Scientific Learning (SCIL) 10-Q/A 2004 Q2 Quarterly report (amended)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q/A

Amendment No. 1

þ	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended June 30, 2004
	OR
o	TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from ___to ___

Commission File number # 000-24547

Scientific Learning Corporation

(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of
incorporation or organization) 94-323445
(I.R.S. Employer Identification No.)

300 Frank H. Ogawa Plaza, Suite 600
Oakland, California 94612
(510) 444-3500
(Address of Registrants principal executive offices, including zip code, and
telephone number, including area code)

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. Yesþ Noo

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ

The number of shares of the Registrant’s Common Stock, $.001 par value per share, outstanding at July 31, 2004 was 16,604,510.

EXPLANATORY NOTE

This Amendment No. 1 on Form 10-Q/A amends our Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, filed on August 16, 2004 (the “Original Form 10-Q”) to reflect the restatement of our balance sheets as of December 31, 2003 and June 30, 2004 and our statements of operations and cash flow for the interim periods ended June 30, 2003 and 2004. The restatement of these financial statements principally relates to a correction in our method of revenue recognition for most of our K-12 school contracts. This correction has resulted in changes to our previously reported revenues in all periods reported in this Form 10-Q/A through June 30, 2004 and to deferred revenues as of December 31, 2003. This correction is more fully described in Note 3 to the Condensed Financial Statements.

We have amended and restated in its entirety each item of the Original Form 10-Q that has been changed to reflect the restatement. These include Part I, Item 1 – Condensed Financial Statements, Item 2 – Management’s Discussion and Analysis, and Item 4 — Controls and Procedures.

Except as stated above, this Report speaks only as of the date of the Original Form 10-Q. Except as specified above, this filing does not reflect any events occurring after August 16, 2004.

The unaudited financial statements contained in this Form 10-Q have been prepared on the basis of all information of which we are presently aware. We believe that the unaudited financial statements 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 report.

Page 2

SCIENTIFIC LEARNING CORPORATION

INDEX TO FORM 10-Q
FOR THE QUARTER ENDED June 30, 2004

		PAGE
PART 1. FINANCIAL INFORMATION
Item 1.	Condensed Financial Statements:
	Condensed Balance Sheets as of June 30, 2004 and December 31, 2003.	4
	Condensed Statement of Operations for the Three and Six Months Ended June 30, 2004 and 2003.	5
	Condensed Statements of Cash Flows for the Six Months Ended June 30, 2004 and 2003.	6
	Notes to Condensed Financial Statements.	7
Item 2.	Management’s Discussion and Analysis of Financial Condition And Results of Operations.	18
Item 4.	Controls and Procedures.	27
PART II. OTHER INFORMATION
Item 6.	Exhibits and Reports on Form 8-K.	28
	Signature.	29

Exhibit 31.1

Exhibit 31.2

Exhibit 32.1

Exhibit 32.2

Page 3

PART I. FINANCIAL INFORMATION

Item 1. Condensed Financial Statements

SCIENTIFIC LEARNING CORPORATION

CONDENSED BALANCE SHEETS

(In thousands)
Unaudited

	June 30,			December 31,
	2004			2003
	(Restated)			(Restated)
Assets
Current assets:
Cash and cash equivalents	$	4,438		$	3,648
Accounts receivable, net		15,760			5,117
Prepaid expenses and other current assets		955			1,144
Total current assets		21,153			9,909
Property and equipment, net		685			537
Notes receivable from current and former officers		3,114			3,114
Other assets		1,940			2,037
Total assets	$	26,892		$	15,597
Liabilities and stockholders’ deficit
Current liabilities:
Accounts payable	$	661		$	481
Accrued liabilities		3,406			3,875
Borrowings under bank line of credit		3,000			—
Deferred revenue		15,548			16,884
Total current liabilities		22,615			21,240
Deferred revenue, long-term		11,990			2,616
Other liabilities		306			285
Total liabilities		34,911			24,141
Stockholders’ deficit:
Common stock		75,326			74,460
Accumulated deficit		(83,345	)		(83,004	)
Total stockholders’ deficit		(8,019	)		(8,544	)
Total liabilities and stockholders’ deficit	$	26,892		$	15,597

See accompanying notes to condensed financial statements.

Page 4

SCIENTIFIC LEARNING CORPORATION

CONDENSED STATEMENT OF OPERATIONS

(In thousands, except share and per share amounts)
Unaudited

	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
	(Restated)			(Restated)			(Restated)			(Restated)
Revenues:
Products	$	5,617		$	6,882		$	10,878		$	12,455
Service and support		1,880			1,192			3,656			2,202
Total revenues		7,497			8,074			14,534			14,657
Cost of revenues:
Cost of products		492			605			831			1,101
Cost of service and support		1,202			839			2,422			1,768
Total cost of revenues		1,694			1,444			3,253			2,869
Gross profit		5,803			6,630			11,281			11,788
Operating expenses:
Sales and marketing		3,754			3,344			7,581			6,626
Research and development		820			935			1,705			1,844
General and administrative		1,212			1,284			2,223			2,396
Total operating expenses		5,786			5,563			11,509			10,866
Operating income (loss)		17			1,067			(228	)		922
Other income from related party		28			—			63			—
Interest expense , net		(97	)		(316	)		(176	)		(625	)
Net income (loss) before income taxes	$	(52	)	$	751		$	(341	)	$	297
Provision for income taxes					6						6
Net income (loss)	$	(52	)	$	745		$	(341	)	$	291
Basic net income (loss) per share:	$	(0.00	)	$	0.05		$	(0.02	)	$	0.02
Shares used in computing basic net income (loss)		16,213,427			16,004,911			16,183,542			15,942,365
Diluted net income per share:				$	0.04					$	0.02
Shares used in computing diluted net income					16,851,181						16,639,960

See accompanying notes to condensed financial statements.

Page 5

\

SCIENTIFIC LEARNING CORPORATION

CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)
Unaudited

	Six months ended June 30,
	2004			2003
	(Restated)			(Restated)
Operating Activities:
Net income (loss)	$	(341	)	$	291
Adjustments to reconcile net income (loss) to cash used in operating activities:
Depreciation and amortization		381			707
Amortization of deferred financing costs		199			608
Stock based compensation		103			144
Changes in operating assets and liabilities:
Accounts receivable		(10,643	)		(1,653	)
Prepaid expenses and other current assets		(10	)		552
Accounts payable		180			132
Accrued liabilities		(469	)		(988	)
Deferred revenue		8,038			(121	)
Other liabilities		21			105
Net cash used in operating activities		(2,541	)		(223	)
Investing Activities:
Purchases of property and equipment, net		(355	)		(102	)
Other non-current assets		(77	)		(76	)
Net cash used in investing activities		(432	)		(178	)
Financing Activities:
Proceeds from issuance of common stock		763			194
Borrowings under bank line of credit		3,000			2,000
Repayments on borrowings under bank line of credit		—			(2,000	)
Net cash provided by financing activities		3,763			194
Increase (decrease) in cash and cash equivalents		790			(207	)
Cash and cash equivalents at beginning of the period		3,648			4,613
Cash and cash equivalents at end of the period	$	4,438		$	4,406
Supplemental disclosure:
Interest Paid	$	29		$	84

See accompanying notes to condensed financial statements.

