                                                                                                         |                                                                                                                                                                                                | $                          | 114,910 |                   | $     
|                                                                                                                         |                                                                                                                                                                                                |                            |         |                   |       

See
accompanying notes to condensed consolidated financial statements.

3

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

|                                            |                                              | Three Months Ended
September 30,                |     | Nine Months Ended
September 30, |       
|------------------------------------------- | -------------------------------------------- | ----------------------------------------------- | --- | ------------------------------- | ------
|
|Revenue:                                    |                                              |                                                 |     |                                 |       
|                                            | Product                                      |                                                 | $   | 13,925                          |       
|                                            | Services                                     |                                                 |     | 21,332                          |       
|                                            |                                              |                                                 |     |                                 |       
|                                            |                                              | Total revenue                                   |     |                                 | 35,257
|                                            |                                              |                                                 |     |                                 |       
|Cost of revenue:                            |                                              |                                                 |     |                                 |       
|                                            | Product                                      |                                                 |     | 2,737                           |       
|                                            | Services                                     |                                                 |     | 8,036                           |       
|                                            |                                              |                                                 |     |                                 |       
|                                            |                                              | Total cost of revenue                           |     |                                 | 10,773
|                                            |                                              |                                                 |     |                                 |       
|                                            |                                              | Gross profit                                    |     |                                 | 24,484
|Operating expenses:                         |                                              |                                                 |     |                                 |       
|                                            | Selling, general and administrative          |                                                 |     | 16,422                          |       
|                                            | Research and development                     |                                                 |     | 5,470                           |       
|                                            | Merger-related costs                         |                                                 |     | 152                             |       
|                                            | Acquired in-process research and development |                                                 |     |                                |       
|                                            |                                              |                                                 |     |                                 |       
|                                            |                                              | Operating income (loss)                         |     |                                 | 2,440 
|Interest and other income, net              |                                              |                                                 | 435 |                                 |       
|                                            |                                              |                                                 |     |                                 |       
|                                            |                                              | Income (loss) before provision for income taxes |     |                                 | 2,875 
|(Benefit) provision for income taxes        |                                              |                                                 | (68 | )                               |       
|                                            |                                              |                                                 |     |                                 |       
|                                            |                                              | Net income (loss)                               |     | $                               | 2,943 
|                                            |                                              |                                                 |     |                                 |       
|Net income (loss) per share:                |                                              |                                                 |     |                                 |       
|                                            |                                              | Basic                                           |     | $                               | 0.12  
|                                            |                                              |                                                 |     |                                 |       
|                                            |                                              | Diluted                                         |     | $                               | 0.11  
|                                            |                                              |                                                 |     |                                 |       
|Weighted-average common shares outstanding: |                                              |                                                 |     |                                 |       
|                                            |                                              | Basic                                           |     |                                 | 23,631
|                                            |                                              |                                                 |     |                                 |       
|                                            |                                              | Diluted                                         |     |                                 | 26,202
|                                            |                                              |                                                 |     |                                 |       

See
accompanying notes to condensed consolidated financial statements.

4

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WITNESS SYSTEMS, INC. AND SUBSIDIARIES
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 in) operating activities: |                                                         |                                      
|                                               |                                                                                                    | Acquired in-process research and development charge     |                                      
|                                               |                                                                                                    | Amortization of intangible assets                       |                                      
|                                               |                                                                                                    | Depreciation and amortization on property and equipment |                                      
|                                               |                                                                                                    | Provision for doubtful accounts                         |                                      
|                                               |                                                                                                    | Other                                                   |                                      
|                                               |                                                                                                    | Changes in operating assets and liabilities:            |                                      
|                                               |                                                                                                    |                                                         | Accounts receivable                  
|                                               |                                                                                                    |                                                         | Prepaid and other assets             
|                                               |                                                                                                    |                                                         | Accounts payable and accrued expenses
|                                               |                                                                                                    |                                                         | Deferred revenue                     
|                                               |                                                                                                    |                                                         |                                      
|                                               |                                                                                                    |                                                         |                                      
|                                               |                                                                                                    |                                                         |                                      
|Cash flows from investing activities:          |                                                                                                    |                                                         |                                      
|                                               | Capital expenditures                                                                               |                                                         |                                      
|                                               | Purchases of investments                                                                           |                                                         |                                      
|                                               | Proceeds from maturities of investments                                                            |                                                         |                                      
|                                               | Proceeds from sales of investments                                                                 |                                                         |                                      
|                                               | Acquisition of Eyretel plc, net of cash acquired of $38,814                                        |                                                         |                                      
|                                               | Purchase of other business assets                                                                  |                                                         |                                      
|                                               |                                                                                                    |                                                         |                                      
|                                               |                                                                                                    |                                                         |                                      
|                                               |                                                                                                    |                                                         |                                      
|Cash flows from financing activities:          |                                                                                                    |                                                         |                                      
|                                               | Proceeds from exercise of stock options and stock purchase plan                                    |                                                         |                                      
|                                               | Repayment of note receivable from stockholder                                                      |                                                         |                                      
|                                               | Stock repurchases                                                                                  |                                                         |                                      
|                                               |                                                                                                    |                                                         |                                      
|                                               |                                                                                                    |                                                         |                                      
|                                               |                                                                                                    |                                                         |                                      
|                                               | Effect of exchange rate changes on cash                                                            |                                                         |                                      
|                                               |                                                                                                    |                                                         |                                      
|                                               |                                                                                                    |                                                         |                                      
|Cash and cash equivalents at beginning of year |                                                                                                    |                                                         | 30,717                               
|                                               |                                                                                                    |                                                         |                                      
|Cash and cash equivalents at end of year       |                                                                                                    | $                                                       | 36,417                               
|                                               |                                                                                                    |                                                         |                                      
|Supplemental cash flow information:            |                                                                                                    |                                                         |                                      
|                                               | Cash paid for interest                                                                             |                                                         | $                                    
|                                               |                                                                                                    |                                                         |                                      
|                                               | Cash paid for income taxes                                                                         |                                                         | $                                    
|                                               |                                                                                                    |                                                         |                                      
|Non-cash investing activities:                 |                                                                                                    |                                                         |                                      
|                                               | Purchase of other business assets with short-term borrowings                                       |                                                         | $                                    
|                                               |                                                                                                    |                                                         |                                      

See
accompanying notes to condensed consolidated financial statements.

5

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WITNESS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2004
(unaudited)

1.     Basis of Presentation

BusinessWitness Systems, Inc. ("Witness") provides an integrated contact center 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.

We
are headquartered in Roswell, Georgia with offices in the United States, Australia, Brazil, Canada, China, Germany, Japan, Mexico, the Netherlands, Singapore and the United Kingdom.
We were originally incorporated in 1988 in Georgia and were reincorporated in Delaware in 1997. We have been a publicly traded company since February 2000.

Principles of ConsolidationThe unaudited interim condensed consolidated financial statements include the financial statements
of Witness Systems, Inc. and its wholly-owned subsidiaries. During the first quarter of 2003, we acquired Eyretel plc ("Eyretel"), a U.K.-based provider of compliance and recording solutions
for customer contact centers. We began consolidating Eyretel's results on March 22, 2003, the date we assumed majority ownership of Eyretel. All significant intercompany balances and
transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation.

The
financial statements included 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 of America. However, in the opinion of
management, all adjustments 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 our Annual Report on Form 10-K for the year ended December 31, 2003, as amended and filed with the U.S. Securities and Exchange Commission.

Use of EstimatesThe preparation of these financial statements requires us to make certain estimates and judgments that affect
our reported assets, liabilities, revenues and expenses, and our related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various assumptions that
we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

2.     Revenue Recognition and Deferred Revenue

We recognize 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. During the nine months ended September 30, 2004
and 2003, we also had $5.5 million and $4.3 million, respectively, in hardware revenue, which commenced upon the acquisition of Eyretel. Product revenue, which includes software and
hardware, is recognized when persuasive evidence of an arrangement exists, delivery of the product has occurred, the fee is fixed or determinable, collection is probable and vendor specific objective
evidence ("VSOE") exists to allocate revenue to the undelivered elements of the

6

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arrangement. We report hardware revenue gross in accordance
with Emerging Issues Task Force ("EITF") No. 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent,because the factors indicating gross reporting outweigh the factors indicating net
reporting. We recognize revenue using the residual method of accounting since we have VSOE of fair value for maintenance and professional services, but not for the software and hardware elements of
the order. Under the residual method, services revenue, including maintenance and professional services, is deferred at an amount equal to its fair value until those elements are delivered.
Consequently, product revenue for the software and hardware may be recognized (i) upon delivery of those products when we have VSOE on the related maintenance and professional services sold and
(ii) at an amount representing the difference between the total order amount and the amount deferred.

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. Reimbursable travel expenses revenue is recognized upon incurrence of the related expenses. The
functionality of the software and any hardware sold is not dependent on installation and training services and customization
is not required to enable our customers to use our products.    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 is deferred and recognized ratably over the term of the related contract.

Deferred
revenue consists of amounts collected from customers for products and services that have not met the criteria for revenue recognition.

