e10vq
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
Form 10-Q
 
 
     
þ
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the quarterly period ended September 30, 2006
or
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from          to          
 
 
Commission File Number: 001-31216
 
McAfee, Inc.
(Exact name of registrant as specified in its charter)
 
 
     
Delaware
  77-0316593
(State or other jurisdiction of
  (I.R.S. Employer
incorporation or organization)
  Identification Number)
3965 Freedom Circle
  95054
Santa Clara, California
  (Zip Code)
(Address of principal executive offices)
   
 
 
Registrant’s telephone number, including area code:
(408) 988-3832
 
 
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 o     No þ
 
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. (Check one):
 
Large accelerated filer  þ     Accelerated filer  o     Non-accelerated filer  o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ
 
As of December 7, 2007, 159,908,615 shares of the registrant’s common stock, $0.01 par value, were outstanding.
 


 

MCAFEE, INC.
 
FORM 10-Q
September 30, 2006
 
 
CONTENTS
 
                 
Item
       
Number
      Page
 
        Explanatory Note Regarding Restatement     3  
             
        PART I: FINANCIAL INFORMATION        
      Financial Statements (Unaudited)        
        Condensed Consolidated Balance Sheets: September 30, 2006 and December 31, 2005 (Restated)     4  
        Condensed Consolidated Statements of Income and Comprehensive Income: Three and nine months ended September 30, 2006 and September 30, 2005 (Restated)     5  
        Condensed Consolidated Statements of Cash Flows: Nine months ended September 30, 2006 and September 30, 2005 (Restated)     6  
        Notes to Condensed Consolidated Financial Statements     7  
      Management’s Discussion and Analysis of Financial Condition and Results of Operations     51  
      Quantitative and Qualitative Disclosures about Market Risk     76  
      Controls and Procedures     76  
             
        PART II: OTHER INFORMATION        
      Legal Proceedings     80  
      Risk Factors     83  
      Unregistered Sales of Equity Securities and Use of Proceeds     83  
      Defaults upon Senior Securities     84  
      Submission of Matters to a Vote of Security Holders     84  
      Other Information     84  
      Exhibits     84  
    85  
    86  
 Certification of CEO and CFO Pursuant to Section 302
 Certification of CEO and CFO Pursuant to Section 906


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EXPLANATORY NOTE REGARDING RESTATEMENT
 
In this quarterly report on Form 10-Q, we are restating our condensed consolidated balance sheet as of December 31, 2005, our condensed consolidated statement of income and comprehensive income for the three and nine months ended September 30, 2005 and the related condensed consolidated statement of cash flows for the nine months ended September 30, 2005, as a result of an independent stock option investigation conducted by a special committee of our board of directors. This restatement is more fully described in Note 3, “Restatement of Condensed Consolidated Financial Statements and Special Committee and Company Findings,” to our condensed consolidated financial statements, in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Part II, Item 1 “Legal Proceedings” in this quarterly report on Form 10-Q and in our “Explanatory Note Regarding Restatement” preceding Part I of our annual report on Form 10-K for the year ended December 31, 2006 (the “2006 Form 10-K”). In our 2006 Form 10-K to be filed with the Securities and Exchange Commission (“SEC”) simultaneously with the filing of this Form 10-Q, we are restating (i) our audited consolidated financial statements as of December 31, 2005 and for each of the two years in the period ended December 31, 2004; (ii) our selected financial data as of and for the years ended December 31, 2005, 2004, 2003 and 2002; and (iii) our unaudited quarterly financial data for the first quarter in the year ended December 31, 2006 and for all quarters in the year ended December 31, 2005.
 
Financial information included in our reports on Form 10-K and Form 10-Q filed prior to July 27, 2006, and the related opinions of our independent registered public accounting firms, all earnings press releases and similar communications and all financial information included in our reports on Form 8-K issued by us prior to December 21, 2007, should not be relied upon and are superseded in their entirety by this quarterly report on Form 10-Q and other reports on Form 10-K, Form 10-Q and Form 8-K filed by us with the SEC on or after December 21, 2007.


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PART I: FINANCIAL INFORMATION
 
Item 1.   Financial Statements (Unaudited)
 
MCAFEE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED BALANCE SHEETS
 
                 
    September 30,
    December 31,
 
    2006     2005  
          (As restated
 
          See Note 3)  
    (In thousands, except share data)  
    (Unaudited)  
 
ASSETS
Current assets:
               
Cash and cash equivalents
  $ 381,962     $ 728,592  
Restricted cash
          50,489  
Short-term marketable securities
    328,978       316,298  
Accounts receivable, net of allowance for doubtful accounts of $1,458 and $2,389, respectively
    132,707       159,130  
Prepaid expenses and prepaid taxes
    123,649       79,132  
Deferred income taxes
    233,250       204,208  
Other current assets
    26,930       28,490  
                 
Total current assets
    1,227,476       1,566,339  
Long-term marketable securities
    523,341       212,131  
Restricted cash
    1,043       939  
Property and equipment, net
    90,950       85,692  
Deferred income taxes
    224,014       237,970  
Intangible assets, net
    75,877       80,086  
Goodwill
    488,696       437,488  
Other assets
    21,486       15,589  
                 
Total assets
  $ 2,652,883     $ 2,636,234  
                 
 
LIABILITIES
Current liabilities:
               
Accounts payable
  $ 36,966     $ 34,678  
Accrued SEC settlement
          50,000  
Accrued income taxes
    93,623       76,740  
Accrued compensation
    53,645       55,781  
Accrued marketing
    17,514       15,172  
Other accrued liabilities
    85,646       70,288  
Deferred revenue
    655,537       575,665  
                 
Total current liabilities
    942,931       878,324  
Deferred revenue, less current portion
    180,510       176,141  
Accrued taxes and other long-term liabilities
    152,754       147,128  
                 
Total liabilities
    1,276,195       1,201,593  
                 
Commitments and contingencies (Notes 12 and 13)
               
 
STOCKHOLDERS’ EQUITY
Preferred stock, $0.01 par value:
               
Authorized: 5,000,000 shares; Issued and outstanding: none in 2006 and 2005
           
Common stock, $0.01 par value:
               
Authorized: 300,000,000 shares; Issued: 172,512,046 shares at September 30, 2006 and 170,453,210 shares at December 31, 2005; Outstanding: 159,935,439 shares at September 30, 2006 and 167,688,210 shares at December 31, 2005
    1,726       1,705  
Treasury stock, at cost: 12,576,607 shares at September 30, 2006 and 2,765,000 shares at December 31, 2005
    (303,074 )     (68,395 )
Additional paid-in capital
    1,510,992       1,443,743  
Deferred stock-based compensation
          (8,146 )
Accumulated other comprehensive income
    30,638       33,923  
Retained earnings
    136,406       31,811  
                 
Total stockholders’ equity
    1,376,688       1,434,641  
                 
Total liabilities and stockholders’ equity
  $ 2,652,883     $ 2,636,234  
                 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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MCAFEE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
          (As restated
          (As restated
 
          See Note 3)           See Note 3)  
    (In thousands, except per share data)
 
    (Unaudited)  
 
Net revenue:
                               
Service and support
  $ 160,388     $ 141,932     $ 466,298     $ 410,591  
Subscription
    110,822       90,891       299,197       236,797  
Product
    15,853       17,466       74,422       77,679  
                                 
Total net revenue
    287,063       250,289       839,917       725,067  
Cost of net revenue:
                               
Service and support
    13,127       5,682       39,736       18,127  
Subscription
    29,624       16,464       76,077       46,058  
Product
    15,415       13,135       45,810       44,402  
Amortization of purchased technology
    5,987       4,501       16,180       13,363  
                                 
Total cost of net revenue
    64,153       39,782       177,803       121,950  
Operating costs:
                               
Research and development
    50,641       47,188       144,426       130,277  
Marketing and sales
    91,260       72,717       264,990       222,498  
General and administrative
    35,055       29,614       127,101       92,299  
SEC and compliance costs
    7,901             11,673        
Amortization of intangibles
    2,656       2,906       8,305       10,036  
Restructuring (benefits) charges
    (1,393 )     (10 )     (274 )     6,013  
In-process research and development
                460       4,000  
SEC settlement charge
          50,000             50,000  
                                 
Total operating costs
    186,120       202,415       556,681       515,123  
                                 
Income from operations
    36,790       8,092       105,433       87,994  
Interest and other income
    13,922       6,657       32,585       18,665  
Gain (loss) on investments, net
    154       (160 )     68       (1,106 )
                                 
Income before provision for income taxes
    50,866       14,589       138,086       105,553  
Provision for income taxes
    16,776       2,276       33,491       26,581  
                                 
Net income
  $ 34,090     $ 12,313     $ 104,595     $ 78,972  
                                 
Other comprehensive income:
                               
Unrealized gain (loss) on marketable securities, net of reclassification adjustment for gains (losses) recognized on marketable securities during the period and income tax
  $ 878     $ (462 )   $ 1,457     $ (943 )
Foreign currency translation gain (loss)
    1,791       3,941       (4,742 )     1,711  
                                 
Comprehensive income
  $ 36,759     $ 15,792     $ 101,310     $ 79,740  
                                 
Net income per share — Basic
  $ 0.21     $ 0.07     $ 0.65     $ 0.48  
                                 
Net income per share — Diluted
  $ 0.21     $ 0.07     $ 0.64     $ 0.47  
                                 
Shares used in per share calculation — Basic
    159,728       166,174       161,343       164,201  
                                 
Shares used in per share calculation — Diluted
    161,485       170,756       163,132       168,534  
                                 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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MCAFEE, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                 
    Nine Months Ended
 
    September 30,  
    2006     2005  
          (As restated
 
          See Note 3)  
    (In thousands)
 
    (Unaudited)  
 
Cash flows from operating activities:
               
Net income
  $ 104,595     $ 78,972  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    50,688       50,939  
Tax benefit from exercise of non-qualified stock options
          22,341  
(Recovery of) provision for doubtful accounts, net
    (197 )     1,309  
Non-cash restructuring (benefit) charge
    (286 )     3,326  
Interest released from restricted cash
    489        
Acquired in-process research and development
    460       4,000  
(Discount) premium amortization on marketable securities
    (5,438 )     461  
Loss (gain) on sale of assets and technology
    207       (499 )
(Gain) loss on sale of investments
    (68 )     1,106  
Deferred income taxes
    (22,224 )     (8,446 )
Non-cash stock-based compensation expenses
    37,988       5,002  
Excess tax benefits from stock-based compensation
    (4,811 )      
Changes in assets and liabilities, net of acquisitions and divestitures:
               
Accounts receivable
    31,328       32,646  
Prepaid expenses, prepaid taxes and other assets
    (45,839 )     (9,098 )
Accounts payable and other accrued liabilities
    (8,342 )     17,167  
Deferred revenue
    65,723       93,426  
                 
Net cash provided by operating activities
    204,273       292,652  
                 
Cash flows from investing activities:
               
Purchase of marketable securities
    (1,034,796 )     (565,824 )
Proceeds from sales of marketable securities
    471,990       345,946  
Proceeds from maturities of marketable securities
    246,694       142,907  
Decrease (increase) in restricted cash
    49,896       (50,007 )
Purchase of property, equipment and leasehold improvements
    (30,707 )     (25,041 )
Proceeds from sale of assets and technology
          1,500  
Acquisitions, net of cash acquired
    (65,871 )     (20,200 )
                 
Net cash used in investing activities
    (362,794 )     (170,719 )
                 
Cash flows from financing activities:
               
Proceeds from issuance of common stock from option and stock purchase plans
    32,007       94,453  
Excess tax benefits from stock-based compensation
    4,811        
Repurchase of common stock
    (234,679 )     (47,351 )
                 
Net cash (used in) provided by financing activities
    (197,861 )     47,102  
                 
Effect of exchange rate fluctuations on cash
    9,752       (19,815 )
                 
Net (decrease) increase in cash and cash equivalents
    (346,630 )     149,220  
Cash and cash equivalents at beginning of period
    728,592       291,155  
                 
Cash and cash equivalents at end of period
  $ 381,962     $ 440,375  
                 
Non-cash investing activities:
               
Unrealized gain (loss) on marketable securities, net
  $ 1,457     $ (943 )
                 
Accrual for purchase of property, equipment and leasehold improvements
  $ 1,849     $  
                 
Fair value of assets acquired in business combinations, excluding cash acquired
  $ 75,158     $ 20,948  
                 
Liabilities assumed in business combinations
  $ 9,289     $ 748  
                 
Non-cash financing activities:
               
Realization of deferred tax assets of acquired company
  $     $ 38,838  
                 
Supplemental disclosure of cash flow information:
               
Cash paid for income taxes
  $ 50,844     $ 34,623  
                 
Cash received from income tax refunds
  $ 2,972     $ 1,790  
                 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
1.   Organization and Business
 
McAfee, Inc. and our wholly-owned subsidiaries (“we”, “us” or “our”) are a worldwide security technology company that secures systems and networks from known and unknown threats around the world. Our security solutions are offered primarily to large enterprises, governments, small and medium-sized businesses and consumers through a network of qualified partners. We operate our business in five geographic regions: North America; Europe, Middle East and Africa (“EMEA”); Japan; Asia-Pacific, excluding Japan; and Latin America.
 
2.   Summary of Significant Accounting Policies and Basis of Presentation
 
The accompanying condensed consolidated financial statements include our accounts as of September 30, 2006 and December 31, 2005 and for the three and nine months ended September 30, 2006 and September 30, 2005. All intercompany accounts and transactions have been eliminated in consolidation. These condensed consolidated financial statements have been prepared by us, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The December 31, 2005 condensed consolidated balance sheet was derived from audited consolidated financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. However, we believe that all disclosures are adequate to make the information presented not misleading. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto, included in our annual report on Form 10-K for the year ended December 31, 2006 filed simultaneously with this quarterly report on Form 10-Q.
 
In the opinion of our management, all adjustments (which consist of normal recurring adjustments, except as disclosed herein) necessary to fairly present our financial position as of September 30, 2006 and results of operations and cash flows for the interim periods presented have been included. The results of operations for the three and nine months ended September 30, 2006 are not necessarily indicative of the results to be expected for the full year or for any future periods.
 
Significant Accounting Policies
 
On January 1, 2006, we adopted a new policy related to stock-based compensation, as more fully described below. Other than this item, there have been no significant changes to our critical accounting policies and estimates during the nine months ended September 30, 2006. Note 2, “Summary of Significant Accounting Policies” of the notes to consolidated financial statements in our annual report on Form 10-K for the year ended December 31, 2006, which is filed simultaneously with this quarterly report on Form 10-Q, describes the significant accounting policies and methods used in the preparation of our consolidated financial statements. We have also described our policy for the restatement of our stock-based compensation expense below.
 
Stock-Based Compensation
 
On January 1, 2006, we adopted Statement of Financial Accounting Standards, No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), which is a revision of SFAS No. 123 “Accounting for Stock-Based Compensation” (“SFAS 123”), and supersedes APB No. 25 “Accounting for Stock Issued to Employees” (“APB 25”). Among other items, SFAS 123(R) requires companies to record compensation expense for stock-based awards issued to employees and directors in exchange for services provided. The amount of the compensation expense is based on the estimated fair value of the awards on their grant dates and is recognized over the required service periods. Our stock-based awards include stock options, restricted stock awards, restricted stock units and our Employee Stock Purchase Plan (“ESPP”).


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Prior to our adoption of SFAS 123(R), we applied the intrinsic value method set forth in APB 25 to calculate the compensation expense for stock-based awards. Under APB 25, we did not recognize any compensation expense for our ESPP. For restricted stock awards and units, the calculation of compensation expense under APB 25 and SFAS 123(R) is the same, with the only exception being that forfeitures are estimated under SFAS 123(R).
 
We adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard to all stock-based awards issued on or after January 1, 2006 and any outstanding stock-based awards that were issued but not vested as of January 1, 2006. Accordingly, our condensed consolidated financial statements for the three and nine months ended September 30, 2005 have not been restated to reflect the impact of SFAS 123(R). During the three and nine months ended September 30, 2005, we recognized stock-based compensation expense of $3.9 million and $5.0 million, respectively, related to grant date intrinsic value resulting from revised accounting measurement dates, the exchange of McAfee.com options in 2002, the re-pricing of options in 1999 and restricted stock awards. See Note 4 for additional information.
 
In the three months ended September 30, 2006, we recognized stock-based compensation expense of $14.9 million in our condensed consolidated financial statements, which included $9.6 million for stock options, $5.0 million for restricted stock awards and units and $0.3 million for our ESPP. In the nine months ended September 30, 2006, we recognized stock-based compensation expense of $40.7 million in our condensed consolidated financial statements, which included $27.3 million for stock options, $11.4 million for restricted stock awards and units and $1.9 million for our ESPP. These amounts include: (i) compensation expense for stock options granted prior to January 1, 2006 but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123, (ii) compensation expense for stock options granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R), (iii) compensation expense for the cash settlement of certain stock options held by former employees that expired during the period from July 2006, when we announced that we might have to restate our historical financial statements as a result of our ongoing stock option investigation, through the date we become current on our reporting obligations under the Securities Exchange Act of 1934, as amended, the (“blackout period”), and were not eligible for extension, (iv) compensation expense for restricted stock award and unit grants made both before and after January 1, 2006 and (v) compensation expense for our ESPP in accordance with SFAS 123(R).
 
The estimated fair value underlying our calculation of compensation expense for stock options is based on the Black-Scholes pricing model. Upon adoption of SFAS 123(R), we changed our method of attributing the value of stock-based compensation to the straight-line, single-option method. Compensation expense for all stock options granted prior to January 1, 2006 will continue to be recognized using the accelerated method. In addition, SFAS 123(R) requires forfeitures of stock-based awards to be estimated at the time of grant and revised, if necessary, in subsequent periods if our estimates change based on the actual amount of forfeitures we have experienced. In the pro forma information required under SFAS 123 for periods prior to January 1, 2006, we accounted for forfeitures as they occurred.
 
SFAS 123(R) requires us to calculate the pool of excess tax benefits, or the additional paid-in capital pool, available as of January 1, 2006 to absorb tax deficiencies recognized in subsequent periods, assuming we had applied the provisions of the standard in prior periods. Pursuant to the provisions of FASB Staff Position 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards,” we adopted the alternative method for determining the tax effects of stock-based compensation, which among other things, provides a simplified method for estimating the beginning additional paid-in capital pool balance.
 
Restatement of Stock-Based Compensation
 
As discussed in Note 3, we have restated our condensed consolidated financial statements as a result of an independent stock option investigation conducted by a special committee of our board of directors. We previously applied APB 25 and its related interpretations, including Financial Accounting Standards Board Interpretation


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
No. 44 “Accounting for Certain Transactions Involving Stock Compensation — an interpretation of APB Opinion No. 25” (“FIN 44”), and provided the required pro forma disclosure under SFAS 123 through the year ended December 31, 2005. Under APB 25, non-cash, stock-based compensation expense is recognized for any option with intrinsic value on the accounting measurement date. An option is deemed to have intrinsic value when the exercise price is below the market price of the underlying stock on the accounting measurement date. Certain of our stock options were incorrectly measured prior to the completion of required approvals and granting actions. After revising the measurement date for these options, certain options were deemed to have intrinsic value and, as a result, there should have been stock-based compensation expense for each of these options under APB 25 equal to the number of option shares multiplied by their intrinsic value on the revised measurement date. That expense should have been amortized over the vesting period of the option. Starting in the year ended December 31, 2006, we adopted SFAS 123(R). As a result, for 2006, the additional stock-based compensation expense required to be recorded for these stock options was equal to the fair value on the revised measurement date for options vesting in 2006 or later. We did not record the additional stock-based compensation expense under APB 25 or SFAS 123(R) related to these stock options in our previously issued financial statements. These financial statements reflect the adjustments required to properly record stock-based compensation for options with revised measurement dates.
 
