10-K 1 fy0510ktextfilev1.txt MARCH 31, 2005 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) |X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended March 31, 2005 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: 000-32967 HPL TECHNOLOGIES, INC. (Exact Name of Registrant as Specified in Its Charter) Delaware 77-0550714 (State of Incorporation) (I.R.S. Employer Identification No.) 2033 Gateway Place, Suite 400, San Jose, California 95110 (Address of Principal Executive Offices) (Zip Code) (408) 437-1466 (Registrant's telephone number, including area code) Securities registered under Section 12(b)of the Act: None Securities registered under Section 12(g)of the Act: Common Stock, $0.001 Par Value (Title of Class) 1 Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. |X| Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 under the Securities Exchange Act of 1934). Yes |_| No |X| The aggregate market value of the shares of the registrant's common stock held by non-affiliates of the registrant (all stockholders other than officers, directors and 5% or greater stockholders) as of September 30, 2004 was $11,359,716 (based upon an average of the closing bid and asked price of $0.57 per share as of such date, as reported in the "Pink Sheets" published by Pink Sheets LLC). As of May 31, 2005, the registrant had outstanding 38,768,065 shares of common stock. TABLE OF CONTENTS

~~TABLE OF CONTENTS~~ PART I Item 1 Business 4 Item 2 Properties 1516 Item 3 Legal Proceedings 1516 Item 4 Submission of Matters to a Vote of Security Holders 1718 PART II Item 5 Market for Registrant's Common Stock, ~~and~~ Related Stockholder Matters 18and Issuer Purchases of Equity 19 Securities Item 6 Selected Financial Data 1819 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations 2021 Item 7A Quantitative and Qualitative Disclosures about Market Risk 40 Item 8 Financial Statements and Supplementary Data 42 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 7067 Item 9A Controls and Procedures 70 PART III Item 10 Directors and Executive Officers of the Registrant 71 -2- Item 11 Executive Compensation 71 Item 12 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 74 Item 13 Certain Relationships and Related Transactions 76 Item 14 Principal Accountant Fees and Services 76 PART IV Item 15 Exhibits, Financial Statement Schedules, and Reports on Form 8-K 7767

~~Name~~PART ~~Age~~III ~~Position~~Item ~~------------------------------------------------~~10 ~~----------~~Directors ~~---------------------------------------------------------------------- Cary D. Vandenberg 48 President~~ and ~~Chief~~ Executive ~~Officer~~Officers ~~Michael~~of P.the ~~Scarpelli~~Registrant 3769 ~~Chief~~Item ~~Financial~~11 ~~Officer,~~Executive ~~Senior~~Compensation ~~Vice~~69 ~~President~~Item of12 ~~Administration~~Security ~~and~~Ownership ~~Secretary Elias Antoun 47 Director, Chairman~~ of ~~the~~Certain ~~Board~~Beneficial ~~Lawrence~~Owners ~~Kraus~~and 41Management ~~Director~~and ~~Dr.~~Related ~~Yervant~~Stockholder ~~Zorian~~Matters 4872 ~~Director~~Item ~~William~~13 ~~Lamkin~~Certain ~~III~~Relationships 60and ~~Senior~~Related ~~Vice~~Transactions ~~President~~73 ~~Sales~~Item &14 ~~Global~~Principal ~~Customer~~Accountant ~~Support~~Fees ~~Dr.~~and ~~Victor~~Services ~~Boksha~~73 43PART ~~Vice~~IV ~~President~~Item of15 ~~Business~~Exhibits ~~Development~~and ~~Dean~~Financial ~~Frazier~~Statement 44Schedules ~~Vice President of Marketing Brian Gordon 46 Vice President of Software Engineering~~74

3 PART I GENERAL FORWARD-LOOKING STATEMENTS This report contains forward-looking statements that involve substantial risks and uncertainties. In some cases you can identify these statements by forward-looking words such as "anticipate", "believe", "could", "estimate", "expect", "intend", "may", "should", "will", and "would" or similar words. You should read statements that contain these words carefully because they may discuss our future expectations, contain projections of our future results of operations or of our financial condition or state other "forward-looking" information. However, there may be events in the future that we are not able to accurately predict or control. The factors listed in Item 7 under the caption "Risk Factors", as well as any cautionary language in this report, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. You should be aware that the occurrence of any of the events described in these risk factors and elsewhere in this report could have a material adverse effect on our business, financial condition and results of operations. ITEM 1. BUSINESS OVERVIEW We are focused on a single objective - to maximize yield potential in every phase of the semiconductor product lifecycle, from process technology development, through design, and into manufacturing and test. By combining our proven, configurable enterprise software platforms and proprietary TestChip Intellectual Property ("TestChip IP"), we enable manufacturers of semiconductors and flat panel displays to quickly identify and correct yield-limiting factors in their design, technology development and manufacturing processes. We provide one of the industry's most comprehensive yield optimization solutions. Unless we specify otherwise, all references to the Company and HPL in this report refer to HPL and its subsidiaries. Our principal executive offices are located at 2033 Gateway Place, Suite 400, San Jose, California 95110 and our telephone number is (408) 437-1466. INDUSTRY BACKGROUND Semiconductor Industry The semiconductor product development process can be grouped into three broad stages: 1) process technology development, 2) design and 3) manufacturing. These stages are described below: 1) Process Technology Development. Semiconductor production begins with the development of "process technology", during which a semiconductor fabricator determines device characteristics and assesses the yield impact on manufacturing margins. Based on the results of the assessment, physical "design rules" and electrical "process parameters" are created to assure that products can be reliably produced in a given fabrication facility. These design rules and process parameters guide the product design process in the second stage of product development, described below. 