3.     Net Income (Loss) Per Share

The following is a reconciliation of the numerator and denominator used in the calculation of basic and diluted net income (loss) per share (in thousands, except
per share data):

|                             |                                                                                   | Three months ended
September 30,  |       | Nine months ended
September 30, |       
|---------------------------- | --------------------------------------------------------------------------------- | --------------------------------- | ----- | ------------------------------- | ------
|
|Net income (loss)            |                                                                                   | $                                 | 2,943 |                                 | $     
|                             |                                                                                   |                                   |       |                                 |       
|                             | Weighted average shares of common stock and common stock equivalents outstanding: |                                   |       |                                 |       
|                             | Basic                                                                             |                                   |       | 23,631                          |       
|                             | Dilutive effect of stock options computed using the treasury stock method         |                                   |       | 2,571                           |       
|                             |                                                                                   |                                   |       |                                 |       
|                             |                                                                                   | Diluted common shares outstanding |       |                                 | 26,202
|                             |                                                                                   |                                   |       |                                 |       
|Net income (loss) per share: |                                                                                   |                                   |       |                                 |       
|                             | Basic                                                                             |                                   | $     | 0.12                            |       
|                             |                                                                                   |                                   |       |                                 |       
|                             | Diluted                                                                           |                                   | $     | 0.11                            |       
|                             |                                                                                   |                                   |       |                                 |       

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We
have excluded all outstanding stock options from the calculation of historical diluted net loss per common share for the three and nine months ended September 30, 2003 because
we reported a loss in both periods and all such securities were anti-dilutive. The total number of shares excluded from the calculations of diluted net loss per common share for the three
and nine months ended September 30, 2003 was 933,051 and 613,052, respectively, using the treasury stock method. For the three months ended September 30, 2004 and 2003, 843,659 and
5,095,887 stock options, respectively, and for the nine months ended September 30, 2004 and 2003, 1,027,343 and 4,329,781 stock options, respectively, were excluded from the computation of
diluted earnings per share because they had exercise prices that exceeded the average fair market value of our common stock during those periods, and therefore had an anti-dilutive effect.

4.     Stock-Based Compensation

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 the disclosure requirements of SFAS No. 123. The following table illustrates the effect on net income (loss) and net
income (loss) per share if we had applied the fair value method as prescribed by SFAS No. 123 (in thousands, except per share data):

|                                                                                                       |            | Three months ended
September 30, |        | Nine months ended
September 30, |     
|------------------------------------------------------------------------------------------------------ | ---------- | -------------------------------- | ------ | ------------------------------- | ----
|
|Reported net income (loss)                                                                             |            | $                                | 2,943  |                                 | $   
|Add back: Stock-based employee compensation expense included in reported net income (loss)             |            |                                  | 44     |                                 |     
|Deduct: Total stock-based compensation expense determined under fair value based method for all awards |            |                                  | (2,458 | )                               |     
|                                                                                                       |            |                                  |        |                                 |     
|Pro forma net income (loss)                                                                            |            | $                                | 529    |                                 | $   
|                                                                                                       |            |                                  |        |                                 |     
|Net income (loss) per share:                                                                           |            |                                  |        |                                 |     
|                                                                                                       | Reported:  |                                  |        |                                 |     
|                                                                                                       |            | Basic                            |        | $                               | 0.12
|                                                                                                       |            |                                  |        |                                 |     
|                                                                                                       |            | Diluted                          |        | $                               | 0.11
|                                                                                                       |            |                                  |        |                                 |     
|                                                                                                       | Pro forma: |                                  |        |                                 |     
|                                                                                                       |            | Basic                            |        | $                               | 0.02
|                                                                                                       |            |                                  |        |                                 |     
|                                                                                                       |            | Diluted                          |        | $                               | 0.02
|                                                                                                       |            |                                  |        |                                 |     

As
of September 30, 2004, there were 1.7 million shares available for future grants under our stock option plans.

8

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5.     Comprehensive Income (Loss)

Total comprehensive income (loss) and accumulated other comprehensive income consisted of the following (in thousands):

|                                   |                                                   | Three months ended
September 30, |       | Nine months ended
September 30, |  
|---------------------------------- | ------------------------------------------------- | -------------------------------- | ----- | ------------------------------- | -
|
|Net income (loss)                  |                                                   | $                                | 2,943 |                                 | $
|Other comprehensive income (loss): |                                                   |                                  |       |                                 |  
|                                   | Unrealized net holding gain (loss) on investments |                                  |       | 70                              |  
|                                   | Foreign currency translation adjustments          |                                  |       | (164                            | )
|                                   |                                                   |                                  |       |                                 |  
|Total comprehensive income (loss)  |                                                   | $                                | 2,849 |                                 | $
|                                   |                                                   |                                  |       |                                 |  

|                                                    |  | September 30,
2004 |       | December 31,
2003 |  
|--------------------------------------------------- |  | ------------------ | ----- | ----------------- | -
|Cumulative foreign currency translation adjustments |  | $                  | 4,272 |                   | $
|Unrealized net holding loss on investments          |  |                    | (104  | )                 |  
|                                                    |  |                    |       |                   |  
|Total accumulated other comprehensive income        |  | $                  | 4,168 |                   | $
|                                                    |  |                    |       |                   |  

6.     Eyretel Acquisition

During the first quarter of 2003, we acquired a controlling interest in Eyretel. We 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 our
presence in international markets and to expand our product line by adding a full-time compliance recording solution. 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.

9

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The following summarizes the total purchase price for Eyretel (in thousands):

Purchase price (paid in cash)

$
55,269Direct transaction costs


4,458$
59,727


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. During the first quarter of 2004, we recorded our final adjustments to the purchase price allocation, the majority of which affected deferred income taxes and intangible assets. The
final purchase price allocation is as follows (in thousands):

Cash and investments

$
38,814Other current assets


22,438Property and equipment, net


2,597Identifiable intangible assets acquired:Acquired technology


10,700Distribution arrangements


4,124Customer lists


1,956Trademarks


1,007In-process research and development


7,840Total assets acquired


89,476Restructuring accruals


(5,254
)Deferred revenue


(5,512
)Other current liabilities


(16,165
)Other long-term liabilities


(2,536
)Deferred income taxes


(282
)Total liabilities assumed


(29,749
)$
59,727


The
fair values of identifiable intangible assets was determined with the assistance of Taylor Consulting Group, Inc., 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. We estimated that $7.8 million of the
purchase price of Eyretel represented acquired in-process research and development ("IPR&D") related to developing enhancements and new products for the voice and data recording, quality
monitoring and analysis industry 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. We 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.

10

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Supplemental
unaudited pro forma information reflecting the acquisition of Eyretel as if it occurred on January 1, 2003 is as follows (in thousands, except per share amounts):

Nine Months ended
September 30, 2003Total revenue

$
88,372Net loss

$
(23,187
)Net loss per sharebasic and diluted

$
(1.06
)Weighted average sharesbasic and diluted


21,947


The
pro forma results above include adjustments for the amortization expense of intangible assets arising from the acquisition and the reduction of interest income assuming the purchase
was paid from available cash. In addition, the pro forma results exclude the IPR&D charge and certain merger-related and other costs directly attributable to the acquisition.

7.     Acquisition-Related Restructuring Accruals and Merger-Related Costs

As a result of the Eyretel acquisition in March 2003, we recorded $5.3 million in certain acquisition-related restructuring accruals comprised of
Eyretel personnel reductions, the closing of certain Eyretel facilities and the accrual of abandoned leased premises. All such costs met the criteria for accrual as outlined in EITF
No. 95-3,Recognition of Liabilities in Connection with a Purchase Business Combination,and were included among the assets acquired
and liabilities assumed in the purchase of Eyretel. The following table summarizes the restructuring accrual activity for the full year 2003 and the nine months ended September 30, 2004,
included in accrued expenses and other long-term liabilities in the accompanying consolidated balance sheets (in thousands):

|                                      |                                                          | Severance
and Benefits |     | Facilities |   | Total |      
|------------------------------------- | -------------------------------------------------------- | ---------------------- | --- | ---------- | - | ----- | -----
|Accrual at December 31, 2002          |                                                          |                        |    |            |   |      |      
|                                      | Acquisition-related restructuring accruals               |                        | $   | 2,522      |   | $     | 2,436
|                                      | Cash payments                                            |                        |     | (2,138     | ) |       | (662 
|                                      | Foreign exchange translation                             |                        |     |           |   |       | 162  
|                                      |                                                          |                        |     |            |   |       |      
|Accrual at December 31, 2003          |                                                          | $                      | 384 |            | $ | 1,936 |      
|                                      | Adjustment to acquisition-related restructuring accruals |                        |     | (97        | ) |       | 393  
|                                      | Cash payments                                            |                        |     | (36        | ) |       | (444 
|                                      | Foreign exchange translation                             |                        |     | 9          |   |       | 94   
|                                      |                                                          |                        |     |            |   |       |      
|Accrual at September 30, 2004         |                                                          |                        | 260 |            |   | 1,979 |      
|                                      | Less: Long-term portion                                  |                        |     |           |   |       | 1,778
|                                      |                                                          |                        |     |            |   |       |      
|Current portion at September 30, 2004 |                                                          | $                      | 260 |            | $ | 201   |      
|                                      |                                                          |                        |     |            |   |       |      

11

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We
also accrued merger-related costs related to Witness lease terminations and severance associated with Witness employee terminations during the merger integration process that are
classified as merger-related costs in the accompanying consolidated statements of operations. All such costs met the criteria for accrual as outlined in Statement of Financial Accounting Standard
("SFAS") No. 146,Accounting for Costs Associated with Exit or Disposal Activities,and were recorded as merger-related costs in the accompanying
consolidated statements of operations for 2004 and 2003. The following table summarizes the merger-related cost accrual activity for the full year 2003 and the nine months ended September 30,
2004, included in accrued expenses in the accompanying consolidated balance sheets (in thousands):

|                              |                          | Severance
and Benefits |     | Facilities |   | Total |     
|----------------------------- | ------------------------ | ---------------------- | --- | ---------- | - | ----- | ----
|Accrual at December 31, 2002  |                          |                        |    |            |   |      |     
|                              | Merger-related provision |                        | $   | 1,470      |   | $     | 722 
|                              | Cash payments            |                        |     | (1,046     | ) |       | (722
|                              |                          |                        |     |            |   |       |     
|Accrual at December 31, 2003  |                          | $                      | 424 |            |   |      |     
|                              | Cash payments            |                        |     | (347       | ) |       |    
|                              |                          |                        |     |            |   |       |     
|Accrual at September 30, 2004 |                          | $                      | 77  |            |   |      |     
|                              |                          |                        |     |            |   |       |     