As a result of the investigation, we determined that the original measurement dates we used for accounting purposes for certain option and restricted stock grants to employees from April 1995 through April 2005 were not appropriate and, in some instances, such dates were chosen with the benefit of hindsight so as to intentionally, and not inadvertently or as a result of administrative error, give more favorable exercise prices. We revised measurement dates and recorded stock-based compensation expense due to the following errors:
 
  •  annual merit grant allocation and/or approval not complete on the original measurement date,
 
  •  the key terms for a substantial portion of the grants in an annual merit grant had been determined with finality prior to the original measurement date, with a reduction in the exercise price on the original measurement date, which represented a repricing,
 
  •  original accounting measurement date prior to approval date,
 
  •  original accounting measurement date prior to employment commencement date,
 
  •  incorrect or inconsistent approval and employment commencement date documentation,
 
  •  clerical errors in director grants,
 
  •  correction of accounting errors, primarily options historically accounted for as variable awards, or
 
  •  post-employment option modifications previously not recorded.
 
After reviewing available relevant documentation, a general hierarchy of documentation was considered when establishing the revised measurement date for accounting purposes. The hierarchy was considered in evaluating each grant on an individual basis based on the particular facts and circumstances. The documentation considered when available was:
 
  •  Minutes of board of directors, compensation committee and/or delegated committee:  Approved minutes represent the best available evidence of grant approval. The investigative team was able to validate the occurrence of board of director and compensation committee meetings on the stated dates in most cases through director payment records, billing records of outside legal counsel who attended the meetings or a signature on the minutes by external legal counsel.
 
  •  Unanimous Written Consents (“UWCs”):  UWCs have an effective date that represents the date grants were approved by the compensation committee or delegated committee. For compensation committee UWCs in 2004 and 2005, we were not able to rely on certain UWC effective dates due to other evidence indicating that certain grants were approved subsequent to the UWC effective date. We were able to locate


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
  other evidence to determine the approval date of these grants, such as approval documentation in emails and evidence of the date UWCs were signed. There were no options granted in compensation committee UWCs from 2001 through 2003. For UWCs prior to 2001, compensation committee members had historically resolved to grant options, and such action was then documented in a UWC, with the effective date being the date the granting action was taken. With the exception of one UWC, no evidence was located that contradicted a UWC effective date as the approval date for any compensation committee grants prior to 2001. We have therefore placed reliance on the compensation committee UWCs prior to 2001.
 
  •  Option allocations for annual merit grants:  Allocations may be evidenced by signed and dated hard-copy schedules or electronic spreadsheets that list the employees and number of options granted to each employee. Email communications to which the electronic spreadsheets were attached also provided evidence of the date allocations were completed. We were able to validate whether allocation schedules were substantially complete by confirming individual grants in the allocation files to the actual grants reflected in our stock administration database. There were minimal changes to allocations after the date we determined that they were substantially complete.
 
  •  Database dates:  The database date (“DB date”) indicates the date an option grant was entered into the stock administration database. Entry into the stock administration database represents the best evidence of a date no later than when the grants were determined with finality.
 
DB dates were applied on a grant by grant basis, resulting in multiple measurement dates for annual merit grants for which there were multiple DB dates.
 
  •  Correspondence or other written documentation:  Written communication was in the form of grant notification letters from the human resource or stock administration departments stating the key terms of a grant, stock option agreements, employment offer or promotion letters stating the number of options to be granted and automated email notifications from human resources or our third-party broker. Written communication was primarily used to corroborate other available evidence used to determine measurement dates for annual merit grants, with the assumption that communication would not occur until the terms of the grants were determined with finality.
 
APB 25 defines the measurement date as the first date upon which the number of options and exercise price are known. Our determination of the revised measurement date was based on our assessment that a grant was determined with finality and was no longer subject to change. Such determinations involved judgment and careful evaluation of all relevant facts and circumstances for each grant. The following are the judgments involved in determining revised measurement dates.
 
Date of Execution of UWC
 
For certain grants, we were unable to locate contemporaneous documentation confirming that a compensation committee meeting, or a meeting by a delegated level of authority, occurred on the effective date of the UWC. For compensation committee UWCs with effective dates in 2004 and 2005, which cover 0.4 million options, we discovered instances in which documented approval actually occurred subsequent to the UWC effective date. The revised measurement date in these instances is the documented approval date. There were no options granted in compensation committee UWCs from 2001 through 2003. For UWCs prior to 2001, which cover 9.4 million options, and all delegated committee UWCs, the compensation or delegated committee resolved to grant options, and later documented such resolutions in UWCs, with an effective date which reflected the date of the granting actions. With the exception of one UWC, no evidence was located that contradicted a UWC with an effective date as the approval date for any compensation committee grants prior to 2001. For UWCs prior to 2001, we did not locate any evidence that caused us to question the reliability of UWCs, outside one instance discussed above. We have therefore placed reliance on the compensation committee UWCs prior to 2001.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Annual Merit Grants
 
For annual merit grants, a pool of options was allocated among non-executive employees, and in certain years for executives as well, in conjunction with their annual performance review. We located evidence that allocations were completed and grants determined with finality on a business unit/geographic region basis, resulting in multiple measurement dates for annual merit grants. For grants not included in complete allocations, we have selected the DB date as the revised measurement date as the terms of grants were determined with finality on or prior to the database entry dates.
 
For the 1999 annual merit grant, we determined that a significant portion of the grants had revised measurement dates prior to the original measurement dates, which resulted in compensation charges. The exercise price for these options was then reduced to the closing stock price on the original measurement date of the options, which we considered to be a repricing. These options have been accounted for as variable awards in the restatement in accordance with FIN 44.
 
Incorrect or Inconsistent Approval and Employment Commencement Documentation
 
We identified certain grants to executives and directors for which the approval documentation and/or employment commencement date documentation were incorrect or inconsistent. These grants were assigned an original grant date other than the approval date, or prior to the actual employment commencement date. In these instances, the occurrence of the meeting on the stated date in the approval documentation was validated based on director payment records or the billing records of external legal counsel who attended the meeting. We were able to determine the correct employment commencement date based on human resources and payroll records. The actual meeting date for the approval of such grants, or employment commencement date, if later, was used as the revised measurement date.
 
Lack of Approval Documentation
 
For grants totaling 2.2 million options, primarily in the years from 1996 through 2001, we were unable to locate approval documentation. In these instances, we examined available evidence, including email communications and grant communication letters, to determine the revised measurement date. We also performed an analysis to determine whether these grants were recorded on dates where the stock price was at a low point, which would result in a lower exercise price. It does not appear that these grants were priced opportunistically, and we did not discover any evidence that contradicted the original grant date. Therefore, we did not revise the measurement dates for these grants.
 
Communication Dates
 
For certain grants, we were unable to locate evidence of communication of the key terms (i.e., number of options and exercise price) to the employee for certain grants. We did not discover any evidence during the investigation that the communication of key terms was intentionally delayed, or there were any significant delays. In the absence of evidence to the contrary, we have concluded that communication of the key terms occurred prior to or within a reasonable period of time of the completion of all required granting actions.
 
We believe that our methodology, based on the best available evidence, results in reasonable measurement dates for our stock option grants.
 
Sales Incentives and Sales Returns
 
We reduce revenue for estimates of sales incentives and sales returns. We offer sales incentives, including channel rebates, marketing funds and end-user rebates for products in our corporate and consumer product lines. Additionally, end-users may return our products, subject to varying limitations, through distributors and resellers or to us directly for a refund within a reasonably short period from the date of purchase. We estimate and record


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
reserves for sales incentives and sales returns based on our historical experience. In each accounting period, we must make judgments and estimates of sales incentives and potential future sales returns related to current period revenue. These estimates affect our net revenue line item on our condensed consolidated statements of income and affect our net accounts receivable, deferred revenue and other accrued liabilities line items on our condensed consolidated balance sheets. These estimates affect all of our operating geographies. Effective September 2006, in connection with the launch of our new consumer products, all consumer incentive rebates are recorded ratably as an offset to revenue over the term of the subscription.
 
Inventory
 
Inventory, which consists primarily of finished goods owned at fulfillment partner locations and inventory sold into our channel which has not been sold through to the end-user, is stated at lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first in, first out basis. Inventory balances are included in other current assets in our condensed consolidated balance sheets, and are $2.7 million as of September 30, 2006 and $4.4 million as of December 31, 2005.
 
Deferred Costs of Revenue
 
Deferred costs of revenue, which consist primarily of costs related to revenue-sharing and royalty arrangements, are included in prepaid expenses and prepaid taxes and other assets in our condensed consolidated balance sheets. We only defer direct and incremental costs related to revenue-sharing arrangements and recognize such deferred costs proportionate to the related revenue recognized. As of September 30, 2006, our deferred costs are $63.2 million compared to $28.8 million as of December 31, 2005.
 
SEC and Compliance Costs
 
SEC and compliance costs include expenses associated with independent consultants engaged to examine and recommend improvements to our internal controls to ensure compliance with federal securities laws as required by our settlement with the SEC, which was finalized in 2006, and expenses related to the investigation into our stock option granting practices.
 
Recent Accounting Pronouncements
 
Noncontrolling Interests
 
In December 2007, the Financial Accounting Standards Board (“FASB”), issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”). SFAS 160 amends Accounting Research Bulletin No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 is effective for us beginning January 1, 2009. We do not expect the adoption of SFAS 160 to have a material impact on our consolidated financial position, results of operations or cash flows.
 
Business Combinations
 
In December 2007, the FASB revised SFAS No. 141, “Business Combinations” (“SFAS 141(R)”), to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. SFAS 141(R) establishes principles and requirements for recognizing and measuring identifiable assets and goodwill acquired, liabilities assumed, and any noncontrolling interest in an acquisition, at their fair value as of the acquisition date. SFAS 141(R) is effective for us beginning January 1, 2009. We are currently assessing how the adoption of SFAS 141(R) will impact our consolidated financial position, results of operations and cash flows.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Fair Value Option
 
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. 1” (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value, with unrealized gains and losses related to these financial instruments reported in earnings at each subsequent reporting date. SFAS 159 is effective for us beginning January 1, 2008. We do not expect the adoption of SFAS 159 to have a material impact on our consolidated financial position, results of operations or cash flows.
 
Fair Value Measurements
 
In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value, and expands disclosure requirements regarding fair value measurement. Where applicable, SFAS 157 simplifies and codifies fair value related guidance previously issued within generally accepted accounting principles. Although SFAS 157 does not require any new fair value measurements, its application may, for some entities, change current practice. SFAS 157 is effective for us beginning January 1, 2008. We do not expect the adoption of SFAS 157 to have a material impact on our consolidated financial position, results of operations or cash flows.
 
Accounting for Uncertainty in Income Taxes
 
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in tax positions. This interpretation requires that we recognize in our 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. The provisions of FIN 48 are effective as of the beginning of 2007, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. As a result of the implementation of FIN 48, as of January 1, 2007 we recognized a decrease of $125.6 million in the liability for unrecognized tax benefits, a $3.4 million increase in acquisition related goodwill, a $101.2 million increase in additional paid-in capital, and a $27.8 million increase in retained earnings. As of January 1, 2007 and after the impact of changes noted above, unrecognized tax benefits totaled $40.2 million and accrued interest and penalties totaled $10.7 million (net of any tax benefit) for an aggregate amount of $50.9 million. Of the $50.9 million, $47.5 million, if recognized, would favorably affect our effective tax rate while the remaining amount would reduce goodwill.
 
We file numerous consolidated and separate income tax returns in the United States federal and state jurisdictions and in many foreign jurisdictions. On an ongoing basis we are routinely subject to examination by taxing authorities throughout the world, including jurisdictions such as Australia, Canada, France, Germany, India, Ireland, Italy, Japan, the Netherlands and the United Kingdom. With few exceptions, we are no longer subject to United States federal income tax examinations for years before 2002 and are no longer subject to state and local or foreign income tax examinations by tax authorities for years before 1996.
 
We are presently under audit in many jurisdictions, including notably the United States and the Netherlands. The Internal Revenue Service is presently conducting a limited scope examination of our United States federal income tax returns for the calendar years 2002, 2003, 2004, and 2005. We are also in pre-filing discussions with the Netherlands tax authorities with respect to tax years 2004 and 2005. Currently, we are not able to predict the conclusion of these examinations.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements
 
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”), which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 is effective as of the end of our 2006 year, allowing a one-time transitional cumulative effect adjustment to beginning retained earnings as of January 1, 2006 for errors that were not previously deemed material, but are material under the guidance in SAB 108. The application of SAB 108 did not have a material impact on our consolidated financial position, results of operations or cash flows.
 
How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement
 
In March 2006, the FASB’s Emerging Issues Task Force released Issue 06-3, “How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement” (“EITF 06-3”). A consensus was reached that entities may adopt a policy of presenting sales taxes in the income statement on either a gross or net basis. If taxes are significant, an entity should disclose its policy of presenting taxes and the amount of taxes if reflected on a gross basis in the income statement. EITF 06-3 is effective for periods beginning after December 15, 2006. We present revenue net of sales taxes in our condensed consolidated statements of income and comprehensive income and did not change our policy as a result of EITF 06-3.
 
Accounting Changes and Error Corrections
 
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”), a replacement of APB Opinion No. 20, “Accounting Changes,” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle. Previously, most voluntary changes in accounting principles required recognition via a cumulative effect adjustment within net income in the period of the change. SFAS 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the statement does not change the transition provisions of any existing accounting pronouncements. We have applied the provisions of SFAS 154 in disclosing the effects of the errors resulting from the incorrect measurement of stock options and other items discussed in these Notes.
 
The Meaning of Other-Than-Temporary Impairment
 
In November 2005, the FASB issued Staff Position No. 115-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP 115-1”), that addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary and the measurement of an impairment loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in FSP 115-1 amends SFAS 115 “Accounting for Certain Investments in Debt and Equity Securities” and APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” FSP 115-1 nullifies certain requirements of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” and supersedes EITF Topic No. D-44, “Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value.” The guidance in FSP 115-1 is effective for reporting periods beginning after December 15, 2005. The adoption of FSP 115-1 did not have a material effect on our consolidated financial position, results of operations or cash flows.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
3.   Restatement of Condensed Consolidated Financial Statements and Special Committee and Company Findings
 
In this quarterly report on Form 10-Q, we are restating our condensed consolidated balance sheet as of December 31, 2005, our condensed consolidated statements of operations for the three and nine months ended September 30, 2005 and the related condensed consolidated statement of cash flows for the nine months ended September 30, 2005, as a result of an independent stock option investigation conducted by a special committee of our board of directors. In our 2006 Form 10-K to be filed with the Securities and Exchange Commission (“SEC”) simultaneously with the filing of this Form 10-Q, we are restating our audited consolidated financial statements and related disclosures for the years ended December 31, 2005 and 2004, and our selected consolidated statement of operations and consolidated balance sheet data for the years ended December 31, 2005, 2004, 2003 and 2002. In addition, we are restating the unaudited quarterly financial information for the interim periods of 2005 and for the three months ended March 31, 2006.
 
In May 2006, we became aware of potential issues with respect to our historical stock option granting practices. Our management discovered irregularities in certain historical stock option grants during its initial internal review, and discussed these findings with the board of directors in late May 2006. Our board of directors established a special committee of independent directors to review our stock option granting practices and related accounting. The special committee was assisted by independent counsel and forensic accountants (the “investigative team”). The special committee investigation was completed in November 2007. The special committee concluded that there were both qualitative issues and accounting and administrative errors relating to our stock option granting practices. In this regard, the special committee concluded that certain former members of management had acted inappropriately, giving rise to qualitative concerns. The qualitative concerns included the following:
 
  •  in the case of our former general counsel, he and a former member of management participated in intentionally modifying one of the former general counsel’s stock option grants so as to create a lower exercise price, and the former general counsel failed to disclose this unauthorized change to the board of directors prior to late May 2006;
 
  •  in some instances, former members of management drafted corporate records, including employment documentation, board and compensation committee meeting minutes and actions by unanimous written consent, with the benefit of hindsight so as to choose measurement dates giving more favorable exercise prices, moreover, certain of these documents were used by us in making accounting determinations with respect to stock-based compensation;
 
  •  during the course of the investigation, certain former members of management did not provide completely accurate or consistent information and in one case, provided documentation to the special committee that the special committee determined was intentionally altered; and
 
  •  certain former members of senior management did not display the appropriate oversight and “tone at the top” expected by the board of directors.
 
In addition to the foregoing, management and the special committee concluded that (i) we had previously determined accounting measurement dates for certain stock option awards incorrectly, and, in some instances, such dates were chosen with the benefit of hindsight so as to intentionally, and not inadvertently or as a result of administrative error, give more favorable exercise prices, (ii) we had incorrectly accounted for a portion of one annual merit grant as fixed awards which should have been accounted for as variable awards as they were repriced, (iii) we had not previously accounted for certain modifications to stock option agreements, (iv) we made certain accounting errors in calculating stock-based compensation expense for options historically accounted for as variable awards and (v) income tax implications exist as a result of the revision of stock option measurement dates. We also corrected for other prior-period errors.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Option grants previously accounted for using incorrect measurement dates
 
Annual merit grant allocation and/or approval not complete on the original measurement date
 
Our investigation found in 1996 through 2004:  (i) differences between the original accounting measurement date and the date of final approval of certain executive merit grants and (ii) inadequate documentation supporting the original accounting measurement date as the actual allocation completion date for non-executive merit grants and certain executive merit grants. We revised approximately 13,000 merit grant measurement dates to be based on the best available evidence of when the grant allocations were substantially complete or approval occurred, if applicable, or lacking that, evidence when the options were input into the stock administration database. In 1996 through 2005, we recorded $70.4 million of additional stock-based compensation to be recognized over the applicable service periods related to these revised measurement dates. Of the total amount of the stock-based compensation expense associated with revising the measurement dates of our annual merit grants, $69.6 million was recognized in periods prior to 2005 and $0.8 million was recognized in 2005. Of the charges recognized in 2005, we recognized $0.2 million and $0.6 million, respectively, related to the three and nine months ended September 30, 2005.
 
Original accounting measurement date prior to approval date
 
In 1996 through 2005, we recorded $15.8 million of additional stock-based compensation expense to be recognized over the applicable service periods for 12.6 million options associated with grants originally measured on dates that preceded the evidenced date of approval by the party with the requisite authority. Of the total amount of stock-based compensation expense associated with revising the measurement dates of grants that previously preceded the evidenced date of approval, $13.5 million was recognized in periods prior to 2005 and $2.3 million was recognized in 2005. Of the expenses related to 2005, we recognized $0.6 million and $1.9 million, respectively, for the three and nine months ended September 30, 2005. These adjustments included a $2.5 million expense for grants to two former executives on the same date, a $2.1 million expense for a grant to a former president and a $1.1 million expense for a grant to a former executive.
 
Original accounting measurement date prior to employment commencement date
 
We corrected accounting measurement dates for 5.4 million options granted from 1995 through 2002 resulting in additional stock-based compensation expense of $6.3 million to be recognized over the applicable service periods for grants that preceded the actual employment commencement date. Substantially all of the stock-based compensation expense resulting from revising the measurement dates of these new hire grants was recognized prior to 2005. These adjustments included a $1.3 million stock-based compensation expense for a grant to a former chief financial officer.
 