Page 6

Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies

Description of Business

Scientific Learning Corporation (the “Company”) is the leading provider of neuroscience-based software products that develop underlying cognitive skills required for reading and learning. The Company’s Fast ForWord^® products are a series of reading intervention products for children, adolescents and adults. We sell primarily to K-12 schools through a direct sales force. The Company also sells to speech and language professionals. To support our products, we provide on-site and remote training and implementation services, as well as technical, professional and customer support and a wide variety of Web-based resources.

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.

Interim Financial Information

The interim financial information as of June 30, 2004 and for the three and six months ended June 30, 2004 and 2003 is unaudited, but includes all normal recurring adjustments that the Company considers necessary for a fair presentation of its financial position at such date and its results of operations and cash flows for those periods.

These condensed financial statements and notes should be read in conjunction with the Company’s audited financial statements and notes thereto, together with management’s discussion and analysis of financial condition and results of operations, contained in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2003.

Revenue Recognition

We derive revenue from the sale of licenses to our software and from service and support fees. Software license revenue is recognized in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9 (SOP 97-2). SOP 97-2 provides specific industry guidance and four basic criteria, which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement; 2) delivery of the product; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected.

Sales to our school customers typically include multiple elements (e.g. Fast ForWord software licenses, Progress Tracker, our Internet-based participant tracking service, support, training, implementation management, and other services). The Company allocates revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor specific objective evidence” (“VSOE”). VSOE of fair value for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for support services, is also measured by the renewal price.

The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized. Deferred revenue is recognized as revenue as discussed below.

Revenue from the licensing of software is recognized as follows: 1) for licenses purchased with Progress Tracker, because the Company has not established VSOE for Progress Tracker, revenue is recognized ratably over the contractual life of the longest undelivered element, typically support and the period of Progress Tracker access, 2) for individual participant licenses, revenue is recognized over the average duration of the product’s use, typically 6 weeks; 3) for perpetual licenses that are not purchased with Internet-based services, revenue is recognized at the

Page 7

Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

later of product shipment or the contract start date, provided that the other criteria stated above are met, and 4) for term licenses revenue is recognized ratably over the license term.

Service and support revenue is derived from a combination of on-site and remote training, implementation, technical and professional services and customer support. Revenue from services sold with license arrangements that include Progress Tracker is recognized ratably over the contractual term of the longest undelivered element purchased, typically support. Revenue from services sold with license arrangements that do not include Progress Tracker, sold alone, or sold only with support is recognized as delivered. Revenue from support is recognized over the contractual support period.

Other Assets

Other assets consist of the following (in thousands):

	2004			2003
Software development costs	$	3,089		$	3,089
Less accumulated amortization		(2,520	)		(2,346	)
Software development costs, net		569			743
Other non current assets		1,371			1,294
	$	1,940		$	2,037

Accrued restructuring costs

In October 2003 the Company entered into an agreement with its landlord to terminate the lease for its Oakland headquarters and commence a new lease agreement for a reduced amount of space in the same building. This reduction in space is expected to decrease total lease payments by approximately $6.5 million (net of lease termination fees described below) through 2008. Under these agreements the Company paid an increased security deposit of $550,000 and lease termination fees totaling $1,370,000 through June 30, 2004. The balance of the lease termination fee, $880,000 will be paid in equal monthly installments through December 31, 2004. The term of the new lease agreement expires December 31, 2013.

The following table sets forth the restructuring activity during the quarter ended June 30, 2004
(in thousands):

	Accrued restructuring					Accrued
	costs, beginning of					restructuring costs,
	the period		Cash paid			end of the period
Lease obligations	$	1,328		(440	)	$	888

Net Income Per Share

Basic net income per share is computed using the weighted average number of common shares outstanding during the period. Dilutive net income per share is computed using the weighted average number of common shares outstanding during the period and, when dilutive, includes potential common shares from options and warrants calculated using the treasury stock method.

Page 8

Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

Stock-Based Compensation

The Company has elected to use the intrinsic value method in accounting for its employee stock options because 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.

Had compensation cost for the Company’s stock-based compensation plans been determined using the fair value at the grant dates for awards under those plans calculated using the Black-Scholes valuation model, the Company’s pro forma net income (loss) and basic and diluted net income (loss) per share would have been as follows:

(in thousands, except per share amounts):

	Three months ended June 30,					Six months ended June 30,
	2004			2003		2004			2003
	Restated			Restated		Restated			Restated
Net income (loss), as reported	$	(52	)	$	745	$	(341	)	$	291
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards		454			354		775			712
Net income (loss), proforma	$	(506	)	$	391	$	(1,116	)	$	(421	)
Net income (loss) per share:
Basic, as reported	$	—		$	0.05	$	(0.02	)	$	0.02
Diluted, as reported	$	—		$	0.04	$	(0.02	)	$	0.02
Basic, pro forma	$	(0.03	)	$	0.02	$	(0.07	)	$	(0.03	)
Diluted, pro forma				$	0.02

The fair value of the options was estimated using the following assumptions: a risk free interest rate of 3%, no dividend yield, a volatility factor of 85% and a weighted average expected life of the options of five years.

The pro forma impact of options on the net income for the three and six months ended June 30, 2004 and 2003 is not representative of the effects on net income for future periods, as future years will include the effects of additional periods of stock option grants.

2. Comprehensive Income

The Company has no items of other comprehensive income, and accordingly the comprehensive income is equal to the net income for all periods reported.

Page 9

Notes to Condensed Financial Statements

3. Restatement

The Company’s previously reported balance sheets at December 31, 2003 and June 30, 2004 and the statements of operations and cash flow for the three and six months ended June 30, 2004 and 2003 have been restated to correct the Company’s method of accounting for the recognition of revenue from most of its K-12 school contracts.

The restatement of revenue resulted from a re-evaluation of our treatment of multiple-element sales from fiscal 2000 onwards.

Perpetual licenses sold requiring Internet access to function:

The Company had historically recognized revenues from services and shrink wrapped product as delivered. Upon review, as the perpetual licenses required Internet access and since VSOE did not exist for the Internet access service, all of the revenue under these arrangements should have been recognized ratably over the longest contractual term stated in the arrangement, in accordance with paragraphs 12 and 58(a) of SOP 97-2.

