On contracts for products not involving significant implementation or customization essential to the product functionality, we recognize license revenue when there is persuasive evidence of an arrangement, the fee is fixed or determinable, collection of the fee is probable and delivery has occurred as prescribed by SOP No. 97-2, "Software Revenue Recognition.".

We assess collection based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. We do not request collateral from our customers. If we determine that collection of a fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon receipt of cash.

For arrangements with multiple elements, we recognize revenue for services and post-contract customer support based upon vendor specific objective evidence ("VSOE") of fair value of the respective elements. VSOE of fair value for the services element is based upon the standard hourly rates we charge for services when such services are sold separately. VSOE of fair value for annual post-contract customer support is established with the optional stated future renewal rates included in the contracts. When contracts contain multiple elements, and VSOE of fair value exists for all undelivered elements, we account for the delivered elements, principally the license portion, based upon the "residual method" as prescribed by SOP No. 98-9, "Modification of SOP No. 97-2 with Respect to Certain Transactions."

In situations in which we are obligated to provide unspecified additional software products in the future, we recognize revenue as a subscription ratably over the term of the commitment period.

For all sales we use either a signed license agreement or a binding purchase order as evidence of an arrangement. Sales through our third party systems integrators are evidenced by a master agreement governing the relationship together with binding purchase orders on a transaction-by-transaction basis. Revenues from reseller arrangements are recognized on the "sell-through" method, when the reseller reports to us the sale of our software products to end-users. Our agreements with customers and resellers do not contain product return rights.

We recognize revenue for post-contract customer support ratably over the support period, generally one year. Our training and consulting services revenues are recognized as such services are performed.

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Restricted cash

At September 30, 2003 and December 31, 2002, we had a balance of $1.5 million in the form of short-term investments, which were restricted from withdrawal.  The balance is classified as long-term restricted cash and serves as a security deposit in a post-contract customer support revenue transaction. At September 30, 2003 and December 31, 2002, we also had an interest bearing certificate of deposit classified as short-term investments and restricted cash which serves as collateral for a $0.4 million letter of credit security deposit for a leased facility.

Stock-based Compensation

We have adopted the disclosure requirements of Statement of Financial Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" during the quarter ended March 31, 2003. SFAS No. 148 amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation and also amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the methods of accounting for stock-based employee compensation and the effect of the method used on reported results. As permitted by SFAS 148 and SFAS 123, we continue to apply the accounting provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." We generally grant stock options at exercise prices equal to the fair market value of the underlying stock on the date of grant and, therefore, under APB Opinion No. 25, no compensation expense is recognized in the statements of operations. Had we recorded compensation expense based on the estimated grant date fair value, as defined by SFAS No. 123, for awards granted under our stock option plans and stock purchase plan, our net loss and loss per share would have been increased to the pro forma amounts below (in thousands, except per share amounts):

Concentrations of credit risk

Financial instruments that potentially subject us to concentrations of credit risk consist of cash, cash equivalents, short-term investments and accounts receivable. To date, we have invested excess funds in money market accounts, commercial paper, municipal bonds and term notes. We deposit cash, cash equivalents and short-term investments with financial institutions that we believe are credit worthy. Our accounts receivable are derived from revenues earned from customers principally located in the Americas and Europe. We perform ongoing credit evaluations of our customers' financial condition and, generally, we do not require collateral from our customers. We maintain reserves for potential credit losses on customer accounts when deemed necessary. 

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The following table summarizes the revenues from customers in excess of 10% of total revenues:

At September 30, 2003, the total amount due to the Company from Royal Bank of Scotland and Canadian Imperial Bank of Commerce accounted for approximately 22% and 10% of accounts receivable, respectively.  At December 31, 2002, the total amount due to the Company from Barclays accounted for approximately 38% of accounts receivable.

Effective January 1, 2003, we adopted SFAS No. 143, "Accounting for Asset Retirement Obligations," and also SFAS No. 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS No. 143 requires that the fair value of an asset retirement obligation be recorded as a liability in the period in which the Company incurs the obligation. SFAS No. 145 requires that certain gains and losses from extinguishment of debt no longer be classified as an extraordinary item. The adoption of these statements did not have a significant impact on our consolidated financial position or results of operations.  

Effective January 1, 2003, we adopted SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 requires that a liability for costs associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. The adoption of this statement did not have a significant impact on our consolidated financial position or results of operations.

Effective January 1, 2003, we adopted SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure." SFAS No. 148 amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS No. 148 amends APB Opinion No. 28, "Interim Financial Reporting," and requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ending after December 15, 2002. The interim disclosure requirements of SFAS No. 148 are effective for interim periods beginning after December 15, 2002 and have been implemented in our financial statements.

In April 2003, the Financial Accounting Standards Board ("FASB") issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities", which amends SFAS No. 133 for certain decisions made by the FASB Derivatives Implementation Group.  In particular, SFAS No. 149 (1) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, (2) clarifies when a derivative contains a financing component, (3) amends the definition of an underlying to conform it to language used in FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, and (4) amends certain other existing pronouncements.  This Statement is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. In addition, most provisions of SFAS No. 149 are to be applied prospectively.  We do not expect the adoption of SFAS No. 149 to have a material impact upon our financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity."  SFAS No. 150 changes the accounting for certain financial instruments that under previous guidance issuers could account for as equity.  It requires that those instruments be classified as liabilities in balance sheets.  The guidance in SFAS No. 150 is generally effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective on July 1, 2003.  We do not expect the adoption of SFAS No. 150 to have a material impact upon our financial position or results of operations.