4 2) Design. The second stage of semiconductor development is product design. Design requires complex software to place and connect individual electrical components (transistors) to construct the functionality of a product. A leading-edge design can call for millions of transistors and interconnections on a square centimeter of silicon. To manufacture a semiconductor product that functions properly, it must be designed with exact precision and expressly for a given semiconductor process technology, described above. 3) Manufacturing. The third step in the semiconductor development process is manufacturing. Manufacturing requires hundreds of individual processing steps to form patterned layers of material on a wafer which create transistors and connect them to form the desired electronic circuitry or function. Additionally, the manufacturing process includes packaging and testing of the individual chips themselves. In the case of new technology, interactions among the various wafer fabrication processes and/or the design frequently cause new types of defects and new sources of failure. Constant and accurate measurement and inspection are required to find defects and eliminate defect sources during wafer manufacturing as well as assembly and test processes. The early detection and subsequent resolution of yield problems can result in significant cost savings to the manufacturer. We believe that two fundamental semiconductor industry trends have aligned to create a significant opportunity for us. The first trend is the continuing fragmentation of the semiconductor development chain. The industry has evolved from classic semiconductor companies (integrated device manufacturers, or IDMs) that were once self-contained with full technology development, design, and manufacturing capabilities contained within one company into an industry of specialized companies with sub-market segments. Over the past twenty years, this outsourcing trend has given birth to many large and growing industry niches including assembly and test subcontractors, Electronic Design Automation ("EDA") companies, pure-play wafer foundries, and intellectual property ("IP") providers. The success of foundries has enabled fabless companies engaged in design and sales/marketing, but not manufacturing, to develop and flourish. The second trend is the increasing complexity of process technologies that accompanies each new technology node, or smaller chip features, such as 90nm and 65nm (known as "nodes"). Process variations and defects that were once a concern for manufacturing only are now having significant impact on design, and new process modules required for advanced device structures are affecting designs in unanticipated ways. For example, low capacitance interconnects and resolution enhancement technologies introduced at the 130nm technology node have necessitated dramatic changes in how circuit topologies are formed. Redundant connections ("vias") between metal lines and optical proximity correction ("OPC") techniques have become mandatory for 130nm devices. These effects were not fully comprehended during the transition to 130nm, and as the industry moves to more advanced technology nodes (90nm, 65nm, 45nm), the interdependency between technology development, semiconductor design and manufacturing will continue to intensify. As the semiconductor industry continues to fragment, tighter linkages between the different stages of the semiconductor development chain are becoming more critical. Because of these two pervasive and divergent trends, we are in a unique position to provide product solutions that bridge the technology development, design, and manufacturing worlds with tools, data, and IP to optimize yields and accelerate time-to-volume. Point solutions are emerging to solve problems in this growing solution space, referred to as Design for Manufacturing ("DFM"). We have a unique combination of products, IP, and expertise to provide high-value, yield-focused, comprehensive solutions in the DFM segment. 5 Importance of Yield Yield is a measurement of the efficiency of a product development process. Specifically, yield is the percentage of properly functioning devices produced at each stage in the manufacturing process. Improvement of yield or "yield learning" is often challenging and involves the continual identification and resolution of the root causes of failure in the design and manufacturing process. New products built with newer, less mature semiconductor manufacturing processes often start with very low yields because fabrication procedures and device technologies are not yet fully optimized. During the transition from early fabrication to volume production, yield improvements can be achieved, but are often difficult as production equipment and processes are stressed to maximize throughput. Even as production volumes increase, yield may often fall as new production equipment is brought on-line and test programs are enhanced to reduce test escapes. Yield improvement is a multi-faceted challenge as thousands of factors in the semiconductor production process may affect