The
following table summarizes our merger-related costs for the three and nine months ended September 30, 2004 and 2003 (in thousands):

|                                                                  |       | Three months ended
September 30, |     | Nine months ended
September 30,
|----------------------------------------------------------------- | ----- | -------------------------------- | --- | -------------------------------
|
|Merger-related restructuring provisions (included in table above) |       |                                  |    |                                
|Integration costs                                                 |       |                                  |    |                                
|Bonus expense                                                     |       | $                                | 152 |                                
|Cost of sterling-based forward exchange contract                  |       |                                  |    |                                
|                                                                  |       |                                  |     |                                
|                                                                  | Total |                                  | $   | 152                            
|                                                                  |       |                                  |     |                                

We
incurred merger-related costs of $0.7 million for the nine months ended September 30, 2004, which related 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 a bonus of £1.0 million to our COO in connection with the Eyretel acquisition
and subsequent integration. In March 2004, £0.4 million of this bonus was paid and the remaining balance of £0.6 million (or $1.1 million as of
September 30, 2004) is due March 2005 but may be payable in advance under certain circumstances, such as a change of control. This COO bonus is being recognized over the related service
period through the first quarter of 2005 and is being recorded as merger-related costs.

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8.     Intangible Assets

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

September 30, 2004Gross
Amount

Accumulated
Amortization

Net
AmountAcquired technology

$
15,345

$
(8,566
)
$
6,779Distribution arrangements


4,281


(1,335
)

2,946Customer lists


2,355


(842
)

1,513Trademarks


1,212


(700
)

512Patents


237


(80
)

157$
23,430

$
(11,523
)
$
11,907


December 31, 2003Gross
Amount

Accumulated
Amortization

Net
AmountAcquired technology

$
17,120

$
(4,696
)
$
12,424Distribution arrangements


5,081


(849
)

4,232Customer lists


2,746


(455
)

2,291Trademarks


1,373


(379
)

994Patents


190


(48
)

142$
26,510

$
(6,427
)
$
20,083


The
intangible assets and amortization expenses are subject to foreign currency translation adjustments. 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,
|------------ | ----------------------------------- | -------------------------------- | ----- | -------------------------------
|
|Included in: |                                     |                                  |       |                                
|             | Cost of product revenue             |                                  | $     | 1,054                          
|             | Selling, general and administrative |                                  |       | 405                            
|             |                                     |                                  |       |                                
|             |                                     | $                                | 1,459 |                                
|             |                                     |                                  |       |                                

9.     Benefit Plans

Change of ControlIn November 2004 we entered into change of control agreements with our senior
officers, including our named executive officers. In general, these agreements provide the officers with severance benefits in the event of a change in control (as defined in the agreements) of the
company. They provide for receipt by the officer of a multiple of his (her) base salary and bonus, in a lump sum, as well as a minimum pro rata bonus for the year in which the change of control
occurs, and payment of COBRA continuation coverage, life insurance premiums and long-term disability insurance premiums for a fixed period of time. In addition, the agreements provide for
a gross-up payment for certain U.S. federal excise taxes that might result from the receipt of the severance payments. The severance payments vary by seniority, and involve multiples of
1.0, 1.5 or 2.0 times base salary and bonus. In the change of control agreements other than those for our CEO, COO and CFO, payments are made only if there is both a change of
control of the company and a termination of employment of the officer without cause, or by the officer for specified reasons. The agreements were approved by the Compensation Committee of our Board of
Directors and by our full Board.

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Director and Key Executive Stock Ownership Incentive PolicyIn December 2003, we adopted the Director and Key Executive
Stock Ownership Incentive Policy (the "Policy"). The Policy is intended to promote the interests of Witness and its stockholders by encouraging members of the Board of Directors and key executives to
purchase shares of our common stock. Under the Policy, an eligible person who purchases at least 500 shares and up to 3,000 shares of our common stock in the open market will be automatically and
immediately granted five options from our Amended and Restated Stock Incentive Plan (the "1999 Plan") for each share purchased, with an exercise price equal to the closing price of our common stock on
the date of purchase. One-half of the options will vest on the first anniversary of the grant date, and the remaining options will vest in 12 equal monthly installments thereafter. In the
first quarter of 2004, the Board of Directors extended the Policy to remain in effect until June 15, 2004, when it expired. As of September 30, 2004, 122,500 options had been granted
under this Policy.

1999 PlanIn June 2004, the Compensation Committee of our Board of Directors directed that the term of stock options to
be issued under the 1999 Plan be fixed at five years for all grants made subsequent to July 1, 2004.

10.   Line of Credit

In March 2004, we extended the maturity date on our $15.0 million line of credit to March 2005. At our election, borrowings under the line of
credit bear interest at the bank's prime rate or LIBOR plus 300 basis points with interest payable monthly. 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 of our assets and requires compliance with various covenants, including liquidity ratios and tangible net worth
requirements, among others. As of September 30, 2004, we were in compliance with all bank covenants.

As
of September 30, 2004, we had no amounts outstanding under the line of credit and the amount available for borrowing was $12.2 million, which was net of outstanding
letters of credit of $2.8 million. The letters of credit secure the leases on the corporate headquarters facility and have decreasing schedules that ultimately expire in 2007. In addition, we
have a £0.3 million letter of credit securing our premises in the United Kingdom.

11.   Segment and Geographic Information

We consider ourselves to be in a single industry segment, specifically licensing and servicing of software applications to the customer interaction recording and
analysis market. Our chief operating decision maker receives financial information by geographic region; however, our operating segments are aggregated into one reportable segment based upon similar
economic characteristics, products, services and delivery methods.

World-wide
annual revenue based on customer domicile is as follows (in thousands):

|               |       | Three months ended
September 30, |        | Nine months ended
September 30,
|-------------- | ----- | -------------------------------- | ------ | -------------------------------
|
|United States  |       | $                                | 17,489 |                                
|United Kingdom |       |                                  | 10,369 |                                
|Rest of world  |       |                                  | 7,399  |                                
|               |       |                                  |        |                                
|               | Total |                                  | $      | 35,257                         
|               |       |                                  |        |                                

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The
rest of world revenue was derived primarily from customers located in Australia, Canada, China, Continental Europe, India, and Japan. No individual customer accounted for more than
10% of consolidated revenue during the three or nine months ended September 30, 2004 or 2003.

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

|               |       | September 30,
2004 |       | December 31,
2003
|-------------- | ----- | ------------------ | ----- | -----------------
|United States  |       | $                  | 5,551 |                  
|United Kingdom |       |                    | 9,437 |                  
|Rest of world  |       |                    | 2,976 |                  
|               |       |                    |       |                  
|               | Total |                    | $     | 17,964           
|               |       |                    |       |                  

12.   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 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 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 and, consequently, an estimate of the potential outcome cannot be made. However, we do not believe the ultimate resolution will have a material adverse effect on our financial position,
results of operations or cash flows.

On
July 20, 2004, STS Software Systems Ltd. ("STS Software"), a wholly-owned subsidiary of NICE Systems, Ltd. ("NICE Ltd."), filed a patent infringement suit
in the U.S. District Court for the Southern District of New York against us. The suit asserts that our products, including eQuality ContactStore for IP, infringe U.S. Patent No. 6,122,665 ("the
'665 patent"). On the same day, we filed a declaratory judgment action against STS Software in the U.S. District Court for the Northern District of Georgia. We are seeking a declaration from the court
that we have not infringed any valid claim of the '665 patent. Both suits are at the most preliminary stages. We are unable to assess the impact, if any, on our financial position, results of
operations or cash flows.

On
August 30, 2004, we filed in the United States District Court for the Northern District of Georgia, Atlanta Division, a lawsuit against NICE Systems, Inc.
("NICE Inc."), a wholly-owned subsidiary of NICE Ltd., alleging patent infringement. Specifically, we have alleged that NICE products, including its screen capture and synchronized
screen and voice capture technologies, infringe claims of United States Patent Nos. 5,790,798 ("the '798 Patent") and 6,510,220 ("the '220 Patent"), both entitled "Method and Apparatus for
Simultaneously Monitoring Computer User Screen and Telephone Activity from a Remote Location." We have sought an injunction and money damages for NICE's infringement of these two patents.
NICE Inc. has answered and counterclaimed for declaratory judgments of non-infringement and invalidity. This suit is at the most preliminary stage. We are unable to assess the
impact, if any, on our financial position, results of operations or cash flows.

15

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We
are not party to any other litigation or other legal proceedings that we believe could have a material adverse effect on our financial position, results of operations or cash flows.

13.   Recent Accounting Pronouncements

In December 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation ("FIN") No. 46-R, Consolidation of Variable Interest
Entities. This Interpretation of Accounting Research Bulletin No. 51,Consolidated
Financial Statements, addresses consolidation by business enterprises of variable interest entities. For enterprises that are not small business issuers, FIN
No. 46-R is to be applied to all variable interest entities by the end of the first reporting period ending after March 15, 2004. Our adoption of FIN
No. 46-R did not have an impact on our financial position, results of operations or cash flows.

