UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2007

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

COMMISSION FILE NO. 000-26937

QUEST SOFTWARE, INC.

(Exact name of registrant as specified in its charter)

California	33-0231678
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

5 Polaris Way Aliso Viejo, California	92656
(Address of principal executive offices)	(Zip code)

Registrant’s telephone number, including area code: (949) 754-8000

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  x    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer   x            Accelerated filer   ¨            Non-accelerated filer   ¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes   ¨     No   x

The number of shares outstanding of the Registrant’s Common Stock, no par value, as of December 11, 2007, was 102,154,171.

QUEST SOFTWARE, INC.

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2007

TABLE OF CONTENTS

		Page Number
PART I. FINANCIAL INFORMATION
EXPLANATORY NOTE		2
Item 1.	Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets as of March 31, 2007 and December 31, 2006	4
	Condensed Consolidated Income Statements for the Three Months Ended March 31, 2007 and 2006 (As Restated)*	5
	Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2007 and 2006 (As Restated)*	6
	Condensed Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2007 and 2006 (As Restated)*	7
	Notes to Condensed Consolidated Financial Statements (As Restated)*	8
	* The Condensed Consolidated (1) Income Statement, (2) Statement of Comprehensive Income and (3) Statement of Cash Flows for the three months ended March 31, 2006 have been restated as discussed in Note 2 of our Notes to Condensed Consolidated Financial Statements contained herein.
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	24
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	40
Item 4.	Controls and Procedures	42
PART II. OTHER INFORMATION
Item 1A.	Risk Factors	44
Item 6.	Exhibits	55
SIGNATURES		56

QUEST SOFTWARE, INC.

EXPLANATORY NOTE

This Quarterly Report on Form 10-Q of Quest Software, Inc. for the quarter ended March 31, 2007 reflects the restatement of our unaudited condensed consolidated financial statements for the three months ended March 31, 2006, and the notes related thereto.

In May 2006, we formed a special committee of the Company’s Board of Directors, comprised of two independent directors (the “Special Committee”), to conduct an investigation into our historic stock option granting practices and related accounting. The investigation was conducted with the assistance of independent outside legal counsel and outside forensic accounting consultants. The background, scope and findings of the investigation are more fully described in Item 2 of this Report.

As a result of the Special Committee’s investigation and management’s review of its findings we have determined that the accounting measurement dates for most of the stock option grants we awarded during the period from June 1998 to April 2002 were not determined in accordance with Generally Accepted Accounting Principles (“GAAP”). Accordingly we have applied revised measurement dates for financial accounting purposes to those option grants and corrected our accounting for such awards.

The Company determined revised accounting measurement dates for options to purchase approximately 21.8 million shares of Common Stock granted in 3,324 awards on 56 grant dates during the period from June 1998 to April 2002. The Company also determined revised accounting measurement dates for options to purchase 778,250 shares of Common Stock granted in 58 individual awards made after April 30, 2002 through December 2005. As a result, the Company recorded $137.7 million in additional stock-based compensation expense on a pre-tax basis for the years 1999 through 2005 and through the quarter ended March 31, 2006. The additional stock-based compensation expense is net of forfeitures related to employee terminations. To determine revised measurement dates, management evaluated all of the available evidence. For those grants where the revised measurement date could not be determined with certainty, management applied judgment to determine what it believes to be the most appropriate accounting measurement date in accordance with GAAP, and considered what different amounts of additional compensation expense that would have resulted had different dates been selected. For a discussion of the judgments underlying the revised measurement dates, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 2 of this Report.

The stock option accounting errors corrected in the restatement were primarily caused by inadequate procedures and controls for stock option granting activity. For most of the grants requiring measurement date changes, the process of obtaining formal approvals of the Company’s Board of Directors or Compensation Committee was generally not completed until after the grant date. For some grants, the Company also had not finalized the recipients and amounts of these options on the originally stated grant date. The Special Committee also concluded that grant dates and exercise prices for many stock options granted during the period from October 1999 to April 2002 were determined retrospectively by means of an administrative practice initially designed for monthly processing of option grants to new employees whereby the grant date was determined to be the date during the month of the employee’s hiring when the Company’s closing stock price had reached its lowest level during the month. This practice was expanded to include option grants to existing employees and, in some cases, the period was expanded from a monthly determination to a quarterly determination. This practice was discontinued after the April 2002 grants.

From May 2002 through December 2005, the Company made significant changes in its stock option granting practices, processes and controls. These changes included revising the form of the unanimous written consent used to document Compensation Committee actions to include an execution date and a delegation of authority by the Board of Directors to a Secondary Committee, consisting of the Company’s Chairman and Chief Executive Officer, to approve option grants subject to certain parameters. Grants to officers and directors and other grants outside of the delegation parameters continued to require Compensation Committee approval but the delegation of authority significantly reduced the number of grants that required Compensation Committee approval. The additional compensation expense resulting from the correction of accounting for options granted after April 2002 was not material to any subsequent interim or annual financial statement period.

The Special Committee made no finding of fraud or intentional misconduct by any current or former employees, officers or directors, and concluded that no further changes in the company’s executive officers will be recommended.

2

QUEST SOFTWARE, INC.

We also recorded approximately $5.3 million of pre-tax accounting adjustments for the years 1999 through 2005 and the quarter ended March 31, 2006 relating to stock option modifications, repricings of stock option grants and other errors in accounting for stock option transactions with our employees and consultants. The Company also determined that additional errors in its historical financial statements required correction as part of the restatement.

The cumulative effect of all adjustments for periods before 2006 is reflected as an adjustment to our accumulated deficit in the amount of $96.6 million, resulting in an accumulated deficit of $54.7 million at January 1, 2006. The after tax impact to net income for the three months ended March 31, 2006 was a $1.1 million benefit to net income.

For a detailed description of the restatement, see Note 2, “Restatement of Previously Issued Financial Statements” to the accompanying unaudited condensed consolidated financial statements and the section entitled “Restatement” in Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in Item 2 of this Report.

Unless otherwise noted, all of the information in this Quarterly Report on Form 10-Q is as of March 31, 2007. This Report does not reflect any events that occurred after March 31, 2007 other than the Special Committee investigation, resulting restatements and related matters, and Note 11 “Subsequent Events” of our Notes to Condensed Consolidated Financial Statements.

We have not amended and do not intend to amend any of our previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the periods affected by the restatement. For this reason, the consolidated financial statements and related financial information contained in any related previously filed financial reports for periods affected by the restatement, and related opinions of the Company’s independent registered public accounting firm, should not be relied upon.

3

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

	March 31, 2007			December 31, 2006
ASSETS
Current assets:
Cash and cash equivalents	$	326,792		$	286,164
Short-term marketable securities		94,769			80,112
Accounts receivable, net of allowances of $7,188 at March 31, 2007 and $9,312 at December 31, 2006		87,513			132,983
Prepaid expenses and other current assets		14,205			14,899
Deferred income taxes		11,246			9,800
Total current assets		534,525			523,958
Property and equipment, net		74,525			75,817
Long-term marketable securities		22,947			23,884
Intangible assets, net		44,849			48,136
Goodwill		445,279			445,059
Deferred income taxes		36,954			33,679
Other assets		10,658			11,004
Total assets	$	1,169,737		$	1,161,537
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	6,436		$	5,182
Accrued compensation		30,587			35,973
Other accrued expenses		30,100			35,949
Income taxes payable		5,316			27,832
Current portion of deferred revenue		174,049			177,372
Total current liabilities		246,488			282,308
Long-term liabilities:
Long-term portion of deferred revenue		57,486			58,187
Income taxes payable		27,159			—
Other long-term liabilities		2,297			2,129
Total long-term liabilities		86,942			60,316
Commitments and contingencies (Notes 6 and 9)
Shareholders’ equity:
Preferred stock, no par value, 10,000 shares authorized; no shares issued or outstanding		—			—
Common stock, no par value, 200,000 shares authorized; 101,819 shares issued and outstanding at March 31, 2007 and December 31, 2006		820,552			815,437
Retained earnings		16,516			4,293
Accumulated other comprehensive loss		(761	)		(817	)
Total shareholders’ equity		836,307			818,913
Total liabilities and shareholders’ equity	$	1,169,737		$	1,161,537

See accompanying Notes to Condensed Consolidated Financial Statements.

4

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED INCOME STATEMENTS

(In thousands, except per share data)

(Unaudited)

	Three Months Ended March 31,
	2007		2006
			As Restated (1)
Revenues:
Licenses	$	74,269	$	66,478
Services		75,500		62,714
Total revenues		149,769		129,192
Cost of revenues:
Licenses		2,003		1,262
Services		12,981		11,471
Amortization of purchased technology		3,057		3,348
Total cost of revenues		18,041		16,081
Gross profit		131,728		113,111
Operating expenses:
Sales and marketing		63,235		59,545
Research and development		28,266		27,819
General and administrative		16,566		14,633
Amortization of other purchased intangible assets		1,541		2,133
In-process research and development		—		300
Total operating expenses		109,608		104,430
Income from operations		22,120		8,681
Other income, net		5,053		2,634
Income before income tax provision		27,173		11,315
Income tax provision		12,266		3,173
Net income	$	14,907	$	8,142
Net income per share:
Basic	$	0.15	$	0.08
Diluted	$	0.14	$	0.08
Weighted average shares:
Basic		101,819		100,424
Diluted		104,892		104,018

(1) See Note 2 of our Notes to Condensed Consolidated Financial Statements.

See accompanying Notes to Condensed Consolidated Financial Statements.

5

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Three Months Ended March 31,
	2007			2006
				As Restated (1)
Cash flows from operating activities:
Net income	$	14,907		$	8,142
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		8,305			9,206
Compensation expense associated with stock option grants		5,115			7,986
Deferred income taxes		(4,688	)		(16	)
Excess tax benefit related to stock-based compensation		—			(3,992	)
Provision for bad debts		(135	)		(143	)
In-process research and development		—			300
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable		45,934			37,167
Prepaid expenses and other current assets		737			1,157
Other assets		363			204
Accounts payable		914			352
Accrued compensation		(5,521	)		(5,143	)
Other accrued expenses		(6,280	)		(7,047	)
Income taxes payable		1,912			(8,796	)
Deferred revenue		(4,062	)		(1,079	)
Other liabilities		(71	)		(32	)
Net cash provided by operating activities		57,430			38,266
Cash flows from investing activities:
Purchases of property and equipment		(2,123	)		(6,556	)
Cash paid for acquisitions, net of cash acquired		(1,127	)		(15,259	)
Purchases of cost-method investments		—			(1,636	)
Sales and maturities of marketable securities		(13,587	)		935
Net cash used in investing activities		(16,837	)		(22,516	)
Cash flows from financing activities:
Repayment of capital lease obligations		(69	)		(64	)
Proceeds from the exercise of stock options		—			12,008
Excess tax benefit related to stock-based compensation		—			3,992
Net cash (used in) provided by financing activities		(69	)		15,936
Effect of exchange rate changes on cash and cash equivalents		104			(708	)
Net increase in cash and cash equivalents		40,628			30,978
Cash and cash equivalents, beginning of period		286,164			121,025
Cash and cash equivalents, end of period	$	326,792		$	152,003
Supplemental disclosures of consolidated cash flow information:
Cash paid for interest	$	47		$	18
Cash paid for income taxes	$	15,046		$	11,816
Supplemental schedule of non-cash investing and financing activities:
Unrealized gain (loss) on marketable securities	$	56		$	(168	)
Capital lease additions	$	132		$	—
Unpaid purchases of property and equipment	$	314		$	—

(1) See Note 2 of our Notes to Condensed Consolidated Financial Statements.

See accompanying Notes to Condensed Consolidated Financial Statements.

6

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands)

(Unaudited)

	Three Months Ended March 31,
	2007		2006
			As Restated (1)
Net income	$	14,907	$	8,142
Other comprehensive income (loss):
Unrealized gain (loss) on marketable securities, net of tax		56		(168	)
Comprehensive income	$	14,963	$	7,974

(1) See Note 2 of our Notes to Condensed Consolidated Financial Statements.

See accompanying Notes to Condensed Consolidated Financial Statements.

7

QUEST SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Organization and Basis of Presentation

Quest Software, Inc. (“Quest,” the “Company,” “we,” “us” or “our”) was incorporated in California in 1987 and is a leading developer and vendor of application, database and Windows management software products. We also provide consulting, training, and support services to our customers. Our accompanying unaudited condensed consolidated financial statements as of March 31, 2007 and for the three months ended March 31, 2007 and 2006 reflect all adjustments (consisting of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

The information included in this Quarterly Report on Form 10-Q should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Quantitative and Qualitative Disclosures About Market Risk,” and the Consolidated Financial Statements and Notes to the Consolidated Financial Statements included in Quest’s Annual Report on Form 10-K for the year ended December 31, 2006 (“2006 Form 10-K”). The results for the interim periods presented are not necessarily indicative of the results that may be expected for any future period.

Recently Issued Accounting Pronouncements

In June 2006 the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. It also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We adopted FIN 48 on January 1, 2007. See Note 6 for more information about the impact of adoption of this guidance on our financial position, results of operations and cash flows.

In September 2006, the FASB issued FASB Staff Position (“FSP”) No. AUG AIR-1, Accounting for Planned Major Maintenance Activities. FSP No. AUG AIR-1 disallowed the use of the accrual method when accounting for planned major maintenance activities, thereby requiring the use of one of the other three approved methods under the AICPA Industry Audit Guide, Audits of Airlines. FSP No. AUG AIR-1 requires retrospective application for all financial statements presented and must be applied to financial statements filed with the Securities Exchange Commission (“SEC”) for fiscal years beginning after December 15, 2006, with early adoption permitted as of the beginning of a fiscal year. Effective fiscal year 2006, we adopted the direct expensing method which requires us to expense engine overhauls, as well as other major maintenance activities, as they were incurred. The adoption of the FSP was considered a change in accounting principle adopted by the FASB with retroactive application as described in SFAS No. 154, Accounting Changes and Error Corrections. As a result of early adoption, we reversed all engine overhaul accruals expensed in each of the appropriate periods from 2002 to the first quarter of 2006 and recorded engine overhaul expenses in the periods charges were incurred. Charges related to the planned major maintenance on our corporate aircraft were incurred in the third quarter of 2006 and the corporate aircraft was subsequently sold in the fourth quarter of 2006. The effect of adopting FSP No. AUG AIR-1 on our condensed consolidated financial statements for the periods presented in this Report was not material. See tables presented in Note 2.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, however, the FASB staff has proposed a one year deferral for the implementation of SFAS 157 for other nonfinancial assets and liabilities. We will adopt this statement effective January 1, 2008. We do not expect the standard to have a material impact on our financial position or results of operations.

8

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115, which permits entities to choose to measure many financial instruments and certain other items at fair value, on an instrument-by-instrument basis. The fair value measurement election is irrevocable and requires that unrealized gains and losses are reported in earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We will adopt this statement effective January 1, 2008. We do not expect the standard to have a material impact on our financial position or results of operations.

In December 2007, the FASB issued SFAS No. 141 (Revised 2007), Business Combinations (“SFAS 141R”). SFAS 141R will significantly change the accounting for business combinations. Under SFAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS 141R will change the accounting treatment for certain specific items, including:

• Acquisition costs will be generally expensed as incurred;

• Noncontrolling interests (formerly known as “minority interests” – see SFAS 160 discussion below) will be valued at fair value at the acquisition date;

• Acquired contingent liabilities will be recorded at fair value at the acquisition date and subsequently measured at either the higher of such amount or the amount determined under existing guidance for non-acquired contingencies;

• In-process research and development will be recorded at fair value as an indefinite-lived intangible asset at the acquisition date;

• Restructuring costs associated with a business combination will be generally expensed subsequent to the acquisition date; and

• Changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense.

SFAS 141R also includes a substantial number of new disclosure requirements. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited. Accordingly, since we are a calendar year-end company we will continue to record and disclose business combinations following existing GAAP until January 1, 2009. We expect SFAS 141R will have an impact on accounting for business combinations once adopted but the effect is dependent upon acquisitions at that time.

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements—An Amendment of ARB No. 51 (“SFAS 160”). SFAS 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement. SFAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. SFAS 160 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Like SFAS 141R discussed above, earlier adoption is prohibited. We have not completed our evaluation of the potential impact, if any, of the adoption of SFAS 160 on our consolidated financial position, results of operations and cash flows.

2. Restatement of Previously Issued Financial Statements

Subsequent to the issuance of the Company’s condensed consolidated financial statements for the quarter ended March 31, 2006, the Company’s management determined that incorrect measurement dates were used for financial accounting purposes for certain stock option grants made in prior periods and that other stock option and non-stock option related errors in its historical financial statements require correction, as described in more detail below. As a result, the condensed consolidated financial statements for the three months ended March 31, 2006 have been restated from the amounts previously reported to correct these errors. The after tax effect of all restatement adjustments amounted to a $1.1 million benefit to net income for the three months ended March 31, 2006.

9

On May 26, 2006, our Board formed a Special Committee of independent directors to conduct an investigation of our historical stock option grant practices and related accounting. For a detailed description of the background and scope of the investigation and information related to our historical stock option granting practices, see the section entitled “Restatement” in Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in this Report.

Findings of the Investigation and Measurement Date Determinations

The Special Committee performed a detailed review of all stock option grants awarded from August 13, 1999 (the date of the Company’s initial public offering) through June 30, 2003 and all annual grants from July 1, 2003 through December 2005, covering grants to purchase 30,739,235 shares of Common Stock made in 7,287 awards on 39 granting dates. The Special Committee also performed limited testing on a sample of stock option grants made prior to the initial public offering covering grants to purchase 10,632,744 shares of Common Stock made in 762 awards on 38 granting dates. The Special Committee also performed limited testing on a sampling of new hire and merit stock option grants awarded after June 30, 2003 covering grants to purchase 5,082,350 shares of Common Stock representing 61% of all new hire and merit options granted during this period.

We classified option grants subject to the investigation into in three time periods: (1) June 1998 through August 1999 (the “Pre-IPO Period”); (2) September 1999 through April 30, 2002; and (3) May 1, 2002 through December 2005. Because annual, broad-based grants were made in a process substantially similar to new hire and merit grants, we did not separately classify option grants by the nature of their granting process. Based on the facts obtained as a result of the Special Committee investigation, we identified grants for which we used an incorrect measurement date for financial accounting purposes, as defined under Generally Accepted Accounting Principles in the United States, or GAAP. To determine the correct accounting measurement dates for these grants we followed the guidance in Accounting Principles Board (“APB”) No. 25, which deems the “measurement date” to be the first date on which all of the following are known with finality: (1) the identity of the individual employee who is entitled to receive the option grant; (2) the number of options that the individual employee is entitled to receive; and (3) the option’s exercise price.

The Special Committee performed a grant date by grant date analysis of approximately 38 option grant dates during the Pre-IPO Period, 36 option grant dates between the IPO and June 30, 2003 and all three annual grants from July 1, 2003 through December 2005 for compliance with APB No. 25. Where we determined that we did not complete the required granting actions by the original grant date, we used judgment to determine corrected accounting measurement dates for all awards included within the granting action on each grant date consistent with what the evidence suggested was our practice or process. If the revised measurement date was not the same date we used previously, we made accounting adjustments as required, which resulted in stock-based compensation and related tax effects when an option had intrinsic value on the revised measurement date.

A total of 3,382 awards covering grants to purchase 22,553,293 shares of Common Stock required measurement date changes, of which options to purchase 3,604,950 shares of Common Stock were granted to employees who were executive officers of the Company at the time of their respective grant dates. None of our non-employee directors received stock option grants requiring measurement date corrections.