Perpetual licenses sold after July 2003 bundled with services and the Company’s Internet reporting application (Progress Tracker):

The Company had historically recognized revenue associated with the perpetual software license ratably over a one year period irrespective of whether or not the Progress Tracker arrangement was for a one year period or longer. Services and shrink wrapped product revenues were recorded as delivered. As there was no VSOE for Progress Tracker, all revenue, including services and shrink wrapped product should have been recognized ratably over the longest contractual period stated in the arrangement (generally the Progress Tracker period that ranges between 1 and 5 years).

Term-based licenses sold with other elements:

Term-based licenses and associated maintenance had been appropriately recorded over the contractual terms. However, the Company had historically recognized the revenue associated with the services and shrink-wrapped product included in these arrangements as these services and products were delivered. Since the Company did not have VSOE for the PCS element in these term arrangements (as it is never sold separately), the revenue for the services and shrink wrapped product should have also been recognized ratably over the contractual license terms in accordance with paragraph 12 of SOP 97-2 because VSOE did not exist to allow the allocation of revenue to the various elements included in the arrangement.

As a result of the restatement of the timing of revenue recognition for these matters the Company has also restated the timing of certain direct costs of products including royalties and the timing of capitalized software amortization, commission expense and income tax provisions.

The following tables summarize the changes to the balance sheets at December 31, 2003 and June 30, 2004 and the statements of operations for the three and six months ended June 30, 2004 and 2003.

Page 10

SCIENTIFIC LEARNING CORPORATION
BALANCE SHEET

(In thousands, except share and per share amounts)

	December 31,					December 31,
	2003					2003
	As reported			Adjustments		Restated
Assets
Current assets:
Cash and cash equivalents	$	3,648				$	3,648
Accounts receivable, net of allowance for doubtful accounts		5,117					5,117
$139 at December 31, 2003
Prepaid expenses and other current assets		1,134			10		1,144
Total current assets		9,899					9,909
Property and equipment, net		537					537
Notes receivable from current and former officers		3,114					3,114
Other assets		2,004			33		2,037
Total assets	$	15,554				$	15,597
Liabilities and stockholders’ deficit
Current liabilities:
Accounts payable	$	481				$	481
Accrued liabilities		3,832			43		3,875
Deferred revenue		16,233			651		16,884
Total current liabilities		20,546					21,240
Borrowings under bank line of credit		—
Deferred revenue, long-term		1,289			1,327		2,616
Other liabilities		285					285
Total liabilities		22,120					24,141
Commitments
Stockholders’ deficit:
Preferred stock, $0.001 par value; 1,000,000 shares authorized, no shares issued or outstanding		—					—
Common stock, $0.001 par value; 40,000,000 shares authorized, 16,150,551 shares issued and outstanding at December 31, 2003		74,460					74,460
Accumulated deficit		(81,026)			(1,978)		(83,004	)
Stockholders’ deficit:		(6,566	)				(8,544	)
Total liabilities and stockholders’ deficit	$	15,554				$	15,597

Page 11

SCIENTIFIC LEARNING CORPORATION
BALANCE SHEET
(In thousands, except share and per share amounts)
Unaudited

	June 30,					June 30,
	2004					2004
	As Reported			Adjustments		Restated
Assets
Current assets:
Cash and cash equivalents	$	4,438				$	4,438
Accounts receivable, net of allowance for doubtful accounts		15,760					15,760
Prepaid expenses and other current assets		922			33		955
Total current assets		21,120					21,153
Property and equipment, net		685					685
Notes receivable from officers		3,114					3,114
Other assets		1,939			1		1,940
Total assets	$	26,858				$	26,892
Liabilities and stockholders’ deficit
Current liabilities:
Accounts payable	$	661				$	661
Accrued liabilities		3,308			98		3,406
Borrowings under line of credit		3,000					3,000
Deferred revenue		22,826			(7,278)		15,548
Total current liabilities		29,795					22,615
Deferred revenue, long-term		2,267			9,723		11,990
Other liabilities		306					306
Total liabilities		32,368					34,911
Commitments
Stockholders’ deficit:
Common stock		75,326					75,326
Accumulated deficit		(80,836	)		(2,509)		(83,345	)
Stockholders’ deficit:		(5,510	)				(8,019	)
Total liabilities and stockholders’ deficit	$	26,858				$	26,892

Page 12

SCIENTIFIC LEARNING CORPORATION
STATEMENT OF OPERATIONS
(In thousands, except share and per share amounts)
Unaudited

	Three months					Three months
	ended					ended
	June 30, 2003					June 30, 2003
	As reported			Adjustments		Restated
Revenues:
Products	$	6,217			665	$	6,882
Service and support		1,140			52		1,192
Total revenues		7,357					8,074
Cost of revenues:
Cost of products		674			(69)		605
Cost of service and support		837			2		839
Total cost of revenues		1,511					1,444
Gross profit		5,846					6,630
Operating expenses:
Sales and marketing		3,367			(23)		3,344
Research and development		935					935
General and administrative		1,284					1,284
Total operating expenses		5,586					5,563
Operating income		260					1,067
Interest expense, net		(316	)				(316	)
Net income (loss) before income tax provision		(56	)				751
Income tax provision		—			6		6
Net income (loss)		(56	)				745
Basic net income (loss) per share:	$	(0.00	)			$	0.05
Shares used in computing basic net income (loss) per share		16,004,911					16,004,911
Diluted net income per share:						$	0.04
Shares used in computing diluted net income (loss) per share							16,851,181

Page 13

SCIENTIFIC LEARNING CORPORATION
STATEMENT OF OPERATIONS
(In thousands, except share and per share amounts)
Unaudited

	Six months					Six months
	ended					ended
	June 30, 2003					June 30, 2003
	As reported			Adjustments		Restated
Revenues:
Products	$	11,548			907	$	12,455
Service and support		2,186			16		2,202
Total revenues		13,734					14,657
Cost of revenues:
Cost of products		1,128			(27)		1,101
Cost of service and support		1,766			2		1,768
Total cost of revenues		2,894					2,869
Gross profit		10,840					11,788
Operating expenses:
Sales and marketing		6,640			(14)		6,626
Research and development		1,844					1,844
General and administrative		2,396					2,396
Restructuring charges		—					—
Total operating expenses		10,880					10,866
Operating income (loss)		(40	)				922
Interest expense , net		(625	)				(625	)
Net income (loss) before income tax provision		(665	)				297
Income tax provision		—			6		6
Net income (loss)	$	(665	)			$	291
Basic net income (loss) per share:	$	(0.04	)			$	0.02
Shares used in computing basic net income (loss) per share		15,942,365					15,942,365
Diluted net income per share:						$	0.02
Shares used in computing diluted net income							16,369,960

Page 14

SCIENTIFIC LEARNING CORPORATION
STATEMENT OF OPERATIONS
(In thousands, except share and per share amounts)
Unaudited

