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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K/A

Amendment No. 1



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(Mark One)

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



FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004



or



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



For The Transition Period From              To
             .



Commission file number 0-27074



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SECURE COMPUTING CORPORATION

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 52-1637226                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|4810 Harwood Road, San Jose, California                        |  | 95124                               
|(Address of principal executive offices)                       |  | (Zip code)                          



Registrants
telephone number, including area code: (408) 979-6100



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Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $.01 per share



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Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.    Yes  x    No ̈



Indicate by check mark if disclosure of delinquent
filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K.  x



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



Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act.):    Yes ̈No  x



The aggregate market value of the Common Stock held by non-affiliates of the
Registrant as of June 30, 2004 was $415,163,769 based on the closing sale price for the Companys Common Stock on that date. For purposes of determining this number, all officers and directors of the Registrant are considered to be
affiliates of the Registrant, as well as individual stockholders holding more than 10% of the Registrants outstanding Common Stock. This number is provided only for the purpose of this report on Form 10-K and does not represent an admission by
either the Registrant or any such person as to the status of such person.



As of November 30, 2005, the Registrant had 36,933,135 shares of Common Stock issued and outstanding.



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##### Table of Contents

EXPLANATORY NOTE



This Amendment on Form 10-K/A amends our Annual Report on Form 10-K for the year ended December 31, 2004, as initially
filed with the Securities and Exchange Commission (the SEC) on March 11, 2005 and is being filed to reflect reclassification of certain expenses which previously had been shown as sales and marketing expenses to cost of revenues.
The reclassification results in a $5.1 million, $5.0 million, and $5.6 million reduction in sales and marketing expenses and increase to costs of revenues for each of the years ended December 31, 2004, 2003 and 2002, respectively. As a result
of the reclassification, gross profit is $76.0 million, $63.6 million, and $51.7 million for each of the years ended December 31 2004, 2003 and 2002, respectively. In addition, gross profit as a percentage of revenues is 81.4%, 83.4%, and 83.4%
for each of the years ended December 31 2004, 2003 and 2002, respectively. The reclassification was done to more accurately report costs associated with revenue from post contract support and professional services. This Amendment amends only
Parts II and IV of Form 10-K, as set forth herein. Unaffected items have not been repeated in this Amendment. This report still speaks as of the filing date of the Form 10-K and, except as expressly stated herein, no attempt has been made to
update this report to reflect events occurring subsequent to the date of the initial filing date of the Form 10-K. All information contained in this Amendment is subject to updating and supplementing, as provided in our periodic reports filed with
the Securities and Exchange Commission subsequent to the date of the filing of the Form 10-K.



TABLE OF CONTENTS



|         |  |                                                                                       |  |     
|-------- |  | ------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                       |  | Page
|PART II  |  |                                                                                       |  |     
|         |  |                                                                                      
|ITEM 6.  |  | SELECTED FINANCIAL DATA                                                               |  | 3   
|         |  |                                                                                      
|ITEM 7.  |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |  | 3   
|         |  |                                                                                      
|PART IV  |  |                                                                                       |  |     
|         |  |                                                                                      
|ITEM 15. |  | EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K                      |  | 11  
|         |  |                                                                                      
|         |  | SIGNATURES                                                                            |  | 31  



2



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##### Table of Contents

PART II



ITEM 6. SELECTED FINANCIAL DATA



The consolidated statement of operations data set forth below for the fiscal years ended December 31, 2004, 2003 and 2002, and the consolidated balance sheet data at December 31, 2004 and 2003, are derived from the audited
consolidated financial statements included elsewhere in this Form 10-K/A. The consolidated statement of operations data set forth below for the fiscal years ended December 31, 2001 and 2000, and the consolidated balance sheet data at
December 31, 2002, 2001 and 2000, are derived from audited consolidated financial statements which are not included in this Form 10-K/A. You should read the data set forth below in conjunction with the financial statements and notes thereto and
Managements Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Form 10-K/A.



|                                                              |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|------------------------------------------------------------- |  | ---------------------------------------------- | ------- | ------- | - | ------- | ------- |  | - | ------ | - |  | ---- | ------ | - |  | - | ------- | -
|                                                              |  | Year ended December 31,                        |        
|                                                              |  | (Table in thousands, except per share amounts) |        
|                                                              |  | 2004(1)                                        |         | 2003(1) |   |         | 2002(2) |  |   | 2001   |   |  | 2000 |       
|STATEMENT OF OPERATIONS DATA:                                 |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Revenue                                                       |  | $                                              | 93,378  |         | $ | 76,213  |         |  | $ | 61,960 |   |  | $    | 48,353 |   |  | $ | 34,649  |  
|Gross profit                                                  |  |                                                | 75,991  |         |   | 63,578  |         |  |   | 51,654 |   |  |      | 37,874 |   |  |   | 21,560  |  
|Net income (loss) from continuing operations                  |  |                                                | 12,835  |         |   | 9,290   |         |  |   | (5,166 | ) |  |      | (7,237 | ) |  |   | (16,967 | )
|Net loss from discontinued operations/disposal of AT division |  |                                                |        |         |   | (1,034  | )       |  |   | (1,310 | ) |  |      | (1,733 | ) |  |   | (2,203  | )
|Net income (loss)                                             |  |                                                | 12,835  |         |   | 8,256   |         |  |   | (6,476 | ) |  |      | (8,970 | ) |  |   | (19,170 | )
|                                                              |  |                                                |         |         |  
|Basic income (loss) per share:                                |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Continuing operations                                         |  |                                                | 0.36    |         |   | 0.29    |         |  |   | (0.18  | ) |  |      | (0.26  | ) |  |   | (0.67   | )
|Discontinued operations                                       |  |                                                |        |         |   | (0.03   | )       |  |   | (0.04  | ) |  |      | (0.06  | ) |  |   | (0.09   | )
|                                                              |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Basic income (loss) per share                                 |  | $                                              | 0.36    |         | $ | 0.26    |         |  | $ | (0.22  | ) |  | $    | (0.32  | ) |  | $ | (0.76   | )
|                                                              |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Diluted income (loss) per share:                              |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Continuing operations                                         |  |                                                | 0.34    |         |   | 0.28    |         |  |   | (0.18  | ) |  |      | (0.26  | ) |  |   | (0.67   | )
|Discontinued operations                                       |  |                                                |        |         |   | (0.03   | )       |  |   | (0.04  | ) |  |      | (0.06  | ) |  |   | (0.09   | )
|                                                              |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Diluted income (loss) per share                               |  | $                                              | 0.34    |         | $ | 0.25    |         |  | $ | (0.22  | ) |  | $    | (0.32  | ) |  | $ | (0.76   | )
|                                                              |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|BALANCE SHEET DATA:                                           |  |                                                |         |         |   |         |         |  |   |        |   |  |      |        |   |  |   |         |  
|Working capital                                               |  | $                                              | 51,391  |         | $ | 28,989  |         |  | $ | 8,817  |   |  | $    | 20,790 |   |  | $ | 22,010  |  
|Total assets                                                  |  |                                                | 130,914 |         |   | 108,475 |         |  |   | 60,943 |   |  |      | 44,833 |   |  |   | 44,971  |  
|Stockholders equity                                          |  |                                                | 91,826  |         |   | 72,014  |         |  |   | 29,663 |   |  |      | 28,696 |   |  |   | 30,626  |  

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|(1) | 2004 and 2003 balance sheet data includes $25.5 million and $26.5 million, respectively, of goodwill related to the acquisition of N2H2, Inc. completed in late 2003 and $13.8
million and $14.0 million, respectively, of goodwill related to the acquisition of the GauntletTMfirewall and VPN
business completed in early 2002.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | 2002 balance sheet data includes $15.2 million of goodwill related to the acquisition of the Gauntlet firewall and VPN business completed in early 2002 and a litigation settlement
accrual of $7.3 million.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



Information Regarding Forward-Looking Statements



The following discussion contains forward-looking statements, including statements regarding our expectations, beliefs, intentions, or strategies
regarding the future. These statements are not guarantees of future performance and are subject to risks, uncertainties, and other factors, some of which are beyond our control and difficult to predict and could cause actual results to differ
materially from those expressed or forecasted in the forward-looking statements. The risks and uncertainties are summarized in Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2004 as filed on March 11, 2005
and in the other documents we file with the SEC. These forward-looking statements reflect our view only as of the date of this report. We cannot guarantee future results, levels of activity, performance, or achievement. We do not undertake any
obligation to update or correct any forward-looking statements.



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##### Table of Contents

Executive Overview



Our specialized solutions are designed to meet our customers needs to balance security and accessibility and to help them create trusted
environments both inside and outside their organizations. Each of our products provides a complete solution in and of itself, and they also integrate well with each other for a more comprehensive, unified, and centrally managed solution. Our
products ability to scale as the infrastructure or number of users grows has always been, and continues to be, one of our hallmarks. Our solutions run on a variety of platforms and integrate well with other enterprise solutions, making our
products a safe and economical choice for organizations worldwide. The three product lines that represent the majority of our revenue are the Sidewinder G2 Security Appliance, our SafeWord products and our Web filtering products.



In February 2004, we released our next-generation Sidewinder G2 Security
Appliance product line. These appliances provide all-in-one, consolidated protection through standard and optional features, including the worlds strongest firewall, anti-virus, and anti-spam gateways, Web content URL filtering, secure DNS,
VPN, and SSL gateways, and more. These appliances are well positioned to satisfy increased market demands for application security.



The release of our new Sidewinder G2 Security Appliance, including the complementary Sidewinder G2 Enterprise Manager for managing distributed appliances,
also represents the completion of our promised two-phase integration of the Sidewinder and Gauntlet firewalls, following the 2002 acquisition of the Gauntlet firewall business from Network Associates.



We continue to find innovative distribution and partnership models to expand
our presence in the strong authentication market with our SafeWord product line. In 2004, we made tremendous strides in extending the reach of our SafeWord product line into both mid-market organizations and large enterprises. We have also gained
traction with our SafeWord For partner program introduced in 2003, and in particular with Citrix and Cisco.



In 2004, with the release of SmartFilter 4.0, we introduced a combined control list based on our prior URL control list and the URL control list acquired
from N2H2 in 2003. The result is a comprehensive list, which solidifies our position as one of the worlds leading suppliers of Web filtering. Containing millions of sites, the new URL control list offers 62 categories and covers over 60
languages.



With the launch of SmartFilter 4.0 in June, the new
control list was introduced, along with its new reporting feature, SmartReporter. SmartReporter adds powerful reporting capabilities to SmartFilter that make reporting on Web usage patterns easy for customers. SmartFilter continues to be the
market-leading de-facto standard for Web filtering on edge or caching devices through OEM relationships.



In addition to increasing functionality, platforms and technology integrations of our products, we continued to expand our market presence through an
extensive worldwide network of value-added resellers, distributors, and OEM partners. These partners generated 70% of our revenues in 2004.



Our customers operate some of the largest and most sensitive networks and applications in the world. Our partners and customers include the majority of
the Dow Jones Global 50 Titans and numerous organizations in the Fortune 1000, as well as banking, financial services, healthcare, telecommunications, manufacturing, public utilities, schools and federal and local governments. We also have close
relationships with the largest agencies in the United States government, both federal and local.



International sales accounted for 31% of total revenue during 2004. Major foreign markets for our products include Europe, Japan, China, the Pacific Rim
and Latin America. In each country, we have independent channel partners responsible for marketing, selling and supporting our products to resellers and end users.



Each of our individual products competes with a different group of competitors and products. In this highly competitive
market, characterized by rapid technological change, our customers purchase decisions are based heavily upon the quality of the security our products provide, the ease of installation and management, and the scalability and flexibility of our
software.



Specific challenges and risks that our product lines
face include, but are not limited to: responding to competitor pricing policies and competitive features; rapid technological change in the network security market; and risk of bugs and other errors in our software.



In 2004, we focused our efforts on strengthening our core product offerings
and developing a stronger worldwide channel. Our year over year improvement in net income from continuing operations was driven by strong revenue growth, strong gross margins and our ability to control operating expenses.



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##### Table of Contents

Results of Operations



The following table sets forth, for the periods indicated, certain items from the statements of operations of our company expressed as a percentage of
revenue:



|                                                 |  |                         |   |  |       |   |  |       |   
|------------------------------------------------ |  | ----------------------- | - |  | ----- | - |  | ----- | --
|                                                 |  | Year ended December 31, |  
|                                                 |  | 2004                    |   |  | 2003  |   |  | 2002  |   
|Revenues:                                        |  |                         |   |  |       |   |  |       |   
|Products                                         |  | 72.4                    | % |  | 68.8  | % |  | 60.7  | % 
|Services                                         |  | 27.6                    |   |  | 31.2  |   |  | 39.3  |   
|                                                 |  |                         |   |  |       |   |  |       |   
|Total revenues                                   |  | 100.0                   |   |  | 100.0 |   |  | 100.0 |   
|                                                 |  |                         |  
|Cost of revenues:                                |  |                         |   |  |       |   |  |       |   
|Products                                         |  | 13.2                    |   |  | 10.0  |   |  | 7.6   |   
|Services                                         |  | 5.4                     |   |  | 6.6   |   |  | 9.0   |   
|                                                 |  |                         |   |  |       |   |  |       |   
|Total cost of revenues                           |  | 18.6                    |   |  | 16.6  |   |  | 16.6  |   
|                                                 |  |                         |   |  |       |   |  |       |   
|Gross profit                                     |  | 81.4                    |   |  | 83.4  |   |  | 83.4  |   
|                                                 |  |                         |  
|Operating expenses:                              |  |                         |   |  |       |   |  |       |   
|Selling and marketing                            |  | 44.1                    |   |  | 44.2  |   |  | 47.4  |   
|Research and development                         |  | 17.3                    |   |  | 19.9  |   |  | 24.1  |   
|General and administrative                       |  | 6.9                     |   |  | 7.3   |   |  | 8.2   |   
|Separation costs                                 |  |                        |   |  |      |   |  | 0.9   |   
|                                                 |  |                         |   |  |       |   |  |       |   
|Total operating expenses                         |  | 68.3                    |   |  | 71.4  |   |  | 80.6  |   
|                                                 |  |                         |   |  |       |   |  |       |   
|Operating income                                 |  | 13.1                    |   |  | 12.0  |   |  | 2.7   |   
|Other non-recurring expense                      |  |                        |   |  |      |   |  | (11.7 | ) 
|Interest and other income                        |  | 0.6                     |   |  | 0.2   |   |  | 0.7   |   
|                                                 |  |                         |   |  |       |   |  |       |   
|Income (loss) from continuing operations         |  | 13.7                    |   |  | 12.2  |   |  | (8.3  | ) 
|Loss from operations of discontinued AT division |  |                        |   |  | (1.0  | ) |  | (2.2  | ) 
|Loss on disposal of discontinued AT division     |  |                        |   |  | (0.4  | ) |  | 0.0   |   
|                                                 |  |                         |   |  |       |   |  |       |   
|Net income (loss)                                |  | 13.7                    | % |  | 10.8  | % |  | (10.5 | )%
|                                                 |  |                         |   |  |       |   |  |       |   



Comparison of Years Ended
December 31, 2004 and 2003.