In
March 2004, the FASB issued EITF Issue No. 03-1,The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments. EITF No. 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity instruments, as
well as new disclosure requirements for investments that are deemed to be temporarily impaired. The accounting guidance provided in EITF No. 03-1 is effective for fiscal years
beginning after June 15, 2004, while the disclosure requirements are effective for annual periods ending after June 15, 2004. We do not expect the adoption of EITF
No. 03-1 will have a material impact on our financial position, results of operations, or cash flows.

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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 28.

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 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.

We
derive product revenue by licensing software and derive services revenue by providing related installation, training, consulting, and maintenance services. We also derived
$5.5 million and $4.3 million of product revenue by selling hardware to customers during the nine months ended September 30, 2004 and 2003, respectively, which commenced upon the
acquisition of Eyretel plc ("Eyretel") in March 2003. To date, eQuality Balance and eQuality ContactStore, our business-driven and/or full-time customer interaction
recording solutions, have generated the majority of our product revenue and will continue to do so throughout 2004. We sell our products through direct and indirect sales channels. Our indirect sales
channel consists of distributors and resellers that purchase product from us at a discount and then resell our products to end-users (or, in the case of distributors, to other resellers)
and referral partners who are paid a fee for referring sales leads and/or assisting us in the sales process.

We
plan to grow our product revenue and maintain our competitive position from a technology perspective through the timely introduction of new products, such as performance analysis and
e-learning management applications, and platforms, such as voice over Internet protocol ("VoIP") product offerings, all of which are currently offered to our customers. Although sales of
such products were not material to our total revenue during the nine months ended September 30, 2004 and 2003, we believe that our VoIP product offerings represent a material growth opportunity
as the market transitions to an Internet protocol ("IP") technology environment. In addition, we believe our product offerings can be marketed toward back-office initiatives for business
process monitoring, which represents a new market for us. We also intend to expand our global sales

17

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channels by continuing to enter into
reseller, distributor and similar arrangements with key vendors in the contact center workforce optimization market. However,
factors that may influence our ability to grow our product revenue include our ability to remain competitive from a technology perspective; market acceptance of our new products; our ability to
maintain our product pricing integrity; and our ability to expand our global sales channels.

We
plan to grow our services revenue in concert with our product revenue. When our customers license our products, they generally purchase installation, training and one year of support
services. Therefore, as we generate product revenue, we also generate related services revenue. In addition, our customers generally renew their maintenance contracts with us each year. Therefore, our
maintenance revenue generally increases as our customer base increases. However, factors that may influence our ability to grow our services revenue include our ability to continue to increase product
revenues and our ability to maintain a high level of customer satisfaction.

Corporate
spending for information technology ("IT") and customer relationship management ("CRM") applications decreased in 2002 and remained relatively flat in 2003, as compared to
prior years. While the economic environment remains challenging, there were indications of an improving economic outlook and IT spending showed signs of improvement beginning in the latter part of
2003. As a result, we have experienced revenue growth throughout 2004 and forecasted additional revenue growth for 2005.

In
April 2004, we announced a strategic initiative to expand our software development capabilities in the Asia-Pacific region. As of September 30, 2004, we have
approximately doubled our development capacity with approximately 150 contractors and incurred approximately $2.5 million for equipment and duplicative ramp-up, salaries, training
and severance costs associated with the development transition. We expect to incur costs of approximately $1.8 million during the fourth quarter of 2004 associated with this initiative.

During
the second quarter of 2003, we completed the acquisition of Eyretel, a United Kingdom-based provider of compliance and recording solutions for customer contact centers, for
$59.7 million. We acquired Eyretel with the intent to extend our presence in international markets and to expand our product line by adding a full-time compliance recording
solution. Our product offerings were complementary to those of Eyretel's. Prior to the acquisition, our principal focus had been software to improve the quality of contact center performance, whereas
substantially all of Eyretel's sales were attributable to its full-time compliance recording solution. In addition to this opportunity to expand our product line, Eyretel was attractive to
us because it derived nearly half of its revenues from Europe, the Middle East and Africa, and another 24% from the Asia Pacific region, and thus afforded us an opportunity to quickly gain access to
those markets, and to quickly expand our indirect sales channel. During 2003, we successfully integrated the two companies in terms of product offerings and business operations. We began consolidating
Eyretel's results on March 22, 2003, the date we assumed majority ownership of Eyretel.

We
are headquartered in Roswell, Georgia and have other offices throughout the United States. We deliver our products and services internationally through our offices in Australia,
Brazil, Canada, China, Germany, Japan, Mexico, the Netherlands, Singapore and the United Kingdom. During the nine months ended September 30, 2004 and 2003, 48% and 44%, respectively, of our
revenue was derived from customers outside the United States. We had 486 full-time employees at September 30, 2004, compared to 517 at September 30, 2003.

18

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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 of America. The preparation of these financial statements requires us to make certain 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 re-evaluate our estimates,
including those related to revenue recognition, the collectibility of receivables, accounting for acquisitions, impairment of long-lived assets, income taxes and stock-based compensation.
We base our estimates on
historical experience and on various assumptions that we believe to be reasonable under the circumstances. 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 revenue
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, results of operations and cash flows. A summary of our critical accounting policies follows.

Revenue Recognition.We recognize revenue in accordance with Statement of Position ("SOP") No. 97-2, Software Revenue Recognition,and SOP No. 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. During the nine
months ended September 30, 2004 and 2003, we also had $5.5 million and $4.3 million, respectively, in hardware revenue, which commenced upon the acquisition of Eyretel. Product
revenue, which includes software and hardware, is recognized when persuasive evidence of an arrangement exists, delivery of the product has occurred, the fee is fixed or determinable, collection is
probable and vendor specific objective evidence ("VSOE") exists to allocate revenue to the undelivered elements of the arrangement. We report hardware revenue gross in accordance with Emerging Issues
Task Force ("EITF") No. 99-19,Reporting Revenue Gross as a Principal versus Net as an Agent,because the factors indicating gross
reporting outweigh the factors indicating net reporting. We recognize revenue using the residual method of accounting since we generally have VSOE of fair value for maintenance and professional
services, but not for the software and hardware elements of the order. Under the residual method, services revenue, including maintenance and professional services, is deferred at an amount equal to
its fair value until those elements are delivered. Consequently, product revenue for the software and hardware may be recognized (i) upon delivery of those products when we have VSOE on the
related maintenance and professional services sold and (ii) at an amount representing the difference between the total order amount and the amount deferred. 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. Reimbursable travel expenses revenue is recognized upon incurrence of the related expenses. The functionality of the software and any hardware
sold is not dependent on installation and training services and customization is not required to enable our customers to use our products. 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 is deferred and recognized ratably over the term of the related
contract.

19

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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 and estimates 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 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 customer credits and other known factors. If future sales credits prove to be greater than the historical data and the estimates we
used to calculate these provisions, our 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 and resulted 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.

Accounting for Acquisitions.Accounting for acquisitions requires management to make judgments and estimates in determining
the purchase price, the fair value of the assets and liabilities acquired and merger-related and restructuring expenses. In recording the Eyretel acquisition in 2003, management estimates primarily
related to the following purchase price components or merger-related costs:



Changes
to purchase price estimates, prior to the completion of the final purchase price allocation, are reflected as adjustments to goodwill and/or other acquired assets. Subsequent
adjustments would be reflected in our results of operations.

Impairment of Long-lived Assets.Long-lived assets, such as property and equipment and intangible
assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. All of our intangible assets are amortized using
the straight-line method. 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 would be 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. The determination of estimated future cash flows, however, would require management to make estimates. Future events and changes in circumstances may require us to record
a significant impairment charge in the period in which such events or changes occur. 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.

20

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Accounting for Income Taxes.We account for income taxes in accordance with Statement of Financial Accounting Standards
("SFAS") No. 109,Accounting for Income Taxes, which requires companies to recognize deferred income tax assets and liabilities using enacted tax
rates for temporary differences between the book and tax bases of recorded assets and liabilities. SFAS No. 109 also requires that deferred income tax assets be reduced by a valuation allowance
if it is more likely than not that some portion or all of the deferred income tax asset will not be realized. We evaluate the realizability of our deferred income tax assets quarterly by assessing our
valuation allowance and by adjusting the amount of such allowance, if necessary. At September 30, 2004, we had net deferred income tax liabilities primarily resulting from temporary differences
between the book and tax bases of assets and liabilities, and loss and credit carry forwards. We continue to provide a valuation allowance on our deferred income tax assets based on an assessment of
the likelihood of their realization. In reaching our conclusion, we evaluated certain relevant criteria including deferred income tax liabilities that can be used to offset deferred income tax assets,
estimates of future taxable income of appropriate character within the carry forward period available under the tax law, and tax planning strategies. Our judgments regarding future taxable income may
change due to market conditions, changes in U.S. or international tax laws, and other factors. These changes, if any, may require material adjustments to these deferred income tax assets, resulting in
a tax benefit if it is estimated that future taxable income is likely.

Once
the deferred income tax asset is realized through the utilization of net operating loss carryforwards, we would expect our provision for income taxes in future periods to reflect a
normalized effective tax rate that would be significantly higher than past periods.

In
addition, we have provided for potential tax liabilities due in foreign jurisdictions. Judgment is required in determining our worldwide income tax expense provision. In the ordinary
course of conducting a global business enterprise, there are many transactions and calculations undertaken whose ultimate tax outcome cannot be certain. Some of these uncertainties arise as a
consequence of transactions and arrangements made among related parties. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome of these matters will
not be different from what is reflected in our historical income tax provisions and accruals. Such differences could have a material impact on our income tax provision and operating results in the
period in which such a determination is made.

