UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2002 or

[ ] 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 0-12167

RATIONAL SOFTWARE CORPORATION
(Exact name of registrant as specified in its charter)

Delaware	54-1217099
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

18880 Homestead Road
Cupertino, California 95014
(Address of principal executive offices including zip code)

408-863-9900
(Registrant's 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 reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ],

Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date.

Class	Shares Outstanding on July 31, 2002
Common Stock, par value $.01 per share	193,161,292

RATIONAL SOFTWARE CORPORATION
TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION	Page No.

Item 1 - Financial Statements (Unaudited):

Condensed Consolidated Balance Sheets	3

Condensed Consolidated Statements of Operations	4

Condensed Consolidated Statements of Cash Flows	5

Notes to Condensed Consolidated Financial Statements	6

Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3 - Quantitative and Qualitative Disclosures about Market Risk	22

PART II - OTHER INFORMATION

Item 1 - Legal Proceedings	23

Item 5 - Other Information	23

Item 6 - Exhibits and Reports on Form 8-K	23

SIGNATURES	24

PART I - FINANCIAL INFORMATION

ITEM 1 - Financial Statements

RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)

                                                                                  
                                                          June 30,       March 31,
                                                            2002          2002
                                                        ------------  ------------
                                                        (unaudited)
                         ASSETS
            -------------------------------------
Current assets:
 Cash and cash equivalents............................ $    411,492  $    374,158
 Short-term investments...............................      602,834       586,225
 Accounts receivable, net of allowance for
   doubtful accounts of $6,182 at June 30,
   2002 and $6,149 at March 31, 2002..................      119,799       149,896
 Deferred income tax assets...........................       19,714        19,714
 Prepaid expenses and other assets....................       24,085        24,525
                                                        ------------  ------------
        Total current assets..........................    1,177,924     1,154,518
                                                        ------------  ------------
Property and equipment, at cost:
 Computer and office equipment........................      141,901       136,048
 Office furniture.....................................       28,778        27,704
 Leasehold improvements...............................       32,331        31,129
                                                        ------------  ------------
                                                            203,010       194,881
 Accumulated depreciation and amortization............     (112,473)     (103,627)
                                                        ------------  ------------
Property and equipment, net...........................       90,537        91,254
Goodwill, net.........................................      185,694       185,694
Intangible assets, net................................       37,418        42,336
Other assets, net.....................................       29,513        29,417
                                                        ------------  ------------
        Total assets.................................. $  1,521,086  $  1,503,219
                                                        ============  ============

             LIABILITIES AND STOCKHOLDERS' EQUITY
            -------------------------------------
Current liabilities:
 Accounts payable..................................... $     10,903  $     11,575
 Accrued employee benefits............................       36,562        46,145
 Income taxes payable.................................       29,156        29,192
 Other accrued expenses...............................       46,108        42,445
 Current portion of accrued merger and integration
  costs...............................................       12,019        11,511
 Deferred revenue.....................................      182,283       181,903
                                                        ------------  ------------
        Total current liabilities.....................      317,031       322,771

Long-term deferred tax liabilities....................        9,751        11,921
Convertible subordinated notes........................      500,000       500,000
Long-term portion of accrued merger and integration
  costs...............................................       27,012        29,369
Other accrued liabilities.............................        1,354         1,182
                                                        ------------  ------------
        Total liabilities.............................      855,148       865,243
                                                        ------------  ------------

Stockholders' equity:
 Common stock, $0.01 par value, 500,000
  shares authorized...................................        2,205         2,196
 Additional paid-in capital...........................    1,281,557     1,272,174
 Deferred stock compensation..........................     (180,984)     (199,055)
 Treasury stock.......................................     (366,101)     (350,902)
 Accumulated deficit..................................      (70,987)      (64,503)
 Accumulated other comprehensive income (loss)........          248       (21,934)
                                                        ------------  ------------
        Total stockholders' equity....................      665,938       637,976
                                                        ------------  ------------
        Total liabilities and stockholders' equity.... $  1,521,086  $  1,503,219
                                                        ============  ============

See accompanying notes to condensed consolidated financial statements.

RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts, unaudited)


                                                Three Months Ended
                                                    June 30,
                                              --------------------
                                                2002       2001
                                              ---------  ---------  
Net product revenues........................ $  59,479  $  83,314
Consulting and support revenues.............    92,985     92,479
                                              ---------  ---------
    Total revenues..........................   152,464    175,793
                                              ---------  ---------

Cost of product revenues....................     9,946      8,184
Cost of consulting and support
  revenues..................................    17,583     20,400
                                              ---------  ---------
    Total cost of revenues..................    27,529     28,584
                                              ---------  ---------
Gross margin................................   124,935    147,209
                                              ---------  ---------
Operating expenses:
  Research and development expenses.........    41,910     47,661
  Sales and marketing expenses..............    68,924     73,564
  General and administrative expenses.......    11,247     12,964
  Amortization of goodwill and
   purchased intangibles....................       307     17,987
  Amortization of deferred stock-based
   compensation.............................    18,071     18,236
  Restructuring costs.......................       ---     17,331
                                              ---------  ---------
        Total operating expenses............   140,459    187,743
                                              ---------  ---------
Operating loss..............................   (15,524)   (40,534)
Other income, net...........................     2,690      6,393
                                              ---------  ---------
        Loss before income taxes............   (12,834)   (34,141)

Benefit from income taxes...................    (6,350)    (9,333)
                                              ---------  ---------
Net loss.................................... $  (6,484) $ (24,808)
                                              =========  =========
Net loss per common share:
  Basic..................................... $   (0.03) $   (0.13)
                                              =========  =========
  Diluted................................... $   (0.03) $   (0.13)
                                              =========  =========
Shares used in computing per share amounts:
  Basic.....................................   190,057    196,872
                                              =========  =========
  Diluted...................................   190,057    196,872
                                              =========  =========

See accompanying notes to condensed consolidated financial statements.

RATIONAL SOFTWARE CORPORATION
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands, unaudited)

                                                                               

                                                            Three  Months Ended
                                                                  June 30,
                                                           --------------------
                                                             2002       2001
                                                           ---------  ---------
Operating activities:                                          
   Net loss.............................................. $  (6,484) $ (24,808)
   Adjustments to reconcile net loss to net
   cash provided by (used in) operating activities:
     Depreciation and amortization.......................    15,167     29,835
     Compensation expense related to stock options.......    18,071     18,236
     Tax benefit from employee stock plans...............       342        ---
     Deferred income tax.................................    (3,106)   (13,606)
     Changes in operating assets and liabilities:
       Accounts receivable, net..........................    30,097     44,011
       Prepaid expenses and other, net...................       440     (9,896)
       Other assets......................................      (657)       344
       Accounts payable..................................      (672)   (12,601)
       Accrued employee benefits and other accrued
          expenses.......................................    (5,748)   (28,165)
       Income taxes payable..............................       (36)    (5,180)
       Accrued merger and integration expenses...........    (1,849)    (3,585)
       Deferred revenues.................................       380      3,915
                                                           ---------  ---------
Net cash provided by (used in) operating activities......    45,945     (1,500)
                                                           ---------  ---------
Investing activities:                                          
   Purchases of short-term investments...................  (139,872)  (202,465)
   Maturities and sales of short-term investments........   125,601    205,805
   Purchases of property and equipment...................    (8,970)    (4,350)
   Purchases of technologies.............................       ---    (20,965)
                                                           ---------  ---------
Net cash used in investing activities....................   (23,241)   (21,975)
                                                           ---------  ---------
Financing activities:                                          
   Net proceeds from issuance of common stock............     9,492     11,575
   Net proceeds from reissuance of treasury stock........     1,661      6,566
   Repurchases of common stock...........................   (17,303)   (44,486)
   Repayment of receivables from stockholders............       ---        633
                                                           ---------  ---------
Net cash used in financing activities....................    (6,150)   (25,712)
                                                           ---------  ---------

Effect of changes in foreign currency
  exchange rates on cash.................................    20,780     (2,980)
                                                           ---------  ---------
Net increase (decrease) in cash and cash equivalents.....    37,334    (52,167)
Cash and cash equivalents at beginning of period.........   374,158    363,717
                                                           ---------  ---------
Cash and cash equivalents at end of period............... $ 411,492  $ 311,550
                                                           =========  =========

See accompanying notes to condensed consolidated financial statements.

