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UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-K/A þ
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 o
Transition Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934 For the transition period from  to COMMISSION FILE NO. 000-24547 SCIENTIFIC LEARNING CORPORATION  DELAWARE
(State or other jurisdiction of
incorporation or organization)
    
    94-3234458
(IRS Employer Identification Number)
 300 FRANK H. OGAWA PLAZA, SUITE 600
OAKLAND, CA 94612-2040
(Address of principal executive offices, including zip code)
510-444-3500
(Registrants telephone number, including area code) Securities registered pursuant to Section 12 (b) of the Act: NONE Securities registered pursuant to Section 12 (g) of the Act:
COMMON STOCK,
PAR VALUE
$0.001 PER SHARE
(Title of Class) 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: þ No: o 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 the 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. o Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act
Rule 12b-2). Yes: o No: þ The aggregate market value of the voting and non-voting common equity held by non-affiliates of the
Registrant, based upon the closing sale price of the Common Stock on June 30, 2004 as reported on
the Nasdaq Small Cap Market was approximately $39,148,211. Shares of Common Stock held by each
executive officer and director and by certain persons who owned 5% or more of the Registrants
outstanding Common Stock on that date have been excluded in that such persons may be deemed to be
affiliates. This determination of affiliate status is not necessarily a conclusive determination
for other purposes.




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As of March 15, 2005 the Registrant had outstanding 16,669,199 shares of Common Stock. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement for the Registrants 2005 Annual Meeting of Stockholders are
incorporated by reference in Part III. EXPLANATORY NOTE This Amendment No. 1 on Form 10-K/A amends our Annual Report on Form 10-K for the year ended
December 31, 2004, filed on April 15, 2005 (the Original Form 10-K) to reflect the restatement of
our balance sheet as of December 31, 2004. The restatement of the balance sheet reflects a
reclassification of $4,902,000 from deferred revenue, long-term to deferred revenue, current in
order to correct a clerical error relating to a contract signed in
June 2004 of $4,398,000 and two computational errors totaling
$504,000. This restatement is described
in more detail in Notes 2 and 16 to the Financial Statements. We have amended and restated in its entirety each item of the Original Form 10-K that has been
changed to reflect the restatement. These items are Part II, Item 6  Selected Financial Data; Part
II, Item 8  Financial Statements and Supplementary Data; Part II, Item 9A  Controls and
Procedures; and certain Exhibits. Except as stated above, this Report speaks only as of the date of the Original Form 10-K. Except as
specified above, this filing does not reflect any events occurring after April 15, 2005. Page 2




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TABLE OF CONTENTS PART IIItem 6.    Selected Financial Data
    
    
    4Item 8.    Financial Statements and Supplementary Data
    
    
    5Item 9A. Controls and Procedures
    
    
    25PART IVItem 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
    
    
    26SIGNATURES
    
    
    27EXHIBIT 23.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  Page 3




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PART II 
 ITEM 6. Selected Financial Data In thousands, except per share amounts Selected Financial Data Year ended December 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000Statement of Operations Data:Revenues:Products
    
    $
    22,802
    
    
    $
    24,491
    
    
    $
    17,879
    
    
    $
    11,702
    
    
    $
    10,983Services and support
    
    
    8,174
    
    
    
    5,425
    
    
    
    3,958
    
    
    
    3,023
    
    
    
    3,079Total revenues
    
    
    30,976
    
    
    
    29,916
    
    
    
    21,837
    
    
    
    14,725
    
    
    
    14,062Cost of revenues:Products
    
    
    1,775
    
    
    
    2,127
    
    
    
    2,109
    
    
    
    1,857
    
    
    
    1,800Services and support
    
    
    4,981
    
    
    
    3,872
    
    
    
    1,502
    
    
    
    2,402
    
    
    
    1,877Total cost of revenues
    
    
    6,756
    
    
    
    5,999
    
    
    
    3,611
    
    
    
    4,259
    
    
    
    3,677Gross profit
    
    
    24,220
    
    
    
    23,917
    
    
    
    18,226
    
    
    
    10,466
    
    
    
    10,385Operating expenses:Sales and marketing
    
    
    16,087
    
    
    
    12,961
    
    
    
    14,554
    
    
    
    19,701
    
    
    
    20,981Research and development
    
    
    3,555
    
    
    
    3,500
    
    
    
    2,985
    
    
    
    3,390
    
    
    
    5,680General and administrative
    
    
    5,313
    
    
    
    4,529
    
    
    
    4,776
    
    
    
    6,348
    
    
    
    5,746Restructuring, lease and asset
impairment write downs
    
    
    
    
    
    
    (7
    )
    
    
    3,365
    
    
    
    2,608
    
    
    
    492Total operating expenses
    
    
    24,955
    
    
    
    20,983
    
    
    
    25,680
    
    
    
    32,047
    
    
    
    32,899Operating income (loss)
    
    
    (735
    )
    
    
    2,934
    
    
    
    (7,454
    )
    
    
    (21,581
    )
    
    
    (22,514
    )Interest income (expense), net
    
    
    (100
    )
    
    
    (1,209
    )
    
    
    (1,332
    )
    
    
    (1,053
    )
    
    
    1,077Other income from related party
    
    
    99
    
    
    
    448
    
    
    
    
    
    
    
    
    
    
    
    Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    91
    
    
    
    21
    
    
    
    2Net income (loss) before income tax
    
    
    (736
    )
    
    
    2,173
    
    
    
    (8,695
    )
    
    
    (22,613
    )
    
    
    (21,435
    )Income tax (benefit) provision
    
    
    (43
    )
    
    
    43
    
    
    
    
    
    
    
    
    
    
    
    Net income (loss)
    
    $
    (693
    )
    
    $
    2,130
    
    
    $
    (8,695
    )
    
    $
    (22,613
    )
    
    $
    (21,435
    )Basic net income (loss) per share
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )
    
    $
    (1.92
    )
    
    $
    (1.92
    )Shares used in computing basic net income (loss) per share
    
    
    16,408
    
    
    
    16,007
    
    
    
    15,642
    
    
    
    11,777
    
    
    
    11,148Diluted net income (loss) per share:
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )
    
    $
    (1.92
    )
    
    $
    (1.92
    )Shares used in computing diluted net income (loss) per share
    
    
    16,408
    
    
    
    16,908
    
    
    
    15,642
    
    
    
    11,777
    
    
    
    11,148Balance Sheet Data:Cash and cash equivalents
    
    $
    10,281
    
    
    $
    3,648
    
    
    $
    4,613
    
    
    $
    4,610
    
    
    $
    818Investments in government securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,169
    
    
    
    7,667Working
capital restated (1)
    
    
    (3,986
    )
    
    
    (11,331
    )
    
    
    (10,879
    )
    
    
    (1,010
    )
    
    
    6,609Total assets
    
    
    22,958
    
    
    
    15,597
    
    
    
    18,531
    
    
    
    23,228
    
    
    
    18,953Long-term debt, including current
portion
    
    
    
    
    
    
    
    
    
    
    5,000
    
    
    
    10,000
    
    
    
    Stockholders (deficit) equity (2)
    
    
    (8,111
    )
    
    
    (8,544
    )
    
    
    (11,363
    )
    
    
    (3,247
    )
    
    
    10,281
   (1) The Company has restated its
December 31, 2004 balance sheet to reclassify $4,902,000 from
long-term deferred revenue into current deferred revenue. This
reduced the previously-reported working capital of $916,000 by
$4,902,000 to ($3,986,000). For more detail about the restatement of this financial information, see Note 2 to the Financial Statements.(2) We have paid no cash dividends since our inception. Page 4