The comparison of years
ended December 31, 2004 and 2003 reflects the classification of the AT division as discontinued operations.



Revenues. Our total revenues increased 22.5% to $93.4 million in 2004, up from $76.2 million in 2003. Our product revenues increased 29.0% to
$67.6 million in 2004, up from $52.4 million in 2003. Our service revenues increased 8.4% to $25.8 million in 2004, up from $23.8 million in 2003. The increase in total revenues in 2004 was driven by growth across all product lines. Our Sidewinder
G2 Firewall product line revenue increase was due to demand for our next-generation security appliance line. Our Web filtering product line revenue increase was due to continued traction through OEM relationships and the incremental Bess and Sentian
revenue contributed as a result of the N2H2, Inc. acquisition late in 2003. The SafeWord product line revenue increase was driven by sustained demand for high assurance solutions. For 2005, revenues are expected to be in the range of $104 million to
$106 million.



Cost of Revenues and Gross
Profit. Total cost of revenues, which includes products and services costs, increased 38.1% to $17.4 million in 2004 up from $12.6 million in 2003. This increase is the direct result of the increase in total revenues. Gross profit as a
percentage of total revenue decreased from 83.4% in 2003 to 81.4% in 2004. Gross profit for products decreased to 81.8% in 2004 compared to 85.5% in 2003. This decline was driven by increased sales volume on products containing a hardware component,
primarily the Sidewinder G2 appliance sales, which have a lower gross profit margin than our software products. Gross margins were also reduced as a result of a larger portion of business being transacted with channel partners versus direct to end
users in 2004 as compared to 2003. Gross profit for services was $20.7 million, or 80.4% in 2004 compared to $18.8 million, or 78.9% in 2003. The improvement in the gross profit rate for services was primarily driven by our services revenue growth
outpacing the growth of our services costs in 2004 compared to 2003.



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Operating Expenses. Operating expenses consist of selling and marketing, research and
development, and general and administrative expenses. Total operating expenses increased 17.3% to $63.8 million for 2004, up from $54.4 million in 2003. This increase was driven primarily by an inflationary increase in payroll and related costs and
inflationary increases in allocated corporate costs. As a percentage of revenue, total operating expenses were 68.3% for 2004 compared to 71.4% in 2003. This improvement was primarily driven by revenue growth outpacing the growth of operating
expenses during 2004 compared to 2003.



Selling and
Marketing. Selling and marketing expenses consist primarily of salaries, commissions, and benefits related to personnel engaged in selling and marketing functions, along with costs related to advertising, promotions, public relations,
travel and allocations of corporate costs, which include information technology, facilities and human resources expenses. Selling and marketing expenses increased 22.3% to $41.2 million in 2004, up from $33.7 million in 2003. This increase was
driven primarily by inflationary increases in payroll and related costs, an increase in commission expense due to expanding revenues, and inflationary increases in allocated corporate costs. As a percentage of revenue, selling and marketing expenses
were 44.1% in 2004 compared to 44.2% in 2003. This rate remained consistent compared to prior year, despite the increase in our selling and marketing expenses, due to revenue growth being consistent with the growth of selling and marketing expenses
in 2004 compared to 2003.



Research and
Development. Research and development expenses consist primarily of salaries and benefits for our product development personnel and allocations of corporate costs, which include information technology, facilities and human resources
expenses. Research and development expenses increased 6.1% to $16.1 million in 2004, up from $15.2 million in 2003. This increase was driven by inflationary increases in payroll, benefits and allocated corporate costs as well as increased facility
costs as a direct result of our N2H2 acquisition in late 2003. As a percentage of revenue, research and development expenses were 17.3% for the year compared to 19.9% in 2003. This improvement was primarily driven by revenue growth outpacing the
growth of research and development expenses during 2004 compared to 2003.



General and Administrative. General and administrative expenses consist primarily of salaries, benefits and related expenses for our executive, finance and legal personnel, directors and officers insurance
and allocations of corporate costs, which include information technology, facilities and human resources expenses. General and administrative expenses increased 16.6% to $6.5 million in 2004, up from $5.5 million in 2003. This increase was driven
primarily by an increase in audit and legal fees, inflationary increases in allocated corporate costs, and to a lesser extent, inflationary increases in payroll and benefits. As a percentage of revenue, general and administrative expenses were 6.9%
for the year compared to 7.3% in 2003. This improvement was primarily driven by revenue growth outpacing the growth of general and administrative expenses during 2004 compared to 2003.



Interest and Other Income. Net interest and other income was $607,000 in 2004, an increase from $141,000 in
2003. The increase reflects higher interest rates on higher cash balances in 2004 as compared to 2003 and a foreign currency translation adjustment related to the liquidation of a foreign entity.



Net Loss From Disposal of AT Division. In 2003, we determined
that we would no longer invest in our AT division and exited the business. Net loss from discontinued operations was $0 and $757,000 for the years ended December 31, 2004 and 2003, respectively. Loss on disposal of AT division was $0 and
$277,000 for the years ended December 31, 2004 and 2003, respectively.



Income Taxes. We recognized a deferred tax benefit of $345,000 in 2004 and $559,000 in 2003, which offset the tax expense incurred in each of those years. The computations of our deferred tax assets and
valuation allowance are based on taxable income we expect to earn on sales of existing products, and projected interest and other income over the next three years. Realization of the $3.6 million of net deferred tax assets is dependent upon our
ability to generate sufficient future taxable income and the implementation of tax planning strategies. We believe it is more likely than not that the net deferred tax assets will be realized based on expected levels of future taxable income in the
United States and certain foreign jurisdictions and the implementation of tax planning strategies. Future taxable income of $9.0 million is required to realize the $3.6 million deferred tax asset at December 31, 2004. We had total net operating
loss carryforwards of approximately $197.9 million at December 31, 2004. Of these carryforwards, $45.1 million relates to stock option exercises and $58.4 million relates to acquired N2H2 net operating losses, which currently have a full
valuation allowance, and when realized for financial statement purposes will not result in a reduction in income tax expense. Rather, the benefit from the stock option exercises will be recorded as an increase to additional paid-in capital and the
benefit from the N2H2 net operating loss carryforwards will be recorded as a decrease to goodwill. Of the remaining benefit associated with the carryforwards, approximately $85.4 million have yet to be recognized as a benefit in the consolidated
statement of operations. However, there are no assurances that these carryforwards will be available to offset future income tax expense when taxable income is realized.



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##### Table of Contents

Comparison of Years Ended December 31, 2003 and 2002.



The comparison of years ended December 31, 2003 and 2002 reflects the
classification of the AT division as discontinued operations.



Revenues. Our total revenues increased 23.0% to $76.2 million in 2003, up from $62.0 million in 2002. Our product revenues increased 39.4% to $52.4 million in 2003, up from $37.6 million in 2002. Our service revenues decreased
2.5% to $23.8 million in 2003, down from $24.4 million in 2002. The increase in total revenues in 2003 was driven by growth across all product lines. Our Sidewinder G2 Firewall product line revenue increase was due to demand for our next generation
firewall released in early 2003. Our Web filtering product line revenue increase was due to continued traction through our OEM relationships and the incremental Bess and Sentian revenue contributed as a result of the N2H2, Inc. acquisition late in
the year. Our SafeWord product lines revenue increase was driven by sustained demand for high assurance solutions.



Cost of Revenues and Gross Profit. Total cost of revenues, which includes products and services costs, increased 22.3% to $12.6 million in
2003 up from $10.3 million in 2002. This increase is the direct result of the increase in total revenues. Gross profit as a percentage of total revenue was 83.4% in 2003 and in 2002. Gross profit for products decreased to 85.5% in 2003 compared to
87.5% in 2002. This decline was driven by increased sales volume on products containing a hardware component, primarily the Sidewinder appliance sales, which have a lower gross profit margin than our software products. Gross profit for services was
$18.8 million, or 78.9% in 2003 compared to $18.8 million, or 77.0% in 2002. The improvement in the gross profit rate for services was primarily driven by our services revenue growth outpacing the growth of our services costs in 2003 compared to
2002.



Operating Expenses. Operating expenses
consist of selling and marketing, research and development, general and administrative expenses, and separation costs. Total operating expenses increased 8.8% to $54.4 million for the full year 2003, up from $50.0 million in 2002. This increase was
driven primarily by an inflationary increase in payroll and related costs and inflationary increases in allocated corporate costs. As a percentage of revenue, total operating expenses were 71.4% for the full year 2003 compared to 80.6% in 2002. This
improvement was primarily driven by revenue growth outpacing the growth of operating expenses during 2003 compared to 2002.



Selling and Marketing. Selling and marketing expenses consist primarily of salaries, commissions, and benefits related to personnel engaged in
selling and marketing functions, along with costs related to advertising, promotions, public relations, travel and allocations of corporate costs, which include information technology, facilities and human resources expenses. Selling and marketing
expenses increased 14.6% to $33.7 million in 2003, up from $29.4 million in 2002. This increase was driven primarily by an inflationary increase in payroll and related costs, an increase in commission expense due to expanding revenues, and
inflationary increases in allocated corporate costs. As a percentage of revenue, selling and marketing expenses were 44.2% in 2003 compared to 47.4% in 2002. This improvement was primarily driven by revenue growth outpacing the growth of selling and
marketing expenses during 2003 compared to 2002.



Research
and Development. Research and development expenses consist primarily of salaries and benefits for our product development personnel and allocations of corporate costs, which include information technology, facilities and human resources
expenses. Research and development expenses increased 1.8% to $15.2 million in 2003, up from $14.9 million in 2002. This increase was driven primarily by inflationary increases in allocated corporate costs. As a percentage of revenue, research and
development expenses were 19.9% for the year compared to 24.1% in 2002. This improvement was primarily driven by revenue growth outpacing the growth of research and development expenses during 2003 compared to 2002.



General and Administrative. General and administrative expenses
consist primarily of salaries, benefits and related expenses for our executive, finance and legal personnel, directors and officers insurance and allocations of corporate costs, which include information technology, facilities and human resources
expenses. General and administrative expenses increased 8.3% to $5.5 million in 2003, up from $5.1 million in 2002. This increase was driven primarily by an increase in directors and officers insurance premiums, inflationary increases in allocated
corporate costs, and to a lesser extent, inflationary increases in payroll and benefits. As a percentage of revenue, general and administrative expenses were 7.3% for the year compared to 8.2% in 2002. This improvement was primarily driven by
revenue growth outpacing the growth of general and administrative expenses during 2003 compared to 2002.



Interest and Other Income. Net interest and other income was $141,000 in 2003, a decrease from $421,000 in 2002. The decrease reflects lower
interest rates in 2003 as compared to 2002 and an increase in other expenses for personal property taxes.



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Net Loss From Disposal of AT Division. During the fourth quarter of 2003, we determined that
we would no longer invest in our AT division and exited the business. Net loss from discontinued operations was $757,000 and loss on disposal of AT division was $277,000 for the year ended December 31, 2003. Loss from operations improved 42.2%
in 2003 compared to 2002 as a result of the gradual contraction of that division.



Income Taxes. We recognized a deferred tax benefit of $559,000, which offset the tax expense incurred in 2003 and none in 2002. The computations of our deferred tax assets and valuation allowance are based
on taxable income we expect to earn on sales of existing products, and projected interest and other income over the next three years. Realization of the $3.3 million of net deferred tax assets is dependent upon our ability to generate sufficient
future taxable income and the implementation of tax planning strategies. We believe it is more likely than not that the net deferred tax assets will be realized based on historical earnings, expected levels of future taxable income in United States
and certain foreign jurisdictions, and the implementation of tax planning strategies. Future taxable income of $8.3 million is required to realize the $3.3 million deferred tax asset at December 31, 2003. We had total net operating loss
carryforwards of approximately $196.1 million at December 31, 2003. Of these carryforwards, $39.0 million relates to stock option exercises and $58.4 million relates to acquired N2H2 net operating losses, which currently have a full valuation
allowance, and when realized for financial statement purposes will not result in a reduction in income tax expense. Rather, the benefit from the stock option exercises will be recorded as an increase to additional paid-in capital and the benefit
from the N2H2 net operating loss carryforwards will be recorded as a decrease to goodwill. Of the remaining benefit associated with the carryforwards, approximately $90.4 million have yet to be recognized as a benefit in the consolidated statement
of operations. However, there are no assurances that these carryforwards will be available to offset future income tax expense when taxable income is realized.



Liquidity and Capital Resources



At December 31, 2004, our principal source of liquidity was $52.3 million of cash, cash equivalents and short term investments, representing an $18.6
million increase from December 31, 2003. The increase is primarily due to cash provided by operating activities, cash received from the exercise of stock options, and the sale of common stock through our employee stock purchase plan, offset by
capital additions. At December 31, 2004, we have net future payments under non-cancelable operating leases of $6.7 million and have no material commitments for capital expenditures. We expect to generate cash during 2005 as we expect revenue to
continue to grow at a faster rate than operating expenses.



Since our inception, we have financed our operations primarily through sales of our equity securities, and more recently, from cash generated from operations.



Net cash provided by operating activities of $13.7 million for the twelve months ended December 31, 2004, was comprised
of net income from continuing operations of $12.8 million, offset by net non-cash related expenses of $3.1 million, a $5.6 million increase in current assets, and a $3.4 million increase in liabilities. Net cash provided by operations was driven by
the increase in revenue outpacing our increase in operating expenses. Terms for cash collections received from customers and cash payments made to vendors were consistent with normal business practices.



Net cash provided by investing activities of $4.8 million for the twelve
months ended December 31, 2004, was comprised primarily of net proceeds from sales/maturities of investments of $7.2 million, offset by $1.6 million of cash used for net capital additions, which were made up of computer equipment, technology
upgrades, and leasehold improvements, and $802,000 used for intangible and other asset additions.