	Three months					Three months
	ended					ended
	June 30, 2004					June 30, 2004
	As reported			Adjustments		Restated
Revenues:
Products	$	6,014			(397)	$	5,617
Service and support		1,809			71		1,880
Total revenues		7,823					7,497
Cost of revenues:
Cost of products		465			27		492
Cost of service and support		1,201			1		1,202
Total cost of revenues		1,666					1,694
Gross profit		6,157					5,803
Operating expenses:
Sales and marketing		3,699			55		3,754
Research and development		820					820
General and administrative		1,212					1,212
Total operating expenses		5,731					5,786
Operating income		426					17
Other income from related party		28					28
Interest expense, net		(97	)				(97	)
Net income before income tax provision		357					(52	)
Income tax provision		4			(4)		—
Net income (loss)	$	353				$	(52	)
Basic net income (loss) per share:	$	0.02				$	(0.00	)
Shares used in computing basic net income per share		16,213,427					16,213,427
Diluted net income per share:	$	0.02
Shares used in computing diluted net income		17,392,637

Page 15

SCIENTIFIC LEARNING CORPORATION
STATEMENT OF OPERATIONS
(In thousands, except share and per share amounts)
Unaudited

	Six months					Six months
	ended					ended
	June 30, 2004					June 30, 2004
	As reported			Adjustments		Restated
Revenues:
Products	$	11,327			(449)	$	10,878
Service and support		3,637			19		3,656
Total revenues		14,964					14,534
Cost of revenues:
Cost of products		787			44		831
Cost of service and support		2,420			2		2,422
Total cost of revenues		3,207					3,253
Gross profit		11,757					11,281
Operating expenses:
Sales and marketing		7,522			59		7,581
Research and development		1,705					1,705
General and administrative		2,223					2,223
Total operating expenses		11,450					11,509
Operating income (loss)		307					(228	)
Other income from related party		63					63
Interest expense , net		(176	)				(176	)
Net income (loss) before income tax provision		194					(341	)
Income tax provision		4			(4)		—
Net income (loss)	$	190				$	(341	)
Basic net income per share:	$	0.01				$	(0.02	)
Shares used in computing basic net income per share		16,183,542					16,183,542
Diluted net income per share:	$	0.01
Shares used in computing diluted net income		17,401,778

Page 16

Notes to Condensed Financial Statements

4. Guarantees

The Company generally provides a warranty for its software products to its customers and accounts for its warranties under the FASB’s Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (FAS No.5) under which estimated losses are recorded if it is probable a liability has been incurred and the amount of the loss can be reasonably estimated. Warranty periods can vary from customer to customer but our standard warranty period is 90 days. In the event there is a failure of the product in breach of such warranties, the Company generally is obligated to correct the product or service to conform to the warranty provision or, if the Company is unable to do so, the customer is entitled to seek a refund of the purchase price of the product. The Company did not provide for a warranty accrual as of June 30, 2004. To date, the Company’s product warranty expense has not been significant.

5. Related Party Transaction

In September 2003 the Company entered into an agreement with Neuroscience Solutions Corporation (“NSC”) to provide NSC with exclusive rights in the healthcare field to certain intellectual property owned or licensed by the Company, along with transfer of certain healthcare research projects. A co-founder, substantial shareholder, and member of the Board of Directors of the Company is a co-founder, officer, director and substantial shareholder of NSC.

For the three and six months ended June 30, 2004 the Company recognized $28,000 and $63,000, respectively, in other income for service provided to NSC and royalties for product licenses.

6. Subsequent Events

We have a line of credit with Comerica Bank totaling $5.0 million, which expires on July 14, 2005. The facility initially totaled $7.0 million and was partially secured by a letter of credit provided by WPV, Inc., an affiliate of Warburg, Pincus Ventures, our largest stockholder. The letter of credit was for $4.0 million through May 30, 2004 and $3.0 million from May 31, 2004 to July 30, 2004. The WPV letter of credit expired on July 30, 2004. The line is subject to limitations based on our accounts receivable balance. Borrowings under the line are subject to various covenants, which may limit our financial and operating flexibility. The need to restate our historical financial statements constitutes an event of default under our agreement with Comerica. This event of default entitles Comerica to decline to advance additional funds under the line.

Page 17

Item 2. Management’s Discussion and Analysis of Financial Conditions and Results of Operations

This report 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. Forward-looking statements are not historical facts but rather are based on current expectations about our business and industry, as well as our beliefs and assumptions. Words such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue” and variations and negatives of these words and similar expressions are used to identify forward-looking statements. All forward-looking statements, including but not limited to those identified with asterisks (*) in this report are not guarantees of future performance or events, and are subject to risks, uncertainties and other factors, many of which are beyond our control and some of which we may not even be presently aware. As a result, our future results and other future events or trends may differ materially from those anticipated in our forward-looking statements. Specific factors that might cause such a difference include, but are not limited to, the risks and uncertainties discussed in this Management’s Discussion, in particular but not limited to those factors discussed under the caption “Factors That May Affect our Results or Stock Price.” We also refer you to the risk factors 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. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our view only as of the date of this report. 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.

Overview

We develop and distribute the Fast ForWord^® family of reading intervention software. Our innovative products apply advances in neuroscience and cognitive research to build the fundamental cognitive skills required to read and learn. Extensive outcomes research by independent researchers, our founding scientists, and our company demonstrates that the Fast ForWord products help students attain rapid, lasting gains in the skills critical for reading. To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support. Our primary market is K-12 schools in the United States, to which we sell using a direct sales force. For the three and six months ended June 30, 2004, K-12 schools accounted for 93% and 92% of booked sales, respectively. By the end of June 2004, approximately 2,800 schools had purchased at least $10,000 of our Fast ForWord product licenses and services, and approximately 380,000 individuals had enrolled in one of our products. As of June 30, 2004 we had 139 full-time employees, compared to 126 at June 30, 2003.

Restatement

The Company’s previously reported balance sheets as of December 31, 2003 and June 30, 2004 and the statements of operations and cash flow for the interim periods ended June 30, 2004 and 2003, have been restated to correct its accounting for the recognition of revenue from certain customer contracts. This restatement is described in more detail in Note 3 to Condensed Financial Statements above.

The correction relates to periods from fiscal 2000 through June 30, 2004. The main impact of the correction of the error in recognizing revenue is to defer to later periods a portion of the revenue that had been previously recognized. The primary impact on the balance sheets is to increase deferred revenue. In the statement of operations, the principal impact of the change in the three and six months ending June 30, 2004 was to decrease revenue and modestly increase cost of goods and sales commissions. For the three and six months ending June 30, 2003 the impact of the adjustment was an increase to revenue and modest decreases in cost of goods and sales commissions. In all cases, the income tax provision was adjusted to reflect the restated results.