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In November 2002, the FASB issued FIN 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN 45 elaborates on the existing disclosure requirements for most guarantees, including residual value guarantees issued in conjunction with operating lease agreements. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value of the obligation it assumes under that guarantee and must disclose that information in its interim and annual financial statements. The initial recognition and measurement provisions of this interpretation apply on a prospective basis to guarantees issued or modified after December 31, 2002.  The adoption of FIN 45 did not have a significant impact on our consolidated financial position or results of operations.

In January 2003, the FASB issued FIN 46, "Consolidation of Variable Interest Entities." FIN 46 requires us to consolidate a variable interest entity if we are subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003.  For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003.  We do not currently have any variable interest entities and, accordingly, the adoption of FIN 46 did not have a significant impact on our consolidated financial position or results of operations.  

NOTE 4--BALANCE SHEET COMPONENTS (Unaudited):

The main components of accounts receivable, net are as follows (in thousands):

Unbilled receivables relate to earned service revenues and licenses delivered that have not yet been billed and maintenance services for future periods that have been purchased by our customers, but have not yet been billed.   

The main components of property and equipment, net are as follows (in thousands):

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The main components of accrued expenses are as follows (in thousands):

The components of intangible assets, excluding goodwill, are as follows (in thousands):

All of our acquired intangible assets, excluding goodwill, are subject to amortization and are carried at cost less accumulated amortization. Amortization is computed over the estimated useful lives which are as follows: Developed technologies-one and one half to three years; purchased technologies-three years; tradenames-three years; customer list-three years. Aggregate amortization expense for intangible assets totaled $2.7 million for both the nine months ended September 30, 2003 and 2002, respectively. We expect amortization expense on purchased intangible assets to be $0.9 million for the remaining three months in fiscal 2003, $1.3 million in fiscal 2004 and $0.1 million in fiscal 2005, at which time existing purchased intangible assets will be fully amortized.

NOTE 5--RESTRUCTURING:

Restructuring Costs

During the nine months ended September 30, 2003 and fiscal year 2002, several areas of the Company were restructured to reduce expenses and improve efficiency to achieve cash flow and profitability breakeven in the near future. This restructuring program included a worldwide workforce reduction and consolidation of excess facilities and certain business functions.

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Workforce reduction

The restructuring program resulted in the reduction of 30 regular employees during the nine months ended September 30, 2003 and 108 regular employees during fiscal year 2002. All areas of the Company were affected by this restructuring. We recorded a total workforce reduction expense relating to severance and benefits of approximately $1.0 million and $3.8 million for the nine months ended September 30, 2003 and the year ended December 31, 2002, respectively. 

Consolidation of excess facilities

We accrued for lease costs of $0.2 million and $2.8 million during the nine months ended September 30, 2003 and the year ended December 31, 2002, respectively, pertaining to the estimated future obligations for non-cancelable lease payments for the consolidation of excess facilities relating to lease terminations and non-cancelable lease costs. This expense included estimated sub-lease income based on current comparable rates for leases in the respective markets. If facilities rental rates continue to decrease in these markets or if it takes longer than expected to sublease these facilities, the maximum amount by which the loss could exceed the original estimate is approximately $1.9 million.

A summary of the restructuring expense and other special charges is outlined as follows (in thousands):

Amounts related to net lease expenses due to the consolidation of facilities will be paid over the lease terms through fiscal 2011.  As of September 30, 2003, $3.5 million related to the restructuring reserve remains outstanding and is included in the accrued expenses line item on the balance sheet.  The remaining accrual primarily relates to the termination and/or sublease of our excess facilities and to severance and other benefits for impacted employees. 

NOTE 6--BORROWINGS:

Notes payable

Borrowings consist of several notes payable for equipment leases assumed by Chordiant upon the acquisition of OnDemand, Inc.  Interest rates range from 12.86% to 15.00%.  The notes are due at various times through 2004.  As of September 30, 2003, the total outstanding notes payable balance for equipment leases was approximately $0.2 million.

In February 2003, we entered into a note payable agreement for our Directors' & Officers' ("D&O") insurance policy totaling $1.0 million.  The interest rate is 6% and principal and interest payments on the note payable will be made on a monthly basis through October 2003.  As of September 30, 2003, there was no outstanding note payable balance related to the D&O insurance policy.

Revolving line of credit

Our two-year line of credit with Comerica Bank, effective from March 28, 2003, is comprised of an accounts receivable line and an equipment line.

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Under the line of credit, our assets collateralize borrowings under both elements, require us to maintain a minimum quick ratio of 2.00 to 1.00, a tangible net worth of at least $15.0 million plus 60% of the proceeds of any equity offerings and subordinated debt issuance subsequent to the effective date of this line of credit agreement, and certain other covenants.

Under the terms and conditions of the accounts receivable line, the total amount of the line of credit is $7.5 million. Borrowings under the accounts receivable line of credit will bear interest at the lending bank's prime rate plus 0.5%. Advances are available on a non-formula basis up to $2,000,000 (non-formula portion), however, if outstanding receivables exceed $2,000,000, then all outstanding receivables shall be covered by 80% of Eligible Accounts.

Borrowings under the $2.5 million equipment line bear interest at the lending bank's prime rate plus 1.0%.  In March 2003, we borrowed $2.5 million against the equipment line of credit.  At September 30, 2003, the outstanding line of credit balance was $1.9 million.  At September 30, 2003, we were in compliance with the respective debt covenants.

