|UNITED STATES  
SECURITIES AND EXCHANGE
COMMISSION


WASHINGTON, D.C. 20549


FORM 10-K


/X/ Annual Report
Pursuant to Section 13 or 15 (d) of the SecuritiesExchange Act of 1934


For the fiscal year
ended December 31, 2002; or


/ / Transition Report
Pursuant to Section 13 or 15 (d) of the SecuritiesExchange Act of 1934


For the transition
period from ___________ to _________________


COMMISSION FILE NO.
000-24547


SCIENTIFIC LEARNING
CORPORATION
(Exact name of
registrant as specified in its charter)
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|DELAWARE
(State or other jurisdiction of
incorporation or organization) | 94-3234458
(IRS Employer Identification Number)
|----------------------------------------------------------------------- | -----------------------------------------------

|300 FRANK H. OGAWA
PLAZA, SUITE 500
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: /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 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. / /


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


The aggregate market value of the
voting stock held by non-affiliates of the Registrant, based upon the closing sale price
of the Common Stock on June 28, 2002 as reported on the Nasdaq National Market, was
approximately $7,237,817. 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 14, 2003 the Registrant
had outstanding 15,879,083 shares of Common Stock.


DOCUMENTS INCORPORATED
BY REFERENCE


Portions of the Proxy Statement for
the Registrants 2003 Annual Meeting of Stockholders to be held on May 21, 2003, at
300 Frank H. Ogawa Plaza, Suite 500, Oakland, CA 94612-2040 are incorporated by reference
in Part III.



2
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|SPECIAL NOTE ON
FORWARD-LOOKING STATEMENTS


This
report on Form 10-K, including the sections captioned Item 1. Business, and
Item 7. Managements Discussion and Analysis of Financial Condition and Result
of Operations, contains forward-looking statements within the meaning of Section 27A
of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act
of 1934, as amended. In some cases, you can identify forward-looking statements by
terminology such as may, will, should,
expects, intends, plans, anticipates,
believes, estimates, predicts, potential,
continue or the negative of these terms or other comparable terminology. These
forward-looking statements relate to future events or our future financial performance and
involve known and unknown risks, uncertainties and other factors that may cause our actual
results, levels of activity, performance or achievements to differ materially from that
expressed or implied by these forward-looking statements. Although we believe that the
expectations reflected in the forward-looking statements are reasonable, we cannot
guarantee future results, levels of activity, performance or achievements. Our actual
results may differ materially from those expected or anticipated in the forward-looking
statements. Specific factors that might cause such a difference include, but are not
limited to, risks and uncertainties discussed in this Report under the caption
Factors That May Affect our Results or Stock Price in Item 1 of this Form 10-K
and those that are or may be discussed from time to time in our public announcements and
filings with the SEC, including our future Forms 8-K, 10-Q and 10-K. We undertake no
obligation to update or revise publicly any forward-looking statements, whether as a
result of new information, future events or otherwise after the date of this report.


TABLE OF CONTENTS
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|           |                                                                                                |         
|---------- | ---------------------------------------------------------------------------------------------- | --------
|PART I     |                                                                                                | PAGE NO.
|Item 1     | Business                                                                                       | 4       
|Item 2     | Properties                                                                                     | 16      
|Item 3     | Legal Proceedings                                                                              | 16      
|Item 4     | Submission of Matters to a Vote of Security Holders                                            | 16      
|PART II   
|Item 5     | Market for Registrants Common Equity and Related Stockholder Matters                          | 19      
|Item 6     | Selected Financial Data                                                                        | 20      
|Item 7     | Managements Discussion and Analysis of Financial Condition and Results of
Operations          | 21      
|Item 7A    | Quantitative and Qualitative Disclosures about Market Risk                                     | 31      
|Item 8     | Financial Statements and Supplementary Data                                                    | 32      
|Item 9     | Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure           | 50      
|PART III  
|Item 10    | Directors and Executive Officers of the Registrant                                             | 50      
|Item 11    | Executive Compensation                                                                         | 50      
|Item 12    | Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters | 50      
|Item 13    | Certain Relationships and Related Transactions                                                 | 50      
|Item 14    | Controls and Procedures                                                                        | 50      
|PART IV   
|Item 15    | Exhibits, Financial Statement Schedules, and Reports on Form 8-K                               | 53      
|SIGNATURES |                                                                                                | 55      

|3
|-

|ITEM 1.  BUSINESS


Our mission is to apply advances in
neuroscience and cognitive research to increase human potential. We produce innovative
products, tools, and implementation strategies that enable people to build the fundamental
cognitive skills required to read and learn. We use technology as appropriate to provide
our customers with the applications that allow each learner to progress based on his or
her individual needs.


To date, our principal focus has been
on the development, marketing and sale of software products that develop the underlying
cognitive skills required for reading. Our Fast ForWord® products are a series of
reading intervention products that incorporate learning from more than 30 years of brain,
language and reading research in order to help children, adolescents and adults build the
cognitive skills they need to learn to read or become better readers. The efficacy of our
major products has been established by extensive outcomes research by independent
researchers, our founding scientists and our company.


To support our products, we provide a
combination of on-site and remote training and implementation services; technical,
professional and customer support; and a wide variety of Web-based resources, including
BrainConnection.com.


During 2002, approximately 1,500
schools used a site license for one or more Fast ForWord products and over 100,000
individuals enrolled in one of our products, bringing the total number of individuals
enrolled to date to more than 230,000.


We are a Delaware corporation. We
incorporated in 1995 in California under the name Scientific Learning Principles
Corporation and reincorporated in 1997 in Delaware under our present name, Scientific
Learning Corporation.


MARKETS


K-12 SECTOR


Our primary market is K-12 public
schools in the United States. In 2002, the K-12 sector represented approximately 82% of
revenue.


The K-12 market is large and growing.
According to the National Center for Education Statistics, US public schools now enroll
more than 47 million students, and enrollment is projected to continue growing through
2009. There are approximately 15,000 public school districts in the US, with approximately
92,000 school buildings.


Eduventures has estimated that in
2001, K-12 schools spent $3.2 billion (46% of the total schools spent on all instructional
products) on supplementary materials of all types. Simba Information, Inc.s report,
Electronic Media for the School Market, Review, Trends and Forecast 2002  2003
estimates the K-12 market for instructional software at $1.47 billion.


The National Center for Education
Statistics reports that in 2000, 98% of schools had Internet access, over 8.8 million
computers were installed in schools and available for instructional purposes, and of
these, 6.7 million instructional computers (77%) were Internet-enabled.


According to the Education Finance
Statistics Center of the National Center for Education Statistics, approximately 93% of
public school funding is from state and local sources. Much of that funding is dedicated
to teacher salaries, plant maintenance and similar ongoing expenses. The economic downturn
has negatively affected state and local resources, and many states are reducing overall
school funding.


However, substantial federal funding
resources remain, and many of those resources are focused on reading improvement. For the
fiscal year 2004, President Bush has requested over $56.5 billion in funding for the U.S.
Department of Education. This request includes $12.4 billion for Title 1 grants, $1.05
billion for Reading First grants, and $100 million for Early Reading First. All these
sources of funding can be used to implement the policies behind the federal No Child Left
Behind Act of 2002, which makes reading achievement a major priority, and focuses on
funding for products and approaches that have been proven to work and are based on
scientific research.


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|The federal government has spent over
$321 billion on educational programs for disadvantaged children in the past 30 years, and
federal discretionary spending on education has more than doubled since 1996. However, in
the aggregate, reading performance has not improved in 15 years. According to the U.S.
Department of Education, fewer than 1/3 of fourth-graders are proficient
readers.  The No Child Left Behind legislation continues the trend of holding schools
accountable for making concrete, measurable improvements in student performance.


PRIVATE SECTOR


We also sell through private practice
professionals and to independent schools, hospitals and clinics. In 2002, the private
sector represented approximately 18% of revenue.


In this sector, private practice
professionals, primarily speech and language professionals, recommend the use of our
products to appropriate clients and then supervise the use of those products in connection
with their other services. Private practice professionals were our first market, and they
have extensive knowledge about our products and their use that can be valuable for all of
our customers. Revenue from private practice professionals has been declining since 1999.


This sector also includes independent
schools. According to the National Center for Education Statistics, there are
approximately 27,000 independent schools, serving over 5 million students. To date,
approximately 100 independent schools have used a Fast ForWord product.


PRODUCTS


Our Fast ForWord software products
develop cognitive skills required to read and learn effectively.  Our products are
based on more than 30 years of research in neuroscience, reading and language, and use
established neuroscience principles to enable student learning. Extensive efficacy
research (see Research and Outcomesbelow) has demonstrated the results that can be
achieved through use of the Fast ForWord products.


COGNITIVE SKILLS
DEVELOPMENT


Effective reading and learning
requires a variety of foundational cognitive skills, all functioning together. The Fast
ForWord products develop pre-requisite skills that enable successful reading, and
complement reading instruction.  Fast ForWord products develop Learning MAPs
skills:


Memory. The
skill to hold information short- and long-term, essential for comprehension of
complex sentences and for remembering instructions.


Attention. The skill to focus on
tasks and ignore distractions.


Processing.  The skill to
address information such as images and sounds quickly enough to discriminate their
differences, a prerequisite for phonemic awareness and reading.


Sequencing.  The skill to
quickly and accurately determine which of two events or stimuli comes first, which is
supported by memory, attention and processing, and is essential for phonics, word fluency,
and reading and oral comprehension.


FAST POWER LEARNING
FORMULA


Neuroscience research has
demonstrated the importance of frequency and intensity, adaptivity, simultaneous
development and timely motivation to effecting change. The Fast ForWord products use these
principles to enable student learning.


Frequency and intensity:  Brain
plasticity research demonstrates that completing a set of learning tasks in a frequent,
intense timeframe is needed to make the changes in brain functioning that enhance
learning.  To maximize the efficacy of our products, we recommend that most major
Fast ForWord products be used in accordance with an intensive protocol, usually 90 to 100
minutes a day, 5 days a week, for a period of 4 to 8 weeks.


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|In early 2003, we released an
alternative protocol for the Fast ForWord Middle & High School product, which
recommends use for 48 minutes per day, 5 days a week, for a period of 6 to 10 weeks. Our
research shows that this new protocol results in middle and high school students making
progress substantially similar to that achieved under the 90-minute per day protocol. We
continue to conduct research to develop additional protocols in order to provide educators
with greater flexibility in using the Fast ForWord products within their schools
scheduling needs, while maintaining the desired impact on student performance. (See
Development and Research; Researchbelow.)


Adaptivity:  The interactive
exercises in the Fast ForWord products adapt to each students skill level and
progress, automatically adjusting content exposure in a variety of ways.  For
example, many of the exercises automatically adjust the specific content presented to the
student so that the student is making correct responses approximately 80% of the time for
each discrete skill. This adjustment is designed to keep the exercises challenging and
engaging, while allowing the student to generate a feeling of accomplishment and to avoid
frequent failure, which can be discouraging and detrimental to learning.


Simultaneous Development: The Fast
ForWord products develop both major and supporting cognitive skills simultaneously to
facilitate enduring improvements in learning.  While each exercise focuses on a
specific set of reading or language tasks, it is designed to also simultaneously develop
underlying cognitive skills such as memory, attention, processing and sequencing.


Timely Motivation: In order for the
brain to learn, the student must be attentive and engaged, and motivation is critical to
maintaining learning improvements.  In the Fast ForWord products, learners are
rewarded for a correct answer on their first attempt only, a scientifically proven
motivational technique. Other motivational techniques include a bonus point system and the
delivery of mastery animations that tie to a variety of learner milestones
that inform students of their progress.


PRODUCTS IN THE FAST
FORWORD FAMILY


During 2002, our Fast ForWord family
of products accounted for 95% of revenue.


Fast ForWord Languagesoftware
includes seven distinct exercises that rapidly develop the cognitive skills known to be
pre-requisites for reading. The software develops oral language comprehension and
listening skills, including phonological awareness, listening comprehension, language
structures, listening accuracy, and working memory.


Fast ForWord Middle and High Schoolsoftware is designed for adolescents and teenagers who lack reading proficiency. The
exercises are similar to those in Fast ForWord Language, but deliver content in an
age-appropriate sports-themed user interface.


Fast ForWord Language to Readingsoftware includes five exercises that rapidly develop skills that help students make the
link between spoken language and written language, such as word analysis, listening
comprehension, working memory, grammar, syntax, and vocabulary.


Fast ForWord to Readingsoftware
develops a core set of reading skills, and is correlated directly to generally-accepted
grade-level reading standards. We currently market the Fast ForWord Reading product (to be
renamed Fast ForWord to Reading 3), which is correlated to end of third grade reading
standards and develops skills in word recognition and fluency, advanced decoding,
spelling, vocabulary and passage comprehension.


In June 2003 we plan to introduce
Fast ForWord to Reading 4, our second product in the Fast ForWord to Reading series, which
will be correlated to end of fourth grade reading standards. Fast ForWord to Reading 4
further develops spelling, extends word level knowledge in the context of semantic,
phonological, morphological and syntactic structures, and covers advanced sentence and
passage comprehension skills.


We also sell Fast ForWord Basics,
software that prepares pre-readers aged 4 to 7 for learning and reading; Reading Edge, a
reading assessment instrument for students from kindergarten to 2nd grade; and Fast
ForWord Bookshelf, an early reading kit that includes five colorful storybooks and a
multimedia CD-ROM.


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|PROGRESS TRACKING SERVICES


Our major products, Fast ForWord
Language, Language to Reading, Middle & High School and Reading, include an optional
remote progress tracking service. Fast ForWord Progress Tracker is an easy to use,
patented Web browser based, server side Java application that allows educators to securely
view student progress and participation over the Internet.


Fast ForWord Progress Tracker
provides printable electronic reports on detailed learning results for individuals or
groups of students for all exercises in each major Fast ForWord product. The reports are
generated from learner data securely transmitted periodically by customers to Scientific
Learnings database. The detailed reports permit educators to see exactly how each
student is progressing on specific skills. Overview reports provide summary-level data for
a class or other group and provide a quick update on the groups progress and
participation levels. Reports can be shared with parents, other teachers or other
authorized personnel.


The Fast ForWord Gateway Edition
release, scheduled for June 2003, is planned to include additional capabilities, including
intervention alerts, automatic emailing of reports, and standards and basal alignments.
(See Development and Research; Developmentbelow.)


TECHNOLOGY PLATFORM


The Fast ForWord software products
function with a wide variety of hardware and software configurations. They are designed to
work with the computer technology widely available in schools and homes. Our products are
typically delivered via a CD ROM. Our Internet based tools use standard Internet
connections and support commercially-available Web browsers.


We use an object-oriented authoring
environment for all our software products. New products and product extensions can be
built off our core object model, allowing all products to benefit from improvements in the
core code and reducing new product development time.


When users upload data to our
Progress Tracker remote monitoring tool, the uploaded data is stored in our unique and
highly scalable database.


RESEARCH AND OUTCOMES


BRAIN IMAGING AND READING
IMPROVEMENTS


A Stanford University study recently
published in the Proceedings of the National Academy of Sciences confirms that, following
Fast ForWord use, students show significant improvements in reading performance coupled
with changes in brain activation patterns. The study involved students aged 8 to 12 who
were identified as dyslexic. Before beginning the study, the students underwent reading,
reading skills and language assessments and functional magnetic resonance imaging (fMRI)
of their brains during a series of reading related tasks. The students then used the Fast
ForWord Language product for five days a week, 100 minutes per day, for an average of 28
days. The fMRIs and assessment tests were then repeated. After Fast ForWord use, the brain
activation patterns of the students showed increased neurologic activity in regions of the
brain involved in skills critical to reading. These later images more closely resemble the
patterns of students reading on or above grade level. A control group showed no similar
changes in fMRI results. The students who used the Fast ForWord product also showed
improvements in a variety of reading skills, including word decoding, single word reading,
naming fluency, and reading comprehension.


OUTCOMES


From the founding of our company, we
have devoted significant resources to demonstrating that our products improve learning.
Independent and company research has clearly demonstrated that Fast ForWord products
improve reading and language skills in a broad spectrum of demographic groups.


Results from the original research
studies combining the work of our scientific founders were published in the journal
Science. In the primary study, students identified with language-based learning problems
worked for approximately 50 hours total over a 20-day period on computer exercises that
later formed the basis of the Fast ForWord products. The exercises used by the
experimental group included slowed, stretched and emphasized speech, and adapted to the
childs progress. The control group received normal speech. The experimental group
showed significant gains of 1.5 years in the oral language skills critical to reading. The
control group did not demonstrate comparable gains.


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|We then funded two additional field
trials. The first study, conducted in 1996, involved children between the ages of 4 and
14, most of whom had been identified as needing specific help in language skills. The
children were supervised by professionals in private clinics and schools throughout the
US. In the study, the children used the Fast ForWord Language product for 100 minutes a
day, five days a week, for four to eight weeks. On average, across various ages and grade
levels, the children demonstrated gains of one to two years on standardized tests of
skills critical to reading.


The second study, conducted in 1997,
included students in 19 public schools in nine districts located in five states. The
students were selected by their teachers as being at risk for later academic failure.
While statistically controlling for grade and gender influences in group assignment, the
students were randomly assigned to control and experimental groups. The experimental group
worked on the Fast ForWord Language exercises for 100 minutes a day, five days a week, for
four to eight weeks. The control group received traditional classroom curriculum for the
same amount of time. More than 70% of the students in the experimental group demonstrated
statistically significant gains in language and reading skills as measured on standardized
tests, with their average improvement being more than 1 1⁄2 years. These improvements
were significantly greater than the gains made by students in the control group.


Researchers have expanded this
initial research as the Fast ForWord family of products has been used for more and more
students. To date, more than 230,000 individuals have enrolled in Fast ForWord products,
and we have accumulated research outcomes on more than 17,000 individuals, including
approximately 11,000 controls. Gains have been confirmed among a variety of groups,
including African-American students, students with limited English proficiency, students
struggling in learning to read, and students of low socio-economic status. Gains on
specific reading skills have been confirmed using the Woodcock Johnson Tests of
Achievement, Revised, a standardized, nationally normed reading test. In addition, schools
that have used the Fast ForWord products have provided us with state achievement test
scores from students before and after they have used Fast ForWord products. Analyses of
these data have demonstrated that following Fast ForWord participation, students achieve
significant improvements on a wide variety of high-stakes tests.


SCIENTIFIC BASIS


The technology that forms the basis
of most of our major products grew out of a scientific collaboration between
neuroscientists working at Rutgers, the State University of New Jersey
(Rutgers) and the University of California at San Francisco (UCSF)
combining insights about language development and learning to read with research on brain
plasticity.


Humans are born with the potential to
learn any language, and one of a childs early tasks is to learn to extract meaning
from speech by identifying its basic auditory building blocks, or phonemes. Children must
be able to recognize and process the phonemes relevant to their language before they can
become skilled in language or reading. The Rutgers group noted that children with
language-based learning problems often have difficulty distinguishing between closely
related phonemes. These individuals frequently have problems in other language and
cognitive skill areas as well, such as morphology, syntax, semantics, grammar, short-term
memory, attention, and event sequencing.


The UCSF group noted that the human
brain changes in response to stimuli, a phenomenon known as brain plasticity. Their work
demonstrated that specific techniques drive the brain to change over time, adjusting how
it processes information.


Bringing together their work at
Rutgers and UCSF, our scientific founders discovered that with the help of technology,
certain aspects of closely-related phonemes can be slowed and emphasized so that, after
working on specifically-designed exercises, students learn to differentiate such phonemes
more quickly and more accurately. Our founders developed computerized exercises that use
thousands of repetitions, adapt according to complex and sophisticated formulas and
provide timely motivation to allow children to quickly master the language and cognitive
skills that are critical to reading. Our company was established to move this research
from the laboratory into products and services that could reach broad groups of learners.


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|FAST FORWORD TO
LEARNING SERVICES


IMPLEMENTATION SERVICES


We provide a variety of services to
assist our customers in implementing the Fast ForWord products at their sites. These
on-site services include professional development sessions that provide extensive hands-on
introduction to product use, suggestions for effective implementation strategies, an
introduction to the science behind our products, and instruction on product installation.
We also offer technical installation, consulting and project management services.
Independent contractors with extensive training on our products generally provide these
onsite services. For cases where in-person training is not practical, we offer CrossTrain,
a self-paced Web-based professional development component.


We believe that appropriate initial
product training, professional development and implementation services are critical to
effective use of the Fast ForWord products and the success of students. We also offer
on-going consultation on data analysis, interpretation and intervention strategies to
facilitate effective continuing implementation.


SUPPORT


Extensive remote support is available
to Fast ForWord customers. Our technical, professional, and customer support is available
by telephone, email and Web-based chat, allowing customers flexibility in how they access
support. Level 1 support services are currently provided by a third party that specializes
in providing telephone support. More difficult questions are escalated to internal support
staff. In our customer surveys, customers using Fast ForWord products generally rate the
support they receive and the professionalism of our support team as excellent.


USER CONFERENCES


Periodically we host forums or
conferences for customers and prospective customers. At these gatherings, speakers provide
our customers with new information about education and neuroscience. Presentations made by
our customers offer attendees concrete case studies on how Fast ForWord products can
impact student achievement and strategies for effective implementation. These sessions
also offer our Fast ForWord users an opportunity to network with one another.


PROFESSIONAL DEVELOPMENT
SEMINARS


We periodically provide educational
seminars on brain research, the connection between oral language comprehension and
learning to read, and the practical application of the Fast ForWord family of products.
Typically, these workshops are one-day intensive seminars and provide continuing education
credits.


WEBSITES


We presently maintain two Websites,
BrainConnection.com and ScientificLearning.com. The BrainConnection.com Web site provides
practical and easily understandable information about how the brain works and how students
learn. Links to information about our products that relate to the topics discussed are
presented throughout the site. The BrainConnection.com site also includes web-based
professional development courses for educators that provide foundational information on
neuroscience, language and reading. Our company Web site, ScientificLearning.com, provides
information about our company and our products and services, as well as extensive
technical and customer support resources


SALES AND MARKETING


We market and sell our products to
two primary channels:  the K-12 sector and the private sector.


K-12 SECTOR


We sell to K-12 school districts
throughout the United States primarily using a direct sales force. At December 31, 2002,
we employed 26 quota-bearing sales representatives focused on the K-12 sector, led by four
regional sales directors. These sales personnel typically are experienced professionals
with backgrounds in selling educational technology to the K-12 segment. Many bring strong
relationships with educators built over many years. We supplement our sales
representatives with senior strategic account managers and consultants who have extensive
experience and relationships in K-12 education.


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|We participate in industry
conferences and trade shows and conduct our own Executive Forums for educational decision
makers. Our sales force typically targets sales at the school district level, although
early seeding sales are also made at the individual school level.


PRIVATE SECTOR


Our private sector consists of two
primary segments: (1) the clinical segment focused on speech and language professionals,
learning centers, child development centers in hospitals and clinics, and psychologists;
and (2) the independent school segment. To reach this sector, we use direct marketing
(mail, web and telesales) and conferences (both industry conferences and forums we conduct
ourselves).


LICENSE TERMS


We license our products in a variety
of configurations to meet the customers needs. Schools typically purchase site or
workstation licenses, which are available either for a perpetual term or on a subscription
or limited term basis. The license package typically contains at least two of our major
products and varying quantities of our other products. An annual support fee is included
in the package license price. New customers are also required to purchase implementation
services, which are critical to successful use of the products. Our license list prices
range from $10,000 to $65,000 per site, depending on the number of products, the number of
workstations, the duration of the license and the volume purchased.


In the private sector, products
licensed for administration by private practice professionals are generally purchased on a
per product per student basis. Our major products list for $850 per product per student.
The private practice professional charges separately for his or his services; those fees
generally range from $1,000 to $2,000 per student. Clinics and independent schools
purchase both per product per student licenses and site or workstation licenses, depending
on their size and needs.


DEVELOPMENT AND
RESEARCH


Our research and development expenses
were approximately $3.0 million, $3.4 million and $5.7 million for the years ended
December 31, 2002, 2001 and 2000, respectively. At December 31, 2002, fifteen of our
employees were engaged in research and development activities, which include both product
development and outcomes research.


DEVELOPMENT


We have announced a major new edition
of our product line, which is scheduled for release to the K-12 sector in June 2003. The
Fast ForWord Gateway Edition is designed to significantly improve the ease of
implementation and use of our products. The Gateway Edition products are designed to:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Unify
the interface for the major products, making navigation conventions more consistent.
|- | ------------------------------------------------------------------------------------------

| | Simplify
administrative procedures and reduce the time required to enroll students and access
reports.
|- | ------------------------------------------------------------------------------------------------------

| | Add
additional local (non-Internet) progress reporting tools.
|- | -------------------------------------------------------------

| | Provide
individualized intervention recommendations based on actual student performance.
|- | ----------------------------------------------------------------------------------------

| | Add
introductory levels to some exercises to enhance student progress.
|- | ----------------------------------------------------------------------

| | Provide
a teacher interface that aligns the Fast ForWord products to state learning standards and
selected core reading programs. This will allow classroom teachers to easily relate the
development of the cognitive skills of their students facilitated by the Fast ForWord
products to their daily classroom instructional work.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Permit
schools to easily move between the Internet and non-Internet connected versions of the
products.
|- | -------------------------------------------------------------------------------------------------------

|Existing customers who wish to move to the Fast ForWord Gateway Edition
will be required to pay an additional charge.


In June 2003 we also plan to expand
our supplementary Fast ForWord to Reading series with the introduction of Fast ForWord to
Reading 4 (see Products; Products in the Fast ForWord Familyabove).


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|RESEARCH


Our research efforts focus on the
following areas:


Independent and
School-Based Research


We provide support for independent
researchers to study the Fast ForWord products. Researchers at universities and other
research institutions who wish to conduct pilot studies that have been approved by the
appropriate Institutional Review Board are eligible to receive complimentary licenses for
Fast ForWord products for use in those pilots.


Currently, school districts
throughout the country are independently studying the impact of Fast ForWord products on
reading achievement. Many of these studies are focused on outcomes related to state
standards and related state assessment programs. We encourage these studies and, when the
results are released to us, expect to make them available on our web site,
www.scientificlearning.com.


Alternative Protocols


Historically, we have recommended
that most major Fast ForWord products be used in accordance with an intensive protocol,
usually 90 to 100 minutes a day, 5 days a week, for a period of 4 to 8 weeks. This
recommendation is based on brain plasticity research, which demonstrates that completing a
set of learning tasks in a frequent, intense timeframe is needed to make the changes in
brain functioning that are necessary to improve processing and thereby enhance
learning.  However, the 90 to 100-minute protocol generally does not fit easily into
a standard school day. In order to permit educators more flexibility to meet their
schools scheduling needs, we are conducting ongoing research to develop and test
alternative protocols that require less time each day but still maintain the
products impact on student performance. We recently released an alternative protocol
for the Fast ForWord Middle & High School product, which recommends use for 48 minutes
per day over a period of six to ten weeks. Our research shows that this new protocol
results in middle and high school students making progress that is substantially similar
to that made when using the 90 minute protocol, but requiring approximately two more weeks
to complete a comparable level of content. We are continuing work on alternative protocols
for our other products. We expect that, generally, the alternative protocols will require
the product to be used over a longer period of weeks, but for less time each day.


Product Sequence Study


We are planning a multi-year
randomized controlled study on the effects of the use of our products in sequence: first
Fast ForWord Language, followed by, in series, Fast ForWord Language to Reading, Fast
ForWord to Reading 3 and Fast ForWord to Reading 4. We plan for the study to include a
wide variety of students in a broad spectrum of educational settings. We expect to work
with a group of independent researchers respected for their technical expertise in reading
research and study design, who will monitor the research design, methods and data analyses
procedures. We are currently in the study design phase, and we expect to begin student
enrollment in the study at the beginning of the 2003  2004 school year.


We expect this study to yield
additional scientific research-based information over the study period that will provide
specific data that we can use to improve current products for specific student populations
and learning requirements, build new products, and establish better implementation models
for our customers based on student demographics and learning needs.


11
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|INTELLECTUAL PROPERTY


We have a broad intellectual property
strategy addressing both product technology and product concepts. We aggressively protect
our proprietary rights in our products and technology through a combination of patents,
trademarks, copyrights, trade secret laws, confidentiality procedures and contractual
provisions.


At December 31, 2002, we held 43
issued U.S. patents and 12 pending U.S. applications.  We also held 2
issued patents from other countries and had 18 applications pending abroad.  We
were the exclusive licensee under 11 issued U.S. patents, and 5 pending foreign
patent applications. The licensed patents and applications are owned by the Regents of the
University of California and Rutgers, the State University of New Jersey, and relate to
the basic speech and sound modification and adaptive technology developed at those
institutions. In 2002, approximately 82% of our product revenues were derived from selling
products that use the licensed inventions.


This license requires payment of
royalties based upon cumulative net sales of our products, subject to certain minimum
royalty amounts. In 2002 and each year thereafter, the minimum royalty payment is
$150,000. In 2002 and 2001, we had approximately $723,000 and $635,000, respectively in
royalty and milestone expense under the license. The final milestone payment under the
license was paid in 2001.


Unless otherwise terminated, the
license remains in effect until the later of the expiration of the last-to-expire patent
licensed or the abandonment of the last patent application licensed. The licensor may
terminate the license agreement if we fail to perform or violate its terms without curing
the violation within 60 days of receiving written notice of the violation.


COMPETITION


The educational market in which we
operate is very competitive. We believe that the principal competitive factors in the
industry are efficacy, ability to deliver measurable results, cost, efficiency of
delivery, relationships, ability to provide effective product implementation, and ability
to complement and supplement the school curriculum. We believe that we compete favorably
on the basis of these factors.


Our products are highly
differentiated by their neuroscience basis and their focus on the development of cognitive
skills through scientifically-based methods. However, particularly in the K-12 sector, we
compete vigorously against other companies offering educational software and other
language and reading programs, as well as with providers of traditional methods of
teaching language and reading. Many of the companies providing these competitive offerings
are much larger than us, are more established in the school market than we are, offer a
broader range of products to schools and have greater financial, technical, marketing and
distribution resources than we do. In addition, although the traditional approaches to
language and reading are fundamentally different from the approach we take, the
traditional methods are more widely known and accepted and, therefore, represent
significant competition for available funds.


EMPLOYEES


As of December 31, 2002, we had 115
full-time employees. We believe our relations with employees are good. None of our
employees is represented by a union or subject to collective bargaining agreements.


12
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|FACTORS THAT MAY AFFECT
OUR RESULTS OR STOCK PRICE


The following factors as well as
other information contained in this Report on Form 10K should be considered in making any
investment decision related to our common stock. If any of the following risks actually
occur, our business, financial condition or results of operations could be materially and
adversely affected and the trading price of our common stock could decline.


The success of our
business depends on increasing acceptance of our products in the K-12 sector.


In 2002, approximately 1,550 schools,
or 1% of the schools in the US, used a site license for one or more Fast ForWord products.
We believe that most educators who have used Fast ForWord products are early
adopters. To grow and to become profitable, we need to increase the acceptance of
our products among mainstream educational purchasers. We believe that our success in
moving our products to the mainstream will depend largely on the following critical
factors:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Our
ability to convince key education decision-makers to use Fast ForWord products even
though our methods differ from the way schools have traditionally addressed reading
problems. K-12 educational practices are slow to change, and it can be difficult to
convince educators of the value of a substantially different approach.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Our
ability to convince schools and teachers to incorporate our products into their
curriculum, despite the substantial amount of time that must be devoted to those products
out of the limited school day.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Our
ability to effectively implement our products in schools and better connect to classroom
teachers, in a scaleable and efficient model.
|- | ------------------------------------------------------------------------------------------------------------------------------------------

| | The
availability of government funding for public schools and for our products in particular.
State and local funding for schools has been adversely affected by reductions in tax
revenue resulting from the economic downturn. Federal education funding could be
adversely affected in the future by the need to reduce other expenditures on account of
the military action in Iraq.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
extent to which our products qualify for particular sources of funding, particularly
funding under the No Child Left Behind Act of 2002 and other specific types of federal
education funding.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Our quarterly
operating results are susceptible to fluctuations, which could cause our stock price to
decline.


Since our formation, our quarterly
operating results have fluctuated significantly, and we expect these fluctuations to
continue. One reason our quarterly results fluctuate is our long and somewhat
unpredictable sales cycle. Our sales cycle is lengthy in part because the nature of our
products requires us to provide a significant level of education about our products to
decision-makers, because implementing our products involves a significant commitment of
time and resources from schools, and because K-12 sales frequently require multiple levels
of approval and involve many different departments in a district. In addition, sales to
schools are subject to budgeting constraints, which may require schools to find available
discretionary funds, obtain grants or wait until subsequent budget cycles. As a result,
our sales cycle generally takes several months, and in some cases, can take a year or
longer.


In addition, demand for our products
is subject to seasonal influences. Historically, in the K-12 sector, our sales in the
first quarter have tended to be particularly slow, as have third quarter sales. Demand has
been stronger in the second and fourth quarters. The school calendar also affects contract
start dates, and hence the timing of revenue recognition. In the private sector, demand
for our products tends to be lower during the school year than in the summer, because our
products intensive nature can be more conducive to use during school vacation.
However, our history has been relatively limited, especially in the K-12 sector, and our
current seasonal patterns may not be entirely stable.


The quarterly revenue recognized from
our sales can also be unpredictable. Our various license and service packages have
substantially differing revenue recognition periods, and it is often difficult to predict
which license package a customer will purchase, even when the amount and timing of a sale
can be projected. See Managements Discussion and Analysis  Application
of Critical Accounting Policies for a discussion of our revenue recognition policy.
In addition, the timing of a single large order or its implementation can significantly
impact the level of sales and revenue in a given quarter.


Our expense levels are based on our
expectations of future revenues and are primarily fixed in the short term. We cannot
assure you that we will be able to predict our future revenues accurately or that we will
be able to adjust spending in a timely manner to compensate for any unexpected revenue
shortfall.


13
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|We have a history of
losses and negative cash flow.


We started operations in February
1996 and have incurred significant operating losses and negative cash flow since
inception. At December 31, 2002, we had an accumulated deficit of approximately $81.9
million from inception. During 2002, however, we did generate positive cash flow from
operating activities of approximately $3.7 million and reduced our net loss from $19.3
million in 2001 to $10.1 million in 2002. During 2003, we plan to continue to generate
positive cash flow from operations and to achieve operating profitability. However,
accomplishing these objectives will require achieving aggressive sales goals in a soft
K-12 market. To meet our sales targets, we will need to make substantial expenditures. We
cannot assure you that we will meet our targets with respect to sales, revenues or
operating results.


Our cash flow may be
insufficient for us to permit us to repay our outstanding debt when due.


In March 2001, we entered into an
agreement with Fleet National Bank for a revolving line of credit of $15 million. At
December 31, 2002, we had an outstanding obligation of $5 million under the line. The line
of credit is guaranteed by WPV, Inc., an affiliate of Warburg, Pincus Ventures, our major
shareholder. To secure our obligation to repay WPV, Inc. any amounts it is required to pay
to satisfy its guarantee, we granted WPV, Inc. a security interest in substantially all of
our assets. In March 2002, we entered into an agreement with Fleet National Bank and WPV,
Inc. to extend the term of the line of credit to June 2004. We repaid $5 million of this
debt during 2002.