Incorrect or inconsistent approval and employment commencement date documentation
 
In 2000 through 2005, we recorded additional stock-based compensation expense of $4.8 million to be recognized over the applicable service periods for seven grants of stock options or restricted stock awards to former executives and a director where the documented approval date or employment commencement date was different than the actual approval date or employment commencement date. Of the total amount of stock-based compensation expense associated with revising the measurement dates of these grants, $4.5 million was recognized in periods prior to 2005, and $0.3 million was recognized in 2005. Of the stock-based compensation expense related to 2005, we recognized $0.1 million and $0.2 million, respectively, for the three and nine months ended September 30, 2005. Specifically the $4.8 million of expense consists of the items discussed in the remainder of this paragraph. We corrected the measurement date for options and restricted stock awarded to a former executive where the original measurement date was prior to his employment commencement date and evidence of approval by a committee with requisite authority. We recorded $3.3 million of stock-based compensation expense related to this revised measurement date. We corrected the measurement date for options granted to our former chief executive officer


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
that had been originally measured and recorded on the day following the compensation committee’s actual approval date, resulting in $0.7 million of additional stock-based compensation expense. In addition, we determined that the actual start date for a former executive was two weeks subsequent to the original measurement date; therefore, we corrected the measurement date for the options and recorded $0.5 million of additional stock-based compensation expense. In addition, we recorded a stock-based compensation expense totaling $0.3 million to correct three executive or director grants where the documented grant effective date originally used in the measurement of stock-based compensation expense was different than the available evidence supporting the actual approval date due to clerical errors.
 
Repriced annual merit grant
 
The 1999 annual merit grant consisted of 2.1 million options which had an original measurement date of April 20, 1999. We determined that the key terms were determined with finality for approximately 1.6 million of these options in March 1999, and that the exercise price was reduced to $11.06 on April 20, 1999, which represents a repricing. As the stock price on the revised measurement date in March 1999 exceeded the exercise price, there was grant date intrinsic value, which was recognized over the requisite service period. Additionally, the options are accounted for as variable awards in accordance with FIN 44 due to the repricing on April 20, 1999. The total stock-based compensation expense associated with the repricing is $6.7 million, $6.9 million of which we recognized in periods prior to 2005, and a $0.2 benefit which we recognized in 2005. We recognized variable expenses of $0.2 million and a $0.1 million benefit, respectively, for the three and nine months ended September 30, 2005.
 
Post-employment option modifications previously not recorded
 
We identified various modifications of fixed awards that had previously not been accounted for that resulted in additional stock-based compensation expense of $23.1 million. These adjustments had no impact in periods subsequent to 2005. Modifications include extensions of time allowed to exercise options after an employee has terminated or continued vesting of option awards subsequent to termination. Specifically the $23.1 million of expense includes the two items discussed in the remainder of this paragraph. For one grant in 1998, we did not correctly account for a continuation of vesting of employee options for an employee and director. Upon termination as an employee, the director began providing services to us under a separate agreement. Our investigation determined that we should have accounted for the employee options that continued to vest subsequent to his termination using the fair value method, which resulted in additional stock-based compensation expense of $3.7 million from 1998 through 2002. In addition, for a separate award in 1998 we recorded additional stock-based compensation expense of $6.5 million for an in-substance acceleration of vesting when we entered into an arrangement allowing a former employee to continue vesting in his options for nine months after termination.
 
Correction of accounting errors, primarily options historically accounted for as variable awards
 
On April 22, 1999 we offered to substantially all of our employees, excluding executive officers, the right to cancel certain outstanding stock options and receive new options with exercise prices at the current fair value of the stock. These repriced options were granted in the money, as the exercise price of the repriced options, which was based on the $11.06 closing price on April 22, 1999, was less than the closing price of $13.75 on April 28, 1999, the date the repricing price was accepted by the employees. We recognized the resulting intrinsic value of the options as compensation expense over the requisite service periods. In accordance with FIN 44, the repriced stock options were subject to variable accounting treatment beginning on July 1, 2000, the FIN 44 effective date.
 
We previously applied the transition guidance provided in FIN 44 for 2.6 million unvested repriced options at July 1, 2000 inappropriately. Upon properly applying FIN 44 transition guidance, we recognized additional stock-based compensation expense of $9.2 million over the remaining service periods of the unvested options. We recognized $9.3 million in periods prior to 2005 and a $0.1 million benefit in 2005. Of the stock-based


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
compensation expense related to 2005, we recognized a benefit of less than $0.1 million and a $0.1 million benefit, respectively, for the three and nine months ended September 30, 2005.
 
We recognized a $0.2 million reduction in stock-based compensation expense previously recognized related to the accounting for the exchange of options upon the acquisition of the remaining minority interest of our McAfee.com subsidiary. We recognized a benefit of less than $0.1 million and $0.4 million in expense for the three and nine months ended September 30, 2005, respectively, for this correction.
 
We also recognized stock-based compensation expense totaling $0.9 million related to the grant of equity instruments of one of our subsidiaries to corporate employees, all of which was recognized prior to 2005. We have accounted for these grants using the fair value method.
 
Effect of errors on stock-based compensation, before tax
 
As a result of the investigation, the original accounting measurement dates for approximately 15,600 grants were revised in the periods 1995 through 2005, errors to variable awards were corrected and expenses for modifications previously unaccounted for were recorded resulting in a total of $137.4 million additional stock-based compensation expense to be recognized over the applicable vesting periods, including $134.0 million for periods prior to January 1, 2005 and $3.4 million for 2005, respectively. Approximately 98% of the total intrinsic value (the stock price on the revised measurement minus the exercise price) recognized as a result of the investigation results from grants made during the period 1995 through 2003. The following table classifies by year total additional stock-based compensation expense by the reason for the revision to the accounting measurement date (in thousands):
 
                                                 
    1995     1996     1997     1998     1999     2000  
 
Reason for revised accounting measurement date:
                                               
Annual merit grant allocation and/or approval not complete on the original measurement date
  $     $ 82     $ 1,485     $ 12,931     $ 11,409     $ 13,242  
Original accounting measurement date prior to approval date
          262       291       809       1,701       1,302  
Original accounting measurement date prior to employment commencement date
    487       1,659       1,713       1,181       908       271  
Incorrect or inconsistent approval and employment commencement date documentation
                                  14  
Clerical errors in director grants
          10       43       57       47       16  
                                                 
Total of intrinsic charges for revised measurement dates
    487       2,013       3,532       14,978       14,065       14,845  
Repriced annual merit grant
                                  1,003  
Post-employment option modifications previously not recorded
                      11,420       3,502       3,419  
Correction of accounting errors, primarily options historically accounted for as variable awards
                            275       1,223  
                                                 
Total
  $ 487     $ 2,013     $ 3,532     $ 26,398     $ 17,842     $ 20,490  
                                                 
 


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
                                                 
    2001     2002     2003     2004     2005     Total  
 
Reason for revised accounting measurement date:
                                               
Annual merit grant allocation and/or approval not complete on the original measurement date
  $ 12,630     $ 8,551     $ 6,038     $ 3,245     $ 745     $ 70,358  
Original accounting measurement date prior to approval date
    1,516       2,292       2,498       2,852       2,279       15,802  
Original accounting measurement date prior to employment commencement date
    57       28       20       12       5       6,341  
Incorrect or inconsistent approval and employment commencement date documentation
    (1,875 )     4,211       1,502       686       274       4,812  
Clerical errors in director grants
    11       2       24       28       32       270  
                                                 
Total of intrinsic charges for revised measurement dates
    12,339       15,084       10,082       6,823       3,335       97,583  
Repriced annual merit grant
    6,629       (2,078 )     (249 )     1,569       (180 )     6,694  
Post-employment option modifications previously not recorded
    1,345       3,430       (207 )     234             23,143  
Correction of accounting errors, primarily options historically accounted for as variable awards
    9,124       (1,942 )     (1,219 )     2,217       260       9,938  
                                                 
Total
  $ 29,437     $ 14,494     $ 8,407     $ 10,843     $ 3,415     $ 137,358  
                                                 
 
                                 
    Three Months Ended        
    March 31,
    June 30,
    September 30,
    Nine Months Ended
 
    2005     2005     2005     September 30, 2005  
 
Reason for revised accounting measurement date:
                               
Annual merit grant allocation and/or approval not complete on the original measurement date
  $ 249     $ 176     $ 163     $ 588  
Original accounting measurement date prior to approval date
    749       601       554       1,904  
Original accounting measurement date prior to employment commencement date
    1             1       2  
Incorrect or inconsistent approval and employment commencement date documentation
    76       66       66       208  
Clerical errors in director grants
    7       7       9       23  
                                 
Total of intrinsic charges for revised measurement dates
    1,082       850       793       2,725  
Repriced annual merit grant
    (365 )     143       152       (70 )
Correction of accounting errors, primarily options historically accounted for as variable awards
    (197 )     525       (50 )     278  
                                 
Total
  $ 520     $ 1,518     $ 895     $ 2,933  
                                 
 
Diluted earnings per share
 
Diluted shares increased by less than 0.1 million and 0.2 million for the three and nine months ended September 30, 2005, respectively, as a result of the restatement adjustments to correct the past accounting for stock

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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
options. We use the treasury stock method to calculate the weighted-average shares used in the diluted EPS calculation. These calculations assume that: (i) all in-the-money options are exercised, (ii) we repurchase shares with the proceeds and tax benefits of these hypothetical exercises, using each period’s effective tax rate and (iii) the average unamortized deferred stock-based compensation is also used to repurchase shares.
 
Related tax adjustments
 
In conjunction with our determination that certain of our measurement dates were not determined appropriately, we also reviewed our stock option grants to assess any related tax implications. We have recorded adjustments to deferred tax assets in those jurisdictions where a tax deduction can be claimed totaling an increase of $0.9 million as of December 31, 2005, to reflect future tax deductions to the extent we believe such assets to be recoverable. We also had to adjust, as required by Internal Revenue Code Section 162(m), tax deductions in prior years for stock option related compensation paid to certain executives. Section 162(m) prohibits tax deductions for non-performance based compensation paid to the chief executive officer and the four highest compensated officers in excess of $1.0 million in a taxable year, adjusted in 2006 and subsequent years to exclude the principal financial officer. Compensation attributable to stock options issued under our employee stock option plan meets the requirements for treatment as qualified performance-based compensation and is an exception from the $1.0 million deduction limit to certain executives provided the exercise price is greater than or equal to the fair market value of our common stock on the date of grant. However, as a result of determining that certain stock options were granted at an exercise price below the fair market value of our common stock on the revised measurement date, we concluded that certain tax deductions related to stock options exercised by these specified employees are not allowed under Section 162(m). We had recorded an increase to additional paid-in capital and reductions to income taxes payable in prior years related to tax benefits realized upon the exercise of employee stock options. Since certain deductions are now disallowed, we have reduced such increases recorded to additional paid-in capital by $4.5 million from amounts previously reported as of December 31, 2005, with corresponding adjustments to certain deferred tax assets and income taxes payable. We have not recorded interest and penalties because we anticipate we will offset tax liabilities with existing tax attributes, such as net operating losses and other general business credits.
 
Other prior-period errors
 
We also have identified errors with respect to the income statement, that are principally timing-related differences between when certain items should have been recorded and when they were recorded. We had previously considered the errors under SFAS No. 154, “Accounting Changes and Error Corrections” (and previously under APB Opinion No. 20, “Accounting Changes”), and Staff Accounting Bulletin 99, “Materiality” (“SAB 99”). We have recorded these adjustments in the proper accounting periods, with the restatement of our financial statements for the non-cash stock-based compensation expense discussed above. The aggregate effect on net income was a decrease of $9.6 million, and $19 million in the three and nine months ended September 30, 2005 and an increase in net income by $6.1 million in periods prior to 2005 as discussed further below.
 
Revenue corrections
 
We identified and corrected various errors in previously reported net revenue. In this restatement we decreased net revenue by $2.6 million and $9.0 million in the three and nine months ended September 30, 2005, respectively, and increased revenue by $0.7 million in periods prior to 2005 to correct accounting errors in the periods they originally arose. These errors resulted from: (i) incorrectly configured financial systems resulting in net revenue being recognized in an incorrect period, (ii) improperly recorded product revenue when certain bundled products with support were discounted, (iii) incorrect amount and/or timing of support revenue deferral, (iv) inaccurate rebate accruals and return reserves and (v) manual journal entries not recorded in a timely manner.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Cost of net revenue
 
We increased cost of net revenue by $2.7 million and $9.3 million for the three and nine months ended September 30, 2005, respectively, and increased cost of net revenue by $4.7 million in periods prior to 2005 to correct accounting errors in the periods they originally arose resulting from: (i) incorrect recording of inventory held by a third-party distributor on our behalf, (ii) incorrect classification of certain department cost centers to cost of net revenue that had been allocated in error to operating costs, (iii) manual journal entries for intercompany accounts not being reconciled timely, (iv) incorrect calculation and classification of revenue-share payments as cost of net revenue and (v) incorrect recording of amortization of purchase technology due to incorrect amortization periods and recording of purchase accounting adjustments.
 
Operating costs
 
We increased operating costs by $1.1 million and $0.4 million in the three and nine months ended September 30, 2005, respectively, and increased operating costs by $0.7 million in periods prior to 2005 to correct accounting errors in the periods they originally arose resulting from: (i) improper recording of accruals, (ii) lack of timely write-off of an abandoned information technology project, (iii) incorrect recording of depreciation for an internal information technology project, (iv) incorrect classification of certain department cost centers to cost of net revenue that had been allocated in error to operating costs, (v) incorrect commission expense and related reclassification entries and (vi) adjusting reserves for subsequent events which occurred prior to the filing of our financial reports.
 
Interest and other income
 
Interest and other income decreased by $0.7 million in the three months ended September 30, 2005, increased by $1.5 million in the nine months ended September 30, 2005 and decreased $1.6 million in periods prior to 2005 to correct accounting errors in the periods they originally arose resulting from foreign currency gains and losses.
 
Tax provision
 
We adjusted the tax provision by increasing tax expense by $3.5 million and $5.6 million in the three and nine months ended September 30, 2005 and decreasing tax expense by $9.4 million in periods prior to 2005, to correct tax expense-related accounting errors in the periods they originally arose resulting from: (i) inclusion of tax attributes not previously recorded, (ii) incorrect recognition of intercompany transactions, (iii) incorrect recording of withholding taxes in foreign jurisdictions, (iv) incorrect calculation of tax reserves, (v) incorrect recognition of deferred tax assets and liabilities and (vi) incorrect recording in tax accounts of the effects of previously recorded purchase accounting adjustments. To record the tax impact of all other prior period errors, we further adjusted the tax provision by decreasing tax expense by $1.0 million, $3.8 million and $3.0 million in the three and nine months ended September 30, 2005 and in periods prior to 2005, respectively.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Restatement Impact on Financial Statements
 
The following table reconciles previously reported net income to restated net income (in thousands):
 
                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2005     September 30, 2005  
 
Net income, as previously reported
  $ 22,547     $ 100,215  
Additional stock-based compensation expense
    (895 )     (2,933 )
Income tax impact of additional stock-based compensation expense
    230       690  
Other adjustments, net of tax
    (9,569 )     (19,000 )
                 
Net income, as restated
  $ 12,313     $ 78,972  
                 
 
The impact of the restatement on stock-based compensation expense, which was previously reported as a component of operating expenses or cost of net revenue, and the cumulative effect of all restatement adjustments on the January 1, 2005 beginning balance of retained earnings are as follows (in thousands):
 
                                         
                      Income Tax
       
                      Benefit on
       
    Stock-Based
                Additional
    Additional
 
    Compensation
    Additional
    Stock-Based
    Stock-Based
    Stock-Based
 
    Expense, as
    Stock-Based
    Compensation
    Compensation
    Compensation
 
For the Year Ended
  Previously
    Compensation
    Expense,
    Expense, as
    Expense, Net of
 
December 31,
  Reported     Expense(1)     as Restated     Restated(2)     Tax, as Restated  
 
2004
  $ 14,320     $ 10,843     $ 25,163     $ (3,662 )   $ 7,181  
2003
    12,507       8,407       20,914       (2,626 )     5,781  
2002
    22,404       14,494       36,898       (3,544 )     10,950  
2001
    24,871       29,437       54,308       (10,843 )     18,594  
2000
    10,116       20,490       30,606       (7,081 )     13,409  
1999
    15,570       17,842       33,412       (6,450 )     11,392  
1998
    668       26,398       27,066       (9,854 )     16,544  
1997
          3,532       3,532       (1,236 )     2,296  
1996
          2,013       2,013       (744 )     1,269  
1995
          487       487       (178 )     309  
                                         
Total
  $ 100,456     $ 133,943     $ 234,399     $ (46,218 )   $ 87,725  
                                         
Income tax impact of additional stock-based compensation expense
            (46,218 )                        
                                         
Cumulative effect of stock-based compensation adjustments through December 31, 2004
            87,725                          
Other adjustments, net of tax, through December 31, 2004
            (6,133 )                        
                                         
Cumulative effect at January 1, 2005 in the beginning balance of retained earnings
          $ 81,592                          
                                         
 
 
(1) Additional compensation expense is the result of improper measurement dates for stock option grants, improper accounting for modifications of the key terms of certain stock option awards and the correction of accounting errors primarily related to variable awards.
 
(2) Includes income tax benefit on additional stock-based compensation expense, adjustments for tax deductions prohibited under Section 162(m) of the Internal Revenue Code as a result of the additional stock-based


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
compensation expense and various other adjustments resulting from the impact of additional stock-based compensation recorded in the applicable year.
 
The following table reflects the impact of the restatement on stock-based compensation expense in our consolidated statements of income for the quarters ended March 31, 2005, June 30, 2005 and September 30, 2005 (in thousands):
 
                                         
                      Income Tax
       
                      Benefit on
       
    Stock-Based
                Additional
    Additional
 
    Compensation
    Additional
    Stock-Based
    Stock-Based
    Stock-Based
 
    Expense, as
    Stock-Based
    Compensation
    Compensation
    Compensation
 
    Previously
    Compensation
    Expense,
    Expense, as
    Expense, Net of
 
Three Months Ended
  Reported     Expense(1)     as Restated     Restated(2)     Tax, as Restated  
 
March 31, 2005
  $ (3,292 )   $ 520     $ (2,772 )   $ (230 )   $ 290  
June 30, 2005
    2,368       1,518       3,886       (230 )     1,288  
September 30, 2005
    2,993       895       3,888       (230 )     665  
 
 
(1) Additional compensation expense is the result of improper measurement dates for stock option grants, improper accounting for modifications of the key terms of certain stock option awards and the correction of accounting errors primarily related to variable awards.
 