RATIONAL SOFTWARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

BASIS OF PRESENTATION
- The condensed consolidated financial statements have been prepared without an audit and in accordance with the Company's accounting policies, as described in its latest Annual Report on Form 10-K filed with the Securities and Exchange Commission, and include the consolidated accounts of the Company and its subsidiaries. In the opinion of management, all adjustments, which consist only of normal recurring adjustments necessary for a fair presentation of the Company's financial position, results of operations and cash flows for the interim periods presented, have been made. Certain prior year amounts have been reclassified to conform to current year presentation. As permitted by Form 10-Q, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. These statements should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended March 31, 2002. The results of operations for the interim periods presented are not necessarily indicative of the results that may be expected for any subsequent interim period or the fiscal year ending March 31, 2003.

NET LOSS PER COMMON SHARE
- The following table sets forth the computation of basic and diluted net loss per share (in thousands, except per share amounts):

                                                                    
                                                Three Months Ended
                                                    June 30,
                                              --------------------
                                                2002       2001
                                              ---------  ---------
Numerator:                                                          
  Net loss                                   $  (6,484) $ (24,808)
                                              =========  =========  
Denominator:                                                        
  Weighted average shares of common
  stock outstanding                            193,516    201,496

  Less: Weighted average shares subject
  to repurchase                                 (3,459)    (4,624)
                                              ---------  ---------
  Denominator for basic and diluted
  net loss per share -
  weighted average shares                      190,057    196,872
                                              =========  =========

Net loss per share - basic                   $   (0.03) $   (0.13)
                                              =========  =========
Net loss per share - diluted                 $   (0.03) $   (0.13)
                                              =========  =========

The computation of diluted net loss per share for the quarter ended June 30, 2002 excluded the impact of all outstanding options to purchase 54,669,051 shares of Common Stock and 3,458,225 shares of Common Stock subject to repurchase, as the impact would be antidilutive. The computation of diluted net loss per share for the quarter ended June 30, 2001 excluded the impact of all outstanding options to purchase 37,018,795 shares of Common Stock and 4,624,114 shares of Common Stock subject to repurchase, as the impact would be antidilutive. The impact of converting 13,997,760 shares of Common Stock from outstanding Convertible Notes issued in 2000 was not included for any periods in diluted net loss per share, because the assumed conversion would be antidilutive.

COMPREHENSIVE INCOME (LOSS)
- The Company follows Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income." SFAS 130 requires unrealized gains or losses on the Company's available-for-sale securities and foreign translation adjustments, which have been included in stockholders' equity and excluded from net income, to be included in comprehensive income. For the quarter ended June 30, 2002, total comprehensive income was approximately $15.7 million compared to comprehensive loss of approximately $28.4 million for the same period last year.

RECENT PRONOUNCEMENTS -
On April 1, 2002, the Company adopted SFAS 141, "Business Combinations," and SFAS 142, "Goodwill and Other Intangible Assets." SFAS 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting. As required by SFAS 142, the Company discontinued amortizing the remaining balances of goodwill beginning April 1, 2002. All remaining and future acquired goodwill will be subject to impairment tests annually, or

earlier if indicators of potential impairment exist, using a fair-value-based approach. All other intangible assets will continue to be amortized over their estimated useful lives and assessed for impairment under SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." Upon adoption of the new business combination rules under SFAS 141, assembled workforce no longer meets the definition of an identifiable intangible asset. As a result, the net balance of $3.1 million has been reclassified to goodwill in the first quarter of fiscal 2003. See further discussion under Note 7 "Goodwill and Other Intangible Assets." In connection with the transitional goodwill impairment evaluation under SFAS 142, the Company has completed a goodwill review as of the date of adoption - April 1, 2002 and found no impairment.

In October 2001, the Financial Accounting Standards Board (FASB) issued SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which supersedes SFAS 121 and the provisions of Accounting Principles Board (APB) Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" with regard to reporting the effects of a disposal of a segment of a business. SFAS 144 retains many of the provisions of SFAS 121 but significantly changes the criteria that would have to be met to classify an asset as held for disposal such that long-lived assets to be disposed of other than by sale are considered held and used until disposed of. In addition, SFAS 144 retains the basic provisions of APB 30 for presentation of discontinued operations in the statement of operations but broadens that presentation to a component of an entity. The Company adopted SFAS 144 on April 1, 2002. The adoption of SFAS 144 did not have any material impact on the Company's financial position and results of operations.

In November 2001, the FASB issued an announcement on the topic of "Income Statement Characterization of Reimbursements Received for Out of Pocket Expenses Incurred" (the Announcement). The Announcement requires companies to characterize reimbursements received for out of pocket expenses incurred as revenues in the income statement. The Company adopted the Announcement in the quarter ended March 31, 2002. Historically, the Company has netted reimbursements received for out of pocket expenses against the related expenses in the accompanying consolidated statements of operations. The adoption of the Announcement had no impact on the Company's gross margin or net loss but increased its consulting and support revenues and cost of consulting and support revenues by approximately $163,000 for the quarter ended June 30, 2002. The adoption of the Announcement did not have a material impact on the Company's financial position, results of operations or cash flows and, accordingly, the Company did not reclassify prior period results.

DERIVATIVE FINANCIAL INSTRUMENTS -
The Company adopted SFAS 133, "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS 137 and SFAS 138, in the first fiscal quarter of fiscal 2002. SFAS 133 establishes new standards of accounting and reporting for derivative instruments and hedging activities, and requires that all derivatives, including foreign currency exchange contracts, be recognized on the balance sheet at fair value. Changes in the fair value of derivatives that do not qualify for hedge treatment, as well as the ineffective portion of any hedges, must be recognized currently in earnings. All of the Company's derivative financial instruments are recorded at their fair value in prepaid expenses and other assets. The transition adjustment upon adoption of SFAS 133 was not material.

The Company conducts business in a number of foreign countries, with certain transactions denominated in local or "functional" currencies. The purpose of the Company's foreign currency management is to mitigate the impact of foreign currency exchange rate fluctuations on balance sheet exposures denominated in currencies other than the "functional" currency. The terms of currency instruments used for hedging purposes are generally consistent with the timing of the committed transactions being hedged. The Company does not use derivative financial instruments for speculative trading purposes, nor does it hold or issue leveraged derivative financial instruments.

The Company uses short-term forward exchange

contracts to hedge certain foreign currency denominated assets or liabilities. These derivatives do not qualify for SFAS 133 hedge accounting treatment. Accordingly, changes in the fair value of these hedges are recorded immediately in earnings to offset the changes in the fair value of the assets or liabilities being hedged.