The following table summarizes certain information with respect to option awards requiring accounting measurement date changes:

Time Period	Number of Granting Dates	Number of Awards	Number of Shares
Pre-IPO Period	35	757	10,519,744
Initial Public Offering through April 30, 2002	21	2,567	11,255,299
After April 30, 2002	11	58	778,250
Total	67	3,382	22,553,293

10

A summary of incremental pre-tax stock-based compensation expense related to options awarded in each time period covering the period from June 1998 through March 31, 2006 (“restatement period”) resulting from a change in the accounting measurement date (in thousands), is as follows:

Time Period	Pre-Tax Stock-based Compensation Expense, Net of Forfeitures
Pre-IPO Period	$	23,288
Initial Public Offering through April 30, 2002		114,140
After April 30, 2002		319
Cumulative effect for options vested through March 31, 2006	$	137,747

Pre-IPO Period Grants

During the course of the investigation, information and documentation relating to stock option grants made prior to the Company’s initial public offering was evaluated. The Special Committee determined that accounting measurement dates for most of the stock option grants during the period from June 23, 1998 through August 11, 1999 were incorrectly determined. These instances involved an aggregate of 757 stock option grants awarded to employees covering 10,519,744 shares of Common Stock. Specifically, the Special Committee discovered evidence that required details of 588 awards covering 9,373,344 shares covered by all grants between June 1998 and June 9, 1999 did not have the required level of finality or were not supported by sufficient documentation until June 9, 1999, the date on which the Company’s 1999 Stock Incentive Plan was adopted by the Company and approved by its shareholders.

For the stock option grants awarded between June 10, 1999 through August 11, 1999, the Company was unable to locate evidence of completion of required granting actions (specifically, approval of the stock option grants by the Company’s Board of Directors or Compensation Committee). These instances involved an aggregate of 169 stock option grants to employees to purchase an aggregate of 1,146,400 shares of the Company’s Common Stock. None of these stock options were granted to executive officers or senior officers who participated in the stock option granting processes associated with these grants. The Company has been honoring these stock options awards and settling them with stock and intends to continue doing so. Measurement date determinations for these option grants were made on the basis of all available relevant information and reflect the Company’s reasonable conclusion as to the most likely option granting actions that occurred and related facts and circumstances. Specifically, we used evidence of the dates on which the Notices of Grant were executed on behalf of the Company as the best evidence of the granting actions actually completed, and used those dates as the revised measurement dates for financial reporting purposes.

Corrections to the measurement dates for option grants during the Pre-IPO Period resulted in the recording of additional pre-tax stock based compensation of $23.3 million, all of which was recorded prior to January 1, 2006.

Post IPO Grants - September 1999 through April 2002

In the fourth quarter of 1999, the Company initiated a practice of processing option grants to newly-hired employees and merit or promotion grants to existing employees on a monthly basis, starting with the grants dated September 1999, and to determine a single grant date for stock options granted within each of those particular months. The Special Committee found evidence demonstrating that stock option grants made in any given month were routinely made as of the trading date associated with the lowest closing sale price reported by Nasdaq for our Common Stock from September 1999 through April 2002, with only a few grants during such period made on other dates. The Special Committee also found evidence that the option grant dating practice expanded to quarterly, rather than monthly, grant date determinations.

For stock option grants during this time period, the Special Committee determined that:

• administrative approvals for required granting actions were generally documented by unanimous written consents of the Board or the Compensation Committee, and were dated “as of” the date corresponding to the trading date in a given month or quarter on which the Company’s last sale price was determined to be the lowest in that period;

• all of such unanimous written consents were prepared after the selected grant dates and were executed by members of the Board or Compensation Committee at a later time, in some cases as much as up to three months after the selected grant date; and

• in certain cases, the lists reflecting stock option grants processed by the Company’s stock plan administrator were different than the lists provided to and approved by either the Board or Compensation Committee, as the case may be.

11

For each of the 21 discretionary grants affected by the Special Committee’s findings during this period, the Special Committee determined an accounting measurement date based on information and documentation evidencing the date as of which the related action by unanimous written consent (“UWC”) had been signed by all of the directors or, in the case of Compensation Committee action, members of the Compensation Committee. However, in many cases, the Company was unable to locate definitive and complete documentation evidencing the date on which the last required approval of a UWC was signed by certain directors and received by the Company. For these stock option grants, the Company’s measurement date determinations were made on the basis of all available relevant information and reflect the Company’s reasonable conclusion as to the most likely option granting actions that occurred based on related facts and circumstances. For grants where there was insufficient evidence to determine when all required written consents were actually obtained, but there was evidence of the dates of receipt of individual written consents (such as contemporaneous electronic messages to or from individuals involved in the granting activities or facsimile header dates on signed unanimous written consent forms), we used this information as evidence of when the Compensation Committee approval was obtained, and used that date as the revised measurement date for financial reporting purposes. In other cases where we could not locate evidence of the date or dates on which required granting approvals were obtained, we used evidence of the dates on which the Notices of Grant were executed on behalf of the Company as the best evidence of the granting actions actually completed, and used those dates as the revised measurement dates for financial reporting purposes. We believe that these grants were communicated to employees in a timely manner. In some cases, we awarded option grants that were different in amount than that approved by the required granting actions or to employees whose awards were not included in lists approved by the Board of Directors or Compensation Committee. In each of these circumstances, we evaluated the existing information related to each individual grant and we established a new measurement date when we determined that the terms of the award were fixed with finality, which was generally the date on which the related Notice of Grant was signed on behalf of the Company.

Section 16 Insiders received stock options covering an aggregate of 2,904,950 shares of Common Stock in these grant events, which collectively resulted in $24.0 million of additional compensation expense over the restatement period. See the discussion under the heading “Remedial Actions” within the section entitled “Restatement” in Management’s Discussion and Analysis of Financial Condition and Results of Operations for actions taken by the Company with respect to option awards to Section 16 Insiders. Employees other than Section 16 Insiders received options to purchase an aggregate of 8,350,349 shares in these grant events. Corrections to the measurement dates for all of the misdated grants during the period from September 1999 through April 2002 resulted in the recording of additional stock-based compensation expense of $114.1 million, of which $0.8 million was recorded in the three months ended March 31, 2006.

Post IPO Grants – May 1, 2002 through December 2005

The Special Committee performed a detailed review of all stock option grants awarded between May 1, 2002 and June 30, 2003 and all annual grants awarded between May 1, 2002 and December 2005. Measurement date exceptions were noted for 45 grants covering options to purchase 294,750 shares, for which an additional stock-based compensation expense of approximately $278,000 was recorded in periods prior to January 1, 2006. Based on the significant improvements in the Company’s stock option granting practices during this period, the Special Committee determined to conduct limited sampling and testing of new hire and merit stock option grants awarded after June 30, 2003. The Special Committee sampled 88 new hire and merit grants, covering 5,082,350 shares of Common Stock (61% of all shares covered by new hire and merit option grants). The remaining new hire and merit stock option grants occurring during the period from July 1, 2003 through December 31, 2005 were not individually reviewed and did not appear to have any unusual pricing or other characteristics indicating a need for full individual review. Sampling and other analysis indicated that these remaining grants consisted of new hire and merit grants to non-officer employees. Various tests were performed to determine whether these remaining grants had any unique pricing or other characteristics. None were identified, although measurement date exceptions were noted for 13 grants covering options to purchase 483,500 shares, for which an additional stock-based compensation expense of approximately $41,000 was recorded in periods prior to January 1, 2006. Given the immaterial number of shares and limited income statement impact, along with the absence of unique pricing or other characteristics, additional review procedures were not deemed necessary for these remaining grants occurring after June 30, 2003 and were therefore not applied.

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Other Stock Option Related Adjustments

In addition to adjustments to our reported stock-based compensation expenses resulting from corrections to accounting measurement dates, the restatement also reflects stock-option related adjustments arising from a variety of other issues discovered during our investigation:

• We recorded compensation expense as a result of modifications to stock options made or deemed to have been made to certain employees in connection with their termination of employment or extended leaves of absence. Typically such modifications related to, or resulted in, extensions of the time periods following cessation of service within which these employees could exercise vested stock options. We recorded incremental pre-tax stock-based compensation expense associated with such modifications in the aggregate amount of $2.0 million, of which approximately $41,000 was recorded in the three months ended March 31, 2006.

• We identified certain stock option grants awarded to non-executive employees which were repriced or otherwise modified in circumstances which required variable accounting treatment. We also identified an option grant awarded to a non-employee consultant deemed to have been granted in exchange for services. We recorded incremental pre-tax stock-based compensation expense associated with these stock option awards in the aggregate amount of $4.3 million, all of which was recorded prior to January 1, 2006.

• We determined that our accounting treatment for a restricted stock issuance in 2000 was incorrect. We issued 339,200 shares of common stock to an employee in connection with his initial employment with the Company as Vice President, Marketing, and accepted this employee’s secured promissory note in the principal amount of $15.8 million as payment of the purchase price for the shares. In June 2002, we determined that we should have treated the promissory note as a non-recourse obligation and, accordingly, treated the transaction as a stock option for financial reporting purposes. We also determined that we should not have accrued approximately $1.4 million of interest income on the promissory note that we accrued from 2000 through March 31, 2002 but deemed the error to be immaterial to our results of operations. We have recorded an adjustment to our beginning retained earnings balance as of January 1, 2006 to reverse the interest income previously recorded on this promissory note.

• We incorrectly calculated the intrinsic value of unvested stock options assumed by the Company in connection with certain acquisition transactions. As a result, we have reduced the stock-based compensation expense resulting from the amounts of unearned compensation recorded in connection with those acquisitions in the aggregate amount of $2.5 million, of which approximately $0.2 million was recorded in the three months ended March 31, 2006.

• We determined that volatility assumptions used previously to estimate the fair value of our stock option grants required correction. As a result, we revised our fair value estimates based on corrected volatility assumptions for the period beginning January 1, 2001 and ending December 31, 2005.

As a result of the errors in determining measurement dates, certain options were determined to have been granted at an exercise price below the fair market value of our stock on the actual grant date. The primary adverse tax consequences are: (1) that the re-measured options vesting after December 31, 2004 are potentially subject to option holder excise tax under Section 409A of the Internal Revenue Code (and, as applicable, similar excise taxes under state law) and (2) certain incentive stock options previously granted, could be deemed granted at below market value producing incremental payroll tax liabilities. As a result, the Company recorded approximately $0.3 million in liabilities during the three months ended March 31, 2006, related to the anticipated settlement by the Company of payroll and excise taxes on behalf of the Company’s employees for options that were exercised during 2006.

Regarding potential future liabilities associated with Section 409A, the Company has yet to determine whether it will either implement a plan to assist the affected employees for the amount of this tax, adjust the terms of the original option grant, or adjust the terms of the original option grant and pay the affected employees an amount to compensate such employees for this lost benefit. As such, no additional expense has been recorded in the consolidated financial statements in the adjustments discussed above in connection with potential future liabilities related to this matter.

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Non-Stock Option Related Adjustments

The Company has determined that additional errors in its historical financials statements require correction in this restatement. Many of these errors were identified by the Company or its auditors in connection with the restatement related procedures. Other adjustments include items identified in prior periods, but deemed not to be material to the Company’s results of operations, and are included in this restatement. A summary of the impact of these adjustments to pre-tax income for the three months ended March 31, 2006 (in thousands), is as follows:

(Increase) Decrease in Pre-Tax Income
Category	Three Months Ended March 31, 2006
Revenue Adjustments
Financial system programming error	$	152
Incorrect interpretation of complex orders		(2,338	)
Inconsistent application of Company policies		(52	)
Other		565
Total revenue adjustments		(1,673	)
Operating Expense Adjustments
Incorrect application of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets		(103	)
Impact on expense from incorrect interpretation of complex orders		412
Other		(237	)
Total operating expense adjustments		72
Other Income (Expense), Net Adjustment
Other		64
Net increase in pre-tax income	$	(1,537	)

Revenue Adjustments

Based upon a review of more than 100,000 software license and services transactions over the restatement period, the Company identified several instances where previously reported revenues were required to be corrected and recognized across various reporting periods. There were several categories of revenue adjustments, but most were attributable to the following three categories of errors:

First, a programming error made at the time of our financial system’s initial implementation in 2000, resulted in a systematic miscalculation of the timing of revenue recognition across certain of the Company’s orders that contained a post-contract technical support services (referred to as PCS) line item. The error was identified and corrected in 2005 however we failed to evaluate the impact of the programming error and its effect on previously reported revenues. This error caused a shift in the timing of revenue recognition for all affected orders across numerous quarters and years, resulting in periodic quarterly over- and understatements of revenue.

Second, incorrect interpretations of certain complex orders resulted in an overstatement of license and/or PCS revenue either early in the contract or around the time of initial customer purchase and an understatement of the corresponding revenue either later in the contract or over a ratable period designated in the contract.

Third, inconsistent application of the Company’s revenue recognition policies in geographies outside North America resulted in an overstatement of license and PCS revenue at and around the time of initial customer purchase and an understatement of the corresponding revenue at the time of cash collection.

In addition to the revenue items covered specifically above, there were several additional adjustments also included in these restatement items that were grouped into the “other” category given their minimal individual impact. Many of these adjustments include certain errors that were not previously recorded because in each case, and in the aggregate, the underlying errors were not considered by management to be material to our consolidated financial statements.

Operating Expenses and Other Income (Expense), Net Adjustments

The Company also identified several instances where previously reported operating expenses or other income (expense), net items were required to be corrected and recognized across various reporting periods.

One of these items related to an incorrect application of SFAS No. 144, “Accounting for the Impairment or Disposal of Long Lived Assets,” where we performed our impairment analysis of acquired technology at the acquisition level as opposed to a product-by-product level approach, which resulted in an understatement of intangibles amortization expense related to acquired assets in the period that the impairment occurred and a corresponding overstatement of the related expense over that asset’s remaining estimated useful life.

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In addition to the operating expense item covered specifically above, there were several additional adjustments also included in these restatement items that were grouped into the “other” categories given their minimal individual impact. Many of these adjustments include certain errors that were not previously recorded because in each case, and in the aggregate, the underlying errors were not considered by management to be material to our consolidated financial statements.

All the items identified above generally affect the timing pattern of revenue, expense and income recognition. As such, they do not generally change the cumulative revenues, expenses, pre-tax operating income, liquidity or cash flow of the Company.

Impact of Errors on Previously Issued Consolidated Financial Statements

As a result of the findings of the Special Committee’s investigation with respect to employee stock options and the other adjustments described in this footnote, our condensed consolidated financial statements for the three months ended March 31, 2006 have been restated. We recorded additional stock-based compensation expense and other accounting adjustments, and related tax adjustments, affecting our previously-reported financial statements for 1999 through 2005, the effects of which are summarized below in cumulative effect on our January 1, 2006 opening accumulated deficit.

The financial information presented in this Report has been adjusted to reflect the incremental impact of the foregoing restatement adjustments on our results of operations for the three months ended March 31, 2006, as follows (in thousands):

Summary of Impact of Restatement Adjustments

	(Increase) Decrease in Pre-Tax Income								Tax Effect of Adjustments
Quarter Ended	Stock Option Related Adjustments (1)		Other Adjustments (2)			Total Adjustments, Pre-Tax			Option Related Payroll Tax Adjustments (3)		Income Tax Effect of All Adjustments			Total Adjustments, Net of Tax
Cumulative effect on our January 1, 2006 opening retained earnings	$	142,283	$	8,264		$	150,547		$	1,905	$	(55,236	)	$	97,216	(4)
March 31, 2006		699		(1,537	)		(838	)		341		(593	)		(1,090	)
Total	$	142,982	$	6,727		$	149,709		$	2,246	$	(55,829	)	$	96,126

(1) Comprised of $137.7 million of stock-based compensation expense adjustments arising from measurement date corrections and $5.3 million of other stock option related adjustments.

(2) Other non-stock option related adjustments to revenue, operating expenses, and other income (expense), net.

(3) Relates to potential payroll tax liabilities for incentive stock options deemed to be granted at below market value and is included with the appropriate compensation expense.

(4) The cumulative effect does not include the cumulative impact of the retrospective adoption of a change in accounting for planned major maintenance activities on our corporate aircraft of $0.6 million.

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The following tables present the impact of the Restatement on the Company’s previously issued condensed consolidated income statements, statement of cash flows and statements of comprehensive income for the three months ended March 31, 2006:

CONDENSED CONSOLIDATED INCOME STATEMENTS

(In thousands, except per share data)

	Three Months Ended March 31, 2006
	As Previously Reported		Adjustments						As Restated
Revenues:
Licenses	$	63,680	$	2,798		$	—		$	66,478
Services		63,839		(1,125	)		—			62,714
Total revenues		127,519		1,673			—			129,192
Cost of revenues:
Licenses		1,262		—			—			1,262
Services (1)		11,458		13			—			11,471
Amortization of purchased technology		3,451		(103	)		—			3,348
Total cost of revenues		16,171		(90	)		—			16,081
Gross profit		111,348		1,763			—			113,111
Operating expenses:
Sales and marketing (1)		58,949		596			—			59,545
Research and development (1)		27,406		413			—			27,819
General and administrative (1)		14,440		193			—			14,633
Amortization of other purchased intangible assets		2,133		—			—			2,133
In-process research and development		300		—			—			300
Total operating expenses		103,228		1,202			—			104,430
Income from operations		8,120		561			—			8,681
Other income, net		2,284		(63	)		413	(2)		2,634
Income before income tax provision		10,404		498			413			11,315
Income tax provision		3,765		(592	)		—			3,173
Net income	$	6,639	$	1,090		$	413		$	8,142
Basic net income per share	$	0.07	$	0.01		$	—		$	0.08
Diluted net income per share	$	0.06	$	0.02		$	—		$	0.08
Weighted-average shares:
Basic		100,424		—			—			100,424
Diluted		103,755		263			—			104,018
(1) Stock-Based Compensation and Related Payroll Taxes:
Cost of licenses	$	2	$	—		$	—		$	2
Cost of services		338		6			—			344
Sales and marketing		3,149		337			—			3,486
Research and development		2,505		413			—			2,918
General and administrative		1,628		284			—			1,912
Total stock-based compensation and related payroll taxes	$	7,622	$	1,040		$	—		$	8,662

(2) Represents adjustments related to the retrospective adoption of a change in accounting for planned major maintenance activities on our corporate aircraft. See Note 1 above.

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

	Three Months Ended March 31, 2006
	As Previously Reported			Adjustments						As Restated
Cash flows from operating activities:
Net income	$	6,639		$	1,090	(1-3)	$	413	(4)	$	8,142
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		9,394			(188	) (2)		—			9,206
Compensation expense associated with stock option grants		7,287			699	(1)		—			7,986
Deferred income taxes		(16	)		—			—			(16	)
Excess tax benefit related to stock-based compensation		(2,349	)		(1,643	) (3)		—			(3,992	)
Provision for bad debts		(146	)		3	(2)		—			(143	)
In-process research and development		300			—			—			300
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable		40,007			(2,840	) (2)		—			37,167
Prepaid expenses and other current assets		1,107			50	(2)		—			1,157
Other assets		204			—			—			204
Accounts payable		352			—			—			352
Accrued compensation		(5,997	)		854	(2)		—			(5,143	)
Other accrued expenses		(6,711	)		77	(2)		(413	) (4)		(7,047	)
Income taxes payable		(8,204	)		(592	) (3)		—			(8,796	)
Deferred revenue		(2,228	)		1,149	(2)		—			(1,079	)
Other liabilities		(32	)		—			—			(32	)
Net cash provided by operating activities		39,607			(1,341	)		—			38,266
Cash flows from investing activities:
Purchases of property and equipment, net		(6,254	)		(302	) (2)		—			(6,556	)
Cash paid for acquisitions, net of cash acquired		(15,259	)		—			—			(15,259	)
Purchases of cost method investments		(1,636	)		—			—			(1,636	)
Sales and maturities of marketable securities		935			—			—			935
Net cash used in investing activities		(22,214	)		(302	)		—			(22,516	)
Cash flows from financing activities:
Repayment of capital lease obligations		(64	)		—			—			(64	)
Proceeds from the exercise of stock options		12,008			—			—			12,008
Excess tax benefit related to stock-based compensation		2,349			1,643	(3)		—			3,992
Net cash provided by financing activities		14,293			1,643			—			15,936
Effect of exchange rate changes on cash and cash equivalents		(708	)		—			—			(708	)
Net increase in cash and cash equivalents		30,978			—			—			30,978
Cash and cash equivalents, beginning of period		121,025			—			—			121,025
Cash and cash equivalents, end of period	$	152,003		$	—		$	—		$	152,003
Supplemental disclosures of consolidated cash flow information:
Cash paid for interest	$	18		$	—		$	—		$	18
Cash paid for income taxes	$	11,816		$	—		$	—		$	11,816
Supplemental schedule of non-cash investing and financing activities:
Unrealized loss on marketable securities	$	168		$	—		$	—		$	168

(1) Stock option related adjustments.