(2) Includes income tax benefit on additional stock-based compensation expense, adjustments for tax deductions prohibited under Section 162(m) of the Internal Revenue Code as a result of the additional stock-based compensation expense and various other adjustments resulting from the impact of additional stock-based compensation recorded in the applicable year.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
 
The following tables reconcile the impact of the additional non-cash expenses for stock-based compensation, other adjustments that were previously considered to be immaterial, and the related tax effects on our financial statements as of December 31, 2005 and for the three and nine months ended September 30, 2005:
 
Condensed Consolidated Balance Sheet
 
                         
    December 31, 2005  
    (As previously
    (Adjustments)(1)     (As restated)  
    reported)              
    (In thousands)  
 
ASSETS
Current assets:
                       
Cash and cash equivalents
  $ 728,592     $     $ 728,592  
Restricted cash
    50,489             50,489  
Short-term marketable securities
    316,298             316,298  
Accounts receivable, net of allowance for doubtful accounts of $2,389
    158,680       450       159,130  
Prepaid expenses and prepaid taxes
    78,945       187       79,132  
Deferred income taxes
    206,811       (2,603 )     204,208  
Other current assets
    27,846       644       28,490  
                         
Total current assets
    1,567,661       (1,322 )     1,566,339  
Long-term marketable securities
    212,131             212,131  
Restricted cash
    939             939  
Property and equipment, net
    85,641       51       85,692  
Deferred income taxes
    241,315       (3,345 )     237,970  
Intangible assets, net
    80,782       (696 )     80,086  
Goodwill
    438,396       (908 )     437,488  
Other assets
    15,759       (170 )     15,589  
                         
Total assets
  $ 2,642,624     $ (6,390 )   $ 2,636,234  
                         
 
LIABILITIES
Current liabilities:
                       
Accounts payable
  $ 34,678     $     $ 34,678  
Accrued SEC settlement
    50,000             50,000  
Accrued income taxes
    81,227       (4,487 )     76,740  
Accrued compensation
    50,617       5,164       55,781  
Accrued marketing
    15,172             15,172  
Other accrued liabilities
    66,839       3,449       70,288  
Deferred revenue
    570,458       5,207       575,665  
                         
Total current liabilities
    868,991       9,333       878,324  
Deferred revenue, less current portion
    175,962       179       176,141  
Accrued taxes and other long-term liabilities
    142,638       4,490       147,128  
                         
Total liabilities
    1,187,591       14,002       1,201,593  
                         
 
STOCKHOLDERS’ EQUITY
Preferred stock
                 
Common stock
    1,705             1,705  
Treasury stock
    (68,395 )           (68,395 )
Additional paid-in capital
    1,356,881       86,862       1,443,743  
Deferred stock-based compensation
    (474 )     (7,672 )     (8,146 )
Accumulated other comprehensive income
    31,302       2,621       33,923  
Retained earnings
    134,014       (102,203 )     31,811  
                         
Total stockholders’ equity
    1,455,033       (20,392 )     1,434,641  
                         
Total liabilities and stockholders’ equity
  $ 2,642,624     $ (6,390 )   $ 2,636,234  
                         
 
 
(1) Includes adjustments for the impact of accounting errors on the year ended December 31, 2005, as well as the impact of errors in 2004 and prior.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
 
Condensed Consolidated Statements of Income and Comprehensive Income
 
                                                 
    Three Months Ended September 30, 2005     Nine Months Ended September 30, 2005  
    (As previously
    (Adjustments)     (As restated)     (As previously
    (Adjustments)     (As restated)  
    reported)                 reported)              
    (In thousands, except per share data)
 
    (Unaudited)  
 
Net revenue:
                                               
Service and support
  $ 141,195 (1)   $ 737     $ 141,932     $ 406,553     $ 4,038     $ 410,591  
Subscription
    90,891 (1)           90,891       236,797             236,797  
Product
    20,825 (1)     (3,359 )     17,466       90,670       (12,991 )     77,679  
                                                 
Total net revenue
    252,911       (2,622 )     250,289       734,020       (8,953 )     725,067  
Cost of net revenue:
                                               
Service and support
    7,847 (1)     (2,165 )     5,682       22,496       (4,369 )     18,127  
Subscription
    14,909 (1)     1,555       16,464       39,128       6,930       46,058  
Product
    10,399 (1)     2,736       13,135       39,308       5,094       44,402  
Amortization of purchased technology
    3,938       563       4,501       11,674       1,689       13,363  
                                                 
Total cost of net revenue
    37,093       2,689       39,782       112,606       9,344       121,950  
Operating costs:
                                               
Research and development
    46,960       228       47,188       130,074       203       130,277  
Marketing and sales
    71,878       839       72,717       219,198       3,300       222,498  
General and administrative
    28,626       988       29,614       92,473       (174 )     92,299  
Amortization of intangibles
    2,876       30       2,906       10,109       (73 )     10,036  
Restructuring (benefits) charges
    (10 )           (10 )     5,962       51       6,013  
In-process research and development
                      4,000             4,000  
SEC settlement charge
    50,000             50,000       50,000             50,000  
                                                 
Total operating costs
    200,330       2,085       202,415       511,816       3,307       515,123  
                                                 
Income from operations
    15,488       (7,396 )     8,092       109,598       (21,604 )     87,994  
Interest and other income
    7,313       (656 )     6,657       17,155       1,510       18,665  
Gain (loss) on investments, net
    (160 )           (160 )     (1,106 )           (1,106 )
                                                 
Income before provision for income taxes
    22,641       (8,052 )     14,589       125,647       (20,094 )     105,553  
Provision for income taxes
    94       2,182       2,276       25,432       1,149       26,581  
                                                 
Net income
  $ 22,547     $ (10,234 )   $ 12,313     $ 100,215     $ (21,243 )   $ 78,972  
                                                 
Other comprehensive income:
                                               
Unrealized gain (loss) on marketable securities, net of reclassification adjustment for losses recognized on marketable securities during the period and income tax
  $ (462 )   $     $ (462 )   $ (943 )   $     $ (943 )
Foreign currency translation loss
    3,072       869       3,941       2,578       (867 )     1,711  
                                                 
Comprehensive income
  $ 25,157     $ (9,365 )   $ 15,792     $ 101,850     $ (22,110 )   $ 79,740  
                                                 
Net income per share — Basic
  $ 0.14     $ (0.07 )   $ 0.07     $ 0.61     $ (0.13 )   $ 0.48  
                                                 
Net income per share — Diluted
  $ 0.13     $ (0.06 )   $ 0.07     $ 0.60     $ (0.13 )   $ 0.47  
                                                 
Shares used in per share calculation — Basic
    166,221       (47 )     166,174       164,245       (44 )     164,201  
                                                 
Shares used in per share calculation — Diluted
    170,712       44       170,756       168,383       151       168,534  
                                                 
 
 
(1) During 2005, we made certain reclassifications from product revenue to service and support revenue, primarily related to online subscriptions. Total net revenue was not impacted by these reclassifications. As of January 1, 2006, we changed the presentation of our net revenue and cost of net revenue to include three categories: (i) product, which includes hardware and perpetual licenses, (ii) subscription, which includes subscription-


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
based offerings and (iii) service and support, which includes maintenance, consulting and training. Previously, we chose to allocate our subscription business between product revenue and service and support revenue instead of presenting it as a separate category. We believe this new presentation is consistent with the way we currently manage our business as we grow the subscription component of both our corporate and consumer businesses. In the table below, we have applied the change in presentation retrospectively to the balances previously reported for the three and nine months ended September 30, 2005. Total net revenues and cost of net revenues were not affected by the change.
 
The following table presents our three and nine months ended September 30, 2005 net revenue and cost of net revenue as previously reported on our quarterly report on Form 10-Q filed on November 4, 2005 (in thousands):
 
                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2005     September 30, 2005  
    (As previously reported)     (As previously reported)  
 
Net revenue:
               
Product
  $ 32,578     $ 121,528  
Service and support
    220,333       612,492  
                 
Total net revenue
  $ 252,911     $ 734,020  
                 
Cost of net revenue:
               
Product
  $ 10,282     $ 38,793  
Service and support
    22,873       62,139  
Amortization of purchased technology
    3,938       11,674  
                 
Total cost of net revenue
  $ 37,093     $ 112,606  
                 
 
The following table presents our revised net revenue and cost of net revenue presentation for the three and nine months ended September 30, 2005, prior to the effect of restatement adjustments (in thousands):
 
                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2005     September 30, 2005  
 
Net revenue:
               
Service and support
  $ 141,195     $ 406,553  
Subscription
    90,891       236,797  
Product
    20,825       90,670  
                 
Total net revenue
  $ 252,911     $ 734,020  
                 
Cost of net revenue:
               
Service and support
  $ 7,847     $ 22,496  
Subscription
    14,909       39,128  
Product
    10,399       39,308  
Amortization of purchased technology
    3,938       11,674  
                 
Total cost of net revenue
  $ 37,093     $ 112,606  
                 


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The restatement did not impact net cash flows from operating, investing or financing activities. However, certain items within net cash provided by operating activities were impacted by the adjustments. The following table shows the effects of the restatement on previously reported cash flow items within operating activities (in thousands):
 
                         
    Nine Months Ended September 30, 2005  
    (As previously
    (Adjustments)     (As restated)  
    reported)              
    (Unaudited)  
 
Cash flows from operating activities:
                       
Net income
  $ 100,215     $ (21,243 )   $ 78,972  
Adjustments to reconcile net income to net cash provided by operating activities:
                       
Depreciation and amortization
    49,556       1,383       50,939  
Deferred income taxes
    (13,020 )     4,574       (8,446 )
Stock-based compensation charges
    2,069       2,933       5,002  
Tax benefit from exercise of nonqualified stock options
    27,900       (5,559 )     22,341  
Changes in assets and liabilities, net of acquisitions and divestitures:
                       
Accounts receivable
    30,927       1,719       32,646  
Prepaid expenses, prepaid taxes and other assets
    (11,133 )     2,035       (9,098 )
Accounts payable and other accrued liabilities
    10,587       6,580       17,167  
Deferred revenue
    85,848       7,578       93,426  
                         
Net effect on cash flows from operations
          $          
                         
Supplemental disclosure of cash flow information:
                       
Cash paid for income taxes
    34,275       348       34,623  
                         
Cash received from income tax refunds
          1,790       1,790  
                         
 
4.   Employee Stock Benefit Plans
 
Employee Stock Purchase Plan
 
In April 2002, our board of directors adopted McAfee’s 2002 Employee Stock Purchase Plan (“ESPP”), which reserved 2.0 million shares of our common stock for issuance to our employees. In December 2003 and May 2005, our stockholders approved an additional 2.0 million and 1.0 million shares for issuance, respectively, bringing the total number of shares reserved under the plan to 5.0 million. Generally, individuals who are employed for 30 days and perform at least 20 hours of service per week are eligible to participate in the ESPP.
 
Prior to August 1, 2005, we offered shares of stock for purchase to eligible employees through a series of two-year offering periods. Each two-year offering period was comprised of four consecutive six-month purchase periods. Beginning August 1, 2005, the term of the offering period was changed to six months. Outstanding offering periods that commenced prior to August 1, 2005 continued until the end of the two-year offering period, however, beginning in July 2006, we suspended purchases under our employee stock purchase plan, returned all withholdings for the most recent offering period to our participating employees, including interest based on a 5% per annum interest rate, and prohibited our employees from exercising stock options due to the announced investigation into our historical stock option granting practices and our inability to become current on our reporting obligations under the Securities Exchange Act of 1934, as amended.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
During an offering period, employees make contributions to the ESPP through payroll deductions. At the end of each purchase period, we use the accumulated contributions to issue shares of our stock to the participating employees. The issue price of those shares is equal to the lesser of (i) 85% of our stock price on the first day of the offering period, or (ii) 85% of our stock price on the purchase date. No participant may be issued more than $25,000 of common stock in any one calendar year and the maximum number of shares a participant may be issued during a single offering period is 10,000 shares. There were no shares issued in the three months ended September 30, 2006 and 0.4 million shares were issued in the three months ended September 30, 2005 under the ESPP. The total intrinsic value of shares issued under the ESPP during the three months ended September 30, 2005 was $6.3 million at a weighted average issue price of $15.16. In the nine months ended September 30, 2006 and September 30, 2005, 0.4 million and 0.8 million shares were issued under the ESPP at a weighted-average issue price of $17.22 and $14.54, respectively. The total intrinsic value of shares issued under the ESPP during the nine months ended September 30, 2006 and September 30, 2005 was $2.4 million and $11.1 million, respectively. During the three and nine months ended September 30, 2006 we recognized $0.3 million and $1.9 million, respectively, of stock compensation associated with the ESPP.
 
Company Stock Incentive Plans
 
Under the terms of our amended 1997 Stock Incentive Plan (the “1997 Plan”), we have reserved a total of 38.5 million shares for issuance to employees, officers, directors, third-party contractors and consultants through awards provided in the form of options, restricted stock awards, restricted stock units or stock appreciation rights. As of September 30, 2006, we have no stock-based issuances outstanding with third-party contractors or consultants.
 
Certain options issued under the 1997 Plan may be exercised immediately upon granting, however the majority contain graded vesting provisions, whereby 25% vest one year from the date of grant and thereafter in monthly increments over the remaining three years. All unexercised options expire ten years after the grant date. Restricted stock awards and restricted stock units also vest over a specified period, generally for restricted stock awards ratably over three years and for restricted stock units 50% two years from the grant date and 50% three years from the grant date. Restricted stock awards are common stock issued to the recipient that have not vested. Restricted stock units are promises to issue stock in the future.
 
Under the Stock Option Plan for Outside Directors, we have reserved 1.1 million shares of our common stock for issuance to certain members of our board of directors who are not employees of ours or any of our affiliated entities. The exercise price for these options is equal to the market value of our common stock on the grant date. Initial grants to each outside director generally vest ratably over a three-year period, while any subsequent grants are exercisable three years from the grant date. All unexercised options expire ten years after the grant date.
 
In connection with our acquisition of Foundstone, Inc. in October 2004, we assumed the obligations of their 2000 Stock Plan and converted their outstanding options into options to purchase 0.4 million shares of our common stock. We have reserved 0.7 million shares of our common stock for issuance under this plan. The plan provides for an option price no less than 85% of the fair value of our common stock on the date of grant. The options contain graded vesting provisions, whereby 25% vest one year from the date of grant and thereafter in monthly increments over the remaining three years. All unexercised options expire ten years after grant date.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Plan Activity
 
A summary of the activity of our employee stock options during the three and nine months ended September 30, 2006, and details regarding the options outstanding and exercisable at September 30, 2006 are provided below (in thousands, except per share data):
 
                                                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2006     September 30, 2006  
                            Weighted-
       
          Weighted-
          Weighted-
    Average
       
          Average
          Average
    Remaining
    Aggregate
 
    Number of
    Exercise
    Number of
    Exercise
    Contractual
    Intrinsic
 
    Options     Price     Options     Price     Life (Yrs)     Value  
 
Outstanding at beginning of period
    14,756     $ 20.58       16,065     $ 19.77                  
Options granted
    434       22.49       1,842       24.19                  
Options exercised
    (161 )     14.67       (1,634 )     15.53                  
Options canceled
    (560 )     21.29       (1,804 )     20.85                  
                                                 
Outstanding at end of period
    14,469     $ 20.68       14,469     $ 20.68                  
                                                 
Options outstanding, expected to vest
    12,135     $ 20.34       12,135     $ 20.34       6.5     $ 62,467  
                                                 
Options exercisable
    7,365     $ 18.89       7,365     $ 18.89       5.2     $ 47,766  
                                                 
 
The total intrinsic value of options exercised during the three months ended September 30, 2006 and September 30, 2005 was $1.5 million and $29.0 million, respectively. The total intrinsic value of options exercised during the nine months ended September 30, 2006 and September 30, 2005 was $16.2 million and $89.7 million, respectively. From July 2006, when we announced that we might have to restate our historical financial statements as a result of our ongoing stock option investigation, through the date we become current on our reporting obligations under the Securities Exchange Act of 1934, as amended, we have not been able to issue any shares, including those pursuant to stock option exercises.
 
The tax benefit realized from stock option exercises and employee stock purchase rights in the three and nine months ended September 30, 2006 was $0.9 million and $6.9 million, respectively. We realized a tax benefit of $31.9 million in the three and nine months ended September 30, 2005.
 
A summary of the activity for restricted stock awards and restricted stock units during the three and nine months ended September 30, 2006 is provided below (in thousands, except per share data):
 
                                                                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2006     September 30, 2006  
          Weighted-
          Weighted-
          Weighted-
          Weighted-
 
    Restricted
    Average
    Restricted
    Average
    Restricted
    Average
    Restricted
    Average
 
    Stock
    Grant Date
    Stock
    Grant Date
    Stock
    Grant Date
    Stock
    Grant Date
 
    Units     Fair Value     Awards     Fair Value     Units     Fair Value     Awards     Fair Value  
 
Unvested at beginning of period
    3,424     $ 23.78       190     $ 29.02           $       185     $ 29.79  
Grants
    24       23.23                   3,625       23.77       30       23.76  
Vested
                (37 )     30.74                   (62 )     29.79  
Canceled
    (100 )     23.71                   (277 )     23.65              
                                                                 
Unvested at end of period
    3,348     $ 23.78       153     $ 28.61       3,348     $ 23.78       153     $ 28.61  
                                                                 


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The weighted-average remaining contractual life for unvested restricted stock units and restricted stock awards at September 30, 2006 was 2.4 years and 1.9 years, respectively. The 24,000 restricted stock units granted in the three months ended September 30, 2006 under the 1997 Plan were valued at $0.3 million when reduced by estimated forfeitures. The total fair value of restricted stock awards vested during the three months ended September 30, 2006 was $0.8 million. No restricted stock awards vested during the three months ended September 30, 2005.
 
The 3.6 million restricted stock units granted in the nine months ended September 30, 2006 under the 1997 Plan were valued at $50.5 million when reduced by estimated forfeitures. The total fair value of restricted stock awards vested during the nine months ended September 30, 2006 and September 30, 2005 was $1.5 million and $1.2 million, respectively.
 
Shares available for future grants to employees under our stock incentive plans totaled 4.8 million at September 30, 2006. Our management currently plans to issue new shares for the vesting of restricted stock awards and restricted stock units and exercises of stock options.
 
Valuation and Expense Information under SFAS 123(R)
 
As indicated in Note 2, we adopted the provisions of SFAS 123(R) on January 1, 2006. The following table summarizes stock-based compensation expense in accordance with the provisions of SFAS 123(R) (in thousands):
 
                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2006     September 30, 2006  
 
Amortization of fair value of options issued to employees
  $ 6,955     $ 24,677  
Cash settlement of options
    2,668       2,668  
Restricted stock awards and units
    4,984       11,447  
Employee Stock Purchase Plan
    257       1,864  
                 
Total stock-based compensation expense
  $ 14,864     $ 40,656  
                 
 
Amortization of fair value of options issued to employees.  We recognize the fair value of stock options issued to employees as stock-based compensation expense over the vesting period of the awards. As we adopted SFAS 123(R) using the modified prospective method, these expenses include compensation expense for stock options granted prior to January 1, 2006 but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123, and compensation expense for stock options granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R).
 
Cash settlement of options.  Certain stock options held by terminated employees expired during the blackout period as they could not be exercised during the 90 day period subsequent to termination. In January 2007, we determined that we would settle these options in cash. The cash payment to settle these options will be based upon an average closing price of our common stock subsequent to us becoming current on our reporting obligations under the Securities Exchange Act of 1934, as amended. As of September 30, 2006, we have recorded a liability based on the intrinsic value of these options using our January 7, 2007 closing stock price. We will continue to adjust this amount in future reporting periods based on the closing price of our common stock.
 
Restricted stock awards and units.  We recognize stock-based compensation expense for the fair value of restricted stock awards and restricted stock units. Fair value is determined as the difference between the closing price of our common stock on the grant date and the purchase price of the restricted stock awards and units. The fair value of these awards is recognized to expense over the requisite service period of the awards.
 
Employee Stock Purchase Plan.  We recognize stock-based compensation expense for the fair value of employee stock purchase rights issued pursuant to our ESPP. The estimated fair value of employee stock purchase


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
rights is based on the Black-Scholes pricing model. Expense is recognized ratably based on contributions and the total fair value of the employee stock purchase rights estimated to be issued.
 
The following table summarizes the stock-based compensation expense by income statement line item that we recorded in accordance with the provisions of SFAS 123(R) (in thousands):
 
                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2006     September 30, 2006  
 
Cost of net revenue — service and support
  $ 546     $ 1,503  
Cost of net revenue — subscription
    180       485  
Cost of net revenue — product
    190       576  
                 
Stock-based compensation expense included in cost of net revenue
    916       2,564  
Research and development
    4,299       11,637  
Marketing and sales
    6,158       16,257  
General and administrative
    3,491       10,198  
                 
Stock-based compensation expense included in operating expenses
    13,948       38,092  
                 
Total stock-based compensation expense related to stock-based equity awards
    14,864       40,656  
                 
Deferred tax benefit
    (2,966 )     (10,014 )
                 
Total stock-based compensation expense related to stock-based equity awards, net of tax
  $ 11,898     $ 30,642  
                 
 
We had no stock-based compensation costs capitalized as part of the cost of an asset.
 