This indebtedness and security
interest could limit our ability to obtain other financing or to react to changes in our
business or market. The loan agreement provides that an event of default under the loan
occurs upon certain changes in the composition of the board of directors or the
acquisition of more than 40% of our stock by a person or group other than Warburg, Pincus
or its affiliates. Such a default could occur at a time when we would be unable to repay
the loan.


Our directors and
executive officers and their affiliates effectively control the voting power of our
company.


At March 14, 2003, Warburg, Pincus
Ventures, our largest shareholder, owned approximately 48% of the Companys
outstanding stock and, as a whole, our directors and executive officers and their
affiliates beneficially owned more than 68% of the Company. As a result, these
stockholders are able to exercise significant influence over all matters requiring
stockholder approval, including the election of directors and approval of significant
corporate transactions. This concentration of ownership may also delay, prevent or deter a
change in control of our company.


Our common stock is
thinly traded and its price is volatile.


Our common stock trades on the OTC
Bulletin Board and our trading volume is limited. For example, during the 4th quarter of
2002, our average daily trading volume was approximately 6,700 shares. The market price of
our common stock has been highly volatile since our July 1999 initial public offering and
could continue to be subject to wide fluctuations.


On July 22, 2002, we were delisted
from the Nasdaq National Market for failure to meet the market capitalization or tangible
net assets alternative tests. Our delisting from the Nasdaq National Market may (1)
increase the volatility of our stock and affect the price at which we are able to raise
capital; (2) reduce the ability of holders of our common stock to purchase or sell shares
as quickly and as inexpensively as they could have done in the past; and (3) have a
material adverse effect on the price of our common stock.


We may not be able to
compete effectively in the education market.


The market in which we operate is
very competitive. While the Fast ForWord products are unique in many respects, we
vigorously compete with other companies offering educational software products or
non-software-based programs to improve reading or language skills. Existing competitors,
including large software developers and educational publishers, may continue to broaden
their product lines, and new competitors may enter our market. Many competitors have
substantially greater financial, technical, marketing and distribution resources than we
do. We cannot assure you that we will be able to compete effectively.


14
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|We need to continue to
develop new products and enhance our current products.


The markets in which we compete are
characterized by frequent product introductions and evolving educational standards and
approaches. Our future success will depend, in significant part, on our ability to enhance
our existing products and develop and successfully introduce new products. We have
announced a new edition of our major products, the Fast ForWord Gateway Edition, and the
second product in our Fast ForWord to Reading series. We expect both of these to be
available in June 2003. We expect to launch additional products in the Fast ForWord to
Reading series in 2004. We cannot guarantee that we will meet the projected introduction
schedule for future products or that future products will have acceptable margins or be
well received in the market.


Our sales to the
private channel have declined over the past three years. Further decreases in sales to
this channel could adversely affect our business.


Within our private sector channel,
the largest proportion of our sales are sales to and through speech and language
professionals in private practice (SLPs). Selling through and to SLPs was our
initial market, but we have shifted our emphasis to the K-12 sector because we believe it
has greater growth potential. Our revenues from the private channel have fallen each of
the last three years, from $7.2 million in 1999 to $3.6 million in 2002. We expect that
sales to the private channel may continue to decline as we continue to focus our limited
resources on the K-12 sector.


We rely on our
intellectual property rights and may be unable to maintain or protect these rights.


Our ability to compete effectively
depends in part on whether we are able to continue to develop and maintain the proprietary
aspects of our technology and to operate without infringing on the proprietary rights of
others. We rely on a combination of patents, trademarks, copyrights, trade secret laws,
confidentiality procedures and contractual provisions to protect our proprietary rights in
our products and technology. We cannot assure you that our issued patents will offer
protection against competitors with similar technology or that our pending patent
applications will result in the issuance of patents.


In addition, we could become party to
patent infringement claims, litigation or interference proceedings. These proceedings
could result from claims that we are violating the rights of others or may be necessary to
enforce or determine the scope of our own rights. Any such proceedings would result in
substantial expense and significant diversion of effort by our technical and management
personnel. An adverse determination in such proceedings could subject us to significant
liabilities or require us to seek licenses from third parties, which may not be available
on commercially reasonable terms or at all.


Our most important products are based
on licensed inventions owned by two universities. If we were to lose our rights under this
license, it would materially harm our business. The licensor may terminate the license if
we fail to perform our obligations and do not timely cure the violation. We believe that
we are currently in compliance with the license in all material respects.


We are subject to
government regulations that could impose additional costs on the conduct of our business.


Our business is potentially subject
to or affected by a variety of federal, state and local laws and regulations. These
include, without limitation, laws and regulations relating to:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | government
funding for and other matters related to education;
|- | --------------------------------------------------------------

| | licensing
of speech and language professionals in private practice and delivery of speech and
language testing and remediation services;
|- | ----------------------------------------------------------------------------------------------------------------------------------------

| | consumer
protection and anti-fraud and related protections, including the regulation of referrals
by professionals; and
|- | -----------------------------------------------------------------------------------------------------------------------

| | disclosure
and accounting for public companies. The Sarbanes-Oxley Act of 2002 requires changes in
some of our corporate governance and disclosure and compliance practices. Additional SEC
and other regulations are expected. We expect these developments to increase our legal
and compliance costs.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Compliance with these and other laws
and regulations impose additional costs on the conduct of our business, and failure to
comply with these laws and regulations, changes in these laws and regulations, or in their
applicability to our business may impose additional costs.


15
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Our charter provisions
could have the effect of delaying or preventing corporate takeovers.


Our certificate of incorporation
authorizes our board of directors to issue up to 1,000,000 shares of preferred stock and
to determine the price, rights, preferences and privileges, including voting rights, of
those shares without any further vote or action by the stockholders. The rights of the
holders of common stock will be subject to, and may be adversely affected by, the rights
of the holders of any preferred stock that may be issued in the future. The authority to
issue this preferred stock could enable our board of directors to deter acquisitions of
our company. Additionally, our certificate of incorporation and bylaws also provide for a
classified board of directors, prevent stockholders from acting by written consent,
disallow cumulative voting and require advance notice of director nominations and
stockholder proposals, all of which could have the effect of delaying or preventing
corporate takeovers.


ITEM 2.    PROPERTIES


We lease approximately 70,000 square
feet of office space in Oakland, California under an eight-year lease that expires in
March, 2009. The lease includes an option to expand into an additional 13,000 square feet
and two five-year options to extend the term of the lease. We are seeking to sublease
portions of this facility. We believe our facilities are more than adequate for our
operations currently and will be sufficient to meet our needs for at least the next three
years.


ITEM 3.    LEGAL
PROCEEDINGS


On January 9, 2003 we sent a demand
letter to Metropolitan Teaching and Learning Company (Metropolitan), claiming
that the latters use of the term Fast Forward in connection with childrens
educational materials infringed our rights in our registered trademark Fast ForWord. On or
about January 21, 2003, Metropolitan filed a declaratory relief action in federal court in
the Southern District of New York, seeking a judicial declaration that its Fast Forward
mark does not infringe our trademarks, as well as attorneys fees and other
unspecified damages. The complaint was served on us on or about February 7, 2003. We are
required to respond to the complaint by April 8, 2003. We believe our positions have merit
and intend to pursue the lawsuit vigorously. Because the lawsuit is still in the pre-trial
discovery stage, we cannot determine the total expense or possible loss, if any, that may
result from this claim.


ITEM 4.    SUBMISSION OF
MATTERS TO A VOTE OF SECURITY HOLDERS


None.


16
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|EXECUTIVE OFFICERS


The following table sets forth
various information concerning our executive officers, as of March 19, 2003:
|--------------------------------------------------------------------------------------------------------------------------------

|NAME                   |  | AGE |  | POSITION | 
|---------------------- |  | --- |  | -------- | 
|Robert C. Bowen        |  |     |  | 61       | 
|James R. Bray          |  |     |  | 58       | 
|Linda L. Carloni       |  |     |  | 49       | 
|Glenn G. Chapin        |  |     |  | 47       | 
|Jane A. Freeman        |  |     |  | 49       | 
|Dr. William M. Jenkins |  |     |  | 52       | 
|Dr. Steven L. Miller   |  |     |  | 39       | 
|Gillian M. Rutter      |  |     |  | 47       | 
|Sherrelle J. Walker    |  |     |  | 56       | 

|Robert C. Bowenjoined us as Chairman
and Chief Executive Officer in June 2002. From 1989 to 2001, he served as a senior
executive and officer of National Computer Systems. His last assignment there, from 1995
to 2001, was as President of NCS Education, a leading provider of enterprise software for
K-12 school districts. NCS was acquired by Pearson, PLC in July 2002. After retiring from
NCS in 2001, Mr. Bowen consulted for various businesses in education until joining us.
Previously, Mr. Bowen held senior executive positions with other leading education and
publishing companies, including seventeen years with McGraw-Hill. Early in his career, Mr.
Bowen was a high school math teacher, a coach, and a school district administrator. Mr.
Bowen received his bachelors and masters degrees from the University of
Tennessee, Chattanooga.


James R. Brayjoined us as Vice
President, Business Development and Government Affairs in January 2003. Starting in 1990,
Mr. Bray held a variety of executive positions at NCS Pearson and its predecessors in
their education, assessment, and testing products businesses. From 1999 through 2002, Mr.
Bray was Vice President Business Development of Pearson Education Technologies and its
predecessors. During 2001 and 2002, Mr. Bray also served as chairman of NCS Pearsons
corporate marketing committee. During 1998 and 1999 Mr. Bray was Vice President and
General Manager of Realskills, an NCS company, and from 1997 to 1998 he was Vice President
Business Development Assessment and Testing. Prior to joining NCS, Mr. Bray spent more
than 20 years at IBM/Science Research Associates in Chicago, completing his IBM service as
vice president of education assessment and testing. Mr. Bray is a former member of the St.
Paul (Minn.) School District Foundation and received his bachelors degree in
marketing from Northwestern University.


Linda L. Carlonijoined the Company
as General Counsel in October 1999, became our Secretary in March 2000 and was elected
Vice President in June 2000. From April 1996 to September 1999, Ms. Carloni was a
founder and Vice President of Alere Medical Incorporated, a healthcare services start-up.
From May 1994 to April 1996, Ms. Carloni served as a senior licensing
officer for the University of California Office of Technology Transfer. From
April 1992 to April 1994, Ms. Carloni was a partner at the law firm of
Cooley Godward LLP. Earlier in her career, Ms. Carloni was the general counsel of
Nellcor Incorporated, a medical device company, and an associate and a partner at Cooley
Godward. She received her bachelors degree in political science from Case Western
Reserve University and her law degree from Boalt Hall School of Law at the University of
California, Berkeley.


Glenn G. Chapinjoined the Company as
Vice President, Sales in April 2001. Prior to joining the Company, Mr. Chapin served as a
Regional Vice President at CompassLearning, an educational technology company starting in
1995. Prior to CompassLearning, Mr. Chapin was a sales executive for National Computer
Systems (NCS), a provider of educational assessment, testing and administrative software
and services, where he held positions of increasing responsibility over a 15 year period
from serving as the Midwest territory sales representative to Southern Region Sales VP.
Mr. Chapin is a graduate of St. John Fischer College in Rochester, NY where he received
his Bachelor of Science degree in Business Administration.


17
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Jane A. Freemanjoined us as Vice
President, Finance and Treasurer in August 1999 and was named Chief Financial Officer in
January 2000. She also served as our Vice President Business Development from August
1999 until June 2000. From April 1988 through December 1998, she was employed by
Rockefeller & Co., a global investment firm. Among her investment
responsibilities at Rockefeller & Co. were the leadership of the global asset
allocation process and the management of the U.S. Small Capitalization equity product. She
also served on the Management Committee of the firm. From January 1978 to March 1988,
Ms. Freeman was employed by Scudder, Stevens and Clark as an analyst and Manager of
the Scudder Development Fund. She is a director of four mutual funds managed by Harding
Loevner, LLP. Ms. Freeman holds a B.A. in Mathematics and Chemistry and an M.B.A. (with
distinction) from Cornell University and a License in Applied Economics from the
University of Louvain in Belgium.


Dr. William
M. Jenkinswas elected Senior Vice President, Product Development in November
2000. Dr. Jenkins is a founder and served as our Vice President, Product
Development from June 1997 until November 2000. From March 1996 to June 1997,
Dr. Jenkins was our Vice President, Research and Development. From 1990 to
1996, Dr. Jenkins was an Adjunct Associate Professor at UCSF. Dr. Jenkins
has served on the editorial board in the Systems Plasticity section of
Restorative Neurology and Neuroscience. Dr. Jenkins is the principal
developer of our current software products. Dr. Jenkins holds a B.S. in
Psychology, an M.A. in Psychobiology and a Ph.D. in Psychobiology from Florida
State University, with additional post-doctoral training from UCSF.


Dr. Steven
L. Millerwas elected Senior Vice President, Research and Outcomes in November
2000. Dr. Miller is a founder and served as our Vice President, Outcomes
Research or Vice President, Research from June 1997 until November 2000. From
May 1996 to June 1997, Dr. Miller was our Vice President, Professional
Relations and Outcomes. From September 1991 to May 1996, he held research
appointments at the Center for Molecular and Behavioral Neuroscience at
Rutgers. Dr. Miller has extensive experience in organizing clinical
research studies and conducting longitudinal studies of children and adults who
have language and reading problems. Dr. Miller holds a B.A. in Psychology
from Bloomsburg University of Pennsylvania, an M.A. in Neuroscience from the
University of Hartford and a Ph.D. in Psychology from the University of North
Carolina at Greensboro. He received additional training in Clinical
Neuropsychology at the Bowman Gray School of Medicine at Wake Forest
University.


Gillian M. Rutterjoined us as Vice
President, Operations in October 2002. Prior to joining us, Ms. Rutter had served as vice
president of professional and technical services for NCS Learn (Pearson Education) since
2000. From 1994 through 2000, she was the vice president of customer support for NovaNET,
an E-learning company. Earlier in her career, Ms. Rutter worked in management and field
positions at Jostens Learning, an educational software company. Ms. Rutter began her
career as an elementary and middle school teacher and was a master of teacher training in
Tucson, Arizona. She holds a bachelor of science in elementary education and a bachelor of
science in special education and learning disabled K-12 from the University of Arizona.


Sherrelle J. Walkerjoined us as
Chief Education Officer in July 2002. Prior to joining us, Ms. Walker had served as Vice
President Curriculum at NCS Pearson, an educational software company since 1998. During
1998, Ms. Walker was vice president products at American Cybercasting Corporation, which
provided on-line curriculum products for teachers and students. Ms. Walker also has more
than 25 years experience as an educator and educational administrator, beginning as a
teacher in the Hartford Public Schools, and serving as an Assistant Principal, Principal
and Director of Secondary Education in the Renton, Washington Public Schools and as
Assistant Superintendent of the public schools in Federal Way, Washington. Ms. Walker
played a leading role in the development of the Washington State Essential Academic
Learning Requirements and has been an adjunct professor at the University of Washington.
Ms. Walker completed her BS in teaching at Hampton University in Hampton Virginia, and her
MA at the University of Connecticut.


18
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|PART II


ITEM 5.    MARKET FOR
THE REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS


(a) Market
Information. Our common stock currently is traded on the OTC Bulletin Board
under the symbol SCIL. Until July 22, 2002, our common stock was
traded on the Nasdaq National Market. The following table sets forth, for the
periods indicated, the closing high and low sales prices per share of our
common stock as reported on the Nasdaq National Market or the OTC Bulletin
Board, as applicable.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2001 |  | High           |  | Low |  
| | ---- |  | -------------- |  | --- | -
| |      |  | First quarter  |  |     | $
| |      |  | Second quarter |  |     | $
| |      |  | Third quarter  |  |     | $
| |      |  | Fourth quarter |  |     | $
| |      |  | 2002           | 
| |      |  | First Quarter  |  |     | $
| |      |  | Second Quarter |  |     | $
| |      |  | Third Quarter  |  |     | $
| |      |  | Fourth Quarter |  |     | $

|The foregoing reflect inderdealer
prices without retail mark-up, mark-down or commission and may not reflect actual
transactions.


Holders.


As of February 28, 2003, the
approximate number of stockholders of record of our common stock was 157.


Dividend Policy.


We have never declared or paid cash
dividends on our common stock, and we do not anticipate paying any cash dividends in the
foreseeable future.


Securities Authorized
for Issuance under Equity Compensation Plans.


For information regarding securities
authorized for issuance under equity compensation plans, see Item 12.


(b) Not applicable


19
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ITEM 6.    SELECTED
FINANCIAL DATA
|----------------------------------

| | In
thousands, except per share amounts
| | --------------------------------------

|                                     | Year ended December 31,
|------------------------------------ | -----------------------
|
|Statement of Operations Data:        |                        
|Revenues:                            |                        
|Products                             |                        
|Services                             |                        
|                                     |                        
|Total revenues                       |                        
|Cost of revenues:                    |                        
|Products                             |                        
|Services                             |                        
|                                     |                        
|Total cost of revenues               |                        
|                                     |                        
|Gross profit                         |                        
|Operating expenses                   |                        
|Sales and marketing                  |                        
|Research and development             |                        
|General and administrative           |                        
|Restructuring, lease and asset       |                        
|impairment write downs               |                        
|                                     |                        
|Total operating expenses             |                        
|Operating loss                       |                        
|Interest (expense) income, net       |                        
|Other income (expense), net          |                        
|                                     |                        
|Net loss                             |                        
|                                     |                        
|Basic and diluted net loss per share |                        
|                                     |                        
|Shares used in computing basic and   |                        
|diluted net loss per share           |                        
|                                     |                        
|Balance Sheet Data:                  |                        
|Cash and cash equivalents            |                        
|Investments in government securities |                        
|Working capital                      |                        
|Total assets                         |                        
|Long-term debt, including current    |                        
|portion                              |                        
|Redeemable convertible preferred     |                        
|stock                                |                        
|Stockholders (deficit) equity  (1)  |                        

|(1) | We
have paid no cash dividends since our inception
|--- | --------------------------------------------------

|20
|--

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


OVERVIEW


Our mission is to apply advances in
neuroscience and cognitive research to increase human potential. We produce innovative
products, tools, and implementation strategies that enable people to build the fundamental
cognitive skills required to read and learn. We use technology as appropriate to provide
our customers with the applications that allow each learner to progress based on his or
her individual needs.


To date, our principal focus has been
on the development, marketing and sale of software products that develop the underlying
cognitive skills required for reading. Our Fast ForWord® products are a series of
reading intervention products that incorporate learning from more than 30 years of brain,
language and reading research in order to help children, adolescents and adults build the
cognitive skills they need to learn to read or become better readers. The efficacy of our
products has been established by extensive outcomes research by independent researchers,
our founding scientists and our company. Our primary products are Fast ForWord Language,
Fast ForWord Language to Reading, Fast ForWord Reading (to be renamed Fast ForWord to
Reading 3) and Fast ForWord Middle & High School.


We have significant proprietary
technology. At December 31, 2002, we held 43 issued U.S. patents and 12 pending U.S.
applications.  We also held 2 issued patents from other countries and
had 18 applications pending abroad.  We were the exclusive licensee
under 11 issued U.S. patents and 5 pending foreign patent applications.


To support our products, we provide a
combination of on-site and remote training and implementation services; technical,
professional and customer support; and a wide variety of Web-based resources, including
BrainConnection.com.


Our primary market is US K-12 public
schools. We address this market primarily through a direct sales force. Other distribution
channels include referrals from speech and language professionals in private practice,
direct sales to independent schools and a limited number of independent sales
representatives in the public school and adult education markets. In 2002, sales to public
schools represented approximately 82% of total revenues compared to 76% in 2001 and 60% in
2000.


Fast ForWord Language, our first
product, was launched in April 1997. Since that time we have invested in expanding our
product line and sales and marketing activities to support future growth. To date we have
not reported a profit. Our goal is to report an operating profit in 2003. During 2001 and
early 2002, we significantly reduced personnel and operating expenses. We expect operating
costs to increase in 2003 compared to 2002 as our business grows. If we do not meet our
revenue targets, we may incur greater losses than expected and we may be forced to further
reduce our expenses, which may negatively impact our business.


We have limited visibility on our
quarterly revenue and revenue may fluctuate substantially. Approximately 86% of our booked
sales for the year ended December 31, 2002 were to public schools. Our sales to the K-12
sector are typically the largest in the second and fourth quarters, coinciding with school
spending cycles. Our sales cycle has lengthened as we concentrate on this market and
on increasing the size of our average sale. Our various license and service packages have
substantially different revenue recognition periods and it is often difficult to predict
which license package a customer will purchase even when the amount and timing of a sale
can be predicted.


We have announced a major new edition
of our product line, which is scheduled for release to the K-12 sector in June 2003. Fast
ForWord Gateway Edition is designed to significantly improve the ease of implementation
and use of our product. The Gateway Edition will also include a new release of Progress
Tracker, our patented Web browser based reporting tool. The new release will include
additional capabilities, including intervention alerts, automatic emailing of reports, and
standards and basal alignments. Existing customers who wish to move to the Fast ForWord
Gateway edition will be required to pay an additional charge. We plan to introduce
Fast ForWord to Reading 4, our second product in the Fast ForWord to Reading series that
correlates to fourth grade reading standards. We expect sales of these new releases to
existing customers to represent less than 5% of revenue in 2003. We expect to introduce
additional Fast ForWord to Reading products in 2004.


21
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|APPLICATION OF CRITICAL
ACCOUNTING POLICIES


Our financial statements are prepared
in accordance with accounting principles generally accepted in the United States
(GAAP). These accounting principles require us to make certain estimates,
assumptions and judgments. We believe that the estimates, assumptions and judgments upon
which we rely are reasonable based upon information available to us at the time. The
estimates, assumptions and judgments that we make can 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. To the extent there are
material differences between these estimates and actual results, our financial statements
would have been affected.


The impact of changes in estimates,
assumptions and judgments pertaining to revenue recognition, allowance for doubtful
accounts, software development costs and long lived assets are most critical to understand
and evaluate our reported financial results. A detailed discussion of our use of
estimates, assumptions and judgments as they relate to these polices is presented below.
We have discussed the application of these critical accounting policies with the Audit
Committee of the Board of Directors. See Note 1 to the Financial Statements for additional
information regarding our accounting policies.


Revenue Recognition


The Company derives revenue from the
sale of licenses to its software and from service fees. Software license revenue is
recognized in accordance with AICPA Statement of Position 97-2, Software Revenue
Recognition, (SOP 97-2) as amended by Statement of Position 98-9. 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. For
software orders with multiple elements, we allocate revenue to each element of a
transaction based upon its fair value as determined in reliance on vendor specific
objective evidence. Vendor specific objective evidence 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
additionally measured by the renewal price. If we cannot objectively determine the fair
value of any undelivered element included in bundled software and service orders, we defer
revenue until all elements are delivered and all services have been performed, or until
fair value can objectively be determined. When the fair value of a license element has not
been established, we use the residual method to record license revenue if the fair value
of all undelivered elements is determinable. Under the residual method, the fair value of
the undelivered elements is deferred and the remaining portion of the arrangement fee is
allocated to the delivered elements and is recognized as revenue.


The Companys revenue
recognition policy is also based on the Securities and Exchange Commissions Staff
Accounting Bulletin 101 (SAB 101) that requires companies that provide an ongoing service
to recognize revenue over the term of the services agreement.


The value of software licenses and
services invoiced during a particular period is recorded as deferred revenue until
recognized. Customers license the right to use Fast ForWord software, but do not acquire
unlimited rights to the products.


Revenues from the licensing of
software are recognized as follows: 1) for perpetual licenses that require ongoing
Internet-based participant tracking services, revenue is recognized over the period in
which the Company provides such services, typically from 1 to 3 years; 2) for limited term
site licenses, revenue is recognized over the life of the license, typically 3 to 12
months; 3) for individual participant licenses, revenue is recognized over the average
duration of the products use, typically 6 weeks; and 4) for perpetual licenses with
no ongoing support requirement, revenue is recognized when the product has been shipped,
provided that the fees are fixed or determinable and collectible.


Service revenues are derived from a
combination of on-site and remote training and implementation services. Revenue from
services is recognized on delivery.


Allowance for Doubtful
Accounts


The Company maintains an allowance
for doubtful accounts for estimated losses due to the inability of customers to make
payments. These estimates are based on historical experience and, to date, have been
approximately 2% of revenue. Cancellations and refunds are allowed in limited
circumstances, and such amounts have not been significant. Provisions are made for
cancellations and refunds as revenue is recorded.


22
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Software Development
Costs


The Company capitalizes software
development cost in accordance with Financial Accounting Standards Board (FASB) No. 86
Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise
Marketed, under which software development costs incurred subsequent to the
establishment of technological feasibility are capitalized and amortized over the
estimated life of the related product.


Prior to the establishment of
technological feasibility we expense all software development cost associated with a
product. Technological feasibility is deemed established upon completion of a working
version. The Company estimates the useful life of its developed products to be 3 years.


On an ongoing basis, the Company
evaluates the net realizable value of the capitalized software development cost by
estimating the future revenue to be generated from the product and compares this to the
unamortized cost of the product. At December 31, 2002, future revenues from sale of these
products are anticipated to be well in excess of the unamortized development costs.


Impairment of Long
Lived Assets


The Company regularly reviews the
carrying value of loans to current and former officers, capitalized software development
costs and property and equipment. We continually make estimates regarding future cash
flows 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.


23
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|RESULTS OF OPERATIONS


The following table sets forth, for
the periods indicated, various financial data expressed as a percentage of revenues
(unless otherwise noted).
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                               | Year ended December 31,
|------------------------------ | -----------------------
|
|Revenues:                      |                        
|Products                       |                        
|Services                       |                        
|                               |                        
|Total revenues                 |                        
|Cost of revenues:              |                        
|Cost of products(1)            |                        
|Cost of services (2)           |                        
|                               |                        
|Total cost of revenues         |                        
|                               |                        
|Gross profit                   |                        
|Expenses:                      |                        
|Sales and marketing            |                        
|Research and development       |                        
|General and administrative     |                        
|Restructuring, lease and asset |                        
|impairment write downs         |                        
|                               |                        
|Total operating expenses       |                        
|Operating loss                 |                        
|Interest (expense) income, net |                        
|Other income (expense), net    |                        
|                               |                        
|Net loss                       |                        
|                               |                        

|
|

|(1) | Product
costs are expressed as a percentage of product revenues.
|--- | ----------------------------------------------------------------

|(2) | Service
          costs are expressed as a percentage of service revenues.
|--- | --------------------------------------------------------------------------

|Year Ended December
31, 2002 Compared to Year Ended December 31, 2001


Revenues


Revenues increased 13% to $20.3
million for 2002, compared to $17.9 million for 2001. Product revenues (which we
previously referred to as program revenues) increased 24% to $19.2 million for 2002,
compared to $15.5 million in 2001. Product revenues increased from the K-12 sector and, as
expected, decreased from the private sector. Service revenues decreased 54% to $1.1
million in 2002, compared to $2.4 million in 2001. In 2002, we revamped our service
business to offer training and implementation services at a lower price than in 2001. In
addition, we sold fewer training days than in 2001 as the percentage of our business from
existing customers increased. Existing customers are less likely to buy services. K-12
sector revenues were 82% of total revenues in 2002, compared to 76% for 2001. Revenues
from the private sector were 18% of total revenues for 2002, compared to 24% in 2001.


Booked sales increased by 35% to
$28.3 million for 2002, compared to $20.9 million in 2001. Booked sales is a non-GAAP
financial measure that we believe to be a useful measure of the current level of business
activity both for management and for investors. Booked sales equals the total value (net
of allowances) of software and services invoiced in the period. Because a significant
portion of our software license revenue is recognized over a period of months, booked sales
is a better indicator of current selling activity. The Company records booked sales and
deferred revenue when all of the requirements for revenue recognition have been met, other than the
requirement that the revenue for software licenses and services has been earned.


24
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|In the K-12 sector booked sales
increased by 52% to $24.4 million compared to $16.0 million in 2001. The K-12 sector
represented 86% of booked sales in 2002 compared to 76% in 2001. During the year, the
company sold 809 site license packages to the K-12 sector, compared to 921 site licenses
in 2001. The average sale per school increased in 2002 compared to 2001 since we did not
repeat a lower priced sampling package in 2002. In addition, perpetual licenses, which
have a higher average price per school, have become a more significant portion of our
sales mix. Booked sales to the private sector were down 21% compared to 2001. We expect
sales to the private sector to continue at about the same level in 2003.


Deferred revenue rose to $15.6
million at December 31, 2002, an increase of 105% compared to $7.6 million in 2001. In
2003 we expect deferred revenue to grow more slowly than in 2002, because a higher
proportion of our business is expected to come from the sale of services and we believe
that our mix of perpetual and term licenses has stabilized. The following reconciliation
table sets forth our booked sales, revenues and change in deferred revenue for the years
ended December 31, 2002 and 2001, respectively.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                             | Year ended December 31,
|------------------------------------------------------------ | -----------------------
|
|Booked sales                                                 |                        
|Less revenues                                                |                        
|                                                             |                        
|Net increase in current and long-term deferred revenue       |                        
|Current and long-term deferred revenue beginning of the year |                        
|                                                             |                        
|Current and long-term deferred revenue end of the year       |                        
|                                                             |                        

|Cost of Revenues


Total cost of revenues decreased by
$607,000, to $3.5 million for 2002, compared to $4.1 million in 2001. As a percentage of
revenues, total cost of revenues decreased to 17% compared to 23% for 2001. The
improvement in gross margins is primarily due to the increased proportion of products in
our revenue mix. Cost of products consists of manufacturing, packaging and fulfillment
costs, amortization of capitalized software, royalties and technical support costs. Cost
of product revenues decreased to 14% in 2002, compared to 16% in 2001. The reduction was
primarily due to lower customer support costs as a result of improved product usability
and a decline in sales to the private sector, as well as slightly lower royalty costs.
Service costs consist primarily of costs to provide customer training including personnel,
materials and travel. In 2002, cost of service revenues increased to 78% of service
revenues, up from 67% in 2001, primarily due to lower service prices. In 2002, we
primarily used per diem consultants rather than full time employees to provide training
services.


Sales and Marketing
Expenses


Sales and marketing expenses consist
principally of salaries and compensation paid to employees engaged in sales and marketing
activities, advertising and promotional materials, public relations costs and travel. At
December 31, 2002, we had 26 quota-bearing sales personnel selling to public schools.
Sales and marketing expenses decreased $5.1 million, or 26%, to $14.6 million in 2002
compared to 2001. The decrease is primarily attributable to a decrease in personnel in the
marketing department, as well as lower spending on conferences, trade shows and marketing
materials. We expect sales and marketing expense to increase slightly in 2003 to support a
projected increase in booked sales in the public school market.


Research and
Development Expense


Research and development expenses
principally consist of salaries and compensation paid to employees and consultants engaged
in research and product development activities and product testing, together with software
and equipment costs. Research and development expenses decreased $405,000, or 12%, to $3.0
million for 2002, compared to 2001. The decrease in research and development expenses was
due to a reduction in research and development staff as we continued to reduce spending on
activities other than improving our core products. Once technological feasibility has been
established, costs associated with the development of a product are capitalized. In 2002,
$116,000 in software development costs were capitalized, compared to $1.2 million in 2001.
We expect research and development expenses to increase in 2003 in conjunction with the
launch our new Fast ForWord Gateway Edition and other investments in new products.


25
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|General and
Administrative Expenses


General and administrative expenses
principally consist of salaries and compensation paid to Company executives and other
employees. These expenses also include travel expenses for these employees, as well as
outside legal and accounting fees. General and administrative expenses decreased $1.6
million or 25%, to $4.8 million in 2002, compared to $6.3 million in 2001. The decrease
was mostly attributable to decreases in personnel and legal costs. We anticipate that
these costs will remain at a comparable level in 2003.


Restructuring, Lease
and Asset Impairment Write Downs


For the year ended December 31, 2002
management approved a plan to further restructure operations by reducing the workforce
while continuing to focus on the public school market. In connection with the plan, 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 our
Oakland office in the marketing or customer service departments. We expect the
restructuring will result in an operating expense reduction of approximately $1.9 million
annually. As of December 31, 2002, termination benefits totaling $632,000 had been paid to
employees terminated in 2001 or 2002. The balance in accrued severance benefits at
December 31, 2002 will be paid to employees by August 31, 2003.


Due to continued weakness in the
commercial real estate market the Company recorded an additional charge for excess office
space at our corporate office of $2.3 million. This charge reflects adjustments to the
assumptions on which the 2001 write down for excess office space had been made, including
our assumptions regarding the time period that the excess office space would be vacant and
any 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. Based on this information we assumed that no subtenant
would be found over the next two years. During the year ended December 31, 2002, $759,000
was paid against the reserve established in 2001 for excess office space. The $3.0 million
accrued at December 31, 2002 will be paid over the next two years.


The following table sets forth the
restructuring activity during the year ended December 31, 2002 (in thousands).
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                   | Accrued restructuring costs,
December 31, 2001 | Restructuring Charges | Cash paid | Accrued restructuring costs,
December 31, 2002
|------------------ | ---------------------------------------------- | --------------------- | --------- | ----------------------------------------------
|Lease obligation   |                                                |                       | $         | 1,458                                         
|Severance benefits |                                                |                       |           | 82                                            
|                  
|Total              |                                                |                       | $         | 1,540                                         
|                  

|Provision for Income
Taxes


We have recorded no provision for
income taxes as we have incurred losses since inception. At December 31, 2002, we had net
operating loss carryforwards for federal income tax purposes of approximately $72.8
million. Unutilized net operating loss carryforwards will expire in years 2011 through
2022. Utilization of the net operating losses may be subject to a substantial annual
limitation due to the ownership change limitations provided by the Internal Revenue Code
of 1986. Previous or future equity transactions may result in such an ownership change.
The annual limitation may result in the expiration of net operating losses before they
become available to reduce future tax liabilities. At December 31, 2002, we had
approximately $29.5 million of deferred tax assets, comprised primarily of net operating
loss carryforwards. 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.


26
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Interest Income and
Expense


In 2002 we recorded $1.5 million in
interest expense and $0.2 million in interest income compared to $1.4 million in interest
expense and $0.4 million in interest income in 2001. Interest expense included
amortization of the estimated value of a stock warrant issued to WPV, Inc., an affiliate
of Warburg, Pincus Ventures, a significant stockholder of the Company, for providing an
unlimited guarantee for our bank line of credit. The estimated value of the warrant at the
date of issuance was $3.6 million and is being amortized by a charge to interest expense
over the three-year term of the guarantee. Amortization for the years ended December 31,
2002 and 2001 was $1.2 million and $1.0 million, respectively. The slightly higher net
interest expense in 2002 was not only a result of higher amortization of deferred
financing costs, but also a result of lower interest income resulting from the sale of all
of our investment in government securities in the first quarter of 2002.


Year Ended December
31, 2001 Compared to Year Ended December 31, 2000


Revenues


Total revenues increased by $2.6
million, or 17%, to $17.9 million in 2001 compared to 2000. Product revenue increased by
$1.4 million, or 10%, to $15.5 million in 2001 compared to 2000 as a result of a 43%
increase in revenue from the K-12 sector. The increase was partially offset by a 23%
decline in revenue from the private sector. Service revenues increased by $1.2 million, or
97%, to $2.4 million due to an increase in the number of training sessions for the K-12
sector, partially offset by a decline in trainings for the private sector.


Booked sales increased $5.3 million,
or 34%, to $20.9 million in 2001 compared to 2000. Booked sales is a non-GAAP financial
measure that we believe to be a useful measure of the current level of business activity
both for management and for investors. Booked sales equals the total value (net of
reserves) of software and services invoiced in the period. Because a significant portion
of our software license revenue is recognized over a period of months, booked sales is a
better indicator of current selling activity. The Company records booked sales and
deferred revenue when all of the requirements for revenue have been met other than the
requirement that the revenue for software licenses and services has been earned.


Booked sales to the K-12 sector rose 54%
and represented approximately 76% of booked sales in 2001 compared to approximately 69% in 2000. The increase was primarily due to an increase in the number of site
license packages sold to public and private schools. The Company sold 921 site license
packages in 2001 compared to 332 in 2000. Booked sales to the private sector declined 7%
in 2001 compared to 2000.


Deferred revenue was $7.6 million at
December 31, 2001, an increase of 67% compared to $4.6 million in 2000. The following
reconciliation table sets forth our booked sales, revenue and change in deferred revenue
for the years ended December 31, 2001 and 2000, respectively.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                             | Year ended December 31,
|------------------------------------------------------------ | -----------------------
|
|Booked sales                                                 |                        
|Less revenues                                                |                        
|                                                             |                        
|Net increase in current and long-term deferred revenue       |                        
|Current and long-term deferred revenue beginning of the year |                        
|                                                             |                        
|Current and long-term deferred revenue end of the year       |                        
|                                                             |                        

|Cost of Revenues


Total cost of revenues increased by
$0.5 million, or 15%, to $4.1 million in 2001 compared to 2000. As a percentage of
revenues, cost of revenues in 2001were approximately equal to 2000 at 23%. Cost of
products consists of manufacturing, packaging and fulfillment costs, amortization of
capitalized software, royalties and technical support costs. Cost of product revenues was
unchanged at 16% of product revenues for both 2001 and 2000. Service costs consist
primarily of cost to provide training seminars including personnel, materials and travel.
Cost of service revenues decreased to 67% of service revenues in 2001 down from 105% in
2000. The reduction was attributed to greater efficiencies from combining individual
school training seminars within a district.


27
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Sales and Marketing
Expenses


Sales and marketing expenses
decreased $1.3 million, or 6%, to $19.7 million in 2001 compared to 2000. The decrease was
primarily attributable to a reduction in spending on advertising and trade shows. At
December 31, 2001, we had 25 quota-bearing sales personnel selling to public schools.


Research and Development
Expenses


Research and development expenses
decreased $2.3 million, or 40%, to $3.4 million in 2001 compared to 2000. The decrease was
due to a significant reduction in research and development staff as we decreased our
spending on activities other than improving our core products. Once technological
feasibility has been established, costs associated with the development of a product are
capitalized. For the years ended December 31, 2001 and 2000 we capitalized $1.2 million
and $1.5 million, respectively.


General and
Administrative Expenses


General and administrative expenses
increased $0.6 million, or 10%, to $6.3 million in 2001 compared to 2000. The increase was
attributed to cost associated with moving to our new facility.


Restructuring, Lease
and Asset Impairment Write Down


In 2001 management approved a plan to
restructure operations including consolidating operations to focus on the K-12 market. In
connection with the plan, the Company recorded a restructuring, lease and asset impairment
charge of $2.6 million in operating expenses. The restructuring resulted in a workforce
reduction of approximately 50 employees and a total charge to operations for severance
benefits of $456,000. All affected employees had been terminated or notified of their
severance benefits as of December 31, 2001. As of December 31, 2001, termination benefits
totaling $374,000 had been paid to employees. Along with reducing the number of employees,
the Company recorded an asset impairment charge of $361,000 to write down the value of
long-lived assets to net realizable value. The write down included the remaining
capitalized development cost for ReWord. This product specifically targets the adult
market, which is not our focus. As well, we reduced the value of furniture and leasehold
improvements related to excess office space.


The Company recorded $1.8 million as
a charge to operations in conjunction with excess unoccupied office space in its current
and former corporate office facilities. For our current facility the cost included a
portion of the lease liability and brokerage fees reduced by estimated sublease income
over the remaining lease term. The estimated cost of excess lease facilities and the
estimated value of the sublease were based on market information provided by a commercial
real estate brokerage firm. At December 31, 2001 accrued liabilities included $1.5 million
relating to the excess office space and termination benefits.


The following table sets forth the
restructuring activity during the year ended December 31, 2001 (in thousands).
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                       | Charged to restructuring expense in 2001: | Cash paid | Asset write downs | Accrued restructuring costs at December 31, 2001
|---------------------- | ----------------------------------------- | --------- | ----------------- | ------------------------------------------------
|Lease impairment costs |                                           |           | $                 | 1,791                                           
|Asset write-downs      |                                           |           |                   | 361                                             
|Severance benefits     |                                           |           |                   | 456                                             
|                      
|Total                  |                                           |           | $                 | 2,608                                           
|                      

|In 2000 the Company implemented a
restructuring program, resulting in a charge of $492,000. Under the plan we reduced our
workforce by 22 employees and incurred legal costs of $200,000 and asset impairment
charges of $164,000. All such amounts had been paid or written off at December 31, 2000.


28
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Deferred Compensation


Deferred compensation represents the
difference between the exercise price and the deemed fair value of certain stock options
granted to employees through December 31, 1999. The amount has being amortized by charges
to operations over the vesting periods of the individual stock options. Deferred
compensation was fully amortized at December 31, 2001. The amortization amounted to
$72,000 and $429,000 for the years ended December 31, 2001 and 2000, respectively. The
charges were recorded within the operating expense categories of the individuals that gave
rise to the charges.


Interest Income and
Expense


In 2001 we recorded $1.4 million in
interest expense and $0.4 million in interest income compared to $1,000 in interest
expense and $1.1 million in interest income in 2000. The shift was a result of lower cash
levels, amortization of deferred financing costs and interest paid on the line of credit
from Fleet National Bank in 2001. In March 2001 a stock warrant was issued to WPV, Inc.,
an affiliate of Warburg, Pincus Ventures, a significant stockholder of the Company, for
providing an unlimited guarantee for our bank line of credit. The estimated value of the
warrant at the date of issuance was $3.6 million and is being amortized by a charge to
interest expense over the three-year term of the guarantee. Amortization for the year
ended December 31, 2001 was $1.0 million.


Liquidity and Capital
Resources
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                 | Year ended December 31,
|------------------------------------------------ | -----------------------
|
|Cash provided by (used in) operating activities  |                        
|Cash provided by investing activities            |                        
|Cash (used in) provided by  financing activities |                        

|Net cash provided by operating
activities was $3.7 million in 2002 compared to cash used in operating activities of $12.5
million and $19.5 million for the two years ended December 31, 2001 and 2000,
respectively. The $16.2 million decrease in cash used in 2002 was primarily attributable
to an increase in booked sales and a decrease in expenses in sales and marketing and
general and administrative, together with increases in accrued liabilities. The increase
in accrued liabilities was mostly attributed to restructuring costs to be paid in future
periods (see Restructuring, Lease and Asset Impairment Write-Downs above). The increase in
booked sales is attributable to the increase in perpetual license sales to the K-12
sector, which are typically recognized over a 12-month period. We expect that the cash
from operations will continue to be positive in 2003 based on our expectations of
increased sales and continued expense control. If we are unable to meet our sales and
revenue targets, or our expenses are higher than our current plans, our cash generation
could be less than planned, or we could consume cash.


Net cash provided by investing
activities was $0.8 million, $0.9 million and $3.1 million for the years ended December
31, 2002, 2001 and 2000, and was primarily generated from the sale of government
securities. This was partially offset by an increase in capitalized software development
costs of $1.2 million and $1.5 million for the years ended December 31, 2001 and 2000, and
purchase of property and equipment of $1.4 million and $1.2 million for the years ended
December 31, 2001 and 2000. In addition, in 2001 we made loans to current and former
officers totaling $3.1 million.


Net cash used in financing activities
was $4.6 million for 2002 mostly attributed to repayment of borrowing under our line of
credit. The average interest rate for the year under the line of credit was 2.7%. In 2001
and 2000 net cash provided by financing activities was $15.4 million and $1.5 million,
respectively. Net cash provided by financing activities in 2001 was from the proceeds of
issuance of common stock and from borrowing under our line of credit. Net cash provided by
financing activities in 2000 was primarily due to the exercise of stock options.


As of December 31, 2002, we had cash
and cash equivalents of $4.6 million. We believe that our cash and cash equivalents,
combined with the available borrowing capacity under the Fleet National Bank facility will
be sufficient to finance our operations and planned capital expenditure requirements over
the next 12 months. To date the Company has paid no dividends. We have no plans to
initiate dividends in the foreseeable future.


29
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|We currently have an outstanding
balance of $5 million on our line of credit with Fleet National Bank. The total credit
line is $15 million. In March 2002, the agreement was extended to June 30, 2004. WPV,
Inc., an affiliate of Warburg Pincus Ventures, a significant stockholder of the Company,
has provided an unlimited guarantee for the facility. The guarantee expires in March 2004.


We also have a non-cancelable lease
agreement for our corporate office facilities. The minimum lease payment on our office
facility is approximately $174,000 per month in 2003. The base lease payment increases at
a compound annual rate of 3%. The lease terminates in March 2009.


The following summarizes the
Companys outstanding borrowings and contractual obligations at December 31, 2002 and
the effects such obligations are expected to have on our liquidity and cash flow in future
periods (in thousands).
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                    | Total | Less than 1 year | 1 - 3 years | 4 - 8 years
|----------------------------------- | ----- | ---------------- | ----------- | -----------
|Borrowing under bank line of credit |       |                  | $           | 5,000      
|Non-cancelable operating leases     |       |                  |             | 14,823     
|Minimum royalty payments            |       |                  |             | 1,050      
|                                   
|Total                               |       |                  | $           | 20,873     
|                                   

|At December 31, 2002 we have accrued
$3.0 million of future non-cancelable operating lease payments included above on excess
office space.


Loans to Current and Former Officers


In March 2001 we made full recourse
loans to certain officers of the Company totaling $3.1 million. The total receivable at
December 31, 2002 and 2001 was $3.4 million and $3.2 million respectively. Accrued interest
of $265,000 and $112,000 for the years ended December 31, 2002 and 2001 was included in
Other Assets on the Balance Sheet. In 2002 some of the officers left the Company. The
Notes are full recourse loans secured by shares of the Companys Common Stock owned
by the current and former officers. The loans bear interest at 4.94%. Principal and interest
are due December 31, 2005.


Recent Accounting
Pronouncements


In July 2002, the FASB issued SFAS
No. 146 (SFAS 146"), Accounting for Costs Associated with Exit or
Disposal Activities.SFAS 146 addresses financial accounting and reporting for costs
associated with an exit or disposal activity and requires such costs to be recognized when
the liability is incurred. Previous guidance in EITF No. 94-3, Liability Recognition
for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Certain
Costs Incurred in a Restructuring) required that a liability for an exit cost be
recognized at the date of a companys commitment to an exit plan. The provisions of
SFAS 146 are effective for exit or disposal activities that are initiated by a company
after December 31, 2002. The adoption of SFAS 146 is not expected to have a material
effect on the Companys financial position or results of operations.


On December 31, 2002, the FASB issued
SFAS No. 148, Accounting for Stock-Based Compensation  Transition and
Disclosure. SFAS 148 amends SFAS 123 to provide alternative methods of transition to
SFAS 123s fair value method of accounting for stock-based employee compensation.
SFAS 148 also amends the disclosure provisions of SFAS 123 and APB No. 28, Interim
Financial Reporting, to require disclosure in the summary of significant accounting
policies of the effects of an entitys accounting policy with respect to stock-based
employee compensation on reported net income and earnings per share in annual and interim
financial statements. While SFAS 148 does not amend SFAS 123 to require companies to
account for employee stock options using the fair value method, the disclosure provisions
of SFAS 148 are applicable to all companies with stock-based employee compensation,
regardless of whether they account for that compensation using the fair value method of
SFAS 123 or the intrinsic value method of APB 25. Since we account for our stock-based
compensation under APB 25, and have no current plans on switching to SFAS 123, the impact
of SFAS 148 will be limited to the interim reporting of the effects on net income and
earnings per share if the Company accounted for stock-based compensation under SFAS 123.
SFAS 148 is effective for fiscal years ending after December 15, 2002.


30
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|In November 2002, the EITF reached a
consensus on Issue 00-21, addressing how to account for arrangements that involve the
delivery or performance of multiple products, services, and/or rights to use assets.
Revenue arrangements with multiple deliverables are divided into separate units of
accounting if the deliverables in the arrangement meet the following criteria: (1) the
delivered item has value to the customer on a standalone basis; (2) there is objective and
reliable evidence of the fair value of undelivered items; and (3) delivery of any
undelivered item is probable. Arrangement consideration should be allocated among the
separate units of accounting based on their relative fair values, with the amount
allocated to the delivered item being limited to the amount that is not contingent on the
delivery of additional items or meeting other specified performance conditions. The final
consensus will be applicable to agreements entered into in fiscal periods beginning after
June 15, 2003 with early adoption permitted. The Company is evaluating the impact of this
consensus on the Companys financial position and operating results.


ITEM 7A.
    Quantitative and Qualitative Disclosures About Market Risk


Interest Rate Risk


Our exposure to market risk for
changes in interest rates relates primarily to the rate of interest we will pay on our
revolving credit facility with Fleet National Bank (Fleet). Interest rates on loans
extended under that facility are at LIBOR (London Interbank Offered Rate) plus one
percent, or at Fleets Base Rate at our choice. A hypothetical increase
or decrease in market interest rates by 10% from the market interest rates at December 31,
2002 would not have a material affect on our expenses or loss.


31
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ITEM 8.    FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA


Report of Ernst &
Young LLP, Independent Auditors


The Board of Directors
and Stockholders
Scientific Learning Corporation


We have audited the accompanying
balance sheets of Scientific Learning Corporation (the Company) as of
December 31, 2002 and 2001, and the related statements of operations,
stockholders (deficit) equity, and cash flows for each of the three years in the
period ended December 31, 2002. Our audit also included the financial statement
schedule included in Item 15. These financial statements and financial statement schedule
are the responsibility of the Companys management. Our responsibility is to express
an opinion on these financial statements and financial statement schedule based on our
audits.


We conducted our audits in accordance
with auditing standards generally accepted in the 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. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.


In our opinion, the financial
statements referred to above present fairly, in all material respects, the financial
position of Scientific Learning Corporation at December 31, 2002 and 2001, and the results
of its operations and its cash flows for each of the three years in the period ended
December 31, 2002, in conformity with accounting principles generally accepted in the
United States. Also, in our opinion, the selected 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
February 7, 2003,


32
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Scientific Learning
Corporation
Balance Sheet(In thousands, except share and per share amounts)
|-----------------------------------------------------------------------------------------------

|                                                                         | December 31,
|------------------------------------------------------------------------ | ------------
|
|Assets                                                                   |             
|Current assets:                                                          |             
|Cash and cash equivalents                                                |             
|Investments in government  securities                                    |             
|Accounts receivable, net of allowance for doubtful accounts              |             
|$270 and $248  at December 31, 2002 and 2001, respectively               |             
|Prepaid expenses and other current assets                                |             
|                                                                         |             
|Total current assets                                                     |             
|Property and equipment, net                                              |             
|Notes receivable from current  and former officers                       |             
|Other assets                                                             |             
|                                                                         |             
|Total assets                                                             |             
|                                                                         |             
|Liabilities and stockholders (deficit) equity                           |             
|Current liabilities:                                                     |             
|Accounts payable                                                         |             
|Accrued liabilities                                                      |             
|Deferred revenue                                                         |             
|                                                                         |             
|Total current liabilities                                                |             
|Borrowings under bank line of credit                                     |             
|Deferred revenue, long-term                                              |             
|Other liabilities                                                        |             
|                                                                         |             
|Total liabilities                                                        |             
|Commitments and contingencies                                            |             
|Stockholders (deficit) equity:                                          |             
|Preferred stock, $0.001 par value:                                       |             
|Authorized shares - 1,000,000                                            |             
|Issued and outstanding shares - none in 2002 and 2001                    |             
|Common stock, $0.001 par value:                                          |             
|Authorized shares - 40,000,000                                           |             
|Issued and outstanding shares -15,879,083 in 2002 and 15,475,619 in 2001 |             
|Accumulated deficit                                                      |             
|                                                                         |             
|Stockholders (deficit) equity:                                          |             
|                                                                         |             
|Total liabilities and stockholders (deficit) equity                     |             
|                                                                         |             

|See accompanying notes.


33
|----------------------------

|Scientific Learning
Corporation 
Statement of Operations(In thousands, except per share
amounts)
|------------------------------------------------------------------------------------------------

|                                     | Year ended December 31,
|------------------------------------ | -----------------------
|
|Revenues:                            |                        
|Products                             |                        
|Services                             |                        
|                                     |                        
|Total revenues                       |                        
|Cost of revenues                     |                        
|Cost of products                     |                        
|Cost of services                     |                        
|                                     |                        
|Total cost of revenues               |                        
|                                     |                        
|Gross profit                         |                        
|Expenses:                            |                        
|Sales and marketing                  |                        
|Research and development             |                        
|General and administrative           |                        
|Restructuring, lease and asset       |                        
|impariment write downs               |                        
|                                     |                        
|Total operating expenses             |                        
|                                     |                        
|Operating loss                       |                        
|Interest (expense) income, net       |                        
|Other income                         |                        
|                                     |                        
|Net loss                             |                        
|                                     |                        
|Basic and diluted net loss per share |                        
|                                     |                        
|Shares used in computing basic and   |                        
|diluted net loss per share           |                        
|                                     |                        

|See accompanying notes.


34
|----------------------------

|Scientific Learning
Corporation
Statements of Stockholders(Deficit) Equity(In thousands,
except share amounts)
|---------------------------------------------------------------------------------------------------------------

|                                                                                        | Common Stock | Deferred | Accumulated | Total
Stockholders
|--------------------------------------------------------------------------------------- | ------------ | -------- | ----------- | -------------------
|
|Balances at December 31, 1999                                                           |              |          |             | 10,507,185         
|Issuance of common stock under stock option plan                                        |              |          |             | 734,955            
|Issuance of stock under employee stock purchase plan                                    |              |          |             | 94,240             
|Reduction of deferred compensation relating to cancelled       stock options            |              |          |             |                   
|Amortization of deferred compensation                                                   |              |          |             |                   
|Net loss and comprehensive loss                                                         |              |          |             |                   
|                                                                                        |             
|Balances at December 31, 2000                                                           |              |          |             | 11,336,380         
|Issuance of common stock under stock option plan                                        |              |          |             | 7,395              
|Issuance of common stock under employee stock purchase       plan                       |              |          |             | 131,844            
|Issuance of common stock in a private placement, net of       offering costs            |              |          |             | 4,000,000          
|Issuance of common stock warrants in connection with        guarantee of line of credit |              |          |             |                   
|Amortization of deferred compensation                                                   |              |          |             |                   
|Net loss and comprehensive loss                                                         |              |          |             |                   
|                                                                                        |             
|Balance December 31, 2001                                                               |              |          |             | 15,475,619         
|Issuance of common stock under stock option plan                                        |              |          |             | 274,471            
|Issuance of common stock under employee stock purchase       plan                       |              |          |             | 116,861            
|Compensation charge relating to granting of common stock       options                  |              |          |             |                   
|Stock issue in exchange for services                                                    |              |          |             | 12,132             
|Net loss and comprehensive loss                                                         |              |          |             |                   
|                                                                                        |             
|Balance December 31, 2002                                                               |              |          |             | 15,879,083         
|                                                                                        |              |          |             |                    

|See accompanying notes


35
|---------------------------

|Scientific Learning
Corporation
Statement of Cash Flows(In thousands)
|---------------------------------------------------------------------

|                                                                        | Year ended December 31,
|----------------------------------------------------------------------- | -----------------------
|
|Operating Activities:                                                   |                        
|Net loss                                                                |                        
|Adjustments to reconcile net loss to cash used in operating activities: |                        
|Depreciation                                                            |                        
|Amortization of software development costs                              |                        
|Amortization of deferred financing costs                                |                        
|Stock based compensation                                                |                        
|Amortization of deferred compensation                                   |                        
|Asset impairment write downs                                            |                        
|Changes in operating assets and liabilities:                            |                        
|Accounts receivable                                                     |                        
|Prepaid expenses and other current assets                               |                        
|Accounts payable                                                        |                        
|Accrued liabilities                                                     |                        
|Deferred revenues                                                       |                        
|Other liabilities                                                       |                        
|                                                                        |                        
|Net cash provided by (used in) operating activities                     |                        
|Investing Activities:                                                   |                        
|Sale of government securities                                           |                        
|Purchases of property and equipment, net                                |                        
|Notes receivable from current and former officers                       |                        
|Increase in capitalized software development costs                      |                        
|(Increase) decrease in other non-current assets                         |                        
|                                                                        |                        
|Net cash provided by investing activities                               |                        
|Financing Activities:                                                   |                        
|Proceeds from issuance of common stock, net                             |                        
|Borrowings under bank line of credit                                    |                        
|Repayments of borrowings under bank line of credit                      |                        
|                                                                        |                        
|Net cash (used in) provided by financing activities                     |                        
|                                                                        |                        
|Increase (decrease) in cash and cash equivalents                        |                        
|Cash and cash equivalents at beginning of year                          |                        
|                                                                        |                        
|Cash and cash equivalents at end of year                                |                        
|                                                                        |                        
|Supplemental disclosure                                                 |                        
|Interest paid                                                           |                        
|                                                                        |                        
|Supplemental disclosure of noncash investing and financing activities:  |                        
|Issuance of common stock warrants in connection with guarantee          |                        
|of line of credit                                                       |                        
|                                                                        |                        

|See accompanying notes.


36
|----------------------------

|Notes to Financial
Statements


1. Summary of
Significant Accounting Policies


Description of
Business


Scientific Learning Corporation (the
Company) was incorporated on November 30, 1995 in the State of California and
was reincorporated on May 2, 1997 in the State of Delaware. The Company commenced
operations in February 1996. We develop, market and sell software products that develop
underlying cognitive skills required for reading and learning. Our Fast ForWord®
products are a series of reading intervention products that incorporate learning from more
than 30 years of brain, language and reading research in order to help children,
adolescents and adults build the cognitive skills that enable successful reading. We sell
primarily to K-12 public schools. We also sell through speech and language professionals
and to private schools and clinics. To support our products, we provide a combination of
on-site and remote training and implementation services, as well as technical,
professional and customer support and a wide variety of Web-based resources.


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. To the
extent that there are material differences between these estimates and actual results, our
financial statements could be affected.


Revenue Recognition


The Company derives revenue from the
sale of licenses to its software and from service fees. Software license revenue is
recognized in accordance with AICPA Statement of Position 97-2, Software Revenue
Recognition, (SOP 97-2) as amended by Statement of Position 98-9. 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. For
software orders with multiple elements, we allocate revenue to each element of a
transaction based upon its fair value as determined in reliance on vendor specific
objective evidence. Vendor specific objective evidence 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
additionally measured by the renewal price. If we cannot objectively determine the fair
value of any undelivered element included in bundled software and service orders, we defer
revenue until all elements are delivered and services have been performed, or until fair
value can objectively be determined. When the fair value of a license element has not been
established, we use the residual method to record license revenue if the fair value of all
undelivered elements is determinable. Under the residual method, the fair value of the
undelivered elements is deferred and the remaining portion of the arrangement fee is
allocated to the delivered elements and is recognized as revenue.


The Companys revenue
recognition policy is also based on the Securities and Exchange Commissions Staff
Accounting Bulletin 101 (SAB 101) that requires companies that provide an ongoing service
to recognize revenue over the term of the services agreement.


The value of software licenses and
services invoiced during a particular period is recorded as deferred revenue until
recognized. Customers license the right to use Fast ForWord software, but do not acquire
unlimited rights to the products.


Revenues from the licensing of
software are recognized as follows: 1) for perpetual licenses that require ongoing
Internet-based participant tracking service, revenue is recognized over the period in
which the Company provides such services, typically from 1 to 3 years; 2) for limited term
site licenses, revenue is recognized over the life of the license, typically 3 to 12
months; 3) for individual participant licenses, revenue is recognized over the average
duration of the products use, typically 6 weeks; and 4) for perpetual licenses with
no ongoing support requirement, revenue is recognized when the product has been shipped,
provided that the fees are fixed or determinable and collectible.


37
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Notes to Financial
Statements


1. Summary
of Significant Accounting Policies (continued)


Service revenues are derived from a
combination of on-site training and implementation services. Revenue from services is
recognized on delivery.


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.


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. The Company capitalized $116,000 and
$1.2 million of software development costs for the years ended December 31, 2002 and 2001,
respectively. Software costs are amortized to cost of revenues over the estimated useful
life of the software, which is three years: amortization was $666,000, $493,000 and
$384,000 for the years ended December 31, 2002, 2001 and 2000, respectively.


Long-Lived Assets


On January 1, 2002, the Company
adopted SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived
Assets", which supersedes certain provisions of APB 30 "Reporting the Results of
Operations  Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactionsand
supersedes SFAS No. 121 "Accounting for the Impairment of Long-Lived Assets to be
Disposed of. There was not a cumulative transition adjustment upon adoption. In
accordance with SFAS 144, the Company evaluates long-lived assets, other than goodwill,
for impairment whenever events or changes in circumstances indicate that the carrying
value of an asset may not be recoverable based on expected undiscounted cash flows
attributable to that asset. The amount of any impairment is measured as the difference
between the carrying value and the fair value of the impaired asset.


Cash and Cash
Equivalents


Cash and cash
equivalents consist of cash and highly liquid short-term investments with original
maturities of three months or less.


Investments in Government
Securities


The Company classifies all of its
investments as available-for-sale securities. These investments consisted of United States
Government and Federal Agency securities, which were carried at amounts, which approximate
fair value, with unrealized gains and losses on such securities reflected as other
comprehensive income (loss) in stockholders equity (deficit) until disposition.
Unrealized gains and losses have not been material. Realized gains and losses on
investments in government securities are included in interest income. There were no
realized gains or losses in the years ended December 31, 2002 or 2001. Amortized cost
approximated the fair market value of the available-for-sale securities at December 31,
2001. At December 31, 2002 there were no investments in government securities.


38
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Notes to Financial
Statements


1. Summary
of Significant Accounting Policies (continued)


Fair Value of
Financial Instruments


The carrying amounts of the
Companys cash and cash equivalents, investments in government securities, accounts
receivable, notes receivable from current and former officers, and accounts payable
approximate fair value. The Company determined the fair value of its investments in
government securities based on quoted market prices.


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.


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 loss per share is determined as if the Company had accounted
for its employee stock options using the fair value method. The fair value of each option
granted is estimated on the date of grant using the Black Scholes valuation model. The
risk-free interest rate was 3.0%, 4.5% and 5.8% for the years ended December 31, 2002,
2001 and 2000, respectively. The weighted average expected life of all options granted in
2002, 2001 and 2000, was 5 years. No dividend and a volatility factor of 85% were used.


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. Because
the Companys employee stock options have characteristics significantly different
from those of traded options and because changes in the subjective input assumptions can
materially affect the fair value of the estimate, in managements opinion, the
existing models do not necessarily provide a reliable single measure of the fair value of
its employee stock options.


39
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Notes to Financial
Statements


1. Summary
of Significant Accounting Policies (continued)


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 net loss and basic and diluted net loss per share would have
been increased to the pro forma amounts indicated below (in thousands, except per share
amounts):
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                                                                | Year Ended December 31,
|--------------------------------------------------------------------------------------------------------------- | -----------------------
|
|Net loss, as reported                                                                                           |                        
|Add: Stock-based employee compensation expense included in the determination of net loss, as reported           |                        
|                                                                                                                |                        
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards |                        
|                                                                                                                |                        
|Net loss, proforma                                                                                              |                        
|                                                                                                                |                        
|Basic and diluted net loss per share, as                                                                        |                        
|reported                                                                                                        |                        
|                                                                                                                |                        
|Basic and diluted net loss per share, pro                                                                       |                        
|forma                                                                                                           |                        
|                                                                                                                |                        

|The weighted-average grant-date fair
value of options granted was $.90, $2.51 and $10.70 for grants made during years ended
December 31, 2002, 2001 and 2000, respectively.


The pro forma impact of options on
the net loss for the years ended December 31, 2002, 2001 and 2000, 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 $4,000, $61,000 and $1.3 million for the years ended
December 31, 2002, 2001 and 2000, 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 Loss Per Share


Basic and diluted net loss per share
information for all periods is presented under the requirement of FAS No. 128,
Earnings per Share (FAS 128"). Basic earnings per share have been
computed using the weighted-average number of shares outstanding during the period and
excludes any dilutive effects of stock options, warrants, and convertible securities.
Potentially dilutive securities have been excluded from the computation of diluted net
loss per share, as their inclusion would be antidilutive.


40
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Notes to Financial
Statements


1. Summary
of Significant Accounting Policies (continued)


If the Company had reported net
income, the calculation of diluted earnings per share would have included approximately an
additional 64,000, 36,000, and 463,000 common equivalent shares (computed using the
treasury stock method) related to the outstanding options and warrants not included above
for the years ended December 31, 2002, 2001 and 2000, respectively.


Recent Accounting
Pronouncements


In July 2002, the FASB issued SFAS
No. 146 (SFAS 146"), "Accounting for Costs Associated with Exit or
Disposal Activities. SFAS 146 addresses financial accounting and reporting for costs
associated with an exit or disposal activity and requires such costs to be recognized when
the liability is incurred. Previous guidance in EITF No. 94-3, Liability Recognition
for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Certain
Costs Incurred in a Restructuring) required that a liability for an exit cost be
recognized at the date of a companys commitment to an exit plan. The provisions of
SFAS 146 are effective for exit or disposal activities that are initiated by a company
after December 31, 2002. The adoption of SFAS 146 is not expected to have a material
effect on the Companys financial position or results of operations.


On December 31, 2002, the FASB issued
SFAS No. 148, Accounting for Stock-Based Compensation  Transition and
Disclosure. SFAS 148 amends SFAS 123 to provide alternative methods of transition to
SFAS 123s fair value method of accounting for stock-based employee compensation.
SFAS 148 also amends the disclosure provisions of SFAS 123 and APB No. 28, Interim
Financial Reporting, to require disclosure in the summary of significant accounting
policies of the effects of an entitys accounting policy with respect to stock-based
employee compensation on reported net income and earnings per share in annual and interim
financial statements. While SFAS 148 does not amend SFAS 123 to require companies to
account for employee stock options using the fair value method, the disclosure provisions
of SFAS 148 are applicable to all companies with stock-based employee compensation,
regardless of whether they account for that compensation using the fair value method of
SFAS 123 or the intrinsic value method of APB 25. Since we account for our stock-based
compensation under APB 25, and have no current plans on switching to SFAS 123, the impact
of SFAS 148 will be limited to the interim reporting of the effects on net income and
earnings per share if the Company accounted for stock-based compensation under SFAS 123.
SFAS 148 is effective for fiscal years ending after December 15, 2002.


In November 2002, the EITF reached a
consensus on Issue 00-21, addressing how to account for arrangements that involve the
delivery or performance of multiple products, services, and/or rights to use assets.
Revenue arrangements with multiple deliverables are divided into separate units of
accounting if the deliverables in the arrangement meet the following criteria: (1) the
delivered item has value to the customer on a standalone basis; (2) there is objective and
reliable evidence of the fair value of undelivered items; and (3) delivery of any
undelivered item is probable. Arrangement consideration should be allocated among the
separate units of accounting based on their relative fair values, with the amount
allocated to the delivered item being limited to the amount that is not contingent on the
delivery of additional items or meeting other specified performance conditions. The final
consensus will be applicable to agreements entered into in fiscal periods beginning after
June 15, 2003 with early adoption permitted. The Company is evaluating the impact of this
consensus on the Companys financial position and operating results.


Reclassifications


Certain reclassifications have been
made to the prior year balances to conform to the current presentation.


2. Restructuring,
Lease and Asset Impairment Write Downs


For the year ended December 31, 2002
management approved a further plan to restructure operations by reducing the workforce
while continuing to focus on the public school market. In connection with the plan, 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 our
Oakland office in the marketing or customer service
departments. We expect the restructuring will result in an operating expense reduction of
approximately $1.9 million annually. As of December 31, 2002, termination benefits
totaling $632,000 had been paid to employees terminated in 2001 or 2002. The balance in
accrued severance benefits at December 31, 2002 will be paid to employees by August 31,
2003.


41
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Notes to Financial
Statements


2. Restructuring,
Lease and Asset Impairment Write Downs (continued)


Due to continued weakness in the
commercial real estate market the Company recorded an additional charge for excess office
space at our corporate office of $2.3 million. This charge reflects adjustments to the
assumptions on which the 2001 write down for excess office space had been made, including
our 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. Based on this information we assumed that no subtenant
would be found in the next two years. During the year ended December 31, 2002, $759,000
was paid against the reserve established in 2001 for excess office space. The $3.0 million
accrued at December 31, 2002 will be paid over the next two years.


The following table sets forth the
restructuring activity during the year ended December 31, 2002 (in thousands).
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                   | Accrued restructuring costs,
December 31, 2001 | Restructuring Charges | Cash paid | Accrued restructuring costs,
December 31, 2002
|------------------ | ---------------------------------------------- | --------------------- | --------- | ----------------------------------------------
|Lease obligation   |                                                |                       | $         | 1,458                                         
|Severance benefits |                                                |                       |           | 82                                            
|                  
|Total              |                                                |                       | $         | 1,540                                         
|                  

|In 2001 management approved a plan to
restructure operations including consolidating operations to focus on the K-12 market. In
connection with the plan, the Company recorded a restructuring, lease and asset impairment
charge of $2.6 million in operating expenses. The restructuring resulted in a workforce
reduction of approximately 50 employees and a total charge to operations for severance
benefits of $456,000. All affected employees had been terminated or notified of their
severance benefits as of December 31, 2001. As of December 31, 2001, termination benefits
totaling $374,000 had been paid to employees. Along with reducing the number of employees,
the Company recorded an asset impairment charge of $361,000 to write down the value of
long-lived assets to net realizable value. The write down included the remaining
capitalized development cost for ReWord. This product specifically targets the adult
market, which is not our focus. As well, we reduced the value of furniture and leasehold
improvements related to excess office space.


The Company recorded $1.8 million as
a charge to operations in conjunction with excess office space in its current and former
corporate office facilities. For our current facility the cost included a portion of the
lease liability and brokerage fees reduced by estimated sublease income over the remaining
lease term. The estimated cost of excess lease facilities and the estimated value of the
sublease were based on market information provided by a commercial real estate brokerage
firm. At December 31, 2001 accrued liabilities included $1.5 million relating to the
excess office space and termination benefits.


42
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Notes to Financial
Statements


2. Restructuring,
Lease and Asset Impairment Write Downs (continued)
|----------------------------------------------------------------------------------------------------

|                       | Charged to restructuring expense in 2001: | Cash paid | Asset write downs | Accrued restructuring costs at December 31, 2001
|---------------------- | ----------------------------------------- | --------- | ----------------- | ------------------------------------------------
|Lease impairment costs |                                           |           | $                 | 1,791                                           
|Asset write-downs      |                                           |           |                   | 361                                             
|Severance benefits     |                                           |           |                   | 456                                             
|                      
|Total                  |                                           |           | $                 | 2,608                                           
|                      

|In 2000 the Company implemented a
restructuring program, resulting in a charge of $492,000. Under the plan we reduced our
workforce by 22 employees and incurred legal costs of $200,000 and asset impairment
charges of $164,000. All such amounts had been paid or written off at December 31, 2001.