We have no material commitments for capital expenditures or strategic commitments and we anticipate a low rate of capital expenditures. We may use cash to acquire or license technology, products or businesses related to our current business. In addition, we anticipate that we will experience low growth in our operating expenses for the foreseeable future and that our operating expenses will continue to be a material use of our cash resources.

NOTE 7--LITIGATION: 

Beginning in July 2001, we and certain of our officers and directors, as well as the underwriters of our initial public offering ("IPO") and hundreds of other companies ("Issuers"), individuals and IPO underwriters, were named as defendants in a series of class action shareholder complaints filed in the United States District Court for the Southern District of New York. Those cases are now consolidated under the caption, In re Initial Public Offering Securities Litigation, Case No. 91 MC 92.   In the amended complaint against Chordiant, the plaintiffs allege that Chordiant, certain of our officers and directors and our IPO underwriters violated section 11 of the Securities Act of 1933 based on allegations that Chordiant's registration statement and prospectus failed to disclose material facts regarding the compensation to be received by, and the stock allocation practices of, the IPO underwriters. The complaint also contains a claim for violation of section 10(b) of the Securities Exchange Act of 1934 based on allegations that this omission constituted a deceit on investors. The plaintiffs seek unspecified monetary damages and other relief.  In October 2002, the parties agreed to toll the statute of limitations with respect to Chordiant's officers and directors until September 30, 2003, and on the basis of this agreement, our officers and directors were dismissed from the lawsuit without prejudice. In February 2003, the court issued a decision denying the motion to dismiss the Section 11 claims against Chordiant and almost all of the other company defendants and denying the motion to dismiss the Section 10(b) claims against Chordiant and many of the company defendants. In June 2003, Issuers and Plaintiffs reached a tentative settlement agreement that would, among other things, result in the dismissal with prejudice of all claims against the Issuers and their officers and directors in the IPO Lawsuits. In addition, the tentative settlement guarantees that, in the event that the Plaintiffs recover less than $1 billion in settlement or judgment against the Underwriter defendants in the IPO Lawsuits, the Plaintiffs will be entitled to recover the difference between the actual recovery and $1 billion from the insurers for the Issuers. Although Chordiant has approved this settlement proposal in principle, it remains subject to a number of procedural conditions, as well as formal approval by the Court.  In September 2003, in connection with the possible settlement, those officers and directors who had entered tolling agreements with Plaintiffs (described above) agreed to extend those agreements so that they would not expire prior to any settlement being finalized.

We are also subject to various other claims and legal actions arising in the ordinary course of business.  The ultimate disposition of these various other claims and legal actions is not expected to have a material effect on our business, financial condition or results of operations.

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NOTE 8 --COMMITMENTS AND CONTINGENCIES:

Future payments due under debt and lease obligations as of September 30, 2003 are as follows (in thousands):

We have entered into a two-year agreement, beginning March 19, 2002, with Merit International ("Merit"), pursuant to which Merit will provide exclusive training and certain non-exclusive consulting services for a fixed fee. Upon the effective date of the agreement, we transferred to Merit our training operations including selected employees. In addition, Merit will provide to our customers resource development services in exchange for an agreed-upon fee negotiated on a transaction-by-transaction basis. We believe this agreement will provide us with high quality training and consulting services.  As part of the original agreement, we were required to pay Merit certain minimum revenue amounts and were subject to an early termination fee.  In September 2003, we amended the agreement by extending its effective date through March 2006 and we are no longer required to make minimum revenue payments to Merit or an early termination fee.  As part of the amendment, Merit has agreed to share a portion of Merit-Chordiant monthly consulting revenues with us as follows:  0% revenue share of Merit-Chordiant monthly consulting revenues of (British Pounds) 0 to 157,000; 10% revenue share of Merit-Chordiant monthly consulting revenues exceeding (British Pounds) 157,001 and up to 300,000; and 15% revenue share of Merit-Chordiant monthly consulting revenues exceeding (British Pounds) 300,001.

Indemnifications

As permitted under Delaware law, we have agreements whereby we indemnify our officers, directors and certain employees for certain events or occurrences while the employee, officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is for the officer's or director's lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a Director and Officer insurance policy that limits our exposure and may enable us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. 

We enter into standard indemnification agreements in our ordinary course of business. Pursuant to these agreements, we indemnify, defend, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements as of September 30, 2003.

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We enter into arrangements with our business partners, whereby a business partner agrees to provide services as a subcontractor for our implementations. We may, at our discretion and in the ordinary course of business, subcontract the performance of any of our services. Accordingly, we enter into standard indemnification agreements with our customers, whereby we indemnify them for other acts, such as personal property damage, of our subcontractors. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have general and umbrella insurance policies that may enable us to recover a portion of any amounts paid. We have not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements as of September 30, 2003.

When as part of an acquisition we acquire all of the stock or all of the assets and liabilities of a company, we may assume the liability for certain events or occurrences that took place prior to the date of acquisition. The maximum potential amount of future payments we could be required to make for such obligations is undeterminable at this time. All of these obligations were grandfathered under the provisions of FIN 45 as they were in effect prior to March 31, 2003.  Accordingly, we have no liabilities recorded for these liabilities as of September 30, 2003.

We warrant that our software products will perform in all material respects in accordance with our standard published specifications and documentation in effect at the time of delivery of the licensed products to the customer for a specified period of time. Additionally, we warrant that our maintenance and consulting services will be performed consistent with generally accepted industry standards through completion of the agreed upon services. If necessary, we would provide for the estimated cost of product and service warranties based on specific warranty claims and claim history, however, we have not incurred significant expense under our product or services warranties to date. As a result, we believe the estimated fair value on these warranties is minimal. Accordingly, we have no liabilities recorded for these warranties as of September 30, 2003.