The adoption of SFAS 123(R) compared to the prior accounting policy we applied to stock-based compensation had the following impact to results reported for the three months ended September 30, 2006 (in thousands, except per share data):
 
                         
          Adjustments
       
    Using
    for
    Using
 
    APB 25     SFAS 123(R)     SFAS 123(R)  
 
Stock-based compensation expense included in cost of net revenue and operating expenses
  $ 10,056     $ 4,808     $ 14,864  
Income from operations
    41,598       (4,808 )     36,790  
Income before provision for income taxes
    55,674       (4,808 )     50,866  
Net income
    37,172       (3,082 )     34,090  
Net income per share — basic
  $ 0.23     $ (0.02 )   $ 0.21  
Net income per share — diluted
  $ 0.23     $ (0.02 )   $ 0.21  


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The adoption of SFAS 123(R) compared to the prior accounting policy we applied to stock-based compensation had the following impact to results reported for the nine months ended September 30, 2006 (in thousands, except per share data):
 
                         
          Adjustments
       
    Using
    for
    Using
 
    APB 25     SFAS 123(R)     SFAS 123(R)  
 
Stock-based compensation expense included in cost of net revenue and operating expenses
  $ 19,821     $ 20,835     $ 40,656  
Income from operations
    126,268       (20,835 )     105,433  
Income before provision for income taxes
    158,921       (20,835 )     138,086  
Net income
    117,950       (13,355 )     104,595  
Net income per share — basic
  $ 0.73     $ (0.08 )   $ 0.65  
Net income per share — diluted
  $ 0.72     $ (0.08 )   $ 0.64  
Cash flows from operating activities
    209,084       (4,811 )     204,273  
Cash flows from financing activities
    (202,672 )     4,811       (197,861 )
 
At September 30, 2006, the estimated fair value of all unvested stock options, restricted stock units, restricted stock awards and employee stock purchase rights that have not yet been recognized as compensation expense was $77.9 million, net of expected forfeitures. We expect to recognize this amount over a weighted-average period of 2.5 years.
 
Assumptions Used under SFAS 123(R) and SFAS 123
 
As indicated in Note 2, under both SFAS 123(R) and SFAS 123 we used the Black-Scholes model to estimate the fair value of our option awards and employee stock purchase rights issued under the ESPP. The key assumptions used in the model during the three and nine months ended September 30, 2006 and 2005 are provided below:
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Stock option grants:
                               
Risk free interest rate
    4.9 %     4.0 %     4.8 %     3.9 %
Weighted average expected lives (years)
    5.9       4.0       5.6       4.0  
Volatility
    34.0 %     49.5 %     38.4 %     55.6 %
Dividend yield
                       
ESPP:
                               
Risk free interest rate
            3.5 %     4.6 %     3.1 %
Weighted average expected lives (years)
            0.5       0.5       1.1  
Volatility
            38.0 %     38.0 %     40.0 %
Dividend yield
                         
 
During the three months ended September 30, 2006 we did not have any ESPP grants.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The fair value per share of the option awards and employee stock purchase rights were:
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Weighted-average grant date fair value of options granted
  $ 9.41     $ 12.94     $ 10.51     $ 11.16  
Weighted-average fair value of employee stock purchase rights
          $ 7.92     $ 6.11     $ 8.41  
 
We derive the expected term of our options through the use of a lattice model that factors in historical data on employee exercise and post-vesting employment termination behavior. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. Since January 1, 2006, we have used the implied volatility of options traded on our stock with a term of six months or more to calculate the expected volatility of our option grants. Prior to that time, the expected volatility was based solely on the historical volatility of our stock. We changed our method of estimating volatility to using implied volatility because we believe that using implied volatility of options traded on our stock is a better measure of volatility than historical volatility. We have not declared any dividends on our stock in the past and do not expect to do so in the foreseeable future.
 
Pro Forma Information under SFAS 123 for Periods Prior to January 1, 2006
 
As indicated in Note 2, we applied the provisions of APB 25 to determine our stock-based compensation expense for all periods prior to January 1, 2006. The following table illustrates the effect on net income and net income per share if we had applied the fair value recognition provision of SFAS 123 to our stock-based compensation plans during the three and nine months ended September 30, 2005 (in thousands, except per share data):
 
                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2005     September 30, 2005  
 
Net income, as restated
  $ 12,313     $ 78,972  
Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of tax
    (10,114 )     (27,622 )
Add back: Stock-based compensation expense, net of tax, included in reported net income under APB 25
    2,653       3,627  
                 
Pro forma net income
  $ 4,852     $ 54,977  
                 
Basic net income per share, as restated
  $ 0.07     $ 0.48  
                 
Diluted net income per share, as restated
  $ 0.07     $ 0.47  
                 
Basic net income per share, pro forma
  $ 0.03     $ 0.33  
                 
Diluted net income per share, pro forma
  $ 0.03     $ 0.33  
                 


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Stock-Based Compensation Recognized Prior to January 1, 2006
 
In the three and nine months ended September 30, 2005, we recorded stock-based compensation expenses under APB 25 which consisted of the following items (in thousands):
 
                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2005     September 30, 2005  
 
Grant date intrinsic value
  $ 913     $ 3,170  
Exchange of McAfee.com options
    1,552       1,207  
Repriced options
    1,180       10  
Restricted stock awards
    243       615  
                 
Total stock-based compensation expense
    3,888       5,002  
Deferred tax benefit
    (1,235 )     (1,375 )
                 
Total stock-based compensation expense, after-tax
  $ 2,653     $ 3,627  
                 
 
Grant date intrinsic value.  We recognize stock-based compensation expense over the vesting period of the awards for the excess of the fair value of our common stock as of the revised measurement date over the exercise price of the options. During the three and nine months ended September 30, 2005, we recognized stock-based compensation expense totaling $0.8 million and $2.8 million, respectively, related to the grant date intrinsic value. For additional information regarding the intrinsic charges resulting from revised measurement dates, refer to Note 3.
 
In connection with the acquisition of Foundstone in October 2004, we exchanged options to purchase shares of our common stock for Foundstone stock options. A portion of the fair value of our stock options was included in the Foundstone purchase price. In accordance with FIN 44, we recorded $2.3 million of deferred stock-based compensation related to the exchange of unvested stock options which are subject to vesting provisions as employment services are provided to us by the former Foundstone employees. The unvested stock options granted to Foundstone employees vest over periods ranging through 2008. We recorded stock-based compensation of $0.1 million and $0.4 million in the three and nine months ended September 30, 2005, respectively, related to the unvested stock options exchanged in the Foundstone acquisition.
 
Exchange of McAfee.com options.  On September 13, 2002, we acquired the remaining minority interest in our McAfee.com subsidiary. McAfee.com option holders received options for 0.675 of a share of our common stock plus $11.85 in cash, which is paid to the option holder upon exercise of the option and without interest. McAfee.com options to purchase 4.1 million shares were converted into options to purchase 2.8 million shares of our common stock. The assumed options were subject to variable accounting treatment, which means that the compensation expense was measured initially at the date of the closing of the acquisition and is remeasured each reporting period based on our common stock fair market value at the end of each report period.
 
The stock-based compensation expense of $1.6 million in the three months ended September 30, 2005 was due to an increase in our stock price from $26.18 at June 30, 2005 to $31.42 at September 30, 2005. The stock-based compensation expense of $1.2 million in the nine months ended September 30, 2005 was due to an increase in our stock price from $28.93 at December 31, 2004 to $31.42 at September 30, 2005.
 
Repriced options.  The 1999 annual merit grant consisted of 2.1 million options which had an original measurement date of April 20, 1999. The key terms were determined with finality for 1.6 million of these options in March 1999, and the exercise price was reduced to $11.06 on April 20, 1999, which was considered a repricing.
 
On April 22, 1999, we offered to substantially all of our employees, excluding executive officers, the right to cancel certain outstanding stock options and receive new options with an exercise price of $11.06, the fair value of our common stock as of that day. Options to purchase a total of 9.5 million shares, which excluded the 1999 annual merit grant discussed above, were cancelled and the same number of new options were granted. These new options vested at the same rate that they would have under the terms of the original options.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
FIN 44 became effective July 1, 2000 and required any repricings which occurred subsequent to December 15, 1998 to be accounted for as variable awards. Compensation for variable awards is remeasured and adjusted on a cumulative basis at each reporting date. Compensation expense for the options referred to in the previous two paragraphs that were vested as of July 1, 2000 is measured based on the fair value of our common stock above $20.38, the closing price of our common stock upon the effective date of FIN 44. Compensation expense for unvested options as of July 1, 2000 is measured based on the fair value of our common stock above the exercise price of the repriced options. We remeasure compensation cost at each financial reporting date until the earlier of the date of exercise, forfeiture, cancellation without replacement or the effective date of SFAS 123(R). This compensation expense is recorded as an expense over the remaining vesting period of the options, using the accelerated method of amortization under FIN 28. We began accounting for the repriced options as variable awards on July 1, 2000 as required by FIN 44. The stock-based compensation expense of $1.2 million in the three months ended September 30, 2005 was due to an increase in our stock price from $26.18 at June 30, 2005 to $31.42 at September 30, 2005. The stock-based compensation expense of less than $0.1 million in the nine months ended September 30, 2005 was due to an increase in our stock price from $28.93 at December 31, 2004 to $31.42 at September 30, 2005. These options were fully vested prior to December 31, 2005, therefore, no stock-based compensation expense was recognized after the adoption of SFAS 123(R).
 
Restricted stock awards.  In September 2005, the compensation committee of our board of directors granted a total of 110,000 shares of restricted stock, which vest through September 2008, to key employees. The price of the underlying shares is $0.01 per share. In January 2005, our board of directors granted 75,000 shares of restricted stock to our chief financial officer. The price of the underlying shares is $0.01 per share. The shares will vest over three years from the date of grant. The fair value of the restricted stock award was determined to be $2.1 million and was based on the difference between the exercise price of the restricted stock award and the fair value of the common stock on the date of grant. We recorded total expense of $0.2 million and $0.6 million during the three and nine months ended September 30, 2005, respectively, related to the stock-based compensation associated with restricted stock award grants.
 
In January 2002, our board of directors approved a grant of 50,000 shares of restricted stock to our former chief executive officer. The price of the underlying shares is $0.01 per share. The shares vested and our right to repurchase such shares lapsed as follows: 3,000 vested as of the grant date and 47,000 were restricted until January 15, 2005. The fair value of the restricted stock was determined to be $1.4 million and was determined based on the difference between the exercise price of the restricted stock and the fair value of the common stock on the date of grant. During the three months ended September 30, 2005, we recorded no stock-based compensation related to our former chief executive officer’s 2002 restricted stock grant. During the nine months ended September 30, 2005, we recorded less than $0.1 million related to stock-based compensation associated with our former chief executive officer’s restricted stock award grant.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The pre-tax stock-based compensation expense of $3.9 million and $5.0 million in the three and nine months ended September 30, 2005, respectively, is included in the following line items in our condensed consolidated statement of income (in thousands):
 
                 
    Three Months Ended
    Nine Months Ended
 
    September 30, 2005     September 30, 2005  
 
Cost of net revenue — service and support
  $ 6     $ 10  
Cost of net revenue — subscription
    15       25  
Cost of net revenue — product
    (1 )     (4 )
                 
Stock-based compensation expense included in cost of net revenue
    20       31  
Research and development
    2,080       1,221  
Marketing and sales
    786       1,480  
General and administrative
    1,002       2,270  
                 
Stock-based compensation expense included in operating expenses
    3,868       4,971  
                 
Total stock-based compensation expense related to stock-based equity awards
  $ 3,888     $ 5,002  
                 
 
5.   Business Combinations and Divestitures
 
Preventsys
 
In June 2006, we acquired 100% of the outstanding capital shares of Preventsys, Inc. (“Preventsys”), a creator of security risk management and automated security compliance reporting, for $4.4 million in cash and $0.4 million in direct acquisition costs, totaling $4.8 million. We have added Preventsys products to our existing portfolio of corporate security offerings.
 
Our management determined the purchase price allocation based on estimates of the fair values of the tangible and intangible assets acquired and liabilities assumed. These estimates were arrived at utilizing recognized valuation techniques. We recorded $0.2 million of goodwill (none of which is deductible for tax purposes).
 
We recorded $0.5 million for in-process research and development, which was fully expensed upon purchase because technological feasibility had not been achieved and there was no alternative use for the projects under development. The in-process research and development included the development of a new version of the security risk management system that will include increased functionality and new features, which we plan to introduce in the fourth quarter of 2006. At the date of acquisition, we estimated that 40% of the development effort had been completed and that the remaining 60% of development would take two months to complete and would cost $0.5 million. As of September 30, 2006, this development effort was complete. The intangible assets, other than goodwill, are being amortized over their useful lives of 3.0 to 5.0 years or a weighted-average period of 3.2 years. As part of the acquisition, we did not assume any outstanding stock options or warrants. A performance and retention plan, which provides for payment of up to $0.8 million through 2007, was established at the close of the acquisition. At September 30, 2006, $0.1 million had been expensed related to this performance plan and no payments had been made.
 
SiteAdvisor
 
In April 2006, we acquired 100% of the outstanding capital shares of SiteAdvisor, Inc., (“SiteAdvisor”) a web safety consumer software company that tests and rates internet sites on an ongoing basis, for $60.8 million in cash


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
and $0.2 million in direct acquisition costs, totaling $61.0 million. We have bundled the SiteAdvisor technology with our existing consumer product offerings.
 
Our management determined the purchase price allocation based on estimates of the fair values of the tangible and intangible assets acquired and liabilities assumed. These estimates were arrived at utilizing recognized valuation techniques. We recorded $50.6 million of goodwill (none of which is deductible for tax purposes). We recorded no in-process research and development related this acquisition.
 
The intangible assets, other than goodwill, are being amortized over their useful lives of 2.0 to 4.0 years or a weighted-average period of 3.0 years. As part of the acquisition, we did not assume any outstanding stock options or warrants. A performance and retention plan, which provides for payment of up to $9.2 million through 2008, was established at the close of the acquisition. At September 30, 2006, $3.3 million had been expensed and paid related to this performance plan.
 
The following is a summary of the assets acquired and liabilities assumed in the acquisition of Preventsys and SiteAdvisor as adjusted for resolution of ongoing purchase price valuation procedures (in thousands):
 
                         
    Preventsys     Site Advisor     Total  
 
Technology
  $ 3,540     $ 15,450     $ 18,990  
Other intangibles
    890       420       1,310  
Goodwill
    210       50,622       50,832  
Cash
    23       14       37  
Other assets
    661       485       1,146  
Deferred tax assets
    2,043       377       2,420  
                         
Total assets acquired
    7,367       67,368       74,735  
Accrued liabilities
    1,030       37       1,067  
Deferred revenue
    203             203  
Deferred tax liabilities
    1,750       6,269       8,019  
                         
Total liabilities assumed
    2,983       6,306       9,289  
                         
Net assets acquired
    4,384       61,062       65,446  
                         
In-process research and development expensed
    460             460  
                         
Total acquisition cost
  $ 4,844     $ 61,062     $ 65,906  
                         
 
The results of operations for both Preventsys and SiteAdvisor have been included in our results of operations since the date of acquisition. Pro forma results of operations have not been presented because the effects of these acquisitions, individually or in the aggregate, were not material to our results of operations.
 
Wireless Security Corporation
 
In June 2005, we acquired 100% of the outstanding shares of Wireless Security Corporation, a provider of home and small business wireless network security products, for $20.0 million in cash and $0.3 million of direct expenses, totaling $20.3 million. We acquired Wireless Security Corporation to continue to develop their patent-pending technology, introduce a new consumer offering and plan to utilize the technology in our small business managed solutions. The results of operations of Wireless Security Corporation have been included in our results of operations since the date of acquisition.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Our management determined the purchase price allocation based on estimates of the fair values of the tangible and intangible assets acquired and liabilities assumed. These estimates were arrived at utilizing recognized valuation techniques. We recorded $13.2 million of goodwill (none of which is deductible for tax purposes). The following is a summary of the assets acquired and liabilities assumed in the acquisition of Wireless Security Corporation as adjusted for purchase price valuation procedures (in thousands):
 
         
Technology
  $ 1,500  
Other intangibles
    300  
Goodwill
    13,247  
Cash
    131  
Other assets
    34  
Deferred tax assets
    1,870  
         
Total assets acquired
    17,082  
Accrued liabilities
    40  
Deferred tax liabilities
    711  
         
Total liabilities assumed
    751  
         
Net assets acquired
    16,331  
         
In-process research and development expensed
    4,000  
         
Total acquisition cost
  $ 20,331  
         
 
We recorded $4.0 million for in-process research and development, which was fully expensed upon purchase because technological feasibility had not been achieved. The in-process research and development included the development of the consumer wireless security product that we introduced in the third quarter of 2005. In addition, the in-process research and development included existing wireless security offerings that we plan to integrate in our small business managed solution. At the date of acquisition, we estimated that 60% of the development effort had been completed and that the remaining 40% of the development would take three months to complete. As of December 31, 2005, we had completed the remaining development efforts and costs were $0.6 million. The intangible assets, other than goodwill, are being amortized over their useful lives of 2.0 to 3.5 years or a weighted-average period of 3.2 years. As part of the acquisition, we did not assume any outstanding stock options or warrants. A performance and retention plan was established at the close of the acquisition. We expect payments under the plan to total $1.3 million. At September 30, 2006, $1.1 million had been expensed and $0.8 million had been paid related to this performance plan. The results of operations for Wireless Security Corporation prior to the acquisition would not have a material impact on our results of operations on a pro forma basis.
 
McAfee Labs
 
In April 2005, we completed the sale of our McAfee Labs assets to SPARTA, Inc. for $1.5 million and recognized a gain on the sale of $1.3 million. The carrying value of McAfee Labs assets and liabilities, which were sold in this agreement, were not significant. The operations of McAfee Labs, which are not material to our condensed consolidated results of operations, are included in income from operations through the date of sale for the three and nine months ended September 30, 2005.
 
We had no net revenue from McAfee Labs in the three months ended September 30, 2005 and $1.9 million in the nine months ended September 30, 2005, respectively.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
6.   Goodwill and Other Intangible Assets
 
We account for goodwill and other intangible assets in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” Specifically, we perform an impairment review of our goodwill on at least an annual basis and amortize all other intangible assets over their estimated useful lives.
 
Our goodwill impairment review is conducted as of October 1 of each year or earlier if indicators of impairment exist. In 2005, our analysis indicated that goodwill was not impaired. The fair value of the reporting units was estimated using the average of the present value of estimated future cash flows and of the market multiple value. We will continue to test for impairment on an annual basis and on an interim basis if an event occurs or circumstances change that would more likely than not reduce the fair value of our reporting units below their carrying amounts.
 
Goodwill by geographic region is as follows (in thousands):
 
                                         
                      Effects of
       
                      Foreign
       
    December 31,
    Goodwill
          Currency
    September 30,
 
    2005     Acquired     Adjustments     Exchange     2006  
 
North America
  $ 353,032     $ 34,160     $ (9 )   $ 315     $ 387,498  
EMEA
    49,929       10,554       (1 )     243       60,725  
Japan
    17,500       1,266       (1 )           18,765  
Asia-Pacific (excluding Japan)
    5,943       3,932                   9,875  
Latin America
    11,084       920             (171 )     11,833  
                                         
Total
  $ 437,488     $ 50,832     $ (11 )   $ 387     $ 488,696  
                                         
 
The adjustment to goodwill during the nine months ended September 30, 2006 resulted from Foundstone stock compensation and the realization of net deferred tax assets from the Foundstone acquisition in the first quarter of 2006. During the second quarter of 2006, we acquired SiteAdvisor and Preventsys. See Note 5 for additional information.
 