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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Report of Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Stockholders
Scientific Learning Corporation We have audited the accompanying balance sheets of Scientific Learning Corporation as of
December 31, 2004 and 2003 and the related statements of operations, stockholders deficit, and cash
flows for each of the three years in the period ended December 31, 2004. Our audits also included
the financial statement schedule listed in the index at Item 15 (a). These financial statements and
schedule are the responsibility of Scientific Learning Corporations management. Our responsibility
is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material
misstatement. We were not engaged to perform an audit of the Companys internal control over
financial reporting. Our audit included consideration of internal control over financial reporting
as a basis for designing audit procedures that are appropriate in the circumstances, but not for
the purpose of expressing an opinion on the effectiveness of the Companys internal control over
financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of Scientific Learning Corporation as of December 31, 2004 and
2003, and the results of its operations and its cash flows for each of the three years in the
period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
Also, in our opinion, the related financial statement schedule, when considered in relation to the
basic financial statements taken as a whole, presents fairly in all material respects the
information set forth therein. /s/
Ernst & Young LLP Walnut Creek, California
April 11, 2005, except as to Note 2, as to which the date is May 25, 2005. Page 5




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Scientific Learning Corporation
Balance Sheet
(In thousands, except share and per share amounts) December 31,2004
    
    
    2003RestatedAssetsCurrent assets:Cash and cash equivalents
    
    $
    10,281
    
    
    $
    3,648Accounts
receivable, net of allowance for doubtful accounts $121 and $139 at December 31, 2004 and 2003, respectively
    
    
    5,661
    
    
    
    5,117Notes and interest receivable from current and former officers
    
    
    3,688
    
    
    
    Prepaid expenses and other current assets
    
    
    1,306
    
    
    
    1,144Total current assets
    
    
    20,936
    
    
    
    9,909Property and equipment, net
    
    
    755
    
    
    
    537Notes and interest receivable from current and former officers
    
    
    
    
    
    
    3,533Other assets
    
    
    1,267
    
    
    
    1,618Total assets
    
    $
    22,958
    
    
    $
    15,597Liabilities and stockholders deficitCurrent liabilities:Accounts payable
    
    $
    603
    
    
    $
    481Accrued liabilities
    
    
    4,338
    
    
    
    3,875Deferred revenue
    
    
    19,981
    
    
    
    16,884Total current liabilities
    
    
    24,922
    
    
    
    21,240Deferred revenue, long-term
    
    
    5,803
    
    
    
    2,616Other liabilities
    
    
    344
    
    
    
    285Total liabilities
    
    
    31,069
    
    
    
    24,141Commitments and contingenciesStockholders deficit:Preferred stock, $0.001 par value; 1,000,000 shares authorized,
no shares issued or outstanding
    
    
    
    
    
    
    Common stock, $0.001 par value; 40,000,000 shares authorized,
16,657,589 and 16,150,551 shares issued and outstanding
at December 31, 2004 and 2003, respectively
    
    
    75,586
    
    
    
    74,460Accumulated deficit
    
    
    (83,697
    )
    
    
    (83,004
    )Stockholders deficit:
    
    
    (8,111
    )
    
    
    (8,544
    )Total liabilities and stockholders deficit
    
    $
    22,958
    
    
    $
    15,597
 See accompanying notes. Page 6




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Scientific Learning Corporation
Statement of Operations
(In thousands, except share and per share amounts) Year ended December 31,2004
    
    
    2003
    
    
    2002Revenues:Products
    
    $
    22,802
    
    
    $
    24,491
    
    
    $
    17,879Service and support
    
    
    8,174
    
    
    
    5,425
    
    
    
    3,958Total revenues
    
    
    30,976
    
    
    
    29,916
    
    
    
    21,837Cost of revenues:Cost of products
    
    
    1,775
    
    
    
    2,127
    
    
    
    2,109Cost of service and support
    
    
    4,981
    
    
    
    3,872
    
    
    
    1,502Total cost of revenues
    
    
    6,756
    
    
    
    5,999
    
    
    
    3,611Gross profit
    
    
    24,220
    
    
    
    23,917
    
    
    
    18,226Operating expenses:Sales and marketing
    
    
    16,087
    
    
    
    12,961
    
    
    
    14,554Research and development
    
    
    3,555
    
    
    
    3,500
    
    
    
    2,985General and administrative
    
    
    5,313
    
    
    
    4,529
    
    
    
    4,776Restructuring
    
    
    
    
    
    
    (7
    )
    
    
    3,365Total operating expenses
    
    
    24,955
    
    
    
    20,983
    
    
    
    25,680Operating income (loss)
    
    
    (735
    )
    
    
    2,934
    
    
    
    (7,454
    )Other income from related party
    
    
    99
    
    
    
    448
    
    
    
    Interest expense, net
    
    
    (100
    )
    
    
    (1,209
    )
    
    
    (1,332
    )Other income (expense), net
    
    
    
    
    
    
    
    
    
    
    91Net income (loss) before income tax
    
    
    (736
    )
    
    
    2,173
    
    
    
    (8,695
    )Income tax (benefit) provision
    
    
    (43
    )
    
    
    43
    
    
    
    Net income (loss)
    
    $
    (693
    )
    
    $
    2,130
    
    
    $
    (8,695
    )Basic net income (loss) per share:
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )Shares used in computing basic net income (loss)
    
    
    16,408,039
    
    
    
    16,006,565
    
    
    
    15,641,849Diluted net income (loss) per share:
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )Shares used in computing diluted net income (loss)
    
    
    16,408,039
    
    
    
    16,908,361
    
    
    
    15,641,849
 See accompanying notes. Page 7




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Scientific Learning Corporation Statements of Stockholders Deficit
(In thousands, except share amounts) TotalCommon Stock

    
    
    
    Accumulated
    
    
    StockholdersShares
    
    
    Amount
    
    
    Deficit
    
    
    DeficitBalance December 31, 2001
    
    
    15,475,619
    
    
    $
    73,192
    
    
    $
    (76,439
    )
    
    $
    (3,247
    )Issuance of common stock under stock option plan
    
    
    274,471
    
    
    
    318
    
    
    
    
    
    
    
    318Issuance of common stock under employee stock purchase plan
    
    
    116,861
    
    
    
    119
    
    
    
    
    
    
    
    119Compensation charge relating to granting of common stock options
    
    
    
    
    
    
    122
    
    
    
    
    
    
    
    122Stock issued in exchange for services
    
    
    12,132
    
    
    
    20
    
    
    
    
    
    
    
    20Net loss and comprehensive loss
    
    
    
    
    
    
    
    
    
    
    (8,695
    )
    
    
    (8,695
    )Balance December 31, 2002
    
    
    15,879,083
    
    
    
    73,771
    
    
    
    (85,134
    )
    
    
    (11,363
    )Issuance of common stock under stock option plan
    
    
    207,438
    
    
    
    264
    
    
    
    
    
    
    
    264Issuance of common stock under employee stock purchase plan
    
    
    52,912
    
    
    
    180
    
    
    
    
    
    
    
    180Compensation charge relating to granting of common stock options
    
    
    
    
    
    
    198
    
    
    
    
    
    
    
    198Stock issued in exchange for services
    
    
    11,118
    
    
    
    47
    
    
    
    
    
    
    
    47Net income and comprehensive income
    
    
    
    
    
    
    
    
    
    
    2,130
    
    
    
    2,130Balance December 31, 2003
    
    
    16,150,551
    
    
    
    74,460
    
    
    
    (83,004
    )
    
    
    (8,544
    )Issuance of common stock under stock option plan
    
    
    417,773
    
    
    
    645
    
    
    
    
    
    
    
    645Issuance of common stock under employee stock purchase plan
    
    
    78,468
    
    
    
    300
    
    
    
    
    
    
    
    300Compensation charge relating to granting of common stock options
    
    
    
    
    
    
    110
    
    
    
    
    
    
    
    110Stock issued in exchange for services
    
    
    10,797
    
    
    
    71
    
    
    
    
    
    
    
    71Net loss and comprehensive loss
    
    
    
    
    
    
    
    
    
    
    (693
    )
    
    
    (693
    )Balance December 31, 2004
    
    
    16,657,589
    
    
    $
    75,586
    
    
    $
    (83,697
    )
    
    $
    (8,111
    )
 See accompanying notes Page 8




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Scientific Learning Corporation
Statement of Cash Flows
(In thousands) Year ended December 31,2004
    