NOTE 9--RELATED PARTY TRANSACTIONS:

During the quarter ended March 31, 2002, two of our executives exercised 285,000 stock options in exchange for notes receivable (the "Notes") of $496,000. The Notes were full-recourse collateralized by the underlying stock. The Notes were due in February and March of 2003 and accrued interest between 6.0% and 6.5% per annum, which was deemed market rates for the individuals. Both notes were paid in full during the quarter ended March 31, 2003. 

Basic and diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of shares of common stock outstanding during the period. The calculation of diluted net loss per share includes potential common stock unless their effect is antidilutive. Potential common stock consist of common shares issuable upon the exercise of stock options (using the treasury stock method) and common shares subject to repurchase by us.

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

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The following table sets forth the potential common shares that are excluded from the calculation of diluted net loss per share as their effect is antidilutive (in thousands):  

The components of comprehensive loss, net of tax, are as follows (in thousands):

For the three and nine months ended September 30, 2003 and 2002, amortized costs of available-for-sale investments approximated their fair values due to their short maturities.  As such, unrealized gains or losses on available-for-sale investments were insignificant for the three and nine months ended September 30, 2003 and 2002.

Based on the information that our chief operating decision maker reviews for assessing performance and allocating resources, we have concluded that we have one reportable segment.

License revenues for enterprise solutions amounted to $5.6 million and $8.0 million for the three months ended September 30, 2003 and 2002, respectively.  License revenues for enterprise solutions amounted to $13.5 million and $21.8 million for the nine months ended September 30, 2003 and 2002, respectively.  License revenues for application products were approximately $1.0 million and $0.6 million for the three months ended September 30, 2003 and 2002, respectively.  License revenues for application products were approximately $3.8 million and $3.9 million for the nine months ended September 30, 2003 and 2002, respectively.

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Service revenues consist of consulting assistance and implementation, customization and integration and post-contract customer support, training and certain reimbursable out-of-pocket expenses.  Service revenues for enterprise solutions were approximately $8.6 million and $6.8 million for the three months ended September 30, 2003 and 2002, respectively.  Service revenues for enterprise solutions were approximately $23.9 million and $22.3 million for the nine months ended September 30, 2003 and 2002, respectively.  Service revenues for application products were approximately $2.5 million and $3.5 million for the three months ended September 30, 2003 and 2002, respectively.  Service revenues for application products were approximately $7.5 million and $8.7 million for the nine months ended September 30, 2003 and 2002, respectively. 

Foreign revenues are based on the country in which the customer is located. The following is a summary of total revenues by geographic area (in thousands):

Property and equipment information is based on the physical location of the assets. The following is a summary of property and equipment, net by geographic area (in thousands):

NOTE 13--SUBSEQUENT EVENT:

On October 21, 2003, Steve Vogel announced he was leaving the company after serving approximately two and a half years as Chief Financial Officer and Senior Vice President of Finance effective immediately after the filing of the Company's quarterly report on Form 10-Q for the three and nine months ended September 30, 2003. Concurrent with this announcement, the company announced the appointment of Michael Shannahan as Senior Vice President of Finance commencing October 27, 2003.  Mr. Shannahan will assume the position of Chief Financial Officer upon Mr. Vogel's departure.

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Overview  

Chordiant Software, Inc. ("Chordiant", "the Company", or "we") is an enterprise software vendor that offers transactional customer software solutions for global companies that seek to improve the quality of customer interactions and to reduce costs through increased employee productivity and process efficiencies. Chordiant concentrates on serving global customers in retail financial services, communications and consumer direct industries.

We deliver a complete customer system that includes software applications and tools and services that enable businesses to successfully integrate their customer information and corporate systems for an accurate, real-time view of their customers across multiple forms of customer interaction.

We believe our system offers great flexibility to businesses to set business policies and processes to control the quality of servicing, fulfillment and marketing to their customers. Our system enables companies to control and change their business policies and process. We believe that we are leaders in providing business process driven solutions for customer management.

Our software architecture is based on the J2EE (Java 2 Enterprise Edition) industry standard that is widely supported by vendors and widely adopted by business customers in the industries we serve. We believe that solutions based on other architectures are less capable of meeting the current and future requirements of global companies.

We believe that the application of accounting standards is as important as a company's reported financial position, results of operations and cash flows. We believe that our accounting policies are prudent and provide a clear view of our financial performance. We have formed a Disclosure Committee, composed of senior financial and legal personnel, to help ensure the completeness and accuracy of our financial results and disclosures. In addition, prior to the release of our financial results, our key management reviews our annual and quarterly results, along with key accounting policies and estimates, with our audit committee, which is composed of independent board members. We do not use off-balance-sheet arrangements with unconsolidated related parties, nor do we use other forms of off-balance-sheet arrangements such as research and development arrangements.

We have completed acquisitions in previous years. As a result of these acquisitions, comparison of prior period revenues and expenses may not be meaningful.  One of our business strategies includes pursuing opportunities to grow our business, both through internal growth and through acquisitions of companies, technology and other assets and could include strategic combinations of the Company and other similarly sized or larger companies.  To implement this strategy, we may be involved in one or more of these types of transactions in the future. 