STOCK REPURCHASE -
In April 2001, the Company's Board of Directors authorized the repurchase of 20.0 million shares of the Company's Common Stock from time to time in the open market. The Company repurchased

1.5 million shares of its Common Stock for a total cash outlay of approximately $17.3 million for the quarter ended June 30, 2002. As of June 30, 2002, the Company had repurchased approximately 9.7 million shares of its Common Stock under this program for an aggregate cost of approximately $113.0 million. Repurchases help offset dilution from stock issued under our stock option and stock purchase plans. The timing and size of any future stock repurchases are subject to market conditions, stock prices, the Company's cash position and other cash requirements going forward.

GOODWILL AND OTHER INTANGIBLE ASSETS -
On April 1, 2002, the Company adopted SFAS 142 and as a result will no longer amortize goodwill, but will test it for impairment annually or earlier if indicators of potential impairment exist.

For comparative purposes, the pro forma adjusted net income (loss) per share excluding amortization of goodwill and assembled workforce is as follows (in thousands,

except per share amounts):

                                                                     
                                                Three Months Ended
                                                    June 30,
                                              ---------------------
                                                2002        2001
                                              ---------  ----------
                                                                     
Net loss                                     $  (6,484) $  (24,808)
Add back SFAS 142 adjustments:
  Amortization of goodwill, net of tax             ---      16,833
  Amortization of assembled workforce,
    net of tax                                     ---         547
                                              ---------  ----------
Adjusted net loss                            $  (6,484) $   (7,428)
                                              =========  ==========

Basic and diluted net loss per share         $   (0.03) $    (0.13)
Add back SFAS 142 adjustments:
  Amortization of goodwill, net of tax             ---        0.09
  Amortization of assembled workforce,
    net of tax                                     ---        0.00
                                              ---------  ----------
Pro forma adjusted basic and diluted
  net loss per share                         $   (0.03) $    (0.04)
                                              =========  ==========

                                                                              
                                                     Fiscal Years Ended
                                                           March 31,
                                              --------------------------------
                                                2002        2001       2000
                                              ---------  ----------  ---------
                                                                              
Net income (loss)                            $ (75,948) $   72,144  $  85,314
Add back SFAS 142 adjustments:
  Amortization of goodwill, net of tax          66,981      21,641      3,900
  Amortization of assembled workforce,
    net of tax                                   2,184         552         71
                                              ---------  ----------  ---------
Adjusted net income (loss)                   $  (6,783) $   94,337  $  89,285
                                              =========  ==========  =========

Basic net income (loss) per share            $   (0.39) $     0.38  $    0.49
Add back SFAS 142 adjustments:
  Amortization of goodwill, net of tax            0.34        0.12       0.02
  Amortization of assembled workforce,
    net of tax                                    0.01        0.00       0.00
                                              ---------  ----------  ---------
Pro forma adjusted basic net income (loss)
  per share                                  $   (0.04) $     0.50  $    0.51
                                              =========  ==========  =========

Diluted net income (loss) per share          $   (0.39) $     0.35  $    0.45
Add back SFAS 142 adjustments:
  Amortization of goodwill, net of tax            0.34        0.11       0.02
  Amortization of assembled workforce,
    net of tax                                    0.01        0.00       0.00
                                              ---------  ----------  ---------
Pro forma adjusted diluted net income (loss)
  per share                                  $   (0.04) $     0.46  $    0.47
                                              =========  ==========  =========

The following table provides a summary of the carrying amount of goodwill which includes amounts originally allocated to assembled workforce (in thousands):

                                                                     

                                              June 30,   March 31,
                                                2002        2002
                                              ---------  ----------
                                                                     
Gross carrying amount of goodwill            $ 282,552  $  274,727
Gross carrying amount of assembled
  workforce reclassified to goodwill               ---       7,825
                                              ---------  ----------
Adjusted gross carrying amount
  of goodwill                                  282,552     282,552
Accumulated amortization of goodwill           (96,858)    (92,103)
Accumulated amortization of assembled
  workforce reclassified to goodwill               ---      (4,755)
                                              ---------  ----------
Net carrying amount of goodwill              $ 185,694  $  185,694
                                              =========  ==========

The following tables provide a summary of the carrying amount of other intangible assets that will continue to be amortized and excludes amounts originally allocated to assembled workforce (in thousands):


                                                         June 30, 2002
                                              --------------------------------
                                                Gross                     Net
                                              Carrying   Accumulated   Carrying
                                               Amount    Amortization   Amount
                                              ---------  ------------  ---------
Acquired developed and core technology       $  52,714  $  (22,608)   $  30,106
Acquired contract                                9,299      (4,391)       4,908
Acquired customer list and trade name            3,989      (1,585)       2,404
                                              ---------  ----------    ---------
   Total                                     $  66,002  $  (28,584)   $  37,418
                                              =========  ==========    =========

                                                         March 31, 2002
                                              --------------------------------
                                                Gross                     Net
                                              Carrying   Accumulated   Carrying
                                               Amount    Amortization   Amount
                                              ---------  ------------  ---------
Acquired developed and core technology       $  52,714  $  (18,776)   $  33,938
Acquired contract                                9,299      (3,616)       5,683
Acquired customer list and trade name            3,989      (1,274)       2,715
                                              ---------  ----------    ---------
   Total                                     $  66,002  $  (23,666)   $  42,336
                                              =========  ==========    =========

Amortization expense (before tax) related to intangible assets was approximately $4.9 million and $5.1 million for the quarters ended June 30, 2002 and 2001, respectively.

The total expected future amortization related to other intangible assets is provided in the table below (in thousands):

                                                                     
                                              Future Amortization
                                              ---------------------
                                                           Net of
                                                Gross    Estimated
                Fiscal Year                    Amount    Tax Benefit
            ----------------                  --------  ------------
                                                                     
Remainder of 2003 (9 months)                 $  14,760  $    8,856
2004                                            17,355      10,413
2005                                             4,288       2,573
2006                                             1,015         609
                                              ---------  ----------
  Total                                      $  37,418  $   22,451
                                              =========  ==========

RESTRUCTURING COSTS -
In April 2001, the Company announced a restructuring program to focus the Company's efforts towards concentrating on its strongest opportunities, reducing operating expenses and improving the Company's allocation of resources. The restructuring included a worldwide workforce reduction, consolidation of excess facilities and restructuring of certain business functions. As a result of the restructuring program, the Company recorded restructuring costs of approximately $17.3 million, which were classified within operating expenses in the quarter ended June 30, 2001. The restructuring program resulted in the reduction of approximately 500 employees across all business functions and geographic regions. The worldwide workforce reductions started in April 2001 and employees were terminated in the quarter ended June 30, 2001. The Company recorded a workforce reduction charge of approximately $10.1 million relating primarily to severance and fringe benefits. The consolidation of excess facilities included the closure of certain corporate facilities and sales offices related to business activities that have been exited. The Company recorded a restructuring charge of approximately $3.7 million for excess facilities relating primarily to lease termination fees and non-cancelable lease costs. The Company also recorded other charges of approximately $3.5 million relating primarily to payments to third parties to terminate contractual agreements as a result of the restructuring program.

A summary of the restructuring costs is outlined as follows (in thousands):

                                                                         
                                                  Termination
                                    Consolidation   of Other
                         Workforce   of Excess    Third-Party
                         Reduction   Facilities    Agreements     Total
                         ---------  ------------  ------------  ---------
Provision recorded at
  restructuring         $  10,149  $      3,719  $      3,463  $  17,331
Non-cash charges              ---           ---          (856)      (856)
Cash payments              (9,912)       (1,268)       (2,607)   (13,787)
                         ---------  ------------  ------------  ---------
Balance, March 31, 2002       237         2,451           ---      2,688
Cash payments                (224)         (559)          ---       (783)
                         ---------  ------------  ------------  ---------
Balance, June 30, 2002  $      13  $      1,892  $        ---  $   1,905
                         =========  ============  ============  =========

The Company had substantially completed the implementation of its restructuring program as of March 31, 2002. Remaining cash expenditures relating to workforce reductions will be paid in the quarter ended September 30, 2002. Amounts related to the net lease expenses due to the consolidation of facilities will be paid over the respective lease terms (through fiscal 2006). The Company's estimated costs to exit these facilities are based on available commercial rates. The actual loss incurred in exiting these facilities could exceed the Company's estimates.

COMMITMENTS AND CONTINGENCIES

Letters of credit .
The Company assumed a letter of credit with IBM totaling $1,985,823 in connection with the Catapulse acquisition in fiscal 2001. As part of a strategic business alliance between Catapulse and IBM, IBM agreed to provide services to Catapulse in exchange for an upfront payment of $1,237,477 related to development work through December 31, 2001, and monthly recurring fees of approximately $425,000 commencing upon IBM's completion of the development work and continuing till December 31, 2003. The upfront payment of $1,237,477 was paid during fiscal 2001 and the monthly recurring fees are related to ongoing services to be provided by IBM. The Company has notified IBM of its intention to terminate this relationship. In connection with such termination, the Company is obligated to pay to IBM a termination fee of approximately $850,000, in addition to the monthly recurring fees for services through August 2002. The Company may also be obligated to pay a fee of approximately $153,000 for other related services performed by IBM prior to the termination. Upon termination of this relationship and payment of the termination charges, the letter of credit with IBM will be terminated.

Legal matters.
On July 3, 2001, a purported derivative lawsuit, entitled Krim v. Levy, et al., No. CV799591 (Supr. Ct. Santa Clara Cty.), was filed. Defendants' demurrer to the complaint was sustained with leave to amend on September 18, 2001. An amended complaint was filed on September 24, 2001. The complaint

names as defendants the Company's Board of Directors and certain unnamed persons. The Company is a nominal defendant. The complaint alleges that defendants breached their fiduciary duties to the Company by deciding to invest in and to purchase Catapulse Inc. The complaint seeks various equitable remedies and compensatory and special damages in unspecified amounts plus legal fees and costs from the defendants. The Court held a hearing on January 14, 2002 regarding the defendants' demurrer to the amended complaint. On January 22, 2002, the Court issued an order overruling defendants' demurrer. The Company and the other defendants believe that the claims asserted in this action are without merit and intend to defend against them vigorously.

From time to time, the Company is subject to legal claims. Historically, the cost of resolution of these claims has not been significant. However, any adverse outcome of current or future lawsuits against the Company may result in a material adverse effect on the Company's financial condition.

SUBSEQUENT EVENTS
- In July 2002, the Company announced a restructuring program related to the cessation of selected development activities associated with the Company's hosted development service. The Company expects to record a restructuring charge in the range of $5.0 million to $15.0 million in the quarter ending September 30, 2002.

On July 22, 2002, the Company acquired NeuVis, Inc. (NeuVis), a privately held provider of an e-business rapid application development (RAD) platform for agile, enterprise-class applications, for approximately $22.0 million in cash. In connection with the acquisition, the Company will also issue approximately 707,876 shares of Common Stock to former employees of NeuVis. These shares will vest over two years based on the continued employment of the former NeuVis employees.

ITEM 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations

This quarterly report on Form 10-Q contains forward-looking statements within the meaning of the federal securities laws. These forward-looking statements include without limitation statements regarding the following: our expectations that we will not record an impairment charge for goodwill as of April 1, 2002 upon completion of our evaluation under SFAS 142; our beliefs and expectations regarding the cost of consolidating excess facilities; our expectations regarding the cost of terminating a services arrangement with IBM and the termination of a letter of credit with IBM; our expectations and beliefs regarding the merits of and outcome of legal proceedings and litigation matters; our expectations regarding the restructuring charge arising from the cessation of selected development activities associated with our hosted development service; our beliefs and expectations regarding international sales and our revenues; our belief that expected cash flow from operations, existing cash, cash equivalents and short- term investments will be sufficient to meet our cash requirements; our beliefs regarding the relationship of our service revenues to our license revenues; our beliefs and expectations regarding our future growth and financial performance; our beliefs and expectations regarding broad market acceptance of off-the-shelf products; our beliefs and expectations regarding the development of industry standards; our beliefs and expectations regarding the development of our industry and the market for our products and services, including usage in the Internet and intranet environments; our beliefs regarding product-development investments; our beliefs and expectations regarding competition and our ability to compete including the elements on which we compete; our beliefs and expectations regarding hiring and retaining qualified individuals and the efforts and abilities of senior management personnel; our beliefs and expectations regarding our future revenue growth and our ability to expand our direct sales force and maintain a high level of consulting, training and customer support; our beliefs and expectations regarding our development, distribution and marketing strategies and our strategic relationships; our beliefs and expectations regarding errors or defects in our products; our beliefs and expectations regarding the scope of United States patent protection; our beliefs and expectations regarding infringement claims; our beliefs and expectations regarding financial and strategic benefits of past and future acquisitions; and our beliefs and expectations regarding foreign currency exchange rate and interest rate risks. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially. These risks and uncertainties include without limitation those identified in the section of this quarterly report on Form 10-Q entitled "Factors That May Affect Future Results" below. We undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this quarterly report on Form 10-Q.

As used in this quarterly report on Form 10-Q, unless the context otherwise requires, the terms "we," "us," "the Company" and "Rational" refer to Rational Software Corporation, a Delaware corporation, and its subsidiaries.

Overview

Our revenues are derived from product license fees and charges for services, including technical consulting, training, and customer support. In accordance with generally accepted accounting principles, our software license revenues are generally recognized when a customer written contract or purchase order has been received and accepted, the software product has been shipped, there are no uncertainties surrounding product acceptance, the fees are fixed or determinable, and collection is considered probable. For customer license agreements that meet these recognition criteria, the portion of the fees related to software licenses is generally recognized in the current period, while the portion of the fees related to services is recognized as the services are performed. Revenues from consulting and training are recognized when earned. Our license agreements do not provide a right of return, and an allowance is maintained for potential credit losses.

Comparative Analysis of Operating Results for the Three Months Ended June 30, 2002 and June 30, 2001

Revenues

Total revenues for the three-month period ended June 30, 2002 decreased 13% from the corresponding prior year period.

Net product revenues.
Net product revenues for the three-month period ended June 30, 2002 decreased 29% from the corresponding prior year period. The decrease in product revenues was a result of reduced sales across the majority of our products due primarily to the slowdown in the economy and reduced spending on information technology.

Consulting and support revenues.
Consulting and support revenues for the three-month period ended June 30, 2002 increased 1% from the corresponding prior year period. The net increase in consulting and support revenues was a result of increased renewals of our customer support arrangements offset by a decrease in consulting revenues.

International sales.
Revenues from international product sales and consulting and support accounted for 41% of total revenues for the three-month period ended June 30, 2002 compared to 42% for the comparable prior year period. We expect international sales to continue to account for a major portion of total revenues in future periods, although the percentage of international revenues could fluctuate from period to period due to economic or other factors in international regions. Our international sales are priced principally in local currencies. We enter into short-term forward currency contracts to hedge against the impact of foreign currency exchange rate fluctuations on balance sheet exposures denominated in currencies other than the local, or "functional," currency of our subsidiaries or us. The total amount of these contracts is approximately offset by the underlying assets and liabilities denominated in non-functional currencies and such contracts are carried at fair market value. The associated gains and losses were not material to our results of operations in any period presented.

Cost of Revenues

Cost of product revenues.
Cost of product revenues consists principally of materials, packaging and freight, amortization of purchased technology and royalties. Cost of product revenues for the three-month period ended June 30, 2002 increased 22% from the corresponding prior year period. These costs represented 17% of net product revenues for the three-month period ended June 30, 2002, compared to 10% of net product revenues for the corresponding prior year period. The increases in period over period cost of product revenues and cost of product revenues as a percentage of product revenues were primarily a result of increased amortization of purchased technology and royalty costs.

Cost of consulting and support revenues.
Cost of consulting and support revenues consists principally of personnel costs for training, consulting, and customer support. Cost of consulting and support revenues for the three-month period ended June 30, 2002 decreased 14% from the corresponding prior year period. These costs represented 19% of total consulting and support revenues for the three-month period ended June 30, 2002 compared to 22% for the corresponding prior year period. The decrease in cost of consulting and support revenues was primarily a result of a decrease in consulting revenues for the same periods. The decrease in cost of consulting and support revenues as a percentage of total consulting and support revenues was due primarily to an increased mix of higher margin support revenues versus lower margin consulting revenues.

Operating Expenses

Research and development.
Research and development expenses for the three-month period ended June 30, 2002 decreased 12% from the corresponding prior year period. These costs represented 28% of total revenues for the three-month period ended June 30, 2002 compared to 27% of total revenues for the corresponding prior year period. The period over period decrease in expenditures for research and development was primarily related to reduced spending on outside consultants and decreased headcount related costs as a result of cost control measures.

Sales and Marketing.
Sales and marketing expenses for the three-month periods ended June 30, 2002 decreased 6% from the corresponding prior year period. These costs represented 45% of total revenues for the three- month period ended June 30, 2002 compared to 42% of total revenues for the corresponding prior year period. The decrease in expenditures for sales and marketing was primarily due to decreased headcount related costs as a result of cost control measures and lower commission related expenses as a result of lower sales.

General and administrative.
General and administrative expenses for the three-month period ended June 30, 2002 decreased 13% from the corresponding prior year period. These costs represented 7% of total revenues for both the three-month periods ended June 30, 2002 and 2001. The period over period decrease in general and administrative expenses resulted primarily from lower bad debt expenses recorded in the quarter ended June 30, 2002 and decreased headcount related costs as a result of cost control measures.

Amortization of goodwill, purchased intangibles, and deferred stock-based compensation.
In the fourth quarter of fiscal 2001, we acquired Attol Testware and the remaining outstanding shares of Catapulse not already owned by Rational, both of which were accounted for under the purchase method of accounting. Accordingly, we recorded goodwill and purchased intangibles representing the excess of the purchase price paid over the fair value of the net assets acquired. In fiscal 2000, we acquired ObjecTime Limited, which was also accounted for under the purchase method of accounting. Also as part of the acquisitions of Attol Testware and the remaining outstanding shares of Catapulse in fiscal 2001, we recorded approximately $295.0 million of deferred stock-based compensation relating to the unvested stock options and restricted stock assumed in the acquisitions. In fiscal 2000, in connection with the grant of certain stock options to employees of Catapulse, the results of which were consolidated with Rational's results, we recorded deferred stock-based compensation of approximately $3.0 million representing the difference between the deemed fair value of the Common Stock for accounting purposes and the exercise price of these options at the date of grant. Amortization of goodwill and purchased intangibles was approximately $0.3 million for the three-month period ended June 30, 2002 compared to approximately $18.0 million for the corresponding prior year period. The period over period decrease was primarily due to the adoption of Statement of Financial Accounting Standards (SFAS) 142, "Goodwill and Other Intangible Assets," which ceased the amortization of goodwill beginning April 1, 2002. (See Note 7 of Notes to Condensed Consolidated Financial Statements for additional information related to SFAS 142.) Amortization of deferred stock-based compensation was approximately $18.1 million and $18.2 million, respectively, for the three-month periods ended June 30, 2002 and 2001.

Restructuring costs.
In April 2001, we announced a restructuring program to focus our efforts towards concentrating on our strongest opportunities, reducing operating expenses and improving our allocation of resources. The restructuring included a worldwide workforce reduction, consolidation of excess facilities and restructuring of certain business functions. As a result of the restructuring program, we recorded restructuring costs of approximately $17.3 million, which were classified within operating expenses in the quarter ended June 30, 2001.

Worldwide work force reduction

The restructuring program resulted in the reduction of approximately 500 employees across all business functions and geographic regions. The worldwide workforce reductions started in April 2001 and the employment of the affected employees was terminated in the quarter ended June 30, 2001. We recorded a workforce reduction charge of approximately $10.1 million relating primarily to severance and fringe benefits.

Consolidation of excess facilities

The consolidation of excess facilities included the closure of certain corporate facilities and sales offices related to business activities that have been exited. We recorded a restructuring charge of approximately $3.7 million for excess facilities relating primarily to lease termination fees and non-cancelable lease costs.

Termination of other third-party agreements

We also recorded other charges of approximately $3.5 million relating primarily to payments to third parties to terminate contractual agreements as a result of the restructuring program.

A summary of the restructuring costs is outlined as follows (in thousands):

                                                                         
                                                  Termination
                                    Consolidation   of Other
                         Workforce   of Excess    Third-Party
                         Reduction   Facilities    Agreements     Total
                         ---------  ------------  ------------  ---------
Provision recorded at
  restructuring         $  10,149  $      3,719  $      3,463  $  17,331
Non-cash charges              ---           ---          (856)      (856)
Cash payments              (9,912)       (1,268)       (2,607)   (13,787)
                         ---------  ------------  ------------  ---------
Balance, March 31, 2002       237         2,451           ---      2,688
Cash payments                (224)         (559)          ---       (783)
                         ---------  ------------  ------------  ---------
Balance, June 30, 2002  $      13  $      1,892  $        ---  $   1,905
                         =========  ============  ============  =========

We had substantially completed the implementation of our restructuring program as of March 31, 2002. Remaining cash expenditures relating to workforce reductions and termination of agreements will be paid in the quarter ended September 30, 2002. Amounts related to the net lease expenses due to the consolidation of facilities will be paid over the respective lease terms (through fiscal 2006). Our estimated costs to exit these facilities are based on available commercial rates. The actual loss incurred in exiting these facilities could exceed our estimates.

Other Income, net

Other income, net consists primarily of interest income, interest expense, and gains and losses due to fluctuations in currency exchange rates. Other income, net has fluctuated as a result of the amount of cash available for investment in interest-bearing instruments and from fluctuations in currency exchange rates. Other income, net decreased 58% for the three- month period ended June 30, 2002 from the corresponding prior year period. The current year decrease was due primarily to lower interest income as a result of lower interest rates.

Income Taxes

The effective income tax rate benefit was 49% for the three-month period ended June 30, 2002 compared with 27% for the corresponding prior year period. The changes in our effective tax rate were primarily due to the nondeductibility of certain accounting charges associated with our merger and acquisition activities. Excluding these accounting charges, our effective rates were 28% and 30%, respectively, for the three-month periods ended June 30, 2002 and 2001. The benefit from income taxes for the three-month periods ended June 30, 2002 and 2001 differ from the benefit from income taxes computed at the federal statutory income tax rate due primarily to the impact of nondeductible merger and acquisition charges and foreign and state income taxes offset by earnings permanently reinvested in offshore operations and research credits.

Liquidity and Capital Resources

At June 30, 2002, we had cash, cash equivalents, and short-term investments of $1.0 billion and working capital of $860.9 million. Net cash provided by operating activities for the three months ended June 30, 2002 was composed primarily of the net loss plus noncash charges for depreciation and amortization, tax benefit from employee stock plans, compensation expenses related to stock options, decreases in accounts receivable and prepaid expenses and other, and an increase in deferred revenues. These were offset primarily by an increase in other assets and decreases in accounts payable, accrued employee benefits and other accrued expenses, income taxes payable, accrued merger and integration expenses, and net deferred tax liability. Net cash used in investing activities resulted primarily from a net increase in short-term investments and capital expenditure purchases. Net cash used in financing activities resulted primarily from cash used to repurchase our Common Stock, offset by net proceeds received from issuance of Common Stock under the employee stock plans and net proceeds received from reissuance of treasury stock under employee stock plans.

In April 2001, our Board of Directors authorized the repurchase of 20.0 million shares of our Common Stock from time to time in the open market. We repurchased 1.5 million shares of our Common Stock for total cash outlay of approximately $17.3 million for the quarter ended June 30, 2002. As of June 30, 2002, we had repurchased approximately 9.7 million shares of our Common Stock under this program for an aggregate cost of approximately $113.0 million. Repurchases help offset dilution from stock issued under our stock option and stock purchase plans. The timing and size of any future stock repurchases are subject to market conditions, stock prices, our cash position, and other cash requirements going forward.

In fiscal 2000, we completed an offering of 5% Convertible Subordinated Notes in the aggregate principal amount of $500.0 million (the Notes), which mature on February 1, 2007. The interest on the Notes is payable on February 1 and August 1 of each year. The Notes are convertible into shares of our Common Stock at any time prior to the close of business on the maturity date, unless previously redeemed, at a conversion price of $35.72 per share, subject to antidilution adjustments.

We believe that expected cash flow from operations combined with existing cash, cash equivalents and short-term investments will be sufficient to meet our cash requirements for the next 12 months and the foreseeable future.

15

Factors That May Affect Future Results

Significant unanticipated fluctuations in our quarterly revenues and operating results may cause us not to meet securities analysts' or investors' expectations and may result in a decline in the prices of our Common Stock and our Convertible Notes.

Our net revenues and operating results are difficult to predict and may fluctuate significantly from quarter to quarter. If our revenues, operating results, earnings, or future projections are below the levels expected by securities analysts, the prices of our Common Stock and Convertible Notes are likely to decline.

Factors that may cause quarterly fluctuations in our operating results include, but are not limited to:

- global economic conditions;

- decreased spending on technology due to adverse economic conditions;

- the discretionary nature of our customers' purchase and budget cycles;

- difficulty predicting the size and timing of customer orders;

- long sales cycles;

- seasonal variations in operating results;

- introduction or enhancement of our products or our competitors' products;

- changes in our pricing policies or the pricing policies of our competitors;

- an increase in our operating costs;

- whether we are able to expand our sales and marketing programs;

- the mix of our products and services sold;

- the level of sales incentives for our direct sales force;

- the mix of sales channels through which our products and services are sold;

- the mix of our domestic and international sales;

- the ability of our sales force to effectively sell and support new products;

- an increase in the level of our product returns;

- fluctuations in foreign currency exchange rates;

- changes in accounting pronouncements applicable to us;

- costs associated with acquisitions; and

- the impact of terrorist attacks and wars.

In addition, the timing of our product revenues is difficult to predict because our sales cycles vary substantially from product to product and customer to customer. We base our operating expenses on our expectations regarding future revenue levels. As a result, if total revenues for a particular quarter are below our expectations, we could not proportionately reduce operating expenses for that quarter. Therefore, a revenue shortfall would have a disproportionate effect on our operating results for that quarter. In addition, because our service revenues are largely correlated with our license revenues, a decline in license revenues could also cause a decline in our service revenues in the same quarter or subsequent quarters.

Although we experienced growth in revenues in years prior to the year ended March 31, 2002, there can be no assurance that, in the future, we will again achieve or maintain revenue growth or be profitable on a quarterly or annual basis. Nor can there be any assurance that, in the future, we will meet investors' or securities analysts' expectations. For example, our operating results were below the expectations of some securities analysts for the fiscal quarter ended June 30, 2002. The revenues and operating results experienced by us in recent quarters are not necessarily indicative of future results. As a result of the factors described above and other factors, our operating results are subject to significant variation from quarter to quarter, and we believe that period-to-period comparisons of our results of operations are not necessarily useful. If our operating results do not support the prices of our Common Stock or Convertible Notes or are below investors' or securities analysts' expectations, the prices of our Common Stock and Convertible Notes could decline.

If market acceptance of our sophisticated software development tools fails to grow adequately, our business may suffer.

Our future growth and financial performance will depend in part on broad market acceptance of off-the-shelf products that address critical elements of the software development process. Currently, the number of software developers using our products is relatively small compared with the number of developers using more traditional technology and products, internally developed tools, or manual approaches. Potential customers may be unwilling to make the significant capital investment needed to purchase our products and retrain their software developers to build software using our products rather than traditional techniques. Many of our customers have purchased only small quantities of our products, and these or new customers may decide not to broadly implement or purchase additional units of our products.

If industry standards relating to our business do not gain general acceptance, we may be unable to continue to develop and market our products and our business may suffer.

Our future growth and financial performance depends on the development of industry standards that facilitate the adoption of component-based development, as well as enhance our ability to play a leading role in the establishment of those standards. For example, we led the development of the Unified Modeling Language, or UML for visual modeling, which was adopted by the Object Management Group, or OMG, a software industry consortium, for inclusion in its object analysis and design facility specification. The official sanction in the future of a competing standard by the OMG or the promulgation of a competing standard by one or more major platform vendors could harm our marketing and sales efforts and, in turn, our business.

If we do not develop and enhance new and existing products to keep pace with technological, market, and industry changes, our revenues may decline.

The industry for tools automating software application development and management is characterized by rapid technological advances, changes in customer requirements, and frequent new product introductions and enhancements. If we fail to anticipate or respond adequately to technology developments, industry standards, or practices and customer requirements, or if we experience any significant delays in product development, introduction, or integration, our products may become obsolete or unmarketable, our ability to compete may be impaired, and our revenues may decline. We must respond rapidly to developments related to Internet and intranet applications, hardware platforms, operating systems, and programming languages. These developments will require us to make substantial product-development investments.

In addition, rapid growth of, interest in, and use of Internet and intranet environments has occurred only in the last few years and is still an emerging phenomena. Our success may depend, in part, on the compatibility of our products with Internet and intranet applications. We may fail to effectively adapt our products for use in Internet or intranet environments, or to produce competitive Internet and intranet applications. For example, our decision to cease selected development activities associated with our hosted development service will likely adversely impact our ability to offer our products for use in Internet environments.

If we do not effectively compete with new and existing competitors, our revenues and operating margins will decline.

The industry for automating software application development and management is extremely competitive and rapidly changing. We expect to continue to experience significant and increasing levels of competition in the future. Bases of competition include:

- corporate and product reputation;

- innovation with frequent product enhancement, including the support of the development of the new set of emerging standards and tools for building Web services applications and the support of rapidly changing standards and technologies used in the development of Web-based applications and off-the-shelf products;

- breadth of integrated product lines and the availability of integrated suites and bundles, including the development of a broader line of products for programming languages such as C#, C/C++, Visual Basic and Java;

- product architecture, functionality, and features, including the support of multiple platforms (including Microsoft Windows operating systems, Microsoft .NET, J2EE, IBM, UNIX, Linux and various embedded systems development platforms);

- product quality, performance, and ease of use;

- quality of support and availability of technical consulting services, including the use of the latest technologies to support Web-based development of business-critical applications; and

- price.

We face intense competition for each product in our product lines, generally from both Windows and UNIX-based vendors. Current and potential competitors in one or more of our markets include, among others, Applied Microsystems Corporation, Aonix, Artisan Components, BEA Systems, Borland, Broadvision, CanyonBlue, Computer Associates, Compuware, Documentum, Elsinore Technologies, Embarcadero, Empirix, Fujitsu, IBM, I-Logix, Integrated Chipware, Interwoven, MagicDraw, Magna Solutions, Merant, Mercury Interactive, Microsoft, MKS, Object Domain Systems, Oracle, ParaSoft, Perforce, Popkin Software, Pragma Systems Corporation, RadView Software, Serena, Sitraka, Soffront Software, Softera Starbase Corporation, Stellent, Sybase, TeamShare, Telelogic, TogetherSoft, Vector Software, Visual Object Modelers, and WebGain, as well as numerous other public and privately held software application development and tools suppliers. Because individual product sales are often the first step in a broader customer relationship, our success will depend in part on our ability to successfully compete with numerous competitors at each point in their product lines.

We believe that we will continue to experience increasing competition. Some of our competitors have, and new competitors may have, larger technical staffs, more established distribution channels, and greater financial resources than we do. There can be no assurance that either existing or new competitors will not develop products that are superior to our products or that achieve greater market acceptance. In addition, many of our strategic partners compete with each other and this may adversely impact our relationship with an individual partner or a number of partners.

We also face competition from the internal development teams of our customers. Potential customers may create their own software development tools and processes, including ad hoc integrations of stand-alone development tools from different vendors. Customers may be reluctant to purchase products offered by independent vendors such as ours. If we are unable to educate prospective customers about the advantages of our products versus internally developed software quality systems, our results of operations may be adversely affected.

Our future success will depend in large part on our ability to increase our share of target markets and to license additional products and product enhancements to existing customers. Future competition may result in price reductions, reduced margins, or loss of sales, which in turn would have a material adverse effect on our business, results of operations, and financial condition.

Our international operations expose us to greater management, collections, currency, intellectual property, regulatory, and other risks.

International sales accounted for approximately 41% of our revenues for the three-month period ended June 30, 2002 compared to 42% for the comparable prior year period. We expect that international sales will continue to account for a significant portion of our revenues in future periods. The results of our international operations have declined in the most recent period. Our business would be harmed if our international operations experienced a further material downturn. In addition, international sales are subject to inherent risks, including:

- unexpected changes in regulatory requirements and tariffs;

- unexpected changes in global economic conditions;

- adverse effects of terrorist attacks, political turmoil or wars;

- difficulties in staffing and managing foreign operations;

- difficulties in ensuring compliance with U.S. business and accounting standards and practices;

- longer payment cycles;

- potentially adverse tax consequences;

- price controls or other restrictions on foreign currency;

- difficulties in obtaining export and import licenses;

- costs of localizing products for some markets;

- lack of acceptance of localized products in international markets; and

- the effects of high local wage scales and other expenses.

Our international sales are generally transacted through our international sales subsidiaries. The revenues generated by these subsidiaries, as well as their local expenses, are generally denominated in local currencies. Accordingly, the functional currency of each international sales subsidiary is the local currency. We have engaged in limited hedging activities to protect us against losses arising from remeasuring assets and liabilities denominated in currencies other than the functional currency of the related subsidiary. We are also exposed to foreign exchange rate fluctuations as the financial results of international subsidiaries are translated into U.S. dollars in consolidation. As exchange rates vary, these results, when translated, may vary from expectations and adversely impact our overall expected profitability. We currently do not hedge against this exposure. Fluctuations in foreign currencies could harm our financial condition and operating results.

If we lose key personnel or cannot hire enough qualified personnel, our ability to manage our business, develop new products, and increase our revenues will suffer.

We believe that the hiring and retaining of qualified individuals at all levels in our organization will be essential to our ability to manage the development of our business and products successfully. Competition for highly qualified technical personnel is intense, and we may not be successful in attracting and retaining the necessary personnel, which may limit the rate at which we can develop products and generate sales. We will be particularly dependent on the efforts and abilities of our senior management personnel. The departure of any of our senior management members or other key personnel could harm our business. In addition, merger activities can be accompanied or followed by the departure of key personnel, which could compound the difficulty of integrating the operations of the parties to the business combination and adversely affect our business.

If we fail to maintain and expand our distribution channels, our business will suffer.

We currently distribute our products primarily through field sales personnel teamed with highly trained technical support personnel, as well as through our telesales organizations, our Web site, and indirectly through channels such as value-added resellers and distributors. Our ability to achieve revenue growth in the future will depend in large part on our success in expanding our direct sales force and in maintaining a high level of technical consulting, training, and customer support.

We depend on strategic relationships and business alliances for continued growth of our business.

Our development, marketing, and distribution strategies rely increasingly on our ability to form long-term strategic relationships with major software and hardware vendors, many of whom are substantially larger than us. These business relationships often consist of cooperative marketing programs, joint customer seminars, lead referrals, or joint development projects. For example, we are currently a party to relationships with Microsoft and IBM related to the use of our Rational XDE product in their platforms. Although certain aspects of some of these relationships are contractual in nature, many important aspects of these relationships depend on the continued cooperation of each party with us. Merger activity, such as the acquisitions of NeuVis, Catapulse, and Attol, may disrupt these relationships or activities, and some companies may reassess the value of their relationship with us as a result of such merger activity. Divergence in strategy or change in focus or competitive product offerings by any of these companies may interfere with our ability to develop, market, sell, or support our products, which in turn could harm our business. In addition, one or more of these companies may use the information they gain from their relationship with us to develop or market competing products or to develop the functionality of our products into their existing products.

Our products could contain software defects that could result in a loss of our revenues and make it more difficult for us to achieve market acceptance of our products.

Complex software products such as ours often contain undetected errors, or ''bugs,'' or performance problems. These defects are most frequently found during the period immediately following the introduction of new products or enhancements to existing products. Despite extensive product testing prior to introduction, our products have in the past contained software errors that were discovered after commercial introduction. Errors or performance problems may also be discovered in the future. Any future software defects discovered after shipment of our products could result in loss of revenues or delays in market acceptance, which could harm our business. Further, because we rely on our own products in connection with the development of our software, these errors may make it more difficult to sell our products in the future.

If we fail to adequately protect our intellectual property rights, competitors may use our technology and trademarks, which could weaken our competitive position, reduce our revenues, and increase our costs.

We rely on a combination of copyright, trademark, patent, and trade-secret laws, employee and third-party nondisclosure agreements, and other arrangements to protect our proprietary rights. Despite these precautions, it may be possible for unauthorized third parties to copy our products or obtain and use information that we regard as proprietary to create products that compete against ours. In addition, some license provisions protecting against unauthorized use, copying, transfer, and disclosure of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries.

In addition, the laws of some countries do not protect proprietary rights to the same extent as do the laws of the United States. To the extent that we increase our international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase.

The scope of United States patent protection in the software industry is not well defined and will evolve as the United States Patent and Trademark Office grants additional patents. Because patent applications in the United States are not publicly disclosed until the patent is issued, applications may have been filed that would relate to our products.

We rely on software licensed from third parties that is used in our products.

We also rely on software that we license from third parties, including open source software, that is integrated with internally developed software and used in our products to perform key functions. Licenses to such third-party software may not be available to us on commercially reasonable terms or at all, and could adversely affect our ability to protect our proprietary rights. Further, the third-party software may not be appropriately verified, supported, maintained, or enhanced by the licensors. Our loss of licenses to or the inability to support, maintain, and enhance any of this software would likely result in increased costs and delays or reductions in our product shipments until we are able to develop functionally equivalent software or identify and obtain licenses to alternative third party software with comparable functionality, which we may be unable to do. We also may be liable for substantial damages in the event of unauthorized use of third-party software. If any of these events occur, our business and operating results could be materially and adversely affected.