The components of intangible assets are as follows (in thousands):
 
                                                     
    September 30, 2006     December 31, 2005  
              Accumulated
                Accumulated
       
              Amortization
                Amortization
       
              (Including
                (Including
       
    Weighted
        Effects of
                Effects of
       
    Average
  Gross
    Foreign
    Net
    Gross
    Foreign
    Net
 
    Useful
  Carrying
    Currency
    Carrying
    Carrying
    Currency
    Carrying
 
    Life   Amount     Exchange)     Amount     Amount     Exchange)     Amount  
 
Other intangible assets:
                                                   
Purchased technologies
  4.9 years   $ 163,289     $ (110,387 )   $ 52,902     $ 141,999     $ (91,884 )   $ 50,115  
Trademarks and patents
  5.0 years     28,944       (28,783 )     161       28,944       (27,051 )     1,893  
Customer base and other intangibles
  6.7 years     64,272       (41,458 )     22,814       62,970       (34,892 )     28,078  
                                                     
        $ 256,505     $ (180,628 )   $ 75,877     $ 233,913     $ (153,827 )   $ 80,086  
                                                     
 
The aggregate amortization expenses for the intangible assets listed above totaled $8.6 million and $7.4 million in the three months ended September 30, 2006 and 2005, respectively, and $24.5 million and $23.4 million in the nine months ended September 30, 2006 and 2005, respectively.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Expected future intangible asset amortization expense as of September 30, 2006 is as follows (in thousands):
 
         
Years:
       
Remainder of 2006
  $ 8,088  
2007
    29,391  
2008
    21,555  
2009
    11,307  
2010
    4,414  
Thereafter
    1,122  
         
    $ 75,877  
         
 
7.   Restructuring Charges
 
2005 Restructuring
 
During 2005, we permanently vacated several leased facilities and recorded a $1.8 million accrual for estimated lease related costs associated with the permanently vacated facilities. The remaining costs associated with vacating the facilities are primarily comprised of the present value of remaining lease obligations, along with estimated costs associated with subleasing the vacated facility, net of estimated sublease rental income. We also recorded a restructuring charge of $0.2 million related to a reduction in headcount of 14 employees.
 
The following table summarizes our restructuring accrual established in 2005 and activity through September 30, 2006 (in thousands):
 
                                 
    Lease
    Severance
             
    Termination
    and Other
    Other
       
    Costs     Benefits     Costs     Total  
 
Balance, January 1, 2005
  $     $     $     $  
Restructuring accrual
    1,800       216       4       2,020  
Cash payments
    (1,205 )     (216 )     (4 )     (1,425 )
Effects of foreign currency exchange
    (14 )                 (14 )
Accretion
    23                   23  
                                 
Balance, December 31, 2005
    604                   604  
Cash payments
    (551 )                 (551 )
Adjustment to liability
    (23 )                 (23 )
Effects of foreign currency exchange
    (21 )                 (21 )
Accretion
    12                   12  
                                 
Balance, September 30, 2006
  $ 21     $     $     $ 21  
                                 
 
As of September 30, 2006, the remaining balance of this restructuring accrual is due within 12 months and has been classified as current accrued liabilities and will be paid through July 2007. Lease termination costs are net of estimated sublease income of $0.1 million at September 30, 2006.
 
2004 Restructuring
 
During 2004, we recorded several restructuring charges primarily due to the sale of Magic in January 2004, announced cost-savings measures, the move of our European headquarters to Ireland, permanently vacating an additional two floors in our Santa Clara headquarters building and permanently vacating several other leased facilities. During 2004, we reduced our workforce totaling 441 employees in our sales, technical support and general and administrative functions. We recorded several restructuring charges totaling $8.4 million, of which


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
$2.8 million related to North America, $4.7 million related to EMEA, $0.7 million related to Latin America, and $0.2 million to Asia-Pacific, excluding Japan.
 
We recorded an additional $10.0 million accrual in 2004 for the estimated lease related costs associated with permanently vacating two additional floors in our Santa Clara headquarters building and other leased facilities, partially offset by a $1.3 million write-off of deferred rent liability. The remaining costs associated with vacating the facility are primarily comprised of the present value of remaining lease obligations, net of estimated sublease income along with estimated costs associated with subleasing the vacated facility. The remaining costs will generally be paid over the remaining lease term ending in 2013. We also recorded a non-cash charge of $0.8 million related to asset disposals and discontinued use of certain leasehold improvements and furniture and equipment.
 
During 2004, we adjusted the restructuring accruals related to severance costs and lease termination costs recorded in 2004. We recorded a $0.3 million adjustment to reduce the EMEA severance accrual for amounts that were no longer necessary after paying out the former employees. We also recorded a $0.2 million reduction in lease termination costs due to changes in estimates related to the sublease income to be received over the remaining lease term of our Santa Clara headquarters building.
 
During 2005, we completed the move of our European headquarters to Ireland and vacated the planned space in Amsterdam. We recorded an additional $1.5 million restructuring charge for estimated lease related costs associated with the permanently vacated facilities and a $1.4 million restructuring charge for severance costs. All of these restructuring charges were related to the EMEA operating segment. During 2005, we also made adjustments to our restructuring accrual totaling $0.8 million due to a change in assumptions related to utility costs and sublease income.
 
During the first quarter of 2006, we made adjustments to our restructuring accrual totaling $0.3 million attributable to a change in assumptions related to commissions on new and existing subleases. During the second quarter of 2006, we made adjustments to our restructuring accrual totaling $0.1 million attributable to a change in assumptions related to property taxes on an existing lease.
 
During the third quarter of 2006, we decreased our restructuring accrual by $0.4 million attributable to subleased facilities in Amsterdam and Santa Clara.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The following table summarizes our restructuring accruals established in 2004 and activity through September 30, 2006 (in thousands):
 
                                 
    Lease
                   
    Termination
    Severance and
    Other
       
    Costs     Other Benefits     Costs     Total  
 
Balance, January 1, 2004
  $     $     $     $  
Restructuring accrual
    9,973       7,932       480       18,385  
Cash payments
    (579 )     (4,175 )     (63 )     (4,817 )
Adjustment to liability
    (231 )     (275 )           (506 )
Accretion
    74                   74  
                                 
Balance, December 31, 2004
    9,237       3,482       417       13,136  
Restructuring accrual
    1,454       1,382       20       2,856  
Cash payments
    (2,747 )     (4,864 )     (297 )     (7,908 )
Adjustment to liability
    (810 )           (140 )     (950 )
Effects of foreign currency exchange
    (46 )                 (46 )
Accretion
    341                   341  
                                 
Balance, December 31, 2005
    7,429                   7,429  
Cash payments
    (1,745 )                 (1,745 )
Adjustment to liability
    (21 )                 (21 )
Effects of foreign currency exchange
    44                   44  
Accretion
    203                   203  
                                 
Balance, September 30, 2006
  $ 5,910     $     $     $ 5,910  
                                 
 
As of September 30, 2006, $1.7 million of the restructuring accrual is due within 12 months and has been classified as current accrued liabilities, while the remaining balance of $4.2 million has been classified as other long-term liabilities, and will be paid through 2013. Lease termination costs are net of estimated sublease income of $5.0 million at September 30, 2006.
 
2003 Restructuring
 
In January 2003, as part of a restructuring effort to gain operational efficiencies, we consolidated operations formerly housed in three leased facilities in the Dallas, Texas area into our regional headquarters facility in Plano, Texas. The facility houses employees working in finance, information technology, legal, human resources, field sales and the customer support and telesales groups.
 
As part of the consolidation of activities into the Plano facility, we relocated employees from the Santa Clara, California headquarters site. As a result of this consolidation, in March 2003, we recorded a $15.7 million accrual for estimated lease related costs associated with permanently vacated facilities, partially offset by a $1.9 million write-off of deferred rent liability. The remaining costs associated with vacating the facility are primarily comprised of the present value of remaining lease obligations, net of estimated sublease income, along with estimated costs associated with subleasing the vacated facility. The remaining costs will generally be paid over the remaining lease term ending in 2013. We also recorded a non-cash charge of $2.1 million related to asset disposals and discontinued use of certain leasehold improvements and furniture and equipment. This restructuring charge was allocated to our North American segment.
 
During 2003, we recorded restructuring charges of $7.4 million, which consisted of $6.7 million related to a headcount reduction of 210 employees and $0.7 million related to other expenses such as legal expenses incurred in international locations in conjunction with the headcount reduction. The restructuring charge related to headcount


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
reductions was $0.9 million and $5.8 million in our North American and EMEA operating segments, respectively. The employees were primarily in the sales, product development and customer support areas. In 2003, we reversed a total of $0.7 million of restructuring accrual in EMEA that was no longer necessary after paying out substantially all accrued amounts to the former employees. We also decreased the restructuring accrual related to lease termination costs as a result of changes in estimates for sublease income and related commissions of $0.3 million.
 
In 2004, we decreased the restructuring accrual related to lease termination costs previously recorded in 2003. The adjustments decreased the liability by $0.5 million in 2004, due to favorable changes in estimates related to the sublease income to be received over the remaining lease term. Also in 2004, we recorded a $0.1 million adjustment to reduce the restructuring accrual for severance and benefits from our EMEA operating segment that would not be utilized.
 
During 2005, we decreased our restructuring accrual totaling $1.0 million due to a change in assumptions related to utility costs and sublease income.
 
During the first quarter of 2006, we made adjustments to our restructuring accrual totaling $0.1 million attributable to a change in assumptions related to commissions on existing subleases. During the second quarter of 2006, we made adjustments to our restructuring accrual totaling $0.2 million attributable to a change in assumptions related to property taxes on an existing lease. During the third quarter of 2006, we decreased our restructuring accrual by $1.1 million attributable to favorable changes in the market rates associated with our subleased space.
 
The following table summarizes our restructuring accrual established in 2003 and activity through September 30, 2006 (in thousands):
 
                                 
    Lease
                   
    Termination
    Severance and
    Other
       
    Costs     Other Benefits     Costs     Total  
 
Balance, January 1, 2003
  $     $     $     $  
Restructuring accrual
    15,734       6,692       739       23,165  
Cash payments
    (1,707 )     (6,259 )     (167 )     (8,133 )
Adjustment to liability
    (273 )     (116 )     (572 )     (961 )
Accretion
    463                   463  
                                 
Balance, December 31, 2003
    14,217       317             14,534  
Cash payments
    (1,841 )     (194 )           (2,035 )
Adjustment to liability
    (483 )     (123 )           (606 )
Accretion
    548                   548  
                                 
Balance, December 31, 2004
    12,441                   12,441  
Cash payments
    (1,279 )                 (1,279 )
Adjustment to liability
    (1,006 )                 (1,006 )
Accretion
    498                   498  
                                 
Balance, December 31, 2005
    10,654                   10,654  
Cash payments
    (1,271 )                 (1,271 )
Adjustment to liability
    (753 )                 (753 )
Accretion
    308                   308  
                                 
Balance, September 30, 2006
  $ 8,938     $     $     $ 8,938  
                                 
 
As of September 30, 2006, $2.0 million of the restructuring accrual is due within 12 months and has been classified as current accrued liabilities, while the remaining balance of $6.9 million has been classified as other


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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
long-term liabilities and will be paid through 2013. Lease termination costs are net of estimated sublease income of $8.9 million at September 30, 2006.
 
Our estimate of the excess facilities charges may vary significantly depending, in part, on factors which may be beyond our control, such as our success in negotiating with our lessor, the time periods required to locate and contract suitable subleases, and the market rates at the time of such subleases and the amount of commissions paid in association with sublease activities. Adjustments to the facilities accrual will be made if actual lease exit costs or sublease income differ from amounts currently expected. The facility restructuring charges in 2005 were primarily allocated to the EMEA, Japan, and North America operating segments and the facility restructuring charges in 2004 and 2003 were primarily in the North America operating segment.
 
8.   Line of Credit
 
We have a 14.0 million Euro credit facility with a bank. The credit facility is available on an offering basis, meaning that transactions under the credit facility will be on such terms and conditions, including interest rate, maturity, representations, covenants and events of default, as mutually agreed between us and the bank at the time of each specific transaction. The credit facility is intended to be used for short-term credit requirements, with terms of one year or less. The credit facility can be cancelled at any time. No balances were outstanding as of September 30, 2006 and December 31, 2005.
 
9.   Net Income Per Share
 
A reconciliation of the numerator and denominator of basic and diluted net income per share is provided as follows (in thousands, except per share amounts):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Numerator — Basic and diluted net income
  $ 34,090     $ 12,313     $ 104,595     $ 78,972  
                                 
Denominator — Basic
                               
Basic weighted average common stock outstanding
    159,728       166,174       161,343       164,201  
                                 
Denominator — Diluted
                               
Basic weighted average common stock outstanding
    159,728       166,174       161,343       164,201  
Effect of dilutive securities:
                               
Common stock options, restricted stock units, Employee Stock Purchase Plan shares and shares subject to repurchase(1)
    1,757       4,582       1,789       4,333  
                                 
Diluted weighted average shares
    161,485       170,756       163,132       168,534  
                                 
Net income per share — Basic
  $ 0.21     $ 0.07     $ 0.65     $ 0.48  
                                 
Net income per share — Diluted
  $ 0.21     $ 0.07     $ 0.64     $ 0.47  
                                 
 
 
(1) In the three months ended September 30, 2006 and 2005, 8.2 million and 0.7 million options and restricted stock units to purchase common stock and shares subject to repurchase, respectively, were excluded from the calculation since the effect was anti-dilutive. In the nine months ended September 30, 2006 and 2005, 8.1 million and 1.7 million options and restricted stock units to purchase common stock, respectively, were excluded from the calculation since the effect was anti-dilutive.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
 
10.   Income Taxes
 
Our consolidated provision for income taxes for the three months ended September 30, 2006 and 2005 was $16.8 million and $2.3 million, respectively, reflecting an effective tax rate of 33% and 16%, respectively. The effective tax rate for the three months ended September 30, 2006 differs from the United States federal statutory rate (“statutory rate”) primarily due to the benefit of lower tax rates in certain foreign jurisdictions offset by adjustments to tax reserves. The effective tax rate for the three months ended September 30, 2005 differs from the statutory rate primarily due to the benefit of lower tax rates in certain foreign jurisdictions and adjustments to tax reserves. Our consolidated provision for income taxes for the nine months ended September 30, 2006 and 2005 was $33.5 million and $26.6 million, respectively, reflecting an effective tax rate of 24% and 25%, respectively. The effective tax rate for the nine months ended September 30, 2006 differs from the statutory rate primarily due to the benefit of lower tax rates in certain foreign jurisdictions and adjustments to valuation allowances partially offset by adjustments to tax reserves. The effective tax rate for the nine months ended September 30, 2005 differs from the statutory rate primarily due to the benefit of lower tax rates in certain foreign jurisdictions and adjustments to valuation allowances and tax reserves.
 
11.   Business Segment Information
 
We have concluded that we have one business and operate in one industry. We develop, market, distribute and support computer security solutions for large enterprises, small and medium-sized business and consumer users, as well as resellers and distributors. Management measures operations based on our five operating segments: North America; Europe, Middle East and Africa (“EMEA”); Japan; Asia-Pacific, excluding Japan; and Latin America. Our chief operating decision maker is our chief executive officer.
 
We market and sell anti-virus and security software, hardware and services through our geographic regions. These products and services are marketed and sold worldwide primarily through resellers, distributors, systems integrators, retailers, original equipment manufacturers, internet service providers and directly by us. In addition, we offer web sites, which provide suites of online products and services personalized for the user based on the users’ personal computer configuration, attached peripherals and resident software. We also offer managed security and availability applications to corporations and governments on the internet.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Summarized financial information concerning our net revenue and income from operations by geographic region is as follows (in thousands):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Net revenue by region:
                               
North America
  $ 164,166     $ 140,983     $ 466,249     $ 414,751  
EMEA
    87,417       76,457       260,685       207,337  
Japan
    18,535       19,741       63,537       56,806  
Asia-Pacific, excluding Japan
    11,241       9,011       30,733       29,233  
Latin America
    5,704       4,097       18,713       16,940  
                                 
Net revenue
  $ 287,063     $ 250,289     $ 839,917     $ 725,067  
                                 
Income from operations by region:
                               
North America
  $ 62,369     $ 54,479     $ 170,212     $ 149,946  
Europe
    46,761       38,123       138,805       92,558  
Japan
    10,062       11,372       36,533       30,668  
Asia-Pacific, excluding Japan
    436       1,502       416       7,188  
Latin America
    2,981       1,490       10,132       9,093  
Corporate
    (85,819 )     (98,874 )     (250,665 )     (201,459 )
                                 
Income from operations
  $ 36,790     $ 8,092     $ 105,433     $ 87,994  
                                 
 
The difference between income from operations and income before taxes is reflected on the face of our condensed consolidated statements of income.
 
The corporate expenses, which are not considered attributable to any specific geographic region, are as follows (in thousands):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
General and administrative and other operating costs
  $ 39,675     $ 26,039     $ 125,007     $ 79,391  
Corporate marketing
    13,929       10,200       43,042       29,957  
Stock-based compensation
    14,864       3,888       40,656       5,002  
Amortization of purchased technology and other intangibles
    8,643       7,407       24,485       23,399  
SEC settlement charge
          50,000             50,000  
SEC and compliance costs
    7,901             11,673        
Acquisition and retention bonuses
    2,146       934       5,409       3,562  
Restructuring (benefit) charges
    (1,393 )     (10 )     (274 )     6,013  
In-process research and development
                460       4,000  
Loss (gain) on sale of assets and technology
    54       212       207       (499 )
Divestiture costs
          207             996  
Reimbursement from transition services agreement
          (3 )           (362 )
                                 
Corporate expenses
  $ 85,819     $ 98,874     $ 250,665     $ 201,459  
                                 


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
12.   Litigation
 
Settled Cases
 
In February 2007, we reached a confidential settlement of a breach of contract, fraud and bad faith lawsuit filed in June 2002 in the United States District Court, District of Massachusetts. As part of the settlement, we acquired and recorded ownership of intangible assets valued at $9.3 million with all remaining claims settled for $6.2 million, of which $5.0 million was recognized as expense in the three months ended June 30, 2006 with the balance of $1.2 million being expensed in 2004 and prior periods. The case was dismissed in March 2007.
 
On March 22, 2002, the SEC notified us that it had commenced a “Formal Order of Private Investigation” into our accounting practices. On September 29, 2005, we announced we had reserved $50.0 million in connection with the proposed settlement with the SEC and we had deposited $50.0 million in an escrow account with the SEC as the designated beneficiary. On February 9, 2006, the SEC entered the final judgment for the settlement with us. We also agreed to release $50.0 million to the SEC for the civil penalty on February 13, 2006 and certain other conditions, such as engaging independent consultants to examine and recommend improvements to our internal controls to ensure compliance with federal securities laws.
 
Open Cases
 
We have described below our material legal proceedings and investigations that are currently pending and are not in the ordinary course of business. If management believes that a loss arising from these matters is probable and can reasonably be estimated, we record the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than another. As additional information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if necessary. While we cannot predict the likelihood of future claims or inquiries, we expect that new matters may be initiated against us from time to time. The results of claims, lawsuits and investigations also cannot be predicted, and it is possible that the ultimate resolution of these matters, individually and in the aggregate, may have a material adverse effect on our business, financial condition, results of operations or cash flows.
 