Service revenues as a percentage of total revenues were 63% and 54% for the three months ended September 30, 2003 and 2002, respectively.  Service revenues as a percentage of total revenues were 65% and 55% for the nine months ended September 30, 2003 and 2002, respectively. 

We sell our products through our direct sales force, and we augment our sales efforts through relationships with systems integrators, application service providers and technology vendors. 

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For the three and nine months ended September 30, 2003 and 2002, revenues were principally derived from customer accounts in the Americas and Europe (principally the United Kingdom). For the three months ended September 30, 2003 and 2002, international revenues were $12.7 million and $9.0 million, or approximately 71% and 48% of our total revenues, respectively.  For the nine months ended September 30, 2003 and 2002, international revenues were $38.5 million and $39.7 million, or approximately 79% and 70% of our total revenues, respectively. We believe international revenues will continue to represent a significant portion of our total revenues in future periods. 

A small number of customers account for a significant portion of our total revenues. As a result, the loss or delay of individual orders or delays in the product implementations for a customer can have a material impact on our revenues. We expect that revenues from a small number of customers will continue to account for a majority of our total revenues in the future as historical implementations are completed and replaced with new projects from new and existing customers. Customer concentration has reduced and we expect that trend to continue.

Pricing pressure during the past year has intensified particularly with application products. Several of our competitors continue to aggressively price their products with large discounts in comparison to our prices. Our strategy is to continue to offer products with functionality that is different and superior to our competitors.

Our international revenue has continued to outpace our United States revenue. We feel this has occurred because our leadership and market presence has been very strong internationally, particularly in the United Kingdom.

We have experienced a lengthening of our customers' contract cycle and have adjusted our forecasting model accordingly.  We expect this trend to continue so long as the economic environment for enterprise software remains weak.

Since our inception, we have incurred substantial research and development costs and have invested heavily in the expansion of our product development, sales, marketing and professional services organizations in order to build an infrastructure to support our long-term growth strategy. The number of our full-time employees decreased from 328 at December 31, 2002, to 282 at September 30, 2003, representing a decrease of approximately 14%.

In April 2003, we implemented a workforce reduction intended to align our cost base with our expected operating performance. The restructuring charge for the nine months ended September 30, 2003 was $1.2 million. The restructuring charge is comprised of severance and associated employee termination costs and accruals for lease costs pertaining to the estimated future obligations for non-cancelable lease payments for additional excess facilities that were vacated due to reductions in workforce. As we continue to monitor our operating expenses and strategize for the future, further expense reductions may become necessary to improve operating performance, including further reductions of our workforce in nonperforming regions or outsourcing to companies located in foreign jurisdictions.

Because the restructuring charge and related benefits are derived from management's estimates, which are based on currently available information, our restructuring may not achieve the benefits currently anticipated or on the timetable or at the level, currently contemplated. In addition, our software license revenues and operating performance may continue to be negatively impacted by: (i) the uncertainty in the information technology industry and associated reductions in capital expenditures; (ii) geopolitical uncertainties; (iii) additional terrorist attacks; (iv) a lack of confidence in corporate governance and accounting practices; (v) the diversity in global economic conditions; (vi) continued intense competition; (vii) business and chief executive officer confidence in the economy; and (viii) other factors described under "Risk Factors" below. Accordingly, additional actions, including a further restructuring of our operations, may be required in the future. As a result, the demand for our products and services and, ultimately, our future financial performance, are difficult to predict with any degree of certainty.

We believe that period-to-period comparisons of our operating results should not be relied upon as indicative of future performance. Our prospects must be considered given the risks, expenses and difficulties frequently encountered by companies in early stages of development, particularly companies in new and rapidly evolving businesses. There can be no assurance we will be successful in addressing these risks and difficulties. Moreover, we may not achieve or maintain profitability in the future.

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Results of Operations

The following table sets forth, as a percentage of total revenues, condensed consolidated statements of operations data for the periods indicated:

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Comparison of the Three Months Ended September 30, 2003 and 2002

Revenues

License. Total license revenues decreased to $6.6 million for the quarter ended September 30, 2003 from $8.6 million, or approximately 23%, for the quarter ended September 30, 2002. License revenues for enterprise solutions decreased to $5.6 million for the quarter ended September 30, 2003 from $8.0 million, or approximately 29%, for the quarter ended September 30, 2002. License revenues for application products increased to $1.0 million for the quarter ended September 30, 2003 from $0.6 million, or approximately 45%, for the quarter ended September 30, 2002. The overall license revenue decrease was primarily due to smaller aggregate dollar sales to new and existing customers for our enterprise solutions.

Service. Total service revenues, including reimbursement of out-of-pocket expenses, increased to $11.1 million for the quarter ended September 30, 2003 from $10.3 million, or approximately 8%, for the quarter ended September 30, 2002. Service revenues for enterprise solutions increased to $8.6 million for the quarter ended September 30, 2003 from $6.8 million, or approximately 28%, for the quarter ended September 30, 2002. Service revenues for application products decreased to $2.5 million for the quarter ended September 30, 2003 from $3.5 million, or approximately 29%, for the quarter ended September 30, 2002. The overall service revenues increase was primarily due to a continuation in large customer implementations as well as maintenance, support and consulting revenues associated with license agreements.

Cost of revenues

License. Cost of license revenues increased to $0.3 million for the quarter ended September 30, 2003 from $0.2 million, or approximately 64%, for the quarter ended September 30, 2002. These costs resulted in license gross margins of approximately 96% and 98% for the quarters ended September 30, 2003 and 2002, respectively.  The cost of license revenues reflects a higher royalty mix in the quarter ended September 30, 2003.  We expect cost of license revenues to remain in the four to six percent range of license revenues.