Business Highlights

For the three months ended June 30, 2004, our revenue declined 7% compared to the same period in 2003; for the six months ended June 30, 2004, revenue declined 1% compared to the same period in 2003. This reflected a substantial increase in service and support revenues in both periods, more than offset by a decline in product revenues, which constitute the bulk of our revenues.

Page 18

For the three months ended June 30, 2004 our total booked sales increased by 64% over the same period in 2003, and for the six months ended June 30, 2004 total booked sales increased 55% over the same period in 2003. (For more explanation on booked sales, seeRevenue, below). During the 2004 second quarter, we closed a major contract with the School District of Philadelphia, with a total contract price of $10.4 million, of which $6.0 million was recorded as booked sales. The remainder of the contract’s value represents future years of services and support, and is scheduled to be booked over the next four calendar years.*

For both the three and six months ended June 30, 2004, gross margins decreased, reflecting our revenue mix shift towards lower-margin service and support, partially offset by improvement in both product and service and support margins compared to 2003 periods.

Operating expenses were higher in the three and six months ended June 30, 2004 compared to the same periods in 2003 mainly due to staff additions and consultants.

We recorded a loss for the three and six months ended June 30, 2004 compared to a profit for the comparable periods in 2003 due to lower gross profit and higher spending.

At June 30, 2004 we had $3 million outstanding against our credit line. The $3.0 million credit line outstanding at June 30, 2004 was repaid during July 2004. On December 31, 2003, we had no outstanding borrowings under the credit line.

Results of Operations

Revenues

	Three months ended June 30					Six months ended June 30
(dollars in thousands)	2004		Change	2003		2004		Change	2003
	Restated			Restated		Restated			Restated
Products	$	5,617	-18%	$	6,882	$	10,878	-13%	$	12,455
Service and support	$	1,880	58%	$	1,192	$	3,656	66%	$	2,202
Total revenues	$	7,497	-7%	$	8,074	$	14,534	-1%	$	14,657

Revenues:

Product revenues, which comprise the bulk of our revenue, declined during the three and six months ended June 30, 2004 compared to the same periods in 2003. The decline in product revenue primarily reflected three factors. First, our product mix has shifted, so that a greater proportion of revenue in the 2004 quarter is from products with longer revenue recognition period. In particular, a higher proportion of licenses included Progress Tracker, our online monitoring and diagnostic system. We expect that trend to continue into the future.* Second, as we described at year end, sales were slower than expected in the fourth quarter of 2003. Because we recognize most revenue in periods following the quarter of the sale, we expect that the sales miss in the 2003 fourth quarter will affect revenue throughout 2004*. Finally, an increase in larger transactions and promotions has resulted in greater volume discounts. In general, we do not discount service or support prices, which has resulted in a smaller proportion of revenue being allocated to products.

Our service and support revenue increased substantially during the three and six months ended June 30, 2004, compared to the same periods in 2003. Because we believe that services are important to effective product use, we have had a major initiative to increase the amount of services we sell to customers. Support revenue is growing due to an increased number of customers on support contracts.

Booked sales and selling activity: Because a significant portion of our software, services and support revenue is recognized in periods after the invoice date, management uses booked sales to evaluate current selling activity. Booked sales is a non-GAAP financial measure that we believe is useful for investors as well as management as a measure of current demand for our products and services. Booked sales equals the total value (net of allowances) of software, services and support invoiced in the period. We record booked sales and deferred revenue when all of the

Page 19

requirements for revenue recognition have been met, other than the requirement that the revenue for software licenses and services has been earned. We use booked sales information for resource allocation, planning, compensation and other management purposes. We believe that revenue is the most comparable GAAP measure to booked sales. However, booked sales should not be considered in isolation from revenues, and is not intended to represent a substitute measure of revenues or any other performance measure calculated under GAAP.

The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue for the three and six months ended June 30, 2004 and 2003.

	Three months ended June 30							Six months ended June 30
(dollars in thousands)	2004		Change			2003		2004		Change			2003
Booked sales	$	18,181		64	%	$	11,067	$	22,572		55	%	$	14,536
Less revenue	$	7,497		-7	%	$	8,074	$	14,534		-1	%	$	14,657
Net increase in deferred revenue	$	10,684				$	2,993	$	8,038				$	(121	)
Current and long-term deferred revenue beginning of the period	$	16,854				$	15,598	$	19,500				$	18,712
Current and long-term deferred revenue end of the period	$	27,538		48	%	$	18,591	$	27,538		48	%	$	18,591

Booked sales in the K-12 sector, which accounted for 92% of booked sales in the second quarter of 2004, grew 70% to $16.7 million, compared to $9.8 million in the same period in 2003, due to several large transactions, including our major sale to the School District of Philadelphia. Because the Philadelphia contract included five years of support, revenue from that contract will be recognized over five years.*

Booked sales to non-school customers, primarily private practice clinicians, increased by $166,000, or 13%, for the three months ending June 30, 2004. For the six months ended June 30, 2004, sales in this sector were up $228,000, or 14%. Sales to non-school customers have declined over the past several years.

We believe large sales are an important indicator of mainstream education industry acceptance and an important factor in continuing to increase the productivity of our sales force.* During the second quarter of 2004, we closed 29 sales that had a contract value in excess of $100,000 compared to 21 during the same period in 2003. For the six months ended June 30, 2004 we closed 33 sales in excess of $100,000 compared to 24 during the same period in 2003.

Although federal, state and local budget pressures make for an uncertain funding environment for our customers, we believe that we are positioned to achieve continued growth in the K-12 market.* However, achieving our sales growth objectives will depend on increasing mainstream customer acceptance of our products, which requires us to continue to focus on improving our products’ ease of use, their fit with school requirements, and our connection with classroom teachers and administrators.* A key part of our growth strategy is to increase our sales force productivity.* This may be challenging in a K-12 market that is still negatively impacted by tight state and local funding. For a discussion of some of the other important factors that affect our results, see“Factors that May Affect Results of Operations or Stock Price.”In addition, the revenue recognized from our sales can 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 reasonably 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 at any given time.

Page 20

Gross Profit and Cost of Revenues

	Three months ended June 30,								Six months ended June 30,
	2004				2003				2004				2003
(dollars in thousands)	$ Profit		Margin %		$ Profit		Margin %		$ Profit		Margin %		$ Profit		Margin %
	Restated				Restated				Restated				Restated
Gross profit on products	$	5,125		91%	$	6,277		91%	$	10,047		92%	$	11,354		91%
Gross profit on services and support	$	678		36%	$	353		30%	$	1,234		34%	$	434		20%
Total gross profit	$	5,803		77%	$	6,630		82%	$	11,281		78%	$	11,788		80%

The overall gross profit margin decreased for the three and six months ended June 30, 2004 compared to the same periods in 2003, as stable to improving margins in each revenue sub-category were more than offset by our revenue mix shift to lower-margin services. In both the three and six months periods ended June 30, 2004, our revenue mix was 75% product and 25% service and support compared to 85% product and 15% service and support in the same periods in 2003. Margin improvement in services and support was the result of improved operating leverage, as revenue growth provided better fixed cost coverage. Product margins improved due to lower amortization of capitalized product development as well as lower royalty expenses.

Operating Expenses

	Three months ended June 30,						Six months ended June 30,
(dollars in thousands)	2004		Change		2003		2004		Change		2003
	Restated				Restated		Restated				Restated
Sales and marketing	$	3,754		12%	$	3,344	$	7,581		14%	$	6,626
Research and development	$	820		-12%	$	935	$	1,705		-8%	$	1,844
General and administrative	$	1,212		-6%	$	1,284	$	2,223		-7%	$	2,396
Total operating expenses	$	5,786		4%	$	5,563	$	11,509		6%	$	10,866

Sales and Marketing Expenses:For the three and six months ended June 30, 2004, our sales and marketing expenses increased due to increased staff, consultant expense, temporary staff, and marketing expenses. At June 30, 2004, we had 26 quota-bearing sales personnel selling to public schools.

Research and Development Expenses:Research and development expenses decreased in the three and six months ended June 30, 2004 compared to the same period in 2003. Research and development expenses principally consist of compensation paid to employees and consultants engaged in research and product development activities and product testing, together with software and equipment costs. Higher 2003 spending was due to expenses associated with a June 2003 product launch.

General and Administrative Expenses:General and administrative expenses decreased modestly for the three and six months ended June 30, 2004. The most significant factor was a decline in 2004 legal expenses compared to 2003.

Other Income from Related Party

In September 2003, we signed an agreement with Neuroscience Solutions Corporation (“NSC”), transferring technology to NSC for use in the health field. During the second quarter of 2004 we recorded $27,500 in royalties received and services provided to NSC. For the first two quarters of 2004, we have recorded $62,500 in royalties and services provided. As the original transaction occurred in September 2003, nothing was recorded for the three and six months ended June 30, 2003. Amounts received to date and any future receipts are being reported as other income as we do not consider the sale of these rights to be part of recurring operations.

Page 21

Interest Expense, net

	Three months ended June 30,									Six months ended June 30,
(dollars in thousands)	2004			Change			2003			2004			Change			2003
Interest income/(expense), net		($97	)		-69	%		($316	)		($176	)		-72	%		($625	)

Interest expense, net decreased for the three and six months ended June 30, 2004 compared to the same period in 2003 primarily because of lower amortization of deferred financing charges related to warrants issued in connection with earlier borrowing and lower borrowing in 2004 compared to 2003. The amortization of deferred financing charges was $99,000 and $199,000 for the three and six months ended June 30, 2004 compared to $304,000 and $608,000 for the same periods in 2003.

Provision for Income Taxes

In the three and six months ending June 30, 2004, we recorded no tax provision as we had no taxable income. For the three and six months ended June 30, 2003 we recorded $6,000 in income tax provision.

Liquidity and Capital Resources

Our cash and cash equivalents were $4.4 million at June 30, 2004, compared to $3.6 million at December 31, 2003. We expect that our cash flow from operations and our current cash balances will be the primary source of liquidity and will be sufficient to provide the necessary funds for our operations and capital expenditures during 2004.* Accomplishing this, however, will require us to meet specific sales targets in the K-12 market. We cannot assure you that we will meet our targets with respect to sales, revenues, expenses or operating results.

Historically, our first quarter is our lowest sales quarter, reflecting school purchasing cycles and a trend in our industry.* Therefore, we may have negative cash flow in some quarters, particularly the first quarter, and may borrow under our line of credit from time to time.*

Net cash used in operating activities for the six months ended June 2004 was $2.5 million versus $223,000 during the same period in 2003. Payments for previously expensed restructuring charges were $440,000 and $885,000 for the three and six months ended June 30, 2004 and $467,000 and $1.0 million for the same periods in 2003. Cash generated was lower in 2004 as many of large sales were closed in the final days of the quarter, significantly increasing the accounts receivable balance compared to year end 2003.

Net cash used in investing activities for the six months ended June 30, 2004 was $432,000 compared to $178,000 for the same period in 2003. Spending in this area primarily consists of purchases of computer hardware and software. We expect that our capital spending will be higher in 2004 than in 2003, reflecting the purchase of new business systems software as well as additional computer hardware.*

For the six months ended June 30, 2004 we borrowed $3.0 million under our bank line of credit. This compared to no net borrowing during the six month period ending June 30, 2003. As of July 31, 2004 we had approximately $10 million of cash and no borrowings outstanding under the line of credit, reflecting the collection of several large accounts receivable that were outstanding at June 30, 2004.

We have a line of credit with Comerica Bank totaling $7.0 million, which expires on July 14, 2005. The facility was partially secured by a letter of credit provided by WPV, Inc., an affiliate of Warburg, Pincus Ventures, our largest stockholder. The letter of credit was for $4.0 million through May 30, 2004 and $3.0 million from May 31, 2004 to July 30, 2004. The WPV letter of credit expired on July 30, 2004. The line is subject to limitations based on our accounts receivable balance. Borrowings under the line are subject to various covenants, which may limit our financial and operating flexibility. The need to restate our historical financial statements constitutes an event of default under our agreement with Comerica. This event of default entitles Comerica to decline to advance additional funds under the line. There is no borrowing currently outstanding under the line, and we do not foresee that we will

Page 22

need to draw down under the line during its term.* Therefore, we do not believe that this default will have a material impact on us.*

After 2004, we expect that cash flow from operations will continue to be our primary source of funds for the next several years.* Again, this will require us to meet certain sales and expense levels. If the Company is unable to achieve sufficient cash flow from operations, the Company may seek other sources of debt or equity financing, or may be required to reduce expenses.* Reducing the Company’s expenses could adversely affect operations by reducing the resources available for sales, marketing, research or product development. We cannot assure you that we will be able to secure additional debt or equity financing on acceptable terms.

Contractual Obligations and Commitments

We have a non-cancelable lease agreement for our corporate office facilities. The minimum lease payment is approximately $78,000 per month through 2008. After 2008 the base lease payment increases at a compound annual rate of approximately 5%. The lease terminates in December 2013.

The following table summarizes our outstanding borrowings and contractual obligations at June 30, 2004 and the effects such obligations are expected to have on our liquidity and cash flow in future periods.

			Less than 1
(dollars in thousands)	Total		year		1 - 3 years		4 - 5 years		Thereafter1.
Lease termination agreement		888		888		—		—		—
Borrowing under bank line of credit		3,000		3,000		—		—		—
Non-cancelable operating leases		9,636		940		1,880		1,902		4,914
Minimum royalty payments		1,500		150		300		300		750
Total	$	15,024	$	4,978	$	2,180	$	2,202	$	5,664

1. Non-cancelable operating leases expire December 31, 2013. Minimum royalty payments expire in 2014.

Our purchase order commitments at June 30, 2004 are not material.

Loans to Current and Former Officers

In March 2001 we made full recourse loans to certain of our officers, in amounts totaling $3.1 million. The total receivable including accrued interest at June 30, 2004 was $3.6 million. Accrued interest of $496,000 for the periods ending June 30, 2004 was included in Other Assets on the Balance Sheet. In 2002 some of these officers left our Company. The Notes are full recourse loans secured by shares of our Common Stock owned by the current and former officers. The loans bear interest at 4.94%. Principal and interest are due December 31, 2005.

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 be affected.

We believe that the estimates, assumptions and judgments pertaining to revenue recognition, allowance for doubtful accounts, software development costs and long-lived assets are the most critical assumptions to understand in order to 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.

Page 23

Revenue Recognition

We derive revenue from the sale of licenses to our software and from service and support fees. Software license revenue is recognized in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9 (SOP 97-2). SOP 97-2 provides specific industry guidance and four basic criteria, which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement; 2) delivery of the product; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected.

Sales to our school customers typically include multiple elements (e.g. Fast ForWord software license, Progress Tracker, our Internet-based participant tracking service, support, training, implementation management, and other services). The Company allocates revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor specific objective evidence” (“VSOE”). VSOE of fair value for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for support services, is also measured by the renewal price.

The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized. Deferred revenue is recognized as revenue as discussed below.

Revenue from the licensing of software is recognized as follows: 1) for licenses purchased with Progress Tracker, because the Company has not established VSOE for Progress Tracker, revenue is recognized ratably over the contractual life of the longest undelivered element, typically support and Progress Tracker access, 2) for individual participant licenses, revenue is recognized over the average duration of the product’s use, typically 6 weeks; and 3) for perpetual licenses that are not purchased with Internet-based services, revenue is recognized at the later of product shipment or the contract start date, provided that the other criteria stated above are met.

Service and support revenue is derived from a combination of on-site and remote training, implementation, technical and professional services and customer support. Revenue from services sold with license arrangements that include Progress Tracker is recognized ratably over the contractual term of the longest undelivered element purchased, typically support. Revenue from services sold with license arrangements that do not include Progress Tracker, sold alone, or sold only with support is recognized as delivered. Revenue from support is recognized over the contractual support period.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses due to the inability of customers to make payments. These estimates are based on historical experience. In 2003 and the first half of 2004 our bad debt experience has been less than 1% of revenue. To the extent experience requires it, we may in the future adjust this reserve.* For the second quarter of 2004, the reserve calculation was adjusted down, because at the time of estimating the allowance, several large accounts had already paid the balances outstanding at June 30. Cancellations and refunds are allowed in limited circumstances, and such amounts have not been significant.

Software Development Costs

We capitalize 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. We estimate the useful life of our developed products to be 3 years.

On an ongoing basis, we evaluate the net realizable value of the capitalized software development cost by estimating the future revenue to be generated from the product and compare this estimate to the unamortized cost of the product. At June 30, 2004 future revenues from sale of products for which development costs remain on the balance

Page 24

sheet are anticipated to exceed the $569,000 of unamortized development costs.* No software development costs were capitalized in the three or six months ended June 30, 2004 or 2003.

Impairment of Long-Lived Assets

We regularly review the carrying value of, capitalized software development costs and property and equipment. We continually make estimates regarding the probability of future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, the Company may be required to record impairment charges for these assets.

FACTORS THAT MAY AFFECT RESULTS OF OPERATIONS OR STOCK PRICE

Our results are impacted by a variety of factors, many of which are beyond our control. The following factors, as well as other information discussed in this quarterly report on Form 10-Q/A, in our Annual Report on Form 10-K/A for the year ended December 31, 2003 (under the headings “Business – Factors that May Affect our Results or Stock Price” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”), and other documents filed with the Securities and Exchange Commission should be carefully considered in evaluating our results and our business.

The extent to which mainstream educational purchasers will broadly accept our products is unproven.

•   Our products are novel to many educators, and have many attributes that are not common to educational software. K-12 educational practices are slow to change, and it can be difficult to convince educators of the value of a substantially different approach.

•   Using our products in schools requires educators to devote a substantial amount of time to Fast ForWord use out of a limited school day. Our new protocols have significantly reduced the daily time required to use our program, significantly decreasing one of the most critical challenges to broad use of our products. However, the product use protocol still requires a substantial time commitment from students and educators, which can be difficult for schools.

•   We have not yet widely demonstrated implementation models that are scalable, acceptable to educators and profitable, while remaining highly effective in improving student achievement.

•   We need to continue and expand our demonstration to educators that our products significantly improve student achievement. Unless our products are implemented well and used in accordance with one of our protocols, they may not achieve the desired student achievement results.

The availability of government funding for public school reading intervention purchases, and for our products in particular, is uncertain.

•   We believe that the funding for a substantial portion of our K-12 sales comes from federal funding, so continuing to qualify for major sources of federal funding is critical to our sales success. The current federal budget deficit may impact the availability of federal education funding.

•   The general availability of funding for public schools fluctuates from time to time. State and local school funding can be significantly impacted by fluctuations in tax revenues due to changing economic conditions. Since 2002, the education technology industry has generally experienced soft sales, frequently attributed to tight funding. We expect that future levels of state and local school spending will be significantly affected by the economic conditions and outlook.

Our business experiences seasonal fluctuations and a long sales cycle.

•   Public school calendars and budget cycles have caused, and we expect them to continue to cause, substantial quarterly fluctuations in sales and revenues. Like other companies in the instructional market, our sales to K-12 schools are typically particularly slow in the first quarter.

•   Demand for our products through private clinicians 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.

•   In K-12 schools, the cost of some of our license packages requires multiple levels of approval in a political environment, which results in a time-consuming sales cycle that is difficult to predict. When a district decides to finance its license purchases, the time required to obtain these approvals can be extended even further.

Page 25

We may experience difficulties in launching new products efficiently, on schedule and without significant technical issues.

•   We are developing additional products in our Fast ForWord to Reading series as part of our strategy to reach mainstream reading intervention customers. Unexpected challenges could make these development projects longer or more expensive.

•   New technology products usually contain bugs that were not discovered in the testing process and tend to be more challenging to implement when they are first introduced, especially in the diverse and challenging K-12 technology environment. During the second quarter of 2003, we launched the new Gateway Edition of our major products. Although our customers received the added features and benefits of the Gateway Edition enthusiastically, we encountered technical issues with the new release that required significant time from our sales and service teams. This led to additional service and support costs, and slowed the purchasing decisions for a number of transactions, resulting in lower than expected fourth quarter sales and higher than planned service costs in the first quarter of 2004.