Government Inquiries Relating to Historical Stock Option Practices
 
On May 23, 2006, the SEC notified us that an investigation had begun regarding our historical stock option grants. On June 7, 2006, the SEC sent us a subpoena requesting certain documents related to stock option grants from January 1, 1995 through the date of the subpoena. At or around the same time, we received a notice of informal inquiry from the United States Department of Justice, the (“DOJ”), concerning our stock option granting practices. On August 15, 2006, we received a grand jury subpoena from the U.S. Attorney’s Office for the Northern District of California relating to the termination of our former general counsel, his stock option related activities and the investigation. On November 6, 2006, we received a document request from the SEC for option grant data for McAfee.com, previously one of our consolidated subsidiaries that was a publicly traded company from December 1999 through September 2002.
 
On November 2, 2006, the investigative team met with the Enforcement Staff of the SEC in Washington D.C. and presented the initial findings of the investigation. Pursuant to discussions between the investigative team and the SEC during that meeting, the scope of the investigation was expanded to include a review of the historical McAfee.com option grants, our historical exercise activity to consider potential exercise date manipulation and post-employment arrangements with former executives.
 
We have provided documents requested by, and we are cooperating with, the SEC and DOJ. The SEC investigation is still in its preliminary stages thus we are unable to determine the ultimate outcome at this time. As such, no provision has been recorded in the financial statements for this matter.


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
Securities Cases
 
On May 31, 2006, a purported stockholder derivative lawsuit — styled Dossett v. McAfee, Inc., No. 5:06CV3484 (JF) — was filed in the United States District Court for the Northern District of California against certain of our current and former directors and officers (“Dossett”). On June 7, 2006, another purported stockholder’s derivative lawsuit — styled Heavy & General Laborers Locals 472 & 172 Pension & Annuity Funds v. McAfee, Inc., No. 5:06CV03620 (JF) — was filed in the United States District Court for the Northern District of California against certain of our current and former directors and officers (“Laborers”). The Dossett and Laborers actions generally allege that we improperly backdated stock option grants between 1997 and the present, and that certain of our current and former officers or directors either participated in this backdating or allowed it to happen. The Dossett and Laborers actions assert claims purportedly on behalf of us for, inter alia, breach of fiduciary duty, abuse of control, constructive fraud, corporate waste, unjust enrichment, gross mismanagement, and violations of the federal securities laws. On July 13, 2006, the United States District Court for the Northern District of California entered an order consolidating the Dossett and Laborers actions as In re McAfee, Inc. Derivative Litigation, Master File No. 5:06CV03484 (JF) (the “Consolidated Action”). On January 22, 2007, we moved to dismiss the complaint in the Consolidated Action on the grounds that plaintiffs lack standing to sue on our behalf because, inter alia, they did not make a pre-suit demand on our board of directors. At the parties’ request, the Court has continued on several occasions the due date for the plaintiffs’ opposition to our motion to dismiss and the date for the hearing of that motion.
 
On August 7, 2007, a new stockholders’ derivative lawsuit — styled Webb v. McAfee, Inc., No. C 07 4048 (PVT) — was filed in the United States District Court for the Northern District of California against certain of our current and former directors and officers (“Webb”). The new lawsuit generally alleges the same facts and causes of action that plaintiffs have asserted in the Consolidated Action. The plaintiff in Webb has requested that his action be consolidated with the Consolidated Action. On September 21, 2007, the Court consolidated the Webb action with the Consolidated Action.
 
On June 2, 2006, three identical lawsuits — styled Greenberg v. Samenuk, No. 106CV064854, Gordon v. Samenuk, No. 106CV064855, and Golden v. Samenuk, No. 106CV064856 — were filed in the Superior Court of the State of California, County of Santa Clara against certain of our current and former directors and officers (the “State Actions”). Like the Consolidated Action, the State Actions generally allege that we improperly backdated stock option grants between 2000 and the present, and that certain of our current and former officers or directors either participated in this backdating or allowed it to happen. Like the Consolidated Action, the State Actions assert claims purportedly on behalf of us for, inter alia, breach of fiduciary duty, abuse of control, corporate waste, unjust enrichment, and gross mismanagement. On June 23, 2006, we moved to dismiss these actions in favor of the first-filed Consolidated Action. On September 18, 2006, the Court consolidated the State Actions and denied our motions to dismiss, but stayed the State Actions due to the first-filed action in federal court. The Court has continued the stay on several occasions.
 
In December 2007, we reached a tentative settlement with the plaintiffs in the Consolidated Action and the State Actions. We have accrued $13.8 million in the condensed consolidated financial statements as of June 30, 2006 related to expected payments pursuant to the tentative settlement and expect to complete the documentation and the required approvals in late December 2007 or early in the first quarter of 2008. While we cannot predict the ultimate outcome of the lawsuits, the provision recorded in the financial statements represents our best estimate at this time.
 
Certain investment bank underwriters, our company, and certain of our directors and officers have been named in a putative class action for violation of the federal securities laws in the United States District Court for the Southern District of New York, captioned In re McAfee.com Corp. Initial Public Offering Securities Litigation, 01 Civ. 7034 (SAS). This is one of a number of cases challenging underwriting practices in the initial public offerings (“IPOs”), of more than 300 companies. These cases have been coordinated for pretrial proceedings as In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS). Plaintiffs generally allege that certain underwriters engaged


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
in undisclosed and improper underwriting activities, namely the receipt of excessive brokerage commissions and customer agreements regarding post-offering purchases of stock in exchange for allocations of IPO shares. Plaintiffs also allege that various investment bank securities analysts issued false and misleading analyst reports. The complaint against us claims that the purported improper underwriting activities were not disclosed in the registration statements for McAfee.com’s IPO and seeks unspecified damages on behalf of a purported class of persons who purchased our securities or sold put options during the time period from December 1, 1999 to December 6, 2000. On February 19, 2003 the Court issued an Opinion and Order dismissing certain of the claims against us with leave to amend. We accepted a settlement proposal on July 15, 2003.
 
We, together with the other issuer defendants and plaintiffs, entered into a stipulation of settlement and release of claims against the issuer defendants that was submitted to the Court for approval in June 2004. On August 31, 2005, the Court preliminarily approved the settlement which, among other things, was conditioned upon class certification. In December 2006, the appellate court overturned the certification of classes making it unlikely that the proposed settlement would receive final Court approval. As a result, on June 25, 2007, the Court entered an order terminating the proposed settlement. Plaintiffs have indicated that they will seek to amend their allegations and file amended complaints. It is uncertain whether there will be any revised or future settlement. Thus, the ultimate outcome, and any ultimate effect on us, cannot be precisely determined at this time.
 
Other
 
On August 17, 2006, a patent infringement lawsuit — captioned Deep Nines v. McAfee, Inc., No. 9:06CV174, (“Deep Nines litigation”) was filed in the United States District Court for the Eastern District of Texas. The lawsuit asserts that (i) several of our Enterprise products infringe on a Deep Nines’ patent, and (ii) we falsely marked certain of its products with a McAfee patent which was abandoned after its issuance. The lawsuit seeks preliminary and permanent injunctions against the sale of certain products as well as damages. We have counter-asserted that Deep Nines has infringed various McAfee patents. The Deep Nines litigation is still in its preliminary stages thus we are unable to determine the ultimate outcome at this time. However, we believe that we have meritorious defenses to this lawsuit and intend to vigorously defend against it. No provision has been recorded in the financial statements for this matter.
 
In addition, we are engaged in certain legal and administrative proceedings incidental to our normal business activities and believe that these matters will not have a material adverse effect on our financial position, results of operations or cash flows.
 
13.   Warranty Accrual and Guarantees
 
We offer warranty on our hardware and software products and record a liability for the estimated future costs associated with warranty claims, which is based upon historical experience and our estimate of the level of future costs. A reconciliation of the change in our warranty obligation as of September 30, 2006 and December 31, 2005 follows (in thousands):
 
         
    Warranty
 
    Accrual  
 
Balance, January 1, 2005
  $ 1,818  
Additional accruals
    3,514  
Costs incurred during the period
    (4,249 )
         
Balance, December 31, 2005
    1,083  
Additional accruals
    1,855  
Costs incurred during the period
    (1,977 )
         
Balance, September 30, 2006
  $ 961  
         


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MCAFEE, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
 
The following is a summary of certain guarantee and indemnification agreements as of September 30, 2006:
 
  •  Under the terms of our software license agreements with our customers, we agree that in the event the software sold infringes upon any patent, copyright, trademark, or any other proprietary right of a third-party, we will indemnify our customer licensees against any loss, expense, or liability from any damages that may be awarded against our customer. We include this infringement indemnification in all of our software license agreements and selected managed service arrangements. In the event the customer cannot use the software or service due to infringement and we can not obtain the right to use, replace or modify the license or service in a commercially feasible manner so that it no longer infringes then we may terminate the license and provide the customer a pro-rata refund of the fees paid by the customer for the infringing license or service. We have recorded no liability associated with this indemnification, as we are not aware of any pending or threatened infringement actions that are probable losses. We believe the estimated fair value of these intellectual property indemnification clauses is minimal.
 
  •  Under the terms of certain vendor agreements, in particular, vendors used as part of our managed services, we have agreed that in the event the service provided to the customer by the vendor on behalf of us infringes upon any patent, copyright, trademark, or any other proprietary right of a third-party, we will indemnify our vendor, against any loss, expense, or liability from any damages that may be awarded against our vendor. No maximum liability is stipulated in these vendor agreements. We have recorded no liability associated with this indemnification, as we are not aware of any pending or threatened infringement actions or claims that are probable losses. We believe the estimated fair value of these indemnification clauses is minimal.
 
  •  As permitted under Delaware law, we have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is not limited; however, we have director and officer insurance coverage that reduces our exposure and may enable us to recover a portion or all of any future amounts paid. We believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.
 
  •  Under the terms of our agreement to sell Magic in January 2004, we agreed to indemnify the purchaser for any breach of representations or warranties in the agreement as well as for any liabilities related to the assets prior to sale that were not included in the purchaser assumed liabilities (undiscovered liabilities). Subject to limited exceptions, the maximum potential loss related to the indemnification is $10.0 million. To date, we have paid no amounts under the representations and warranties indemnification. We have not recorded any accruals related to these agreements.
 
  •  Under the terms of our agreement to sell Sniffer in July 2004, we agreed to indemnify the purchaser for any breach of representations or warranties in the agreement as well as for any liabilities related to the assets prior to sale that were not included in the purchaser assumed liabilities (undiscovered liabilities). Subject to limited exceptions, the maximum potential loss related to the indemnification is $200.0 million. To date, we have paid no amounts under the representations and warranties indemnification. We have not recorded any accruals related to these agreements.
 
  •  Under the terms of our agreement to sell McAfee Labs assets in December 2004, we agreed to indemnify the purchaser for any breach of representations or warranties in the agreement as well as for any liabilities related to the assets prior to sale that were not included in the purchaser assumed liabilities (undiscovered liabilities). Subject to limited exceptions, the maximum potential loss related to the indemnification is $1.5 million. We have not recorded any accruals related to these agreements.
 
If we believe a liability associated with any of the aforementioned indemnifications becomes probable and the amount of the liability is reasonably estimable or the minimum amount of a range of loss is reasonably estimable, then an appropriate liability will be established.


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Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Forward-Looking Statements; Trademarks
 
This Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. These statements include, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Report on Form 10-Q are based on information available to us on the date hereof. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results to differ materially from those implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “could,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “targets,” “goals,” “projects,” “continue,” or variations of such words, similar expressions, or the negative of these terms or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Neither we nor any other person can assume responsibility for the accuracy and completeness of forward-looking statements. Important factors that may cause actual results to differ from expectations include, but are not limited to, those discussed in “Risk Factors” in Part II, Item 1A in this quarterly report. We undertake no obligation to revise or update publicly any forward-looking statements for any reason. We encourage you to read these sections carefully.
 
This report includes registered trademarks and trade names of McAfee and other corporations. Trademarks or trade names owned by McAfee and/or our affiliates include: “McAfee,” “Network Associates,” “ McAfee Security,” “ePO,” “ePolicy Orchestrator,” “SpamKiller,” “VirusScan,” “Avert,” “IntruShield,” “Entercept,” and “Foundstone.”
 
Overview and Executive Summary
 
We are a leading dedicated security technology company that secures systems and networks from known and unknown threats around the world. We empower home users, businesses, government agencies, service providers and our partners with the ability to block attacks, prevent disruptions, and continuously track and improve their security.
 
We apply business discipline and a pragmatic approach to security that is based on four principles of security risk management (identify and prioritize assets; determine acceptable risk; protect against threats; enforce and measure compliance). We incorporate some or all of these principles into our solutions. Our solutions protect systems and networks, blocking immediate threats while proactively providing protection from future threats. We also provide software to manage and enforce security policies for organizations of any size. Finally, we incorporate expert services and technical support to ensure a solution is actively meeting our customers’ needs. These integrated solutions help our customers solve problems, enhance security and reduce costs.
 
We have one business and operate in one industry, developing, marketing, distributing and supporting computer security solutions for large enterprises, governments, small and medium-sized business and consumers either directly or through a network of qualified partners. We derive our revenue and generate cash from customers from primarily three sources (i) service and support revenue, which includes maintenance, training and consulting revenue, (ii) subscription revenue, which includes revenue from subscription-based offerings and (iii) product revenue, which includes hardware and perpetual license revenue. We continue to focus our efforts on building a full line of complementary network and system protection solutions. During the nine months ended September 30, 2006, we acquired SiteAdvisor and Preventsys to enhance and complement our current offerings. The acquisition of SiteAdvisor in April 2006 significantly enhances our internet security solutions. Our system security management and vulnerability management capabilities were further advanced with the acquisition of Preventsys in June 2006.
 
We evaluate our consolidated financial performance utilizing a variety of indicators. Two of the primary indicators that we utilize are total net revenue and net income. As discussed more fully below, our net revenue in the three and nine months ended September 30, 2006 grew by 15% and 16%, respectively, compared to the same prior-year period. We believe net revenue is a key indicator of the growth and health of our business. Our net revenue is directly impacted by corporate information technology, government and consumer spending levels. We believe net


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income is a key indicator of the profitability of our business. Our net income for the three and nine months ended September 30, 2006 grew by 177% and 32%, respectively, compared to the same prior-year period.
 
The following discussion and analysis should be read in conjunction with the “Explanatory Note Regarding Restatement” and the audited consolidated financial statements and the notes thereto, included in our annual report on Form K for the year ended December 31, 2006 filed simultaneously with this quarterly report Form 10-Q. The following discussion and analysis also reflects the restatement of financial results, which is more fully described in Note 3, “Restatement of Condensed Consolidated Financial Statements and Special Committee and Company Findings” to the condensed consolidated financial statements included in this quarterly report Form 10-Q.
 
Special Committee Investigation of Historical Stock Option Practices
 
We became aware of potential issues with respect to our historical stock option grants in May 2006 after the Center for Financial Research and Analysis (“CFRA”) released a report titled “Options Backdating — Which Companies are at Risk?” This report concluded there was a high probability that we backdated option grants from 1997 to 2002, based on stock price trends around certain grant dates. Upon becoming aware of the CFRA report, management immediately commenced a voluntary internal review involving the examination of certain stock option grants. In May 2006, management notified our board of directors that an internal review was in process in response to the analysis in the CFRA report.
 
On May 25, 2006, we announced we had voluntarily initiated a review of our stock option grant practices during the late 1990s and early 2000s timeframe. Management discovered irregularities in certain historical stock option grants during its initial internal review, and discussed these findings with our board of directors in late May 2006. Our board of directors established a special committee of independent directors to review our stock option granting practices and related accounting. The special committee was assisted by independent counsel and forensic accountants (collectively referred to as “the investigative team”). The investigation primarily focused on the processes used to establish option exercise prices and obtain approvals of stock option grants and post-employment option modifications. The investigation, which covered the time period from January 1, 1995 through March 31, 2006, included a review of our historical stock option practices, accounting policies, accounting records, supporting documentation, email communications and other documentation, as well as interviews with a number of current and former directors, officers and employees.
 
On October 10, 2006, the special committee presented its initial findings to the board of directors. As part of this presentation, the special committee communicated to our board of directors information concerning irregularities with respect to the new hire option grant of our former president. Following that presentation, our chairman and chief executive officer retired and our president was terminated. The board determined this termination was a termination for cause. In November 2006, certain members of the investigative team met with the staff of the SEC’s Division of Enforcement and presented the initial findings of the investigation. As a result of that meeting, the scope of the investigation was expanded to include a review of the: (i) historical option grants by McAfee.com, (ii) historical exercise activity with respect to our option grants to consider potential exercise date manipulation and (iii) post-employment arrangements with former executives.
 
The special committee investigation was completed in November 2007. The special committee concluded that there were both qualitative issues and accounting and administrative errors relating to our stock option granting process. In this regard, the special committee concluded that certain former members of management had acted inappropriately, giving rise to qualitative concerns. The qualitative concerns included the following:
 
  •  in the case of our former general counsel, he and a former member of management participated in intentionally modifying one of the former general counsel’s stock option grants so as to create a lower exercise price, and the former general counsel failed to disclose this unauthorized change to the board of directors prior to late May 2006;
 
  •  in some instances, former members of management drafted corporate records, including employment documentation, board and compensation committee meeting minutes and actions by unanimous written consent, with the benefit of hindsight so as to choose measurement dates giving more favorable exercise


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  prices, moreover certain of these documents were used by us in making accounting determinations with respect to stock-based compensation;
 
  •  during the course of the investigation, certain former members of management did not provide completely accurate or consistent information and in one case, provided documentation to the special committee that the special committee determined was intentionally altered; and
 
  •  certain former members of senior management did not display the appropriate oversight and “tone at the top” expected by the board of directors.
 
In addition to the foregoing, the special committee concluded that certain stock option awards were previously accounted for using incorrect measurement dates because: (i) we had previously determined accounting measurement dates for certain stock option awards incorrectly, and, in some instances, such dates were chosen with the benefit of hindsight so as to intentionally, and not inadvertently or as a result of administrative error, give more favorable exercise prices, (ii) the key terms for a substantial portion of the grants in an annual merit grant had been determined with finality prior to the original measurement date, with a reduction in the exercise price on the original measurement date, which represented a repricing, (iii) original accounting measurement dates occurred prior to approval dates, (iv) original accounting measurement dates occurred prior to employment commencement dates, (v) approval and employment commencement date documentation was incorrect or inconsistent and (vi) certain director grants contained clerical errors.
 
In each instance, we revised the accounting measurement date after considering all available relevant evidence. The special committee concluded that there were procedures in place after April 2005 to provide reasonable assurance that stock options were granted at the fair market value of the stock price on the grant date.
 
The special committee determined that we did not previously record appropriate charges associated with certain option modifications. These modifications occurred upon the termination of an employee and, in some cases, provided for the extension of the post-termination time period in which options could be exercised and allowed for the continued vesting of options subsequent to the former employee’s termination date. These option modifications occurred from 1998 to 2004.
 
The investigation also identified an error in our accounting for options historically accounted for as variable awards. This error was comprised of our application of transition guidance provided by FIN 44, which required us to account for repriced options as variable awards beginning July 1, 2000.
 
To correct our past accounting for stock options under Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” (“APB 25”), we recorded additional pre-tax, non-cash, stock-based compensation expense totaling $137.4 million, consisting of $3.4 million ($2.5 million, net of tax) for the year ended December 31, 2005, and $134.0 million ($87.7 million, net of tax) for the periods 1995 through 2004. Of the $3.4 million stock-based compensation expense recorded in 2005, we recorded $0.9 million and $2.9 million respectively for the three and nine months ended September 30, 2005. We also expect to amortize, from July 1, 2006, an additional $0.1 million of such pre-tax charges under Statement of Financial Accounting No. 123(R) “Share-Based Payment” (“SFAS 123(R)”), in periods through December 31, 2009.
 