Service. Cost of service revenues decreased to $6.7 million for the quarter ended September 30, 2003 from $7.1 million, or approximately 5%, for the quarter ended September 30, 2002. These costs resulted in service gross margins of 39% and 31% for the quarters ended September 30, 2003 and 2002, respectively.  Service gross margins improved mainly as the result of combined effects of restructuring actions implemented, increased efficiencies and reduced spending. 

Operating Expenses

Sales and marketing. Sales and marketing expenses decreased to $5.3 million for the quarter ended September 30, 2003 from $7.7 million, or approximately 31%, for the quarter ended September 30, 2002. The decrease in these expenses was mainly attributable to a decrease of $1.8 million in personnel related expenses due to a decrease in headcount and commission expenses, a decrease of $0.3 million in marketing programs and trade shows and a decrease of approximately $0.5 million in office, facilities, depreciation and other related expenses due to restructuring actions implemented.  These decreases are partially offset by an increase of approximately $0.2 million of non-cash compensation expense. 

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Research and development. Research and development expenses decreased to $4.5 million for the quarter ended September 30, 2003 from $5.5 million, or approximately 18%, for the quarter ended September 30, 2002. The decrease in these expenses was mainly attributable to a decrease of $0.8 million in personnel related expenses due to a decrease in headcount and a decrease of approximately $0.4 million in office, facilities and depreciation related expenses due to restructuring actions implemented.  These decreases were partially offset by an increase of $0.2 million of non-cash compensation expense.

Purchased in-process research and development. In-process research and development expense represents technology acquired that on the date of acquisition, the technology had not achieved technological feasibility and there was no alternative future use based on the state of development. Because the product under development may not achieve commercial viability, the amount of acquired in-process research and development was immediately expensed. The nature of the efforts required to develop the purchased in-process research and development into a commercially viable product principally relate to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish that the product can be produced to meet its designed specifications, including functions, features and technical performance requirements. During both the quarters ended September 30, 2003 and 2002, there were no expenses related to purchased in-process research and development. 

General and administrative. General and administrative expenses decreased to $2.1 million for the quarter ended September 30, 2003 from $2.4 million, or approximately 12%, for the quarter ended September 30, 2002.  The decrease in these expenses was mainly attributable to a decrease of $0.7 million in personnel related expenses due to a decrease in headcount, a decrease of $0.1 million in office, facilities and depreciation related expenses due to restructuring actions implemented and a decrease of $0.1 million in professional services and other expenses.   These decreases were partially offset by an increase of approximately $0.5 million of non-cash compensation expense primarily related to vesting of restricted stock. 

Amortization of intangibles. Amortization of intangibles was $0.9 million for the quarter ended September 30, 2003 compared to $1.0 million for the quarter ended September 30, 2002. 

Restructuring expenses.  Restructuring expenses were none and $0.2 million for the three months ended September 30, 2003 and 2002, respectively.  All areas of the Company were affected by the restructuring in the three months ended September 30, 2002 which resulted in the reduction of 19 regular employees.  The restructuring was part of the Company's continued efforts to reduce expenses and improve efficiency to achieve cash flow and profitability breakeven in the near future.

Non-cash compensation expense. We recorded amortization of stock-based compensation expense of $0.2 million for the quarter ended September 30, 2003 compared to $0.4 million for the quarter ended September 30, 2002 in relation to options granted prior to our initial public offering with an exercise price lower than the deemed fair market value of the underlying common stock at the date of issuance.  At September 30, 2003, approximately $0.4 million of stock-based compensation remained to be amortized. 

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On August 23, 2002, we implemented a stock option exchange program (the "Program"). Under the Program, holders of outstanding options with an exercise price of $3.00 or greater per share (the "Eligible Options") were given the choice of retaining these options or canceling the options in exchange for (i) restricted shares of common stock ("Restricted Stock") to be issued as soon as possible after the expiration of the Program period and/or (ii) replacement options issuable six (6) months and one (1) day following the cancellation of the Program at the closing market price on that date. On October 4, 2002, we amended the Program to provide the Chief Executive Officer and Chief Financial Officer of the Company, if they participated in the Program, with a Separate Restricted Stock Agreement (the "CEO and CFO Agreement"), which includes specific vesting provisions based on achieving certain financial performance goals. 11,668,875 options were subject to the Program, which closed on October 9, 2002.

Employees tendered 8,109,640 stock options and received 2,780,967 shares of Restricted Stock pursuant to the Program. In addition, employees tendered 672,948 stock options, which were cancelled and to the extent an employee was still with the Company were replaced six (6) months and one (1) day following expiration of the Program. The tendered stock options represented approximately 59% of our total outstanding stock options as of the expiration date of the Program.

In addition, in October 2002, we issued 3,706,745 shares of Restricted Stock to our employees residing in the United Kingdom, including to our Chief Executive Officer. The Restricted Stock issued to our Chief Executive Officer is subject to the CEO and CFO Agreement.

