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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark one)

For the quarterly period ended June 30th, 2006

OR

For the transition period from                      to                     

Commission File Number 000-24733

ENTRUST, INC.

(Exact name of registrant as specified in its charter)

ONE HANOVER PARK, SUITE 800

16633 DALLAS PARKWAY

ADDISON, TX 75001

(Address of principal executive offices & zip code)

Registrant’s telephone number, including area code: (972) 713-5800

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  ¨                    Accelerated filer  x                    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

There were 59,676,929 shares of the registrant’s Common stock, par value $0.01 per share, outstanding as of August 4, 2006.

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ENTRUST, INC.

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Entrust, Entrust-Ready, and getAccess are registered trademarks of Entrust, Inc. or a subsidiary of Entrust, Inc. in certain countries. Entrust Authority, Entrust TruePass, Entrust GetAccess, Entrust Entelligence, Entrust Cygnacom, are trademarks or service marks of Entrust, Inc. or a subsidiary of Entrust, Inc. in certain countries. All other trademarks and service marks used in this quarterly report are the property of their respective owners.

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PART I. FINANCIAL INFORMATION

ENTRUST, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these financial statements.

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ENTRUST, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

The accompanying notes are an integral part of these financial statements.

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ENTRUST, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of these financial statements.

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ENTRUST, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share data, unless indicated otherwise)

NOTE 1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared on the same basis as the audited annual consolidated financial statements and, in the opinion of management, include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial position, results of operations and cash flows of Entrust, Inc., a Maryland corporation, and its consolidated subsidiaries (collectively, the “Company”). The results of operations for the three and six months ended June 30, 2006 are not necessarily indicative of the results to be expected for the full year. Certain information and footnote disclosures normally contained in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the Notes to Consolidated Financial Statements for the year ended December 31, 2005 contained in the Company’s Annual Report on Form 10-K.

NOTE 2. ACQUISITION OF ORION SECURITY SOLUTIONS, INC.

On June 15, 2006, the Company completed the acquisition of all of the issued and outstanding shares of common stock of Orion Security Solutions, Inc. (“Orion”), a Virginia corporation, pursuant to a stock purchase agreement dated as of June 15, 2006 (“Stock Purchase Agreement”) among the Company, Orion, and the stockholders of Orion. The Company acquired all of the common stock of Orion, a privately-held provider of public key infrastructure services to defense-related governmental agencies and other customers, such as the Department of Defense, the United States Marine Corps and the National Security Agency and commercial companies in the healthcare industry, in exchange for $9,000 in cash and $135 in acquisition-related costs. The acquisition was made in order to extend the Company’s overall leadership in the United States government vertical, by further strengthening the Company’s ability to provide identity and information security to the United States civilian government agencies, adding key defense agencies to the Company’s customer base. The Company intends to continue Orion’s business substantially in the manner conducted by Orion immediately prior to the acquisition, however, it plans to integrate the business into Entrust Cygnacom, a wholly owned subsidiary of the Company, located in McLean, Virginia.

The acquisition was accounted for under the purchase method of accounting, and, accordingly, the purchase price of approximately $9,135 was allocated to the fair value of the tangible and intangible assets and liabilities acquired, with the remainder allocated to goodwill. In addition, the results of operations of Orion have been included in the Company’s consolidated financial statements commencing from June 1, 2006, the effective date of the acquisition for accounting purposes. No amortization has been recorded in the three months ended June 30, 2006, related to customer relationships and non-competition agreement assets arising from this acquisition. In connection with the purchase price allocation, the Company undertook an appraisal of the intangible assets, which resulted in the purchase price of these assets being allocated, on a preliminary basis, as follows:

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The following unaudited pro forma data summarize the combined results of operations of the Company and Orion for the three and six months ended June 30, 2006 and 2005, respectively, as if the acquisition had taken place as of the beginning of the respective periods, and, accordingly, include a full period’s amortization of the assets related to customer relationships and non-competition agreements in each period shown.

These pro forma amounts are not necessarily indicative of future results of operations.

NOTE 3. SUBSEQUENT EVENT - ACQUISITION OF BUSINESS SIGNATURES CORPORATION

On July 19, 2006, subsequent to the end of the Company’s second fiscal quarter, the Company completed the acquisition of all of the issued and outstanding shares of capital stock and options of Business Signatures Corporation (“Business Signatures”), a privately-held supplier of Zero Touch Fraud Detection solutions that provide non-invasive real time online fraud detection capability and that require no change to business applications, based in Redwood City, California, in exchange for approximately $49,000 in cash and options to purchase shares of the Company’s Common stock with an aggregate fair value of approximately $1,000. The Company also estimates that it will incur approximately $1,000 in acquisition-related expenses and will assume net liabilities of Business Signatures of approximately $1,100. The acquisition enables the Company to combine Business Signatures’ zero touch capability with its IdentityGuard authentication platform in order to offer customers strong consumer authentication solutions, that are easy to implement, user-friendly and cost effective with the ability to evolve over time, to help meet the Federal Financial Institutions Examination Council (“FFIEC”) requirement to implement stronger security measures for online customers, as well as other requirements for online transaction security and integrity.

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NOTE 4. INVESTMENT IN OHANA WIRELESS, INC.

Ohana was incorporated on July 10, 2003. It was formed to design, assemble and install high frequency wireless communications systems. On September 30, 2003, the Company loaned Ohana $650 in the form of a convertible loan pursuant to the terms of a convertible loan agreement (the “Loan Agreement”). Because the Company believed that its security solutions can be integrated with Ohana’s products and anticipated that an investment in Ohana would assist the Company in furthering the development of its distribution capability in Asia through technology and distribution partnerships. This convertible loan was structured to automatically convert into Ohana’s stock if Ohana was successful in closing a round of equity financing by July 31, 2004, based on minimum terms set out in the Loan Agreement.

In the second and third quarters of 2004, the Company made additional advances of $300 and $275, respectively, resulting in a total outstanding convertible loan of $1,225 which by July 2004 was secured with certain exclusive rights to Ohana’s intellectual property.

In the third quarter of 2004, the Company determined that the loan was unlikely to be repaid. Also in the third quarter of 2004 we concluded a term sheet with Ohana and certain of its shareholders and creditors which anticipated that Ohana would become a wholly owned subsidiary of ADML Holdings, Ltd. (“ADML Holdco”) and all loans, together with accrued interest, would convert into stock of ADML Holdco (“Ohana Restructuring”). In view of these factors we classified the loans as long-term in nature.

If the Ohana Restructuring had materialized on September 30, 2004, we would have held the equivalent of approximately 12% ownership interest in ADML Holdco (exclusive of the anticipated final disbursement in the fourth quarter of 2004). Also, we had concluded that because of the additional investment in July 2004, and additional rights obtained through the security granted in connection with the loans, we gained the potential ability to exercise significant influence over the operations of Ohana. Therefore, beginning the third quarter of 2004, the Company accounted for its investment in Ohana under the equity method. Accordingly, the Company included its share of losses of Ohana for the period of July 1, 2004 to December 17, 2004, in the amount of $193, in its consolidated statement of operations for 2004.

The Ohana Restructuring closed on November 16, 2004 and the Company received approximately 14.3% of the issued common shares of ADML Holdco and a warrant that will become exercisable for additional shares of ADML Holdco at one tenth of one penny ($0.001) per share if, and to the extent, that the valuation of Asia Digital Media, as determined by an arm’s length investor contributing a minimum amount of cash for equity in Asia Digital Media is less than the total consideration contributed by ADML Holdco, the Company, and another investor for equity in Asia Digital Media.

In December 2004 ADML Holdco directly subscribed for 60.6% of the share capital of Asia Digital Media in exchange for a contribution of the entire issued share capital of Ohana. However, this transaction was subsequently rescinded on December 27, 2005, when the Company entered into the Rescission Agreement with Asia Digital Media and ADML Holdco to rescind such subscription, resulting in the return of the shares of Asia Digital Media issued to ADML Holdco for cancellation and the corresponding return of the entire issued capital of Ohana to ADML Holdco.

Upon conclusion of the Rescission Agreement, the Company owned approximately 14.3% of the issued share capital of Ohana. The carrying value of this cost investment was $750 at December 31, 2005. The Company has recorded cumulative losses from its investment in Ohana of $750 since the fourth quarter of 2004, including $461 and $193 in 2005 and 2004, respectively. As a consequence of the Rescission Agreement, there are no additional terms associated with the Company’s investment in ADML Holdco that would impact its accounting for this investment under FIN 46 (R), the Company has no further commitments or other arrangements to provide funding for any shortfalls ADML Holdco may incur, and there are no variable interests with respect to ADML Holdco, other than its common stock interest of 14.3%.

Dr. Anthony E. Hwang, a director of the Company from August 4, 2003 to December 27, 2005, was interim Chief Executive Officer of Ohana at the time of the September 2003 Loan Agreement through to March 1, 2004. Dr. Hwang was also a director of Ohana from August 4, 2003 through March 31, 2004.

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Dr. Hwang and his family members own a controlling interest in Fil-Fibers Manufacturing Inc., Ltd. (“Fil-Fibers”).

Fil-Fibers was both a creditor and shareholder in Ohana immediately prior to the Ohana Restructuring. After the Ohana Restructuring, Fil-Fibers was a minority shareholder in ADML Holdco.

During the first quarter of 2006, the Company was informed of an Ohana re-financing, which coupled with the changes in the business outlook, led the Company to conclude that the expectations for Ohana had not materialized and an impairment charge was required to adjust the net carrying value of the Company’s equity ownership. As a result, the Company recorded in the first quarter of fiscal 2006 an impairment of its investment in Ohana of $659. No amount of the charge will result in future cash expenditures. After this impairment, the remaining carrying value of the Company’s investment in Ohana at June 30, 2006 was $91.

NOTE 5. ASIA DIGITAL MEDIA JOINT VENTURE

On September 16, 2004, the Company and certain other investors agreed to subscribe for shares in a newly formed joint venture called Asia Digital Media pursuant to a subscription agreement (as amended, the “Subscription Agreement”). The investment closed on December 17, 2004.

The parties agreed that: (i) the Company would directly subscribe for approximately 16.7% of the share capital of Asia Digital Media in exchange for a cash contribution of $2,000 and in-kind contribution of $1,300, both of which, after intercompany profit eliminations, aggregated to $3,088; (ii) ADML Holdco, in which the Company held a 14.3% ownership interest, would directly subscribe for 60.6% of the share capital of Asia Digital Media in exchange for a contribution of the entire issued share capital of Ohana; and (iii) the remaining capital stock of Asia Digital Media would be owned by two investors and China Aerospace New World Technology Limited (“CANW”), a company incorporated in Hong Kong, in exchange for cash and/or in-kind contributions.

After the closing, the Company’s total direct and indirect equity holdings in Asia Digital Media were approximately 25.3%. During the first quarter of 2005, the Company received additional shares of common stock of Asia Digital Media as reimbursement for legal costs incurred by the Company on behalf of Asia Digital Media during its formation and for administrative services provided by the Company. These additional shares were valued at $458 and resulted in an increase of the Company’s total direct and indirect equity holdings in Asia Digital Media to 27.4% at June 30, 2005.

Dr. Anthony E. Hwang, a former director of the Company, and Mr. F. William Conner, Chairman, President and Chief Executive Officer of the Company, became directors of Asia Digital Media on December 17, 2004. Dr. Hwang subsequently resigned from the Board of Directors of Entrust, Inc. effective November 17, 2005. Concurrently with this resignation, Mr. Conner resigned as a director of Asia Digital Media effective November 18, 2005.

On December 27, 2005, the Company entered into the Rescission Agreement with Asia Digital Media and ADML Holdco to rescind the Subscription Agreement in part, resulting in the return of the shares of Asia Digital Media issued to ADML Holdco for cancellation and the corresponding return of the entire issued capital of Ohana to ADML Holdco. In addition, Dr. Hwang resigned as a director of Asia Digital Media. Upon conclusion of the Rescission Agreement, the Company owned approximately 44% of the issued share capital of Asia Digital Media. Entrust appointed Mr. James D. Kendry, Vice President and Chief Governance Officer, as a director of Asia Digital Media. After the Rescission Agreement was executed, the Company’s conclusion that Asia Digital Media did not meet the definition of a variable interest entity remained unchanged.

The Company accounts for its investment in Asia Digital Media under the equity method. Accordingly, the Company has included its share of losses of Asia Digital Media, in the amount of $122 and $293, in its condensed consolidated statement of operations for the three and six months ended June 30, 2006, respectively, and $136 and $273 for the three and six months ended June 30, 2005, respectively. The Company has recorded cumulative losses through June 30, 2006 from its investment in Asia Digital Media of $959 since its investment in the fourth quarter of 2004.

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During the first quarter of 2006, the Company was informed of changes in its Chinese partner’s ability to invest in the second funding round of Asia Digital Media. This factor, among others, had significant negative implications for Asia Digital Media. The Company had concluded that expectations for Asia Digital Media had not materialized and an impairment charge was required to adjust the net carrying value of the Company’s equity ownership. As a result, the Company recorded in the first quarter of fiscal 2006 an impairment of its investment in Asia Digital Media in the amount of $2,357. No amount of the charge will result in future cash expenditures. After this impairment, the remaining carrying value of the Company’s investment in Asia Digital Media at June 30, 2006 was $230.

NOTE 6. STOCK-BASED COMPENSATION AND STOCK OPTION PLANS

On May 5, 2006 stockholders approved the 2006 Stock Incentive Plan (the “2006 Plan”). The Board adopted the 2006 Plan because it believes that continued grants of stock options, as well as grants of restricted stock and other stock-based awards, are an important element in attracting, retaining and motivating persons who are expected to make important contributions to the Company.

The Amended and Restated 1996 Stock Incentive Plan, the enCommerce, Inc. 1997 Stock Option Plan, as amended and restated, and the 1999 Non-Officer Employee Stock Incentive Plan, as amended (together, the “Prior Plans”), terminated and no further grants are permitted under the Prior Plans. This termination of the Prior Plans does not affect awards that are outstanding under the Prior Plans.

SFAS No. 123(R) Adoption

In December 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). SFAS No. 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends FASB Statement No. 95, “Statement of Cash Flows”. Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement, over the service period, based on their grant-date fair values. Pro forma disclosure is no longer an alternative.

SFAS No. 123(R) is effective for the first annual period beginning after June 15, 2005 and, therefore, the Company adopted SFAS No. 123(R) in the first quarter of 2006, recognizing compensation expense for employee stock awards. The Company adopted SFAS No. 123(R) using the modified-prospective transition method, in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date.

As previously permitted by SFAS No. 123, the Company formerly accounted for share-based payments to employees using APB Opinion No. 25’s intrinsic value method and, as such, generally did not recognize compensation cost for employee stock options. For all options granted to employees in the periods disclosed prior to 2006, the exercise price of each option granted was equal to the fair value of the underlying stock at the date of grant and therefore, no stock-based compensation costs were reflected in earnings for these options.

Accordingly, the adoption of SFAS No. 123(R)’s fair value method has had, and will continue to have, a significant impact on the Company’s result of operations. The continued impact of adoption of SFAS No. 123(R) will depend on levels of share-based awards granted in the future. In general, the annual stock-based compensation expense is expected to decline in future years when compared to the expense reported in prior years in the Company’s pro forma stock-based compensation disclosures. This decline is primarily the result of a change in stock-based compensation strategy as determined by management.

For the three and six months ended June 30, 2006 compensation cost of $877 and $1,579, respectively, was recognized for employee stock options, RSUs and SARs. This compensation cost included estimation of expected forfeitures. Forfeiture estimations are based on analysis of historical forfeiture rates.

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As a result of adopting SFAS No. 123(R) on January 1, 2006, the Company’s net loss for the three and six months ending June 30, 2006 is approximately $509 higher and $923 higher, respectively, than if it had continued to account for share based compensation under Opinion 25. Also, the Company’s net loss per share was higher by $0.01 and $0.02 for the three and six months ended June 30, 2006, respectively, than under our previous accounting method for share based compensation. This difference is primarily the addition of the stock option expense and the impact of forfeiture rate estimations for RSUs and SARs.

In addition to ongoing recognition of stock-based compensation expense, the Company recognized a one-time cumulative transition adjustment in the first quarter of 2006. A net reduction of $32 to compensation expense was recorded in the first quarter, related to the effect of estimated forfeitures on outstanding awards. This net reduction is with respect to the compensation cost that would not have been recognized in prior periods had forfeitures been estimated during those periods. This adjustment applies only to compensation cost recognized in fiscal 2005 related to RSU and SAR awards that are unvested at adoption date.

In accordance with the provisions of SFAS No. 123(R), no unearned deferred compensation expense was recorded for stock-based awards to employees. Compensation costs related to stock based awards are treated as a credit to Additional Paid in Capital in Shareholder’s Equity when the expense is recognized over the requisite service period. Unearned deferred compensation recorded in 2005 of $1,814 related to SARs and RSUs granted in that year had been subsequently reversed in the first quarter of 2006 to comply with the SFAS No. 123(R) provisions which prohibit such practice.

In addition, had the Company adopted SFAS No. 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123, as described in the disclosure of pro forma net income (loss) and earnings per share in the following table.

Impact on the Statement of Cash Flows

Share based awards are settled by issuance of common shares and are recorded as non-cash items in net loss on the statement of cash flows. No tax benefits related to share based awards exercised in the quarter were realized.

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Valuation of Stock Options Granted Prior to the Adoption of SFAS No. 123(R)

Under the previous provisions of SFAS No. 123, the fair value of options was estimated, as of the date of grant, using the Black-Scholes option pricing model. The Company believes the inputs and method used to value these options under SFAS No. 123 pro-forma disclosures were reasonable, and hence, no correction to the original fair value estimation has been made to outstanding, unvested, stock options as at January 1, 2006. Under the Black-Scholes option pricing model, input assumptions are determined at the time of option grant and are not adjusted for the life of that grant. The following weighted average assumptions were used in the option fair value calculations.

In the second quarter of 2006, compensation cost of $509 related to unvested options outstanding at January 1, 2006 was recognized. No further stock option grants were made in the six months ended June 30, 2006. Compensation cost of stock options is recognized in accordance with the accelerated method with the cost to be recognized over the remaining requisite service period.

The total compensation cost related to non-vested stock option awards not yet recognized and the related weighted –average period remaining for stock options is as follows:

Restricted Stock Units (“RSUs”)

During the three months ended June 30, 2006, the Company issued 11,669 restricted stock units to employees with an average grant date value of $3.32 per unit. Restricted stock units are valued at fair value of the underlying stock on the date of grant. Compensation cost related to RSUs is recognized over the requisite service period, which is generally between two to four years. The total compensation cost related to non-vested RSUs awards not yet recognized, and the related weighted-average requisite service period remaining is as follows:

The following tables summarize information concerning outstanding RSUs for the three month period ended June 30, 2006.

The aggregate intrinsic value of RSUs outstanding at June 30, 2006 is $2,293.

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Stock Appreciation Rights (“SARs”)

SARs give the issuer a right to participate in the appreciation of the underlying stock up to a ‘capped’ value of four times the stock price on date of grant. SARs are settled by issuance of common stock.

A total of 75,000 SARs were granted to employees in the three and six months ended June 30, 2006, which had a strike price of $3.32 per right, equivalent to the underlying share price on the date of grant. These instruments vest over four years and have a contractual life of seven years.

A total of 132,668 SARs were granted to the members of our Board of Directors in 2005 and have a vesting period of three years and a contractual life of seven years.

The total compensation cost related to these SARs awards not yet recognized is displayed in the following table along with the related weighted-average period remaining.

SFAS No. 123(R) requires stock-based compensation to be determined based upon the fair value of the award on the date of grant. If the fair value is not readily determinable, a valuation technique that reflects all substantive characteristics of the instrument is required. Management has selected the Black-Scholes option valuation model to determine the fair value of issued SARs. All substantive characteristics of the instrument have been incorporated into the formula, including the ‘capped’ value portion.

Significant input assumptions required to estimate the fair value of SARs include the following:

The following weighted average assumptions were used in estimating the fair value of issued SARs.

The weighted average estimated fair value of SARs granted during the three months ended June 30, 2006 is $86.

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Stock Options and SARs

The following tables summarize information concerning outstanding stock options and SARs as at June 30, 2006:

Stock Option and SARs In-the-Money and Out-of-the-Money Information as of June 30, 2006 ⁽¹⁾ 

Stock Award Plans Summary of Activity

On March 15, 2006, the Board of Directors adopted resolutions, subject to stockholder approval, to approve entry into the 2006 Stock Incentive Plan (the “2006 Plan”). The plan was approved at the annual shareholders meeting held May 5, 2006. The Board adopted the 2006 Plan because it believes that continued grants of stock options, as well as grants of restricted stock and other stock-based awards, are an

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important element in attracting, retaining and motivating persons who are expected to make important contributions to the Company.

The Amended and Restated 1996 Stock Incentive Plan, the enCommerce, Inc. 1997 Stock Option Plan, as amended and restated, and the 1999 Non-Officer Employee Stock Incentive Plan, as amended (together, the “Prior Plans”), will terminate and no further grants will be permitted under the Prior Plans, provided that, this termination of the Prior Plans will not affect awards that are outstanding under the Prior Plans.

Summary of activity for stock options and SARs under the 2006 Plan and the Prior Plans is set forth below:

Subsequent to the end of the Company’s second fiscal quarter, and pursuant to the merger agreement with Business Signatures, the Company assumed the Business Signature’s 2002 Stock Plan, which will provide for options to purchase 1,099,868 shares of the Company’s Common stock, of which 835,622 options are vested, as at the date of acquisition of Business Signatures.

NOTE 7. STOCK REPURCHASE PROGRAM

On July 29, 2002, the Company announced that its Board of Directors had authorized the Company to repurchase up to an aggregate of 7,000,000 shares of its Common stock. The program has subsequently been extended three times, most recently on July 22, 2005 when the Board of Directors authorized a further extension of this stock repurchase program to permit the purchase of up to 10,000,000 shares of the Company’s Common stock through December 15, 2006. This quantity of shares of Common stock is in addition to the 6,928,640 shares of the Company’s Common stock already purchased under the Company’s stock repurchase program through June 30, 2005. During the three months ended June 30, 2006, the Company repurchased 298,000 shares of its Common stock for a total cash outlay of $988, at an average price of $3.32 per share, including commissions paid to brokers. During the six months ended June 30, 2006, the Company repurchased 703,000 shares of its Common stock for a total cash outlay of $2,519, at an average price of $3.58 per share, including commissions paid to brokers. As of June 30, 2006, the Company has repurchased 8,530,124 of the authorized 16,928,640 shares of its Common stock under this program, for a total cash outlay of $33,610, at an average price of $3.94 per share, including commissions paid to brokers.

Repurchases under the stock repurchase program may take place from time to time until December 15, 2006, or an earlier date determined by the Company’s board of directors, in open market, negotiated or block transactions, and may be suspended or discontinued at any time. The Company’s management will determine the timing and amount of shares repurchased based on its evaluation of market and business

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conditions. The repurchased shares will be considered authorized but unissued shares of the Company and will be available for issuance under the Company’s stock incentive, employee stock purchase and other stock benefit plans, and for general corporate purposes, including possible acquisitions. The stock repurchase program will be funded using the Company’s working capital.

NOTE 8. ALLOWANCE FOR DOUBTFUL ACCOUNTS

The Company performs ongoing credit evaluations of its customers and, generally, does not require collateral from its customers to support accounts receivable. The Company maintains an allowance for doubtful accounts due to credit risk; to provide adequate protection against estimated losses resulting from the inability of customers to make required payments. The Company bases its ongoing estimate of allowance for doubtful accounts primarily on the aging of balances in its accounts receivable, historical collection patterns and changes in the creditworthiness of its customers. Based upon this analysis, the Company records an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. The allowance for doubtful accounts is established based on the best information available to the Company and is re-evaluated and adjusted as additional information is received. The following table summarizes the changes in the allowance for doubtful accounts for the six months ended June 30, 2006:

NOTE 9. ACCRUED RESTRUCTURING CHARGES

May 2003 Restructuring Plan

Following the first quarter of 2003, when the Company’s revenues fell short of its expectations and guidance, management began a re-assessment of the Company’s operations to ensure that expenses were optimally aligned to its customers and markets, and structured such that costs would not exceed revenues by the fourth quarter of 2003.

On May 27, 2003, the Company announced a restructuring plan aimed at lowering costs and better aligning its resources to customer needs. The plan allows the Company to have tighter integration between customer touch functions, which better positions the Company to take advantage of the market opportunities for its new products, and solutions. The restructuring plan included eliminating positions to lower operating costs, closing under-utilized office capacity, and re-assessing the useful life of related excess long-lived assets. The Company also announced non-cash charges related to the impairment of a long-term strategic investment and the impairment of purchased product rights acquired through the enCommerce acquisition of June 2000.

The workforce portion of the restructuring plan included severance and related costs of $4,813 in 2003 for 151 positions from all functional areas of the Company and had been significantly completed by December 31, 2003. The consolidation of under-utilized facilities included costs relating to lease obligations through the first quarter of 2009, primarily from the excess space in the Company’s Santa Clara, California and Addison, Texas facilities, and accelerated amortization of related leaseholds and equipment. The facilities plan was executed by September 30, 2003 and, as a result, the Company recorded $4,116 of charges during 2003 relating to these facilities, including $1,310 for accelerated amortization on leaseholds and equipment whose estimated useful lives had been impacted by the plan to cease using the

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related excess capacity in the Company’s facilities and $2,806 for lease obligations related to excess capacity at Company locations for which the cease-use date occurred during 2003. The total amount of the workforce and facilities charges was $8,929.

The Company has evaluated and pursued all reasonable possibilities to settle the lease obligations associated with the May 2003 restructuring, but has been unable to find an acceptable outcome. Therefore, the Company has concluded that it is appropriate to classify the portion of the outstanding liabilities that is not payable within the next 12 months as long-term liabilities. However, in terms of long-term liquidity requirements, the current obligations would require the Company to fund $100 of its accrued restructuring charges for the May 2003 restructuring before the end of fiscal 2006, with the remaining accrued restructuring charges for the May 2003 restructuring to be paid as follows: $150 in fiscal 2007 and $150 in fiscal 2008.

Summary of Accrued Restructuring Charges for May 2003 Restructuring

The following table is a summary of the accrued restructuring charges related to the May 2003 plan at June 30, 2006:

June 2001 Restructuring Plan

On June 4, 2001, the Company announced a Board-approved restructuring plan to refocus on the Company’s most significant market opportunities and to reduce operating costs due to the macroeconomic factors that were negatively affecting technology investment in the market. The restructuring plan included a workforce reduction, consolidation of excess facilities, and discontinuance of non-core products and programs.

The workforce portion of the restructuring plan was largely completed by the end of the fourth quarter of 2001 and primarily related to severance costs, fringe benefits due to severed employees and outplacement services.

The consolidation of excess facilities included the closure of eight offices throughout the world, but the majority of the costs related to the Company’s facility in Santa Clara, California. These costs are payable contractually over the remaining term of the Santa Clara facility lease, which runs through 2011, reduced by estimated sublease recoveries. The discontinuance of non-core products and programs was primarily related to the discontinuance of certain of the Company’s business program initiatives and certain applications that had not achieved their growth and profitability objectives. In addition, the Company withdrew from certain committed marketing events and programs. The cash outflow related to the majority of these discontinued products and programs was substantially completed by the end of the second quarter of 2002, while remaining marketing and distribution agreement obligations related to certain discontinued products were settled in the third quarter of 2003. The Company had initiated all actions required by the restructuring plan by the end of the second quarter of 2002.

During the first and second quarters of 2006, the Company made further adjustments to the restructuring charges that had previously been recorded related to the June 2001 restructuring plan with respect to our Santa Clara, California facility. The building is currently subleased, but the current sublease was scheduled to end in December 2006. Although the Company had been monitoring the sublet market on an on-going basis, the extension offer it received during the first quarter of

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2006, coupled with the preparations the Company had begun for placing the facility on the market, caused the Company to revisit its estimated sublease recoveries at that time. The Company had concluded that it would need to increase the restructuring charges that it had previously recorded related to its June 2001 restructuring plan by a further $2,895 in the first quarter of fiscal 2006 to reflect a change in the Company’s projected sublet lease recoveries as evidenced by the market for leased facilities in that region. This charge represented a reduction in the cash that the Company expected to recover from future subtenants. During the second quarter of 2006, the Company concluded an extension agreement with the current sublessee to sublease the California facility through to March 31, 2011, which represents substantially all of the remaining lease period on the building. As a result of the conclusion of the final sublease arrangement during the second quarter of 2006, the Company adjusted its accrual related to the June 2001 restructuring downward by $130 to reflect the known sublet lease recoveries under the extension agreement. These adjustments have been charged to the restructuring charges line in the consolidated statement of operations.

The Company has evaluated and pursued all reasonable possibilities to settle the lease obligations associated with the June 2001 restructuring, but has been unable to find an acceptable outcome. Therefore, the Company has concluded that it is appropriate to classify the portion of the outstanding liabilities that is not payable within the next 12 months to long-term liabilities. However, the current obligations would require the Company to fund $2,000 of its accrued restructuring charges for the June 2001 restructuring before the end of fiscal 2006, with the remaining accrued restructuring charges for the June 2001 restructuring to be paid as follows: $5,300 in fiscal 2007, $5,300 in fiscal 2008, $5,500 in fiscal 2009 and $8,300 in fiscal 2010 and beyond.

Summary of Accrued Restructuring Charges for June 2001 Restructuring

The following table is a summary of the accrued restructuring charges related to the June 2001 plan at June 30, 2006:

As of June 30, 2006, the Company had estimated a total of $13,500 of sublease recoveries in our restructuring accrual. Of this amount, $13,400 is related to the Santa Clara facility. In addition, $13,400 of the $13,500 is recoverable under existing sublease agreements, with only approximately $100 of rent recoveries being based on estimates that may be subject to adjustments based upon changes in the real estate sublet markets.

NOTE 10. NET INCOME (LOSS) PER SHARE AND SHARES OUTSTANDING

Basic net income (loss) per share is computed by dividing the net income (loss) by the weighted average number of shares of Common stock of all classes outstanding during the period. Diluted net income (loss) per share is computed by dividing the net income (loss) by the weighted average number of shares of Common stock and potential Common stock outstanding, and when dilutive, options to purchase Common stock using the treasury stock method. The options to purchase Common stock are excluded from the computation of diluted net income (loss) per share if their effect is antidilutive. The antidilutive effect excluded from the diluted net loss per share computation related to options to purchase Common stock under the treasury stock method for the three and six months ended June 30, 2006 was 881,120 and 244,318 shares, respectively, compared to a dilutive effect of 1,290,663 and 1,158,971 shares for the three and six months ended June 30, 2005, respectively, which increased the weighted average common shares outstanding used in the computation of diluted net income (loss) per share. In addition, 8,657,847 and 8,838,350 out-of-the-money exercisable options that had exercise prices in excess of the average market price for the three months ended June 30, 2006 and 2005, respectively, were excluded from the computation of diluted net income (loss) per share in accordance with the treasury stock method.

In the three and six months ended June 30, 2006, the Company issued 108,257 and 394,603 shares of Common stock, respectively, related to the exercise of employee stock options.

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NOTE 11. MARKETABLE AND OTHER INVESTMENTS

The Company maintains marketable investments mainly in a strategic cash management account. This account is invested primarily in highly rated corporate securities, in securities guaranteed by the U.S. government or its agencies and highly rated municipal bonds, primarily with a remaining maturity of not more than 24 months. The Company has the intent and ability to hold all of these investments until maturity. Therefore, all such investments are classified as held to maturity investments, and are stated at amortized cost. At June 30, 2006, the amortized cost of the Company’s held to maturity investments approximated fair value. Based on contractual maturities, these marketable investments were classified in either current assets or long-term assets.

The Company holds equity securities stated at cost, which represent long-term investments in private companies made in 2000 and 2001 for business and strategic alliance purposes. The Company’s ownership share in these companies ranges from 1% to 10% of the outstanding voting share capital. The strategic investments made in 2000 and 2001 had no net remaining carrying value at June 30, 2006. The Company monitors and assesses the ongoing operating performance of the underlying companies for evidence of impairment. Since 2001, the Company has recorded impairments totaling $14,818 with respect to these investments as a result of other than temporary declines in fair value. In addition, the Company holds an investment recorded at cost in ADML Holdings, Ltd., and its affiliate, Ohana Wireless, Inc. (collectively, “Ohana”), which at June 30, 2006 represented approximately 14% of the voting share capital of Ohana.

The Company also holds an equity interest in Asia Digital Media, which at June 30, 2006 represented approximately 44% of the voting share capital of this company. This investment is accounted for by the Company using the equity method of accounting for investments in common stock. See Notes 4 and 5 for additional discussion.

The Company recorded no revenues from Asia Digital Media for the three and six months ended June 30, 2006. Revenues recorded by the Company from Asia Digital Media represented less than 1% of total revenues for the three and six months ended June 30, 2005.

The Company did not generate any sales with companies in which it has made strategic equity investments recorded at cost in the three and six months ended June 30, 2006 and 2005.

NOTE 12. SEGMENT AND GEOGRAPHIC INFORMATION

Segment information

The Company conducts business in one operating segment: namely, the design, production and sale of software products and related services for securing digital identities and information. The nature of the Company’s different products and services is similar and, in general, the type of customers for those products and services is not distinguishable. The Company does, however, prepare information for internal use by the Chairman, President and Chief Executive Officer on a geographic basis. Accordingly, the Company has included a summary of the financial information, on a geographic basis, as reported to the Chairman, President and Chief Executive Officer.

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Geographic information

Revenues are attributed to specific geographical areas based on where the sales orders originated. Company assets are identified with operations in the respective geographic areas.

The Company operates in three main geographic areas as follows:

NOTE 13. COMPREHENSIVE INCOME

The components of comprehensive income are as follows:

NOTE 14. LEGAL PROCEEDINGS

The Company is subject, from time to time, to various legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these claims cannot be predicted with certainty, management does not believe that the outcome of any of these legal matters will have a material adverse effect on the Company’s consolidated results of operations or consolidated financial position. Certain legal proceedings in which we are involved are discussed in Part 1. Item 3. of our Annual Report on Form 10-K for the year ended December 31, 2005. Unless otherwise indicated, all proceedings in that earlier Report remain outstanding.

NOTE 15. CONTINGENCIES

Entrust entered into a contract with the General Services Administration (“GSA”) on March 31, 2000. It had come to the Company’s attention that it might have a potential liability to the GSA under this contract, and the Company has advised the GSA of this matter. The Company conducted a self-assessment of its compliance and internal processes with respect to the agreement, as well as the pricing requirements of the agreement, which was completed in September 2004. The Company estimated its probable minimum liability at $352 and accrued this estimated amount in 2003. The results of the Company’s self-assessment indicate that the liability is not significantly different from its estimate in 2003. Payment of the amount of this liability has now been made to the GSA, but is subject to audit.

NOTE 16. RECENTLY ISSUED ACCOUNTING STANDARDS

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109”, (“FIN No. 48”), which clarifies the accounting for uncertainty in tax positions. FIN No. 48 requires that the Company recognize in its financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN No. 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. The provisions of FIN No. 48 will be effective for the Company as of the beginning of its 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company is currently evaluating the impact of adopting FIN No. 48 on its consolidated financial position and results of operations.

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This report contains forward-looking statements that involve risks and uncertainties. The statements contained in this report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including without limitation statements regarding our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this report are based on information available to us, up to and including, the date of this document, and we assume no obligation to update any such forward-looking statements. Our actual results could differ significantly from those anticipated in these forward-looking statements as a result of certain factors, including those set forth below under “Overview” and “Risk Factors” and elsewhere in this report. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and notes thereto appearing elsewhere in this report.

EXECUTIVE OVERVIEW

We are a global provider of software that secures digital identities and information. Over 1,500 enterprises and government agencies in more than 50 countries use our solutions to help secure the digital lives of their citizens, customers, employees and partners. Our proven software and services can help customers achieve regulatory and corporate compliance, while helping to turn security challenges such as identity theft and e-mail security into business opportunities.

We conduct business in one operating segment. We develop, market and sell software solutions that secure digital identities and information. We also perform professional services to install, support and integrate our software solutions with other applications. All of these activities may be fulfilled in conjunction with partners and are managed through our global organization.

As an innovator and pioneer in the Internet security field, Entrust’s market leadership and expertise in delivering award-winning identity and data protection management software solutions is demonstrated by the diversity of its products, geographic representation, and customer segments. We continue to drive revenue in our key products.

On July 19, 2006 we acquired Business Signatures. Business Signatures is a leading provider of Zero Touch Real Time fraud detection solutions. Unlike other fraud detection solutions, the Business Signatures eFraud™ product provides a real time fraud detection capability that requires no changes to the business application. Organizations rapidly can deploy the solution and begin passively monitoring user activity—quickly identifying and responding to suspicious behavior. This also allows for sophisticated fraud analytics to be performed to identify and respond to evolving threats. The zero touch nature of the eFraud product helps allow organizations to take advantage of these capabilities in a fraction of the time compared to other approaches.

By the end of the year, financial institutions in the United States have to offer stronger security measures for online customers according to the Federal Financial Institutions Examination Council’s (FFIEC) guidance. The addition of Business Signatures eFraud product combined with our Entrust IdentityGuard platform gives us one of the most complete set of solutions on the market. Customers now have the flexibility to meet the FFIEC guidance with either our fraud solution or stronger authentication solutions. They can then utilize additional capabilities from Entrust to add additional security in the future. This combined offering makes us one of the best positioned company’s to help banks and financial institutions meet the looming FFIEC deadlines.

We expect Business Signatures to add in the range of $3.0 million to $4.0 million in revenue over the remainder of 2006 and targets approximately $10.0 million in revenue over the next twelve months. The revenue projections include product revenue, which can be purchased both perpetual or as subscription, and

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services revenue from professional services and annual support and maintenance agreements. In addition, we anticipate that the acquisition will be dilutive in 2006 and will be accretive in 2007.

With the addition of Business Signatures, Entrust now has three key platforms, Authentication, Fraud and Information Protection. We now have a unique end-to-end platform for securing digital identities and information. This end-to-end software platform is easy to implement, user friendly and cost effective with the ability to evolve over time to grow with our customers needs.

Product Category Financial Metrics:

We also provide support services and professional services, including architecture, installation, and integration services related to the products that we sell. These services represent a significant portion of our revenues, but are closely related to the demand for our products. In addition, the margins on our products are significantly higher than margins on our services. As a result, we are primarily focused on growing our product revenues.

Entrust sells its solutions globally, with an emphasis on North America, Europe and Asia. These primary areas have demonstrated the most potential for early adoption of the broadest set of Entrust solutions. Entrust extends to other non-core geographies through strategic partner relationships, which increases the leverage of our direct sales channel worldwide. In North America, Entrust is targeting a return to revenue growth in its software business by leveraging Entrust’s historical strength in selling to key verticals such as government (Federal, State, Provincial), financial services and healthcare organizations. Europe is a region where Entrust’s products and solutions continue to experience strong demand and we believe that the European market will provide growth, with increased momentum from governments and enterprises leveraging Entrust’s solutions to transform their business processes and to leverage the Internet and networking applications.

We market and sell our products and services in both the enterprise and government market space. In the second quarter of 2006, 43% of our product sales were in our extended government vertical market, which includes healthcare. This revenue has been driven by key global projects that have started to increase product purchases. In the extended government vertical market, we have a strong penetration in the U.S. Federal government, the governments of Canada, Singapore, Denmark, the United Kingdom and across continental Europe. Our largest product transaction in the quarter was with the U.S. Federal government for our Public Key technology.

One of the key areas of government spending has been for National ID programs. We have experienced success in these initiatives with our digital certificate technology. We won the Spanish National ID Card in Q2, 2005. We continued our success by winning the National ID Card for a Middle Eastern Government in Q1, 2006. This government bought the initial infrastructure and will buy licenses on deployment. As governments continue to increase spending on e-government initiatives and information security projects, we are well positioned to help them.

In the second quarter of 2006, 57% of our product sales were in our extended enterprise vertical market. We continue to see demand from global enterprises as they continue to respond to regulatory and governance compliance demands and extend their internal and external networks to more and more individuals inside and outside their domain. We have experienced a change in the shape of many enterprise deals. Specifically, Enterprises are buying for their immediate need and then adding to their purchases as the projects begin roll out.

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A key driver of our product growth has been the recent spotlight on identity theft due to breaches at companies like Choicepoint and LexisNexis. These breaches have proven that self-regulation over the past few years has been insufficient at addressing the underlying issues. Recent legislation has addressed these concerns. California S.B. 1386 has cast more visibility on the issue for citizens, corporations, and the government. The law requires both corporations and the government to notify California residents if their sensitive data has been breached unless encryption technology is deployed. Additionally, 21 other states have now passed breach notification requirements, and another 17 states have legislation waiting to be enacted. On a national level, bills are being written to protect citizens from identity theft and alert them if their information has been stolen.

Entrust for years has been a leader in secure digital identities and information. In the fourth quarter of 2004, we introduced IdentityGuard which is our easy-to-use second factor of authentication. We now have 183 pilots under way for IdentityGuard. In Q2 2006, IdentityGuard accounted for $0.7 million dollars of product revenue. IdentityGuard’s low cost relative to hardware, its simplicity for the mass market, and its effectiveness in countering online theft and phishing, are the key drivers for the increased revenue growth we are experiencing. Along with the revenue growth for second factor authentication, we are also seeing customers increasingly interested in data protection and encryption. With a combination of Entrust IdentityGuard, GetAccess and TruePass, customers can accomplish authentication and role based access control, digital signature, and encryption from one solution provider.

Entrust has a goal to develop new channels to market, in addition to our direct sales force. In the second quarter of 2005, our largest deal was through our partnership with SIA, with whom we won the national ID card. Our largest IdentityGuard transaction in the second quarter and the third quarter of 2005, were also with strategic regional distribution partners. In Q2, 2006, seven of our seventy-one transactions were fulfilled through partners, helping us generate 9% of our product revenue in the quarter. This success was driven by U.S. distribution partners, which now totals 52 in the TrustedPartner Program.

In March 2006, Entrust introduced a Managed PKI service. This service was launched in May 2006 in response to customer requests for Entrust to offer a hosted service to give them a choice between a service offering for PKI certificates and our traditional PKI software purchase option. Our service offering is designed to help enterprises and government agencies grow and accelerate their core business security, without having to develop PKI expertise internally. Our managed service offering will allow our customers the flexibility to now have our market leading technology delivered in an outsourced service model. This is not our first entrance into the services arena. We have been helping our customers for years design, deploy and manage our solutions. We have also been successful in growing our SSL certificate business by almost 25% year-over-year. Our new Managed PKI Service offering will give us access to a new market of customers that can help us drive both additional license revenue, as well as new ratable services revenues.

Entrust relies significantly on large deals in each quarter. Our software revenue from our top five customers in Q2, 2006 was approximately 13% of our total revenue in that quarter and we had one product deal over $1 million. This was within our historical range, which is generally between 10% and 25% of revenue from the top five customers and zero to four transactions over $1 million. We continue to be impacted from time to time on our software revenue by the timing of our customers buying process, which may include proof of concepts, senior management reviews and budget delays that sometimes results in longer than anticipated sales cycles. We are also impacted by our customers’ recent buying behavior, which is to buy only for immediate need as opposed to making a larger purchase in order to get a better discount. Any of these factors may impact our revenue on a quarterly basis.

Our management uses the following metrics to measure performance:

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BUSINESS OVERVIEW

During the second quarter of 2006, we continued our strategy of focusing on core vertical and geographic markets. Revenues of $22.1 million represented an 11% decrease from the second quarter of 2005, and consisted of 33% product sales and 67% services and maintenance. Services and maintenance revenues decreased 5% from the second quarter of 2005, due to decreased demand for both consulting services and support and maintenance services, while product revenues decreased 21% from the second quarter of 2005, driven by a reduced product transaction closure rate and lower average purchase value compared to the same quarter of 2005. Net loss for the second quarter of 2006 was $1.3 million, or $0.02 per share, compared to net income of $1.1 million, or $0.02 per share for the same period of 2005, with total expenses increasing 1% to $23.9 million. We generated $0.2 million in cash flow from operations in the second quarter of 2006, compared to net cash used in operations of $3.0 million in the same quarter of 2005. Entrust Emerging Growth Products accounted for 17% of product revenue, which is an increase of 100% from Q2, 2005 and an increase of 20% from Q1, 2006. Entrust PKI Products accounted for 78% of product revenue, which is a decrease of 26% from Q2, 2005 and an increase of 12% from Q1, 2006. Entrust Certificate Services revenues, a component of our PKI Product solutions suite, increased 27% over Q2, 2005 and 8% over Q1, 2006. Entrust Single Sign-On Products accounted for 5% of product revenue, which is a decrease of 60% from Q2, 2005 and a decrease of 20% from Q1, 2006. Extended Government accounted for 43% and Extended Enterprise accounted for 57% of the product revenue in the quarter. The financial vertical accounted for approximately 27% of second quarter 2006 product revenues, an increase of 82% over Q2, 2005, driven by increased demand for strong authentication.

Other highlights from the second quarter of 2006 included:

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CRITICAL ACCOUNTING POLICIES

In the second quarter of 2006, our most complex accounting judgments were made in the areas of software revenue recognition, allowance for doubtful accounts, restructuring charges and related adjustments, accounting for long-term strategic and equity investments, purchase accounting, the provision for income taxes and stock-based compensation. The restructuring and related charges are not anticipated to be recurring in nature. However, the financial reporting of restructuring and related charges will continue to require judgments until such time as the corresponding accruals are fully paid out and/or no longer required. Software revenue recognition, allowance for doubtful accounts, accounting for long-term strategic and equity investments, purchase accounting, provision for income taxes and stock-based compensation are expected to continue to be ongoing elements of our critical accounting processes and judgments.

Software Revenue Recognition

With respect to software revenue recognition, we recognize revenues in accordance with the provisions of the American Institute of Certified Public Accountants’ Statement of Position No. 97-2, “Software Revenue Recognition”, Statement of Position No. 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions” and related accounting guidance and pronouncements. Due to the complexity of some software license agreements, we routinely apply judgments to the application of software revenue recognition accounting principles to specific agreements and transactions. We analyze various factors, including a review of the specifics of each transaction, historical experience, credit worthiness of customers and current market and economic conditions. Changes in judgments based upon these factors could impact the timing and amount of revenues and cost recognized. Different judgments and/or different contract structures could lead to different accounting conclusions, which could have a material effect on our reported earnings.

Revenues from perpetual software license agreements are recognized when we have received an executed license agreement or an unconditional order under an existing license agreement, the software has been shipped (if there are no significant remaining vendor obligations), collection of the receivable is reasonably assured, the fees are fixed and determinable and payment is due within twelve months. Revenues from license agreements requiring the delivery of significant unspecified software products in the future are accounted for as subscriptions and, accordingly, are recognized ratably over the term of the agreement from the first instance of product delivery. License revenues are generated both through direct sales to end users as well as through various partners, including system integrators, value-added resellers and distributors. License revenue is recognized when the sale has occurred for an identified end user, provided all other revenue recognition criteria are met. We are notified of a sale by a reseller to the end user customer in the same period that the product is actually sold through to the end user customer. We do not offer a right of return on sales of our software products.

For all sales, we use a binding contract, purchase order or another form of documented agreement as evidence of an arrangement with the customer. Sales to our distributors are evidenced by a master agreement governing the relationship, together with binding purchase orders on a transaction-by-transaction basis. We consider delivery to occur when we ship the product, so long as title and risk of loss have passed to the customer. If an arrangement includes undelivered products or services that are essential to the functionality of the delivered product, delivery is not considered to have occurred until these products or services are delivered.

At the time of a transaction, we assess whether the sale amount is fixed or determinable based upon the terms of the documented agreement. If we determine the fee is not fixed or determinable at the outset, we recognize revenue when the fee becomes fixed and determinable. We assess if collection is reasonably assured based on a number of factors, including past transaction history with the customer and the

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creditworthiness of the customer. If we determine that collection is not reasonably assured, we do not record revenue until such time as collection becomes probable, which is generally upon the receipt of cash.

We do not generally include acceptance provisions in arrangements with customers. However, if an arrangement includes an acceptance provision, we recognize revenue upon the customer’s acceptance of the product, which occurs upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.

We are sometimes subject to fiscal funding clauses in our software licensing transactions with the United States government and its agencies. Such clauses generally provide that the license is cancelable if the legislature or funding authority does not appropriate the funds necessary for the governmental unit to fulfill its obligations under the licensing arrangement. In these circumstances, software licensing arrangements with governmental organizations containing a fiscal funding clause are evaluated to determine whether the uncertainty of a possible license arrangement cancellation is remote. If the likelihood of cancellation is assessed as remote, then the software licensing arrangement is considered non-cancelable and the related software licensing revenue is recognized when all other revenue recognition criteria have been met.

For arrangements involving multiple elements, we allocate revenue to each component based on the vendor-specific objective evidence of the fair value of the various elements. These elements may include one or more of the following: software licenses, maintenance and support, consulting services and training. We first allocate the arrangement fee, in a multiple-element transaction, to the undelivered elements based on the total fair value of those undelivered elements, as indicated by vendor-specific objective evidence. This portion of the arrangement fee is deferred. Then the difference (residual) between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements. We attribute the discount offered in a multiple-element arrangement entirely to the delivered elements of the transaction, which are typically software licenses. Fair values for the future maintenance and support services are based upon substantially similar sales of renewals of maintenance and support contracts to other customers. Fair value of future services, training or consulting services is based upon substantially similar sales of these services to other customers. In some instances, a group of contracts or agreements with the same customer may be so closely related that they are, in effect, part of a single multiple-element arrangement, and therefore, we would undertake to allocate the corresponding revenues amongst the various components, as described above.

We generally do not engage in non-monetary transactions.

We also eliminate intercompany profits on revenue transactions with unconsolidated subsidiaries that are accounted for under the equity method to the extent of our ownership interest in that related party, if the product and/or services have not been sold through to an unrelated third party end-user customer.

Our consulting services generally are not essential to the functionality of the software. Our software products are fully functional upon delivery and do not require any significant modification or alteration. Customers purchase these consulting services to facilitate the adoption of our technology and dedicate personnel to participate in the services being performed, but they may also decide to use their own resources or appoint other consulting service organizations to provide these services. When the customization is essential to the functionality of the licensed software, then both the software license and consulting services revenues are recognized under the percentage of completion method, which requires revenue to be recognized based upon the percentage of work effort completed on the project.

Allowance for Doubtful Accounts

We maintain doubtful accounts allowances for estimated losses resulting from the inability of our customers to make required payments. We assess collection based on a number of factors, including previous transactions with the customer and the creditworthiness of the customer. We do not request collateral from our customers.

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We base our ongoing estimate of allowance for doubtful accounts primarily on the aging of the balances in the accounts receivable, our historical collection patterns and changes in the creditworthiness of our customers. Based upon the analysis and estimates of the uncollectibility of our accounts receivable, we record an increase in the allowance for doubtful accounts when the prospect of not collecting a specific account receivable becomes probable. The allowance for doubtful accounts is established based on the best information available to us and is re-evaluated and adjusted as additional information is received. We exhaust all avenues and methods of collection, including the use of third party collection agencies, before writing-off a customer balance as uncollectible. While credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Each circumstance in which we conclude that a provision for non-payment by a customer may be required must be carefully considered in order to determine the true factors leading to that potential non-payment to ensure that it is proper for it to be categorized as an allowance for bad debts. We have focused on improving our accounts receivable aging and, as a result, had been able to reduce our corresponding allowance for doubtful accounts in 2004 and 2005 in the process. However, a significant change in the financial condition of a major customer could have a material impact on our estimates regarding the sufficiency of our allowance. Our accounts receivable include material balances from a limited number of customers, with five customers accounting for 23% of gross accounts receivable at June 30, 2006, compared to 41% of gross accounts receivable at June 30, 2005. One customer accounted for 9% of net accounts receivable at June 30, 2006. For more information on our customer concentration, see our related discussion in “Risk Factors”. Therefore, changes in the assumptions underlying this assessment or changes in the financial condition of our customers, resulting in an impairment of their ability to make payments, and the timing of information related to the change in financial condition could result in a different assessment of the existing credit risk of our accounts receivable and thus, a different required allowance, which could have a material impact on our reported earnings.

During the first half of 2006, we became aware of financial concerns regarding one of our European distributors and, as a result, we concluded that it was necessary to record an increase to our provision for doubtful accounts in the aggregate amount of $495 thousand in the quarter, as a charge against sales and marketing expenses.

Restructuring Charges and Adjustments

June 2001 Restructuring Plan

On June 4, 2001, we announced that our Board of Directors had approved a restructuring plan to refocus on the most significant market opportunities and to reduce operating costs due to the macroeconomic factors that were negatively affecting technology investment in the market. The restructuring plan included a workforce reduction, consolidation of excess facilities, and discontinuance of non-core products and programs.