(2) Other non-stock option related adjustments.

(3) Tax effect of all restatement adjustments.

(4) Represents adjustments related to the retrospective adoption of a change in accounting for planned major maintenance activities on our corporate aircraft. See Note 1 above.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands)

(Unaudited)

	Three Months Ended March 31, 2006
	As Previously Reported		Adjustments				As Restated
			(1)		(2)
Comprehensive income	$	6,471	$	1,090	$	413	$	7,974

(1) Represents adjustments related to our restatement as described throughout Note 2.

(2) Represents adjustments related to the retrospective adoption of a change in accounting for planned major maintenance activities on our corporate aircraft. See Note 1 of our Notes to Condensed Consolidated Financial Statements.

3. Stock-Based Compensation

We have authorized the issuance of an aggregate of 38.5 million shares of common stock to employees, directors and consultants under the Quest Software, Inc. 1999 Stock Incentive Plan, as amended (the “1999 Plan”) and the Quest Software, Inc. 2001 Stock Incentive Plan (the “2001 Plan” and, together with the 1999 Plan, the “Plans”). Non-qualified stock options granted under the Plans generally have a 10-year life and vest ratably over a four to five year period, generally at the rate of 20% one year after the grant date and 10% semi-annually thereafter. The exercise price of all options granted under the Plans is to be established by the Plan Administrator; provided, however, that the Plans were amended in November 2007 to require that the exercise price of stock options shall not be less than the market value of our common stock on the date of grant. The Plan Administrator for the Plans is the Compensation Committee of the Board of Directors, with certain authority delegated to a secondary committee pursuant to the terms of Plans. As of March 31, 2007, 5.3 million shares were available for grant under the Plans. No options were granted or exercised during the three months ended March 31, 2007.

We account for stock-based compensation awards in accordance with the provisions of SFAS No. 123 (revised 2004), Share-Based Payment, which requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of the portion of the awards ultimately expected to vest is recognized as expense over the requisite service period. We recognized stock-based compensation expense, including the impact of related payroll taxes, of $5.2 million, or $2.8 million net of tax, in our condensed consolidated income statements for the three months ended March 31, 2007 as compared to compensation expense of $8.7 million, or $6.2 million net of tax, for the three months ended March 31, 2006. The decrease in stock-based compensation expense is primarily due to the fact that no options have been granted since September 2006.

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The following table presents the income statement classification of stock-based compensation expense, including the impact of related payroll taxes, for the three months ended March 31, 2007 and 2006 (in thousands, except per share data):

	Three Months Ended March 31,
	2007		2006
Cost of licenses	$	2	$	2
Cost of services		263		344
Sales and marketing		2,091		3,486
Research and development		1,911		2,918
General and administrative		911		1,912
Reduction of income from operations and income before income tax provision		5,178		8,662
Income tax effect using the effective tax rate for each period		2,335		2,430
Reduction of net income	$	2,843	$	6,232
Reduction of net income per share:
Basic	$	0.03	$	0.06
Diluted	$	0.03	$	0.06

As of March 31, 2007, total unrecognized stock-based compensation cost related to unvested stock options was $43.3 million, which is expected to be recognized over a weighted-average period of 2.8 years.

4. Goodwill and Intangible Assets, Net

Intangible assets, net are comprised of the following (in thousands):

	March 31, 2007							December 31, 2006
	Gross Carrying Amount		Accumulated Amortization			Net		Gross Carrying Amount		Accumulated Amortization			Net
Acquired technology	$	96,346	$	(66,348	)	$	29,998	$	95,351	$	(63,291	)	$	32,060
Customer lists		21,436		(14,145	)		7,291		21,411		(13,677	)		7,734
Existing maintenance contracts		4,020		(2,176	)		1,844		4,020		(1,981	)		2,039
Non-compete agreement		10,506		(7,517	)		2,989		10,215		(6,908	)		3,307
Trademarks		5,970		(3,243	)		2,727		5,970		(2,974	)		2,996
	$	138,278	$	(93,429	)	$	44,849	$	136,967	$	(88,831	)	$	48,136

Amortization expense for intangible assets was $4.6 million and $5.5 million for the three months ended March 31, 2007 and 2006, respectively. Estimated annual amortization expense related to intangible assets reflected on our March 31, 2007 balance sheet is as follows (in thousands):

	Estimated Annual Amortization Expense
2007 (remaining 3 quarters)	$	13,848
2008		15,608
2009		9,165
2010		4,386
2011 and thereafter		1,842
	$	44,849

All intangible assets reflected on our March 31, 2007 balance sheet are expected to be fully amortized by the end of 2012.

The changes in the carrying amount of goodwill by reportable operating segment for the three months ended March 31, 2007 are as follows (in thousands):

	Licenses		Services		Total
Balance as of December 31, 2006	$	345,218	$	99,841	$	445,059
Acquisition		132		88		220
Balance as of March 31, 2007	$	345,350	$	99,929	$	445,279

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5. Other Income, Net

Other income, net consists of the following (in thousands):

	Three Months Ended March 31,
	2007			2006
Interest income	$	4,459		$	2,167
Interest expense		(22	)		(50	)
Foreign currency gain, net		304			1,264
Other (1)		312			(747	)
Total	$	5,053		$	2,634

(1) The “other” category includes several other components, of which the majority in 2006 relates to costs incurred with operating and maintaining our corporate aircraft (which was sold in November 2006). Adjustments for the minority interest in Vizioncore’s net income (loss), which was not material during the three months ended March 31, 2007 or 2006, are also included in this “other” category.

6. Income Tax Provision

Effective Tax Rate. During the three months ended March 31, 2007, the provision for income taxes increased to $12.3 million from $3.2 million in the comparable period of 2006, representing an increase of $9.1 million. The effective income tax rate for the three months ended March 31, 2007 was approximately 45.1% compared to 28.0% in the comparable period of 2006. The increase in our effective tax rate for the quarter is substantially due to the mix of income between high and low tax jurisdictions, the impact of net operating losses and associated valuation allowances in certain foreign jurisdictions (as assessed under FIN No. 18, “Accounting for Income Taxes in Interim Periods”) and the inclusion of interest expense related to prior period unrecognized tax benefits (as assessed under FIN 48).

Adoption of FASB Interpretation No. 48. Effective January 1, 2007, we adopted FIN 48. FIN 48 prescribes a more-likely-than-not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on de-recognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, accounting for income taxes in interim periods and income tax disclosures. At January 1, 2007, the balance of gross unrecognized tax benefits was $29.0 million, of which approximately $21.0 million would impact the effective tax rate if recognized. The cumulative effects of applying this interpretation have been recorded as a decrease of $2.7 million to retained earnings, an increase of $5.0 million to net deferred income tax assets and an increase of $7.7 million to income taxes payable as of January 1, 2007.

In conjunction with the adoption of FIN 48, we have classified uncertain tax positions as non-current income tax liabilities unless expected to be paid in one year. Penalties and tax-related interest expense are reported as a component of our income tax provision. As of March 31 and January 1, 2007, the total amount of accrued income tax-related interest and penalties included in the Condensed Consolidated Balance Sheets was approximately $1.9 million and $1.5 million, respectively.

As of March 31, 2007, we are no longer subject to U.S. federal tax audits for years through December 31, 2002. We were also subject to examination in various state and foreign jurisdictions for the 1997-2006 tax years. We are currently under examination by the Internal Revenue Service for the 2004 tax year and the French Tax Authority for the 2001-2004 tax years.

We believe appropriate provisions for all outstanding issues have been made for all jurisdictions and all open years. However, due to the risk that audit outcomes and the timing of audit settlements are subject to significant uncertainty and as we continue to evaluate such uncertainties in light of current facts and circumstances, our current estimate of the total amounts of unrecognized tax benefits could increase or decrease for all open tax years. As of the date of this report, we do not anticipate that there will be any material change in the unrecognized tax benefits within the next twelve months.

7. Net Income Per Share

Basic earnings per share is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities by including other common stock equivalents, including stock options, in the weighted-average number of common shares outstanding for a period, if dilutive.

The table below sets forth the reconciliation of the denominator of the earnings per share calculation (in thousands):

	Three Months Ended March 31,
	2007	2006
Shares used in computing basic net income per share	101,819	100,424
Dilutive effect of stock options (1)	3,073	3,594
Shares used in computing diluted net income per share	104,892	104,018

(1) Options to purchase 9.6 million and 9.8 million shares of common stock were outstanding during the three months ended March 31, 2007 and 2006, respectively, but were not included in the computation of net income per share as inclusion would have been anti-dilutive.

8. Geographic and Segment Information

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by our chief operating decision maker, or decision-making group, in assessing performance and in deciding how to allocate resources.

Our reportable operating segments are Licenses and Services. The Licenses segment develops and markets licenses to use our software products. The Services segment provides after-sale support for software products and fee-based training and consulting services related to our software products.

We do not separately allocate operating expenses to these segments, nor do we allocate specific assets to these segments. Therefore, segment information reported includes only revenues, cost of revenues, and gross profit.

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Reportable segment data is as follows (in thousands):

	Licenses		Services		Total
Three months ended March 31, 2007
Revenues	$	74,269	$	75,500	$	149,769
Cost of Revenues		5,060		12,981		18,041
Gross profit	$	69,209	$	62,519	$	131,728
Three months ended March 31, 2006
Revenues	$	66,478	$	62,714	$	129,192
Cost of Revenues		4,610		11,471		16,081
Gross profit	$	61,868	$	51,243	$	113,111

Revenues are attributed to geographic areas based on the location of the entity to which the products or services were delivered. Revenues and long-lived assets concerning principal geographic areas in which we operate are as follows (in thousands):

	United States		United Kingdom		Other International (2)		Total
Three months ended March 31, 2007:
Revenues	$	89,297	$	20,052	$	40,420	$	149,769
Long-lived assets (1)	$	69,817	$	5,234	$	10,132	$	85,183
Three months ended March 31, 2006:
Revenues	$	80,046	$	15,984	$	33,162	$	129,192
Long-lived assets (1)	$	80,443	$	5,482	$	7,322	$	93,247

(1) Consists of property and equipment, net and other assets.

(2) No single country within Other International accounts for greater than 10% of total revenues.

9. Commitments and Contingencies

Securities Litigation. From June 2006 through August 2006 a number of purported Quest Software shareholders filed putative shareholder derivative actions against the Company, the members of our Board of Directors, and certain current or former officers, alleging, among other things, that the defendants improperly dated certain Quest Software employee stock option grants. Two of these cases, Eng v. Smith, et al. (Case No. 06-cv-751 DOC(RNBx)) and Freedman v. Smith, et al. (Case No. 06-cv-763 DOC(RNBx)) have been consolidated in the United States District Court for the Central District of California. The plaintiffs filed a consolidated amended complaint in November 2006 and a further amended consolidated complaint in September 2007. In addition, two putative shareholder derivative actions, Patterson v. Aronoff, et al. (Case No. 06CC00115) and Hodge v. Aronoff, et al. (Case No. 06CC06787), were filed in the California Superior Court for the County of Orange. The state court derivative actions were consolidated in July 2006.

In August 2007, an additional putative shareholder derivative action was filed against the Company (as nominal defendant), the members of our Board of Directors and certain current or former officers, alleging generally that the individual defendants violated United States securities laws by improper stock option grant practices and related accounting and disclosures. This case, City of Livonia Employees’ Retirement System v. Smith, et al. (Case No. SACV07-901 DOC (ANx)) was also filed in the United States District Court for the Central District of California.

The putative state and federal derivative actions identified above are collectively referred to as the “Options Derivative Actions”. The plaintiffs in the Options Derivative Actions contend, among other things, that the defendants’ conduct violated United States and California securities laws, breached defendants’ fiduciary duties, wasted corporate assets, unjustly enriched the defendants, and caused errors in our financial statements. The plaintiffs seek, among other things, unspecified damages and disgorgement of profits from the alleged conduct, to be paid to the Company.

In November 2007, we entered into a Stipulation of Settlement with the plaintiffs in the Options Derivative Actions, pursuant to which the Options Derivative Actions shall be settled and dismissed with prejudice, subject to approval of the U.S. District Court for the Central District of California, as to the Company and all of its current and former officers and directors. As part of the settlement, the company agreed to adopt certain remedial measures and corporate governance

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changes, in addition to the actions taken by the Special Committee of the Company’s Board arising from the stock option investigation, and the plaintiffs will be entitled to payment of an amount representing their attorneys’ fees, which is expected to be provided by the Company’s directors’ and officers’ liability insurance carrier.

In October 2006 a purported shareholder class action was filed in the United States District Court for the Central District of California against Quest Software and certain of its current or former officers and directors, entitled Middlesex Retirement System v. Quest Software, Inc., et al. (Case No. CV06-6863 DOC (RNBx)) (the “Options Class Action”). The essence of the plaintiff’s allegations in the Options Class Action is that the Company improperly backdated stock options, resulting in false or misleading disclosures concerning, among other things, Quest Software’s financial condition. Plaintiffs also allege that the individual defendants sold Quest Software stock while in possession of material nonpublic information, and that the defendants’ conduct caused damages to the putative plaintiff class. The plaintiff asserts claims under Sections 10(b), 20(a) and 20A of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. In January 2007, the Court appointed Middlesex Retirement System as lead class plaintiff and entered a stipulated order establishing a pleading schedule for the plaintiff’s first amended complaint and the defendants’ response thereto. The first amended class action complaint was filed with the Court in March 2007. In October 2007, the Court issued its order on the Company’s motion to dismiss the amended class action complaint. The Court dismissed the plaintiff’s claims under Section 10(b) with respect to Michael Lambert, the Company’s former Chief Financial Officer, and the plaintiff’s claims under Section 20(a) with respect to the Company and to Doug Garn, the Company’s President, which claims have been dismissed without prejudice. The Court also held in abeyance the plaintiff’s claims under Section 20A pending plaintiff’s filing of an amended complaint. Otherwise, the Court denied the Company’s motion to dismiss as it related to the Company and other individual defendants. The Company and the individual defendants have filed a motion with the U.S. District Court requesting certification of the Court’s order for interlocutory appellate review. The Company intends to defend the Options Class Action vigorously.

SEC Investigation and United States Attorney’s Office Information Request. In June 2006 the Company received an informal request for information from the staff of the Los Angeles regional office of the Securities and Exchange Commission regarding its option granting practices. In January 2007 the SEC issued a formal order of investigation and a subpoena for the production of documents. The Company is cooperating with the SEC, but does not know when the inquiry and investigation will be resolved or what, if any, actions the SEC may require it to take as part of that resolution. Quest Software has also been informally contacted by the U.S. Attorney’s Office for the Central District of California (“U.S. Attorney’s Office”) and has been asked to produce on a voluntary basis documents many of which it previously provided to the SEC. The Company is fully cooperating with both the SEC and the U.S. Attorney’s Office. Any action by the SEC, the U.S. Attorney’s Office or other governmental agency could result in civil or criminal sanctions against the Company and/or certain of its current or former officers, directors and/or employees.

Initial Public Offering Securities Litigation. In November 2001, the Company, three of its current and former officers (“Individual Defendants”) and the underwriters in the Company’s initial public offering (“IPO”) were named as defendants in a consolidated shareholder lawsuit in the United States District Court for the Southern District of New York. This case is one of a number of actions coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, 21 MC 92. Plaintiffs in the coordinated proceeding have brought claims under the federal securities laws against approximately 300 companies, underwriters, and individuals, alleging generally that defendant underwriters engaged in improper and undisclosed activities concerning the allocation of shares in the companies’ IPOs from late 1998 through 2000. The amended complaint in the Company’s case seeks unspecified damages on behalf of a purported class of purchasers of its common stock between August 13, 1999 and December 6, 2000. Pursuant to a tolling agreement, the Court dismissed the Individual Defendants without prejudice. In February 2003, the Court denied the Company’s motion to dismiss the claims against it. The issuer defendants and plaintiffs negotiated a stipulation of settlement for the claims against the issuer defendants, including the Company, which was submitted to the Court for approval in June 2004 and preliminarily approved in August 2005. In December 2006, the Court of Appeals for the Second Circuit overturned the certification of classes in the six test cases that were selected by the underwriter defendants and plaintiffs in the coordinated proceeding. Because class certification was a condition of the settlement, it became unlikely that the settlement would receive final court approval. On June 25, 2007, the Court entered an order terminating the proposed settlement based upon a stipulation among the parties to the settlement.

On August 14, 2007, the plaintiffs filed a second amended class action complaint against the Company. The amended complaint contains a number of changes, including changes to the definition of the purported class of investors, and the elimination of the Individual Defendants as defendants. On September 27, 2007, the plaintiffs filed a motion for class

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certification against the Company. The Company filed a motion to dismiss the claims against it on November 14, 2007. It is uncertain whether the parties will be able to negotiate a revised or future settlement that complies with the standards set forth in the Second Circuit’s decision. The Company believes that it has meritorious defenses to the plaintiffs’ claims and intends to defend the action vigorously.

Intellectual Property Litigation. In December 2006, Diagnostic Systems Corporation (“DSC”) filed a complaint for patent infringement against Quest Software, Inc. and five other software companies. The complaint was filed in the United States District Court for the Central District of California, as Case No. SACV06-1211 CJc(ANx). DSC is a subsidiary of Acacia Research Corporation, and asserts that it is the owner by assignment of all rights and interests in U.S. patent nos. 5,701,400 and 5,537,590, and that certain of Quest’s software products infringe these two patents. DSC seeks injunctive relief and damages. Quest filed an answer denying infringement on the two patents asserted and asserting various affirmative defenses to DSC’s claims. Discovery in this matter is only recently beginning. If any of our products were found to infringe such patents, the patent holder could seek an injunction to enjoin our use of the infringing product. If we were required to settle such a claim, it could have a material impact on our business, results of operations, financial condition or cash flows.

Acquisitions. The Company has entered into escrow agreements with acquired companies to satisfy certain indemnification obligations of selling shareholders. Certain of these escrow agreements designate Quest as the holder of the escrow money. As of March 31, 2007, we hold approximately $0.7 million in cash related to these agreements, all of which is included in cash and cash equivalents.

General. The Company and its subsidiaries are also involved in other legal proceedings, claims and litigation arising in the ordinary course of business.

In the normal course of our business, we enter into certain types of agreements that require us to indemnify or guarantee the obligations of other parties. These commitments include (i) intellectual property indemnities to licensees of our software products, (ii) indemnities to certain lessors under office space leases for certain claims arising from our use or occupancy of the related premises, or for the obligations of our subsidiaries under leasing arrangements, (iii) indemnities to customers, vendors and service providers for claims based on negligence or willful misconduct of our employees and agents, (iv) indemnities to our directors and officers to the maximum extent permitted under applicable law, and (v) letters of credit and similar obligations as a form of credit support for our international subsidiaries and certain resellers. The terms and duration of these commitments varies and, in some cases, may be indefinite, and certain of these commitments do not limit the maximum amount of future payments we could become obligated to make thereunder; accordingly, our actual aggregate maximum exposure related to these types of commitments cannot be reasonably estimated. Historically, we have not been obligated to make significant payments for obligations of this nature, and no liabilities have been recorded for these obligations in our financial statements included in this report, as the estimated fair value of these obligations as of March 31, 2007 was considered nominal.

10. Related Party Transactions

In 2000, we received a note receivable with a face amount of $15.8 million from one of our then executive officers for the purchase of 339,200 shares of our common stock at a purchase price of $46.50 per share. The officer granted Quest a security interest in the shares and also assigned, transferred, and pledged the shares to Quest in order to secure his obligations under the Note. The Company maintains physical possession of the certificates representing the shares purchased as collateral until payment of the principal and interest under the note is made. The former officer remained employed by Quest as of March 31, 2007. The maturity date of the note receivable was August 2007, when the principal amount and accrued interest became due and payable. The note receivable bears interest at 6.33% per annum. We are pursuing collection. The note receivable is deemed to be a non-recourse obligation of the former officer for financial reporting purposes as such we recorded the note as a reduction to shareholders’ equity in accordance with Emerging Issues Task Force Issue No. 85-1, Classifying Notes Received for Capital Stock, and recorded a corresponding credit to common stock. As part of our restatement, discussed in Note 2, we reduced the carrying value of the note receivable for interest income incorrectly recorded in other income (expense), net of $0.4 million and $1.0 million in 2000 and 2001, respectively, and we reclassified the face amount of the note to common stock on our accompanying condensed consolidated balance sheet.

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11. Subsequent Events

In August 2007 we acquired ScriptLogic Corporation (“ScriptLogic”), a privately held company that provides systems lifecycle management solutions for Windows-based networks, for purchase consideration of approximately $88.8 million. In connection with the acquisition, Quest also offered key members of the management team of ScriptLogic an opportunity to participate in a post-closing incentive bonus plan in an aggregate amount of up to $8.0 million payable over a four-year period (the “Incentive Plan”). A portion of the payments under the Incentive Plan will be based on the satisfaction of financial performance objectives and a portion of the payments will be based solely on continued employment. All bonus payments will be recorded as compensation expense in the periods such bonuses are earned. Of the cash amount paid at closing, $12.0 million was deposited in an escrow account to secure certain indemnification obligations of the selling shareholders. The acquisition will be accounted for as a purchase and the purchase price is expected to be allocated primarily to goodwill and other intangible assets.

Certain venture capital funds associated with Insight Venture Partners (the “Insight Funds”) previously holding shares of ScriptLogic’s preferred stock became entitled to receive (in respect of those shares of preferred stock) cash in an aggregate amount of up to approximately $37.7 million (subject to claims against an indemnity escrow fund).

Jerry Murdock, a director of Quest Software, is a Managing Director and the co-founder of Insight Venture Partners and an investor in the Insight Funds. Vincent Smith, Quest’s Chairman of the Board and CEO, and Raymond Lane and Paul Sallaberry, directors of Quest Software, are passive limited partners in one or more of the Insight Funds. As a result of their interests in the Insight Funds, Messrs. Murdock, Smith, Lane and Sallaberry have interests in the ScriptLogic transaction. We believe that the financial interests of Messrs. Smith, Lane and Sallaberry in this transaction are not material to them.

We believe that the related party transaction set forth above was made on terms no less favorable to us than could have been otherwise obtained from unaffiliated third parties.

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

The following discussion of our financial condition and results of operations (“MD&A”) should be read in conjunction with the condensed consolidated financial statements and notes to those statements included elsewhere in this Report, and gives effect to the restatement discussed below and in Note 2 of our Notes to Condensed Consolidated Financial Statements. Certain statements in this Report, including statements regarding our business strategies, operations, financial condition and prospects are forward-looking statements. Use of the words “believe,” “expect,” “anticipate,” “will,” “contemplate,” “would” and similar expressions that contemplate future events may identify forward-looking statements.

Numerous important factors, risks and uncertainties affect our operations and could cause actual results to differ materially from those expressed or implied by these or any other forward-looking statements made by us or on our behalf. Readers are urged to carefully review and consider the various disclosures described under Item 1A – “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2006, and in other filings with the SEC that attempt to advise interested parties of certain risks and factors that may affect our business. Readers are cautioned not to place undue reliance on these forward-looking statements, which are based on current expectations and reflect management’s opinions only as of the date thereof. We do not assume any obligation to revise or update forward-looking statements. Finally, our historic results should not be viewed as indicative of future performance.

Restatement

Subsequent to the issuance of the Company’s condensed consolidated financial statements for the quarter ended March 31, 2006, the Company’s management determined that incorrect measurement dates were used for financial accounting purposes for certain stock option grants made in prior periods and that other stock option and non-stock option related errors in its historical financial statements require correction, as described in more detail below. As a result, the condensed consolidated financial statements for the three months ended March 31, 2006 have been restated from the amounts previously reported to correct these errors. The after tax effect of all restatement adjustments amounted to a $1.1 million benefit to net income for the three months ended March 31, 2006.

Background and Scope of the Investigation

On May 17, 2006, a financial analyst at Deutsche Bank published a report entitled “Infrastructure SW Update: Analyzing potential for back dated stock options.” The report analyzed the likelihood of various software companies having historically back dated equity awards. Quest Software was identified in this report as one company with characteristics similar to other companies which had previously announced stock option investigations. After reviewing the Deutsche Bank report, our General Counsel and then Chief Financial Officer initiated an internal review of the facts and circumstances of our historical stock option granting practices and related documentation. On May 22, 2006, the Board of Directors was briefed on the existence of the Deutsche Bank report and preliminary results of the internal review.

On May 26, 2006, our Board formed a Special Committee of independent directors to conduct an investigation of our historical stock option granting practices and related accounting. The Special Committee was initially comprised of Kevin M. Klausmeyer and Augustine L. Nieto II, both members of the Audit Committee, with the understanding that Mr. Nieto would serve temporarily until another independent, disinterested member was appointed. On June 8, 2006, H. John Dirks joined our Board and was appointed to the Audit Committee and the Special Committee, replacing Mr. Nieto as a member of the Special Committee. The Special Committee retained outside legal counsel, Duane Morris LLP, and Duane Morris retained forensic accounting consultants, Navigant Consulting, Inc., to assist in the investigation.

The Special Committee’s investigation covered facts, circumstances and timing of stock option grants made by the Company from June 1998 to December 2005. The Special Committee and its advisors reviewed voluminous electronic and hard copy documents, including files of the Company’s current and former employees, officers and directors involved in the administration and approval of, as well as in the accounting for, stock option grants made under the Company’s stock option programs. In addition to the documents reviewed, the Special Committee’s lawyers conducted interviews with more than 20 individuals that had knowledge of our stock option granting practices, including current and former employees, officers and directors.

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Historical Stock Option Granting Practices

Prior to January 1, 2006, we accounted for our stock option grants under Accounting Principles Board Opinion No. 25 (“APB No. 25”) and had provided the required disclosures pursuant to the provisions of Statement of Financial Accounting Standards, or SFAS, No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). On January 1, 2006, we adopted SFAS No. 123R, Share-Based Payment (“SFAS 123R”), under the modified prospective method. For the accounting measurement date revisions made, we revised the historical pro forma footnote disclosures in accordance with SFAS 123. Additionally, we restated our condensed consolidated financial statements for the three months ended March 31, 2006 to reflect the impact of revised measurement dates on compensation expense recognized in accordance with SFAS 123R.

As permitted by the terms of our stock incentive plans, the Board of Directors was vested with the authority to administer and grant stock options under the plans, and the Board of Directors had delegated general authority for stock option plan administration to the Compensation Committee of the Board. Until August 2003, all employee stock option grants were required to be approved by the Board of Directors or the Compensation Committee. Beginning in August 2003 and as permitted by the terms of our stock incentive plans, the Board of Directors delegated authority, subject to specific parameters, to our Chief Executive Officer as a “Secondary Committee” to approve stock option awards to employees other than officers or directors of the Company. Option grants to officers and directors and other grants outside of the parameters discussed below continued to require Compensation Committee approval in order to complete the required granting actions.

From June 1998 through December 2005, the exercise price for all stock option grants was typically set at the closing sale price of our Common Stock on the original stated grant date, as reported by Nasdaq. During this period, we made the following types of grants of stock options to employees, including officers, and members of our Board of Directors:

• Annual, broad-based grants to large numbers of employees (referred to as annual grants);

• Grants to newly hired employees and grants to existing employees from time to time (referred to as new hire or merit grants);

• Options granted or assumed in connection with acquisitions; and

• Options granted to non-employee members of our Board of Directors according to the automatic grant program of our 1999 Stock Incentive Plan.

For our stock option grants dated from June 1998 through early 2001, we generally sought approval of the entire Board of Directors, including all new hire, merit and annual grants. Prior to September 1999, we did not have a defined process for determining the date on which we made grants, and no regular granting pattern could be established from our review of the facts and circumstances of those granting actions. Accordingly, the Special Committee concluded that required granting actions for stock option grants during the pre-IPO period between June 1998 and June 1999 were not completed with the required specificity and finality until June 9, 1999. On this date, we adopted our 1999 Stock Incentive Plan in contemplation of our IPO, which was completed in August 1999.

Beginning in late 1999, we changed our stock option granting practices by implementing a practice where we typically dated new hire and merit grants to employees on a monthly basis, where the grant date for any given new hire would be based on the month during which the new hire signed an employment offer letter or started employment with the Company. When option grants were granted to existing employees as merit grants, they were approved using the same practice and included in the monthly new-hire grant procedure. Option grants for these grants for a given month were dated as of the trading date during that month on which the closing price for our Common Stock reported by Nasdaq was determined to be the lowest monthly closing price, and the exercise price established for those option grants was the closing sale price of the Common Stock on such date. We made annual or broad-based, company-wide grants in 2000, 2001 and 2002 to executive and non-executive employees as of grant dates determined on the same basis as new hire or merit grants. The Special Committee also determined that approvals for certain option grants made in connection with acquisitions were obtained in connection with new hire or merit grants during this period, and that the period within which new hire and merit grant dates were determined was expanded from monthly to quarterly on a few occasions.

All discretionary employee grants required approval by the Board of Directors or the Compensation Committee to complete the required granting actions. For most grants we did not obtain approval from the Board of Directors or Compensation Committee (most often by means of a form of unanimous written consent that reflected an “as of” approval date), until after the end of the period (the particular month or quarter) within which the original grant date was intended.

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Beginning with our April 2001 granting action, we sought Compensation Committee approval for all discretionary stock option grants to employees and other eligible participants, including consultants. We also changed our stock option granting practices by determining grant dates and exercise prices as of the date when the required granting actions were actually completed, beginning with our monthly new hire and merit granting action in February 2002. As a result, our April 2002 monthly new hire and merit grant was the last monthly grant for which the originally stated grant date was determined with hindsight.

In August 2003, the Board of Directors established a Secondary Committee under the terms of our 1999 Stock Incentive Plan and 2001 Stock Incentive Plan, consisting of Vincent C. Smith, our Chairman of the Board and Chief Executive Officer, and delegated authority to the Secondary Committee to approve awards of stock options to employees within specific parameters. The delegation provided authority to grant up to 50,000 options to any employee in connection with his or her hiring into the Company, and up to 20,000 options to existing employees; provided, however, than no authority was delegated with respect to option grants to officers or directors of the Company. Compensation Committee approval continued to be a required granting action for all stock option grants outside of the parameters of the delegated authority. For grants outside the scope of delegated of authority, the Compensation Committee approved such grants at a meeting or by unanimous written consent form.

Prior to the restatement discussed below, we used the originally stated grant dates as set forth above as the measurement date for financial accounting purposes. Accordingly, in each case the exercise price was determined to be equal to the closing stock price of our Common Stock as reported by Nasdaq on that date, other than a limited number of grants for which we intentionally awarded discounted option grants. Other than compensation expense associated with those discounted option grants, we did not record stock-based compensation expense in connection with our stock option grants. In the restatement, we revised the accounting measurement dates for many grants and recorded stock-based compensation expense when the revised measurement date resulted in intrinsic value.

Findings of the Investigation and Measurement Date Determinations

The Special Committee performed a detailed review of all stock option grants awarded from August 13, 1999 (the date of the Company’s initial public offering) through June 30, 2003 and all annual grants from July 1, 2003 through December 2005, covering grants to purchase 30,739,235 shares of Common Stock made in 7,287 awards on 39 granting dates. The Special Committee also performed limited testing on a sample of stock option grants made prior to the initial public offering covering grants to purchase 10,632,744 shares of Common Stock made in 762 awards on 38 granting dates. The Special Committee also performed limited testing on a sampling of new hire and merit stock option grants awarded after June 30, 2003 covering grants to purchase 5,082,350 shares of Common Stock representing 61% of all new hire and merit options granted during this period.

We classified option grants subject to the investigation into in three time periods: (1) June 1998 through August 1999 (the “Pre-IPO Period”); (2) September 1999 through April 30, 2002; and (3) May 1, 2002 through December 2005. Because annual, broad-based grants were made in a process substantially similar to new hire and merit grants, we did not separately classify option grants by the nature of their granting process. Based on the facts obtained as a result of the Special Committee investigation, we identified grants for which we used an incorrect measurement date for financial accounting purposes, as defined under Generally Accepted Accounting Principles in the United States, or GAAP. To determine the correct accounting measurement dates for these grants we followed the guidance in APB No. 25, which deems the “measurement date” to be the first date on which all of the following are known with finality: (1) the identity of the individual employee who is entitled to receive the option grant; (2) the number of options that the individual employee is entitled to receive; and (3) the option’s exercise price.

The Special Committee performed a grant date by grant date analysis of approximately 38 option grant dates during the Pre-IPO Period, 36 option grant dates between the IPO and June 30, 2003 and all three annual grants from July 1, 2003 through December 2005 for compliance with APB No. 25. Where we determined that we did not complete the required granting actions by the original grant date, we used judgment to determine corrected accounting measurement dates for all awards included within the granting action on each grant date consistent with what the evidence suggested was our practice or process. If the revised measurement date was not the same date we used previously, we made accounting adjustments as required, which resulted in stock-based compensation and related tax effects when an option had intrinsic value on the revised measurement date.

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The documents and information considered in connection with the measurement date adjustments that we have made included, but was not limited to:

• minutes of Board of Directors and Compensation Committee meetings;

• actions by unanimous written consent signed by directors, together with evidence relating to the date such consents were requested and/or signed and returned;

• information contained in employee personnel files;

• electronic mail messages and other electronic files retrieved from our computer system and in back up media;

• information concerning the date or dates on which a stock option was entered into our stock option tracking system, Equity Edge;

• information concerning the date on which a notice of stock option grants (and accompanying stock option agreement) was signed on behalf of Quest by an executive officer, which we considered to represent the Company’s contractual commitment to complete the particular grant;

• correspondence, memoranda and other documentation supporting the option grant; and

• information obtained during interviews conducted by the Special Committee’s legal counsel of numerous individuals, including current and former officers, directors, employees and outside professionals.

A total of 3,382 awards covering grants to purchase 22,553,293 shares of Common Stock required measurement date changes, of which options to purchase 3,604,950 shares of Common Stock were granted to employees who were executive officers of the Company at the time of their respective grant dates. None of our non-employee directors received stock options grants requiring measurement date corrections.

The Special Committee determined that both current and former senior management contributed to the Company’s lack of controls and inappropriate grant practices. Specifically, the Special Committee determined that two former Chief Financial Officers and a former Corporate Controller failed to perform the responsibilities of their positions. One former Chief Financial Officer resigned from the Company for unrelated reasons in January 2001. The other Chief Financial Officer resigned from the Company on November 18, 2006, after declining to be interviewed by the Special Committee. The Corporate Controller was reassigned from his accounting management role in October 2006.

The Special Committee made no finding of fraud or intentional misconduct by any current or former employees, officers or directors, and concluded that no further changes in the Company’s executive officers will be recommended.

The following table summarizes certain information with respect to option awards requiring accounting measurement date changes:

Time Period	Number of Granting Dates	Number of Awards	Number of Shares
Pre-IPO Period	35	757	10,519,744
Initial Public Offering through April 30, 2002	21	2,567	11,255,299
After April 30, 2002	11	58	778,250
Total	67	3,382	22,553,293

A summary of incremental pre-tax stock-based compensation expense related to options awarded in each time period covering the period from June 1998 through March 31, 2006 (“restatement period”) resulting from a change in the accounting measurement date (in thousands), is as follows:

Time Period	Pre-Tax Stock-based Compensation Expense, Net of Forfeitures
Pre-IPO Period	$	23,288
Initial Public Offering through April 30, 2002		114,140
After April 30, 2002		319
Cumulative effect for options vested through March 31, 2006	$	137,747

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Pre-IPO Period Grants

During the course of the investigation, information and documentation relating to stock option grants made prior to the Company’s initial public offering was evaluated. The Special Committee determined that accounting measurement dates for most of the stock option grants during the period from June 23, 1998 through August 11, 1999 were incorrectly determined. These instances involved an aggregate of 757 stock option grants awarded to employees covering 10,519,744 shares of Common Stock. Specifically, the Special Committee discovered evidence that required details of 588 awards covering 9,373,344 shares covered by all grants between June 1998 and June 9, 1999 did not have the required level of finality or were not supported by sufficient documentation until June 9, 1999, the date on which the Company’s 1999 Stock Incentive Plan was adopted by the Company and approved by its shareholders.

For the stock option grants awarded between June 10, 1999 through August 11, 1999, the Company was unable to locate evidence of completion of required granting actions (specifically, approval of the stock option grants by the Company’s Board of Directors or Compensation Committee). These instances involved an aggregate of 169 stock option grants to employees to purchase an aggregate of 1,146,400 shares of the Company’s Common Stock. None of these stock options were granted to executive officers or senior officers who participated in the stock option granting processes associated with these grants. The Company has been honoring these stock options awards and settling them with stock and intends to continue doing so. Measurement date determinations for these option grants were made on the basis of all available relevant information and reflect the Company’s reasonable conclusion as to the most likely option granting actions that occurred and related facts and circumstances. Specifically, we used evidence of the dates on which the Notices of Grant were executed on behalf of the Company as the best evidence of the granting actions actually completed, and used those dates as the revised measurement dates for financial reporting purposes.

Corrections to the measurement dates for option grants during the Pre-IPO Period resulted in the recording of additional pre-tax stock based compensation of $23.3 million, all of which was recorded prior to January 1, 2006.

Post IPO Grants–September 1999 through April 2002

In the fourth quarter of 1999, the Company initiated a practice of processing option grants to newly-hired employees and merit or promotion grants to existing employees on a monthly basis, starting with the grants dated September 1999, and to determine a single grant date for stock options granted within each of those particular months. The Special Committee found evidence demonstrating that stock option grants made in any given month were routinely made as of the trading date associated with the lowest closing sale price reported by Nasdaq for our Common Stock from September 1999 through April 2002, with only a few grants during such period made on other dates. The Special Committee also found evidence that the option grant dating practice expanded to quarterly, rather than monthly, grant date determinations.

For stock option grants during this time period, the Special Committee determined that:

• administrative approvals for required granting actions were generally documented by unanimous written consents of the Board or the Compensation Committee, and were dated “as of” the date corresponding to the trading date in a given month or quarter on which the Company’s last sale price was determined to be the lowest in that period;

• all of such unanimous written consents were prepared after the selected grant dates and were executed by members of the Board or Compensation Committee at a later time, in some cases as much as up to three months after the selected grant date; and

• in certain cases, the lists reflecting stock option grants processed by the Company’s stock plan administrator were different than the lists provided to and approved by either the Board or Compensation Committee, as the case may be.

For each of the 21 discretionary grants affected by the Special Committee’s findings during this period, the Special Committee determined an accounting measurement date based on information and documentation evidencing the date as of which the related action by unanimous written consent (“UWC”) had been signed by all of the directors or, in the case of Compensation Committee action, members of the Compensation Committee. However, in many cases, the Company was unable to locate definitive and complete documentation evidencing the date on which the last required approval of a UWC was signed by certain directors and received by the Company. For these stock option grants, the Company’s measurement

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date determinations were made on the basis of all available relevant information and reflect the Company’s reasonable conclusion as to the most likely option granting actions that occurred based on related facts and circumstances. For grants where there was insufficient evidence to determine when all required written consents were actually obtained, but there was evidence of the dates of receipt of individual written consents (such as contemporaneous electronic messages to or from individuals involved in the granting activities or facsimile header dates on signed unanimous written consent forms), we used this information as evidence of when the Compensation Committee approval was obtained, and used that date as the revised measurement date for financial reporting purposes. In other cases where we could not locate evidence of the date or dates on which required granting approvals were obtained, we used evidence of the dates on which the Notices of Grant were executed on behalf of the Company as the best evidence of the granting actions actually completed, and used those dates as the revised measurement dates for financial reporting purposes. We believe that these grants were communicated to employees in a timely manner. In some cases, we awarded option grants that were different in amount than that approved by the required granting actions or to employees whose awards were not included in lists approved by the Board of Directors or Compensation Committee. In each of these circumstances, we evaluated the existing information related to each individual grant and we established a new measurement date when we determined that the terms of the award were fixed with finality, which was generally the date on which the related Notice of Grant was signed on behalf of the Company.

Section 16 Insiders received stock options covering an aggregate of 2,904,950 shares of Common Stock in these grant events, which collectively resulted in $24.0 million of additional compensation expense over the restatement period. See the discussion under the heading “Remedial Actions” below with respect to actions taken by the Company with respect to option awards to Section 16 Insiders. Employees other than Section 16 Insiders received options to purchase an aggregate of 8,350,349 shares in these grant events. Corrections to the measurement dates for all of the misdated grants during the period from September 1999 through April 2002 resulted in the recording of additional stock-based compensation expense of $114.1 million, of which $0.8 million was recorded in the three months ended March 31, 2006.

Post IPO Grants – May 1, 2002 through December 2005

The Special Committee performed a detailed review of all stock option grants awarded between May 1, 2002 and June 30, 2003 and all annual grants awarded between May 1, 2002 and December 2005. Measurement date exceptions were noted for 45 grants covering options to purchase 294,750 shares, for which an additional stock-based compensation expense of approximately $278,000 was recorded in periods prior to January 1, 2006. Based on the significant improvements in the Company’s stock option granting practices during this period, the Special Committee determined to conduct limited sampling and testing of new hire and merit stock option grants awarded after June 30, 2003. The Special Committee sampled 88 new hire and merit grants, covering 5,082,350 shares of Common Stock (61% of all shares covered by new hire and merit option grants). The remaining new hire and merit stock option grants occurring during the period from July 1, 2003 through December 31, 2005 were not individually reviewed and did not appear to have any unusual pricing or other characteristics indicating a need for full individual review. Sampling and other analysis indicated that these remaining grants consisted of new hire and merit grants to non-officer employees. Various tests were performed to determine whether these remaining grants had any unique pricing or other characteristics. None were identified, although measurement dates exceptions were noted for 13 grants covering options to purchase 483,500 shares, for which an additional stock-based compensation expense of approximately $41,000 was recorded in periods prior to January 1, 2006. Given the immaterial number of shares and limited income statement impact, along with the absence of unique pricing or other characteristics, additional review procedures were not deemed necessary for these remaining grants occurring after June 30, 2003 and were therefore not applied.

Other Stock Option Related Adjustments

In addition to adjustments to our reported stock-based compensation expenses resulting from corrections to accounting measurement dates, the restatement also reflects stock-option related adjustments arising from a variety of other issues discovered during our investigation:

• We recorded compensation expense as a result of modifications to stock options made or deemed to have been made to certain employees in connection with their termination of employment or extended leaves of absence. Typically such modifications related to, or resulted in, extensions of the time periods following cessation of service within which these employees could exercise vested stock options. We recorded incremental pre-tax stock-based compensation expense associated with such modifications in the aggregate amount of $2.0 million, of which approximately $41,000 was recorded in the three months ended March 31, 2006.

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• We identified certain stock option grants awarded to non-executive employees which were repriced or otherwise modified in circumstances which required variable accounting treatment. We also identified an option grant awarded to a non-employee consultant deemed to have been granted in exchange for services. We have recorded incremental pre-tax stock-based compensation expense associated with these stock option awards in the aggregate amount of $4.3 million, all of which was recorded prior to January 1, 2006.

• We determined that our accounting treatment for a restricted stock issuance in 2000 was incorrect. We issued 339,200 shares of common stock to an employee in connection with his initial employment with the Company as Vice President, Marketing, and accepted this employee’s secured promissory note in the principal amount of $15.8 million as payment of the purchase price for the shares. In June 2002, we determined that we should have treated the promissory note as a non-recourse obligation and, accordingly, treated the transaction as a stock option for financial reporting purposes. We also determined that we should not have accrued approximately $1.4 million of interest income on the promissory note that we accrued from 2000 through March 31, 2002 but deemed the error to be immaterial to our results of operations. We have recorded an adjustment to our beginning accumulated deficit balance as of January 1, 2006 to reverse the interest income previously recorded on this promissory note.

• We incorrectly calculated the intrinsic value of unvested stock options assumed by the Company in connection with certain acquisition transactions. As a result, we have reduced the stock-based compensation expense resulting from the amounts of unearned compensation recorded in connection with those acquisitions in the aggregate amount of $2.5 million, of which approximately $0.2 million was recorded in the three months ended March 31, 2006.

• We determined that volatility assumptions used previously to estimate the fair value of our stock option grants required correction. As a result, we revised our fair value estimates based on corrected volatility assumptions for the period beginning January 1, 2001 and ending December 31, 2005.

We may also incur additional expenses as a result of certain federal and state income tax consequences of the findings of our stock option investigation. We have determined that many of our outstanding stock option awards are deemed to have been granted at an exercise price below the market value of our stock on the actual accounting measurement date. The primary adverse tax consequences are: (1) that the re-measured options vesting after December 31, 2004 are potentially subject to option holder excise tax under Section 409A of the Internal Revenue Code (and, as applicable, similar excise taxes under state law); and (2) certain incentive stock options previously granted, could be deemed granted at below market value producing incremental payroll tax liabilities. We have recorded approximately $0.3 million of expenses in the three months ended March 31, 2006 relating to the anticipated settlement by the Company of federal and applicable state income taxes on behalf of the Company’s employees for tainted options that were exercised during the three months ended March 31, 2006. Employees of the Company who continue to hold tainted options that vested after December 31, 2004 or are still unvested may be subject to additional taxes, penalties and interest under Section 409A if no action is taken to cure the options from exposure under Section 409A before December 31, 2008. The Company has yet to determine whether it will either implement a plan to assist the affected employees for the amount of this tax, adjust the terms of the original option grant, or adjust the terms of the original option grant and pay the affected employees an amount to compensate such employees for this lost benefit with respect to the unexercised options that vested after December 31, 2004.

Remedial Actions

The following remedial steps were directed or recommended by the Special Committee in December 2006:

• For stock options which required measurement date changes granted to officers of the Company (“Section 16 Insiders”) who, at the time of grant, were required to file the reports required pursuant to Section 16 of the Securities Exchange Act of 1934 (“Executive Options”), the Special Committee required amendments to those Executive Option agreements to increase the exercise price of any such stock options which remain outstanding to the market value of our Common Stock as reported by Nasdaq on the revised accounting measurement date.

Officer	Original Grant Date	Options Outstanding	Original Exercise Price		Amended Exercise Price
Vincent C. Smith	April 4, 2001	300,000	$	14.81	$	26.51
Vincent C. Smith	October 1, 2001	485,000	$	10.74	$	24.40
Douglas F. Garn	April 14, 2000	80,000	$	26.50	$	55.25
Douglas F. Garn	April 4, 2001	300,000	$	14.81	$	26.51
Douglas F. Garn	October 1, 2001	72,900	$	10.74	$	24.40
M. Brinkley Morse	April 4, 2001	100,000	$	14.81	$	26.51
M. Brinkley Morse	October 1, 2001	300,000	$	10.74	$	24.40
Kevin E. Brooks	October 1, 2001	5,000	$	10.74	$	24.40
Anthony Foley	April 29, 2002	34,000	$	11.91	$	12.96

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The increase to the exercise prices of such options held by Messrs. Smith, Garn, Morse, and Brooks were also intended to avoid potential tax consequences to them under Section 409A of the Internal Revenue Code and comparable provisions of applicable state tax law.

• In addition to amending the exercise price of outstanding stock options, the Special Committee directed the Company to request repayment from Section 16 Insiders of an amount representing the estimated after-tax gain realized by such Section 16 Insiders from exercises of such stock options, except for Anthony Foley, and Eyal Aronoff (whose requested payment is subject to a cap of $200,000). As of the date of this report, the Company has received repayments totaling $157,831. Mr. Smith and Mr. Morse have never exercised any stock options granted to them by the Company and had no such gain to repay.

Officer	Gain To Repay
Eyal Aronoff	$	200,000
Douglas F. Garn	$	64,000
David M. Doyle	$	59,056
Kevin E. Brooks	$	34,775

• The Special Committee also determined to adopt a variety of process and corporate governance changes, including changes adopted in connection with the proposed settlement of the Company’s shareholder derivative litigation. The proposed corporate governance measures include, among other things, implementing certain policies, procedures and guidelines for stock option grants, adopting additional standards of director independence, adopting the “majority vote” standard for uncontested elections of directors, incorporating term limits for independent directors (16 years) and for audit committee members (10 consecutive years), and incorporating additional policies, procedures and guidelines. In addition, the Board approved certain amendments to the Company’s 1999 Stock Incentive Plan and 2001 Stock Incentive Plan. The stock option plan amendments include a new requirement that the exercise price for all nonqualified stock options (i.e., stock options which do not qualify for “incentive stock option” treatment under applicable provisions of the Internal Revenue Code of 1986, as amended) must be not less than the market value of Quest’s common stock on the grant date. Prior to this change, the exercise price for nonqualified stock options was required by the plans to be established by the applicable Plan Administrator. The Company’s Board of Directors also approved related updates to the written charters of the Board’s Audit Committee, Compensation Committee and Nominating & Corporate Governance Committee, and a related update to the Company’s Corporate Governance Guidelines.

Non-Stock Option Related Adjustments

The Company has determined that additional errors in its historical financials statements require correction in this restatement. Many of these errors were identified by the Company or its auditors in connection with the restatement related procedures. Other adjustments include items identified in prior periods, but deemed not to be material to the Company’s results of operations, and are included in this restatement. A summary of the impact of these adjustments to pre-tax income for the three months ended March 31, 2006 (in thousands), is as follows:

(Increase) Decrease in Pre-Tax Income

Category	Total Pre-Tax Adjustment
Revenue Adjustments
Financial system programming error	$	152
Incorrect interpretation of complex orders		(2,338	)
Inconsistent application of Company policies		(52	)
Other		565
Total revenue adjustments		(1,673	)
Operating Expense Adjustments
Incorrect application of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets		(103	)
Impact on expense from incorrect interpretation of complex orders		412
Other		(237	)
Total operating expense adjustments		72
Other Income (Expense), Net Adjustment
Other		64
Net increase in pre-tax income	$	(1,537	)

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Revenue Adjustments

Based upon a review of more than 100,000 software license and services transactions over the restatement period, the Company identified several instances where previously reported revenues were required to be corrected and recognized across various reporting periods. There were several categories of revenue adjustments, but most were attributable to the following three categories of errors:

First, a programming error made at the time of our financial system’s initial implementation in 2000, resulted in a systematic miscalculation of the timing of revenue recognition across certain of the Company’s orders that contained a post-contract technical support services (referred to as PCS) line item. The error was identified and corrected in 2005 however we failed to evaluate the impact of the programming error and its effect on previously reported revenues. This error caused a shift in the timing of revenue recognition for all affected orders across numerous quarters and years, resulting in periodic quarterly over and understatements of revenue.

Second, incorrect interpretations of certain complex orders resulted in an overstatement of license and/or PCS revenue either early in the contract or around the time of initial customer purchase and an understatement of the corresponding revenue either later in the contract or over a ratable period designated in the contract.

Third, inconsistent application of the Company’s revenue recognition policies in geographies outside North America resulted in an overstatement of license and PCS revenue at and around the time of initial customer purchase and an understatement of the corresponding revenue at the time of cash collection.

In addition to the revenue items covered specifically above, there were several additional adjustments also included in these restatement items that were grouped into the “other” category given their minimal individual impact. Many of these adjustments include certain errors that were not previously recorded because in each case, and in the aggregate, the underlying errors were not considered by management to be material to our consolidated financial statements.

Operating Expenses and Other Income (Expense), Net Adjustments

The Company also identified several instances where previously reported operating expenses or other income (expense), net items were required to be corrected and recognized across various reporting periods.

One of these items related to an incorrect application of SFAS No. 144, “Accounting for the Impairment or Disposal of Long Lived Assets,” where we performed our impairment analysis of acquired technology at the acquisition level as opposed to a product-by-product level approach, which resulted in an understatement of intangibles amortization expense related to acquired assets in the period that the impairment occurred and a corresponding overstatement of the related expense over that asset’s remaining estimated useful life.

In addition to the operating expense item covered specifically above, there were several additional adjustments also included in these restatement items that were grouped into the “other” categories given their minimal individual impact. Many of these adjustments include certain errors that were not previously recorded because in each case, and in the aggregate, the underlying errors were not considered by management to be material to our consolidated financial statements.

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All the items identified above generally affect the timing pattern of revenue, expense and income recognition. As such, they do not generally change the cumulative revenues, expenses, pre-tax operating income, liquidity or cash flow of the Company.

Impact of Errors on Previously Issued Condensed Consolidated Financial Statements

As a result of the findings of the Special Committee’s investigation with respect to employee stock options and the other adjustments described in this Report, our condensed consolidated financial statements for the three months ended March 31, 2006 have been restated. We recorded additional stock-based compensation expense and other accounting adjustments, and related tax adjustments, affecting our previously-reported financial statements for 1999 through 2005, the effects of which are summarized below in cumulative effect on our January 1, 2006 opening accumulated deficit.

The financial information presented in this Report has been adjusted to reflect the incremental impact of the foregoing Restatement adjustments on our results of operations for the three months ended March 31, 2006, as follows (in thousands):

Summary of Impact of Restatement Adjustments

	(Increase) Decrease in Pre-Tax Income								Tax Effect of Adjustments
Quarter Ended	Stock Option Related Adjustments (1)		Other Adjustments (2)			Total Adjustments, Pre-Tax			Option Related Payroll Tax Adjustments (3)		Income Tax Effect of All Adjustments			Total Adjustments, Net of Tax
Cumulative effect on our January 1, 2006 opening retained earnings	$	142,283	$	8,264		$	150,547		$	1,905	$	(55,236	)	$	97,216	(4)
March 31, 2006		699		(1,537	)		(838	)		341		(593	)		(1,090	)
Total	$	142,982	$	6,727		$	149,709		$	2,246	$	(55,829	)	$	96,126

(1) Comprised of $137.7 million of stock-based compensation expense adjustments arising from measurement date corrections and $5.3 million of other stock option related adjustments.

(2) Other non-stock option related adjustments to revenue, operating expenses, and other income (expense), net.

(3) Relates to potential payroll tax liabilities for incentive stock options deemed to be granted at below market value and is included with the appropriate compensation expense.

(4) The cumulative effect does not include the cumulative impact of the retrospective adoption of a change in accounting for planned major maintenance activities on our corporate aircraft of $0.6 million.

Overview

Our Company and Business Model

Quest Software, Inc. delivers innovative products that help IT organizations get more performance from their computing environment. Our product areas are Application Management, Database Management and Windows Management. The focus of our products is based upon generating higher levels of performance, manageability and productivity throughout our customers’ IT infrastructure and with products and services that enable them to manage the investments they have made within their IT environment.

We derive revenues from three primary sources: (1) software licenses, (2) post-contract technical support services (referred to as PCS) and (3) professional consulting and training services (referred to as PSO). Our software licensing model is primarily based on perpetual license fees, and our license fees are typically calculated either on a per-server basis or a per-seat basis.

PCS contracts entitle a customer to telephone or internet support and unspecified maintenance releases, updates and enhancements. First-year PCS contracts are typically sold with the related perpetual software license and renewed on an annual basis thereafter at the customer’s option. Annual PCS renewal fees are priced as a percentage of the net initial customer purchase price (which includes both the fee for a perpetual license and first year PCS). Revenue is allocated to first year PCS based on vendor-specific objective evidence (“VSOE”) of fair value and amortized over the term of the maintenance contract, typically 12 months although at times we sell PCS with terms of greater than 12 months.

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Over the last few years revenues generated by our PCS offerings have become a larger contributor to the total revenue base of the company. As our PCS customer base grows, the PCS renewal rate has a larger influence on the PCS revenue growth rate and the amount of new software license revenues has a diminishing effect. Therefore, the growth rate of total revenues does not necessarily correlate directly to the growth rate of new software license revenues in a given period. The primary determinant of changes in our PCS revenue profile is the rate at which our customers renew their annual maintenance and support agreements. If our PCS renewal rates were to decline materially, our PCS revenues and total revenues would likely decline materially as well. Although we do not currently expect our PCS renewal rates to deteriorate, there can be no assurance they will not.

We also provide PSO services which relate to installation of our products and do not include significant customization to or development of the underlying software code. Revenue is allocated to PSO services based on VSOE of fair value and recognized as the services are performed. Such revenues represent 12.4% and 13.9% of total service revenues for the three months ended March 31, 2007 and 2006, respectively.

Total revenues for the quarter ended March 31, 2007, includes approximately $5.5 million of revenue as a result of a change to the Company’s revenue recognition practices for certain large reseller transactions. In 2006 and prior years, revenue from those transactions was deferred until the related reseller account receivable was collected. The modified practice of recognizing revenue at the time of sale has been implemented effective as of January 1, 2007 due to a change in circumstances involving improved cash collection histories with these resellers.

Our primary expenses are our personnel costs, which include compensation, benefits and payroll related taxes, which are a function of our world-wide headcount. We estimate that these personnel related costs represented approximately 66% of total expenses in the three months ended March 31, 2007 and 2006. Our full-time employee headcount at the end of the first quarter of 2007 was approximately 2,900 compared to approximately 2,850 at the end of the first quarter in 2006. Total stock-based compensation expense and related payroll taxes decreased from $8.7 million in the three months ended March 31, 2006 to $5.2 million in the three months ended March 31, 2007, representing a 40% year-over-year change for the three month period due primarily to the fact that no options were granted since September 2006. With the filing of this report and our other 2007 quarterly reports we expect option granting activity to resume in the first quarter of 2008.

We invest heavily in research and development in order to design, develop and enhance a wide variety of products and technologies. We have also maintained an approach of using acquisitions as a strategy to obtain incremental products and technology that will be attractive to our customers. In addition, we are primarily a direct-sales driven organization that expends significant selling costs in order to secure new customer license sales and the follow-on PCS revenue stream that can continue forward beyond the initial license sale.

Our foreign currency gains or losses are predominantly attributable to translation gains or losses on our net balances of monetary assets and liabilities in our foreign subsidiaries, including accounts receivable and cash, which were primarily denominated in the Euro, and to a lesser extent, the British Pound and Canadian Dollar. The foreign currency translation adjustments to these balance sheet items are calculated by comparing the currency spot rates at the end of a quarter to the spot rates at the end of the previous quarter. On this basis, we recorded in other income (expense), net, a net gain of $0.3 million and a net gain of $1.3 million for the three months ended March 31, 2007 and 2006, respectively.

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with generally accepted accounting principles requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses. On an on-going basis, we make and evaluate estimates and judgments, including those related to revenue recognition, asset valuations (including accounts receivable, goodwill and intangible assets), stock-based compensation, income taxes and functional currencies for purpose of consolidation. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances. Our estimates form the basis for making judgments about amounts and timing of revenue and expenses, the carrying values of assets, and the recorded amounts of liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and such estimates may change if the underlying conditions or assumptions change. We have discussed the development and selection of the critical accounting policies with

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the Audit Committee of our Board of Directors, and the Audit Committee has reviewed our related disclosures. The critical accounting policies related to the estimates and judgments listed above are discussed further in our Annual Report on Form 10-K for fiscal 2006 under Management’s Discussion and Analysis of Financial Condition and Results of Operations. There have been no material changes to our critical accounting policies or estimates during the three months ended March 31, 2007, except for a change in our revenue recognition practices for reseller transactions described below and our adoption of Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (FIN 48), discussed under the heading “Recently Adopted Accounting Pronouncements.”

We modified our practice of recognizing revenue from certain large reseller transactions at the time of sale as of January 1, 2007 due to a change in circumstances involving improved cash collection histories with these resellers. Total revenues for the three months ended June 30, 2007 includes approximately $5.5 million of revenue as a result of this change. In 2006 and prior years, revenue from those transactions was deferred until the related reseller account receivable was collected.

Recently Adopted Accounting Pronouncement

Effective January 1, 2007, we adopted FIN 48. As a result of the implementation of FIN 48, we recognize liabilities for uncertain tax positions based on the two-step process prescribed within the interpretation. Both steps presume that the tax position will be examined by the appropriate taxing authority that has full knowledge of all relevant information. The first step is to evaluate the tax position for recognition by determining if, based on the weight of available evidence, it is more likely than not that the position will be sustained on examination. The second step requires us to estimate and measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement with a taxing authority. It is inherently difficult and subjective to estimate such amounts, as this may require us to determine the probability of various possible outcomes. We reevaluate these uncertain tax positions on a periodic basis. This evaluation is based on factors including, but not limited to, current year tax positions, expiration of statutes of limitations, litigation, legislative activity, or other changes in facts and circumstances. Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision in that period.

See Note 1 of our Notes to Condensed Consolidated Financial Statements for information regarding recently issued accounting pronouncements.

Results of Operations

Except as otherwise indicated, the following are percentage of total revenues:

	Three Months Ended March 31,
	2007		2006
Revenues:
Licenses	49.6	%	51.5	%
Services	50.4		48.5
Total revenues	100.0		100.0
Cost of revenues:
Licenses	1.3		1.0
Services	8.7		8.9
Amortization of purchased technology	2.0		2.6
Total cost of revenues	12.0		12.5
Gross profit	88.0		87.5
Operating expenses:
Sales and marketing	42.2		46.1
Research and development	18.9		21.5
General and administrative	11.1		11.3
Amortization of other purchased intangible assets	1.0		1.7
In-process research and development	—		0.2
Total operating expenses	73.2		80.8
Income from operations	14.8		6.7
Other income, net	3.4		2.0
Income before income taxes	18.2		8.7
Income tax provision	8.2		2.5
Net income	10.0	%	6.2	%

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Comparison of Three Months Ended March 31, 2007 and 2006

Revenues

Total revenues and year-over-year changes are as follows (in thousands, except for percentages)

	Three Months Ended March 31,				Increase
	2007		2006		Dollars		Percentage
Revenues:
Licenses
North America	$	43,433	$	40,392	$	3,041	7.5	%
Rest of World		30,836		26,086		4,750	18.2	%
Total license revenues		74,269		66,478		7,791	11.7	%
Services
North America		51,392		44,665		6,727	15.1	%
Rest of World		24,108		18,049		6,059	33.6	%
Total service revenues		75,500		62,714		12,786	20.4	%
Total revenues	$	149,769	$	129,192	$	20,577	15.9	%

Licenses Revenues — Increased sales of our Windows products continued to be the main driver of license revenue growth over the comparable period in the prior year. Sales of licenses to Virtualization products by Vizioncore also contributed to our overall license revenue growth. Growth in these product areas was offset slightly by a decrease in license revenues from our Database Management products.

Services Revenues — Growth in new license sales leading to a larger customer installed base, which in turn drives PCS revenues and renewals of annual PCS, was the primary driver of our 20.4% growth in services revenues. Maintenance revenues from our Windows and maintenance renewals on our Database Management products were the main drivers of services revenues growth during the period.

Cost of Revenues

Total cost of revenues and year-over-year changes are as follows (in thousands, except for percentages).

	Three Months Ended March 31,				Increase/(Decrease)
	2007		2006		Dollars			Percentage
Cost of revenues:
Licenses	$	2,003	$	1,262	$	741		58.7	%
Services		12,981		11,471		1,510		13.2	%
Amortization of purchased technology		3,057		3,348		(291	)	(8.7	)%
Total cost of revenues	$	18,041	$	16,081	$	1,960		12.2	%

Cost of Licenses — Cost of licenses primarily consists of third-party software royalties, product packaging, documentation, duplication, delivery and personnel costs. Cost of licenses as a percentage of license revenues was 2.7% and 1.9% for the three months ended March 31, 2007 and 2006, respectively. The increase in cost of licenses, both in terms of absolute dollars and as a percentage of license revenues, is primarily the result of increased sales of licenses to royalty-bearing products.

Cost of Services — Cost of services primarily consists of personnel, outside consultants, facilities and systems costs used in providing PCS and PSO. Cost of services does not include development costs related to bug fixes and upgrades which are classified in research and development and which are not separately determinable. Personnel related costs increased by approximately $0.4 million, primarily due to growth in technical support headcount (average headcount in the three months ended March 31, 2007 increased approximately 4% over the same period in 2006). Fees paid to outside

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professional services consultants in connection with new system implementation support increased by $1.1 million in the three months ended March 31, 2007 over the comparable period in 2006 as the demand for our professional services along the lines of our Windows products exceeded our ability to provide these services. Cost of services as a percentage of service revenues was 17.2% and 18.3% in the three months ended March 31, 2007 and 2006, respectively.

Amortization of Purchased Technology — Amortization of purchased technology includes amortization of the fair value of acquired technology associated with acquisitions. The 8.7% decrease in amortization of purchased technology is due to certain purchased technologies being fully amortized prior to the first quarter of 2007. We expect amortization of purchased technology within the cost of revenues to be approximately $3.0 million to $5.0 million in each of the remaining three quarters of 2007.

Operating Expenses

Total operating expenses and year-over-year changes are as follows (in thousands, except for percentages):

	Three Months Ended March 31,				Increase/(Decrease)
	2007		2006		Dollars			Percentage
Operating expenses:
Sales and marketing	$	63,235	$	59,545	$	3,690		6.2	%
Research and development		28,266		27,819		447		1.6	%
General and administrative		16,566		14,633		1,933		13.2	%
Amortization of other purchased intangible assets		1,541		2,133		(592	)	(27.8	)%
In-process research and development		—		300		(300	)	(100.0	)%
Total operating expenses	$	109,608	$	104,430	$	5,178		5.0	%

Sales and Marketing — Sales and marketing expenses consist primarily of compensation and benefit costs for sales and marketing personnel, sales commissions, related facilities and information systems (“IS”) costs, and costs of trade shows, travel and entertainment and various discretionary marketing programs. Sales and marketing expense increased $3.7 million during the three months ended March 31, 2007 as compared to the same period in 2006. Personnel related costs increased approximately $3.7 million. The increase in personnel related costs is primarily due to growth in headcount within our presales professionals and to commissions on the increased amount of sales.

Research and Development — Research and development expenses consist primarily of compensation and benefit costs for software developers who develop new products, bug fixes and upgrades to existing products and at times provide engineering support for PCS services, software product managers, quality assurance and technical documentation personnel, associated facilities and IS costs and payments made to outside software development consultants in connection with our ongoing efforts to enhance our core technologies and develop additional products. Research and development expense increased $0.4 million during the first quarter of 2007 when compared to the first quarter of 2006. Personnel related costs, excluding stock-based compensation, increased approximately $1.2 million. Stock-based compensation decreased by $1.0 million during the three months ended March 31, 2007 as compared to the same period in 2006.

General and Administrative — General and administrative expenses consist primarily of compensation and benefit costs for our executive, finance, legal, human resources, administrative and IS personnel, and professional fees for audit, tax and legal services, associated facilities and IS costs. General and administrative expense increased $1.9 million during the first quarter of 2007 as compared to the same period in 2006. Personnel related costs, excluding stock-based compensation, increased $1.7 million. The increase in personnel related costs was primarily due to additional headcount hired to support the company’s growth. Average headcount in the three months ended March 31, 2007 increased approximately 12% over the same period in 2006. Expenses associated with our stock option investigation and related matters contributed $1.9 million to the overall increase in general and administrative expenses for the three months ended March 31, 2007. These increases were offset slightly by a reduction of $1.0 million in stock-based compensation expense.

Amortization of Other Purchased Intangible Assets — Amortization of other purchased intangible assets includes the amortization of customer lists, trademarks, non-compete agreements and maintenance contracts associated with acquisitions. We expect amortization of other purchased intangible assets within operating expenses to be approximately $1.5 million to $2.0 million in each of the remaining three quarters of 2007.

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In-Process Research and Development — In-process research and development expenses in the three months ended March 31, 2006 related to in-process technology acquired from AfterMail in January of 2006. These costs were charged to operations as the technologies had not reached technological feasibility and did not have alternative future uses at the date of acquisition.

Other Income, Net

Other income, net includes interest income on our investment portfolio, gains and losses from foreign exchange fluctuations and gains or losses on other financial assets as well as a variety of other non-operating expenses, such as costs incurred with operating and maintaining our corporate aircraft (which was sold in the fourth quarter of 2006) and the minority interest in Vizioncore. Other income, net increased to $5.1 million in the first quarter of 2007 from $2.6 million in the first quarter of 2006. Interest income was $4.5 million and $2.2 million in the three months ended March 31, 2007 and 2006, respectively. We had a foreign currency gain of $0.3 million and $1.3 million in the first quarter of 2007 and 2006, respectively. Our foreign currency gains or losses are predominantly attributable to translation gains or losses on net monetary assets, including accounts receivable and cash, which were primarily denominated in the Euro, and to a lesser extent, the British Pound and Canadian Dollar.

Income Tax Provision

During the three months ended March 31, 2007, the provision for income taxes increased to $12.3 million from $3.2 million in the comparable period of 2006, representing an increase of $9.1 million. The effective income tax rate for the three months ended March 31, 2007 was approximately 45.1% compared to 28.0% in the comparable period of 2006. The increase in our effective tax rate for the quarter is substantially due to the mix of income between high and low tax jurisdictions, the impact of net operating losses and associated valuation allowances in certain foreign jurisdictions (as assessed under FIN No. 18, “Accounting for Income Taxes in Interim Periods”) and the inclusion of interest expense related to prior period unrecognized tax benefits (as assessed under FIN 48).

Liquidity and Capital Resources

Cash and cash equivalents and marketable securities were approximately $444.5 million and $272.8 million as of March 31, 2007 and 2006, respectively. Cash and cash equivalents consisted of cash and highly liquid investments purchased with original maturities of three months or less. Marketable securities consisted primarily of short-term investment-grade bonds and United States government and agency securities with original maturities of greater than three months. Our investment objectives were to preserve principal and provide liquidity, while at the same time maximizing market return without significantly increasing risk. We generally hold investments in marketable securities until maturity.

Summarized cash flow information is as follows (in thousands):

	Three Months Ended March 31,						Increase/ (Decrease)
	2007			2006
Cash provided by operating activities	$	57,430		$	38,266		$	19,164
Cash used in investing activities		(16,837	)		(22,516	)		5,679
Cash (used in) provided by financing activities		(69	)		15,936			(16,005	)
Effect of exchange rate changes		104			(708	)		812
Net increase in cash and cash equivalents	$	40,628		$	30,978		$	9,650

Operating Activities

Our primary source of operating cash flows is the collection of accounts receivable from our customers. Our primary use of cash from operating activities is for compensation and personnel-related expenditures. We intend to continue to fund our operating expenses through cash flows from operations.

The analyses of the changes in our operating assets and liabilities are as follows:

• Accounts receivable decreased to $87.5 million resulting in a decrease in operating assets, reflecting a cash inflow of $45.9 million for the three months ended March 31, 2007. The decrease in accounts receivable was due to a reduction in day’s sales outstanding (DSO), which is calculated by dividing period end accounts receivable by average daily sales for the quarter, and daily sales. DSO fell from 73 days at December 31, 2006 to 53 days at March 31, 2007 and our daily sales decreased to $1.7 million for the quarter ended March 31, 2007 compared to $1.8 million for the quarter ended December 31, 2006. Collection of accounts receivable and related DSO could fluctuate in future periods due to the timing and amount of our revenues and their linearity and the effectiveness of our collection efforts.

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• One of the primary cash outflows within operating assets and liabilities during the three months ended March 31, 2007 and 2006 was $15.0 million and $11.8 million, respectively, paid for taxes. The timing of these tax payments, offset by the impact from adopting FIN 48, resulted in an increase in income taxes payable in the 2007 period, reflecting a cash inflow of $1.9 million and, with respect to the 2006 period, the timing of tax payments resulted in a decrease in income taxes payable, reflecting a use of cash of $8.8 million.

Investing Activities

Our primary source of investing cash flows was proceeds from the sale of marketable securities, typically at maturity. Our primary uses of cash from investing activities were for capital expenditures and cash payments for acquisitions.

Capital expenditures in the first quarter of 2006 included $3.0 million for leasehold improvements and furniture and fixtures for the lease of our new EMEA headquarters office in Maidenhead, United Kingdom.

Cash payments for acquisitions in the three months ended March 31, 2007, consisted of $1.1 million net cash paid for our acquisition of the assets from Workplace Architects, Inc. (excluding cash retained to secure Workplace Architects’ indemnification obligations). Cash payments for acquisitions in the three months ended March 31, 2006, consisted of $15.3 million net cash paid for our acquisition of AfterMail Limited (“AfterMail”) and $1.6 million net cash paid for minority cost-method investments in two early stage private companies for business and strategic purposes. In addition to the initial $15.3 million purchase price we paid to acquire AfterMail, we have potential earn-out payment obligations to former AfterMail shareholders. The earn-out payments are based on the AfterMail products’ total revenue growth in 2006, 2007 and 2008 and are capped at $30 million. The AfterMail revenue targets required to make an earn-out payment have not been achieved, as such there is no earn-out payment obligation as of March 31, 2007. Our earn-out payment obligation related to all acquisitions was immaterial as of March 31, 2007.

We will continue to purchase property and equipment needed in the normal course of our business. We also plan to use cash generated from operations and/or proceeds from investments in marketable securities to fund other strategic investment and acquisition opportunities that we continue to evaluate. We plan to use excess cash generated from operations to invest in short and long-term marketable securities consistent with past investment practices.

Financing Activities

Our primary source of financing cash flows has historically been from the issuance of our common stock under our employee stock option plans. We have also financed acquisitions and capital expenditures with net borrowings under a repurchase agreement in prior periods.

Because we announced our determination to restate our previously issued financial statements and have become delinquent in our periodic reporting obligations under the Securities Exchange Act of 1934, as amended, we determined that we could no longer rely upon the Registration Statements on Form S-8 previously filed with the U.S. Securities Exchange Commission to register the shares of our common stock issuable upon exercise of stock options granted under our various stock option plans. Accordingly, we took action in the third quarter of 2006 to block exercises of all stock options based on our determination that doing so was necessary to prevent violations of applicable securities law and as a result, we do not expect to receive proceeds from the exercise of stock options until after all of our delinquent reports are filed with the SEC. With the filing of this report and our other 2007 quarterly reports we expect option exercising activity to resume in the first quarter of 2008.

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Based on our current operating plan, we believe that our existing cash, cash equivalents, investment balances and cash flows from operations will be sufficient to finance our operational cash needs through at least the next 12 to 24 months. Our ability to generate cash from operations is subject to substantial risks as described in Item 1A – “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2006. One of these risks is that our future business does not stay at a level that is similar to, or better than, our recent past. Should a general economic downturn or similar event occur, or should the company’s products become uncompetitive or less attractive to end customers, we may be unable to generate or sustain positive cash flow from operating activities. We would then be required to use existing cash, cash equivalents and investment balances to support our working capital and other cash requirements. Also, acquisitions are an important part of our business model. As such, significant amounts of cash could and will likely be used in the future for additional acquisitions or strategic investments. If additional funds are required to support our working capital requirements, acquisitions or other purposes, we may seek to raise funds through public or private equity or debt financing or from other sources. We can provide no assurance that additional financing will be available at all or, if available, that we would be able to obtain additional financing on terms favorable to us.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Foreign Exchange Risk

We are a U.S. Dollar functional company and transact business in a number of different foreign countries around the world. In most instances, revenues are collected and operating expenses are paid in the local currency of the country in which we are transacting. Accordingly, we are exposed to both transaction and translation risk relating to changes in foreign exchange rates.

Our exposure to foreign exchange risk is composed of the combination of our foreign net profits and losses denominated in currencies other than the U.S. Dollar, as well as our net balances of monetary assets and liabilities in our foreign subsidiaries. These exposures have the potential to produce either gains or losses depending on the directional movement of the foreign currencies versus the U.S. Dollar and our operational profile in foreign subsidiaries. Our cumulative currency gains or losses in any given period may be lessened by the economic benefits of diversification and low correlation between different currencies, but there can be no assurance that this pattern will continue to be true in future periods. During the quarter ended March 31, 2007, we had a $0.3 million foreign currency gain compared to a $1.3 million foreign currency gain in the comparable period in 2006.

The foreign currencies to which we currently have the most significant exposure are the Euro, the Canadian Dollar, the British Pound and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our foreign exchange exposures, nor do we use such instruments for speculative trading purposes. We regularly monitor the potential cost and benefits of hedging foreign exchange exposures with derivatives and there remains the possibility that our foreign exchange hedging practices could change accordingly in time.

Interest Rate Risk

Our exposure to market interest-rate risk relates primarily to our investment portfolio. We have not used derivative financial instruments to hedge the market risks of our investments. We place our investments with high-quality issuers and, by policy, limit the amount of credit exposure to any one issuer other than the United States government and its agencies. Our investments in marketable securities consist primarily of investment-grade bonds and United States government and agency securities. Investments purchased with an original maturity of three months or less are considered to be cash equivalents. We classify all of our investments as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of shareholders’ equity.

We presently do not intend to liquidate our short and long-term investments prior to their scheduled maturity dates. However, in the event that we did liquidate these investments prior to their scheduled maturities and there were no changes in market interest rates, we could be required to recognize a realized loss on those investments when we liquidate. At March 31, 2007, we have an unrealized loss of $0.8 million on our investments in debt securities compared to $1.9 million at March 31, 2006. Our remaining investment positions and duration of the portfolio would not be materially affected by a 100 basis point shift in interest rates.

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Information about our investment portfolio is presented in the table below, which states the amortized book value and related weighted-average interest rates by year of maturity (in thousands):

	Amortized Book Value		Weighted Average Rate
Investments maturing by March 31,
2008 (1)	$	297,249	5.16	%
2009		—	—	%
2010		—	—	%
2011		23,659	4.48	%
Thereafter		—	—	%
Total portfolio	$	320,908	5.11	%

(1) Includes cash and cash equivalents of $202.5 million.

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Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures designed to provide reasonable assurance that information required to be disclosed in reports filed under the Securities Exchange Act of 1934 (the “Act”) is recorded, processed, summarized and reported within the specified time periods and accumulated and communicated to management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2007. Based on that evaluation, management concluded that, as of that date, the Company’s disclosure controls and procedures were not effective at the reasonable assurance level because of the identification of the material weakness in its internal control over financial reporting, described below, which the Company views as an integral part of its disclosure controls and procedures.

Internal Control over Financial Reporting, Financial Close and Reporting Process

As described in Item 9A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, the Company determined that a material weakness in our internal control over financial reporting related to our financial close and reporting process existed as of December 31, 2006. As of March 31, 2007, this material weakness continued to exist and had not yet been remediated. A description of the material weakness in our internal control over financial reporting related to our financial close and reporting process is provided below.

Our financial and accounting organization was not adequate to support our financial accounting and reporting needs given the growth of our business. Furthermore, we failed to effectively design and implement our financial accounting system to facilitate the needs of our financial close process across all reporting units. Specifically, we did not maintain a sufficient complement of personnel with an appropriate level of accounting knowledge and training in the application of GAAP, nor did we adequately use our financial accounting system commensurate with our financial reporting requirements to support the financial reporting and close process. Moreover, due to the lack of sufficient staffing it was necessary to place undue reliance on external consultants to assist in the financial reporting and close process. The lack of a sufficient complement of personnel with an appropriate level of accounting knowledge and training coupled with an inadequate design and implementation of our financial accounting system across all reporting units resulted in significant manual processes for the existing personnel. This reduced the likelihood that such individuals could detect the need for a material adjustment to the Company’s books and records or anticipate, identify, and resolve accounting issues in the normal course of performing their assigned functions. This material weakness resulted in not only the need to record various adjustments, and a significant delay in the issuance of these financial statements, but also resulted in a more than reasonable possibility that a material misstatement to the annual or interim financial statements would not have been prevented or detected.

Changes in Internal Control over Financial Reporting

There was no change in internal control over financial reporting that occurred in the first quarter of 2007 that has materially affected or is reasonably likely to materially affect our internal control over financial reporting, except as described below. The changes described below have materially affected our internal control over financial reporting which we believe have remediated the material weakness in our internal control over financial reporting for revenue (which is described in more detail in our Annual Report on Form 10-K for the year ended December 31, 2006):

• The Company completed the development of automated queries that are applied against the financial system database to identify and account for those situations where revenue has not been recognized within the correct reporting period. These queries form the structure for monitoring the financial accounting system.

• We hired an additional revenue recognition manager based in the United States and hired a revenue recognition manager based in the United Kingdom.

• The Company provided enhanced training for our revenue recognition team, contracts department and sales personnel to increase general understanding of revenue recognition principles and enhance awareness of the implications associated with non-standard arrangements requiring specific revenue recognition treatment.

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Plan for Remediation of Material Weaknesses

We are undertaking efforts to improve our internal controls over financial reporting and to remediate the material weakness identified above. The identified material weakness was caused, in part, by insufficient staffing of experienced, specialized accounting personnel. Therefore, our remediation plan for the material weakness includes the hiring of additional personnel trained and experienced in the complex accounting areas of revenue recognition and revenue accounting as well as GAAP. In the interim, we have engaged a number of qualified accounting personnel on a temporary basis to compensate for a lack of adequate permanent finance and accounting staff. With these additional resources, management has performed additional analysis and other post-closing procedures in an effort to ensure our Consolidated Financial Statements are fairly stated as of and for the quarter ended March 31, 2007.

We believe that the actions described above and resulting improvement in controls will generally strengthen our disclosure controls and procedures, as well as our internal control over financial reporting, and will, over time, address the material weaknesses that we identified in our internal control over financial reporting as of March 31, 2007. However, because many of the remedial actions we have undertaken are very recent and because they relate, in part, to the hiring of additional personnel and many of the controls in our system of internal controls rely extensively on manual review and approval, the successful operation of these controls for, at least, several fiscal quarters may be required prior to management being able to conclude that the material weakness has been remediated.

Limitations on Effectiveness of Controls

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, within Quest have been detected. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that internal controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

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PART II—OTHER INFORMATION

Item 1A. Risk Factors

An investment in our shares involves risks and uncertainties. You should carefully consider the factors described below before making an investment decision in our securities. The risks described below are the risks that we currently believe are material risks of the business and the industry in which we compete.

Our business, financial condition and results of operations could be adversely affected by any of the following risks. If we are adversely affected by such risks, then the trading price of our common stock could decline, and you could lose part or all of your investment.

Matters relating to or arising from our stock option investigation, including regulatory proceedings, litigation matters and potential additional expenses, may adversely affect our business and results of operations

As described in the Explanatory Note to this Report, Part I, Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note 2 of our Notes to Condensed Consolidated Financial Statements included in this Report, we are restating our consolidated financial statements for periods through March 31, 2006 to reflect the findings of a voluntary, independent investigation of our stock option granting practices and related accounting. This investigation was conducted by a Special Committee of the Board of Directors with the assistance of independent outside legal counsel and outside forensic accounting consultants. To date, we have incurred significant expenses related to legal, accounting, tax and other professional services in connection with the investigation, the related restatements and related regulatory inquiries or proceedings and litigation matters, and may incur significant expenses in the future with respect to such matters. These events, even if resolved favorably, may be time-consuming, expensive and disruptive to normal business operations, and the outcomes of regulatory proceedings or litigation matters are difficult to predict and could have a material adverse effect on our business, results of operations and financial condition.

Although we believe we have made appropriate judgments in determining the financial and tax impacts of our historical stock option granting practices, we cannot provide assurance that the Securities and Exchange Commission (“SEC”) or the Internal Revenue Service (“IRS”) will agree with the manner in which we have accounted for and reported, or not reported, the financial and tax impacts. For a discussion of the judgments underlying the revised measurement dates, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part I, Item 2 of this Report. If the SEC or the IRS disagrees with our financial or tax adjustments or related disclosures and such disagreement results in material changes to our historical financial statements, we may be required to further restate our prior financial statements, amend prior filings with the SEC or take other action that is not currently contemplated.

In June 2006 we received an informal request for information from the Securities and Exchange Commission regarding our stock option practices. In January 2007 we were informed that the SEC issued a formal order of investigation in the matter. We have also been informally contacted by the U.S. Attorney’s Office for the Central District of California and have been asked to voluntarily produce documents relating to our stock option granting practices. We are cooperating with the SEC and the U.S. Attorney’s Office in connection with these matters, but can not predict if, when or how they will be resolved or what, if any, actions we may be required to take as part of any resolution of these matters. Any action by the SEC, the U.S. Attorney’s Office or other governmental agency could result in civil or criminal sanctions against us and/or certain of our current and former officers, directors and employees.

Additionally, as discussed in Note 9 of our Notes to Condensed Consolidated Financial Statements, included in Item 1 of this Report, we currently are engaged in civil litigation with parties that have alleged a variety of claims against Quest and certain of our current and former officers and directors relating to our stock option grant practices and related accounting. Although we and the other defendants intend to defend these claims vigorously, there are many uncertainties associated with any litigation, and we cannot assure you that these actions will be resolved without substantial costs and/or settlement charges. We have entered into indemnification agreements with each of our present and former directors and executive officers under which Quest is required to indemnify each such directors or executive officers against expenses, including attorneys’ fees, judgments, fines and settlements, paid by such individual in connection with the pending litigation (other than indemnified liabilities arising from willful misconduct or conduct that is knowingly fraudulent or deliberately dishonest).

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The resolution of the pending investigations by the SEC and U.S. Attorney’s Office, the defense of our pending civil litigation and any additional litigation relating to our past stock option grant practices or related restatement of our financial statements could result in significant costs and diversion of the attention of management and other key employees.

If we do not maintain compliance with Nasdaq listing requirements, our common stock could be delisted, which could, negatively impact the trading market for our securities and impact our ability to maintain equity-based stock incentive programs for our employees

As a result of the stock option investigation and the restatement of our consolidated financial statements we could not timely file certain of our periodic reports with the SEC and, accordingly, our Common Stock was subject to delisting from the Nasdaq Global Select Market. With the filing of our Annual Report on Form 10-K for the year ended December 31, 2006, our Quarterly Reports for the quarters ended June 30, 2006, September 30, 2006, March 31, 2007, June 30, 2007 and September 30, 2007, we believe we have returned to full compliance with Nasdaq’s requirements with respect to filing periodic reports with the SEC. However, achieving compliance with the SEC reporting requirements does not address the other basis for the pending Nasdaq delisting matter. We were unable to solicit proxies for annual meetings of shareholders in 2006 or 2007 because we could not provide annual reports to shareholders until our accounting restatement was completed. As a result, we remain out of compliance with the Nasdaq requirement to hold an annual meeting of shareholders. Our intention is to hold an annual meeting of shareholders as soon as practicable following the filing of all of our delinquent periodic reports. If the SEC has comments on our recently filed SEC reports (or other reports that we previously filed) that require us to file amended reports, or if the Nasdaq Listing Qualifications Panel does not concur that we are in compliance with applicable listing requirements, we may be unable to maintain our Nasdaq listing.

If our securities are delisted from the Nasdaq Global Select Market, they would subsequently be transferred to the National Quotation Service Bureau, or “Pink Sheets”. The trading of our common stock through the Pink Sheets might reduce the price of our common stock and the levels of liquidity available to our stockholders. In addition, the trading of our common stock through the Pink Sheets could materially and adversely affect our access to the capital markets and our ability to raise capital through alternative financing sources on terms acceptable to us, or to raise capital at all. Securities that trade through the Pink Sheets are no longer eligible for margin loans, and a company trading through the Pink Sheets cannot avail itself of federal preemption of state securities or “blue sky” laws, which adds substantial compliance costs to securities issuances, including pursuant to employee option plans, stock purchase plans and private or public offerings of securities. Increased compliance burdens can also be expected to impact our ability to maintain and administer stock option programs and other forms of equity incentives for our employees, which could also impair our ability to recruit and retain key employees. If we are delisted in the future from the Nasdaq Global Select Market and transferred to the Pink Sheets, we could also be subject to other negative implications, including the potential loss of confidence by suppliers, customers and employees and the loss of institutional investor interest in our securities. Any or all of the foregoing consequences of delisting could adversely affect our business and results of operations.

We had material weaknesses in internal control over financial reporting and cannot assure you that material weaknesses will not be identified in the future. If our internal control over financial reporting or disclosure controls and procedures are not effective, there may be errors in our financial statements that could require a restatement or our filings may not be timely and investors may lose confidence in our reported financial information, which could lead to a decline in our stock price

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal control over financial reporting as of the end of each year, and to include a management report assessing the effectiveness of our internal control over financial reporting in each Annual Report on Form 10-K. Section 404 also requires our independent registered public accounting firm to attest to, and report on, management’s assessment of our internal controls over financial reporting. In assessing the findings of the Special Committee’s review and the restatement set forth in this Report, our management concluded that there were material weaknesses, as defined in the Public Company Accounting Oversight Board’s Auditing Standard No. 2, in our internal controls over financial reporting as of December 31, 2006. See the discussion included in Part I, Item 4 of this Report for additional information regarding our internal control over financial reporting.

Our management does not expect that our internal control over financial reporting will prevent all error or all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Controls can be circumvented by the

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individual acts of some persons, by collusion of two or more people, or by management override of the controls. Over time, controls may become inadequate because changes in conditions or deterioration in the degree of compliance with policies or procedures may occur. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

We cannot assure you that all significant deficiencies and material weaknesses identified in this Report will be adequately remedied or will be fully remedied by any specific date, although we believe that our material weakness in internal controls relating to revenue recognition has been remedied as of the date of filing of this Report. In addition, we can provide no assurances that significant deficiencies or material weaknesses in our internal control over financial reporting will not be identified in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in significant deficiencies or material weaknesses, cause us to fail to timely meet our periodic reporting obligations, or result in material misstatements in our financial statements. Any such failure could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding the effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder. The existence of a material weakness could result in errors in our financial statements that could result in a restatement of financial statements, cause us to fail to timely meet our reporting obligations and cause investors to lose confidence in our reported financial information, leading to a decline in our stock price.

We may incur additional expenses in order to assist our employees with potential federal and state income tax liabilities which may arise under Section 409A of the Internal Revenue Code

As a result of our stock option investigation, we have determined that many of our outstanding stock option awards are deemed to have been granted at an exercise price below the fair market value of our stock on the actual accounting measurement date. The primary adverse tax consequences are: (1) that the re-measured options vesting after December 31, 2004 are potentially subject to option holder excise tax under Section 409A of the Internal Revenue Code (and, as applicable, similar excise taxes under state law); and (2) certain incentive stock options previously granted, could be deemed granted at below market value producing incremental payroll tax liabilities. We have recorded approximately $0.6 million of expenses in the year ended December 31, 2006 relating to the anticipated settlement by the Company of federal and applicable state income taxes on behalf of the Company’s employees for tainted options that were exercised during 2006. Employees of the Company who continue to hold tainted options may be subject to additional taxes, penalties and interest under Section 409A if no action is taken to cure the options from exposure under Section 409A before December 31, 2008.

Regarding potential future liabilities associated with Section 409A, we have yet to determine whether we will either implement a plan to assist the affected employees for the amount of this tax, adjust the terms of the original option grant, or adjust the terms of the original option grant and pay the affected employees an amount to compensate such employees for this lost benefit. As such, no additional expense has been recorded in the consolidated financial statements.

Our future success may be impaired and our operating results will suffer if we cannot respond to rapid market, competitive and technological conditions in the software industry

The market for our software products and services is characterized by:

• rapidly changing technology;

• frequent introduction of new products and services and enhancements to existing products and services by platform vendors of database, application and Windows products and by our competitors;

• increasing complexity and interdependence of software applications;

• consolidation of the software industry;

• changes in industry standards and practices; and

• changes in customer requirements and demands.

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To maintain our competitive position, we must continue to enhance our existing products and develop new products and services, functionality, and technology that address the increasingly sophisticated and varied needs of our customers and prospective customers, which requires significant investment in research and development resources and capabilities, involves significant technical and business risks and requires substantial lead-time and significant investments in product development. If we fail to anticipate new technology developments, customer requirements, industry standards, or if we are unable to develop new products and services that adequately address these new developments, requirements, and standards in a timely manner, or if we are incapable of timely bringing new or enhanced products to market, our products and services may become obsolete, we may not generate suitable returns from our research and development investments, and our ability to compete may be impaired, our revenue could decline, and our operating results may suffer.

During the past three years, a large portion of our revenue growth has been attributable to the growth of our Microsoft Systems Management products and services, and we have relied upon sustained revenue and cash flow generation from our database management products in order to fund sales, marketing and research and development initiatives associated with our other product areas. We cannot provide any assurance that the revenues we derive from these product areas will continue to grow. In addition, over the last few years we have committed significant resources to development of new and enhanced application management products and have expanded our sales and services organizations to address anticipated business opportunities presented by our expanding application management product and services lines. We cannot provide any assurance that this strategy will be successful or that the release of our enhanced application management products or other new products or services will increase our revenue growth rate.

Our quarterly operating results may fluctuate in future periods and, as a result, we may fail to meet expectations of investors and analysts, causing our stock price to fluctuate or decline

Our revenues and operating results may vary significantly from quarter-to-quarter due to a number of factors. These factors include the following:

• the size and timing of customer orders. See “Variations in the size and timing of our customer orders and differing nature of our products and services could expose us to revenue fluctuations and higher operating costs;”

• the discretionary nature of our customers’ purchasing decisions and budget cycles;

• the timing of revenue recognition for sales of software products and services;

• the extent to which our customers renew their maintenance contracts with us;

• exposure to general economic conditions and reductions in corporate or public sector IT spending;

• changes in our level of operating expenses and our ability to control costs;

• our ability to attain market acceptance of new products and services and enhancements to our existing products;

• our ability to introduce new products or enhancements to existing products and services in a timely manner;

• our ability to maintain our field and inside sales organizations with adequate numbers of sales and services personnel, and to minimize our costs of sales and marketing through efficient allocation of sales resources and methods to products having different sales characteristics and profiles;

• the introduction of new or enhanced products and services by our competitors and changes in the pricing policies of these competitors;

• the relative growth rates of competing operating system, database and application platforms and competitive conditions among vendors of these platforms;

• the unpredictability of the timing, level of sales and subsequent revenue recognition of our expanded efforts within our indirect sales channels;

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• costs related to acquisitions of technologies or businesses, including acquired in-process research and development and amortization costs for intangible assets and possible impairments and uncertainties arising from the integration of products, services, employees and operations of acquired companies; and

• the timing of releases of new versions of third-party software products that our products support or with which our products compete.

In addition, the timing of our software product revenues is difficult to predict and can vary substantially from product-to-product and customer-to-customer. We budget our operating expenses on our expectations regarding future revenue levels. The timing of larger orders and customer buying patterns are difficult to forecast. Therefore, we may not learn of shortfalls in revenue or earnings or other failures to meet our expectations until late in a particular quarter. As a result, if total revenues for a particular quarter are below our expectations, we would not be able to proportionately reduce operating expenses for that quarter.

We have experienced seasonality in our orders and revenues, which may result in seasonality in our earnings. The fourth quarter of the year typically has the highest orders and revenues for the year and higher orders and revenues than the first quarter of the following year. We believe that this seasonality results primarily from the budgeting cycles of our customers being typically higher in the third and fourth quarters and, to a lesser extent, from the structure of our sales commission program. In addition, the tendency of some of our customers to wait until the end of a fiscal quarter to finalize orders has resulted in higher order volumes towards the end of the quarter. We expect this seasonality to continue in the future.

Due to these factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Fluctuations in our results of operations are also likely to affect the market price of our common stock, if our operating results differ from expectations of investors or securities analysts, and may not be related to or indicative of our long-term performance.

Variations in the size and timing of our customer orders and differing nature of our products and services could expose us to revenue fluctuations and higher operating costs

Our license revenues in any quarter are substantially dependent on orders booked and delivered in that quarter. Our revenues in a given quarter could be adversely affected if we are unable to complete one or more large license transactions or if the contract terms were to prevent us from recognizing revenue during that quarter. The sales cycles for certain of our software products can last from three to nine months, or longer, and often require pre-purchase evaluation periods and customer education, which can affect timing of orders. Further, we have often booked a large amount of our sales in the last month, weeks or days of each quarter and delays in the closing of sales near the end of a quarter could cause quarterly revenue to fall short of anticipated levels. Finally, while a portion of our revenues each quarter is recognized from previously deferred revenue, our quarterly performance will depend primarily upon current order volumes to generate revenues for that quarter. These factors may cause significant periodic variation in our license revenues. In addition, we incur or commit to operating expenses based on anticipated revenue levels, and generally do not know whether revenues in any quarter will meet expectations until the end of that quarter.

Our product portfolio is engineered for a broad variety of operating system, database and application platforms, and having a diverse set of functions and features. Some products, such as our database management products and other component products, are directed at database administrators and are generally sold at lower price points, and we strive to generate demand for these products through our telesales organization and marketing programs designed to maximize lead generation and website traffic. Sales of other, enterprise-wide products, primarily SharePlex and Foglight, require substantial time and effort from our sales and support staff as well as involvement by our professional services organizations and, to an increasing degree, our systems integrator partners. Large individual sales, or even small delays in customer orders, can cause significant variation in our revenues and adversely affect our results of operations for a particular period. Historically, we have not placed significant reliance on large sales transactions in any given quarter, with a substantial volume of our revenues being driven from smaller transactions. However, if we encounter difficulty sustaining our component product volumes, and cannot generate a sufficient number of large customer orders, or if customers delay or cancel such orders in a particular quarter, our revenues and operating results may be adversely affected. For these reasons, we face increasing complexity in building and sustaining the optimum combination of field and inside sales personnel to address the various and changing sales and distribution characteristics of our products, which in turn impacts our ability to manage and minimize our sales and marketing costs.

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We rely heavily on our direct sales activities for license and services revenues, including renewals of annual maintenance contracts. We have in the past restructured or made other adjustments to our sales force in response to management changes, product changes, performance issues and other internal considerations. We recently made some adjustments to our coverage model to increase focus on global and other major accounts. We’ve also recently increased headcount in our telesales and sales associate groups. These changes can result in a temporary lack of focus and reduced productivity, which could have temporary negative effects on our license or services revenues.

Accordingly, if our revenue growth rates slow or our revenues decline, or if we fail to efficiently correlate our sales and marketing resources to our various products and their differing sales and distribution strategies, our operating results could be seriously impaired because many of our expenses are relatively fixed in nature and cannot be easily or quickly changed.

Many of our products are vulnerable to direct competition from Oracle and other platform vendors

We compete with Oracle in the market for database management solutions and the competitive pressure continues to increase. We expect that Oracle’s commitment to and presence in the database management product market will increase in the future and therefore substantially increase competitive pressures. We believe that Oracle will continue to incorporate database management technology into its server software offerings and expand their development products possibly at no additional cost to its users. Competition from Oracle with certain of our Database Management products including SharePlex and Quest Central for Oracle has increased over the last two years and has continued to increase with Oracle’s introduction of the next version of its database, known as Oracle 11g. Oracle 11g has enhanced capabilities in the functions competitive with SharePlex, Quest Central for Oracle and with the Oracle monitoring capabilities of Foglight including monitoring capabilities from the entire application stack. We believe increased competition from Oracle has materially depressed our SharePlex and Quest Central for Oracle revenues over the last four years. Oracle recently released SQL Developer which competes with TOAD, our market leading Database Development product for Oracle databases which contributes significantly to our revenues and net income.

In addition to the increasing competitive pressure from Oracle, Microsoft has continually upgraded the functionality of its platform offerings, which we also believe will increase competitive pressure for our Microsoft products in the future.

In some cases these types of platform vendor-provided tools are bundled with the platform and in other cases they are separately chargeable products, albeit at significantly lower price points. The inclusion of the functionality of our software as standard features of the underlying database solution or application supported by our products or sale at much lower cost could erode our revenues, particularly if the competing products and features were of comparable capability to our products. Even if the functionality provided as standard features or lower costs by these system providers is more limited than that of our software, there can be no assurance that a significant number of customers would not elect to accept more limited functionality in lieu of purchasing our products. Moreover, there is substantial risk that the mere announcements of competing products or features by large competitors such as Oracle could result in the delay or cancellation of customer orders for our products in anticipation of the introduction of such new products or features.

Our migration products for Microsoft’s Active Directory and Exchange are vulnerable to fluctuations in the rate at which customers migrate to these products

Our products for the migration, administration and management of Microsoft’s Active Directory and Exchange products currently contribute approximately one-quarter of our Windows platform revenue. Our ability to sell licenses for our Active Directory and Exchange migration products depends in part on the rate at which customers migrate to newer versions of Microsoft’s Active Directory or to newer versions of Microsoft Exchange, and from other messaging platforms to Exchange. If these migration rates were to materially decrease, our license revenues from these migration products would likely decline.

Many of our products are dependent on database or application technologies of others; if these technologies lose market share or become incompatible with our products, or if these vendors introduce competitive products or acquire or form strategic relationships with our competitors, the demand for our products could suffer

We believe that our success has depended in part, and will continue to depend in part for the foreseeable future, upon our relationships with providers of major database and enterprise software programs, including Oracle, IBM, Microsoft and

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SAP. Our competitive advantage consists in substantial part on the integration between our products and products provided by these major software providers, and our extensive knowledge of their products and technologies. If these companies for any reason decide to promote technologies and standards that are not compatible with our technologies, or if they lose market share for their database or application products, our business, operating results and financial condition would be materially adversely affected. Furthermore, these major software vendors could attempt to increase their presence in the markets we serve by either introducing products that compete with our products or acquiring or forming strategic alliances with our competitors. These companies have longer operating histories, larger installed bases of customers and substantially greater financial, distribution, marketing and technical resources than we do, as well as well-established relationships with many of our present and potential customers, and may be in better position to withstand and respond to the current factors impacting this industry. As a result, we may not be able to compete effectively with these companies in the future, which could materially adversely affect our business, operating results and financial condition.

If we fail to manage our operations and grow revenue or fail to continue to effectively control expenses, our future operating results could be adversely affected

Historically, the scope of our operations, the number of our employees and the geographic area of our operations and our revenue have grown rapidly. In addition, we have acquired both domestic and international companies. This growth and the assimilation of acquired operations and their employees could continue to place a significant strain on our managerial, operational and financial resources. To manage our current growth and any future growth effectively, we need to continue to implement and improve additional management and financial systems and controls. We may not be able to manage the current scope of our operations or future growth effectively and still exploit market opportunities for our products and services in a timely and cost-effective way.

We cannot assure you that our operating expenses will be lower than our estimated or actual revenues in any given quarter. If we experience a shortfall in revenue in any given quarter, we likely will not be able to further reduce operating expenses quickly in response. Any significant shortfall in revenue could immediately and adversely affect our results of operations for that quarter. Also, due to the fixed nature of many of our expenses and our current expectation for revenue growth, our income from operations and cash flows from operating and investing activities could be lower than in recent years.

Failure to develop and sustain additional distribution channels in the future may adversely affect our ability to grow revenues

We intend to direct additional efforts to drive domestic and international revenue growth through sales of our products and services through indirect distribution channels, such as global hardware and software vendors, systems integrators, or value-added resellers. Our ability to increase future revenues depends on our ability to expand our indirect distribution channels. If we fail in our efforts to maintain, expand and diversify our indirect distribution channels, our business, results of operations and financial condition could be adversely affected. Increasing activity in indirect distribution channels will present a number of additional risks, including:

• we may face conflicts between the activities of our indirect channels and our direct sales and marketing activities, which may result in lost sales and customer confusion;

• our channel partners can cease marketing and distributing our products and services with limited or no notice and with little or no penalty;

• our channel partners may not be able to effectively sell our products and services;

• our channel partners may experience financial difficulties that might lead to delays, or even default, in their payment obligations;

• we may not be able to recruit additional channel partners, or replace any of our existing ones; and

• our channel partners may also offer competitive products and services, and may not give priority to marketing our products or services.

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Intense competition in the markets for our products could adversely affect our results of operations

The markets for our products are highly competitive. As a result, our future success will be affected by our ability to, among other things, outperform our competitors in meeting the needs of current and prospective customers and identifying and addressing new technological and market opportunities. Our competitors may develop more advanced technology, adopt more aggressive pricing policies and undertake more effective sales and marketing campaigns and may be able to leverage more extensive financial, technical or partner resources. If we are unable to maintain our competitive position, our revenues may decline and our operating results may be adversely affected.

Our operating results may be negatively impacted by fluctuations in foreign currency exchange rates

Our international operations are generally conducted through our international subsidiaries, with the associated revenues and related expenses, and balance sheets, denominated in the currency of the country in which the international subsidiaries operate. As a result, our operating results may be harmed by fluctuations in exchange rates between the U.S. Dollar and other foreign currencies. The foreign currencies to which we currently have the most significant exposure are the Canadian Dollar, the British Pound, the Euro and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our exposure to fluctuations in foreign currency exchange rates.

Our international operations and our planned expansion of our international operations expose us to certain risks

We maintain research and development operations primarily in Canada, Australia, Russia and Israel, and continue to expand our international sales activities, with particular focus in Asia Pacific (including Japan), as part of our business strategy. As a percentage of total revenues, total revenues outside of North America were 36.7% and 34.2% for the three months ended March 31, 2007 and 2006, respectively. As a result, we face increasing risks from our international operations, including, among others:

• difficulties in staffing, managing and operating our foreign operations;

• difficulties in coordinating the activities of our geographically dispersed and culturally diverse operations;

• difficulties in adapting our existing foreign operations, particularly in Asia, to the control structure and requirements of a US public entity given those Asian countries historical environment and their cultural approach to conducting business;

• longer payment cycles and difficulties in collecting accounts receivable;

• seasonal reductions in business activity during the summer months in EMEA and in other periods in other countries;

• increased financial accounting and reporting burdens and complexities;

• difficulties in hedging foreign currency transaction exposures;

• limitations on future growth or inability to maintain current levels of revenue from international operations if we do not invest sufficiently in our international operations;

• potentially adverse tax consequences;

• potential loss of proprietary information due to piracy, misappropriation or weaker laws regarding intellectual property protection;

• delays in localizing our products;

• political unrest or terrorism, particularly in areas in which we have facilities;

• our ability to adapt and conform to accepted local business practices and customs, including providing letters of credit or other forms of support to or for the benefit of our subsidiaries or resellers;

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• compliance with a wide variety of complex foreign laws and treaties, including employment restrictions; and

• compliance with licenses, tariffs and other trade barriers.

Operating in international markets also requires significant management attention and financial resources and will place additional burdens on our management, administrative, operational and financial infrastructure. We cannot be certain that investment and additional resources required in establishing facilities in other countries will produce desired levels of revenue or profitability. In addition, we have limited experience in developing localized versions of our products and marketing and distributing them internationally.

Acquisitions of companies or technologies may result in disruptions to our business and diversion of management attention

We have in the past made and we expect to continue to make acquisitions of complementary companies, products or technologies. Acquisitions require us to assimilate the operations, products and personnel of the acquired businesses and train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may subject us to liabilities and risks that are not known or identifiable at the time of the acquisition or may cause disruptions in our operations and divert management’s attention from day-to-day operations, which could impair our relationships with our current employees, customers and strategic partners. We may have to use cash, incur debt or issue equity securities to pay for any future acquisitions. Use of cash or debt may affect our liquidity and use of cash would reduce our cash reserves and reduce our financial flexibility. The issuance of equity securities for any acquisition could be substantially dilutive to our shareholders. In addition, our profitability may suffer because of acquisition-related costs or amortization costs for intangible assets with indefinite useful lives. In consummating acquisitions, we are also subject to risks of entering geographic and business markets in which we have no or limited prior experience. If we are unable to fully integrate acquired businesses, products or technologies with our existing operations, we may not receive the intended benefits of an acquisition.

Accounting for equity investments in companies may affect our operating results

We have made equity investments in other software companies and a private equity fund. We regularly consider opportunities to make equity investments in other companies focused on software development or marketing activities, and expect from time to time to complete additional investments. These investments are risky because the market for the products and technologies being developed by these companies are typically in the early stages and may never materialize. In addition, we have made at least one investment in a private software company that has required us to consolidate the results of operations of this company into ours and we may determine in the future to invest in additional companies at similar levels. Estimating the fair value of our equity investments is inherently subjective and may contribute to volatility in our reported results of operations. We have recognized accounting charges due to the impairment of the value of our investments in the past and may need to do so again in the future if we cannot substantiate the fair value of our strategic equity investments. If we are required to consolidate the operating results of these companies, use the equity method of accounting, or write down the value of our cost-method investments, our operating results may be adversely affected.

We face risks associated with governmental contracting

We derive a portion of our revenues from contracts with the United States government and its agencies and from contracts with state and local governments or agencies. Demand and payment for our products and services are impacted by public sector budgetary cycles and funding availability, with funding reductions or delays adversely impacting public sector demand for our products and services. Public sector customers may also change the way they procure new contracts and may adopt new rules or regulations governing contract procurement, including required competitive bidding or use of “open source” products, where available. These factors may limit the growth of or reduce the amount of revenues we derive from the public sector, which could negatively affect our results of operations.

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We may not generate increased business from our current customers, which could slow our revenue growth in the future

Most of our customers initially make a purchase of our products for a single department or location. Many of these customers may choose not to expand their use of our products. If we fail to generate expanded business from our current customers, our business, operating results and financial condition could be materially adversely affected. In addition, as we deploy new modules and features for our existing products or introduce new products, our current customers may choose not to purchase this new functionality or these new products. Moreover, if customers elect not to renew their maintenance agreements, our service revenues would be materially adversely affected.

Failure to develop or leverage strategic relationships could harm our business by denying us selling opportunities and other benefits

Our development, marketing, and distribution strategies rely increasingly on our ability to form strategic relationships with software and other technology companies. These business relationships often consist of cooperative marketing programs, joint customer seminars, lead referrals, and cooperation in product development. Many of these relationships are not contractual and depend on the continued voluntary cooperation of each party with us. Divergence in strategy or change in focus by, or competitive product offerings by, any of these companies may interfere with our ability to develop, market, sell, or support our products, which in turn could harm our business. Further, if these companies enter into strategic alliances with other companies or are acquired, they could reduce their support of our products. Our existing relationships may be jeopardized if we enter into alliances with competitors of our strategic partners. In addition, one or more of these companies may use the information they gain from their relationship with us to develop or market competing products.

Failure to adequately protect our intellectual property rights could harm our competitive position

Our success and ability to compete are dependent on our ability to develop and maintain the proprietary aspects of our technology. We generally rely on a combination of trademark, trade secret, patent, copyright law and contractual restrictions to establish and protect our proprietary rights in our products and services.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, and to determine the validity and scope of the proprietary rights of others. Any such resulting litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management and financial resources, which could harm our business.

Our means of protecting our proprietary rights may prove to be inadequate and competitors may independently develop similar or superior technology. Policing unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. We also believe that, because of the rapid rate of technological change in the software industry, trade secret and copyright protection are less significant than factors such as the knowledge, ability and experience of our employees, frequent product enhancements and the timeliness and quality of customer support services.

Third parties may claim that our software products or services infringe on their intellectual property rights, exposing us to litigation that, regardless of merit, may be costly to defend

Our success and ability to compete are also dependent upon our ability to operate without infringing upon the proprietary rights of others. Third parties may claim that our current or future products infringe their intellectual property rights. Any such claim, with or without merit, could have a significant effect on our business and financial results. Any future third party claim could be time consuming, divert management’s attention from our business operations and result in substantial litigation costs, including any monetary damages and customer indemnification obligations, which may result from such claims. In addition, parties making these claims may be able to obtain injunctive or other equitable relief affecting our ability to license the products that incorporate the challenged intellectual property. As a result of such claims, we may be required to obtain licenses from third parties, develop alternative technology or redesign our products. We cannot be sure that such licenses would be available on terms acceptable to us, if at all. If a successful claim is made against us and we are unable to develop or license alternative technology, our business and financial results and position could be materially adversely affected.

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Our business may be adversely affected if our software contains errors or security flaws

The software products we offer are inherently complex. Despite testing and quality control, we cannot be certain that errors or security flaws will not be found in current versions, new versions or enhancements of our products after commencement of commercial shipments. Significant technical challenges also arise with our products because our customers purchase and deploy our products across a variety of computer platforms and integrate them with a number of third-party software applications and databases. If new or existing customers have difficulty deploying our products or require significant amounts of customer support, our operating margins could be harmed. Moreover, we could face possible claims and higher development costs if our software contains undetected errors or security flaws or if we fail to meet our customers’ expectations. As a result of the foregoing, we could experience:

• loss of or delay in revenues and loss of market share;

• loss of customers;

• damage to our reputation;

• failure to achieve market acceptance;

• diversion of development resources;

• increased service and warranty costs;

• legal actions by customers against us which could, whether or not successful, increase costs and distract our management; and

• increased insurance costs.

The detection and correction of any security flaws can be time consuming and costly. In addition, a product liability claim, whether or not successful, could harm our business by increasing our costs and distracting our management.

We incorporate software licensed from third parties into some of our products and any significant interruption in the availability of these third-party software products or defects in these products could reduce the demand for, or prevent the shipping of, our products

Certain of our software products contain components developed and maintained by third-party software vendors. We expect that we may have to incorporate software from third-party vendors in our future products. We may not be able to replace the functionality provided by the third-party software currently offered with our products if that software becomes obsolete, defective or incompatible with future versions of our products or is not adequately maintained or updated. Any significant interruption in the availability of these third-party software products or defects in these products could harm our sales unless and until we can secure an alternative source. Although we believe there are adequate alternate sources for the technology licensed to us, such alternate sources may not provide us with the same functionality as that currently provided to us.

Natural disasters or power outages could disrupt our business

A substantial portion of our operations is located in California, and we are subject to risks of damage and business disruptions resulting from earthquakes, floods, wildfires and similar events, as well as from power outages. We have in the past experienced limited and temporary power outages in our California facilities due to power shortages, and we expect in the future to experience additional power losses. While the impact to our business and operating results has not been material, we cannot assure you that natural disasters or power outages will not adversely affect our business in the future. Since we do not have sufficient redundancy in our networking infrastructure, a natural disaster or other unanticipated problem could have an adverse effect on our business, including both our internal operations and our ability to communicate with our customers or sell and deliver our products.

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Failure to attract and retain personnel may negatively impact our business

Our success and ability to compete depends largely on the continued contributions of our key management, sales, engineering, marketing, support, professional services and finance personnel. We have recently had moderate turnover in our sales and research and development organizations, significant turnover in the management of our accounting and finance department, and many key positions are held by people who are new to the Company or to their roles. If these people are unable to quickly become familiar with the issues they face in their roles or are not well suited to their new roles, then this could result in the Company having problems in executing its strategy or in reporting its financial results. We are uniquely dependent upon the talents, relationships and contributions of a few executives and have no guarantee of their retention. We have been targeted by recruitment agencies seeking to hire our key management, finance, engineering, sales and marketing and professional services personnel.

We historically have used stock options as a significant component of our employee compensation program in order to align employees’ interests with the interests of our shareholders, encourage employee retention and provide competitive compensation packages. During the pendency of our stock option investigation and related restatement, we were unable to continue granting stock options to new and existing employees and did not permit exercises of outstanding stock options. These actions have impacted our overall competitive posture with respect to employee compensation and retention of qualified personnel. If we are unable to hire or retain qualified personnel, or if newly hired personnel fail to develop the necessary skills or fail to reach expected levels of productivity, our ability to develop and market our products will be weakened.

Item 6. Exhibits

Exhibit Number	Exhibit Title
3.1	Second Amended and Restated Articles of Incorporation. (1)
3.2	Certificate of Amendment of Articles of Incorporation of Quest Software, Inc. (2)
3.3	Bylaws of Quest Software, Inc. (3)
4.1	Form of Registrant’s Specimen Common Stock Certificate. (1)
31.1	Certification of the Chief Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.
31.2	Certification of the Chief Financial Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.
32.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1) Incorporated herein by reference to our Registration Statement on Form S-1 and all amendments thereto (File No. 333-80543).

(2) Incorporated herein by reference to our Quarterly Report on Form 10-Q for the period ended September 30, 2005.

(3) Incorporated herein by reference to our Current Report on Form 8-K filed November 7, 2007.

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SIGNATURES

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

	QUEST SOFTWARE, INC.
Date: December 31, 2007	/s/ Scott J. Davidson
	Scott J. Davidson Senior Vice President, Chief Financial Officer
	/s/ Scott H. Reasoner
	Scott H. Reasoner, Vice President, Corporate Controller

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