The Program has been accounted for under the guidance of Emerging Issues Task Force Issue No. 00-23 "Issues Related to the Accounting for Stock Compensation under APB Opinion No. 25" and Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation - an Interpretation of APB Opinion No. 25." Because we offered to cancel existing fixed stock options in exchange for a grant of restricted stock within six months of the cancellation date of the existing options, the Eligible Options became subject to variable accounting treatment at the commencement date of the Program. Variable accounting ceased upon cancellation of the tendered options. A total of 2,886,287 Eligible Options that were not tendered will remain subject to variable accounting. We recorded $6.1 million of unearned stock-based compensation expense based on the fair market value of the Restricted Stock at the date of issuance.  For the quarter ended September 30, 2003, $1.5 million was recorded as stock-based compensation expense. The compensation expense on variable options will be re-measured at the end of each operating period until the options are exercised, forfeited or have expired. Depending upon movements in the market value of our common stock, this accounting treatment may result in significant additional stock-based compensation charges in future periods.

As part of the Program implemented in 2002, we issued 499,068 replacement options at the current market value of $0.88 per share on April 11, 2003 to employees.

The total stock-based compensation expense by operating classification is described as follows (in thousands):

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Other Income (Expense), net, and Interest Expense

Interest and other income, net, consist primarily of interest income generated from our cash, cash equivalents, short-term investments, foreign currency gains and losses and other non-operating income and expenses. Interest expenses are incurred in connection with outstanding borrowings. Other income (expense), net, decreased to none for the quarter ended September 30, 2003 from $0.2 million for the quarter ended September 30, 2002.  The decrease is mainly attributable to a lower return on our investments as a result of declining investment balances and lower interest rates and an asset write-off of disposed property and equipment.

We have not generated taxable income since inception and, as a result, no provision for income taxes was recorded during the periods presented. Our deferred tax assets primarily consist of net operating loss carryforwards, nondeductible allowances and research and development tax credits. We have recorded a valuation allowance for the full amount of our net deferred tax assets, as the future realization of the tax benefit is not considered by management to be more-likely-than-not.

Comparison of the Nine Months Ended September 30, 2003 and 2002

Revenues

License. Total license revenues decreased to $17.3 million for the nine months ended September 30, 2003 from $25.7 million, or approximately 33%, for the nine months ended September 30, 2002. License revenues for enterprise solutions decreased to $13.5 million for the nine months ended September 30, 2003 from $21.8 million, or approximately 38%, for the nine months ended September 30, 2002. License revenues for application products decreased to $3.8 million for the nine months ended September 30, 2003 from $3.9 million, or approximately 5%, for the nine months ended September 30, 2002. The overall license revenue decrease was primarily due to the lack of growth in the number of product implementations and smaller aggregate dollar sales by new and existing customers as they reduced or delayed spending.

Service. Total service revenues, including reimbursement of out-of-pocket expenses, increased to $31.4 million for the nine months ended September 30, 2003 from $31.0 million, or approximately 1%, for the nine months ended September 30, 2002. Service revenues for enterprise solutions increased to $23.9 million for the nine months ended September 30, 2003 from $22.3 million, or approximately 7%, for the nine months ended September 30, 2002. Service revenues for application products decreased to $7.5 million for the nine months ended September 30, 2003 from $8.7 million, or approximately 13%, for the nine months ended September 30, 2002. The overall service revenues increase was primarily due to a continuation in large customer implementations as well as maintenance, support and consulting revenues associated with license agreements.

Cost of revenues

License. Cost of license revenues decreased to $0.8 million for the nine months ended September 30, 2003 from $1.2 million, or approximately 30%, for the nine months ended September 30, 2002. These costs resulted in license gross margins of approximately 95% for both the nine months ended September 30, 2003 and 2002, respectively.  The aggregate cost of license revenues is in line with the decrease in aggregate license revenues.  We expect cost of license revenues to remain in the four to six percent range of license revenues.

Service. Cost of service revenues decreased to $19.5 million for the nine months ended September 30, 2003 from $23.4 million, or approximately 17%, for the nine months ended September 30, 2002. These costs resulted in service gross margins of 38% and 25% for the nine months ended September 30, 2003 and 2002, respectively.  Service gross margins improved mainly as the result of combined effects of restructuring actions implemented, increased efficiencies and reduced spending. 

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Operating Expenses

Sales and marketing. Sales and marketing expenses decreased to $16.7 million for the nine months ended September 30, 2003 from $25.4 million, or approximately 34%, for the nine months ended September 30, 2002. The decrease in these expenses was mainly attributable to a decrease of $6.1 million in personnel related expenses due to a decrease in headcount and commission expenses, a decrease of $2.2 million in marketing programs, trade shows and professional services and a decrease of approximately $1.1 million in office, facilities, depreciation and other related expenses due to restructuring actions implemented.  These decreases are partially offset by an increase of $0.7 million of non-cash compensation expense. 

Research and development. Research and development expenses decreased to $13.4 million for the nine months ended September 30, 2003 from $16.0 million, or approximately 16%, for the nine months ended September 30, 2002. The decrease in these expenses was mainly attributable to a decrease of $2.3 million in personnel related expenses due to a decrease in headcount and bonus expenses and a decrease of approximately $1.1 million in overhead allocations, office, facilities and depreciation related expenses due to restructuring actions implemented.  These decreases are partially offset by an increase of $0.7 million of non-cash compensation expense.

Purchased in-process research and development. In-process research and development expense represents technology acquired that on the date of acquisition, the technology had not achieved technological feasibility and there was no alternative future use based on the state of development. Because the product under development may not achieve commercial viability, the amount of acquired in-process research and development was immediately expensed. The nature of the efforts required to develop the purchased in-process research and development into a commercially viable product principally relate to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish that the product can be produced to meet its designed specifications, including functions, features and technical performance requirements. During the nine months ended September 30, 2003, there were no expenses related to purchased in-process research and development.  Purchased in-process research and development of $1.0 million for the nine months ended September 30, 2002 is related to the OnDemand, Inc. acquisition that was completed on April 1, 2002.