•   Introduction of new products can slow sales as customers take additional time to evaluate the new offering or wait until the new offering has been available for some period before purchasing.

The restatement of our financial statements has had a material adverse impact on us, including increased costs, the increased possibility of legal or administrative proceedings, the commencement of delisting proceedings and a default under our credit agreement.

In December 2004, as a result of a reconsideration of our revenue recognition practices, the Company’s management and our Audit Committee concluded that we should correct our revenue recognition practices for most of the Company’s K-12 school contracts. As a result, we have restated our financial statements for the period from 2000 through June 30, 2004, as described in more detail in Note 3 to the Condensed Financial Statements.

As a result of these events, we have become subject to the following risks:

•   We have incurred substantial unanticipated costs for accounting and legal fees.

•   It is not uncommon for lawsuits claiming to be class actions to be brought against companies that restate their historical financial statements and their directors and officers. If such actions were to be brought, it is likely that we would incur substantial defense costs regardless of their outcome. Likewise, such actions might cause a diversion of our management’s time and attention. Likewise, if such actions were brought and we did not prevail, we could be required to pay substantial damages or settlement costs.

•   It is also not uncommon for the Securities and Exchange Commission to investigate companies that restate their historical financial statements. If any such investigation were commenced, it would likely divert more of our management’s time and attention and cause us to incur substantial costs. Such investigations could also lead to fines or injunctions or orders with respect to future activities.

•   The need to reconsider our accounting treatment and the restatement of our financial statements caused us to be late in filing our required report on Form 10-Q for the quarter ended September 30, 2004. In November 2004, we received notice from Nasdaq that we are subject to delisting because this delay in our filing has caused us to be out of compliance with the continued listing requirements of the Nasdaq National Market. In January 2005, we received the determination of Nasdaq Hearing Panel in this matter, which permits the Company’s securities to remain listed on the Nasdaq National Market so long as the Company has filed its Form 10-Q for the quarter ended September 30, 2004, as well as any amendments required by the restatement, no later than February 15, 2005. The determination also requires that the Company remain in compliance with all requirements for continued listing and give Nasdaq prompt notice of any significant events during this time, and provides that the Hearing Panel reserves the right to reconsider the terms of the exception granted to the Company and to review any compliance document filed by the Company. In addition, under Nasdaq rules, it is still possible that upon reconsideration the Company could be delisted as a result of the delay in our filings.

•   The need to restate our historical financial statements constitutes an event of default under our credit agreement, which permits our lender to decline to advance additional funds under the credit facility. There is no borrowing currently outstanding under the line, and we do not foresee that we will need to draw down under the line during its term. However, if we did wish to borrow under the line, it might be unavailable to us.

Page 26

The factors discussed above could materially and adversely affect our business, results of operations, financial condition and the trading price of our stock.

Item 4. Controls and Procedures

In connection with the Original Form 10-Q, as required under Rule 13a-15(b) of the Exchange Act, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2004.

In December 2004, the Company’s management and the Audit Committee of the Company’s Board of Directors concluded that the Company should change its revenue recognition method for most of the Company’s K-12 school contracts. As a result, the Company is restating its historical financial statements for the period from 2000 through June 30, 2004. This restatement is described in more detail in Note 3 to the Condensed Financial Statements.

This change in the Company’s revenue recognition treatment reflects a correction in the Company’s application of AICPA Statement of Position 97-2, to these historical transactions. Our restatement of our historical financial statements results from a correction in the application of an accounting policy.

Controls over the application of accounting policies are within the scope of internal controls. Therefore, management has concluded that there was a material weakness in the Company’s internal controls, as defined by the Public Company Accounting Oversight Board.

In connection with the filing of this Form 10-Q/A Report, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, has re-evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2004. Solely because of the revenue recognition issue discussed above, the Company’s Chief Executive Officer and Chief Financial Officer have now concluded that the Company’s disclosure controls and procedures were not effective as of June 30, 2004.

The Company has reflected the revised revenue recognition treatment in this Form 10-Q/A and Forms 10-K/A for 2003 and 10-Q/A for the first quarter of 2004. We are in the process of evaluating what changes should be made in our internal controls over financial reporting with respect to revenue recognition. Except for these changes, for the quarter ended June 30, 2004, there were no changes in the Company’s internal controls over financial reporting that materially affected, or are reasonably likely to materially affect the Company’s internal control over financial reporting.

It should be noted that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. As a result, there can be no assurance that a control system will succeed in preventing all possible instances of error and fraud. The Company’s disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and the conclusions of our Chief Executive Officer and the Chief Financial Officer are made at the “reasonable assurance” level.

Page 27

PART II. OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

Exhibit No.	Description of Document
3.1 (1)	Restated Certificate of Incorporation.
3.2 (2)	Amended and Restated Bylaws.
31.1	Certification of Chief Executive Officer (Section 302)
31.2	Certification of Chief Financial Officer (Section 302)
32.1	Certification of Chief Executive Officer (Section 906)
32.2	Certification of Chief Financial Officer (Section 906)

(1)	Incorporated by reference to Exhibit 3.3 previously filed with the Company’s Registration Statement on Form S-1 (SEC File No. 333-77133).
(2)	Incorporated by reference to Exhibit 3.4 previously filed with the Company’s Form 10-Q for the quarter ended September 30, 2003 (SEC File No. 000-24547).

(b) Reports on Form 8-K.

i.   On April 27, 2004, the Company filed a Report on Form 8-K furnishing its press release announcing its financial results for the quarter ended March 31, 2004 and the transcript of its conference call discussing those earnings.

ii.   On June 15, 2004, the Company filed a Report on Form 8-K disclosing actions that could be viewed as waivers of its Code of Conduct with respect to previously-disclosed historical transactions involving ongoing conduct, as required by NASDAQ interpretations.

Page 28

SIGNATURE

     Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated: February 10, 2005

Scientific Learning Corporation
(Registrant)
 

/s/ Jane A. Freeman  

Jane A. Freeman

Chief Financial Officer
(Authorized Officer and Principal Financial and
Accounting Officer) 

Page 29

Index to Exhibits

Exhibit No.	Description of Document
3.1 (1)	Restated Certificate of Incorporation.
3.2 (2)	Amended and Restated Bylaws.
31.1	Certification of Chief Executive Officer (Section 302)
31.2	Certification of Chief Financial Officer (Section 302)
32.1	Certification of Chief Executive Officer (Section 906)
32.2	Certification of Chief Financial Officer (Section 906)

(1)	Incorporated by reference to Exhibit 3.3 previously filed with the Company’s Registration Statement on Form S-1 (SEC File No. 333-77133).
(2)	Incorporated by reference to Exhibit 3.4 previously filed with the Company’s Form 10-Q for the quarter ended September 30, 2003 (SEC File No. 000-24547).