    
    2003
    
    
    2002Operating Activities:Net (loss) income
    
    $
    (693
    )
    
    $
    2,130
    
    
    $
    (8,695
    )Adjustments to reconcile net income (loss) to cash provided by operating activities:Depreciation
    
    
    428
    
    
    
    721
    
    
    
    1,082Amortization of software development costs
    
    
    351
    
    
    
    617
    
    
    
    718Amortization of deferred financing costs
    
    
    232
    
    
    
    1,215
    
    
    
    1,216Stock based compensation
    
    
    181
    
    
    
    245
    
    
    
    142Asset impairment write downs
    
    
    
    
    
    
    
    
    
    
    50Changes in operating assets and liabilities:Accounts receivable
    
    
    (544
    )
    
    
    (250
    )
    
    
    887Prepaid expenses and other current assets
    
    
    (162
    )
    
    
    428
    
    
    
    (52
    )Accounts payable
    
    
    122
    
    
    
    194
    
    
    
    (157
    )Accrued liabilities
    
    
    463
    
    
    
    (1,339
    )
    
    
    1,814Deferred revenue
    
    
    6,284
    
    
    
    788
    
    
    
    6,515Other liabilities
    
    
    59
    
    
    
    (199
    )
    
    
    197Net cash provided by operating activities
    
    
    6,721
    
    
    
    4,550
    
    
    
    3,717Investing Activities:Sale of government securities
    
    
    
    
    
    
    
    
    
    
    1,169Purchases of property and equipment, net
    
    
    (646
    )
    
    
    (256
    )
    
    
    (124
    )Increase in capitalized software development costs
    
    
    
    
    
    
    
    
    
    
    (116
    )Increase in other non-current assets
    
    
    (387
    )
    
    
    (703
    )
    
    
    (80
    )Net cash (used in) provided by investing activities
    
    
    (1,033
    )
    
    
    (959
    )
    
    
    849Financing Activities:Proceeds from issuance of common stock, net
    
    
    945
    
    
    
    444
    
    
    
    437Borrowings under bank line of credit
    
    
    3,000
    
    
    
    2,000
    
    
    
    4,000Repayments of borrowings under bank line of credit
    
    
    (3,000
    )
    
    
    (7,000
    )
    
    
    (9,000
    )Net cash provided by (used in) financing activities
    
    
    945
    
    
    
    (4,556
    )
    
    
    (4,563
    )Increase (decrease) in cash and cash equivalents
    
    
    6,633
    
    
    
    (965
    )
    
    
    3Cash and cash equivalents at beginning of year
    
    
    3,648
    
    
    
    4,613
    
    
    
    4,610Cash and cash equivalents at end of year
    
    $
    10,281
    
    
    $
    3,648
    
    
    $
    4,613Supplemental disclosureInterest paid
    
    $
    44
    
    
    $
    134
    
    
    $
    294
 See accompanying notes. Page 9




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Notes to Financial Statements
1. Summary of Significant Accounting Policies Description of Business Scientific Learning Corporation (the Company) provides neuroscience-based software products that
develop underlying cognitive skills required for reading and learning. The Companys Fast
ForWord® products are a series of reading intervention products for children,
adolescents and adults. We sell primarily to K-12 schools through a direct sales force. The
Company also sells to speech and language professionals. To support our products, we provide
on-site and remote training and implementation services, as well as technical, professional and
customer support and a wide variety of Web-based resources. The Company was incorporated in 1995 in the State of California and was reincorporated in 1997 in
the State of Delaware. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted
in the United States requires management to make certain estimates and assumptions that affect the
reported amounts of assets and liabilities as of the date of the financial statements as well as
the reported amounts of revenues and expenses during the periods presented. Actual results may
differ from those estimated. Revenue Recognition We derive revenue from the sale of licenses to our software and from service and support fees.
Software license revenue is recognized in accordance with AICPA Statement of Position 97-2,
Software Revenue Recognition, as amended by Statement of Position 98-9 (SOP 97-2). SOP 97-2
provides specific industry guidance and four basic criteria, which must be met to recognize
revenue. These are: 1) persuasive evidence of an arrangement; 2) delivery of the product; 3) a
fixed or determinable fee; and 4) the probability that the fee will be collected. Sales to our school customers typically include multiple elements (e.g. Fast ForWord software
licenses, Progress Tracker, our Internet-based participant tracking service, support, training,
implementation management, and other services). The Company allocates revenue to each element of a
transaction based upon its fair value as determined in reliance on vendor specific objective
evidence (VSOE). VSOE of fair value for each element of an arrangement is based upon the normal
pricing and discounting practices for those products and services when sold separately and, for
support services, is also measured by the renewal price. The value of software licenses, services and support invoiced during a particular period is
recorded as deferred revenue until recognized. Deferred revenue is recognized as revenue as
discussed below. License revenue Revenue from the licensing of software is recognized as follows: Perpetual licenses  software licensed on a perpetual basis. Revenue is recognized at the
later of product delivery date or contract start date using the residual method. If VSOE does not
exist for all the undelivered elements, all revenue is deferred and recognized ratably over the
service period if the undelivered element is services or when all elements have been delivered. Term licenses  software licensed for a specific time period, generally three to twelve
months. Revenue is recognized ratably over the license term. Individual participant licenses  software licensed for a single participant. Revenue is
recognized over the average period of use, typically six weeks. Page 10




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Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued) Service and support revenue Service and support revenue is derived from a combination of training, implementation, technical
and professional services, online services and customer support. Training, technical and other
professional services are typically sold on a per day basis. If VSOE exists for all elements of an
arrangement or all elements except software licenses, services revenue is recognized as performed.
If VSOE does not exist for all the elements in an arrangement except software licenses, service
revenue is recognized over the longest contractual period in an arrangement. Revenue from services
sold alone or with support is recognized as performed. Cash and Cash Equivalents Cash and cash equivalents consist of cash and highly liquid investments with maturities of three
months or less from the time of purchase. Accounts Receivable The Company conducts business primarily with public school districts and speech and language
professionals in the United States. Ongoing credit evaluations are performed on customers and
collateral is generally not required. Allowances for uncollectible accounts are made for
potential credit issues based on past experience and management assessment of current risks. Inventories Product inventories are stated at the lower of cost or market. Cost is determined using a weighted
average approach, which approximates the first-in first-out method. If inventory costs exceed
expected market value due to obsolescence or lack of demand, reserves are recorded for the
difference between the cost and the market value. Fair Value of Financial Instruments The carrying amounts of the Companys cash and cash equivalents, accounts receivable, notes
receivable from current and former officers, and accounts payable approximate fair value. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentrations of credit risk consist
principally of cash, cash equivalents and accounts receivable. Cash and cash equivalents are invested in major financial institutions in the United States. Such
deposits may be in excess of insured limits and are not insured in other jurisdictions.
Management believes that the financial institutions that hold the Companys investments are
financially sound and, accordingly, minimal credit risk exists with respect to these
investments. The accounts receivable of the Company are derived from sales to customers located primarily in
the United States. The Company performs ongoing credit evaluations of its customers. The
Company does not require collateral. An allowance for doubtful accounts is determined with respect to those accounts that the Company
has determined to be doubtful of collection. At December 31, 2004 and 2003, no customer
accounted for more than 10% of the Companys accounts receivable. The company has no off-balance sheet concentration of credit risk, such as foreign exchange
contracts, option contracts or other hedging arrangements. Property and Equipment Property and equipment are recorded at cost. Depreciation is computed using the straight-line
method over the estimated useful lives of the assets, which range from three to five years. Page 11