General and administrative. General and administrative expenses decreased to $6.6 million for the nine months ended September 30, 2003 from $6.7 million, or approximately 1%, for the nine months ended September 30, 2002. The decrease in these expenses was mainly attributable to a decrease of $1.2 million in personnel related expenses due to a decrease in headcount, a decrease of $0.1 million in office, facilities and depreciation related expenses due to restructuring actions implemented and a decrease of $0.4 million in professional services and other expenses.  These decreases were partially offset by an increase of $1.4 million of non-cash compensation expense primarily related to vesting of restricted stock and an increase of $0.2 million in state tax related expenses. 

Amortization of intangibles. Amortization of intangibles was $2.7 million for both the nine months ended September 30, 2003 and 2002, respectively.

Restructuring expenses.  During the nine months ended September 30, 2003 and fiscal year 2002, several areas of the Company were restructured to reduce expenses and improve efficiency in order to achieve cash flow and profitability breakeven in the near future. This restructuring program included a worldwide workforce reduction and consolidation of excess facilities and certain business functions.

Workforce reduction

The restructuring program resulted in the reduction of 30 regular employees during the nine months ended September 30, 2003 and 108 regular employees during fiscal year 2002. All areas of the Company were affected by this restructuring. We recorded a total workforce reduction expense relating to severance and benefits of approximately $1.0 million and $3.8 million for the nine months ended September 30, 2003 and the year ended December 31, 2002, respectively. 

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Consolidation of excess facilities

We accrued for lease costs of $0.2 million and $2.8 million during the nine months ended September 30, 2003 and the year ended December 31, 2002, respectively, pertaining to the estimated future obligations for non-cancelable lease payments for the consolidation of excess facilities relating to lease terminations and non-cancelable lease costs. This expense included estimated sub-lease income based on current comparable rates for leases in the respective markets. If facilities rental rates continue to decrease in these markets or if it takes longer than expected to sublease these facilities, the maximum amount by which the loss could exceed the original estimate is approximately $1.9 million.

A summary of the restructuring expense and other special charges is outlined as follows (in thousands):

Amounts related to net lease expenses due to the consolidation of facilities will be paid over the lease terms through fiscal 2011.  As of September 30, 2003, $3.5 million related to the restructuring reserve remains outstanding and is included in the accrued expenses line item on the balance sheet.  The remaining accrual primarily relates to the termination and/or sublease of our excess facilities and to severance and other benefits for impacted employees. 

Non-cash compensation expense. We recorded amortization of stock-based compensation expense of $0.6 million for the nine months ended September 30, 2003 compared to $1.4 million for the nine months ended September 30, 2002 in relation to options granted prior to our initial public offering with an exercise price lower than the deemed fair market value of the underlying common stock at the date of issuance.  At September 30, 2003, approximately $0.4 million of stock-based compensation remained to be amortized. 

On August 23, 2002, we implemented a stock option exchange program (the "Program"). Under the Program, holders of outstanding options with an exercise price of $3.00 or greater per share (the "Eligible Options") were given the choice of retaining these options or canceling the options in exchange for (i) restricted shares of common stock ("Restricted Stock") to be issued as soon as possible after the expiration of the Program period and/or (ii) replacement options issuable six (6) months and one (1) day following the cancellation of the Program at the closing market price on that date. On October 4, 2002, we amended the Program to provide the Chief Executive Officer and Chief Financial Officer of the Company, if they participated in the Program, with a Separate Restricted Stock Agreement (the "CEO and CFO Agreement"), which includes specific vesting provisions based on achieving certain financial performance goals. 11,668,875 options were subject to the Program, which closed on October 9, 2002.

Employees tendered 8,109,640 stock options and received 2,780,967 shares of Restricted Stock pursuant to the Program. In addition, employees tendered 672,948 stock options, which were cancelled and to the extent an employee was still with the Company were replaced six (6) months and one (1) day following expiration of the Program. The tendered stock options represented approximately 59% of our total outstanding stock options as of the expiration date of the Program.

In addition, in October 2002, we issued 3,706,745 shares of Restricted Stock to our employees residing in the United Kingdom, including to our Chief Executive Officer. The Restricted Stock issued to our Chief Executive Officer is subject to the CEO and CFO Agreement.

The Program has been accounted for under the guidance of Emerging Issues Task Force Issue No. 00-23 "Issues Related to the Accounting for Stock Compensation under APB Opinion No. 25" and Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation - an Interpretation of APB Opinion No. 25." Because we offered to cancel existing fixed stock options in exchange for a grant of restricted stock within six months of the cancellation date of the existing options, the Eligible Options became subject to variable accounting treatment at the commencement date of the Program. Variable accounting ceased upon cancellation of the tendered options. A total of 2,886,287 Eligible Options that were not tendered will remain subject to variable accounting. We recorded $6.1 million of unearned stock-based compensation expense based on the fair market value of the Restricted Stock at the date of issuance.  For the nine months ended September 30, 2003, $4.4 million was recorded as stock-based compensation expense. The compensation expense on variable options will be re-measured at the end of each operating period until the options are exercised, forfeited or have expired. Depending upon movements in the market value of our common stock, this accounting treatment may result in significant additional stock-based compensation charges in future periods.

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As part of the Program implemented in 2002, we issued 499,068 replacement options at the current market value of $0.88 per share on April 11, 2003 to employees.

The total stock-based compensation expense by operating classification is described as follows (in thousands):