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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended December 31, 2004

For the transition period from              to              .

Commission file number 000-23783

MICROMUSE INC.

(Exact name of registrant as specified in its charter)

139 TOWNSEND STREET

SAN FRANCISCO, CALIFORNIA 94107

(415) 538-9090

(Address, including ZIP code, and telephone number)

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

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

79,129,711 shares of Common Stock, $0.01 par value, were outstanding as of January 31, 2005

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MICROMUSE INC.

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PART I - FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

MICROMUSE INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

See accompanying notes to the condensed consolidated financial statements

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MICROMUSE INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

See accompanying notes to the condensed consolidated financial statements

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MICROMUSE INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See accompanying notes to the condensed consolidated financial statements

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MICROMUSE INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 1. Basis of Presentation

The condensed consolidated financial statements are the unaudited historical financial statements of Micromuse Inc. and subsidiaries (the “Company”) and reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary for a fair presentation of interim period results. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K as filed with the Securities and Exchange Commission on December 14, 2004. The September 30, 2004 condensed consolidated balance sheet included herein was derived from audited financial statements, but does not include all disclosures, including notes, required by generally accepted accounting principles.

The results of operations for the current interim period are not necessarily indicative of results to be expected for the entire current fiscal year or other future interim periods.

Reclassifications

Certain reclassifications, none of which affected net income, have been made to prior amounts to conform to the current year presentation.

Use of Estimates

The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, allocation of technical services department costs among expense categories, provision for doubtful accounts and sales returns, fair value of investments, fair value of acquired intangible assets and goodwill, useful lives of intangible assets and property and equipment, income taxes, restructuring costs, and contingencies and litigation, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ significantly from the estimates made by management with respect to these items and other items that require management’s estimates. The costs of our technical services department are allocated between cost of revenue, sales and marketing expenses, and research and development expenses based upon an estimate of the time spent by the technical services employees in various departments and the areas benefited by that time. Total costs of the technical services department were $5.8 million and $6.2 million for the quarter ended December 31, 2004 and 2003, respectively. The allocation rates applied to these department costs were 32% to cost of revenue, 60% to sales and marketing, and 8% to research and development in the quarter ended December 31, 2004, 20% to cost of revenue, 76% to sales and marketing, and 4% to research and development in the quarter ended December 31, 2003. The allocation estimate is subject to change and, if changed, will impact the allocation of expenses in the statement of operations but will not impact net income or loss.

Cash Equivalents

The Company considers all highly liquid instruments with an original maturity of three months or less to be cash equivalents.

Earnings Per Share

Basic per share amounts are calculated using the weighted-average number of common shares outstanding during the period. Diluted per share amounts are calculated using the weighted-average number of common shares outstanding during the period and, when dilutive, the weighted-average number of potential common shares from the exercise of outstanding options and warrants to purchase common stock using the treasury stock method. Excluded from the computation of diluted income per share for the quarter ended December 31, 2004 were options to acquire 14.4 million shares of common stock because their effect would be anti-dilutive. Also excluded from the computation of the diluted loss per share for the quarter ended December 31, 2004, was a warrant to acquire 50,000 shares of common stock at $7.27 per share, because its effect would be anti-dilutive. Excluded from the computation of diluted earnings per share for the quarter December 31, 2003, were options to acquire 9.0 million shares of common stock because their effect would be anti-dilutive. A reconciliation of the numerators and denominators used in the basic and diluted net income per share amounts follows (in thousands):

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MICROMUSE INC.

Concentration of Revenues

One third-party distributor customer accounted for approximately 20% of revenues the quarter ended December 31, 2004, as compared to 17% in the same period of the prior year. No one end-user customer accounted for greater than 10% of revenues for the quarters ended December 31, 2004 and 2003.

Accounts Receivable

Accounts receivable includes an allowance for doubtful accounts of $1.4 million and $1.0 million as of December 31, 2004 and September 30, 2004, respectively.

Accumulated Other Comprehensive Loss

The only component of accumulated other comprehensive loss is net foreign currency translation adjustments. Other comprehensive loss, net of tax, for the quarters ended December 31, 2004 and 2003 was $1.8 million and $0.1 million, respectively.

Stock-Based Compensation

At December 31, 2004, the Company had two stock-based employee compensation plans, which are described more fully in the notes included in the Form 10-K as filed with the Securities Exchange Commission on December 14, 2004. The Company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. All options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of the grant, therefore no stock-based employee compensation cost is reflected in the condensed consolidated statement of operations related to option grants for the quarter ended December 31, 2004. In February 2005, the Company amended certain provisions of its Employee Stock Purchase Plan (Plan) by adding a sub-plan for new participants (eligible employees who had not participated in the Plan prior to February 1, 2005). The Plan specifically authorizes the Compensation Committee of the Company’s Board of Directors to adopt rules and make other policy decisions with regard to the administration and operation of the Plan. The Committee determined that it was appropriate and advisable to establish a sub-plan to the Plan, with effect from February 1, 2005, for the purpose of allowing eligible employees to participate in a modified form of the Plan beginning with the February 1, 2005 offering period in order to reduce the expense charge associated with the offering of this equity program. In particular, the sub-plan reduced the offering periods to six months, with no look-back or re-set provisions and provided that the purchase price for each share of stock purchased at the close of an offering period under the sub-plan shall be 85% of the Fair Market Value of such share on the last trading day before the commencement of the next applicable offering Period. See also Recently Issued Accounting Pronoucements below concerning new requirements to expense share-based payments.

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, and SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, to stock-based employee compensation.