yield. These factors contribute to yield loss based on the sensitivity and margin of the design and manufacturing. By definition, failures are either random or systematic in nature. Random failures are typically caused by arbitrary particles introduced into the fabrication process, causing circuit faults such as a bridge between two adjacent metal lines. Systematic failures emanate from non-random sources such as equipment or environmental changes, and design sensitivity or material property variations. Due to yield learning, each successive generation of semiconductors becomes somewhat less sensitive to existing failure modes but remain susceptible to new failure modes. This creates a constant need to capture and analyze more data to improve yields. The sheer volume of data, and the amount of complex analysis required, has become an impediment to improving the yield learning curve. To identify factors that affect yield in a new process, semiconductor companies must collect and analyze an immense (and growing) amount of data that is generated throughout the semiconductor product development lifecycle, often from several worldwide locations and, increasingly, from supply chain partners. In any semiconductor fabrication facility, there are likely to be as many as 50 different sets and formats of data produced, each with thousands of individual parameters that need to be tracked. While this data provides important clues to yield enhancement, the efficient collection, correlation and analysis across the various data sets presents a substantial challenge for the semiconductor industry. High yield is an essential requirement for a profitable semiconductor business, especially during the introduction of new products. Selling prices and profit margins are typically higher in the early stages of a new semiconductor product lifecycle. Just a small acceleration along the yield learning curve can create disproportionately greater revenue and profitability. Another benefit of fast yield ramp-up is the increased revenue that is associated with the measured speed of microprocessors, application specific integrated circuits ("ASICs") and telecom devices. High parametric yield enables parts to operate at higher frequencies and subsequently command higher selling prices. As the product lifecycles advance, high yield can accelerate cost reductions and maximize efficiency gains. These factors make it essential that semiconductor companies monitor and maintain yield on an ongoing basis throughout the entire product lifecycle. In today's volatile markets where capacity utilization rates fluctuate, yield improvement remains fundamental to business success. Given the immense costs of a semiconductor fabrication facility and the economics of production efficiency, the rate of yield learning is a critical component in the profitability of any semiconductor company. Flat Panel Industry Continued innovation in the flat panel display ("FPD") industry is driving the proliferation of liquid crystal display ("LCD") applications in entertainment and communication devices such as cell phones, digital cameras, and computer and television monitors, as well as other fields such as industrial, automotive, and aviation. 6 The latest estimates by DisplaySearch predict the global FPD market (including AM-LCD) will grow 140% to $62 billion by the end of 2006. The projected demand for LCD-TVs, forecasted to be at a 76.5% compound annual growth rate, is the future growth driver for the FPD market with about 189 million units expected to be shipped by 2006. Manufacturing cost reductions, faster ramp, improved return on investment, and higher yields driven by yield management solutions will enhance the performance of FPD manufacturers. The move to new FPD substrate sizes (i.e. generations 6 and 7) is expected to reduce manufacturing costs. In addition, the improvements in manufacturing processes are focused on cost reduction with the introduction of new processes in the thin film transistor ("TFT") array, color filter, liquid crystal and module process. These new changes present significant manufacturing and yield management challenges. FPD yield management solutions empower engineers to solve yield related problems by aggregating all yield-relevant data and providing them with sophisticated analysis techniques. Currently, most FPD yield management tools are internally developed by FPD manufacturers. The development and integration of these yield management tools is a significant challenge for FPD manufacturers and a significant driving force for implementing commercial yield management tools that are scalable, collaborative, open, reliable and extensible. HPL PRODUCTS AND TECHNOLOGY HPL provides an integrated suite of yield enhancement software solutions that enables customers to optimize yields in all three stages of semiconductor development: process technology development, design and manufacturing. Derived from years of experience working with leading semiconductor manufacturing companies, HPL has embedded much of the industry's best practices directly into its yield optimization products. HPL's yield optimization software delivers high-impact business results by reducing the time to high yield through streamlined data analysis and enhancing collaboration among process technology development, design and manufacturing. Odyssey(TM) Odyssey is a production-proven defect and yield data management solution. Odyssey and its predecessors are in use at over seventy manufacturing sites worldwide. Odyssey delivers results efficiently and reliably, leveraging error-correcting processes to assure users of maximum up-time. It has an open and equipment vendor-neutral architecture