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Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued) Software Development Costs The Company accounts for software development costs in accordance with Statement of Financial
Accounting Standards (FAS) No. 86, Accounting for the Costs of Computer Software to be
Sold, Leased or Otherwise Marketed,under which certain software development costs incurred
subsequent to the establishment of technological feasibility are capitalized and amortized
over the estimated lives of the related products. Technological feasibility is established
upon completion of a working model. In 2003 and 2004, costs incurred subsequent to the
establishment of technological feasibility were not significant, and were charged to research
and development expense. The Company capitalized $116,000 of software development costs for
the year ended December 31, 2002. Software costs are amortized to cost of product revenues
over the estimated useful life of the software, which is three years. Amortization was
$351,000, $617,000 and $718,000 for the years ended December 31, 2004, 2003 and 2002,
respectively. Long-Lived Assets The Company regularly reviews the carrying value of long-lived assets. We continually make
estimates regarding future cash flows and other factors to determine the fair value of the
respective assets. If these estimates or their related assumptions change in the future, the
Company may be required to record impairment charges for these assets. Accounting for Stock-Based Compensation The Company accounts for stock issued to employees in accordance with Accounting Principles Board
Opinion No. 25 (APB 25), Accounting for Stock Issued to Employeesand complies with the
disclosure provisions of SFAS No. 123 (SFAS 123), Accounting for Stock-Based Compensationand
SFAS No. 148 (SFAS 148), Accounting for Stock-Based Compensation  Transition and Disclosure.
Under APB 25, compensation expense of fixed stock options is based on the difference, if any, on
the date of the grant between the fair value of the Companys stock and the exercise price of the
option. The Company accounts for stock issued to non-employees in accordance with the provisions of
SFAS 123 and EITF No. 96-18, Accounting for Equity Instruments That are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Pro Forma Disclosures of the Effect of Stock-Based Compensation Pro forma information regarding the results of operations and net income (loss) per share is
determined as if the Company had accounted for its employee stock options and employee stock
purchase plan stock using the fair value method. The fair value of each option granted and employee
stock purchase plan stock issued is estimated on the date of grant using the Black Scholes
valuation model with the following assumptions: Year ended December 31,Employee & Director Stock Options
    
    2004
    
    
    2003
    
    
    2002Weighted average expected life of option (in years)
    
    
    5
    
    
    
    5
    
    
    
    5Risk-free interest rate
    
    
    3.0
    %
    
    
    3.0
    %
    
    
    3.0
    %Dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %Volatility
    
    
    85
    %
    
    
    85
    %
    
    
    85
    %Weighted average fair value
    
    $
    4.00
    
    
    $
    2.05
    
    
    $
    0.90
 Year ended December 31,Employee Stock Purchase Plan
    
    2004
    
    
    2003
    
    
    2002Weighted average expected life (in years)
    
    
    0.5 - 1.0
    
    
    
    0.5 - 1.0
    
    
    
    0.5 - 1.0Risk-free interest rate
    
    
    3.0
    %
    
    
    3.0
    %
    
    
    3.0
    %Dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %Volatility
    
    
    85
    %
    
    
    85
    %
    
    
    85
    %Weighted average fair value
    
    $
    2.06
    
    
    $
    1.56
    
    
    $
    1.08
 Page 12




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Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued) The Company has elected to use the intrinsic value method in accounting for its employee stock
options because, as discussed below, the alternative fair value accounting requires the use of
option valuation models that were not developed for use in valuing employee stock options. Under
the intrinsic value method, when the exercise price of the Companys employee stock options equals
the market price of the underlying stock on the date of grant, no compensation expense is
recognized. The option valuation models were 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 life of the option. Had compensation cost for the Companys stock-based compensation plans been determined using the
fair value at the grant dates for awards under those plans calculated using the Black Scholes
valuation model, the Companys pro forma net income (loss) and basic and diluted net income (loss)
per share would have been as follows (in thousands, except per share amounts): Year Ended December 31,2004
    
    
    2003
    
    
    2002Net income (loss), as reported
    
    $
    (693
    )
    
    $
    2,130
    
    
    $
    (8,695
    )Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards
    
    
    (1,668
    )
    
    
    (1,465
    )
    
    
    (2,472
    )Pro forma net income (loss), per share
    
    $
    (2,361
    )
    
    $
    665
    
    
    $
    (11,167
    )Basic, as reported
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )Diluted, as reported
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )Basic, pro forma
    
    $
    (0.14
    )
    
    $
    0.04
    
    
    $
    (0.71
    )Diluted, pro forma
    
    $
    (0.14
    )
    
    $
    0.04
    
    
    $
    (0.71
    )
 The pro forma impact of options on the net income (loss) for the years ended December 31, 2004,
2003 and 2002, is not representative of the effects on net income (loss) for future years, as
future years will include the effects of additional years of stock option grants. Advertising Advertising costs are expensed as incurred. Advertising expense was $13,000, $1,000 and $4,000 for
the years ended December 31, 2004, 2003 and 2002, respectively. Income Taxes The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income
Taxes, which requires the use of the liability method in accounting for income taxes. Under SFAS
No. 109, deferred tax assets and liabilities are measured using enacted tax rates and laws that are
expected to be in effect when the differences are expected to reverse. Valuation allowances are
established when necessary to reduce deferred tax assets to the net amount expected to be realized. Net Income (Loss) per Share Under the provisions of SFAS No. 128, Earnings per Share,basic net income (loss) per share is
computed using the weighted-average number of common shares outstanding during the period. Diluted
net income (loss) per share reflects the potential dilution of securities by adding common stock
equivalents (computed using the treasury stock method) to the weighted-average number of common
shares outstanding during the period, if dilutive. Potentially dilutive securities have been
excluded from the computation of diluted net loss per share as their inclusion is antidilutive. Page 13




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##### Table of Contents



Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued) The following table sets forth the computation of net income (loss) per share (in thousands, except
share and per share data): Year Ended December 31,2004
    
    
    2003
    
    
    2002Net income (loss)
    
    $
    (693
    )
    
    $
    2,130
    
    
    $
    (8,695
    )Weighted average shares used in calculation of basic
net income (loss) per share
    
    
    16,408,039
    
    
    
    16,006,565
    
    
    
    15,641,849Effect of dilutive securities:Employee stock options
    
    
    
    
    
    
    901,796
    
    
    
    Weighted-average diluted common share
    
    
    16,408,039
    
    
    
    16,908,361
    
    
    
    15,641,849Net income (loss) per common share- basic:
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )Net income (loss) per common share- diluted:
    
    $
    (0.04
    )
    
    $
    0.13
    
    
    $
    (0.56
    )
 If the Company had reported net income in 2004 or 2002, the calculation of diluted earnings per
share would have included the shares used in the computation of basic net loss per share as well as
an additional 1,101,352 and 64,000 common equivalent shares (computed using the treasury stock
method) related to outstanding stock options not included in the calculations above for the years
ended December 31, 2004 and 2002, respectively. Recent Accounting Pronouncements SFAS 123(R), Share-Based Payment On December 16, 2004 the FASB issued SFAS 123 (revised 2004), Share-Based Payment,which is a
revision of SFAS 123, Accounting for Stock-Based Compensation.Statement 123(R) supercedes APB
25, Accounting for Stock Issued to Employees,and amends SFAS 95, Statement of Cash Flows.
Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However,
SFAS 123(R) requires all share-based payments to employees, including grants of employee stock
options and purchases under employee stock purchase plans, to be recognized in the statement of
operations based on their fair values. Pro forma disclosure of fair value recognition will no
longer be an alternative. SFAS 123(R) is effective for public companies for annual periods beginning after June 15, 2005,
with earlier adoption permitted. We are required to adopt this new standard in our fiscal year
beginning January 1, 2006. SFAS 123(R) permits public companies to adopt its 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 123(R) 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 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 restatement using amounts previously
disclosed under the pro forma provisions of SFAS 123 either for (a) all prior periods
presented or (b) prior interim periods of the year of adoption. We have not yet chosen a method of adoption for SFAS 123(R). Page 14




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##### Table of Contents



Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued) As permitted by SFAS 123, we currently account for share-based payments to employees using APB 25s
intrinsic value method. As a consequence, we generally recognize no compensation cost for employee
stock options and purchases under our Employee Stock Purchase Plan. Although the adoption of SFAS
123(R)s fair value method will have no adverse impact on our balance sheet or net cash flows, it
will have a significant adverse impact on our net income and net income per share. The pro forma
effects on net income and earnings per share if we had applied the fair value recognition
provisions of SFAS 123 to share-based payments to employees in prior periods are disclosed in Note
1 under Stock-Based Incentive Programs.Although the pro forma effects of applying SFAS 123 may
be indicative of the effects of applying SFAS 123(R), the provisions of these two statements differ
in some important respects. The actual effects of adopting SFAS 123(R) will depend on numerous
factors including the valuation model we use to value future share-based payments to employees,
estimated forfeiture rates and the accounting policies we adopt concerning the method of
recognizing the fair value of awards over the requisite service period. Reclassifications Certain other asset items from prior years have been reclassified to conform to the current
presentation. 2. Restatement The Company has restated its previously reported balance sheet as of December 31, 2004. This
restatement reflects a correction in the Companys classification of the short and long term
deferred revenues totaling $4,902,000. The restatement of deferred
revenues resulted from a clerical error
in the classification between long and short term amounts for a
contract executed in June 2004 of $4,398,000 and two
computational errors totaling $504,000.
The following table summarizes the change to the balance sheet at December 31, 2004: Previously reported
    
    
    Adjustment
    
    
    RestatedCurrent liabilitiesDeferred revenue
    
    
    15,079
    
    
    
    4,902
    
    
    
    19,981Total current liabilities
    
    
    20,020
    
    
    
    4,902
    
    
    
    24,922Deferred revenue, long term
    
    
    10,705
    
    
    
    (4,902
    )
    
    
    5,803
 3. Restructuring, Lease and Asset Impairment Write Downs In 2004, the Company completed lease termination payments of $1.8 million. There were no other
restructuring activities during the year and no accrued restructuring costs as of December 31,
2004. In October 2003 the Company entered into a lease termination agreement with its landlord to
terminate the lease on its Oakland headquarters and entered into a new lease agreement for a
reduced amount of space in the same building. The reduction in space is expected to reduce future
lease payments by $6.5 million (net of lease termination fees described below) through 2008. Under
the lease termination agreement the Company paid an increased security deposit of $550,000 and
lease termination fees totaling $490,000 in 2003. A net credit adjustment of $7,000 was charged to
operations. The adjustment represented an addition to the restructuring reserve of $350,000 for
lease and asset impairment charges, offset by a reduction in deferred rent of $357,000 to account
for the reduction in space under the new lease agreement. In 2002 the Company recorded restructuring, lease and asset impairment charges of $3.4 million in
operating expenses. The restructuring resulted in a workforce reduction of approximately 30
employees and a total charge to operations for severance benefits of $1.1 million. All affected
employees had been terminated or notified of their severance benefits by December 31, 2002. Most of
the employees affected by the workforce reduction were located in the Companys Oakland office in
the marketing and customer service departments. Page 15




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##### Table of Contents



Notes to Financial Statements
3. Restructuring, Lease and Asset Impairment Write Downs (continued) Due to continued weakness in the commercial real estate market in 2002 the Company recorded an
additional charge for excess office space at the Companys Oakland headquarters of $2.3 million.
This charge reflected adjustments to the assumptions on which the 2001 write down for excess office
space had been made, including assumptions about the time period that the excess office space would
be vacant and potential sublease terms. The Company calculated the estimated costs for the
additional facilities restructuring charge based on current market information provided by a
commercial real estate broker. We estimated the $3.0 million accrued at December 31, 2002 would be
paid over the next two years. The following table sets forth the restructuring activity during the three years ended December 31,
2004 (in thousands). Accrued
    
    
    
    
    
    
    
    
    
    
    Accrued
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Accrued
    
    
    
    
    
    
    Accruedrestructuring
    
    
    
    
    
    
    
    
    
    
    restructuring
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    restructuring
    
    
    
    
    
    
    restructuringcosts,
    
    
    
    
    
    
    
    
    
    
    costs,
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    costs,
    
    
    
    
    
    
    costs,December 31,
    
    
    Restructuring
    
    
    
    
    
    
    December 31,
    
    
    Restructuring
    
    
    Asset write-
    
    
    
    
    
    
    December 31,
    
    
    
    
    
    
    December 31,2001
    
    
    Charges
    
    
    Cash paid
    
    
    2002
    
    
    Charges
    
    
    down
    
    
    Cash paid
    
    
    2003
    
    
    Cash paid
    
    
    2004Lease obligation
    
    $
    1,458
    
    
    $
    2,306
    
    
    $
    (759
    )
    
    $
    3,005
    
    
    $
    154
    
    
    
    
    
    
    $
    (1,386
    )
    
    $
    1,773
    
    
    $
    (1,773
    )
    
    $
    Asset write-down
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    196
    
    
    
    (196
    )
    
    
    
    
    
    
    Severance benefits
    
    
    82
    
    
    
    1,059
    
    
    
    (632
    )
    
    
    509
    
    
    
    
    
    
    
    
    
    
    
    (509
    )
    
    
    Total
    
    $
    1,540
    
    
    $
    3,365
    
    
    $
    (1,391
    )
    
    $
    3,514
    
    
    $
    350
    
    
    $
    (196
    )
    
    $
    (1,895
    )
    
    $
    1,773
    
    
    $
    (1,773
    )
    
    $
    
 4. Prepaid Expenses and Other Current Assets Prepaid expenses and other current assets consist of the following (in thousands): December 31,2004
    
    
    2003Prepaid expenses
    
    $
    1,025
    
    
    $
    791Deferred financing
    
    
    
    
    
    
    232Product inventory
    
    
    273
    
    
    
    109Other receivables
    
    
    8
    
    
    
    12$
    1,306
    
    
    $
    1,144
 5. Property and Equipment Property and equipment consists of the following (in thousands): December 31,2004
    
    
    2003Computer equipment
    
    $
    4,517
    
    
    $
    3,978Office furniture and equipment
    
    
    1,489
    
    
    
    1,403Leasehold improvements
    
    
    453
    
    
    
    4326,459
    
    
    
    5,813Less accumulated depreciation
    
    
    (5,704
    )
    
    
    (5,276
    )$
    755
    
    
    $
    537
 Page 16




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##### Table of Contents



Notes to Financial Statements (continued) 6. Notes Receivable from Current and Former Officers Notes receivable from current and former officers was $3.1 million of principal at December 31,
2004 and 2003. The Notes are full recourse loans secured by shares of the Companys common stock
owned by the current and former officers and bear interest at 4.94%. Principal and interest are
due December 31, 2005. Principal and accrued interest of $3.7 million and $3.5 million is recorded
in Notes and Interest Receivable from Current and Former Officers as of December 31, 2004 and
December 31, 2003 respectively. 7. Other Assets Other Assets consist of the following (in thousands): December 31,2,004
    
    
    2,003Software development cost
    
    $
    3,089
    
    
    $
    3,089Less accumulated amortization
    
    
    (2,697
    )
    
    
    (2,346
    )Software development costs, net
    
    
    392
    
    
    
    743Other non current assets
    
    
    875
    
    
    
    875$
    1,267
    
    
    $
    1,618
 8. Accrued Liabilities Accrued liabilities consist of the following (in thousands): December 31,2,004
    
    
    2,003Accrued restructuring costs
    
    $
    
    
    
    $
    1,773Accrued vacation
    
    
    1,036
    
    
    
    831Accrued commissions and bonus
    
    
    2,093
    
    
    
    930Accounts payable accruals
    
    
    671
    
    
    
    196Other accrued liabilities
    
    
    538
    
    
    
    145$
    4,338
    
    
    $
    3,875
 9. Bank Line of Credit On January 30, 2004 the Company entered into a revolving line of credit agreement with Comerica
Bank. The line totaled $7.0 million through July 22, 2004; after that date, the maximum that can
be borrowed under the agreement is $5.0 million. The line expires on July 14, 2005. Borrowing
under the line of credit bears interest at prime plus 0.5%, currently 5.75%. The facility was
partially secured by a letter of credit provided by WPV, Inc., an affiliate of Warburg, Pincus
Ventures, a significant stockholder of the Company. The letter of credit was for $4.0 million
through May 30, 2004 and $3.0 million from May 31, 2004 to July 30, 2004. The nonguaranteed
portion of the line is subject to limitations based on the Companys accounts receivable balance.
To further secure the line the Company granted Comerica a security interest in all of our assets
other than our intellectual property, and agreed not to restrict our ability to grant a security
interest in our intellectual property. Borrowings under the line are subject to various covenants.
There were no borrowings outstanding on the line of credit at December 31, 2004. In consideration of the original guarantee the Company granted a security interest in substantially
all of the Companys assets and issued WPV, Inc. a fully vested and non-forfeitable warrant to
purchase 1,375,000 shares of common stock of the Company at an exercise price of $8.00. The
warrant will expire if unexercised by March 9, 2008. The fair value of the warrant at the date of
issuance was $3.6 million; this amount was amortized as deferred financing costs by a charge to
interest expense through July 31, 2004. Page 17




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##### Table of Contents



Notes to Financial Statements (continued) 10. Income Tax The Company recorded a tax benefit of $43,000 for the year ended December 31, 2004 relating to the
reversal of a provision for U.S. federal alternative minimum tax for the year ended December 31,
2003. The Company has made no provision for U.S. federal, U.S. state or foreign income taxes for
the years ended December 31, 2004, 2003 and 2002 as the Company has incurred tax losses in all
periods and for all jurisdictions. Deferred income taxes reflect the net tax effects of temporary differences between carrying amounts
of assets and liabilities for financial reporting purposes and the amounts used for income tax
purposes. Significant components of the Companys deferred tax assets are as follows, (in
thousands): December 31,2004
    
    
    2003Deferred tax assets:Net operating loss carryforwards
    
    $
    27,637
    
    
    $
    26,272Restructuring reserve
    
    
    
    
    
    
    710Capitalized software and development costs
    
    
    389
    
    
    
    698Deferred revenue
    
    
    395
    
    
    
    1,008Research credit carryforwards
    
    
    1,195
    
    
    
    811Other
    
    
    1,360
    
    
    
    941Total deferred tax assets
    
    
    30,976
    
    
    
    30,440Valuation allowance
    
    
    (30,976
    )
    
    
    (30,440
    )Net deferred tax assets
    
    $
    
    
    
    $
    
 Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount
of which are uncertain. Accordingly, the net deferred tax assets have been fully offset by a
valuation allowance. The valuation allowance decreased from December 31, 2002 to December 31, 2003
in the amount of $357,000. As of December 31, 2004, the Company had net operating loss carryforwards for federal income tax
purposes of approximately $77,286,000, which expire in the years 2011 through 2024 and federal
research tax credits of approximately $823,000, which expire in the years 2011 through 2024. The
Company also had net operating loss carryforwards for state income tax purposes of approximately
$30,315,000 expiring in the years 2006 through 2014 and state research tax credits of approximately
$372,000 which carry forward indefinitely. Utilization of the companys net operating loss carryforwards may be subject to substantial annual
limitation due to the ownership change limitation provided by the Internal Revenue Code and a
similar state provision. Such an annual limitation could result in the expiration of the net
operating loss carryforwards before utilization. Page 18




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Notes to Financial Statements (continued) 11. Stockholders Deficit Common Stock At December 31, 2004, the Company had reserved shares of common stock for future issuance as
follows: Stock Options outstanding
    
    
    3,103,102Stock Options available for future grants
    
    
    1,026,439Employee stock purchase plan
    
    
    225,675Common stock warrants
    
    
    1,375,0005,730,216
 Stock Options The Companys employee stock option plans provide for the issuance of incentive stock options
(ISO), nonstatutory stock options (NSO) and stock awards to eligible participants. The ISOs may be
granted at a price per share not less than the fair market value at the date of grant. The NSOs
may be granted at a price per share not less than 85% of the fair market value at the date of
grant. Certain options previously granted can be exercised prior to vesting, but, if so exercised,
these unvested shares are subject to repurchase by the Company. Options and unvested shares
granted generally vest over a period of four years. Options under the employee plans have a
maximum term of ten years. In the event option holders cease to be employed by the Company, all
unvested options are forfeited and all vested options may be exercised within a 90-day period after
termination. The 90-day exercise period is sometimes extended by agreement with the optionee,
which could result in a modification charge to operations. In May 1999, the Companys stockholders approved the 1999 Equity Incentive Plan, which amended and
restated the Companys previous stock option plan. 3,292,666 shares of common stock were
authorized for issuance under the plan, including shares originally authorized under predecessor
plans and shares added to the plan in 2001. In May 2002, the Companys Board of Directors approved
and in May 2003, the shareholders subsequently approved, adding 1,350,000 shares to the 1999 Equity
Incentive Plan. In January 2004, the Companys Board of Directors approved and in June 2004, the
shareholders subsequently approved, adding an additional 850,000 shares to the 1999 Equity Plan.
The total number of shares authorized for issuance under the plan is now 5,492,666. The Board of
Directors also approved the 2002 CEO Stock Option Plan in May 2002, which was subsequently approved
by the shareholders in May 2003. This plan reserved an aggregate of 470,588 shares for grants of
stock options under the plan. In May 1999, the Companys stockholders approved the 1999 Non-Employee Directors Stock Option Plan
and reserved an aggregate of 75,000 shares of common stock for grants of stock options under the
plan. In May 2003, the Companys stockholders approved an increase in the number of shares
authorized for issue under the plan from 75,000 shares to a total of 150,000 shares. The Company has, on occasion, granted stock options and stock to non-employees and directors. A
compensation charge has been recorded in these instances. In 2004 10,797 shares were issued to
directors as payment for their services; an expense of $71,000 was recorded for the year ended
December 31, 2004. Page 19




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Notes to Financial Statements
11. Stockholders Deficit (continued) A summary of the Companys stock option activity under the plans is as follows: Outstanding OptionsWeighted-Average ExerciseNumber of Shares
    
    
    Price Per ShareOutstanding at December 31, 2001
    
    
    1,653,166
    
    
    $
    9.47Granted
    
    
    2,239,290
    
    
    
    1.36Exercised
    
    
    (274,471
    )
    
    
    1.15Canceled
    
    
    (628,681
    )
    
    
    9.35Outstanding at December 31, 2002
    
    
    2,989,304
    
    
    
    4.20Granted
    
    
    501,834
    
    
    
    3.08Exercised
    
    
    (207,445
    )
    
    
    1.27Canceled
    
    
    (238,666
    )
    
    
    9.85Outstanding at December 31, 2003
    
    
    3,045,027
    
    
    
    3.76Granted
    
    
    552,497
    
    
    
    5.71Exercised
    
    
    (417,773
    )
    
    
    1.54Canceled
    
    
    (76,739
    )
    
    
    7.88Outstanding at December 31, 2004
    
    
    3,103,012
    
    
    $
    4.33Vested and exercisable
    
    
    1,407,373
 The following table summarizes information concerning outstanding and exercisable stock options at
December 31, 2004: Outstanding
    
    
    Vested and ExercisableWeighted-
    
    
    
    
    
    
    WeightedAverage
    
    
    
    
    
    
    AverageWeighted-
    
    
    Remaining
    
    
    
    
    
    
    ExerciseNumber of
    
    
    Average Exercise
    
    
    Contractual Life
    
    
    Number of
    
    
    Price PerPrice Range
    
    Shares
    
    
    Price Per Share
    
    
    (Years)
    
    
    Shares
    
    
    Share$0.2600  $1.3900
    
    
    1,141,600
    
    
    $
    1.37
    
    
    
    7.35
    
    
    
    185,349
    
    
    $
    1.30$1.4000  $6.1250
    
    
    1,539,098
    
    
    $
    4.03
    
    
    
    7.60
    
    
    
    846,464
    
    
    $
    3.70$6.2500  $39.8750
    
    
    422,314
    
    
    $
    13.42
    
    
    
    5.58
    
    
    
    375,560
    
    
    $
    14.293,103,012
    
    
    
    
    
    
    
    
    
    
    
    1,407,373
 Common Stock Warrants In 2001, the Company issued a fully vested non-forfeitable warrant to purchase 1,375,000 shares of
common stock of the Company at an exercise price of $8.00 per share. The warrant was issued to
WPV, Inc., an affiliate of a significant stockholder of the Company, in connection with the
guarantee of a line of credit to the Company. The warrant is outstanding and will expire if
unexercised by March 9, 2008. The fair value of the warrant at the date of issuance was $3.6
million. The value of the warrant was determined using the Black-Scholes model with the following
assumptions: a share price of $3.88, volatility of .85, a risk-free interest rate of 4.94%, no
dividend yield and an expected life of seven years. Page 20




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Notes to Financial Statements
11. Stockholders Deficit (continued) 1999 Employee Stock Purchase Plan In May 1999 the stockholders approved the 1999 Employee Stock Purchase Plan, which became effective
upon the completion of the initial public offering of the Companys common stock. The Company
initially reserved a total of 350,000 shares of common stock for issuance under the plan. In May
2002 the Companys shareholders approved an additional 350,000 shares for a total of 700,000
shares. Eligible employees may purchase common stock at 85% of the lesser of the fair market value
of the Companys common stock on the first day of the applicable one-year offering period or the
last day of the applicable six-month purchase period. The Company issued 78,468 and 52,912 shares
of common stock under the plan during the years ended December 31, 2004 and 2003, respectively. At
December 31, 2004, 225,675 shares were available for issuance under the Plan. 12. Commitments Leases The Company leases its corporate office facility under a non-cancelable operating lease with a term
expiring in 2013. Future minimum payments under this lease as of December 31, 2004 are as follows
(in thousands): 2005
    
    $
    9402006
    
    
    9402007
    
    
    9402008
    
    
    9402009
    
    
    9842010 and thereafter
    
    
    4,423$
    9,167
 Rent expense under all operating leases net of sublease income was $1 million, $1 million and $1.7
million for the years ended December 31, 2004, 2003 and 2002, respectively. License Agreement In September 1996, the Company entered into a license agreement with a university for the use of
the intellectual property underlying its most significant current products. In exchange for the
license, which expires in 2014, the Company issued stock and paid a license-issue fee. The
agreement also provided for milestone payments, all of which have been made, and for royalties
based on sales of products using the licensed technology. Royalty expenses were $746,000, $898,000
and $723,000 for the years ended December 31, 2004, 2003 and 2002, respectively, and are included
in cost of revenues. Annual minimum guaranteed royalty payments are $150,000. If the Company loses or is unable to maintain the license agreement during the term of the
underlying patents, it would materially harm its business. The university may terminate the license
agreement if the Company fails to perform or violates its terms without curing the violation within
60 days of receiving written notice of the violation. 13. Warranties; Indemnification The Company generally provides a warranty that its software products substantially operate as
described in the manuals and guides that accompany the software for a period of 90 days. The
warranty does not apply in the event of misuse, accident, and certain other circumstances. To
date, the Company has not incurred any material costs associated with these warranties and has no
accrual for such items at December 31, 2004. Page 21




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Notes to Financial Statements
13. Warranties; Indemnification (continued) From time to time, the Company enters into contracts that require the Company, upon the occurrence
of certain contingencies, to indemnify parties against third party claims. These contingent
obligations primarily relate to (i) claims against the Companys customers for violation of third
party intellectual property rights caused by the Companys products; (ii) claims resulting from
personal injury or property damage resulting from the Companys activities or products; (iii)
claims by the Companys office lessor arising out of the Companys use of the premises; and (iv)
agreements with the Companys officers and directors under which the Company may be required to
indemnify such persons for liabilities arising out of their activities on behalf of the Company.
Because the obligated amounts for these types of agreements usually are not explicitly stated, the
overall maximum amount of these obligations cannot be reasonably estimated. No liabilities have
been recorded for these obligations on the Companys balance sheet as of December 31, 2004 or 2003. 14. Employee Retirement and Benefit Plan The Company has a defined contribution retirement plan under Section 401(k) of the Internal Revenue
Code, which covers substantially all employees. Eligible employees may contribute amounts to the
plan, via payroll withholding, subject to certain limitations. The Company does not presently match
contributions by plan participants. 15. Related Party Transaction On September 30, 2003 the Company entered into an agreement with Posit Science Corporation (PSC),
formerly Neuroscience Solutions Corporation, to provide PSC with exclusive rights in the healthcare
field to certain intellectual property, patents and software owned or licensed by the Company,
along with transfer of certain healthcare research projects. A co-founder, substantial
shareholder, and member of the Board of Directors of the Company is a co-founder, officer, director
and substantial shareholder of PSC. The rights were acquired by PSC for a combination of cash, stock and future royalties. PSC paid
$500,000 cash, of which $448,000 was recognized at December 31, 2003. The balance will be
recognized over the next nine months as services are provided to PSC. Amounts received to date and
any future receipts are being reported as other income as the Company does not consider the sale of
these rights to be part of its recurring operations. Under the agreement, the Company will receive
net royalties between 2% to 4% on products sold by PSC that use the Companys patents or software.
We did not record a value for the 1.8 million shares of PSC received in the transaction, because
PSC was a private start-up venture, the shares of which had no determinable value. Page 22




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Notes to Financial Statements (continued) 16. Interim Financial Information (unaudited) Quarterly financial data (in thousands, except per share amounts) 2004Quarter endedMarch 31
    
    
    June 30
    
    
    September 30
    
    
    December 31
    
    
    TotalTotal revenues
    
    $
    7,036
    
    
    $
    7,497
    
    
    $
    8,290
    
    
    $
    8,153
    
    
    $
    30,976Gross profit
    
    
    5,477
    
    
    
    5,803
    
    
    
    6,512
    
    
    
    6,428
    
    
    
    24,220Net income (loss)
    
    
    (290
    )
    
    
    (52
    )
    
    
    667
    
    
    
    (1,018
    )
    
    
    (693
    )Net income (loss) per share:Basic
    
    
    (0.02
    )
    
    
    0.00
    
    
    
    0.04
    
    
    
    (0.06
    )
    
    
    (0.04
    )Diluted
    
    
    (0.02
    )
    
    
    0.00
    
    
    
    0.04
    
    
    
    (0.06
    )
    
    
    (0.04
    )
 2003Quarter endedMarch 31
    
    
    June 30
    
    
    September 30
    
    
    December 31
    
    
    TotalTotal revenues
    
    $
    6,583
    
    
    $
    8,074
    
    
    $
    8,293
    
    
    $
    6,966
    
    
    $
    29,916Gross profit
    
    
    5,158
    
    
    
    6,630
    
    
    
    6,724
    
    
    
    5,405
    
    
    
    23,917Net income (loss)
    
    
    (454
    )
    
    
    745
    
    
    
    1,678
    
    
    
    161
    
    
    
    2,130Net income (loss) per share:Basic
    
    
    (0.03
    )
    
    
    0.05
    
    
    
    0.10
    
    
    
    0.01
    
    
    
    0.13Diluted
    
    
    (0.03
    )
    
    
    0.04
    
    
    
    0.10
    
    
    
    0.01
    
    
    
    0.13
 The Company has restated its previously reported balance sheets as of June 30 and September 30,
2004. This restatement reflects a correction in the Companys classification of short and long term
deferred revenues totaling $4,398,000 as of June 30, 2004 and
$4,615,000 as of September 30, 2004. As of June 30, 2004,
the restatement of deferred revenues resulted from a clerical error
in the classification between long and short term amounts for a
contract executed in June 2004. As of September 30, 2004,
the restatement of deferred revenues resulted from a clerical error in the
classification of the same contract and a computation error. The following table summarizes the change to the balance sheet at September 30, 2004: Previously reported
    
    
    Adjustment
    
    
    RestatedCurrent liabilitiesDeferred revenue
    
    
    14,883
    
    
    
    4,615
    
    
    
    19,498Total current liabilities
    
    
    18,539
    
    
    
    4,615
    
    
    
    23,154Deferred revenue, long term
    
    
    10,842
    
    
    
    (4,615
    )
    
    
    6,227
 Page 23




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Notes to Financial Statements
16. Interim Financial Information (unaudited) (continued) The following table summarizes the change to the balance sheet at June 30, 2004: Previously reported
    
    
    Adjustment
    
    
    RestatedCurrent liabilitiesDeferred revenue
    
    
    15,548
    
    
    
    4,398
    
    
    
    19,946Total current liabilities
    
    
    22,615
    
    
    
    4,398
    
    
    
    27,013Deferred revenue, long term
    
    
    11,990
    
    
    
    (4,398
    )
    
    
    7,592
 Page 24




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ITEM 9A. CONTROLS AND PROCEDURES Disclosure controls and procedures are designed to ensure that information required to be disclosed
in our reports filed under the Exchange Act, such as this Annual Report on Form 10-K/A, is
recorded, processed, summarized and reported within the required time periods. These procedures are
also designed to ensure that such information is accumulated and communicated to our management,
including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely
decisions regarding required disclosure. In connection with the Original Form 10-K, as required under Rule 13a-15(b) of the Exchange Act,
the Companys management, including the Chief Executive Officer and Chief Financial Officer,
conducted an evaluation of the effectiveness of the Companys disclosure controls and procedures.
Based on this evaluation, the Companys Chief Executive Officer and Chief Financial Officer
concluded in the Original Form 10-K that the Companys disclosure controls and procedures were not
effective as of December 31, 2004. This determination was based on need to correct the Companys
revenue recognition method that that led to the restatement of the Companys historical financial
statements from 2000 through June 30, 2004. This restatement was effected by through filings
with the SEC on February 15, 2005. The Original Form 10-K was filed on April 15, 2005. In May 2005, in the course of preparing the
first quarter 2005 financial statements, the Companys management determined that the balance
sheets at June 30, September 30, and December 31, 2004 incorrectly classified a portion of deferred
revenue as long term deferred revenue when it should have been classified as current deferred
revenue. As a result, the Companys management and the Audit Committee of the Companys Board of
Directors concluded that the Company should, and in this filing the Company has, restated its
balance sheet at December 31, 2004. As a result of these circumstances, management has concluded that there is a material weakness in
the Companys internal controls, as defined by the Public Company Accounting Oversight Board. As required under Rule 13a-15(b) of the Exchange Act, the Companys management, including the Chief
Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the
Companys disclosure controls and procedures as of the end of the period covered by this report.
Because of the revenue and deferred revenue issues discussed above, the Companys Chief Executive
Officer and Chief Financial Officer concluded that the Companys disclosure controls and procedures
were not effective as of December 31, 2004. We are committed to implementing changes in our
internal controls over financial reporting with respect to revenue and deferred revenue. We have
hired additional accounting staff and we are in the process of evaluating what changes should be
made in our controls. Except for these changes, during the year ended December 31, 2004, there
were no changes in the Companys internal controls over financial reporting that materially
affected, or are reasonably likely to materially affect the Companys internal control over
financial reporting. It should be noted that a control system, no matter how well designed and operated, can provide
only reasonable, not absolute, assurance that the objectives of the control system are met. As a
result, there can be no assurance that a control system will succeed in preventing all possible
instances of error and fraud. The Companys disclosure controls and procedures are designed to
provide reasonable assurance of achieving their objectives, and the conclusions of our Chief
Executive Officer and the Chief Financial Officer are made at the reasonable assurance level. Page 25




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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) Financial Statements Independent Registered Public Accounting Firms Report
Restated Balance Sheet  December 31, 2004 and 2003
Statement of Operations  Years Ended December 31, 2004, 2003 and 2002
Statements of Stockholders (Deficit) Equity  Years Ended December 31, 2004, 2003 and 2002
Restated Statement of Cash Flows  Years Ended December 31, 2004, 2003 and 2002
Notes to the Financial Statements (2) Financial Statement Schedules As required under Item 8, Financial Statements and Supplementary Data, the financial
statement schedule of the Company is provided in this separate section. The financial
statement schedule included in this section is as follows: Schedule II  Valuation and Qualifying Accounts(in thousands) Valuation and Qualifying Accounts which are deducted in the Balance Sheet from the
assets to which they apply: Allowance for Doubtful Accounts Years Ended December 31 Charges to
    
    
    
    
    
    
    AdditionsOpening
    
    
    Operating
    
    
    Charges to
    
    
    (deductions) to
    
    
    ClosingBalance
    
    
    Expenses
    
    
    Allowance
    
    
    Allowance
    
    
    Balance2004
    
    $
    139
    
    
    $
    (3
    )
    
    $
    (100
    )
    
    $
    85
    
    
    $
    1212003
    
    
    270
    
    
    
    
    
    
    
    89
    
    
    
    (220
    )
    
    
    1392002
    
    
    248
    
    
    
    19
    
    
    
    309
    
    
    
    (306
    )
    
    
    270
 (3) Exhibits Exhibit No.
    
    Description of Document23.1
    
    Consent of Ernst & Young, LLP, Independent Registered Public Accounting Firm31.1
    
    Certification of Chief Executive Officer (Section 302)31.2
    
    Certification of Chief Financial Officer (Section 302)32.1
    
    Certification of Chief Executive Officer (Section 906)32.2
    
    Certification of Chief Financial Officer (Section 906)
 (b) Reports on Form 8-K. On October 1, 2003, the Company filed a Report on Form 8-K disclosing the closing under a
technology transfer agreement with Neuroscience Solutions Corporation. On October 3, 2003, the Company filed a Report on Form 8-K disclosing its agreement to
reduce the amount available for borrowing under its credit line. On October 30, 2003, the Company filed a Report on Form 8-K furnishing its press release
announcing its financial results for the quarter ended September 30, 2003 and the transcript
of its conference call discussing those earnings. Page 26




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SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized. SCIENTIFIC LEARNING CORPORATION By /s/ Robert C. Bowen
    
    May 25,
2005Robert C. BowenChief Executive Officer
 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed
below by the following persons on behalf of the registrant and in the capacities and on the dates
indicated. SIGNATURES
    
    TITLE
    
    DATE/s/ Robert C. BowenRobert C. Bowen
    
    Chairman, Chief Executive Officer
and Director (Principal Executive
Officer)
    
    May 25, 2005/s/ Jane A. FreemanJane A. Freeman
    
    Senior Vice President, Chief Financial Officer,
and Treasurer (Principal Financial and
Accounting Officer)
    
    May 25, 2005/s/ Dr. Michael M. MerzenichDr. Michael M. Merzenich
    
    Director
    
    May 25, 2005/s/ Dr. Paula A. TallalDr. Paula A. Tallal
    
    Director
    
    May 25, 2005/s/ Carleton A. HolstromCarleton A. Holstrom
    
    Director
    
    May 25, 2005/s/ Rodman W. Moorhead, IIIRodman W. Moorhead, III
    
    Director
    
    May 25, 2005/s/ Ajit DalviAjit Dalvi
    
    Director
    
    May 25, 2005/s/ Dr. Joseph MartinDr. Joseph Martin
    
    Director
    
    May 25, 2005/s/ Edward Vermont Blanchard, Jr.Edward Vermont Blanchard, Jr.
    
    Director
    
    May 25, 2005/s/ David W. SmithDavid W. Smith
    
    Director
    
    May 25, 2005




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Index to Exhibits Exhibit No.
    
    Description of Document23.1
    
    Consent of Ernst & Young, LLP, Independent Registered Public Accounting Firm31.1
    
    Certification of Chief Executive Officer (Section 302)31.2
    
    Certification of Chief Financial Officer (Section 302)32.1
    
    Certification of Chief Executive Officer (Section 906)32.2
    
    Certification of Chief Financial Officer (Section 906)