Third parties could assert that our software products and services infringe on their intellectual property rights, which could expose us to increased costs and litigation.

We expect that we will be increasingly subject to infringement claims as the number of products and competitors grows and the functionality of products in different industry segments overlaps. Third parties may assert infringement claims against us in the future and their claims may or may not be successful. We could incur substantial costs in defending ourselves and our customers against third-party claims. Parties making their claims may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products in the United States and abroad and could result in an award of substantial damages against us. In the event of a claim of infringement, we may be required to obtain one or more licenses from third parties. We cannot be sure that we can obtain necessary licenses from third parties at a reasonable cost, or at all. Defense of any lawsuit or failure to obtain any required license could delay or prevent shipment of our products and increase our costs. The occurrence of any of these events could materially harm our business and operating results.

Promotional product versions may adversely impact our actual product sales.

Our marketing strategy relies in part on making elements of our technology available for no charge or at a very low price, either directly or by incorporating these elements into products offered by third parties, such as Microsoft, with whom we have strategic alliances. This strategy is designed to expose our products to a broader customer base than our historical customer base and to encourage potential customers to purchase an upgrade or other higher-priced products from us. We may not be able to introduce enhancements to our full-price products or versions of our products with intermediate functionality at a rate necessary to adequately differentiate them from the promotional versions, particularly in cases where our partners are distributing versions of our products with other desirable features, which could reduce sales of our products.

If we cannot successfully integrate our past and future acquisitions and achieve intended financial or strategic benefits, our revenues may decline and our expenses may increase.

We have acquired a number of businesses, technologies, and products, most recently in July 2002. If we fail to achieve the intended financial or strategic benefits of past and future acquisitions, including the acquisitions of NeuVis, Attol, and Catapulse, our operating results will suffer. For example, we recently decided to cease selected development activities relating to the technology developed by Catapulse. Acquisitions entail numerous risks, including:

- difficulty with the assimilation of acquired operations and products;

- failure to achieve targeted synergies;

- inability to retain key employees of the acquired companies;

- loss of key business relationships of the acquired company; and

- diversion of the attention of our management team.

In addition, if we undertake future acquisitions, we may issue dilutive securities, assume or incur additional debt obligations, incur large, one-time expenses, or acquire intangible assets that would result in significant future amortization expense. Any of these events could harm our business or operating results.

Business interruptions could adversely affect our business.

Our operations are vulnerable to interruption by fire, earthquake, power loss, computer viruses, telecommunications and computer network failures, terrorist attacks, wars and other events beyond our control. For example, our facilities in the State of California have been subject to electrical blackouts as a consequence of a shortage of available electrical power. In the event such blackouts occur in the future, they could disrupt the operations of our affected facilities. In addition, we rely on a private network for communication and access to our digital resources. If we lost access to our network as a result of local or general telecommunications failures, our business operations would be adversely affected.

ITEM 3
- Quantitative and Qualitative Disclosures about Market Risk

We are exposed to market risk, including changes in interest rates and currency exchange rates. To manage the volatility relating to these exposures, we employ established policies and procedures to manage our exposure to fluctuations in interest rates and changes in known or forecasted currency exchange rates. As of June 30, 2002 no significant changes concerning market risk have occurred since our Annual Report on Form 10-K for the fiscal year ended March 31, 2002.

Foreign Currency Exchange Rate Risk

A portion of our business is conducted in currencies other than the U.S. dollar. Changes in the value of major foreign currencies relative to the local or "functional" currency of our subsidiaries or us may adversely affect operating results. We enter into short-term forward foreign exchange contracts designed to mitigate the impact of foreign currency exchange rate fluctuations on balance sheet exposures denominated in currencies other than the "functional" currency. The total amount of these contracts is approximately offset by the underlying assets and liabilities denominated in nonfunctional currencies. Forward contracts are accounted for on a mark-to-market basis. Gains and losses on forward contracts are recognized in our Consolidated Statements of Operations when the related transactions being hedged are recognized or the contracts mature. Such contracts meet the criteria established in SFAS 52, "Foreign Currency Translation for Hedge Accounting Treatment." We adopted SFAS 133, "Accounting for Derivative Instruments and Hedging Activities" in the first fiscal quarter of fiscal 2002. The adoption of SFAS 133 did not have a material impact on our financial position or results of operations. As we find it impractical to hedge all foreign currency exposures, we will continue to experience foreign currency gains and losses. We do not use derivative financial instruments for speculative trading purposes, nor do we hold or issue leveraged derivative financial instruments.

Interest Rate Risk

Our exposure to market-rate risk for changes in interest rates relates primarily to our investment portfolio. All our short-term investments are classified as available-for-sale and are recorded at amounts that approximate fair value based on quoted market prices. Realized gains and losses and declines in value judged to be other than temporary on available-for-sale securities are included in interest income. The cost of securities sold is based on the specific identification method. Unrealized gains on available-for-sale securities are included in accumulated other comprehensive income (loss), which is a separate component of stockholders' equity. Our Convertible Subordinated Notes were issued at a fixed interest rate and with fixed conversion rates and therefore do not expose us to the risk of earnings or cash flow loss due to change in market interest rates.

PART II - OTHER INFORMATION
ITEM 1 - Legal Proceedings

On July 3, 2001, a purported derivative lawsuit, entitled Krim v. Levy, et al., No. CV799591 (Supr. Ct. Santa Clara Cty.), was filed. Defendants' demurrer to the complaint was sustained with leave to amend on September 18, 2001. An amended complaint was filed on September 24, 2001. The complaint names as defendants the Company's Board of Directors and certain unnamed persons. The Company is a nominal defendant. The complaint alleges that defendants breached their fiduciary duties to the Company by deciding to invest in and to purchase Catapulse Inc. The complaint seeks various equitable remedies and compensatory and special damages in unspecified amounts plus legal fees and costs from the defendants. The Court held a hearing on January 14, 2002 regarding the defendants' demurrer to the amended complaint. On January 22, 2002, the Court issued an order overruling defendants' demurrer. The Company and the other defendants believe that the claims asserted in this action are without merit and intend to defend against them vigorously.

ITEM 5 - Other Information

Section 10A(i)(2) of the Securities Exchange Act of 1934, as added in Section 202 of the Sarbanes-Oxley Act of 2002, requires us to disclose the approval by our Audit Committee of any non-audit services to be performed by our auditor. The Audit Committee of the Board of Directors of Rational has previously approved the performance of certain tax-related services by our auditor, Ernst & Young LLP.

ITEM 6 - Exhibits and Reports on Form 8-K
(a) Exhibits:

Exhibit No.

Description

10.1

Rational Software Corporation Fiscal Year 2003 Corporate Incentive Compensation Plan

99.1

Certification of Chief Executive Officer and Chief Financial Officer

(b) Reports on Form 8-K: None

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	RATIONAL SOFTWARE CORPORATION


	(Registrant)


	By:	/s/ David J. Henshall



	David J. Henshall
	Vice President, Chief Financial Officer, Treasurer, and Secretary
	(Principal Financial Officer and Chief Accounting Officer) August 14, 2002

EXHIBIT INDEX

Exhibit No.

Description

10.1

Rational Software Corporation Fiscal Year 2003 Corporate Incentive Compensation Plan

99.1

Certification of Chief Executive Officer and Chief Financial Officer

RATIONAL SOFTWARE CORP 10-Q