We have incurred material expenses in 2006 as a direct result of the investigation into our stock option grant practices and related accounting. These costs primarily related to professional services for the investigation, legal, accounting and tax guidance. In addition, we have incurred costs related to litigation, the investigation by the SEC, the grand jury subpoena from the U.S. Attorney’s Office for the Northern District of California and the preparation and review of our restated consolidated financial statements. We expect that we will continue to incur costs associated with these matters and that we may be subject to certain fines and/or penalties resulting from the findings of the investigation. We cannot reasonably estimate a range of fines and/or penalties, if any, that might be incurred as a result of the investigation.


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Critical Accounting Policies
 
Critical Accounting Policies and Estimates
 
Effective September 2006, we changed our policy related to consumer incentive rebates and on January 1, 2006, we adopted a new policy related to stock-based compensation pursuant to our adoption of SFAS 123(R), as more fully described below. We have also described our policy for the restatement of our stock-based compensation. Other than these changes, we have made no significant changes in our critical accounting policies and estimates during the nine months ended September 30, 2006 as compared to the critical accounting estimates disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our annual report on Form 10-K for the year ended December 31, 2005.
 
Restatement of Stock-based Compensation
 
We previously applied APB 25 and its related interpretations and provided the required pro forma disclosure under SFAS 123 through the year ended December 31, 2005. Under APB 25, non-cash, stock-based compensation expense should have been recognized for any option with intrinsic value on the accounting measurement date. An option is deemed to have intrinsic value when the exercise price is below the market price of the underlying stock on the accounting measurement date. Certain of our stock options were incorrectly measured prior to the completion of required approvals and granting actions. After revising the measurement date for these options, certain options were deemed to have intrinsic value and, as a result, there should have been stock-based compensation expense for each of these options under APB 25 equal to the number of options multiplied by their intrinsic value on the revised measurement date. That expense should have been amortized over the vesting period of the option. Starting in the year ended December 31, 2006, we adopted SFAS 123(R). As a result, for 2006, the additional stock-based compensation expense required to be recorded for these stock options was equal to the fair value on the revised measurement date for options vesting in 2006 or later. We did not record the additional stock-based compensation expense under APB 25 or SFAS 123(R) related to these stock options in our previously issued financial statements.
 
As a result of the investigation, we determined that the original measurement dates we used for accounting purposes for certain option and restricted stock grants to employees from April 1995 through April 2005 were not appropriate, and, in some instances such dates were chosen with the benefit of hindsight so as to give more favorable exercise prices. From January 2005 through March 2005, we had no revised measurement dates. Other than director grants with clerical errors, we had no revised measurement dates from May 2005 through March 2006.
 
We revised measurement dates and recorded stock-based compensation expense due to the following errors, certain of which are the result of incorrect measurement dates from the use of hindsight to select more favorable exercise prices:
 
  •  annual merit grant allocation and/or approval not complete on the original measurement dates,
 
  •  the key terms for a substantial portion of the grants in an annual merit grant had been determined with finality prior to the original measurement date, with a reduction in the exercise price on the original measurement date, which represented a repricing,
 
  •  original accounting measurement dates prior to approval dates,
 
  •  original accounting measurement dates prior to employment commencement dates,
 
  •  incorrect or inconsistent approval and employment commencement date documentation,
 
  •  clerical errors in director grants,
 
  •  correction of accounting errors, primarily options historically accounted for as variable awards, or
 
  •  post-employment option modifications previously not recorded.
 
After reviewing available relevant documentation, a general hierarchy of documentation was considered when establishing the revised measurement date for accounting purposes. The hierarchy was considered in evaluating


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each grant on an individual basis based on the particular facts and circumstances. The documentation considered, when available, was:
 
  •  Minutes of board of directors, compensation committee and/or delegated committee:  Approved minutes represent the best available evidence of grant approval. The investigative team was able to validate the occurrence of board of director and compensation committee meetings on the stated dates in most cases through director payment records, billing records of outside legal counsel who attended the meetings or a signature on the minutes by external legal counsel.
 
  •  Unanimous Written Consents (“UWCs”):  UWCs have an effective date that represents the date grants were approved by the compensation committee or delegated committee. For compensation committee UWCs in 2004 and 2005, we were not able to rely on certain UWC effective dates due to other evidence indicating that certain grants were approved subsequent to the UWC effective date. We were able to locate other evidence to determine the approval date of these grants, such as approval documentation in emails and evidence of the date UWCs were signed. There were no options granted in compensation committee UWCs from 2001 through 2003. For UWCs prior to 2001, compensation committee members had historically resolved to grant options, and such action was then documented in a UWC, with the effective date being the date the granting action was taken. With the exception of one UWC, no evidence was located that contradicted a UWC effective date as the approval date for any compensation committee grants prior to 2001. We have therefore placed reliance on the compensation committee UWCs prior to 2001.
 
  •  Option allocations for annual merit grants:  Allocations may be evidenced by signed and dated hard-copy schedules or electronic spreadsheets that list the employees and number of options granted to each employee. Email communications to which the electronic spreadsheets were attached also provided evidence of the date allocations were completed. We were able to validate whether allocation schedules were substantially complete by confirming individual grants in the allocation files to the actual grants reflected in our stock administration database. There were minimal changes to allocations after the date we determined that they were substantially complete.
 
  •  Database dates:  The database date (“DB date”) indicates the date an option grant was entered into the stock administration database. Entry into the stock administration database represents the best evidence of a date no later than when the grants were determined with finality.
 
     DB dates were applied on a grant by grant basis, resulting in multiple measurement dates for annual merit grants for which there were multiple DB dates.
 
  •  Correspondence or other written documentation:  Written communication was in the form of grant notification letters from the human resource or stock administration departments stating the key terms of a grant, stock option agreements, employment offer or promotion letters stating the number of options to be granted and automated email notifications from human resources or our third-party broker. Written communication was primarily used to corroborate other available evidence used to determine measurement dates for annual merit grants, with the assumption that communication would not occur until the terms of the grants were determined with finality.
 
APB 25 defines the measurement date as the first date upon which the number of options and exercise price are known. Our determination of the revised measurement date was based on our assessment that a grant was determined with finality and was no longer subject to change. Such determinations involved judgment and careful evaluation of all relevant facts and circumstances for each grant. In light of the significant judgment used in establishing revised measurement dates, alternate approaches to those used by us could have resulted in different stock-based compensation expense than recorded by us in the restatement. While we considered various alternative approaches, we believe that the approaches we used were the most appropriate under the circumstances. We conducted a sensitivity analysis to assess how the restatement adjustments could have changed under alternative methodologies for determining measurement dates for stock option grants from 1995 through 2005. The following are the judgments involved in determining revised measurement dates.


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Date of Execution of UWC
 
For certain grants, we were unable to locate contemporaneous documentation confirming that a compensation committee meeting, or a meeting by a delegated level of authority, occurred on the effective date of the UWC. For compensation committee UWCs with effective dates in 2004 and 2005, which cover 0.4 million options, we discovered instances in which documented approval actually occurred subsequent to the UWC effective date. The revised measurement date in these instances is the documented approval date. There were no options granted in compensation committee UWCs from 2001 through 2003. For UWCs prior to 2001, which cover 9.4 million options, and all delegated committee UWCs, the compensation or delegated committee resolved to grant options, and later documented such resolutions in UWCs, with an effective date which reflected the date of the granting action. With the exception of one UWC, no evidence was located that contradicted a UWC effective date as the approval date for any compensation committee grants prior to 2001. For UWCs prior to 2001, we did not locate any evidence that caused us to question the reliability of UWCs, outside the one instance discussed above. We have therefore placed reliance on the compensation committee UWCs prior to 2001.
 
There were also instances where UWCs were not signed during the period prior to 2001. These unsigned UWCs were located in our minute books. We did not locate any evidence that contradicted the effective dates of unsigned UWCs as the approval date, therefore, we have placed reliance on unsigned UWCs in this period.
 
Had we used DB dates where available, we would have recognized an additional $4.8 million in stock-based compensation expense from 1999 through 2004. Had we used the highest closing stock price during the one-month period subsequent to the UWC effective date for grants for which DB dates are not available, we would have recognized an additional $26.6 million in stock-based compensation expense from 1995 through 2004.
 
Annual Merit Grants
 
For annual merit grants, a pool of options was allocated among non-executive employees, and in certain years for executives as well, in conjunction with their annual performance review. We located evidence that allocations were completed and grants determined with finality on a business unit/geographic region basis, resulting in multiple measurement dates for annual merit grants. For grants not included in complete allocations, we have selected the DB date as the revised measurement date as the terms of grants were determined with finality on or prior to the database entry dates.
 
The 1999 annual merit grant consisted of 2.1 million options which had an original measurement date of April 20, 1999. We determined that the key terms were determined with finality for approximately 1.6 million of these options in March 1999, and that the exercise price was reduced to $11.06 on April 20, 1999, which represents a repricing. As the stock price on the revised measurement date in March 1999 exceeded the exercise price, there was grant date intrinsic value, which is being recognized over the requisite service period. Additionally, the options are accounted for as variable awards in accordance with FIN 44 due to the repricing on April 20, 1999.
 
For annual merit grants for which we located evidence of substantially completed allocations, not all grants were included in allocations. These grants were revised to DB dates. If these grants had been revised to the date of the last substantially complete allocation for the respective annual merit grant, we would have recognized $1.6 million less in stock-based compensation expense from 1998 through 2005.
 
Incorrect or Inconsistent Approval and Employment Commencement Date Documentation
 
We identified certain grants to executives and directors for which the approval documentation and/or employment commencement date documentation were incorrect or inconsistent. These grants were assigned an original grant date other than the approval date, or prior to the actual employment commencement date. In these instances, the occurrence of the meeting on the stated date in the approval documentation was validated based on director payment records or the billing records of external legal counsel who attended the meeting. We were able to determine the correct employment commencement date based on human resources and payroll records. The actual meeting date for the approval of such grants, or employment commencement date if later, was used as the revised measurement date.


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Lack of Approval Documentation
 
For grants totaling 2.2 million options, primarily in the years from 1996 through 2001, we were unable to locate approval documentation. In these instances, we examined available evidence, including email communications and grant communication letters, to determine the revised measurement date. We also performed an analysis to determine whether these grants were recorded on dates where the stock price was at a low point, which would result in a lower exercise price. It does not appear that these grants were priced opportunistically, and we did not discover any evidence that contradicted the original grant date. Therefore, we did not revise the measurement dates for these grants.
 
If we had used the stock administration DB date, which was available only for grants subsequent to June 1998, the additional stock-based compensation expense would have been $2.5 million from 1998 through 2005. If we had used the highest stock price within 30 days subsequent to the original grant date, the additional stock-based compensation expense would have been $4.2 million from 1995 through 2005.
 
Communication Dates
 
For certain grants, we were unable to locate evidence of communication of the key terms (i.e., number of options and exercise price) to the employee for certain grants. We did not discover any evidence during the investigation that the communication of key terms was intentionally delayed, nor were there any significant delays. In the absence of evidence to the contrary, we have concluded that communication of the key terms occurred prior to or within a reasonable period of time of the completion of all required granting actions.
 
We believe that our methodology, based on the best available evidence, results in reasonable measurement dates for our stock option grants. However, we also conducted a sensitivity analysis to assess how the restatement adjustments would have varied based on different measurement date methodologies. Based on the alternative measurement dates discussed above, the total additional stock-based compensation expense resulting from grant date intrinsic value could have ranged from $96.0 million to $128.4 million.
 
Stock-Based Compensation Expense
 
On January 1, 2006, we adopted SFAS 123(R), which is a revision of SFAS No. 123 “Accounting for Stock-Based Compensation” (“SFAS 123”), and supersedes APB 25. SFAS 123(R) requires the measurement and recognition of compensation expense for all stock-based payment awards made to our employees and directors based on the estimated fair values of the awards on their grant dates. Our stock-based awards include stock options, restricted stock awards, restricted stock units and our ESPP.
 
In the three and nine months ended September 30, 2006, we recognized stock compensation expense of $14.9 million and $40.7 million, respectively. Prior to our adoption of SFAS 123(R), we applied the intrinsic value method set forth in APB 25 to calculate the compensation expense for stock-based awards. During the three and nine months ended September 30, 2005, we recognized stock-based compensation expense of $3.9 million and $5.0 million, respectively, related to grant date intrinsic value resulting from revised accounting measurement dates, the exchange of McAfee.com options in 2002, the re-pricing of options in 1999 and restricted stock awards. See Note 4 to the condensed consolidated financial statements for additional information.
 
We use the Black-Scholes model to estimate the fair value of our option awards and employee stock purchase rights issued under the ESPP. The Black-Scholes model requires estimates of the expected term of the option, as well as future volatility and the risk-free interest rate.


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For options issued during the three and nine months ended September 30, 2006, we estimated the weighted-average fair value to be $9.41 and $10.51, respectively. For employee stock purchase rights issued during the nine months ended September 30, 2006, we estimated the weighted-average fair value to be $6.11. The key assumptions that we used to calculate this value are provided below:
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Stock option grants:
                               
Risk free interest rate
    4.9 %     4.0 %     4.8 %     3.9 %
Weighted average expected lives (years)
    5.9       4.0       5.6       4.0  
Volatility
    34.0 %     49.5 %     38.4 %     55.6 %
Dividend yield
                       
ESPP:
                               
Risk free interest rate
            3.5 %     4.6 %     3.1 %
Weighted average expected lives (years)
            0.5       0.5       1.1  
Volatility
            38.0 %     38.0 %     40.0 %
Dividend yield
                         
 
During the three months ended September 30, 2006, we did not have any ESPP grants.
 
We derive the expected term of our options through a lattice model that factors in historical data on employee exercise and post-vesting employment termination behavior. The risk-free rate for periods within the expected life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. Since January 1, 2006, we have used the implied volatility of options traded on our stock with a term of six months or more to calculate the expected volatility of our option grants. Prior to that time, the expected volatility was based solely on the historical volatility of our stock. We have not declared any dividends on our stock in the past and do not expect to do so in the foreseeable future.
 
The assumptions that we have made represent our management’s best estimate, but they are highly subjective and inherently uncertain. If management had made different assumptions, our calculation of the options’ fair value and the resulting stock-based compensation expense could differ, perhaps materially, from the amounts recognized in our financial statements. For example, if we increased the assumption regarding our stock’s volatility for options granted during the three and nine months ended September 30, 2006 by 10%, our stock-based compensation expense would increase by $0.4 million and $1.9 million, respectively, net of expected forfeitures. This increased expense would be amortized over the options’ 4.0 year vesting period. Likewise, if we increased our assumption of the expected lives for options granted during the three and nine months ended September 30, 2006 by one year, our stock-based compensation expense would increase by $0.2 million and $1.1 million, respectively, net of expected forfeitures. This increased expense would be amortized over the options’ 4.0 year vesting period.
 
In addition to the assumptions used to calculate the fair value of our options, we are required to estimate the expected forfeiture rate of all stock-based awards and only recognize expense for those awards we expect to vest. The stock-based compensation expense recognized in our condensed consolidated statement of operations for the three and nine months ended September 30, 2006 has been reduced for estimated forfeitures. If we were to change our estimate of forfeiture rates, the amount of stock-based compensation could differ, perhaps materially, from the amount recognized in our financial statements. For example, if we had decreased our estimate of expected forfeitures by 50% at September 30, 2006, our stock-based compensation expense for the three and nine months ended September 30, 2006, net of expected forfeitures, would have increased by $4.1 million and $4.1 million, respectively. This decrease in our estimate of expected forfeitures would increase the amount of expense for all unvested stock options, restricted stock units, and restricted stock awards, and employee stock purchase rights that have not yet been recognized by $15.1 million at September 30, 2006, net of expected forfeitures, amortized over a weighted-average period of 2.5 years.


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Sales Incentives and Sales Returns
 
We reduce revenue for estimates of sales incentives and sales returns. We offer sales incentives, including channel rebates, marketing funds and end-user rebates for products in our corporate and consumer product lines. Additionally, end-users may return our products, subject to varying limitations, through distributors and resellers or to us directly for a refund within a reasonably short period from the date of purchase. We estimate and record reserves for sales incentives and sales returns based on our historical experience. In each accounting period, we must make judgments and estimates of sales incentives and potential future sales returns related to current period revenue. These estimates affect our net revenue line item on our statement of income and affect our net accounts receivable, deferred revenue and accrued liabilities line items on our condensed consolidated balance sheet. These estimates affect all of our operating geographies. Effective September 2006, in connection with the launch of our new consumer products, all consumer incentive rebates are recorded ratably as an offset to consumer revenue, which is recognized ratably, over the term of the subscription.
 
At September 30, 2006, our allowance for sales returns and incentives was $37.8 million compared to $32.0 million at December 31, 2005. If our allowance for sales returns and incentives were to increase by 10%, or $3.8 million, our net revenue would decrease by approximately $2.9 million in the nine months ended September 30, 2006 and our deferred revenue would decrease by approximately $0.9 million as of September 30, 2006.
 
Results of Operations
 
Net Revenue
 
The following table sets forth, for the periods indicated, a year-over-year comparison of the key components of our net revenue:
 
                                                                 
    Three Months Ended
          Nine Months Ended
       
    September 30,     2006 vs. 2005     September 30,     2006 vs. 2005  
    2006     2005     $     %     2006     2005     $     %  
          (As restated)                       (As restated)              
    (Dollars in thousands)  
 
Net revenue:
                                                               
Service and support
  $ 160,388     $ 141,932     $ 18,456       13 %   $ 466,298     $ 410,591     $ 55,707       14 %
Subscription
    110,822       90,891       19,931       22       299,197       236,797       62,400       26  
Product
    15,853       17,466       (1,613 )     (9 )     74,422       77,679       (3,257 )     (4 )
                                                                 
Total net revenue
  $ 287,063     $ 250,289     $ 36,774       15 %   $ 839,917     $ 725,067     $ 114,850       16 %
                                                                 
Percentage of total net revenue:
                                                               
Service and support
    56 %     57 %                     55 %     56 %                
Subscription
    39       36                       36       33                  
Product
    5       7                       9       11                  
                                                                 
Total net revenue
    100 %     100 %                     100 %     100 %                
                                                                 
 
The increase in net revenue in the three months ended September 30, 2006 compared to the three months ended September 30, 2005 reflected (i) a $22.5 million increase in our corporate business and (ii) a $14.3 million increase in our consumer business. The increase in net revenue in the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005 reflected (i) a $79.3 million increase in our corporate business and (ii) a $37.5 million increase in our consumer business. This increase was slightly offset by a $1.9 million decrease attributable to McAfee Labs, which was sold in April 2005.
 
Net revenue from our corporate business increased during the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005 primarily due to (i) increased corporate spending on McAfee security products and (ii) increased revenue from our Foundstone and Intrushield product lines. Net revenue from our Intrushield and Foundstone product lines increased $7.8 million and $5.8 million,


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respectively, in the three months ended September 30, 2006 and $20.6 million and $12.7 million in the nine months ended September 30, 2006, respectively. Net revenue from our consumer market increased during the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005 primarily due to (i) online subscriber growth due partly to an increase in our customer base and expansion to additional countries, (ii) increased online renewal subscriptions and (iii) increased royalty revenue from our strategic channel partners, such as Gateway, AOL and Dell.
 
Net Revenue by Geography
 
The following table sets forth, for the periods indicated, net revenue in each of the five geographic regions in which we operate:
 
<
                                                                 
    Three Months Ended
                         
    September 30,     2006 vs. 2005     Nine Months Ended September 30,     2006 vs. 2005  
    2006     2005     $     %     2006     2005     $     %  
          (As restated)                       (As restated)              
    (Dollars in thousands)  
 
Net revenue: