Basis
Since the beginning of 2004, the consolidated financial statements of Software AG have been prepared in accordance with the International Accounting Standards Board’s (IASB) International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS). Software AG complied with the IAS and IFRS, and IFRIC (International Financial Reporting Interpretations Committee, formerly SIC) interpretations applicable on December 31, 2003.

Figures in the consolidated financial statements are, unless otherwise stated, quoted in thousands of euros (€ thousands).

Principals of consolidation
The consolidated financial statements include Software AG and companies under its control. Control is generally taken to be proven where the Group holds, directly or indirectly, the majority of voting rights for authorized capital in a company, and/or can determine the fiscal or business policy of the company.

The financial statements of consolidated companies are compiled according to consistent accounting and valuation principles.

Subsidiaries established by Software AG are consolidated on the date they are formed. However, first-time consolidation occurred after the date of foundation for Softinterest Holding AG and its subsidiaries – which were consolidated for the first time in 1994 – as well as for Asian subsidiary SQL and for SAG-IRL.

The first-time consolidation of all companies was undertaken using the book value method. Subsequent consolidation is derived from the figures employed for first-time consolidation.

Debit balances arising from capital consolidation and relating solely to goodwill from acquisitions before January 31, 2001, were netted against capital reserves, pursuant to Section 309, Subsection 1, of the German Commercial Code (HGB). Goodwill from acquisitions after January 31, 2001, was capitalized and will be amortized over ten years. In accordance with the option granted by IFRS 1.14, the Company has not applied IAS 22 retrospectively, but has continued to use the figures for mergers and acquisitions posted according to HGB.

Revenue, expenses and income, receivables, liabilities, and provisions arising between consolidated companies have been eliminated. Intercompany earnings from services provided within the Group were also eliminated where these were not realized from services to third parties.

Consolidated companies
On May 13, 2004, SAG Systemhaus S.L., Madrid, Spain was founded with subscribed capital of € 60 thousand. As of this date, the new company was consolidated as part of the Software AG Group. This was the only change to the scope of consolidation in comparison with December 31, 2003.

Estimates and assumptions
In a few instances, estimates and assumptions were made which could impact the statement and amount of figures posted for balance-sheet assets, debt, income, expenses and contingent liabilities. True values may deviate from these estimates and assumptions.

Currency translation
The financial statements of foreign subsidiaries are translated using functional currencies: As these companies have organizational, financial, and commercial independence, the respective local currency is identical to the functional currency. Assets and liabilities are translated according to the exchange rate on the balance-sheet date, and expenses and income according to monthly averages. Currency translation differences are posted as such under equity, but not recognized in net profit or loss for the period.

In the individual financial statements for consolidated companies, foreign-currency items are translated on the balance-sheet date, and included in net profit or loss for the period. Translation differences from long-term intercompany cash items are excepted from this rule. These are posted as other comprehensive income under equity, but not recognized in net profit or loss for the period.

Cash on hand and bank balances
This item includes cash and short-term investments, plus short-term cash equivalents.

Cash equivalents are short-term, highly liquid financial investments which can be converted to cash at any time, and which are only subject to immaterial fluctuations in value.

Securities and financial assets
Financial assets are initially valued at the cost of acquisition, including transaction costs. The subsequent valuation depends on their classification.

Financial assets which are available for sale are valued according to their price on the balance-sheet date (i.e. the fair market value). Price gains or losses are posted as other comprehensive income under equity, but not recognized in net profit or loss for the period.

Software AG uses hedging instruments to protect against the risks posed by worldwide currency fluctuations. Company policy is to hedge against currency risks in their totality, and not take specific action for each individual transaction. Open positions in futures transactions are valued at the fair market price, and listed on the balance sheet under securities held for trading purposes. Price gains or losses are included in the net income figure for the relevant year.

Financial assets are recorded at their individual fair market values where this is possible to calculate and the assets have not been held until maturity. Loans and receivables included under this item which are not held for trading purposes, and assets with no publicly available price on an active market, where it is not possible to reliably calculate a fair market price, are valued at the adjusted cost of acquisition. All values are subject to regular, objective impairment testing, and value impairment, where it has occurred, is reflected in earnings for the period.

Inventories
Inventories are recorded at the lower of cost of acquisition/manufacture or net realizable value. Net realizable value is the estimated amount that would be raised from a sale during normal operations, less the estimated costs arising until manufacture is complete, and less sales costs.

Trade receivables
Trade receivables are posted at the fair value applicable when revenues are realized or services provided, and valued at the net book value, less any necessary value adjustments.

This item also includes unbilled services from projects for which a fixed price has been agreed, but for which the percentage of completion method is applied.

Other current assets
Other current assets are valued at cost of acquisition, which corresponds to fair market value.

Intangible assets
Concessions, industrial and similar rights and assets, and licenses to such rights are capitalized at cost of acquisition and amortized over their useful economic lives according to the straight-line method. These assets are regularly subject to impairment testing.

Goodwill
Debit balances arising from capital consolidation as defined by HGB are calculated according to book value, with no disclosure of hidden reserves. Before January 31, 2001, balances were offset against capital reserves, pursuant to Section 309, Subsection 1 of HGB. After this date, goodwill was capitalized and amortized over ten years according to the straight-line method. The term over which goodwill is amortized is established at the time of the acquisition, based on the useful economic life of the goodwill. Software AG makes use of IFRS 1.13, which allows the Company to retain HGB valuations of goodwill arising before the transition to IFRS accounting on January 1, 2003. In accordance with IFRS 3, the historical HGB valuation of goodwill was posted at € 176,591 thousand on this date. IFRS 3 requires that goodwill is no longer amortized, but subject to annual impairment testing and examination of its future useful economic life. The residual book value is written down to its fair value where the value has been impaired.

Property, plant and equipment
Property, plant and equipment are stated at cost of acquisition or manufacture less accumulated depreciation and impairment costs. Where items are sold or scrapped, the relevant cost of acquisition and accumulated write-downs are eliminated – any realized income/loss from the disposal of the asset is shown on the income statement.

Tangible assets acquired for € 410 or less are fully written down in the year they are first posted.

Cost of acquisition/manufacture comprises purchase price, including any customer payments and non-refundable income tax, and costs that are directly attributable to preparing the asset for its intended use. Expenditure such as maintenance incurred once the asset is in use is posted in the period during which it is incurred. Subsequent expenditure is only booked under assets where this improves the condition of the asset beyond its originally assessed standard of performance. Financing costs are not included under cost of acquisition/manufacture.

Property, plant and equipment are depreciated over their useful economic lives according to the straight-line method:
Buildings 50 years
Leasehold improvements 8 – 10 years
Office equipment 3 – 13 years
Computer hardware and accessories 1 – 4 years

Useful economic lives and methods of depreciation are periodically examined to ensure that theoretical values correspond with actual expected values.

Assets under construction are allocated to unfinished property, plant and equipment, and stated at cost of acquisition/manufacture. Depreciation only takes place once manufacture is complete and the asset is in use.

Impairment of the value of intangible assets and property, plant and equipment
Where there is evidence that the value of intangible assets, property, plant and equipment has been impaired, these are immediately written down to their recoverable values, i.e. the higher of net realizable value and value in use. Value in use is the cash value of forecast future cash flows from the continued use of an asset and from disposal at the end of its useful economic life.

Leasing
Fixed assets include assets provided under leasing contracts. Software AG leases property, plant, and equipment. According to IAS 17, leasing contracts are classified as capital leases (where the leased asset is allocated to the lessee) or operating leases (where the leased asset is allocated to the lessor).

Capital leases: Leased items are posted on the balance sheet under both assets and leasing liabilities (at the same amount). The fair market value of the leased item at the beginning of the contract is used, or, where less, the cash value of the total minimum leasing payments. Calculation of this cash value is based on the interest rate of the overall lease agreement, where this figure can be practically identified. Otherwise, the lessee’s threshold borrowing interest rate is used. Capital leases are amortized over their scheduled useful economic lives according to the straight-line method. Future lease installments are posted as financial liabilities.

Operating leases: Operating lease payments are expensed throughout the life of the leasing agreement.

Deferred taxes
Tax assets and liabilities are deferred according to the balance-sheet liability method for temporary differences between figures stated for tax purposes and those on the consolidated balance sheets. Taxes are also deferred on loss carryforwards.

Deferred taxes are calculated according to the tax rate expected to apply in the year in which they will be realized. Dividends are only included once the annual shareholders’ meeting has voted on the use of earnings.

Deferred tax assets and liabilities are not discounted.

The book values of deferred taxes are regularly examined and, where necessary, adjusted.

Prepaid expenses
This item includes prepayments made by Software AG within the scope of license and rental agreements. Amounts are reversed and booked as expense in the accounting period when the service is delivered to Software AG.

Liabilities
Short-term liabilities are stated at their repayment or fulfillment value.

Long-term liabilities are stated at adjusted cost of acquisition, calculated according to the effective interest method, i.e. by discounting expected future repayments.

Provisions
Provisions are formed where the Company has a de jure or de facto obligation to a third party arising from an event in the past, where it is likely that the Company will have to settle this obligation, and a reliable estimate can be made of the value of the liability. Estimates are subject to regular scrutiny and adjustment.

Where the effect of the time value of money is material, the amount of a provision is the present value of the expenditures expected to be required to settle the obligation.

Provisions for pensions
Software AG operates both defined-benefit and defined-contribution pension plans. The actuarial calculation of provisions for pensions follows the projected unit credit method described in IAS 19, whereby expected future increases in pensions and salaries are also included.

For the defined-contribution plan, Software AG has no obligations beyond its undertaking to pay all contributions to earmarked funds.

Deferred income
Deferred income includes prepayments from customers for maintenance services. Amounts are reversed and posted as revenue in the period Software AG delivers the service.

Other comprehensive income
Other comprehensive income comprises differences arising from the translation of the financial statements of commercially independent non-German subsidiaries, and effects from the valuation of financial instruments. Also included are translation differences from cash positions that are primarily part of a net investment in a commercially independent non-German subsidiary. Figures are quoted after tax.

Equity
Development of shareholders equity is shown here.

In addition, contingent capital at June 30, 2004, comprised the following amounts:

• (1.)
  Up to € 3,357 thousand in up to 1,118,962 nopar value shares, reserved to cover subscription rights granted under the first share-option plan (Management Incentive Plan I, MIP I) for Executive Board members and senior executives of the Software AG Group. The terms and conditions of this plan, as well as the numbers of shares allocated/exercised, are given on page 32.
  
  
• (2.)
  Up to € 3,000 thousand in up to 1,000,000 nopar value shares, reserved to cover subscription rights granted under the second share-option plan (Management Incentive Plan II, MIP II) for Executive Board members and senior executives of the Software AG Group. The terms and conditions of this plan, as well as the numbers of shares allocated/exercised, are given here.
  
  
• (3.)
  Up to € 13,515 thousand in up to 4,505,000 nopar value shares, reserved to grant option rights to holders of warrants from cum-warrant bonds, and to grant conversion options to holders of convertible bonds in accordance with the bonds’ terms. The Executive Board is authorized to issue such bonds, with a term of up to 10 years, once or more than once in the period to April 27, 2006, up to a total nominal value of € 500,000 thousand. The Executive Board had not made use of this authorization by June 30, 2004. At the annual shareholders’ meeting on April 30, 2004, the entitlement to draw on this capital was withdrawn and replaced by that detailed under section 4 below.
  
  
• (4.)
  Up to € 36,000 thousand in up to 12,000,000 bearer shares, each with a € 3 share of capital stock, reserved to grant option rights and to agree option obligations arising from optionbonds, and to grant conversion options and option obligations to holders of convertible bonds in accordance with the bonds’ terms (agreed at the annual shareholders’ meeting on April 30, 2004). Subject to the approval of the Supervisory Board, the Executive Board may authorize the exercise of these rights by Software AG or a (directly or indirectly) wholly owned subsidiary by April 29, 2009.
  

In this instance, shareholders are entitled to subscription rights, with the following exceptions:

• The Executive Board is authorized to exclude fractional amounts.
  
• Subject to the approval of the Supervisory Board, the Executive Board is authorized to totally exclude shareholders’ subscription rights in the following instance: Where, upon due examination, the issue price of options or convertible bonds is not thought to be significantly less than its hypothetical market value (i.e. such value being calculated by accepted financial industry methods). However, this right to exclusion only applies to options and convertible bonds with rights or obligations for shares totaling no more than € 8,180 thousand, or, where lower, 10 percent of capital stock at the time the subscription rights are excluded.
  

The Executive Board had not made use of this authorization by June 30, 2004.

At the balance-sheet date, the Executive Board is further authorized, with the consent of the Supervisory Board, to increase the Company’s subscribed capital by up to € 37,989 thousand once or more than once in the period to April 27, 2006, by issuing up to 12,663,036 registered shares against cash and/or non-cash contributions (authorized capital). With the exception of the cases detailed below, shareholders will be granted pre-emptive subscription rights:

• The Executive Board is authorized to deviate from shareholders’ pre-emptive subscription rights with respect to fractional amounts.
  
• The Executive Board is further authorized, with the consent of the Supervisory Board, to deviate from shareholders’ pre-emptive subscription rights with respect to capital increases against non-cash contributions effected for the purpose of acquiring participations, holdings, companies or business units.
  
• The Executive Board is also authorized, with the consent of the Supervisory Board, to deviate from shareholders’ pre-emptive subscription rights provided that the capital increase against cash effected on the basis of this authorization does not exceed 10 percent of the subscribed capital at the time this authorization is first exercised, and provided that the issue price is not significantly lower than the market value.
  
• Finally, the Executive Board is authorized, with the consent of the Supervisory Board, to deviate from shareholders’ pre-emptive subscription rights with respect to a nominal amount not exceeding € 6,503 thousand in order to offer new shares to employees of Software AG and its affiliated companies (in accordance with sections 15 ff. of the German Stock Corporation Act) under an employee share option plan. The new shares can also be transferred to a bank on condition that sale is restricted to entitled persons in accordance with the Company’s instructions.
  

At June 30, 2004, the Executive Board had not exercised its power to increase subscribed capital.

Revenues
Software AG primarily generates revenues from software licenses (for unlimited periods of usage), maintenance, and other services. Incoming monies from software licenses are only posted as revenues once a contract has been signed with the customer, all possible rights of return have expired, the software has been supplied, and a price has been agreed or can be established, and there is sufficient probability that payment will be made.

Maintenance revenues are prorated over the period of service provision.

Revenues from contract work invoiced according to man-hours are recognized once the services have been provided by Software AG.

Pursuant to IAS 11 and IAS 18, revenues from fixedprice service contracts are recognized according to the percentage of completion method where the revenues can be reliably measured, there is sufficient probability that Software AG will receive the economic benefits of the transaction, and that all related costs expected until completion of the service can be reliably measured.

Revenues figures are net of all discounts and rebates.

Costs of manufacture
Costs of manufacture include all production-related costs on the basis of normal utilization levels. They include individual unit costs that can be directly allocated to projects, plus fixed and variable overheads. Borrowing costs are not capitalized in costs of acquisition/manufacture. No unscheduled writedowns on inventories were required during the reporting period.

Research and development costs
Research and development costs are expensed in the income statement as they are incurred.

The creation of and subsequent improvements to software involve closely linked, highly interwoven research and development phases. Accordingly, it is not possible to strictly separate expenses incurred for research from those incurred for development, and the criteria for separately reporting development costs laid out in IAS 38, Section 41, in conjunction with 42, cannot be met.

Sales, marketing and distribution
These include personnel and materials costs, writedowns, and advertising expenses.

Administrative costs
These include personnel and materials costs, and applicable depreciation and amortization.

Earnings per share
Earnings per share are calculated by dividing net income allocable to shareholders for the period by the weighted number of shares outstanding during the period. Software AG only has common stock.