Stock-Based Compensation.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 the disclosure requirements of SFAS No. 123. The pro forma disclosures of stock-based compensation include 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. On March 31, 2004, the Financial Accounting Standard Board
("FASB") issued an Exposure Draft,Share-Based Payment: an amendment of FASB Statements No. 123 and 95, which requires the mandatory expensing of
stock options. While the final statement is subject to change, it is currently anticipated that it will become effective for interim periods beginning after June 15, 2005. We will continue to
monitor communications on this subject from the FASB in order to determine the impact to our financial statements.

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Results of Operations

The following table sets forth the results of operations for the three and nine months ended September 30, 2004 and 2003 expressed as a percentage of total
revenue.

|                                     |                                                 | Three Months Ended
September 30, |    | Nine Months Ended
September 30, |   
|------------------------------------ | ----------------------------------------------- | -------------------------------- | -- | ------------------------------- | --
|
|Revenue:                             |                                                 |                                  |    |                                 |   
|                                     | Product                                         |                                  | 39 | %                               | 39
|                                     | Services                                        |                                  | 61 | %                               | 61
|                                     |                                                 |                                  |    |                                 |   
|                                     |                                                 | Total revenue                    |    | 100                             | % 
|                                     |                                                 |                                  |    |                                 |   
|Cost of revenue:                     |                                                 |                                  |    |                                 |   
|                                     | Product                                         |                                  | 8  | %                               | 9 
|                                     | Services                                        |                                  | 23 | %                               | 23
|                                     |                                                 |                                  |    |                                 |   
|                                     |                                                 | Total cost of revenue            |    | 31                              | % 
|                                     |                                                 |                                  |    |                                 |   
|                                     |                                                 | Gross profit                     |    | 69                              | % 
|Operating expenses:                  |                                                 |                                  |    |                                 |   
|                                     | Selling, general and administrative             |                                  | 46 | %                               | 55
|                                     | Research and development                        |                                  | 16 | %                               | 17
|                                     | Merger-related costs                            |                                  | 0  | %                               | 6 
|                                     | Acquired in-process research and development    |                                  | 0  | %                               | 0 
|                                     |                                                 |                                  |    |                                 |   
|                                     |                                                 | Operating income (loss)          |    | 7                               | % 
|Interest and other income, net       |                                                 | 1                                | %  | 1                               | % 
|                                     |                                                 |                                  |    |                                 |   
|                                     | Income (loss) before provision for income taxes |                                  | 8  | %                               | (9
|(Benefit) provision for income taxes |                                                 | 0                                | %  | 0                               | % 
|                                     |                                                 |                                  |    |                                 |   
|                                     | Net income (loss)                               |                                  | 8  | %                               | (9
|                                     |                                                 |                                  |    |                                 |   

Impact of Eyretel Acquisition

We largely completed the integration of Eyretel during the second quarter of 2003 by substantially combining all product lines, sales, services, development,
marketing and support functions. We estimate that the acquisition of Eyretel contributes approximately $50 million of additional annual revenue and that we have achieved approximately
$20 million of annual expense savings, primarily though reductions in overhead and personnel. We believe that revenue and expenses beginning in the last half of 2003 reflect the full impact of
the Eyretel acquisition and integration. Consequently, the acquisition of Eyretel increased our reported revenues and expenses in the nine months ending September 30, 2004 as compared to the
same year-ago period. In addition, our gross profit margins were adversely impacted during the 2004 and 2003 periods due to the inclusion of hardware revenue without any significant profit
margin and amortization of intangible assets arising from the Eyretel acquisition. Operating expenses, expressed as a percentage of total revenue, decreased in the nine months ending
September 30, 2004, as compared to the same year-ago period, due to the decrease of $7.8 million for the acquired in-process research and development, the
decrease of $5.5 million in merger-related costs and the aforementioned increase in revenue and expense savings following the acquisition of Eyretel.

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Revenue

Total revenue increased 26% and 38% for the three and nine months ended September 30, 2004, respectively, compared to the same year-ago periods
due to increases in product and services revenue. The growth in revenue for the nine months period also reflects three quarters of revenue from the Eyretel acquisition compared to only two full
quarters in 2003. During the third quarter of 2004, we installed an additional 139 customer sites, bringing our total number of installed customer sites to 2,688 versus approximately 2,200 at
September 30, 2003. International revenue increased 50% for the nine months ended September 30, 2004, compared to the same year-ago period, due to the Eyretel acquisition,
which was based in the United Kingdom
and had a broader international presence than we previously had, and due to increased sales in our existing international operations. In addition, the weakening of the U.S. dollar against certain
foreign currencies increased revenue by 5% for both the three and nine months ended September 30, 2004, compared to the same year ago periods.

Product
revenue includes software revenue and hardware revenue. Hardware revenue was a new revenue stream beginning in the second quarter of 2003 resulting from the Eyretel acquisition.
Because hardware sales negatively impact our gross profit, we are working towards transitioning our customers to third-party hardware suppliers and, as a result, expect hardware revenue to eventually
begin to decline. For the three and nine months ended September 30, 2004, product revenue, excluding hardware revenue of $1.2 million and $5.5 million, respectively, increased 27%
and 32%, respectively, compared to the same year-ago periods due to increased sales in international markets and to an increase in the number of product offerings within our software
product suite. The increase during the nine months ended September 30, 2004, compared to the same year-ago period was also attributable to the Eyretel acquisition.

During
the third quarters of 2004 and 2003, 30% and 23%, respectively, of product revenue was attributable to new customers with remaining revenue representing follow-on
revenue from our existing customer base. We receive follow-on product revenue from our customers when they purchase additional user licenses or license additional applications at existing
sites and when they license our products for use at new sites. Product revenue as a percentage of total revenue, excluding hardware revenue, was 37% and 38% in the three and nine months ended
September 30, 2004, respectively, compared to 37% and 39% in the same year-ago periods. Our product pricing has remained relatively consistent over the past two years. We expect
product revenue to remain relatively constant as a percentage of total revenue, excluding hardware revenue, for the remainder of 2004 and into 2005. During the nine months ended September 30,
2004 and 2003, 32% of total product revenue was derived from our indirect sales channel. If a substantial number of our indirect sales partners were to terminate their relationships with us, it could
have a material effect on our revenues.

Services
revenue, consisting of installation, training, consulting, maintenance support and reimbursable travel expenses, increased 26% and 43% in the three and nine months ended
September 30, 2004, respectively, compared to the same year-ago periods. These increases were primarily due to the installation and training services related to new product sales
and customers renewing their maintenance contracts with us thereby increasing our recurring maintenance revenue stream. The increase during the nine months ended September 30, 2004, compared to
the same year-ago period was also attributable to the Eyretel acquisition. The percentage of Witness customers that have renewed their maintenance contracts with us has historically
exceeded 90%. We believe that maintenance contracts will be renewed at a comparable rate for the remainder of 2004 and into 2005. Services revenue as a percentage of total revenue, excluding hardware
revenue, was 63% and 62% in the three and nine months ended September 30, 2004, respectively, compared to 63% and 61% in the same year-ago periods. Our services pricing has remained
consistent over the past two years. We expect services revenue, in absolute dollars, to increase over time due to the compounding effect of renewals of annual maintenance contracts from existing
customer sites, and to remain relatively constant as a percentage of total revenue, excluding hardware revenue, for the remainder of 2004 and into 2005.

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Cost of Revenue

Total cost of revenue increased 21% and 43% in the three and nine months ended September 30, 2004, respectively, compared to the same year-ago
periods. Excluding hardware cost of revenue, which was a new cost beginning in the second quarter of 2003 due to the Eyretel acquisition, and the amortization of intangible assets resulting from the
Eyretel acquisition, gross profit margins remained constant at 75% in the third quarter of 2004 and 2003, and declined slightly to 73% in the nine months ended September 30, 2004, from 74% in
the same year-ago period. We expect our gross profit margin, excluding hardware and amortization of intangible assets, to remain relatively constant for the remainder of 2004 and into
2005.

Cost
of product revenue primarily consists of amortization of acquired technology, hardware, royalties due to third parties for software components that are embedded in our software
applications, amortization of capitalized software product costs and packaging costs. Amortization of acquired technology decreased to $1.1 million in the third quarter of 2004 compared to
$1.3 million in the same year-ago period due to purchase price adjustments finalized in the first quarter of 2004. For the nine months ended September 30, 2004, amortization
of acquired technology increased to $3.8 million from $2.7 million for the same year-ago period due primarily to three quarters in the 2004 period of amortization of the
acquired technology from Eyretel in March 2003 compared to two quarters in the 2003 period. Cost of hardware revenue increased to $1.1 million and $5.1 million for the three and
nine months ended September 30, 2004, respectively, compared to $0.9 million and $3.6 million for the same year-ago periods. We will continue to incur amortization
expense, but expect the cost of hardware to decline as we work towards reducing the amount of hardware sales in the future. For the three and nine months ended September 30, 2004, cost of
product revenue, excluding hardware costs and amortization of acquired technology, increased 218%
and 13%, respectively, compared to the same year-ago periods. The third quarter year-over-year increase was due to capitalized software development product costs
now being amortized and royalties due to third parties for software components that are embedded in our software applications. As we develop upgrades of our existing products and add new offerings to
our product suite, we may embed third-party technology into our software, which would increase the cost of product revenue in the future.