that supports most inspection, review and classification tools with a full range of charting, wafer mapping, statistical analysis and lot dispositioning solutions. Odyssey is easy to use and provides high productivity with its all-in-one graphical user interface ("GUI"). Odyssey simplifies and automates in-line defect analysis, reducing cycle times and enabling engineers to address other critical yield-limiting issues. Odyssey also efficiently correlates different data types to quickly deduce the root cause of manufacturing problems. Advanced Data Mining algorithms uncover hidden correlations, and easy-to-use templates automate daily and repetitive analyses at preset intervals. Odyssey includes several optional analysis modules including: Metrology, which collects and analyzes data from inline production equipment. Metrology captures measurements such as resistivity, critical dimensions, wafer flatness, and oxide and etch rate monitors; Parametric, which analyzes data collected from inline Wafer Electrical Test and end-of-line Wafer Acceptance Test automatic test equipment. Standard support is included for systems such as Agilent and Keithley testers; 7 BIN, which utilizes final wafer sort (chip probe) data, collected with Automated Test Equipment from companies such as Teradyne, Advantest, Credence, LTX and Agilent, and permits users to correlate final yield with all other data types to help identify causes of yield loss; BIT, which analyzes failing bit signatures, failing patterns per die and per wafer, and graphically overlays failure data with defect data; and WIP, which encompasses process flow, tool and route information collected by Manufacturing Execution Systems, such as PROMIS(TM), FACTORYworks(TM), WorkStream(TM) and SiView(TM). A key feature of this module is that it permits the user to investigate problems found in other data domains and identify the tool or tool group which may be the source of the problem, thereby saving significant fab engineering time in diagnosing yield problems. Memory YIELDirector Memory YIELDirector ("MYD") accelerates yield learning and problem resolution for DRAM, SRAM and Flash memory arrays on semiconductor devices. MYD automates analysis of fab and test data for all memory types including embedded memory. Using powerful analysis algorithms, MYD automatically descrambles and classifies failing bitmaps into unique signatures, and correlates them with in-line defect inspection data to determine defect "kill" ratios. MYD also helps correlate bitmap failures with fatal defects (defects that cause failures in the device) to isolate the root causes of failure mechanisms in memories. DSSA Sentry DSSA Sentry is a new production-proven tool that employs defect spatial signature analysis ("DSSA") algorithms to automatically classify the distributions of defects found on semiconductor wafers. These distributions appear visually as streaks, lines or other noticeable patterns of defects and usually cause large yield loss. By detecting these patterns or signatures early in the process, potential yield killers can be caught and the problem sources rapidly identified and fixed. Critical signatures like CMP and handling scratches, photo-lithography induced repeaters, and streaks are easily detected by the DSSA sentry tool. Production use has shown a signature capture rate of over 80%, compared to the typical manual review process which captures only about 5% of actual fab signatures. Consequently, DSSA Sentry offers users a high ROI by finding more yield killers earlier in the process. YieldProjectorTM YieldProjector enables design engineers to improve the projected yield of a design before it ever reaches the manufacturing process. YieldProjector simulates the yield impact of a wide-range of random defects on a design's layout, based on statistical information from similar manufacturing process. It calculates the probable number of fatal defects on each layer of the design along with the projected yield of that layer. YieldProjector graphically highlights yield-limiters in the design layout so design engineers can compare various layout options and critical feature usage to improve a design's immunity to random manufacturing defects. This significantly increases yield and speeds time to volume production. 8 Cell Designer Cell Designer addresses the core issue of Design for Manufacturability ("DFM"): predicting the electrical performance of a circuit manufactured on silicon in a specific process. Starting from a circuit's layout level representation, calibrated process simulation accurately predicts the effects of lithography, etch and process variability to obtain physical predictions for circuit performance and yield. Utilizing tight integration between process and circuit simulation environments, Cell Designer enables rapid, what-if analysis and fast, interactive operation. Cell Designer can be applied to a wide variety of design styles, including memory, standard cell and custom logic. Designers using Cell Designer may produce better, more accurate and better yielding circuits than previously possible. We market and sell Cell Designer under an exclusive agreement with Sequoia Design Systems, Inc., the developer of the product. Recipe Management and Editing ("RME") RME is a universal enterprise solution that facilitates the management and control of process recipes from a central repository. Process recipes are used to control the program process and metrology tools at every step in a semiconductor manufacturing process. RME dramatically reduces product scrap, improves yield and increases productivity of semiconductor fabs. A patented off-line editing module allows engineers to edit process recipes