3. Prepaid Expenses
and Other Current Assets


Prepaid expenses and other current
assets consist of the following (in thousands):
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | December 31,
| |  | ------------
|
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             

|4. Property and
Equipment


Property and equipment consists of the
following (in thousands):
|--------------------------------------------------------------------------------------------

| |  | December 31,
| |  | ------------
|
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             

|5. Notes Receivable
from Current and Former Officers


Notes receivable from current and
former officers was $3.1 million for each of the years ended December 31, 2002 and 2001. 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. Accrued interest of $265,000 and $112,000 at December 31, 2002 and 2001,
respectively is recorded in other assets.


43
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Notes to Financial
Statements


6. Other Assets


Other assets consist of the following
(in thousands):
|-------------------------------------------------------------------------------------------------------

| |  | December 31,
| |  | ------------
|
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             

|7. Accrued Liabilities


Accrued liabilities consist of the
following (in thousands):
|-------------------------------------------------------------------------------------

| |  | December 31,
| |  | ------------
|
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             
| |  |             

|8. Bank Line of Credit


In 2001, the Company entered into a
revolving loan agreement with a bank for an unsecured revolving credit facility in the
amount of $15,000,000, expiring June 30, 2004. Borrowings under the loan agreement bear
interest at the election of the Company at the rate of LIBOR plus one percent or the
banks Base Rate. WPV, Inc., an affiliate of Warburg, Pincus Ventures, a
significant stockholder of the Company, has provided an unlimited guarantee for the
facility. The guarantee expires in March 2004.


In consideration of the 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 and this amount is being amortized as deferred financing costs by a charge to
interest expense over the three-year term of the guarantee.


9. Income Taxes


There has been no provision for U.S.
federal, U.S. state or foreign income taxes for any period as the Company has incurred
operating losses in all periods and for all jurisdictions.


44
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Notes to Financial
Statements


     9.    
          Income Taxes (continued)


Deferred income taxes reflect the net
tax effects of temporary differences between the carrying amounts of assets and
liabilities for financial reporting purposes and the amounts used for income tax purposes.
Significant components of the Companys deferred tax assets are as follows (in
thousands):
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                           | December 31,
|------------------------------------------ | ------------
|
|Deferred tax assets:                       |             
|Net operating loss carryforwards           |             
|Restructuring reserve                      |             
|Capitalized software and development costs |             
|Deferred revenue                           |             
|Research credits carryforwards             |             
|Other                                      |             
|                                           |             
|Total deferred tax assets                  |             
|Valuation allowance                        |             
|                                           |             
|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 increased by $3.5 million and $6.8 million during the years ended
December 31, 2002 and 2001, respectively.


As of December 31, 2002, the Company
had net operating loss carryforwards for federal income tax purposes of approximately
$72.8 million, which expire in the years 2011 through 2022 and federal research tax
credits of approximately $426,000, which expire in the years 2011 through 2022. The
Company also had net operating loss carryforwards for state income tax purposes of
approximately $22.0 million expiring in the years 2003 through 2012 and state research tax
credits of approximately $289,000 which carryforward 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.


10. Stockholders (Deficit)
Equity


Common Stock


At December 31, 2002, the Company had
reserved shares of common stock for future issuance as follows:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  |                                          
| |  |  | -----------------------------------------
| |  |  | Stock Options outstanding                
| |  |  | Stock Options available for future grants
| |  |  | Common stock warrants                    
| |  |  |                                          
| |  |  |                                          
| |  |  |                                          

|Stock Options


The Companys employee stock
option plans provide for the issuance of incentive stock options (ISO) or nonstatutory
stock options (NSO) 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 10 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.


45
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Notes to Financial
Statements


10. Stockholders (Deficit)
Equity (continued)


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 adding 1,350,000 shares to the 1999 Equity Incentive Plan. The total
number of shares authorized for issuance under the plan is now 4,642,666. The Board of
Directors also approved the 2002 CEO Stock Option Plan in May 2002. 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.


A summary of the Companys stock
option activity under the plans is as follows:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                 | Outstanding Options
|-------------------------------- | -------------------
|
|Outstanding at December 31, 1999 |                    
|Granted                          |                    
|Exercised                        |                    
|Canceled                         |                    
|                                 |                    
|Outstanding at December 31, 2000 |                    
|Granted                          |                    
|Exercised                        |                    
|Canceled                         |                    
|                                 |                    
|Outstanding at December 31, 2001 |                    
|Granted                          |                    
|Exercised                        |                    
|Canceled                         |                    
|                                 |                    
|Outstanding at December 31, 2002 |                    
|                                 |                    
|Vested and exercisable           |                    
|                                 |                    

|46
|--

|Notes to Financial
Statements


     10.    
          Stockholders (Deficit) Equity (continued)


The following table summarizes
information concerning outstanding and exercisable stock options at December 31, 2002:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                       | Outstanding |  | Vested and
Exercisable |          
|---------------------- | ----------- |  | ---------------------- | ---------
|
|$  0.2600 - $  1.3700  |             |  |                        | 365,286  
|$  1.3800 - $  1.3900  |             |  |                        | 1,350,000
|$  1.4000 - $  3.5000  |             |  |                        | 407,116  
|$  3.5900 - $  7.0000  |             |  |                        | 404,965  
|$  7.1250 - $  39.8750 |             |  |                        | 461,937  
|                       |             |  |                        |          
|                       |             |  |                        | 2,989,304
|                       |             |  |                        |          

|The Company recorded deferred
compensation of $278,000 during the year ended December 31, 1999, representing the
difference between the exercise price and the deemed fair value of certain of the
Companys stock options granted to employees. The amount has been amortized by
charges to operations over the vesting periods of the individual stock options using a
graded method. Such amortization amounted to $0, $72,000 and $429,000, for the years ended
December 31, 2002, 2001, and 2000, respectively.


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 unexcercised 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.


In 1999 the Company issued a fully
vested warrant to purchase 7,222 shares of Series D Preferred Stock of the Company at an
exercise price of $7.50 per share. The warrant was issued to the placement agent in the
Series D Preferred Stock offering and was converted to an equivalent number of common
stock on completion of the initial public offering. The warrant is outstanding and will
expire in 2004.


In 1998 the Company issued warrants
to purchase 116,666 shares of common stock at $9.00 per share. The warrants were issued to
a significant stockholder of the Company in connection with loans and loan guarantees to
the Company. The warrants are outstanding and will expire in 2003. The Company estimated
the fair value of the warrants to be $780,000, which was amortized by charges to interest
expense during the year ended December 31, 1998.


47
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Notes to Financial
Statements


10. Stockholders (Deficit)
Equity (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 116,861 and 131,844 shares of common stock under the plan during the years
ended December 31, 2002 and 2001, respectively. At December 31, 2002, 357,055 shares were
available for issuance under the Plan.


11. Commitments


Leases


The Company leases its corporate
office facility under a non-cancelable operating lease with a term expiring in 2009.
Future minimum payments under this lease as of December 31, 2002 are as follows (in
thousands):
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                             | 
|---------------------------- | 
|2003                         | 
|2004                         | 
|2005                         | 
|2006                         | 
|2007                         | 
|2008 and thereafter          | 
|                             | 
|Total minimum lease payments | 
|                             | 

|During the year ended December 31,
2001 the Company signed a sublease agreement for approximately 20% of the space at its
corporate office facility. The sublease was terminated in 2003; under the termination
agreement the Company will receive $220,000 for the year ended December 31, 2003.


Rent expense under all operating
leases net of sublease income of $401,000 and $130,000 in 2002 and 2001 was $1.7 million, 2.0 million
and $1.0 million for the years ended December 31, 2002, 2001 and 2000,
respectively.


The Company has the option to extend
the operating lease covering its corporate office facility for two five-year terms at the
end of the original lease term, provided that certain conditions of the lease agreement
are met.


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,
the Company issued 131,192 shares of Series A preferred stock and paid the university a
license-issue fee of $200,000. In March 1997, the number of shares of Series A preferred
stock issued under the agreement was reduced to 114,526. On completion of the initial
public offering these shares were converted to an equivalent number of common shares.


The agreement also provides for
additional royalties and milestone payments based upon revenues from products using the
licensed technology. Royalty and milestone expenses were $723,000, $635,000, and $870,000
for the years ended December 31, 2002, 2001 and 2000, respectively, and are included
in cost of revenues. All milestone payments required under the license have now been paid.
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.


48
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Notes to Financial
Statements


12. 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 match
contributions by plan participants.


13. Legal Proceedings


On January 9, 2003 we sent a demand
letter to Metropolitan Teaching and Learning Company (Metropolitan), claiming
that the latters use of the term Fast Forward in connection with childrens
educational materials infringed our rights in our registered trademark Fast ForWord On or
about January 21, 2003, Metropolitan filed a declaratory relief action in federal court in
the Southern District of New York, seeking a judicial declaration that its Fast Forward
mark does not infringe our trademarks, as well as attorneys fees and other
unspecified damages. The complaint was served on us on or about February 7, 2003. We are
required to respond to the complaint by April 8, 2003. We believe our positions have merit
and intend to pursue the lawsuit vigorously. Because the lawsuit is still in the pre-trial
discovery stage, we cannot determine the total expense or possible loss, if any, that may
result from this claim.


14. Interim
financial information (unaudited)


Quarterly financial data (in
thousands, except per share amounts)
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                    | 2002
|------------------- | ----
|
|Total revenues      |     
|Gross profit        |     
|Net loss            |     
|Net loss per share  |     
|(basic and diluted) |     

|                    | 2001
|------------------- | ----
|
|Total revenues      |     
|Gross profit        |     
|Net loss            |     
|Net loss per share  |     
|(basic and diluted) |     

|See note 2 for non-recurring items.


49
|----------------------------------------

|ITEM 9.  CHANGES IN AND
DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE


None.


Part III


ITEM 10.  DIRECTORS AND
EXECUTIVE OFFICERS OF THE REGISTRANT


The information required by this item
with respect to our executive officers is contained in Part I Executive
Officers and such information is also incorporated by reference in this section.


Information respecting our directors
is set forth under the caption Election of Directors in our Proxy Statement
relating to our 2003 Annual Meeting of Stockholders and is incorporated by reference into
this Form 10-K Report. The Proxy Statement will be filed with the Securities and Exchange
Commission in accordance with Rule 14a-6(c) promulgated under the Securities Exchange Act
of 1934, as amended (the Exchange Act). With the exception of the foregoing
information and other information specifically incorporated by reference into this Form
10-K Report, the Proxy Statement is not being filed as a part hereof.


Information with respect to
compliance with Section 16(a) of the Exchange Act is set forth under the caption
Section 16(a) Beneficial Ownership Reporting Compliance in the Proxy Statement
and is incorporated by reference into this Form 10-K Report.


ITEM 11.   EXECUTIVE
COMPENSATION


Information concerning executive
compensation is set forth under the captions Executive Compensation,
Stock Option Grants and Exercises, Aggregated Option Exercises in 2002
and Year-end Option Values and Compensation Committee Interlocks and Insider
Participation in the Proxy Statement and is incorporated by reference into this Form
10-K Report.


ITEM 12.   SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.


Information concerning security
ownership of certain beneficial owners and management is set forth under the caption
Security Ownership of Certain Beneficial Owners and Management in the Proxy
Statement and is incorporated by reference into this Form 10-K Report.


Information concerning shares
authorized for issuance under equity compensation plans approved by stockholders and not
approved by stockholders is set forth under the caption Equity Compensation Plan
Information in the Proxy Statement and is incorporated by reference into this Form
10-K Report.


ITEM 13.   CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS


Information concerning certain
relationships and related transactions is set forth under the captions Employment
Agreements, Certain Transactions and Termination of Employment
Arrangements in the Proxy Statement and is incorporated by reference into this Form
10-K Report.


ITEM 14.   CONTROLS AND
PROCEDURES


Within the 90 days prior to the date
of this Form 10-K Report, the Companys management, including the Chief Executive
Officer and Chief Financial Officer, performed an evaluation of the effectiveness of the
design and operation of the Companys disclosure controls and procedures. Based on
this evaluation, the Companys Chief Executive Officer and Chief Financial Officer
concluded that the Companys disclosure controls and procedures were effective as of
December 31, 2002. There have been no significant changes in the Companys internal
controls or in other factors that could significantly affect internal controls subsequent
to December 31, 2002.


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, 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.


50
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Our management, including our Chief
Executive Officer and Chief Financial Officer, does not expect that our disclosure
controls and procedures will prevent all error and all fraud. A control system, no matter
how well designed and operated, can provide only reasonable, not absolute, assurance that
the control systems objectives will be met. Further, the design of a control system
must reflect the fact that there are resource constraints, and the benefits of controls
must be considered relative to their costs. The design of any system of controls is based
in part upon certain assumptions about the likelihood of future events, and there can be
no assurance that any design will succeed in achieving its stated goals under all
potential future conditions. Because of the inherent limitations in a cost-effective
control system, misstatements may occur and not be detected.


51
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|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 Auditors Report 
Balance Sheet - December 31, 2002 and
2001 
Statement of Operations  Years Ended December 31, 2002, 2001 and 2000
Statements of Stockholders (Deficit) Equity  Years Ended December 31, 2002,
2001 and 2000
Statement of Cash Flows  Years Ended December 31, 2002, 2001
and 2000 
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:
| | --------------------------------------------------------

| |  | Opening Balance | Charges to
Operating
Expenses | Charges to
Allowance(1) | Deductions | Closing Balance
| |  | --------------- | ----------------------------- | ----------------------- | ---------- | ---------------
| |  |                 | 2002                          |                         |            | $              
| |  |                 | 2001                          |                         |            | $              
| |  |                 | 2000                          |                         |            | $              

|
|

|(1) | The
Company invoiced certain customers whose accounts were deemed potentially uncollectible.
 As such, the accounts were entirely reserved for and no amounts were recognized as
revenue.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|52
|--

| | (3)
Exhibits
| | ------------

| | Exhibit No. | Description
of Document
| | ----------- | -----------------------

| | 3.3(1) | Restated
Certificate of Incorporation.
| | ------ | --------------------------------------

| | 3.4(1) | Amended
and Restated Bylaws.
| | ------ | ----------------------------

| | 4.1(1) | Reference
is made to Exhibits 3.3 and 3.4.
| | ------ | ------------------------------------------

| | 4.2(2) | Amended
and Restated Registration Rights Agreement, dated as of December 31, 1998.
| | ------ | ----------------------------------------------------------------------------------

| | 4.3(1) | Specimen
Stock Certificate.
| | ------ | ---------------------------

| | 4.4(3) | Amendment
No. 1 by and among Scientific Learning Corporation, Warburg, Pincus
                             Ventures, L.P. and WPV, Inc., effective as of March 9, 2001
to Amended and Restated                              Registration Rights Agreement
entered into as of December 30, 1998
| | ------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4.5(11) | Amendment
No. 2 By and Among Scientific Learning Corporation, Warburg, Pincus
                             Ventures, L.P. and WPV, Inc., Effective as of November 30,
2001 to Amended and                              Restated Registration Rights Agreement
Entered Into as of December 30, 1998
| | ------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.1(1)* | Form
of Indemnity Agreement with each of our directors and executive officers.
| | -------- | ------------------------------------------------------------------------------

| | 10.2* | 1999
Equity Incentive Plan, as amended.
| | ----- | ---------------------------------------

| | 10.3* | Forms
of Stock Option Grant Notice, Stock Option Agreement and Stock Award Agreement
                             under the Incentive Plan.
| | ----- | -------------------------------------------------------------------------------------------------------------------------------------------

| | 10.4* | 1999
Non-Employee Directors Stock Option Plan, as amended.
| | ----- | -----------------------------------------------------------

| | 10.5* | Forms
of Nonstatutory Stock Option Agreements under the Non-Employee Directors                             Stock
Option Plan
| | ----- | -----------------------------------------------------------------------------------------------------------------------------

| | 10.6* | 1999
Employee Stock Purchase Plan, as amended.
| | ----- | ----------------------------------------------

| | 10.8* | Form
of 1999 Employee Stock Purchase Plan Offering under the Employee Stock Purchase
                             Plan.
| | ----- | -----------------------------------------------------------------------------------------------------------------------

| | 10.13(1) | Exclusive
License Agreement, dated September 27, 1996, with the Regents of the
                             University of California.
| | --------- | -------------------------------------------------------------------------------------------------------------------------------------

| | 10.15(1) | Securities
Purchase Agreement, dated September 24, 1996, with Warburg, Pincus
                             Ventures, L.P.
| | -------- | -------------------------------------------------------------------------------------------------------------------------

| | 10.16(4) | Lease,
dated as of March 20, 2000, with Rotunda Partners II.
| | -------- | ------------------------------------------------------------

| | 10.17(5) | First
Amendment and Second Amendment to Lease dated as of March 20, 2000, with
                             Rotunda Partners II.
| | -------- | --------------------------------------------------------------------------------------------------------------------------------

| | 10.18(6) | Revolving
Loan Agreement dated as of March 9, 2001 by and between Scientific
                             Learning Corporation and Fleet National Bank
| | -------- | ------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.19(7) | Agreement
to Issue Warrant and Grant of Security Interest dated as of March 9, 2001
                             by and between Scientific Learning Corporation and WPV, Inc.
| | -------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.20(8) | Warrant
to Purchase 1,375,000 Shares of Common Stock of Scientific Learning
                             Corporation
| | -------- | --------------------------------------------------------------------------------------------------------------------

