UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

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, 2004

OR

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

For the transition period from _____ to _____

Commission File number # 000-24547

Scientific Learning Corporation

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

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ       No ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨      No þ

The number of shares of the Registrant’s Common Stock, $.001 par value per share, outstanding at December 31, 2004 was 16,659,192.

EXPLANATORY NOTE

     This filing includes an unaudited restated balance sheet as of December 31, 2003, unaudited restated statements of operations for the three and nine month periods ended September 30, 2003 and unaudited restated statements of cash flows for the nine months ended September 30, 2003. The restatement of these financial statements principally relates to a correction in our method of revenue recognition for most of our K-12 school contracts. This correction has resulted in changes to our previously reported revenues in all periods included in this Report through June 30, 2004 and to deferred revenues as of December 31, 2003. This correction is more fully described in Note 3 to the Condensed Financial Statements.

     We have indicated on the cover page of this quarterly report that we have filed the required reports for the prior 12 months because this Report on Form 10-Q, which is late, brings us current in making our filings.

     The unaudited financial statements contained in this Form 10-Q have been prepared on the basis of all information of which we are presently aware. We believe that the unaudited financial statements fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report.

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SCIENTIFIC LEARNING CORPORATION

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

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PART I. FINANCIAL INFORMATION

Item 1. Condensed Financial Statements

CONDENSED BALANCE SHEETS
(In thousands)
(Unaudited)

See accompanying notes to condensed financial statements.

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SCIENTIFIC LEARNING CORPORATION

See accompanying notes to condensed financial statements.

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SCIENTIFIC LEARNING CORPORATION

See accompanying notes to condensed financial statements.

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Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies

Description of Business

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

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. To the extent that there are material differences between these estimates and actual results, our financial statements could be affected.

Interim Financial Information

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

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

Revenue Recognition

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

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

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

Revenue from the licensing of software is recognized as follows: 1) for licenses purchased with Progress Tracker, because the Company has not established VSOE for Progress Tracker, revenue is recognized ratably over the contractual life of the longest undelivered element, typically support and the period of Progress Tracker access, 2) for individual participant licenses, revenue is recognized over the average duration of the product’s use, typically 6 weeks; 3) for perpetual licenses that are not purchased with Internet-based services, revenue is recognized at the later of product shipment or the contract start date, provided that the other criteria stated above are met, and 4) for term licenses revenue is recognized ratably over the license term.

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Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

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

Other Assets

Other assets consist of the following (in thousands):

Accrued restructuring costs

In October 2003 the Company entered into an agreement with its landlord to terminate the lease for its Oakland headquarters and commence a new lease agreement for a reduced amount of space in the same building. This reduction in space is expected to decrease total lease payments by approximately $6.5 million (net of lease termination fees described below) through 2008. Under these agreements the Company paid an increased security deposit of $550,000 and lease termination fees totaling $1,810,000 through September 30, 2004. The balance of the lease termination fee, $440,000 will be paid in equal monthly installments through December 31, 2004. The term of the new lease agreement expires December 31, 2013.

The following table sets forth the restructuring activity during the quarter ended September 30, 2004

Net Income Per Share

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

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Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

Stock-Based Compensation

The Company has elected to use the intrinsic value method in accounting for its employee stock options because the alternative, fair value accounting requires the use of option valuation models that were not developed for use in valuing employee stock options. Under the intrinsic value method, when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.

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

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

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

2. Comprehensive Income

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

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Notes to Condensed Financial Statements

3. Restatement

The Company’s previously reported balance sheet at December 31, 2003 and the statements of operations for the quarter and nine months ended September 30, 2003 and the statement of cash flows for the nine months ended September 30, 2003 have been restated to correct the Company’s method of accounting for the recognition of revenue from most of its K-12 school contracts.

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

Perpetual licenses sold requiring Internet access to function:

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

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

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

Term-based licenses sold with other elements:

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

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

The following tables summarize the changes to the balance sheet at December 31, 2003 and the statements of operations for the three and nine months ended September 30, 2003.

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

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