Net cash provided by financing activities of $7.2 million for the twelve months ended December 31, 2004 consisted primarily of proceeds received from
the exercise of stock options and the sale of common stock through our employee stock purchase plan.



As of December 31, 2004, we had working capital of $51.4 million. We anticipate using available cash to fund growth in operations, invest in capital
equipment, acquire businesses and to license technology or products related to our line of business. We expect to spend approximately $3.5 million on capital expenditures in 2005.



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A summary of our total contractual cash obligations as of December 31, 2004 is as follows (in
thousands):



|                                   |  |       |       |                        |   |                   |  |                    |       |                 |   |     |  |   |   
|---------------------------------- |  | ----- | ----- | ---------------------- | - | ----------------- |  | ------------------ | ----- | --------------- | - | --- |  | - | --
|                                   |  |       |       | Payments Due by Period
|                                   |  | Total |       | Less ThanOne Year      |   | One toThree Years |  | Three toFive Years |       | After FiveYears
|Operating leases, net of subleases |  | $     | 6,730 |                        | $ | 3,256             |  | $                  | 3,108 |                 | $ | 349 |  | $ | 17



We believe that we
have sufficient financial resources available to fund our current working capital and capital expenditure requirements for at least the next twelve months. We intend to continue to invest our cash in excess of current operating requirements in
interest bearing, short term investments.



Disclosures about Off-Balance
Sheet Arrangements



We did not have any off-balance sheet
arrangements as of December 31, 2004 or as of December 31, 2003.



Critical Accounting Policies and Estimates



Our discussion of the financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States. The
preparation of our financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of any contingent assets and liabilities at the
date of the financial statements. Management regularly reviews its estimates and assumptions, which are based on historical factors and other factors that are believed to be relevant under the circumstances. Actual results may differ from these
estimates under different assumptions, estimates, or conditions.



Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. See Note 1 of the Notes to
Consolidated Financial Statements for additional discussion of the application of these and other accounting policies.



Revenue Recognition. We derive our revenue primarily from two sources: (i) sales of products, including hardware, subscriptions, software
licenses, and royalties and (ii) sales of services, including maintenance arrangements to provide upgrades and customer support and professional services. We recognize revenue in accordance with Statement of Position (SOP) 97-2, Software
Revenue Recognition, as modified by SOP 98-9. Revenue from products is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and determinable, and collection is probable. Subscription-based
contracts are generally for 12, 24 or 36 months in duration. Subscription revenue along with maintenance revenue for providing product upgrades and customer support are deferred and recognized ratably over the service period beginning with the month
the subscription or service begins.



For arrangements with
multiple elements we allocate revenue to the various elements based on the fair value of each element sold. We determine the fair value of each element based on its selling price when sold separately. Evidence of fair value includes the approved
price list and discount schedule and the actual prices charged for comparable arrangements. These price lists and discount schedules may change from time to time in response to factors including market conditions, value of services and product
provided and competitive positioning. Historically, we have not offered significant discounts off of our list prices.



Further, it is our policy that our distributors and resellers are not allowed to hold inventory with the exception of international resellers who are
allowed to hold inventories of Safeword for Citrix (and other Safeword for products). This is a low price-point product with disproportionately high overseas freight costs. As such, we allow the reseller to carry a balance of
inventory and provide end-user sell-through reporting. Revenue is recognized at the point that we receive evidence of end-user sell-through.



Allowance for Doubtful Accounts. We make estimates regarding the collectibility of our accounts receivables. When we evaluate the adequacy of
our allowance for doubtful accounts, we consider multiple factors including historical bad debt experience, the need for specific customer reserves, the aging of our receivables, customer creditworthiness, changes in our customer payment cycles, and
current economic trends. Historically, our allowance for doubtful accounts has been adequate based on actual results. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required.



Valuation of
Long-Lived Assets, Including Goodwill and Other Intangible Assets. Intangible assets consist of patents, trademarks, capitalized software costs, a purchased customer list, a purchased control list, capitalized developed technology and
goodwill, all of which are recorded at cost or fair value. Patents, trademarks, customer and control lists, and capitalized developed technology are amortized using the straight-line method over the estimated useful lives of the assets, which range



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up to 17 years. See accounting policy of capitalized software costs under Research and Development in Note 1 of Notes to
Consolidated Financial Statements. Goodwill is not amortized, but is tested for impairment at least annually at the reporting unit level. If impairment is indicated, a write-down is recorded as an impairment loss in income from operations.



We review our long-lived assets and identified finite-lived
intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, except for goodwill as noted above. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to undiscounted future net cash flows expected to be generated by the assets. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceeds the fair value of the assets.



Deferred Tax Assets. We account for income taxes using the liability method, which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in our
financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and liabilities, using enacted tax rates in effect for the
year in which the differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance when it is more likely than not that some component or all of the deferred tax assets will not be realized. The computations of our
deferred tax assets and valuation allowance are based on taxable income we expect to earn on sales of existing products and projected interest and other income over the next three years. The amount of the deferred tax assets considered realizable
could be reduced in the near term if estimates of future taxable income are reduced.



SFAS No. 109, Accounting for Income Taxes, requires the consideration of a valuation allowance for deferred tax assets if it is more likely than not that benefits of deferred tax assets
will not be realized. Realization of the $3.6 million of net deferred tax assets is dependent upon our ability to generate sufficient future taxable income and the implementation of tax planning strategies. However, the amount of the deferred tax
assets considered realizable could be reduced in the near term if estimates of future taxable income are reduced or we are unable to implement our tax strategies.



Inflation



To date, we have not been significantly affected by inflation.



Recently Issued Accounting Standards



In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 151, Inventory
Costs (SFAS No. 151). SFAS No. 151 requires abnormal amounts of inventory costs related to idle facility, freight handling and wasted material expenses to be recognized as current period charges. Additionally, SFAS No. 151
requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The standard is effective for fiscal years beginning after June 15, 2005. We believe the adoption of
SFAS No. 151 will not have a material impact on our consolidated financial statements.



In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123(R), Accounting for Stock-Based Compensation (SFAS No. 123R). SFAS No. 123R establishes standards for
accounting for transactions in which an entity exchanges its equity instruments for goods or services. SFAS No. 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment
transactions. SFAS No. 123R requires that the fair value of such equity instruments be recognized as expense in the historical financial statements as services are performed. Prior to SFAS No. 123R, only certain pro forma disclosures of
fair value were required. SFAS No. 123R is effective as of the beginning of our first interim or annual reporting period that begins after June 15, 2005, which is our third quarter of 2005.



SFAS No. 123R permits public companies to adopt requirements using one
of two methods: (1) A modified prospective method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123R for all share-based payments granted after the effective
date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date. (2) A modified retrospective method which includes the
requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under FAS 123 for purposes of pro forma disclosures either (a) all prior periods presented or
(b) prior interim periods of the year of adoption. We are currently in the process of evaluating the two methods and have not yet determined which method will be used. The adoption of this new accounting pronouncement will have a material
impact on our consolidated financial statements.



On
October 22, 2004, the President signed into law the American Jobs Creation Act of 2004 (the Bill). We are currently in the process of evaluating the Bill.



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PART IV



ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K



(a) Documents filed as part of this report:



| | 1. | Consolidated Financial Statements:
| | -- | ----------------------------------



Consolidated Balance Sheets as of December 31, 2004 and 2003

Consolidated Statements of Operations for the years ended December 31, 2004, 2003 and 2002

Consolidated Statements of Stockholders Equity for the years ended December 31, 2004, 2003 and 2002

Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002

Notes to Consolidated Financial Statements

Report of Independent Registered Public Accounting Firm

Report of Independent Registered Public Accounting Firm  Section 404



| | 2. | Consolidated Financial Statement Schedule:
| | -- | ------------------------------------------



Schedule II - Valuation and Qualifying Accounts. Such schedule should be read in conjunction with the consolidated financial statements. All other supplemental schedules are omitted because of the absence of conditions
under which they are required.



(b) Reports on Form 8-K:



On December 16, 2004, we filed a report on Form 8-K pursuant to
Item 5.02, Departure of Directors or Principal Officers; Election of Directors; Appointment of Principal Officers, filing the press release issued December 13, 2004 announcing the resignation of Tim McGurran as President, Chief
Operating Officer and member of the Board of Directors of Secure Computing Corporation. John McNulty, Chief Executive Officer and Chairman, has assumed Mr. McGurrans responsibilities.



(c) Exhibits:



The following exhibits are filed as part of this Annual Report on Form 10-K for the fiscal year ended December 31,
2004:



|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  | Description                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|2.1     |  | Agreement and Plan of Merger, dated as of July 28, 2003, among Secure Computing Corporation, Nitro Acquisition Corp., and N2H2, Inc. is incorporated by reference to the corresponding exhibit
to our Registration Statement of Form S-4 (Registration Number 333-107804).                                                                                                                                                                                                                                                                
|        | 
|3.1     |  | Restated Certificate of Incorporation, effective March 6, 1996, as amended by the Certificate of Amendment of Certificate of Incorporation effective December 11, 1988, the Certificate of
Designations of Series E 4% Cumulative Preferred Stock effective January 26, 2000; and the Certificate of Designations of Series F 4% Cumulative Convertible Preferred Stock effective June 30, 2000 is incorporated by reference to the corresponding
exhibit to our Amended Quarterly Report on Form 10-Q for the period ended June 30, 2000.
|        | 
|3.2     |  | By-Laws of the Registrant are incorporated by reference to Exhibit 3.3 to our Registration Statement on Form S-1 (Registration Number 33-97838).                                                                                                                                                                                                                                                                                                                                                                                          
|        | 
|4.1     |  | Specimen of common stock certificate is incorporated by reference to the corresponding exhibit to Amendment No. 2 to our Registration Statement on Form S-1 (Registration Number
33-97838).                                                                                                                                                                                                                                                                                                                                               
|        | 
|4.2     |  | Amended and Restated 1995 Omnibus Stock Plan is incorporated by reference to the Exhibit 10.1 to our Current Report on Form 8-K filed on October 8, 1999.                                                                                                                                                                                                                                                                                                                                                                                 
|        | 
|Exhibit |  | Description                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|4.3     |  | 2002 Stock Option Plan is incorporated by reference to Exhibit 99.3 to our Registration Statement on Form S-8 (Registration Number 333-103595) and to Exhibit 99.1 to our Registration
Statement on Form S-8 (Registration Number 333-115583).                                                                                                                                                                                                                                                                                            
|        | 
|10.1    |  | Employment Agreement with John McNulty is incorporated by reference to the corresponding exhibit of our Quarterly Report on Form 10-K for the period ended March 31, 1999.                                                                                                                                                                                                                                                                                                                                                                



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|     |  |                                                                                                                                                                               
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|     | 
|10.2 |  | Employment Agreement with Timothy Steinkopf is incorporated by reference to the corresponding exhibit of our Quarterly Report on Form 10-Q for the period ended June 30,
2001.
|     | 
|10.3 |  | Employment Agreement with Vince Schiavo is incorporated by reference to Exhibit 10.1 of our Quarterly Report on Form 10-Q for the period ended June 30, 2001.                 
|     | 
|10.4 |  | Employment Agreement with Michael Gallagher is incorporated by reference to Exhibit 10.4 of our Annual Report on Form 10-K for the period ended December 31, 2004.            
|     | 
|10.5 |  | Employment Agreement with Mary Budge is incorporated by reference to Exhibit 10.5 of our Annual Report on Form 10-K for the period ended December 31, 2004.                   
|     | 
|23.1 |  | Consent of Ernst & Young LLP.                                                                                                                                                 
|     | 
|31.1 |  | Certification of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.                                                                               
|     | 
|31.2 |  | Certification of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.                                                                               
|     | 
|32.1 |  | Certification by Chairman, President and Chief Executive Officer Pursuant to Section 906 of Sarbanes-Oxley Act of 2002.                                                       
|     | 
|32.2 |  | Certification by Senior Vice President and Chief Financial Officer Pursuant to Section 906 of Sarbanes-Oxley Act of 2002.                                                     



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##### Table of Contents

SECURE COMPUTING CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)



|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                  |  | December 31,2004 |          |   | December 31,2003 |  
|ASSETS                                                                                                                            |  |                  |          |   |                  |   |          |  
|Current assets                                                                                                                    |  |                  |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                         |  | $                | 37,899   |   |                  | $ | 12,101   |  
|Investments                                                                                                                       |  |                  | 14,407   |   |                  |   | 21,580   |  
|Accounts receivable (net of reserves of 2004 - $450; 2003 - $868)                                                                 |  |                  | 20,263   |   |                  |   | 17,148   |  
|Inventories                                                                                                                       |  |                  | 2,793    |   |                  |   | 1,227    |  
|Deferred income taxes                                                                                                             |  |                  | 3,604    |   |                  |   | 3,259    |  
|Other current assets                                                                                                              |  |                  | 5,228    |   |                  |   | 3,973    |  
|Current assets from discontinued operations                                                                                       |  |                  | 260      |   |                  |   | 545      |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Total current assets                                                                                                              |  |                  | 84,454   |   |                  |   | 59,833   |  
|                                                                                                                                  |  |                 
|Property and equipment                                                                                                            |  |                  |          |   |                  |   |          |  
|Computer equipment and software                                                                                                   |  |                  | 18,100   |   |                  |   | 16,652   |  
|Furniture and fixtures                                                                                                            |  |                  | 2,445    |   |                  |   | 2,388    |  
|Leasehold improvements                                                                                                            |  |                  | 2,415    |   |                  |   | 2,375    |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|                                                                                                                                  |  |                  | 22,960   |   |                  |   | 21,415   |  
|Accumulated depreciation                                                                                                          |  |                  | (18,919  | ) |                  |   | (16,411  | )
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|                                                                                                                                  |  |                  | 4,041    |   |                  |   | 5,004    |  
|                                                                                                                                  |  |                 
|Goodwill                                                                                                                          |  |                  | 39,329   |   |                  |   | 40,416   |  
|Intangible assets(net of accumulated amortization of 2004 - $1,262; 2003 - $603)                                                  |  |                  | 2,482    |   |                  |   | 2,568    |  
|Other assets                                                                                                                      |  |                  | 608      |   |                  |   | 654      |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Total assets                                                                                                                      |  | $                | 130,914  |   |                  | $ | 108,475  |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                              |  |                  |          |   |                  |   |          |  
|Current liabilities                                                                                                               |  |                  |          |   |                  |   |          |  
|Accounts payable                                                                                                                  |  | $                | 2,578    |   |                  | $ | 2,861    |  
|Accrued payroll                                                                                                                   |  |                  | 4,090    |   |                  |   | 3,539    |  
|Acquisition reserve                                                                                                               |  |                  | 879      |   |                  |   | 1,757    |  
|Other accrued expenses                                                                                                            |  |                  | 1,601    |   |                  |   | 1,024    |  
|Deferred revenue                                                                                                                  |  |                  | 23,915   |   |                  |   | 21,663   |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Total current liabilities                                                                                                         |  |                  | 33,063   |   |                  |   | 30,844   |  
|                                                                                                                                  |  |                 
|Acquisition reserve, net of current portion                                                                                       |  |                  | 493      |   |                  |   | 1,839    |  
|Deferred revenue, net of current portion                                                                                          |  |                  | 5,532    |   |                  |   | 3,778    |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Total liabilities                                                                                                                 |  |                  | 39,088   |   |                  |   | 36,461   |  
|                                                                                                                                  |  |                 
|Stockholders equity                                                                                                              |  |                  |          |   |                  |   |          |  
|Convertible preferred stock, par value $.01 per share:                                                                            |  |                  |          |   |                  |   |          |  
|Authorized  2,000,000 shares; issued and outstanding shares - December 31, 2004 and 2003  none                                  |  |                  |         |   |                  |   |         |  
|Common stock, par value $.01 per share:                                                                                           |  |                  |          |   |                  |   |          |  
|Authorized  50,000,000 shares; issued and outstanding shares  December 31, 2004  35,797,695 and December 31, 2003
 34,953,772 |  |                  | 358      |   |                  |   | 350      |  
|Additional paid-in capital                                                                                                        |  |                  | 197,244  |   |                  |   | 190,090  |  
|Accumulated deficit                                                                                                               |  |                  | (105,072 | ) |                  |   | (117,907 | )
|Accumulated other comprehensive loss                                                                                              |  |                  | (704     | ) |                  |   | (519     | )
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Total stockholders equity                                                                                                        |  |                  | 91,826   |   |                  |   | 72,014   |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  
|Total liabilities and stockholders equity                                                                                        |  | $                | 130,914  |   |                  | $ | 108,475  |  
|                                                                                                                                  |  |                  |          |   |                  |   |          |  



See accompanying
notes.



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SECURE COMPUTING CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)



|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|------------------------------------------------ |  | ----------------------- | ------ | ---- | - | ------ | ---- |  | - | ------ | -
|                                                 |  | Year ended December 31, |       
|                                                 |  | 2004                    |        | 2003 |   |        | 2002 | 
|Revenue                                          |  |                         |        |      |   |        |      |  |   |        |  
|Products                                         |  | $                       | 67,625 |      | $ | 52,422 |      |  | $ | 37,603 |  
|Services                                         |  |                         | 25,753 |      |   | 23,791 |      |  |   | 24,357 |  
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Total revenues                                   |  |                         | 93,378 |      |   | 76,213 |      |  |   | 61,960 |  
|                                                 |  |                         |       
|Cost of revenues                                 |  |                         |        |      |   |        |      |  |   |        |  
|Products                                         |  |                         | 12,335 |      |   | 7,621  |      |  |   | 4,707  |  
|Services                                         |  |                         | 5,052  |      |   | 5,014  |      |  |   | 5,599  |  
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|                                                 |  |                         |       
|Total cost of revenues                           |  |                         | 17,387 |      |   | 12,635 |      |  |   | 10,306 |  
|                                                 |  |                         |       
|Gross profit                                     |  |                         | 75,991 |      |   | 63,578 |      |  |   | 51,654 |  
|                                                 |  |                         |       
|Operating expenses                               |  |                         |        |      |   |        |      |  |   |        |  
|Selling and marketing                            |  |                         | 41,201 |      |   | 33,715 |      |  |   | 29,390 |  
|Research and development                         |  |                         | 16,106 |      |   | 15,179 |      |  |   | 14,912 |  
|General and administrative                       |  |                         | 6,456  |      |   | 5,535  |      |  |   | 5,113  |  
|Separation costs                                 |  |                         |       |      |   |       |      |  |   | 568    |  
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|                                                 |  |                         | 63,763 |      |   | 54,429 |      |  |   | 49,983 |  
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Operating income                                 |  |                         | 12,228 |      |   | 9,149  |      |  |   | 1,671  |  
|Other non-recurring expense                      |  |                         |       |      |   |       |      |  |   | (7,258 | )
|Interest and other income                        |  |                         | 607    |      |   | 141    |      |  |   | 421    |  
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Net income (loss) from continuing operations     |  |                         | 12,835 |      |   | 9,290  |      |  |   | (5,166 | )
|Loss from operations of discontinued AT division |  |                         |       |      |   | (757   | )    |  |   | (1,310 | )
|Loss on disposal of AT division                  |  |                         |       |      |   | (277   | )    |  |   |       |  
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Net income (loss)                                |  | $                       | 12,835 |      | $ | 8,256  |      |  | $ | (6,476 | )
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Basic income (loss) per share:                   |  |                         |        |      |   |        |      |  |   |        |  
|Continuing operations                            |  | $                       | 0.36   |      | $ | 0.29   |      |  | $ | (0.18  | )
|Discontinued operations                          |  |                         |       |      |   | (0.03  | )    |  |   | (0.04  | )
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Basic income (loss) per share                    |  | $                       | 0.36   |      | $ | 0.26   |      |  | $ | (0.22  | )
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Weighted average shares outstanding - basic      |  |                         | 35,576 |      |   | 31,986 |      |  |   | 29,307 |  
|                                                 |  |                         |       
|Diluted income (loss) per share:                 |  |                         |        |      |   |        |      |  |   |        |  
|Continuing operations                            |  | $                       | 0.34   |      | $ | 0.28   |      |  | $ | (0.18  | )
|Discontinued operations                          |  |                         |       |      |   | (0.03  | )    |  |   | (0.04  | )
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Diluted income (loss) per share                  |  | $                       | 0.34   |      | $ | 0.25   |      |  | $ | (0.22  | )
|                                                 |  |                         |        |      |   |        |      |  |   |        |  
|Weighted average shares outstanding - diluted    |  |                         | 37,256 |      |   | 33,654 |      |  |   | 29,307 |  



See accompanying
notes.



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##### Table of Contents

SECURE COMPUTING CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

(in thousands, except share amounts)



|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|---------------------------------------------------------- |  | --------------- |  | ------------ | - | ------------------------- | ---------- | ------------------ | - | --- | ---------------------------------- | - | ------- | ------------------------- | - | -------- | - |  | - | ---- | - |  | - | ------ | -
|                                                           |  | Preferred Stock |  | Common Stock |   | Additional Paid-InCapital |            | AccumulatedDeficit |   |     | AccumulatedOther ComprehensiveLoss |   |         | Total StockholdersEquity |  
|                                                           |  | Shares          |  | ParValue     |   | Shares                    |            | ParValue           |   |     |                                    |  
|BALANCE, December 31, 2001                                 |  |                |  | $            |  |                           | 28,830,992 |                    | $ | 288 |                                    | $ | 148,585 |                           | $ | (119,687 | ) |  | $ | (490 | ) |  | $ | 28,696 |  
|Comprehensive loss:                                        |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|Net loss for the year                                      |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   | (6,476   | ) |  |   |     |   |  |   | (6,476 | )
|Foreign currency translation adjustment                    |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   |         |   |  |   | (113 | ) |  |   | (113   | )
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|Total comprehensive loss                                   |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   | (6,589 | )
|Exercise of employee stock options                         |  |                |  |              |  |                           | 191,506    |                    |   | 2   |                                    |   | 1,149   |                           |   |         |   |  |   |     |   |  |   | 1,151  |  
|Employee stock purchase plan activity                      |  |                |  |              |  |                           | 361,607    |                    |   | 3   |                                    |   | 1,405   |                           |   |         |   |  |   |     |   |  |   | 1,408  |  
|Purchase of Gauntlet, net of stock registration fees       |  |                |  |              |  |                           | 300,354    |                    |   | 4   |                                    |   | 4,993   |                           |   |         |   |  |   |     |   |  |   | 4,997  |  
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|BALANCE, December 31, 2002                                 |  |                |  |              |  |                           | 29,684,459 |                    |   | 297 |                                    |   | 156,132 |                           |   | (126,163 | ) |  |   | (603 | ) |  |   | 29,663 |  
|Comprehensive income:                                      |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|Net income for the year                                    |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   | 8,256    |   |  |   |     |   |  |   | 8,256  |  
|Foreign currency translation adjustment                    |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   |         |   |  |   | 90   |   |  |   | 90     |  
|Unrealized loss on investments                             |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   |         |   |  |   | (6   | ) |  |   | (6     | )
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|Total comprehensive income                                 |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   | 8,340  |  
|Exercise of employee stock options                         |  |                |  |              |  |                           | 1,073,964  |                    |   | 11  |                                    |   | 4,238   |                           |   |         |   |  |   |     |   |  |   | 4,249  |  
|Employee stock purchase plan activity                      |  |                |  |              |  |                           | 297,106    |                    |   | 3   |                                    |   | 1,349   |                           |   |         |   |  |   |     |   |  |   | 1,352  |  
|Litigation settlements                                     |  |                |  |              |  |                           | 2,029,729  |                    |   | 20  |                                    |   | 8,375   |                           |   |         |   |  |   |     |   |  |   | 8,395  |  
|Purchase of N2H2, net of cash issued for fractional shares |  |                |  |              |  |                           | 1,868,514  |                    |   | 19  |                                    |   | 19,996  |                           |   |         |   |  |   |     |   |  |   | 20,015 |  
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|BALANCE, December 31, 2003                                 |  |                |  |              |  |                           | 34,953,772 |                    |   | 350 |                                    |   | 190,090 |                           |   | (117,907 | ) |  |   | (519 | ) |  |   | 72,014 |  
|Comprehensive income:                                      |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|Net income for the year                                    |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   | 12,835   |   |  |   |     |   |  |   | 12,835 |  
|Foreign currency translation adjustment                    |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   |          |   |  |   | (183 | ) |  |   | (183   | )
|Unrealized loss on investments                             |  |                |  |              |  |                           |           |                    |   |    |                                    |   |        |                           |   |         |   |  |   | (2   | ) |  |   | (2     | )
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|Total comprehensive income                                 |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   | 12,650 |  
|Exercise of employee stock options                         |  |                |  |              |  |                           | 678,451    |                    |   | 6   |                                    |   | 5,787   |                           |   |         |   |  |   |     |   |  |   | 5,793  |  
|Employee stock purchase plan activity                      |  |                |  |              |  |                           | 165,472    |                    |   | 2   |                                    |   | 1,367   |                           |   |         |   |  |   |     |   |  |   | 1,369  |  
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  
|BALANCE, December 31, 2004                                 |  |                |  | $            |  |                           | 35,797,695 |                    | $ | 358 |                                    | $ | 197,244 |                           | $ | (105,072 | ) |  | $ | (704 | ) |  | $ | 91,826 |  
|                                                           |  |                 |  |              |   |                           |            |                    |   |     |                                    |   |         |                           |   |          |   |  |   |      |   |  |   |        |  



See accompanying
notes.



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##### Table of Contents

SECURE COMPUTING CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------ | -
|                                                                                                                    |  | Year Ended December 31, |        
|                                                                                                                    |  | 2004                    |         |   | 2003 |   |         | 2002 | 
|Operating activities                                                                                                |  |                         |         |   |      |   |         |      |  |   |        |  
|Net income (loss)                                                                                                   |  | $                       | 12,835  |   |      | $ | 8,256   |      |  | $ | (6,476 | )
|Loss from discontinued operations                                                                                   |  |                         |        |   |      |   | 1,034   |      |  |   | 1,310  |  
|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|Net income (loss) from continuing operations                                                                        |  |                         | 12,835  |   |      |   | 9,290   |      |  |   | (5,166 | )
|Adjustments to reconcile net income (loss) from continuing operations to net cash provided by operating activities: |  |                         |         |   |      |   |         |      |  |   |        |  
|Depreciation                                                                                                        |  |                         | 2,515   |   |      |   | 2,711   |      |  |   | 2,758  |  
|Amortization                                                                                                        |  |                         | 887     |   |      |   | 353     |      |  |   | 239    |  
|Loss on disposals of property and equipment                                                                         |  |                         | 1       |   |      |   | 14      |      |  |   | 121    |  
|Loss on disposals of intangible assets                                                                              |  |                         | 47      |   |      |   | 95      |      |  |   |       |  
|Deferred income taxes                                                                                               |  |                         | (345    | ) |      |   | (559    | )    |  |   |       |  
|Changes in operating assets and liabilities, net of acquisitions:                                                   |  |                         |         |   |      |   |         |      |  |   |        |  
|Accounts receivable                                                                                                 |  |                         | (2,795  | ) |      |   | (4,589  | )    |  |   | 90     |  
|Inventories                                                                                                         |  |                         | (1,566  | ) |      |   | (342    | )    |  |   | (128   | )
|Other current assets                                                                                                |  |                         | (1,255  | ) |      |   | (2,079  | )    |  |   | (513   | )
|Accounts payable                                                                                                    |  |                         | (133    | ) |      |   | 956     |      |  |   | (176   | )
|Payroll related accruals                                                                                            |  |                         | 551     |   |      |   | 78      |      |  |   | (256   | )
|Accrued liabilities and reserves                                                                                    |  |                         | (1,033  | ) |      |   | (1,553  | )    |  |   | 218    |  
|Litigation settlement accrual                                                                                       |  |                         |        |   |      |   |        |      |  |   | 7,258  |  
|Deferred revenue                                                                                                    |  |                         | 4,006   |   |      |   | 1,116   |      |  |   | (3,482 | )
|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|Net cash provided by operating activities                                                                           |  |                         | 13,715  |   |      |   | 5,491   |      |  |   | 963    |  
|                                                                                                                    |  |                         |        
|Investing activities                                                                                                |  |                         |         |   |      |   |         |      |  |   |        |  
|Proceeds from sales/maturities of investments                                                                       |  |                         | 17,528  |   |      |   | 2,506   |      |  |   | 8,831  |  
|Purchases of investments                                                                                            |  |                         | (10,355 | ) |      |   | (20,705 | )    |  |   | (7,088 | )
|Purchase of property and equipment, net                                                                             |  |                         | (1,553  | ) |      |   | (1,970  | )    |  |   | (2,095 | )
|(Increase) decrease in intangibles and other assets                                                                 |  |                         | (802    | ) |      |   | (235    | )    |  |   | 236    |  
|Cash acquired in N2H2 purchase                                                                                      |  |                         |        |   |      |   | 4,260   |      |  |   |       |  
|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|Net cash provided by investing activities                                                                           |  |                         | 4,818   |   |      |   | (16,144 | )    |  |   | (116   | )
|                                                                                                                    |  |                         |        
|Financing activities                                                                                                |  |                         |         |   |      |   |         |      |  |   |        |  
|Proceeds from issuance of common stock                                                                              |  |                         | 7,162   |   |      |   | 5,601   |      |  |   | 2,559  |  
|                                                                                                                    |  |                         |        
|Effect of foreign currency translation                                                                              |  |                         | (182    | ) |      |   | 90      |      |  |   | (113   | )
|Net cash provided by (used in) discontinued operations                                                              |  |                         | 285     |   |      |   | (987    | )    |  |   | (1,199 | )
|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|Net (decrease) increase in cash and cash equivalents                                                                |  |                         | 25,798  |   |      |   | (5,949  | )    |  |   | 2,094  |  
|Cash and cash equivalents, beginning of year                                                                        |  |                         | 12,101  |   |      |   | 18,050  |      |  |   | 15,956 |  
|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|Cash and cash equivalents, end of year                                                                              |  | $                       | 37,899  |   |      | $ | 12,101  |      |  | $ | 18,050 |  
|                                                                                                                    |  |                         |         |   |      |   |         |      |  |   |        |  
|Supplemental Cash Flow Disclosure:                                                                                  |  |                         |         |   |      |   |         |      |  |   |        |  
|Common stock issued for purchase of N2H2, Inc.                                                                      |  |                         |        |   |      | $ | 20,019  |      |  |   |       |  
|Common stock issued for litigation settlements                                                                      |  |                         |        |   |      | $ | 8,395   |      |  |   |       |  
|Common stock issued for purchase of Gauntlet                                                                        |  |                         |        |   |      |   |        |      |  | $ | 5,000  |  



See accompanying
notes.



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##### Table of Contents

SECURE COMPUTING CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



1. Summary of Significant Accounting Policies



Organization



We develop network security solutions that create trusted connections between organizations and their customers, partners,
and employeesthereby enabling them to exchange critical information safely, helping them confidently build their businesses. Our technologies enable our customers to secure the sharing of information resources at every connection point, while
implementing a balance between security and accessibility according to their policy objectives. We work closely with our customers to provide them with reliable access control and innovative new features that are comprehensive, easy to manage and
highly effective in securing the connections between people, applications and networks.



Our partners and customers include the majority of the Dow Jones Global 50 Titans and numerous organizations in the Fortune 1000, as well as banking, financial services, healthcare, telecommunications, manufacturing,
public utilities, schools, and federal, state and local governments. We have close relationships with the largest agencies of the United States government, both federal and local. Our customer list also includes numerous international organizations
and foreign governments. Overseas, our customers are concentrated primarily in Europe, Japan, China, the Pacific Rim, and Latin America.



Basis of Consolidation



The consolidated financial statements include the accounts of Secure Computing Corporation and our wholly-owned subsidiaries. All intercompany balances
and transactions have been eliminated in consolidation.



Use of Estimates



The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.



Reclassifications



Certain previously reported amounts have been reclassified to conform to the current presentation format with no impact on
net income (loss). In accordance with Rule 5-03.2 of Regulation S-X, we reclassified certain expenses which previously had been shown as sales and marketing expenses to costs of revenues. The reclassification results in a $5.1 million, $5.0 million,
and $5.6 million reduction in sales and marketing expenses and increase to costs of revenues for each of the years ended December 31, 2004, 2003 and 2002, respectively. As a result of the reclassification, gross profit is $76.0 million, $63.6
million, and $51.7 million for each of the years ended December 31 2004, 2003 and 2002, respectively. In addition, gross profit as a percentage of revenues is 81.4%, 83.4%, and 83.4% for each of the years ended December 31 2004, 2003 and
2002, respectively. The reclassification was done to more accurately report costs associated with revenue from post contract support and professional services. Also, in accordance with Statement of Financial Accounting Standards (SFAS) No. 95,
Statement of Cash Flows, we originally reclassified $5.0 million of taxable auction rate securities from cash equivalents to short-term investments as of December 31, 2003 in our Annual Report on Form 10-K filed on March 11,
2005.



Revenue Recognition



We derive our revenue primarily from two sources: (i) sales of
products, including hardware, subscriptions, software licenses, and royalties and (ii) sales of services, including maintenance arrangements to provide upgrades and customer support and professional services. We recognize revenue in accordance
with Statement of Position (SOP) 97-2, Software Revenue Recognition, as modified by SOP 98-9. Revenue from products is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and
determinable, and collection is probable. Subscription-based contracts are generally for 12, 24 or 36 months in duration. Subscription revenue along with maintenance revenue for providing product upgrades and customer support are deferred and
recognized ratably over the service period beginning with the month the subscription or service begins.



For arrangements with multiple elements we allocate revenue to the various elements based on the fair value of each element sold. We determine the fair
value of each element based on its selling price when sold separately. Evidence of fair value includes the approved price list and discount schedule and the actual prices charged for comparable arrangements. These price lists and discount schedules
may change from time to time in response to factors including market conditions, value of services and product provided and competitive positioning. Historically, we have not offered significant discounts off of our list prices.



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Further, it is our policy that our distributors and resellers are not allowed to hold inventory with the
exception of international resellers who are allowed to hold inventories of Safeword for Citrix (and other Safeword for products). This is a low price-point product with disproportionately high overseas freight costs. As
such, we allow the reseller to carry a balance of inventory and provide end-user sell-through reporting. Revenue is recognized at the point that we receive evidence of end-user sell-through.



Cash Equivalents



We consider all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.
Cash equivalents are carried at cost, which approximates fair value.



Investments



We account for investments with
the provisions of Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. SFAS No. 115 addresses the accounting and reporting for investments in fixed
maturity securities and for equity securities with readily determinable fair values. Currently, all of our investments are classified as available-for-sale. Available-for-sale investments are carried at fair value as determined by quoted market
prices, with unrealized gains and losses, net of tax, reported as a separate component of stockholders equity. The cost basis of investments that are sold or matured is determined using the specific identification method. Interest and
dividends on investments classified as available-for-sale are included in interest income. The gross realized gains and losses for the sale or maturity of available-for-sale investments were not material in all periods presented.



Accounts Receivable



Accounts receivable are initially recorded at fair value upon the sale of products or services to our customers. We make
estimates regarding the collectibility of our accounts receivables. When we evaluate the adequacy of our allowance for doubtful accounts, we consider multiple factors including historical bad debt experience, the need for specific customer reserves,
the aging of our receivables, customer creditworthiness, changes in our customer payment cycles, and current economic trends. The provision for doubtful accounts is included in the selling and marketing expense on the consolidated statement of
operations. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.



Inventories



Inventories consist mainly of purchased components and prepaid licenses and are valued at the lower of cost or market using the first-in, first-out (FIFO)
method.



Property and Equipment



Property and equipment are carried at cost. Depreciation is calculated using
the straight-line method with estimated useful lives ranging from 3 to 8 years. Leasehold improvements are depreciated over the lesser of the useful life of the asset or the term of the lease.



Other Current Assets and Other Assets



Other current assets are carried at cost and consist of unbilled
receivables, interest receivable, and prepaid expenses for items such as directors and officers liability insurance, trade shows, royalties, and foreign taxes to be either expensed or collected within 12 months. Other assets are carried at cost and
include rent deposits, employee notes receivable, and prepaid foreign value-added tax to be collected after 12 months.



Income Taxes



We account for income taxes using the liability method, which requires recognition of deferred tax liabilities and assets for the expected future tax
consequences of events that have been included in our financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax basis of assets and
liabilities, using enacted tax rates in effect for the year in which the differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance when it is more likely than not that some component or all of the deferred tax
assets will not be realized.



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Goodwill and Other Intangible Assets



Intangible assets consist of patents, trademarks, capitalized software costs, purchased customer lists, a purchased control
list, capitalized developed technology and goodwill, all of which are recorded at cost or fair value. Patents, trademarks, customer and control lists, and capitalized developed technology are amortized using the straight-line method over the
estimated useful lives of the assets, which range up to 17 years. See accounting policy of capitalized software costs below under Research and Development.



Goodwill is not amortized, but is tested for impairment at the reporting unit level at least annually. If impairment is indicated, a write-down is
recorded as an impairment loss in income from operations. An impairment charge is recognized only when the calculated fair value of a reporting unit, including goodwill, is less than its carrying amount. In accordance with SFAS No. 142,
Goodwill and Other Intangible Assets, we completed the required impairment tests of goodwill and indefinite lived intangible assets as of November 30, 2004 and 2003 and determined the fair value to be in excess of the carrying value
of these assets. Therefore, goodwill was not impaired and no impairment charge was reported.



Long-Lived Assets



We
review our long-lived assets and identified finite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, except for goodwill as noted above.
Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to undiscounted future net cash flows expected to be generated by the assets. If such assets are considered to be impaired, the impairment to
be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. There were no such impairments during the period presented.



Other Accrued Expenses



At December 31, 2004, other accrued expenses consisted of costs related to professional fees, foreign taxes and accrued marketing CO-OP funds. At
December 31, 2003, other accrued expenses consisted of costs related to professional fees and foreign taxes.



Financial Instruments



Carrying amounts of financial instruments held by us, which include cash equivalents, short-term investments, restricted cash, accounts receivable,
accounts payable and accrued expenses, approximate fair value due to their short-term nature.



Concentrations of Credit Risk



Financial instruments that potentially subject us to concentrations of credit risk consist primarily of accounts receivable. We perform ongoing credit evaluations of our customers, generally require customers to prepay for maintenance and
maintain reserves for potential losses. Our customer base is primarily composed of businesses throughout the United States, Europe and Asia.



Foreign Currency Translation and Transactions



Foreign assets and liabilities were translated using the exchange rates in effect at the balance sheet date. Results of operations were translated using
average exchange rates throughout the year. Translation gains or losses have been reported in other comprehensive income as a component of stockholders equity. Cumulative foreign currency translation loss balances were $696,000 and $513,000 at
December 31, 2004 and 2003, respectively. Any gains or losses resulting from foreign currency transactions are included in the consolidated statements of operations and were not significant during the periods presented.



Selling and Marketing



Selling and marketing expenses consist primarily of salaries, commissions, and benefits related to personnel engaged in
selling and marketing functions, along with costs related to advertising, promotions, public relations and shipping and handling.



Research and Development



Research and development expenditures are charged to operations as incurred. Statement of Financial Accounting Standards (SFAS) No. 86,
Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,



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requires capitalization of certain software development costs subsequent to the establishment of technological
feasibility. Based on our product development process, technological feasibility is established upon completion of a working model. Costs that we incur between completion of the working model and the point at which the product is generally available
for sale are capitalized and amortized over their estimated useful life of three years.



Comprehensive Income (Loss)



The components of
our comprehensive income (loss) are net income (loss), foreign currency translation adjustments, and unrealized loss on investments. Comprehensive income (loss) for all periods presented is included in our consolidated statements of
stockholders equity.



Stock Options



At December 31, 2004, we have eight stock option-based compensation
plans, which are described more fully in Note 9. We account for those plans in accordance with the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee
compensation cost is reflected in the consolidated statements of operations, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table
illustrates the effect on net income (loss) and net income (loss) per share if we had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation (in
thousands, except per share data):



|                                                                                                                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                                                            |  | Year Ended December 31, |        
|                                                                                                                                            |  | 2004                    |         |   | 2003 |   |         | 2002 | 
|Net income (loss), as reported                                                                                                              |  | $                       | 12,835  |   |      | $ | 8,256   |      |  | $ | (6,476  | )
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                         | (11,728 | ) |      |   | (11,326 | )    |  |   | (11,841 | )
|                                                                                                                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Pro forma net income (loss)                                                                                                                 |  | $                       | 1,107   |   |      | $ | (3,070  | )    |  | $ | (18,317 | )
|                                                                                                                                            |  |                         |         |   |      |   |         |      |  |   |         |  
|Net income (loss) per share:                                                                                                                |  |                         |         |   |      |   |         |      |  |   |         |  
|Basic  as reported                                                                                                                         |  | $                       | 0.36    |   |      | $ | 0.26    |      |  | $ | (0.22   | )
|Basic  pro forma                                                                                                                           |  | $                       | 0.03    |   |      | $ | (0.10   | )    |  | $ | (0.63   | )
|Diluted  as reported                                                                                                                       |  | $                       | 0.34    |   |      | $ | 0.25    |      |  | $ | (0.22   | )
|Diluted  pro forma                                                                                                                         |  | $                       | 0.03    |   |      | $ | (0.10   | )    |  | $ | (0.63   | )



The fair value for
these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions:



|                        |  |         |   |  |         |   |  |         |  
|----------------------- |  | ------- | - |  | ------- | - |  | ------- | -
|                        |  | 2004    |   |  | 2003    |   |  | 2002    |  
|Assumptions used:       |  |         |   |  |         |   |  |         |  
|Volatility              |  | 97      | % |  | 107     | % |  | 104     | %
|Risk-free interest rate |  | 3.6     | % |  | 3.0     | % |  | 3.8     | %
|Expected life           |  | 5 years |   |  | 5 years |   |  | 5 years |  
|Dividend-yield          |  |        |   |  |        |   |  |        |  



The Black-Scholes
option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions,
including the expected stock price volatility. Because changes in the subjective input assumptions can materially affect the fair value estimate, in our opinion, the existing models do not necessarily provide a reliable single value of our options
and may not be representative of the future effects on reported net income (loss) or the future stock price of our company. For purposes of pro forma disclosure, the estimated fair value of the options is amortized to expense over the options
vesting periods.



Net Income (Loss) Per Share



In accordance with SFAS No. 128, Earnings Per Share, basic
net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) by the combination of
dilutive common share equivalents, which consist solely of stock options, and the weighted average number of common shares outstanding.



20



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##### Table of Contents

Recently Issued Accounting Standards



In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151, Inventory Costs.
SFAS No. 151 requires abnormal amounts of inventory costs related to idle facility, freight handling and wasted material expenses to be recognized as current period charges. Additionally, SFAS No. 151 requires that allocation of fixed
production overheads to the costs of conversion be based on the normal capacity of the production facilities. The standard is effective for fiscal years beginning after June 15, 2005. We believe the adoption of SFAS No. 151 will not have a
material impact on our consolidated financial statements.



In
December 2004, the FASB issued SFAS No. 123(R), Accounting for Stock-Based Compensation. SFAS No. 123R establishes standards for accounting for transactions in which an entity exchanges its equity instruments for goods or
services. SFAS No. 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123R requires that the fair value of such equity instruments be recognized
as expense in the historical financial statements as services are performed. Prior to SFAS No. 123R, only certain pro forma disclosures of fair value were required. SFAS No. 123R is effective as of the beginning of our first interim or
annual reporting period that begins after June 15, 2005, which is our third quarter of 2005.



SFAS No. 123R permits public companies to adopt requirements using one of two methods: (1) A modified prospective method in which
compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted
to employees prior to the effective date of SFAS 123R that remain unvested on the effective date. (2) A modified retrospective method which includes the requirements of the modified prospective method described above, but also
permits entities to restate based on the amounts previously recognized under FAS 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption. We are currently in the
process of evaluating the two methods and have not yet determined which method will be used. The adoption of this new accounting pronouncement will have a material impact on our consolidated financial statements.



On October 22, 2004, the President signed into law the American Jobs
Creation Act of 2004 (the Bill). We are currently in the process of evaluating the Bill.



2. Discontinued Operations



During the fourth quarter of 2003, we discontinued our Advanced Technology (AT) division. In October 2003, our management determined that we would no longer invest in this business and announced our decision to exit the division. In
accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, this segment is reflected as discontinued operations in our consolidated financial statements. All prior period statements have been
reclassified accordingly, including the reallocation of selling and marketing charges to the AT division. Continued cash flows from discontinued operations pertains to the collection of balances due on contracts that have been completed and are
expected to be collected within the next 12 months.



A summary
statement of operations for the discontinued AT division is as follows (in thousands):



|                                            |  |                         |   |      |   |        |      |  |   |        |  
|------------------------------------------- |  | ----------------------- | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                            |  | Year Ended December 31, |  
|                                            |  | 2004                    |   | 2003 |   |        | 2002 | 
|Revenues                                    |  | $                       |  |      | $ | 2,052  |      |  | $ | 3,877  |  
|Gross profit                                |  |                         |  |      |   | 340    |      |  |   | 1,004  |  
|Loss from operations                        |  |                         |  |      |   | (757   | )    |  |   | (1,310 | )
|Loss on disposal of discontinued operations |  |                         |  |      |   | (277   | )    |  |   |       |  
|                                            |  |                         |   |      |   |        |      |  |   |        |  
|Loss from discontinued operations           |  | $                       |  |      | $ | (1,034 | )    |  | $ | (1,310 | )
|                                            |  |                         |   |      |   |        |      |  |   |        |  



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##### Table of Contents

3. Acquisition of N2H2, Inc.



On October 13, 2003, we acquired 100% of the outstanding common shares of N2H2, Inc. The results of N2H2s
operations have been included in the consolidated financial statements since that date. N2H2 provided Internet filtering and monitoring solutions that are designed to allow Internet users to monitor and filter content categories thereby increasing
productivity, reducing bandwidth consumption, and limiting potential legal liability. N2H2 had two product lines: Sentian for corporate and government markets and Bess for schools, libraries, and non-for-profit organizations. As a result of the
acquisition, we are expected to expand our market share of web filtering services in the markets for Bess and are expected to reduce costs through the economies of scale.



The aggregate purchase price was $20.5 million consisting primarily of 1,868,514 shares of common stock valued at $17.2
million, 422,000 options with a value of $2.9 million, and direct costs of the acquisition of $505,000. The value of the common shares issued was determined based on the average market price of our common shares over the period including two days
before and after the date that the terms of the acquisition were agreed to and announced.



The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition (in thousands):



|                                                                     |  |       |  |   |       
|-------------------------------------------------------------------- |  | ----- |  | - | ------
|Current assets                                                       |  |       |  | $ | 6,300 
|Property and equipment                                               |  |       |  |   | 115   
|Goodwill                                                             |  |       |  |   | 26,452
|Intangible assets subject to amortization:                           |  |       |  |   |       
|Customer list (36 month useful life)                                 |  | 1,141 |  |   |       
|Control list (24 month useful life)                                  |  | 271   |  |   |       
|Capitalized developed technology (18 month useful life)              |  | 42    |  |   |       
|                                                                     |  |       |  |   |       
|                                                                     |  |       |  |   | 1,454 
|Other long-term assets                                               |  |       |  |   | 140   
|                                                                     |  |       |  |   |       
|Total assets acquired                                                |  |       |  |   | 34,461
|                                                                     |  |      
|Current liabilities                                                  |  |       |  |   | 508   
|Acquisition reserve                                                  |  |       |  |   | 4,418 
|Revenue deferred from on-going contractual obligations at fair value |  |       |  |   | 9,516 
|                                                                     |  |       |  |   |       
|Total liabilities assumed                                            |  |       |  |   | 14,442
|                                                                     |  |       |  |   |       
|Net assets acquired                                                  |  |       |  | $ | 20,019
|                                                                     |  |       |  |   |       



We allocated the
purchase price on a preliminary basis using the information then available. The allocation of the purchase prices to the assets and liabilities acquired was finalized in 2004. The primary adjustments to the preliminary allocation were to adjust the
acquisition reserve for severance related items and to adjust the allowance for doubtful accounts for collected N2H2 trade receivables. The final purchase price allocation resulted in a $920,000 decrease to goodwill. We accrued approximately $4.4
million in acquisition related expenses, which included legal and accounting fees, excess capacity fees, directors and officers insurance policy premium, severance costs and other related costs, of which $1.3 million remains as an accrual as of
December 31, 2004.



The following unaudited pro forma
financial information was prepared in accordance with SFAS No. 141 and assumes the acquisition had occurred at the beginning of the periods presented. The unaudited pro forma financial information is provided for informational purposes only.
These pro forma results are based upon the respective historical financial statements of the respective companies, and do not incorporate, nor do they assume, any benefits from cost savings or synergies of operations of the combined company. The pro
forma results are not necessarily indicative of what would have occurred if the acquisition had actually been completed as of the beginning of the periods presented, nor are they necessarily indicative of future consolidated results. The pro forma
results include the estimated amortization of acquired definite lived intangibles.



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##### Table of Contents

3. Acquisition of N2H2, Inc. (continued)



The unaudited combined results of continuing operations are as follows (in thousands, except per share data):



|                                      |  |                         |        |      |   |         |  
|------------------------------------- |  | ----------------------- | ------ | ---- | - | ------- | -
|                                      |  | Year ended December 31, |       
|                                      |  | 2003                    |        | 2002 |  
|Revenue                               |  | $                       | 85,930 |      | $ | 73,229  |  
|Net income (loss)                     |  | $                       | 7,574  |      | $ | (11,080 | )
|Net income (loss) per share  basic   |  | $                       | 0.24   |      | $ | (0.36   | )
|Net income (loss) per share  diluted |  | $                       | 0.23   |      | $ | (0.36   | )



4. Acquisition of the GauntletFirewall and VPN Business



In February 2002, we completed our acquisition of the assets of the Gauntlet firewall and VPN business from Network
Associates, Inc. As a result of the acquisition, we expect to be the worldwide leader in application-layer firewalls. The purchase price, excluding stock registration fees, was 300,354 shares of common stock valued at $5.0 million. The value of the
common shares was determined based on the average market price of our common shares over the period including the five days before the terms of the acquisition were agreed to and announced. The transaction was accounted for as a purchase in
accordance with SFAS No. 141, Business Combinations. Accordingly, the net assets and results of operations have been included in our consolidated financial statements from the date of acquisition. Allocation of the acquisition
purchase price was based on the fair value of the assets acquired and liabilities assumed as follows: $1.0 million allocated to assets acquired, consisting of net accounts receivable and computer equipment; $11.9 million allocated to liabilities
assumed, consisting of support services obligations, acquisition costs, and related accruals; and $15.9 million allocated to goodwill. We allocated the purchase price on a preliminary basis using the information then available. The allocation of the
purchase price to the assets and liabilities acquired was finalized in 2003. The primary adjustment to the preliminary allocation was to adjust the acquisition reserve for severance related items. The final purchase price allocation resulted in a
$1.2 million decrease to goodwill. At December 31, 2004, a balance of $40,000 for liabilities assumed remained compared to $342,000 as of December 31, 2003.



The unaudited combined results of continuing operations for the year ended December 31, 2002 are $63.2 million in
revenue, net loss of $6.5 million and net loss per sharebasic and diluted of $0.19 per share. This unaudited pro forma financial information was prepared in accordance with SFAS No. 141 and assumes the acquisition had occurred at the
beginning of the periods presented. The unaudited pro forma financial information is provided for informational purposes only and does not purport to be indicative of our future results. These pro forma results are based upon the respective
historical financial statements of the respective companies, and do not incorporate, nor do they assume, any benefits from cost savings or synergies of operations of the combined company.



5. Investments



Investments, including cash equivalents, restricted cash and short-term investments were as follows (in thousands):



|                                                 |  |                    |         |   |      |   |        |  
|------------------------------------------------ |  | ------------------ | ------- | - | ---- | - | ------ | -
|                                                 |  | As of December 31, |        
|                                                 |  | 2004               |         |   | 2003 |  
|Money market funds                               |  | $                  | 16,296  |   |      | $ | 6,993  |  
|Commercial paper                                 |  |                    | 14,176  |   |      |   | 8,486  |  
|Federal agencies                                 |  |                    | 1,995   |   |      |   | 2,000  |  
|Government securities                            |  |                    |        |   |      |   | 1,990  |  
|Taxable auction rate securities                  |  |                    | 5,825   |   |      |   | 5,000  |  
|Certificates of deposit                          |  |                    | 281     |   |      |   | 763    |  
|Corporate bonds                                  |  |                    |        |   |      |   | 3,341  |  
|                                                 |  |                    |         |   |      |   |        |  
|Total investments                                |  |                    | 38,573  |   |      |   | 28,573 |  
|Amounts classified as cash equivalents           |  |                    | (24,166 | ) |      |   | (6,993 | )
|                                                 |  |                    |         |   |      |   |        |  
|Total short-term investments and restricted cash |  | $                  | 14,407  |   |      | $ | 21,580 |  
|                                                 |  |                    |         |   |      |   |        |  



All short-term
investments mature within one year. Unrealized losses on available-for-sale investments at December 31, 2004 and 2003 were $8,000 and $6,000, respectively and are reported as a component of other comprehensive income (loss) in the statement of
stockholders equity. We have restricted cash pledged in the form of certificates of deposit and money market funds against our letters of credit of $275,000 and $321,000, respectively, at December 31, 2004. In 2003, we had restricted cash
pledged in the form of certificates of deposit against our letters of credit of $760,000.



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##### Table of Contents

6. Letters of Credit



As of December 31, 2004, we have four letter of credit agreements totaling $596,000. One letter of credit for $275,000 and $310,000, as of
December 31, 2004 and 2003, respectively, is with a bank to secure rental space for our San Jose, CA office and automatically renews for a one year period each year through March 31, 2008. Another letter of credit agreement for $250,000
and $450,000, as of December 31, 2004 and 2003, respectively is with a bank to secure rental space for our Seattle, WA office and automatically renews for a one year period each year through August 31, 2005. Two remaining letters of credit
totaling $71,000 as of December 31, 2004 are to secure business with an international customer, which expire April 2008.



7. Goodwill and Other Intangible Assets



The changes in goodwill during 2004 and 2003 were as follows (in thousands):



|                                                      |  |   |        |  
|----------------------------------------------------- |  | - | ------ | -
|Balance as of January 1, 2003                         |  | $ | 15,195 |  
|Finalization of purchase price allocation of Gauntlet |  |   | (1,231 | )
|Acquisition of N2H2                                   |  |   | 26,452 |  
|                                                      |  |   |        |  
|Balance as of December 31, 2003                       |  |   | 40,416 |  
|Reversal of Gauntlet reserves                         |  |   | (167   | )
|Finalization of purchase price allocation of N2H2     |  |   | (920   | )
|                                                      |  |   |        |  
|Balance as of December 31, 2004                       |  | $ | 39,329 |  
|                                                      |  |   |        |  



Identified intangible
assets subject to amortization are as follows (in thousands):



|                                 |  |                         |       |                         |   |        |     |  |               |       |                         |   |       |     |   |      |   |  |   |      
|-------------------------------- |  | ----------------------- | ----- | ----------------------- | - | ------ | --- |  | ------------- | ----- | ----------------------- | - | ----- | --- | - | ---- | - |  | - | -----
|                                 |  | As of December 31, 2004 |       | As of December 31, 2003
|                                 |  | CarryingValue           |       | AccumulatedAmortization |   |        | Net |  | CarryingValue |       | AccumulatedAmortization |   |       | Net
|Customer list                    |  | $                       | 1,141 |                         | $ | (460   | )   |  | $             | 681   |                         | $ | 1,141 |     | $ | (79  | ) |  | $ | 1,062
|Control lists                    |  |                         | 771   |                         |   | (220   | )   |  |               | 551   |                         |   | 271   |     |   | (28  | ) |  |   | 243  
|Capitalized developed technology |  |                         | 42    |                         |   | (34    | )   |  |               | 8     |                         |   | 42    |     |   | (6   | ) |  |   | 36   
|Patents and trademarks           |  |                         | 1,237 |                         |   | (280   | )   |  |               | 957   |                         |   | 1,135 |     |   | (220 | ) |  |   | 915  
|Capitalized software             |  |                         | 553   |                         |   | (268   | )   |  |               | 285   |                         |   | 582   |     |   | (270 | ) |  |   | 312  
|                                 |  |                         |       |                         |   |        |     |  |               |       |                         |   |       |     |   |      |   |  |   |      
|Total                            |  | $                       | 3,744 |                         | $ | (1,262 | )   |  | $             | 2,482 |                         | $ | 3,171 |     | $ | (603 | ) |  | $ | 2,568
|                                 |  |                         |       |                         |   |        |     |  |               |       |                         |   |       |     |   |      |   |  |   |      



Total amortization
expense was $887,000, $353,000 and $239,000 for the years ended December 31, 2004, 2003 and 2002, respectively. Of the total amortization expense, $219,000, $161,000, and $108,000 pertained to capitalized software costs for the years ended
December 31, 2004, 2003, and 2002. Estimated amortization expense for each of the five succeeding fiscal years based on current intangible assets is expected to be $871,000, $623,000, $208,000, $57,000 and $52,000, respectively.



8. Stock Plans



1995 Omnibus Stock Option Plan



In September 1995, our Board of Directors and stockholders approved our 1995 Omnibus Stock Plan. Under the terms of this
Plan, key employees and non-employees may be granted options to purchase up to 11,494,131 shares of our Common Stock. The majority of options granted under this plan have ten year terms and vest either annually over three years, or fully vest at the
end of three years. Beginning in 2003, all new stock options granted under this plan vest 25% after the first year and then monthly over the following three years.



2002 Stock Option Plan



In July 2002, our Board of Directors approved our 2002 Stock Option Plan. Under the terms of this Plan, key employees and non-employees may be granted
options to purchase up to 3,500,000 shares of our Common Stock. The options granted in 2002 have ten year terms and vest either annually over three years, or fully vest at the end of three years. Directors and Executive officers are not eligible for
this plan. Beginning in 2003, all new stock options granted under this plan vest 25% after the first year and then monthly over the following three years.



24



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##### Table of Contents

8. Stock Plans (continued)



N2H2 Stock Option Plans



In connection with our acquisition of N2H2 in October 2003, we assumed all of the outstanding N2H2 stock options under the 1997 Stock Option Plan, 1999
Stock Option Plan, 1999 Non-Employee Director Plan, 1999/2000 Transition Plan, the 2000 Stock Option Plan, and the Howard Philip Welt Plan (the N2H2 Plans), which were converted into options to purchase approximately 420,000 shares of
our common stock. All stock options assumed were exercisable and vested. These options were assumed at prices between $1.55 and $258.63 per share, with a weighted average exercise price of $9.45 per share. The options granted under these plans have
ten year terms and vest 25% after the first year and then monthly over the following three years.



A summary of changes in outstanding options and common shares reserved under our stock option plans is as follows:



|                                 |  |                           |   |  |                     |   |  |                                          |      
|-------------------------------- |  | ------------------------- | - |  | ------------------- | - |  | ---------------------------------------- | -----
|                                 |  | Shares Availablefor Grant |   |  | Options Outstanding |   |  | Weighted AverageExercise Price per Share
|Balance at December 31, 2001     |  | 957,987                   |   |  | 6,703,542           |   |  | $                                        | 9.86 
|Shares authorized                |  | 1,000,000                 |   |  |                    |   |  |                                          |     
|Granted                          |  | (1,715,944                | ) |  | 1,715,944           |   |  |                                          | 10.68
|Exercised                        |  |                          |   |  | (191,506            | ) |  |                                          | 6.02 
|Canceled                         |  | 508,965                   |   |  | (508,965            | ) |  |                                          | 13.04
|                                 |  |                           |   |  |                     |   |  |                                          |      
|Balance at December 31, 2002     |  | 751,008                   |   |  | 7,719,015           |   |  | $                                        | 9.93 
|Granted                          |  | (1,045,150                | ) |  | 1,045,150           |   |  |                                          | 6.97 
|Assumed upon acquisition of N2H2 |  | 182,260                   |   |  | 419,646             |   |  |                                          | 9.45 
|Exercised                        |  |                          |   |  | (1,075,585          | ) |  |                                          | 5.31 
|Canceled                         |  | 538,013                   |   |  | (538,013            | ) |  |                                          | 10.79
|                                 |  |                           |   |  |                     |   |  |                                          |      
|Balance at December 31, 2003     |  | 426,129                   |   |  | 7,570,213           |   |  | $                                        | 10.09
|Shares authorized                |  | 2,500,000                 |   |  |                    |   |  |                                          |     
|Granted                          |  | (1,762,850                | ) |  | 1,762,850           |   |  |                                          | 9.28 
|Exercised                        |  |                          |   |  | (679,403            | ) |  |                                          | 6.45 
|Expired                          |  | (6,872                    | ) |  |                    |   |  |                                          |     
|Canceled                         |  | 464,451                   |   |  | (464,451            | ) |  |                                          | 14.09
|                                 |  |                           |   |  |                     |   |  |                                          |      
|Balance at December 31, 2004     |  | 1,620,860                 |   |  | 8,189,209           |   |  | $                                        | 9.99 
|                                 |  |                           |   |  |                     |   |  |                                          |      



The following table
summarizes information about the stock options outstanding at December 31, 2004:



|                       |  |                     |  |                                                    |  |                                 |  |                    |  |                                
|---------------------- |  | ------------------- |  | -------------------------------------------------- |  | ------------------------------- |  | ------------------ |  | -------------------------------
|                       |  | Options Outstanding |  | Options Exercisable                               
|Range of ExercisePrice |  | Number Outstanding  |  | Weighted AverageRemaining Contractual Life (Years) |  | Weighted Average Exercise Price |  | Number Exercisable |  | Weighted Average Exercise Price
|$   0.01 - $ 3.02      |  | 319,745             |  | 6.6                                                |  | $2.86                           |  | 108,558            |  | $2.61                          
|$   3.03 - $ 6.04      |  | 1,348,030           |  | 5.9                                                |  | 4.14                            |  | 1,008,510          |  | 4.12                           
|$   6.05 - $ 9.07      |  | 1,565,203           |  | 7.4                                                |  | 7.84                            |  | 649,782            |  | 6.91                           
|$   9.08 - $ 12.09     |  | 2,731,196           |  | 6.7                                                |  | 10.03                           |  | 1,873,914          |  | 10.22                          
|$ 12.10 - $ 15.12      |  | 724,938             |  | 6.9                                                |  | 13.46                           |  | 563,701            |  | 13.48                          
|$ 15.13 - $ 18.14      |  | 1,271,747           |  | 6.6                                                |  | 16.09                           |  | 536,274            |  | 16.89                          
|$ 18.15 - $ 21.17      |  | 107,500             |  | 6.2                                                |  | 18.57                           |  | 106,500            |  | 18.55                          
|$ 21.18 - $ 24.21      |  | 98,383              |  | 4.7                                                |  | 22.13                           |  | 97,383             |  | 22.13                          
|$ 24.22 - $ 27.22      |  | 8,000               |  | 4.5                                                |  | 25.82                           |  | 8,000              |  | 25.82                          
|$ 27.23 - $258.63      |  | 14,467              |  | 5.1                                                |  | 74.52                           |  | 14,467             |  | 74.52                          
|                       |  |                     |  |                                                    |  |                                 |  |                    |  |                                
|$   0.59 - $258.63     |  | 8,189,209           |  | 6.7                                                |  | $9.99                           |  | 4,967,089          |  | $10.10                         
|                       |  |                     |  |                                                    |  |                                 |  |                    |  |                                



Options outstanding
under our stock plans expire at various dates from 2005 to 2014. The number of options exercisable as of December 31, 2004, 2003 and 2002, was 4,967,089, 4,099,834, and 3,482,203 at weighted average exercise prices of $10.10, $9.88 and $8.38,
respectively. The weighted average fair value of options granted and the weighted average remaining contractual life of options granted during 2004, 2003 and 2002 are $9.99, $10.09 and $9.93 and 6.7, 6.8 and 7.4 years, respectively.



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##### Table of Contents

8. Stock Plans (continued)



Employee Stock Purchase Plan



We have an employee stock purchase plan, which enables employees to contribute up to 10% of their compensation toward the
purchase of our common stock at the end of the participation period at a purchase price equal to 85% of the lower of the fair market value of the common stock on the first or last day of the participation period. Common stock reserved for future
employee purchases under the plan totals 1,032,584 shares at December 31, 2004. Common stock issued under the plan totaled approximately 165,000 in 2004, 297,000 in 2003 and 362,000 in 2002.



9. Defined Contribution Plans



We have a voluntary defined contribution plan under Section 401(k) of
the Internal Revenue Code that covers substantially all United States employees. The 401(k) plan provides a discretionary year-end employer matching contribution on employee deferral contributions made during the plan year up to 6% of the
participants contributions. We also have a voluntary defined contribution profit sharing plan that covers substantially all employees. Contributions to the latter are limited to the employers discretionary annual contribution. No
employer contributions were made to either plan during 2004, 2003 or 2002.



10. Income Taxes



There was no income tax
expense for the years ended December 31, 2004, 2003 or 2002. The components for the provision for income taxes were as follows (in thousands):



|              |  |                         |      |   |      |   |      |      |  |   |  
|------------- |  | ----------------------- | ---- | - | ---- | - | ---- | ---- |  | - | -
|              |  | Year ended December 31,
|              |  | 2004                    |      |   | 2003 |   |      | 2002
|Current:      |  |                         |      |   |      |   |      |      |  |   |  
|Federal       |  | $                       |     |   |      | $ |     |      |  | $ | 
|State         |  |                         | 62   |   |      |   | 49   |      |  |   | 
|International |  |                         | 283  |   |      |   | 510  |      |  |   | 
|Deferred:     |  |                         |      |   |      |   |      |      |  |   |  
|Federal       |  |                         | (345 | ) |      |   | (559 | )    |  |   | 
|State         |  |                         |     |   |      |   |     |      |  |   | 
|International |  |                         |     |   |      |   |     |      |  |   | 
|              |  |                         |      |   |      |   |      |      |  |   |  
|Total         |  | $                       |     |   |      | $ |     |      |  | $ | 
|              |  |                         |      |   |      |   |      |      |  |   |  



The effective tax rate
differs from the statutory tax rate primarily as a result of the following (in thousands):



|                                        |  |                         |        |   |      |   |        |      |  |   |        |  
|--------------------------------------- |  | ----------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                        |  | Year ended December 31, |       
|                                        |  | 2004                    |        |   | 2003 |   |        | 2002 | 
|Income taxes at statutory rate          |  | $                       | 4,264  |   |      | $ | 2,807  |      |  | $ | (2,173 | )
|State taxes, net of federal benefit     |  |                         | 249    |   |      |   | 211    |      |  |   | (468   | )
|Foreign taxes                           |  |                         | 203    |   |      |   | 423    |      |  |   | (107   | )
|Change in valuation allowance           |  |                         | (1,543 | ) |      |   | (701   | )    |  |   | 3,518  |  
|Use of net operating loss carryforwards |  |                         | (3,120 | ) |      |   | (3,084 | )    |  |   | (651   | )
|Other                                   |  |                         | (53    | ) |      |   | 344    |      |  |   | (119   | )
|                                        |  |                         |        |   |      |   |        |      |  |   |        |  
|Income tax expense                      |  | $                       |       |   |      | $ |       |      |  | $ |       |  
|                                        |  |                         |        |   |      |   |        |      |  |   |        |  



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9. Income Taxes (continued)



Deferred income tax assets and liabilities result from temporary differences between the carrying values of assets and
liabilities for financial statement and income tax purposes. Significant components of our net deferred tax assets are as follows (in thousands):



|                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|---------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                     |  | Year ended December 31, |        
|                                                     |  | 2004                    |         |   | 2003 |   |         | 2002 | 
|Deferred tax assets:                                 |  |                         |         |   |      |   |         |      |  |   |         |  
|Accrued liabilities                                  |  | $                       | 1,086   |   |      | $ | (26     | )    |  | $ | 3,839   |  
|Liabilities                                          |  |                         | 239     |   |      |   | 252     |      |  |   | 209     |  
|Tax over book amortization                           |  |                         | (612    | ) |      |   | (37     | )    |  |   | (247    | )
|Book over tax depreciation                           |  |                         | 93      |   |      |   | 171     |      |  |   | 171     |  
|Income tax credits                                   |  |                         | 478     |   |      |   | 478     |      |  |   | 478     |  
|Net operating loss carryforward                      |  |                         | 79,172  |   |      |   | 78,425  |      |  |   | 53,958  |  
|                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Total deferred tax assets before valuation allowance |  |                         | 80,456  |   |      |   | 79,263  |      |  |   | 58,408  |  
|Less valuation allowance                             |  |                         | (76,852 | ) |      |   | (76,004 | )    |  |   | (55,708 | )
|                                                     |  |                         |         |   |      |   |         |      |  |   |         |  
|Net deferred tax assets                              |  | $                       | 3,604   |   |      | $ | 3,259   |      |  | $ | 2,700   |  
|                                                     |  |                         |         |   |      |   |         |      |  |   |         |  



SFAS No. 109,
Accounting for Income Taxes, requires the consideration of a valuation allowance for deferred tax assets if it is more likely than not that benefits of deferred tax assets will not be realized. Realization of the $3.6 million
of net deferred tax assets is dependent upon our ability to generate sufficient future taxable income and the implementation of tax planning strategies. We believe it is more likely than not that the net deferred tax assets will be realized based
expected levels of future taxable income in the United States and certain foreign jurisdictions, and the implementation of tax planning strategies. However, the amount of the deferred tax assets considered realizable could be reduced in the near
term if estimates of future taxable income are reduced or we are unable to implement our tax strategies.



At December 31, 2004, we had net operating loss (NOL) carryforwards of $197.9 million that are available to offset taxable income through 2024 and
will start to expire in 2005. These carryforwards are subject to the limitations of Internal Revenue Code Section 382. This section provides limitations on the availability of net operating losses to offset current taxable income if significant
ownership changes have occurred for federal tax purposes. Included in the NOL is approximately $45.1 million related to disqualifying dispositions of stock option exercises, which currently have a full valuation allowance, and when realized for
financial statement purposes will not result in a reduction in income tax expense. Rather, the benefit will be recorded as an increase to additional paid-in capital. Also included in the NOL is approximately $58.4 million related to acquired N2H2
NOL carryforwards, which currently have a full valuation allowance, and when realized for financial statement purposes will not result in a reduction in income tax expense. Rather, the benefit will be recorded as a decrease to goodwill.



No provision has been made for United States federal income taxes on
certain undistributed earnings of foreign subsidiaries that we intend to permanently invest or that may be remitted substantially tax-free. The total of undistributed earnings that would be subject to federal income tax if remitted under existing
law is approximately $1.7 million at December 31, 2004.



Federal income taxes were not paid in 2004, 2003 or 2002. Foreign taxes paid in 2004, 2003 and 2002 were approximately $340,000, $447,000, and $408,000, respectively.



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11. Leases



We lease office space for all of our locations. Renewal options exist for our Concord, CA, and Seattle, WA offices. Future lease payments for all
operating leases, excluding executory costs such as management and maintenance fees and property tax, are as follows (in thousands):



|           |  |                         |       |          |   |      |                             |  |   |      
|---------- |  | ----------------------- | ----- | -------- | - | ---- | --------------------------- |  | - | -----
|           |  | Future LeaseObligations |       | Sublease |   |      | Net Future LeaseObligations
|2005       |  | $                       | 3,562 |          | $ | (306 | )                           |  | $ | 3,256
|2006       |  |                         | 1,783 |          |   | (116 | )                           |  |   | 1,667
|2007       |  |                         | 1,441 |          |   |     |                             |  |   | 1,441
|2008       |  |                         | 308   |          |   |     |                             |  |   | 308  
|2009       |  |                         | 41    |          |   |     |                             |  |   | 41   
|Thereafter |  |                         | 17    |          |   |     |                             |  |   | 17   
|           |  |                         |       |          |   |      |                             |  |   |      
|           |  | $                       | 7,152 |          | $ | (422 | )                           |  | $ | 6,730
|           |  |                         |       |          |   |      |                             |  |   |      



Rent expense including
executory costs, net of sublease income was $3.9 million, $3.8 million, and $3.6 million, for the years ended December 31, 2004, 2003 and 2002, respectively. Sublease income is shown on the consolidated results of operation as a reduction of
general and administrative expenses.



12. Contingencies



In December 2002, we were named as the defendant in an rental property
lawsuit brought by Salvio Pacheco Square LLP in the United States Superior Court of Contra Costa County. The complaint alleges that we had violated our one-time cancellation provision in a lease for our Concord, CA office and asked for relief in the
form of compensatory and other damages. The Court entered a judgment in favor of the plaintiff in June 2004 in the amount of $1.1 million. We believe that the allegations included in the complaint are wholly without merit, have filed an appeal to
the judgment, and intend to defend this litigation vigorously. It is not possible to predict the timing or outcome of this litigation, however, if we do not prevail in the appeal process, we could incur costs for approximately $1.1 to 2 million.



We are engaged in other certain legal proceedings and claims
arising in the ordinary course of our business. The ultimate liabilities, if any, which may result from these or other pending or threatened legal actions against us cannot be determined at this time. However, in the opinion of management, the facts
known at the present time do not indicate that such litigation will have a material effect on our consolidated financial position or results of operation.



13. Litigation Settlements



In April 1999, purported securities class action complaints were filed in the United States District Court for the Northern District of California against
us and certain of our officers and directors. Each complaint alleged that defendants made false and misleading statements about our business condition and prospects during a purported class period of November 10, 1998 through March 31,
1999, and asserts claims for violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. In July 2002, we reached a settlement of the class action complaint. In November 2002, the Court granted final approval of
the settlement for $10.1 million. $2.8 million in cash was covered by our insurance. The $7.3 million balance of the settlement, reflected on the consolidated statement of operations as other non-recurring expense, was contributed by us in common
stock on April 16, 2003, the date of distribution. Total shares distributed were 1,951,807.



On February 11, 2002, Herbert Silverberg filed a shareholder derivative action captioned Silverberg v. McGurran, et al., Case No. CV 805193 in
California Superior Court in Santa Clara County against certain of our current and former officers and directors. We were named as nominal defendant. Plaintiff alleged that defendants breached their fiduciary duties by making false and misleading
statements about our business condition and prospects during the period of November 10, 1998 through March 31, 1999. On April 29, 2002, the Court dismissed the complaint with leave to amend. The parties subsequently negotiated a
settlement of $300,000 by which plaintiff dismissed the action with prejudice. On March 11, 2003 the Court granted final approval of the settlement, which was contributed by us in common stock. Total shares distributed were 77,922.



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14. Net Income (Loss) Per Share



The following table represents the calculation of basic and diluted net income (loss) per share applicable to common
stockholders (in thousands, except per share amounts):



|                                                                                               |  |                         |        |      |   |        |  |   |        |  
|---------------------------------------------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | -
|                                                                                               |  | Year Ended December 31, |       
|                                                                                               |  | 2004                    |        | 2003 |   | 2002   | 
|Net income (loss) applicable to common stockholders                                            |  | $                       | 12,835 |      | $ | 8,256  |  | $ | (6,476 | )
|                                                                                               |  |                         |        |      |   |        |  |   |        |  
|Shares used in computing basic net income (loss) per share applicable to common stockholders   |  |                         | 35,576 |      |   | 31,986 |  |   | 29,307 |  
|Outstanding dilutive stock options                                                             |  |                         | 1,680  |      |   | 1,668  |  |   |       |  
|                                                                                               |  |                         |        |      |   |        |  |   |        |  
|Shares used in computing diluted net income (loss) per share applicable to common stockholders |  |                         | 37,256 |      |   | 33,654 |  |   | 29,307 |  
|Basic net income (loss) applicable to common stockholders                                      |  | $                       | 0.36   |      | $ | 0.26   |  | $ | (0.22  | )
|Diluted net income (loss) applicable to common stockholders                                    |  | $                       | 0.34   |      | $ | 0.25   |  | $ | (0.22  | )



Potential common
shares of 2,533,000, 4,379,000 and 3,594,000 related to our outstanding stock options were excluded from the computation of diluted earnings per share for 2004, 2003 and 2002, respectively, as inclusion of these shares would have been anti-dilutive.



15. Segment Information



As described in Note 2, we discontinued our AT division and have
reclassified the results of operations of AT division as discontinued operations. Therefore, we operate only one business segment called enterprise security solutions.



International sales accounted for 31%, 30% and 28% of total revenue for the years 2004, 2003 and 2002, respectively. Major
foreign markets for our products include Europe, Japan, China, the Pacific Rim, and Latin America. In each country, we have independent channel partners that are responsible for marketing, selling, and supporting our products to resellers and end
users within their defined territories. The following table summarizes our domestic and international sales (in thousands):



|                    |  |                         |        |      |   |        |  |   |       
|------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------
|                    |  | Year ended December 31,
|                    |  | 2004                    |        | 2003 |   | 2002  
|Revenues:           |  |                         |        |      |   |        |  |   |       
|Domestic sales      |  | $                       | 64,431 |      | $ | 53,673 |  | $ | 44,842
|International sales |  |                         | 28,947 |      |   | 22,540 |  |   | 17,118
|                    |  |                         |        |      |   |        |  |   |       
|                    |  | $                       | 93,378 |      | $ | 76,213 |  | $ | 61,960
|                    |  |                         |        |      |   |        |  |   |       



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16. Summarized Quarterly Financial Information (unaudited)



|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|------------------------------------------------------------- |  | --------------------------------------------------- | ------ | - | -------- | - | ------ | ------------- |  | - | ------------ | - |  | - | ------ | -
|                                                              |  | Quarter Ended (in thousands, except per share data) |       
|                                                              |  | March 31,                                           |        |   | June 30, |   |        | September 30, |  |   | December 31, |  
|2004                                                          |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Revenues                                                      |  | $                                                   | 21,216 |   |          | $ | 22,118 |               |  | $ | 24,530       |   |  | $ | 25,514 |  
|Gross profit                                                  |  |                                                     | 17,459 |   |          |   | 18,256 |               |  |   | 19,522       |   |  |   | 20,753 |  
|Net income from continuing operations                         |  |                                                     | 2,205  |   |          |   | 2,518  |               |  |   | 3,565        |   |  |   | 4,547  |  
|Net income for discontinued operations                        |  |                                                     |       |   |          |   |       |               |  |   |             |   |  |   |       |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Net income                                                    |  | $                                                   | 2,205  |   |          | $ | 2,518  |               |  | $ | 3,565        |   |  | $ | 4,547  |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Basic income per share:                                       |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Continuing operations                                         |  |                                                     | 0.06   |   |          |   | 0.07   |               |  |   | 0.10         |   |  |   | 0.13   |  
|Discontinued operations                                       |  |                                                     |       |   |          |   |       |               |  |   |             |   |  |   |       |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Basic income per share                                        |  | $                                                   | 0.06   |   |          | $ | 0.07   |               |  | $ | 0.10         |   |  | $ | 0.13   |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Diluted income per share:                                     |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Continuing operations                                         |  |                                                     | 0.06   |   |          |   | 0.07   |               |  |   | 0.10         |   |  |   | 0.12   |  
|Discontinued operations                                       |  |                                                     |       |   |          |   |       |               |  |   |             |   |  |   |       |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Diluted income per share                                      |  | $                                                   | 0.06   |   |          | $ | 0.07   |               |  | $ | 0.10         |   |  | $ | 0.12   |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|2003                                                          |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Revenues                                                      |  | $                                                   | 16,179 |   |          | $ | 17,630 |               |  | $ | 19,474       |   |  | $ | 22,930 |  
|Gross profit                                                  |  |                                                     | 13,594 |   |          |   | 14,386 |               |  |   | 16,430       |   |  |   | 19,167 |  
|Net income from continuing operations                         |  |                                                     | 962    |   |          |   | 1,225  |               |  |   | 2,776        |   |  |   | 4,327  |  
|Net loss from discontinued operations/disposal of AT division |  |                                                     | (391   | ) |          |   | (216   | )             |  |   | (150         | ) |  |   | (277   | )
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Net income                                                    |  | $                                                   | 571    |   |          | $ | 1,009  |               |  | $ | 2,626        |   |  | $ | 4,050  |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Basic income (loss) per share:                                |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Continuing operations                                         |  |                                                     | 0.03   |   |          |   | 0.04   |               |  |   | 0.08         |   |  |   | 0.13   |  
|Discontinued operations                                       |  |                                                     | (0.01  | ) |          |   | (0.01  | )             |  |   |             |   |  |   | (0.01  | )
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Basic income per share                                        |  | $                                                   | 0.02   |   |          | $ | 0.03   |               |  | $ | 0.08         |   |  | $ | 0.12   |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Diluted income (loss) per share:                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Continuing operations                                         |  |                                                     | 0.03   |   |          |   | 0.04   |               |  |   | 0.08         |   |  |   | 0.12   |  
|Discontinued operations                                       |  |                                                     | (0.01  | ) |          |   | (0.01  | )             |  |   |             |   |  |   | (0.01  | )
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  
|Diluted income per share                                      |  | $                                                   | 0.02   |   |          | $ | 0.03   |               |  | $ | 0.08         |   |  | $ | 0.11   |  
|                                                              |  |                                                     |        |   |          |   |        |               |  |   |              |   |  |   |        |  



17. Subsequent Event



In February 2005, we made a strategic investment in a
privately-held technology company. As a result of this $2.7 million investment, we have a 15 percent ownership stake in this company.



Two of our board members, one of whom is a board member of the investee, are individual investors of the investee. Due to their involvement with the
investee, these two board members recused themselves from our decision to make the investment.



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Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



|                       |  |                              |  |                                                
|---------------------- |  | ---------------------------- |  | -----------------------------------------------
|                       |  | SECURE COMPUTING CORPORATION
|                       |  |                             
|Date: December 6, 2005 |  | By                           |  | /s/ JOHN E. MCNULTY                            
|                       |  |                              |  | John E. McNulty                                
|                       |  |                              |  | Chairman, President and Chief Executive Officer



Pursuant to the
requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities indicated on December 6, 2005.



|                                             |  |                                                                                              
|-------------------------------------------- |  | ---------------------------------------------------------------------------------------------
|Signature                                    |  | Title                                                                                        
|/s/ JOHN E. MCNULTYJohn E. McNulty           |  | Chairman, President and Chief Executive Officer(Principal Executive Officer)                 
|                                             | 
|/s/ TIMOTHY J. STEINKOPFTimothy J. Steinkopf |  | Senior Vice President and Chief Financial Officer(Principal Financial and Accounting Officer)
|                                             | 
|*Robert J. Frankenberg                       |  | Director                                                                                     
|                                             | 
|*James F. Jordan                             |  | Director                                                                                     
|                                             | 
|*Stephen M. Puricelli                        |  | Director                                                                                     
|                                             | 
|*Eric P. Rundquist                           |  | Director                                                                                     
|                                             | 
|*Alexander Zakupowsky, Jr.                   |  | Director                                                                                     

|      |  |                                 
|----- |  | --------------------------------
|      | 
|* By: |  | /S/    JOHN E. MCNULTY          
|      |  | John E. McNulty Attorney-in-fact



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SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS

YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002



|                                    |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|----------------------------------- |  | ---------------------------- | --------- | --------------------------------------- | - | --------------- |  | - | ---------------------- | - |  | - | -------
|Description                         |  | Balance at Beginning of Year |           | Additions Charged to Costs and Expenses |   | Less Deductions |  |   | Balance at End of Year
|Year ended December 31, 2004:       |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|Allowance for doubtful accounts (1) |  | $                            | 868,000   |                                         | $ | 214,000         |  | $ | (632,000               | ) |  | $ | 450,000
|                                    |  |                              |           |                                        
|Year ended December 31, 2003:       |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|Sales return allowance              |  | $                            | 74,000    |                                         | $ |                |  | $ | (74,000                | ) |  | $ |       
|Allowance for doubtful accounts(2)  |  |                              | 440,000   |                                         |   | 659,000         |  |   | (231,000               | ) |  |   | 868,000
|                                    |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|Total                               |  | $                            | 514,000   |                                         | $ | 659,000         |  | $ | (305,000               | ) |  | $ | 868,000
|                                    |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|                                    |  |                              |           |                                        
|Year ended December 31, 2002:       |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|Sales return allowance              |  | $                            | 582,000   |                                         | $ |                |  | $ | (508,000               | ) |  | $ | 74,000 
|Allowance for doubtful accounts     |  |                              | 822,000   |                                         |   | 246,000         |  |   | (628,000               | ) |  |   | 440,000
|                                    |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        
|Total                               |  | $                            | 1,404,000 |                                         | $ | 246,000         |  | $ | (1,137,000             | ) |  | $ | 514,000
|                                    |  |                              |           |                                         |   |                 |  |   |                        |   |  |   |        

---

|(1) | The amount listed in deductions for allowance for doubtful accounts includes $320,000 for acquired N2H2 receivables that were collected in 2004, but had been reserved for in 2003.
Amount was adjusted as part of the finalization of the purchase price of N2H2 noted in footnote 7 above and therefore, did not impact earnings.
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|(2) | The amount listed in additions charged to costs and expenses for allowance for doubtful accounts includes $402,000 for acquired N2H2 receivables, which did not have an expense
impact in 2003.
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