| | 10.21(9)* | Loan
agreements, promissory notes and pledge agreements with each of Sheryle Bolton,
                             Frank Mattson, Steve Miller, and James Mills
| | --------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.22(10) | Stock
Purchase Agreement dated November 9, 2001 between Scientific Learning
                             Corporation and Warburg Pincus Ventures, L.P.
| | --------- | ------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.23(12)* | Letter
Agreement dated March 12, 2002 between the Company and Sheryle Bolton.
| | ---------- | -----------------------------------------------------------------------------

| | 10.24(12) | First
Amendment Agreement, dated March 26, 2002, between the Company and Fleet
                             National Bank amending the agreement filed as Exhibit 10.18.
| | --------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.25(12)* | 2002
Management Incentive Plan.
| | ---------- | -------------------------------

| | 10.26(13)* | Employment Agreement dated as of May 31, 2002 by and between Scientific Learning
                             Corporation and Robert C. Bowen
| | ---------- | ---------------------------------------------------------------------------------------------------------------------------------------------

| | 10.27(14)* | 2002 CEO Option Plan
| | ---------- | --------------------

| | 10.28(15) | Voting Agreement by and among Warburg Pincus Ventures, Carleton Holstrom, the
                             Holstrom Family Partnership, Paula A. Tallal and the Colleen
Osborne 1998                              Irrevocable Trust
| | --------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.29* | Milestone
Equity Incentive Plan
| | ------ | -------------------------------

| | 10.30* | 2003
Management Incentive Plan
| | ------ | ------------------------------

| | 23.1 | Consent
of Ernst & Young, LLP, Independent Auditors
| | ---- | ---------------------------------------------------

| | 99.1 | Certification
of Chief Executive Officer
| | ---- | ----------------------------------------

| | 99.2 | Certification
of Chief Financial Officer
| | ---- | ----------------------------------------

|53
|--

| | (1) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys
Registration                              Statement on Form S-1 (SEC File No. 333-77133).
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (2) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form 10-K
for                              the year ended December 31, 1999 (SEC File No.
000-24547).
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (3) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form 8-K on
                             March 12,2001 (SEC File No. 000-24547).
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (4) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form 10-Q
for                              the quarter ended June 30, 2000 (SEC File No. 000-24547).
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (5) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form 10-Q
for                              the quarter ended June 30,2001 (SEC File No. 000-24547).
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (6) | Incorporated
by reference to Exhibit 99.1 previously filed with the Companys Form 8-K on March
12,2001                              (SEC File No. 000-24547).
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (7) | Incorporated
by reference to Exhibit 99.2 previously filed with the Companys Form 8-K on March
12,2001                              (SEC File No. 000-24547).
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (8) | Incorporated
by reference to Exhibit 99.3 previously filed with the Companys Form 8-K on March
12,2001                              (SEC File No. 000-24547).
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (9) | Incorporated
by reference to Exhibit 10.20 previously filed with the Companys Form 10-Q for the
quarter                              ended March 31, 2001 (SEC File No. 000-24547).
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (10) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form 10-Q
for                              the quarter ended September 30, 2001 (SEC File No.
000-24547).
| | ---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (11) | Incorporated
by reference to Exhibit 4.4 previously filed with the Companys Form 8-K on December
7,2001                              (SEC File No. 000-24547).
| | ---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (12) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form 10-K
for                              the year ended December 31, 2001 (SEC File No.
000-24547).
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (13) | Incorporated
by reference to Exhibit 99.1 previously filed with the Companys Form 8-K on June 7,2002
                             (SEC File No. 000-24547).
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (14) | Incorporated
by reference to Exhibit 99.2 previously filed with the Companys Form 8-K on June 7,2002
                             (SEC File No. 000-24547).
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (15) | Incorporated
by reference to Exhibit 99.3 previously filed with the Companys Form 8-K on June 7,2002
                             (SEC File No. 000-24547).
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------

| |        Certain
portions of this exhibit have been omitted based upon our request for confidential
treatment for portions of the referenced exhibit.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------

| | *        Management
contract or compensatory plan or arrangement.
| | -----------------------------------------------------------------

| | (b) | Reports
on Form 8-K. On November 19, 2002 the Company filed a report on Form 8-K
          disclosing pursuant to Item 5 the election of a new director to its Board of
          Directors.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|54
|--

|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
CORPORATIONBy /s/ Robert C. Bowen
Robert C. BowenChief Executive Officer |  | March 28, 2003
|---------------------------------------------------------------------------------------------------------- |  | --------------

|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. Bowen               |       |     
|                                  |      
|Robert C. Bowen                   |       |     
|                                  |       |     
|                                  |       |     
|/s/ Jane A. Freeman               |       |     
|                                  |      
|Jane A. Freeman                   |       |     
|                                  |       |     
|                                  |       |     
|/s/ Dr. Michael M. Merzenich      |       |     
|                                  |      
|Dr. Michael M. Merzenich          |       |     
|/s/ Dr. Paula A. Tallal           |       |     
|                                  |      
|Dr. Paula A. Tallal               |       |     
|/s/ Carleton A. Holstrom          |       |     
|                                  |      
|Carleton A. Holstrom              |       |     
|/s/ Rodman W. Moorhead, III       |       |     
|                                  |      
|Rodman W. Moorhead, III           |       |     
|/s/ Ajit Dalvi                    |       |     
|                                  |      
|Ajit Dalvi                        |       |     
|/s/ Dr. Joseph Martin             |       |     
|                                  |      
|Dr. Joseph Martin                 |       |     
|/s/ Edward Vermont Blanchard, Jr. |       |     
|                                  |      
|Edward Vermont Blanchard, Jr.     |       |     

|55
|--

|CERTIFICATIONS


I, Robert C. Bowen, certify that:


     1.    
          I have reviewed this annual report on Form 10-K of Scientific Learning
          Corporation;


     2.    
          Based on my knowledge, this annual report does not contain any untrue statement
          of a material fact or omit to state a material fact necessary to make the
          statements made, in light of the circumstances under which such statements were
          made, not misleading with respect to the period covered by this annual report;


     3.    
          Based on my knowledge, the financial statements, and other financial information
          included in this annual report, fairly present in all material respects the
          financial condition, results of operations and cash flows of the registrant as
          of, and for, the periods presented in this annual report;


     4.    
          The registrants other certifying officers and I are responsible for
          establishing and maintaining disclosure controls and procedures (as defined in
          Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:


a)                 designed
such disclosure controls and procedures to ensure that material           information
relating to the registrant, including its consolidated subsidiaries,           is made
known to us by others within those entities, particularly during the           period in
which this annual report is being prepared;


b)                 evaluated
the effectiveness of the registrants disclosure controls and           procedures
as of a date within 90 days prior to the filing date of this annual           report (the
Evaluation Date); and


c)                 presented
in this annual report our conclusions about the effectiveness of the           disclosure
controls and procedures based on our evaluation as of the Evaluation           Date;


     5.    
          The registrants other certifying officers and I have disclosed, based on
          our most recent evaluation, to the registrants auditors and the audit
          committee of registrants board of directors (or persons performing the
          equivalent function):


a)                 all
significant deficiencies in the design or operation of internal controls           which
could adversely affect the registrants ability to record, process,
          summarize and report financial data and have identified for the
          registrants auditors any material weaknesses in internal controls; and


b)                 any
fraud, whether or not material, that involves management or other employees           who
have a significant role in the registrants internal controls; and


     6.    
          The registrants other certifying officers and I have indicated in this
          annual report whether or not there were significant changes in internal controls
          or in other factors that could significantly affect internal controls subsequent
          to the date of our most recent evaluation, including any corrective actions with
          regard to significant deficiencies and material weaknesses.


Date: March 28, 2003
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | /s/ Robert C. Bowen
Robert C. BowenChairman and Chief Executive Officer
| |  | -------------------------------------------------------------------------------------

|56
|--

|CERTIFICATIONS


I, Jane A. Freeman, certify that:


     1.    
          I have reviewed this annual report on Form 10-K of Scientific Learning
          Corporation;


     2.    
          Based on my knowledge, this annual report does not contain any untrue statement
          of a material fact or omit to state a material fact necessary to make the
          statements made, in light of the circumstances under which such statements were
          made, not misleading with respect to the period covered by this annual report;


     3.    
          Based on my knowledge, the financial statements, and other financial information
          included in this annual report, fairly present in all material respects the
          financial condition, results of operations and cash flows of the registrant as
          of, and for, the periods presented in this annual report;


     4.    
          The registrants other certifying officers and I are responsible for
          establishing and maintaining disclosure controls and procedures (as defined in
          Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:


a)                 designed
such disclosure controls and procedures to ensure that material           information
relating to the registrant, including its consolidated subsidiaries,           is made
known to us by others within those entities, particularly during the           period in
which this annual report is being prepared;


b)                 evaluated
the effectiveness of the registrants disclosure controls and           procedures
as of a date within 90 days prior to the filing date of this annual           report (the
Evaluation Date); and


c)                 presented
in this annual report our conclusions about the effectiveness of the           disclosure
controls and procedures based on our evaluation as of the Evaluation           Date;


     5.    
          The registrants other certifying officers and I have disclosed, based on
          our most recent evaluation, to the registrants auditors and the audit
          committee of registrants board of directors (or persons performing the
          equivalent function):


a)                 all
significant deficiencies in the design or operation of internal controls           which
could adversely affect the registrants ability to record, process,
          summarize and report financial data and have identified for the
          registrants auditors any material weaknesses in internal controls; and


b)                 any
fraud, whether or not material, that involves management or other employees           who
have a significant role in the registrants internal controls; and


     6.    
          The registrants other certifying officers and I have indicated in this
          annual report whether or not there were significant changes in internal controls
          or in other factors that could significantly affect internal controls subsequent
          to the date of our most recent evaluation, including any corrective actions with
          regard to significant deficiencies and material weaknesses.


Date: March 28, 2003
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | /s/ Jane A. Freeman
Jane A. FreemanChief Financial Officer
| |  | ------------------------------------------------------------------------

|57
|--

|Index to Exhibits
|-----------------

| | Exhibit No. | Description
of Document
| | ----------- | -----------------------

| | 3.3(1) | Restated
Certificate of Incorporation.
| | ------ | --------------------------------------

| | 3.4(1) | Amended
and Restated Bylaws.
| | ------ | ----------------------------

| | 4.1(1) | Reference
is made to Exhibits 3.3 and 3.4.
| | ------ | ------------------------------------------

| | 4.2(2) | Amended
and Restated Registration Rights Agreement, dated as of December 31, 1998.
| | ------ | ----------------------------------------------------------------------------------

| | 4.3(1) | Specimen
Stock Certificate.
| | ------ | ---------------------------

| | 4.4(3) | Amendment
No. 1 by and among Scientific Learning Corporation, Warburg, Pincus Ventures, L.P.
                  and WPV, Inc., effective as of March 9, 2001 to Amended and Restated
Registration Rights                   Agreement entered into as of December 30, 1998
| | ------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4.5(11) | Amendment
No. 2 By and Among Scientific Learning Corporation, Warburg, Pincus Ventures, L.P.
                  and WPV, Inc., Effective as of November 30, 2001 to Amended and
Restated Registration Rights                   Agreement Entered Into as of December 30,
1998
| | ------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.1(1)* | Form
of Indemnity Agreement with each of our directors and executive officers.
| | -------- | ------------------------------------------------------------------------------

| | 10.2* | 1999
Equity Incentive Plan, as amended.
| | ----- | ---------------------------------------

| | 10.3* | Forms
of Stock Option Grant Notice, Stock Option Agreement and Stock Award Agreement under the
                  Incentive Plan.
| | ----- | --------------------------------------------------------------------------------------------------------------------------------

| | 10.4* | 1999
Non-Employee Directors Stock Option Plan, as amended.
| | ----- | -----------------------------------------------------------

| | 10.5* | Form
of Nonstatutory Stock Option Agreement under the Non-Employee Directors Stock Option Plan
| | ----- | -----------------------------------------------------------------------------------------------

| | 10.6* | 1999
Employee Stock Purchase Plan, as amended.
| | ----- | ----------------------------------------------

| | 10.8* | Form
of 1999 Employee Stock Purchase Plan Offering under the Employee Stock Purchase Plan.
| | ----- | ------------------------------------------------------------------------------------------

| | 10.13(1) | Exclusive
License Agreement, dated September 27, 1996, with the Regents of the University of
                  California.
| | --------- | --------------------------------------------------------------------------------------------------------------------------

| | 10.15(1) | Securities
Purchase Agreement, dated September 24, 1996, with Warburg, Pincus Ventures, L.P.
| | -------- | --------------------------------------------------------------------------------------------

| | 10.16(4) | Lease,
dated as of March 20, 2000, with Rotunda Partners II.
| | -------- | ------------------------------------------------------------

| | 10.17(5) | First
Amendment and Second Amendment to Lease dated as of March 20, 2000, with Rotunda Partners
                  II.
| | -------- | ---------------------------------------------------------------------------------------------------------------------

| | 10.18(6) | Revolving
Loan Agreement dated as of March 9, 2001 by and between Scientific Learning
                  Corporation and Fleet National Bank
| | -------- | -------------------------------------------------------------------------------------------------------------------------------------------

| | 10.19(7) | Agreement
to Issue Warrant and Grant of Security Interest dated as of March 9, 2001 by and
                  between Scientific Learning Corporation and WPV, Inc.
| | -------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.20(8) | Warrant
to Purchase 1,375,000 Shares of Common Stock of Scientific Learning Corporation
| | -------- | ---------------------------------------------------------------------------------------

| | 10.21(9)* | Loan
agreements, promissory notes and pledge agreements with each of Sheryle Bolton, Frank
                  Mattson, Steve Miller, and James Mills
| | --------- | ---------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.22(10) | Stock
Purchase Agreement dated November 9, 2001 between Scientific Learning Corporation and
                  Warburg Pincus Ventures, L.P.
| | --------- | -------------------------------------------------------------------------------------------------------------------------------------------

| | 10.23(12)* | Letter
Agreement dated March 12, 2002 between the Company and Sheryle Bolton.
| | ---------- | -----------------------------------------------------------------------------

| | 10.24(12) | First
Amendment Agreement, dated March 26, 2002, between the Company and Fleet National Bank
                  amending the agreement filed as Exhibit 10.18.
| | --------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.25(12)* | 2002
Management Incentive Plan.
| | ---------- | -------------------------------

| | 10.26(13)* | Employment Agreement dated as of May 31, 2002 by and between Scientific Learning
Corporation                   and Robert C. Bowen
| | ---------- | ----------------------------------------------------------------------------------------------------------------------------------

| | 10.27(14)* | 2002 CEO Option Plan
| | ---------- | --------------------

| | 10.28(15) | Voting Agreement by and among Warburg Pincus Ventures, Carleton Holstrom, the
Holstrom Family                   Partnership, Paula A. Tallal and the Colleen Osborne
1998 Irrevocable Trust
| | --------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 10.29* | Milestone
Equity Incentive Plan
| | ------ | -------------------------------

| | 10.30* | 2003
Management Incentive Plan
| | ------ | ------------------------------

| | 23.1 | Consent
of Ernst & Young, LLP, Independent Auditors
| | ---- | ---------------------------------------------------

|58
|--

| | 99.3 | Certification
of Chief Executive Officer
| | ---- | ----------------------------------------

| | 99.4 | Certification
of Chief Financial Officer
| | ---- | ----------------------------------------

| | (16) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys
                  Registration Statement on Form S-1 (SEC File No. 333-77133).
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (17) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
                  10-K for the year ended December 31, 1999 (SEC File No. 000-24547).
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (18) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
                  8-K on March 12,2001 (SEC File No. 000-24547).
| | ---- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (19) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
                  10-Q for the quarter ended June 30, 2000 (SEC File No. 000-24547).
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (20) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
                  10-Q for the quarter ended June 30,2001 (SEC File No. 000-24547).
| | ---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (21) | Incorporated
by reference to Exhibit 99.1 previously filed with the Companys Form 8-K on March
                  12,2001 (SEC File No. 000-24547).
| | ---- | ---------------------------------------------------------------------------------------------------------------------------------------------------

| | (22) | Incorporated
by reference to Exhibit 99.2 previously filed with the Companys Form 8-K on March
                  12,2001 (SEC File No. 000-24547).
| | ---- | ---------------------------------------------------------------------------------------------------------------------------------------------------

| | (23) | Incorporated
by reference to Exhibit 99.3 previously filed with the Companys Form 8-K on March
                  12,2001 (SEC File No. 000-24547).
| | ---- | ---------------------------------------------------------------------------------------------------------------------------------------------------

| | (24) | Incorporated
by reference to Exhibit 10.20 previously filed with the Companys Form 10-Q for
                  the quarter ended March 31, 2001 (SEC File No. 000-24547).
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (25) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
                  10-Q for the quarter ended September 30, 2001 (SEC File No. 000-24547).
| | ---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (26) | Incorporated
by reference to Exhibit 4.4 previously filed with the Companys Form 8-K on
                  December 7,2001 (SEC File No. 000-24547).
| | ---- | ----------------------------------------------------------------------------------------------------------------------------------------------------

| | (27) | Incorporated
by reference to the same numbered exhibit previously filed with the Companys Form
                  10-K for the year ended December 31, 2001 (SEC File No. 000-24547).
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (28) | Incorporated
by reference to Exhibit 99.1 previously filed with the Companys Form 8-K on June
                  7,2002 (SEC File No. 000-24547).
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------

| | (29) | Incorporated
by reference to Exhibit 99.2 previously filed with the Companys Form 8-K on June
                  7,2002 (SEC File No. 000-24547).
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------

| | (30) | Incorporated
by reference to Exhibit 99.3 previously filed with the Companys Form 8-K on June 7,2002
(SEC File No. 000-24547).
| | ---- | -------------------------------------------------------------------------------------------------------------------------------

| |        Certain
portions of this exhibit have been omitted based upon our request for confidential
treatment for portions of the referenced exhibit.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------

| | *        Management
contract or compensatory plan or arrangement.
| | -----------------------------------------------------------------

|59
|--