Cost
of services revenue for installation, training, consulting and maintenance services include personnel costs and related expenses and allocated overhead. Personnel costs include
salaries, bonuses and benefits. Cost of services revenue increased 23% and 46% in the three and nine months ended September 30, 2004, respectively, compared to the same year-ago
periods, due primarily to an increase in the number of employees and contractors engaged in customer maintenance services. The increase for the nine months ended September 30, 2004, compared to
the same year-ago period, was also attributable to the Eyretel acquisition. Cost of services revenue as a percentage of services revenue was 38% in the third quarter of 2004 compared to
39% in the third quarter of 2003. This slight improvement was primarily due to an increase in the higher margin maintenance revenue as a percentage of total services revenue. For the nine months ended
September 30, 2004, cost of services revenue as a percentage of services revenue was 40% compared to 39% in the same year-ago period. This increase was primarily due to the cost of
providing hardware support, as we had only two full quarters of hardware support in the nine months ended September 30, 2003, contrasted with three quarters in the nine months ended
September 30, 2004. This increase offset the aforementioned third quarter year-over year services margin improvement. We anticipate that our services margins will continue in this
range or may show a slight improvement for the remainder of 2004 and into 2005. We expect our customer service organization to continue to grow over time and, therefore, we anticipate that our cost of
services revenue, in absolute dollars, will increase as we grow our customer base. During the third quarter of 2004, we began to expand our customer support organization in the
Asia-Pacific region. However, we do not expect to incur any significant incremental costs associated with this initiative.

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Operating Expenses

Selling, General and Administrative.Selling, general and administrative ("SG&A") expense consists primarily of personnel
costs, sales commissions, marketing programs, professional fees, the amortization of certain intangible assets and provisions for bad debt expense. SG&A expense increased 7% in the third quarter of
2004 compared to the same year-ago period due primarily to increased third-party costs associated with complying with the rules and regulations of the Sarbanes-Oxley Act of 2002 and
increased legal fees. For the nine months ended September 30, 2004, SG&A expense increased 12% compared to the same year-ago period due primarily to higher personnel and overhead
costs resulting from an increase in the number of employees engaged in sales, marketing and
general and administrative functions as a result of the Eyretel acquisition, increased third-party costs associated with complying with the rules and regulations of the Sarbanes-Oxley Act of 2002 and
increased legal fees. SG&A expense as a percent of total revenue decreased for the three and nine months ended September 30, 2004, compared to the same year-ago periods due to the
increases in total revenue and to a lesser extent due to decreased provisions for bad debt expense in the 2004 periods. We expect SG&A expense as a percentage of total revenue to be relatively
constant in the near future as year-over-year revenue growth offsets increased internal and third-party costs associated with complying with the rules and regulations of the
Sarbanes-Oxley Act of 2002 in addition to increased litigation fees.

Research and Development.Research and development ("R&D") expense consists primarily of personnel and consulting costs to
support product development, and allocated overhead. R&D costs are generally expensed as incurred and include software development costs incurred prior to the establishment of technological
feasibility. Costs incurred subsequent to establishing technological feasibility are capitalized and amortized over their estimated useful lives to cost of product revenue. As of September 30,
2004, $0.8 million in software development costs have been capitalized and $0.2 million has been amortized during the nine months ended September 30, 2004 to cost of product
revenue. R&D expenses increased 14% and 15% in the three and nine months ended September 30, 2004, respectively, compared to the same year-ago periods due primarily to an increase
in the number of employees and consultants engaged in research and development activities. In April 2004, we began implementing a strategic initiative to significantly expand and improve our
development capabilities by transitioning a portion of our development function to the Asia-Pacific region. As of September 30, 2004, we approximately doubled our development
capacity with approximately 150 contractors and incurred approximately $2.5 million for equipment and duplicative ramp-up, training and severance costs associated with the
development transition. We expect to incur approximately an additional $1.8 million during the fourth quarter of 2004 associated with this initiative. We expect total R&D expense in absolute
dollars and as a percentage of total revenue to decrease during 2005 compared to the prior periods.

Merger-related Costs.We incurred merger-related costs of $0.7 million for the nine months ended September 30,
2004, which related 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 a bonus of
£1.0 million to our COO in connection with the Eyretel acquisition and subsequent integration. In March 2004, £0.4 million of this bonus was paid and the
remaining balance of £0.6 million (or $1.1 million as of September 30, 2004) is due March 2005 but may be payable in advance under certain circumstances, such
as a change of control. We incurred merger-related costs of $6.2 million for the nine months ended September 30, 2003, which 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 Witness, $0.7 million of facilities costs to consolidate Witness' facilities, $0.9 million of expenses related to Witness employee severance
and benefits and $0.4 million relating to the partial accrual of a bonus payable to our COO. We expect to incur merger-related costs through the first quarter of 2005 related only to the COO
bonus, which is being recognized over the related service period.

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Acquired In-Process Research and Development Charges.In the first quarter of 2003, 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 as defined by
SFAS No. 86,Accounting for the Cost of Computer Software to Be Sold, Leased or Otherwise Marketed,and had no alternative future use.
Accordingly, these amounts were immediately charged to expense upon consummation of the acquisition. The value of the IPR&D was calculated with the assistance of an independent third-party appraiser
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.

Interest and Other Income, Net

Interest and other income, net consists primarily of interest earned on funds available for investment and foreign currency transaction gains and losses on
settlement of foreign denominated contracts. Interest and other income, net increased 36% in the third quarter of 2004 compared to the same year-ago period due to increased interest income
resulting from higher cash and investment balances. For the nine months ended September 30, 2004, interest and other income, net decreased 37% due primarily to a decrease in net foreign
currency transaction gains in the 2004 periods compared to the same year-ago periods. We expect that interest and other income, net will remain relatively constant through the remainder of
2004 and into 2005 compared to the prior periods.

Provision for Income Taxes

We recorded provisions for foreign income tax and federal alternative minimum tax in both the three and nine months ended September 30, 2004 and 2003. The
provision in the third quarter of 2004 was offset by a benefit resulting from the accretion of a deferred tax liability. Deferred income tax assets are normally recognized for deductible temporary
differences and net operating loss and tax credit carryforwards. We have recorded a valuation allowance against deferred income tax assets generated primarily as a result of net operating loss
carryforwards as the future realization of the tax benefits is not currently considered more likely than not.

Liquidity and Capital Resources

At September 30, 2004, we had $62.9 million in total cash and cash equivalents and investments which was $22.0 million higher than the
$40.9 million held at December 31, 2003. Working capital also increased by $23.1 million from $28.7 million at December 31, 2003 to $51.8 million at
September 30, 2004. Accrued expenses decreased by $7.6 million at September 30, 2004, from December 31, 2003, due primarily to payment of acquisition-related and
merger-related restructuring accruals, accrued merger-related costs and a lower commission accrual at September 30, 2004, compared to December 31, 2003.

Cash
flows from operating activities during the nine months ended September 30, 2004, provided $12.3 million compared to cash flows used in operating activities of
$2.7 million in same year-ago period. This increase was due primarily to the increase in operating income, exclusive of non-cash items, which increased to
$13.3 million during the nine months ended September 30, 2004, from ($1.1) million in the same year-ago period. This increase resulted from the improvement in operating
performance and the reduction in merger-related costs incurred during the respective periods. In addition, our accounts receivable days sales outstanding ("DSO") decreased from 85 days at
December 31, 2003 to 72 days at September 30, 2004. We currently expect our DSO to remain in the low to mid 70s during the remainder of 2004 and during 2005.

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Cash
flows used in investing activities during the nine months ended September 30, 2004, were ($19.0) million, which consisted of the purchase of additional investment securities
and $2.2 million of capital expenditures made primarily for computer equipment and leasehold improvements. Cash flows provided by investing activities were $3.3 million in the nine
months ended September 30, 2003, which included the sale of investment securities of $26.9 million to initially fund the Eyretel acquisition partially offset by the acquisition of
Eyretel for $21.5 million (net of $38.8 million in cash held by Eyretel) and certain other assets purchased for $2.4 million from a software and services company focused on the
business intelligence marketplace.

Cash
flows provided by financing activities during the nine months ended September 30, 2004, were $11.4 million as compared to $0.3 million for the same
year-ago period. The increase was due to a $10.8 million increase in proceeds from the exercise of stock options. At this time, we do not anticipate making any further repurchases
under our $10 million stock repurchase authorization. Under that authorization, we repurchased a total of $3.1 million of our stock, but have made no repurchases in 2004.

At
September 30, 2004, we had $12.2 million available under a line of credit, which was net of outstanding letters of credit of $2.8 million. The letters of credit
secure the lease on our corporate
headquarters facility and have decreasing schedules that ultimately expire in 2007. At our 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. As of September 30, 2004, we were in compliance with all bank covenants.

We
anticipate that capital expenditures will continue to be a material use of our cash resources. We currently expect to have total capital expenditures of approximately
$3.0 million in 2004. 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. Our cash, cash equivalents and investments, plus the availability under our line of credit, may be used to fund future merger or acquisition transactions. Our shelf registration
statement on Form S-3 (including subsequent amendments) with the Securities and Exchange Commission ("SEC") became effective in August 2004. The shelf registration statement
allows us to register up to $80 million of securities, which may consist of common stock or warrants to purchase our common stock. The shelf registration statement provides us the ability to
raise equity capital if and when appropriate for our business. The sale of additional equity securities could result in additional dilution to our stockholders. If cash generated from operations is
insufficient to satisfy our liquidity requirements and we are unable or choose not to raise additional equity capital, we may seek to establish new financing arrangements. We cannot assure that any
financing arrangements will be available in sufficient amounts or on acceptable terms.

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Market Risk

Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and rates. Our market risk exposure primarily relates
to fluctuations in foreign exchange rates and interest rates. Except for the hedge transaction entered into in connection with the Eyretel acquisition, we have not entered into derivative or hedging
transactions to manage risk in connection with foreign exchange fluctuations and have not engaged in any interest rate hedging transactions. Due to the current strength of foreign currencies compared
to the U.S. dollar, foreign currency translations contributed $1.0 million to our September 30, 2004 cash balance as a result of our subsidiaries' cash being denominated in foreign
currencies.

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, as a result of the
acquisition of Eyretel, as well as our other foreign-based operations, we engage in transactions that may be denominated in foreign currencies and thus generate market risk with respect to
fluctuations in the relative value of these currencies as compared to the U.S. dollar. 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, strengthening of the U.S. dollar against foreign currencies
could have a material adverse effect on our financial results. Net foreign currency transaction gains, included in interest and other income, net, were $0.1 million and $0.4 million for
the nine months ended September 30, 2004 and 2003, respectively.

Exposure
to market rate risk for changes in interest rates relates to our investment portfolio. 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 reduce our balance sheet exposure to
variations in asset values, our investment policy guidelines specify that we invest in the highest investment grade securities and maintain a weighted average maturity of nine months for our entire
portfolio. Our investment portfolio may contain securities with maturities of up to three years. While this minimizes our interest rate risk to asset values, our results are exposed to fluctuations in
interest income due to changes in market rates.

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 should consider the following factors in evaluating our business or an
investment in our securities. If any of the following or other risks actually occurs, our business, financial condition and results of operations could be adversely affected. In that case, the trading
price of our common stock could decline.

Because our products have a long sales cycle, it is difficult to plan our expenses and forecast our results; and our operating results may fail to meet investor expectations,
which may adversely affect our stock price.

It
typically takes three to nine months from the time we qualify a sales lead until we sign a sales contract with the customer. As a result, it is difficult for us 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 most of our corresponding expenses. Lengthening of our sales cycle could also increase the total cost of a sale due to additional employee time and costs associated with the sale.
Material changes in our sales cycle could cause our quarterly revenue or operating results to be below the expectations of investors, and the price of our common stock could fall substantially.

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Our
customers' decision process regarding their purchase of our products and services is relatively long due to several factors, including:



If our products and services are not used and accepted by existing and prospective customers, our business and results of operations will be adversely
affected.

The
market for customer relationship management software, including software that records and analyzes customer interactions, is still developing. Our success depends on the use and
acceptance of our software and services by existing and prospective customers. In addition, demand for our software remains uncertain because our existing and potential customers may:



If we experience losses from operations in the future, the market price of our common stock may be materially and adversely affected.

With
the exception of the first nine months of 2004 and the first half of 2002, we have historically experienced quarterly losses from operations. We will need to generate sufficient
revenue to achieve sustained profitability and avoid incurring losses again in the future. As a result of our prior operating losses, we had an accumulated deficit of $43.6 million as of
September 30, 2004.

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Our operating results are difficult to predict and adverse fluctuations in operating results could cause our stock price to fall.

Our
quarterly revenue and operating results are difficult to predict and could fluctuate 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. 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 and training services largely correlates with our product
revenue, a decline in product revenue could also cause a decline in our professional services revenue in the same quarter or in subsequent quarters. Our quarterly revenue is difficult to forecast for
several reasons, including the following:



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

We may be unable to manage and expand our international operations, which may adversely affect our business and operating results.

We
derived $49.3 million and $32.9 million of revenue during the nine months ended September 30, 2004 and 2003, respectively, from customers outside the United
States, principally in the United Kingdom,
Hong Kong/Greater China, Canada, Japan and Australia. During 2003, we completed the purchase of Eyretel plc and significantly expanded our operations outside of North America. Our operations outside
of the United States at September 30, 2004, consisted of 190 dedicated employees located in Australia, Brazil, Canada, China, Germany, Hong Kong, Japan, Malaysia, Mexico, Singapore and the
United Kingdom. We have also established relationships with a number of international resellers.

We
intend to continue to expand our international operations through additional acquisitions, internal business expansion and strategic business relationships. These efforts require
significant management attention and financial resources. We may not be able to successfully penetrate international markets or, if we do, we may not be able to grow or to maintain adequate

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profit margins in these markets.
Because of the complex nature of our international expansion, it may adversely affect our business and operating results. International
expansion and sales are subject to many risks, including the following:



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, because they may possess a better understanding of their local markets and have 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 knowledge, 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.

If we are unable to maintain a productive direct sales force, our business and operating results could be materially adversely affected.

We
believe that our future success will depend on maintaining a productive direct sales force. 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 recruiting sales personnel with experience in computer and telephone integration technologies. We cannot assure you
that we will be able to continue to manage turnover and hire new sales personnel to meet our needs. If the personnel we hire are less qualified than we expect, it may take us more time to train them
before they reach an acceptable level of productivity, which could increase our costs and impact our revenue.

If we are unable to expand the distribution of our products through indirect sales channels, our business and operating results could be materially adversely
affected.

Our
strategy is to continue to increase the proportion of customers served through indirect sales channels, such as select resellers and a variety of strategic marketing alliances.
Product revenue from our indirect sales channel represented approximately 32% of total product revenue during both the nine months ended September 30, 2004 and 2003. We expect revenue from our
indirect sales channel and, accordingly, our dependence on distribution partners, to increase as we establish relationships with companies to resell our software worldwide. We cannot assure you that
we will be able to maintain productive relationships with our current partners, or that we will be able to establish similar relationships with additional resellers on a timely basis, if at all.

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Some
resellers with which we do business 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. We cannot provide assurance that these distribution partners will devote adequate resources to selling our software and services or that our resellers
may not learn about our products and the market for our software and services and develop and sell competing products and services. As a result, our relationships with resellers could lead to
increased competition for us.

Intense competition in our business 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 selling their products and services and adopt more aggressive pricing policies. We cannot assure you that our current or potential competitors will not develop products
comparable or superior in terms of price and performance features to those developed by us.

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 often have strong business relationships with our customers and potential customers. For example, some of our competitors have better and more long standing relationships than we
do with telephone switch vendors. Our competitors may use these business relationships to market and sell their products and compete for potential customers. It is also possible that resellers or
technology partners may acquire or be acquired by one or more of our competitors, which would further solidify their business relationships.

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 market share, any of which could materially and adversely affect our business, financial condition and results of operations.

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Our heavy reliance on sales of our eQuality Balance, eQuality Evaluation and eQuality ContactStore products exposes us to risks of obsolescence due to changes in competitive
product offerings.

We
continue to derive a substantial portion of our product revenues from sales of our eQuality Balance, eQuality Evaluation and eQuality ContactStore software. We expect revenue from
these products to continue to account for most of our revenue for the foreseeable future. As a result, any factors affecting the markets for these products, could materially and adversely affect our
business, financial condition and results of operations. We cannot assure you that the market will continue to demand our current products or that we will be successful in marketing any new or
enhanced products. If our competitors release new products that are superior to our products in performance or price, demand for our products may decline. A decline in demand for our products as a
result of competition, technological change or other factors would reduce our total revenues and harm our ability to maintain profitability.

If we fail to develop new software or improve our existing software, we may not be able to remain competitive.

The
markets for our products are characterized by rapidly changing technology, frequent new product introductions and enhancements, changes in customer demands and evolving industry
standards. Our existing products could be rendered obsolete if we fail to continue to advance our technology. We have also found that the technological life cycles of our products are difficult to
estimate, partially because of changing demands of our customers. We believe that our future success will depend on our ability to continue to enhance our current product line while we concurrently
develop and introduce new products that keep pace with competitive and technological developments. These developments require us to continue to make substantial product development investments.
Although we are presently developing a number of product enhancements to our product suites, we cannot assure you that these enhancements will be completed on a timely basis or gain customer
acceptance.

If our software development activities in the Asia-Pacific region are not successful, we may not be able to meet our development schedules.

In
April 2004, we announced that we will significantly expand our software development capabilities in the Asia-Pacific region in order to optimize available research
and development resources and better meet development timeframes. We have limited experience with remote software development activities. Accordingly, there are a number of risks associated with this
activity, including:



Our
inability to meet development schedules because of our reliance on developers in the Asia-Pacific region may affect our ability to enhance our current product line or
introduce new products, which would have a material adverse affect on our financial results and could harm our reputation. The loss of key development personnel could have a material adverse effect on
our product development process and adversely affect future product revenues.

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Our liability to customers may be substantial if our products fail to perform properly.

Our
software is used in a complex operating environment that requires its integration with computer and telephone networks and other business software applications. If our products fail
to function as required, we may be subject to claims for substantial damages. Courts may not enforce provisions in our contracts that would limit our liability or otherwise protect us from liability
for damages. Although we maintain general liability insurance coverage, including coverage for errors or omissions, this coverage may not continue to be available on reasonable terms or in sufficient
amounts to cover claims against us. In addition, our insurer may disclaim coverage as to any future claim. If claims exceeding
the available insurance coverage are successfully asserted against us, or our insurer imposes premium increases, large deductibles or co-insurance requirements on us, our business and
results of operations could be adversely affected.

Our software may contain undetected errors or "bugs," resulting in harm to our reputation and operating results.

Software
products as complex as those offered by us might contain undetected errors or failures when first introduced or when new versions are released. We cannot assure you, despite
testing by us and by current and prospective customers, that errors will not be found in new products or product enhancements after commercial release. Any errors found may cause substantial harm to
our reputation and result in additional unplanned expenses to remedy any defects as well as a loss in revenue.

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 product line to include advanced compliance recording applications and related services. Many of our Eyretel customers use these
applications to record and store interactions with customers 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 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.

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 performing these functions, the perception that we have improperly handled sensitive, confidential
information could have a negative effect on our business. If, in handling this information, we fail to comply with privacy or 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 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.

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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, in locations where we
price 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. In
locations, where we sell our products in local currencies, we could be competitively unable to increase our prices to reflect fluctuations in exchange rates. We cannot predict the impact that future
exchange rate fluctuations may have on our results.

Certain provisions in agreements that we have entered into may expose us to liability for breach that is not limited in amount by the terms of the
contract.

Certain
contract provisions, principally confidentiality and indemnification obligations in certain of our license agreements, could expose us to risks of loss that, in some cases, are
not limited by contract to a specified maximum amount. If we fail to perform to the standards required by these contracts, we could be subject to additional liability and our business, financial
condition and results of operations could be materially and adversely affected. There have been no material losses to date as a result of any such contractual provisions.

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

Our
success and ability to compete depends to a significant degree upon our proprietary technology. We rely on a combination of patent, trade secret, copyright and trademark laws and
confidentiality 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 infringement of our proprietary rights could negatively impact our future operating results.

As
of September 30, 2004, we had seven registered trademarks, one trademark application pending in the U.S., five U.S. and three international patents, and 15 patent applications
pending in the U.S. and five patent applications pending internationally. There is no guarantee that our pending applications will result in issued trademarks or patents or, if issued, that they will
provide us with any competitive advantage. 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.

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 an owner of legal rights resulting from prior use, registrations, or applications will
bring legal action to challenge our registration of and/or our use of the trademark eQuality®, and may also seek compensation for damages resulting from our use this trademark. 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 certain foreign countries do not protect our intellectual property rights to the same extent, as do the laws of the United States. Furthermore, policing the
unauthorized use of our products is difficult, and litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and
scope of the proprietary rights of others. Litigation could result in substantial costs and diversion of resources and could negatively impact our future operating results.

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

It
is possible that third parties will claim that we have infringed their current or future products. We expect that we and other participants in our industry will be increasingly
subject to infringement claims as the number of competitors and products grows. Any claims, with or without merit, which is generally uninsurable could be time-consuming, result in costly
litigation, require us to reengineer or redevelop our software, cause product shipment delays or require us to enter into royalty or licensing agreements, any of which could negatively impact our
operating results. 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. For example, depending on the outcome of lawsuits involving Knowlagent and NICE (as described in Note 12, "Legal Proceedings"), we may be required to enter into royalty
and licensing agreements on unfavorable terms, to stop selling or redesign our products at issue, or to pay damages or satisfy indemnification commitments with our customers.

In
addition, we cannot assure you that legal action claiming patent infringement will not be commenced against us, or that we would prevail in litigation given the complex technical
issues and inherent uncertainties in patent litigation. In addition, users of our software may become subject to claims if our software is alleged to infringe the intellectual property of others.
These software users could attempt to hold us responsible for these claims and any resulting harm they suffer. If a patent claim against us was successful and we could not obtain a license on
acceptable terms or license a substitute technology or redesign to avoid infringement, we may be prevented from distributing our software or required to incur significant expense and delay in
developing non-infringing software. Such a result would have a material adverse effect on our business, financial condition and results of operations.

If we are unable to maintain the compatibility of our software with certain other products and technologies, our future business would be adversely
affected.

Our
software must integrate with software and hardware solutions provided by a number of our existing and potential 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. 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. If we
cannot adapt our software to changes in necessary 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.

If our professional services employees do not provide installation services effectively and efficiently, our customers may not use our installation services or may stop using
our software.

Our
customers ordinarily purchase installation, training and maintenance services together with our products. We generate a material part of our revenues from these services. 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 or they may not license our software in the future. As a result, we would lose licensing and services revenue, and it could harm our reputation.

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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 that we believe complement our business and assist us in quickly bringing new products to market. We
have limited experience in making acquisitions and investments. As a result, our ability to identify and evaluate prospects, complete acquisitions and properly manage the integration of businesses is
relatively 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:



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

Although
we believe our current cash and borrowing capacity will be sufficient to meet our anticipated cash needs 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 obtain them on acceptable terms, we may be unable to:



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

The loss of third-party hardware suppliers could harm our business.

A number of customers expect us to source hardware to support the implementation of our software. We are working towards reducing the amount of hardware sales in
the future and have transferred the fulfillment of hardware orders to third-party distributors. Thus, we are largely dependent on third parties for the supply of hardware components to our customers.
If these hardware distributors experience financial, operational or quality assurance difficulties, or if there is any other disruption in our relationships, we may be required to locate alternative
hardware sources. We are subject to the following risks due to our hardware distribution system:



Even
if we and/or our distributors are successful in locating alternative sources of supply, alternative suppliers could increase prices significantly. In addition, alternative
components may malfunction or interact with existing components in unexpected ways. The use of new suppliers and the modification of our products to function with new systems would require testing and
may require further modifications, which may result in additional expense, 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.

The requirements of Section 404 of the Sarbanes-Oxley Act of 2002 require that we undertake an evaluation of our internal controls that may identify internal control
weaknesses.

The
Sarbanes-Oxley Act of 2002 imposes new duties on us and our executives, directors, attorneys and independent registered public accountants. In order to comply with the Sarbanes-Oxley
Act, we are evaluating our internal controls systems to allow management to report on, and our independent auditors to attest to, our internal controls. We are currently performing the system and
process evaluation and testing (and any necessary remediation) required in an effort to comply with the management certification and auditor attestation requirements of Section 404 of the
Sarbanes-Oxley Act. While we anticipate being able to fully implement the requirements relating to internal controls and all other aspects of Section 404 in a timely fashion, we cannot be
certain as to the outcome of our testing and resulting remediation actions or the impact of the same on our operations since there is no precedent available by which to measure compliance adequacy. If
we are not able to implement the requirements of Section 404 in a timely manner or with adequate compliance, our auditors may not be able to render the required attestation concerning our
assessment and the effectiveness of the internal controls over financial reporting, we may be subject to investigation and/or sanctions by regulatory authorities, such as the Securities Exchange
Commission or The NASDAQ Stock Market, and our reputation may be harmed. Any such action could adversely affect our financial results and the market price of our common stock.

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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 stock market has experienced significant volatility that has particularly affected the market prices of equity securities of many technology companies and that often has been unrelated
or disproportionate to the operating performance of these companies. Any announcement with respect to any adverse variance in revenue or earnings from levels generally expected by securities analysts
or investors could have a 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 customer relationship management software market, 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.

Our performance may be negatively affected by macro-economic or other external influences.

Beginning
in 2000, a declining United States economy began to adversely affect the performance of many businesses, especially within the technology sector. We are a technology company
selling technology-based solutions with total pricing, including software and services that in some cases exceed $1.0 million. Reductions in the capital budgets of our customers and prospective
customers had an adverse impact on our ability to sell our solutions. Until late in 2003, we continued to experience effects from a weak spending environment for information technology in both the
United States and Europe, in the form of delayed and cancelled buying decisions by customers for our software, services and hardware, deferrals by customers of service engagements previously scheduled
and pressure by our customers and competitors to discount our offerings. If the current improvements now being seen in the general business climate do not continue, this would likely have a material
adverse effect on our business.

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 our customers and us
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 to existing regulations could cause a decline in the use of our software and could result in increased expense for us, particularly if we are required to
modify our software to accommodate these regulations. Moreover, these regulations could subject our customers or us to liability. 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.

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If we are unable to attract and retain key personnel, our ability to effectively manage and grow our business would suffer.

Our
success greatly depends on our ability to hire, train, retain and motivate qualified personnel, particularly in sales, marketing, research and development, service and support. We
face significant competition for individuals with the skills required to perform the services we offer. If we are unable to attract and retain qualified personnel or if we experience high personnel
turnover, it could prevent us from effectively managing and expanding our business.

Our
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, particularly
if lost to competitors, could materially and adversely affect our business.

Our certificate of incorporation and bylaws, as well as Delaware law, may inhibit a takeover of our company, which could limit the price investors might be willing to pay for
our securities.

Our
amended and restated certificate of incorporation and bylaws, as well as Delaware law, contain provisions that might enable our management to resist a takeover of our company. For
example, our stockholders cannot take action by written consent or call a special meeting to remove our board of directors. In addition, our directors serve for staggered terms, which makes it
difficult to remove all our directors at once. Further, 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.

These
anti-takeover provisions might discourage, delay or prevent a change in the control of our company or a change in our management. These provisions could also discourage
proxy contests and make it more difficult for you and other shareholders to elect directors and take other corporate actions. The existence of these provisions could also limit the price that
investors might be willing to pay in the future for our securities.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Information concerning market risk is included in the Management's Discussion and Analysis of Financial Condition and Results of Operations, Item 2 of
Part I of this Report.

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, 2004, 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

Information with respect to this item is included in Note 12 of the Notes to the Condensed Consolidated Financial Statements, of this Report.

Item 2.    Changes in Securities and Use of Proceeds

|Period                       |  | Total Number of Shares Purchased |  | Average Price Paid per Share |  | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs |  | Maximum Number of Shares (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs
|---------------------------- |  | -------------------------------- |  | ---------------------------- |  | -------------------------------------------------------------------------------- |  | ----------------------------------------------------------------------------------------------------------------------
|Jul. 1, 2004 - Jul. 31, 2004 |  |                                 |  |                             |  |                                                                                 |  | $                                                                                                                     
|                             |  |                                  |  |                              |  |                                                                                  |  |                                                                                                                       
|Aug 1, 2004 - Aug 31, 2004   |  |                                 |  |                             |  |                                                                                 |  | $                                                                                                                     
|                             |  |                                  |  |                              |  |                                                                                  |  |                                                                                                                       
|Sep. 1, 2004 - Sep. 30, 2004 |  |                                 |  |                             |  |                                                                                 |  | $                                                                                                                     

Item 6.    Exhibits

|10.1* |  | Form of Change of Control Agreement entered into with certain senior officers of the company.                                              
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------
|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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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 5, 2004 |  | WITNESS SYSTEMS, INC.
|----------------------- |  | ---------------------
|                        |  | BY:                  
|                        |  | BY:                  

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