at their desk or anywhere on the corporate intranet without sacrificing security or increasing tool downtime. Odyssey-FPD Odyssey-FPD is a yield optimization solution built specifically for the unique challenges of FPD manufacturers. Odyssey-FPD leverages our highly scalable Odyssey platform. This enables FPD customers to integrate relevant manufacturing data, including defect, parametric and test, into a seamless and powerful yield optimization environment. Odyssey-FPD is tailored to the FPD industry's yield management needs and provides the information control backbone of fab-wide data. It gathers, integrates and leverages all yield, process and test-floor related data into an automated, customizable and easy to use data collection, analysis and reporting system. The benefits to customers are numerous, but relate primarily to accelerated yield learning rates and reduced time to corrective action for yield and process excursions. With its "analysis recorder" automated functionality and an enterprise development toolkit, production lots are dispositioned more quickly, increasing productivity; excursions are identified in real time, and engineering resources are freed from repetitive tasks, enabling them to concentrate on corrective actions. TestChip Technologies Products and Services Our TestChip products address the needs of semiconductor companies in many aspects of process technology development, design and manufacturing. Developing process technology is a lengthy process that frequently takes 18-24 months, and requires a number of expert resources to design and validate each process step, followed by process qualification. The complexity of smaller chip features, such as 90 nm and 65 nm (known as "nodes"), requires a large number of devices and circuits that characterize not only each process step, but also the integrated process behavior and performance. This increasing complexity, coupled with smaller chip sizes, is causing semiconductor producers to adopt yield solutions such as those offered by our TestChip products. HPL's TestChip products provide capabilities to accelerate semiconductor process technology development to the 65nm node and beyond. Additionally, for advanced technology nodes, these products provide new and innovative methods for semiconductor manufacturing process characterization and monitoring. We have deployed advanced semiconductor process technologies using our TestChip solutions at leading IDMs. Semiconductor manufacturers have used TestChip solutions for more than eight years, at seven technology nodes 9 and across multiple process technologies, such as CMOS, BiCMOS, Radio Frequency ("RF"), Analog and others. HPL has successfully completed TestChip projects for technology nodes from 350nm to 45nm. The TestChip product line consists of a library of proprietary IP and TestChip circuits, supplemented by powerful software products, and services, each of which are described more fully below. HPL will also customize the TestChip Technology IP and services to better enable project success. TestChip Technology Development IP & Chip Sets Our proprietary TestChip IP contains over 1,500 standard module elements to address the full breadth of advanced CMOS technology development concerns, including 193nm lithography, copper and low-k interconnect integration, and advanced transistor development. Our TestChip IP also contains elements for improving yield in test structures, non-volatile memory, Silicon-on-Insulator ("SOI"), high-power devices, Silicon-Germanium, and RF devices. From this IP, we can produce GDSII, HTML documentation and test programs, all generated from a common database resulting in consistent and high quality results. TestChip TechXpress Array Technology Platforms Our TestChip TechXpress(TM) array technology platforms alleviate many issues involved in sub-130nm technology development and monitoring. Traditional methods allow a limited number of devices and circuits to be used for identifying and resolving process and yield issues. Our TechXpress(TM) array platforms dramatically increase the number of devices and circuits that can be used, thereby resulting in more effective identification, diagnosis and resolution of process and yield issues. The TechXpress(TM) Array Family comprises three powerful technology platforms: TDSRAMTM, TDROMTM and TDParametricTM. From these technology platforms HPL has generated over twenty different unique TestChip solutions that span the entire semiconductor lifecycle, each targeted at solving specific problems encountered at the various stages of process life cycle. TestChip Solutions are grouped into four chip sets that are used by process integration and yield engineers to target specific tasks found at each stage of the process life cycle. The chips sets are classified as, ToolBox (for early materials and litho characterization), RaceTrack (for technology development, process integration and primary parameter characterization), OnRamp (for parametric, systematic and random defectivity based Yield Ramp) and Expressway (for parametric and systematic yield monitoring). Within each chip set are test vehicles that target all key areas of nanometer-era Front-End-of-Line (FEOL) and Back-End-of-Line (BEOL) process integration and yield ramp, and have proven effectiveness from 180nm to 45nm. The TestChip solutions are sold as "chip sets" combined with a powerful software analysis tool called TestChip Advantage(TM). TestChip Advantage(TM) has analysis modules customized to each of the unique TestChip solutions that enable the customer to quickly turn large amounts of TestChip data into actionable information for development and debug of their processes. TDSRAM: The TDSRAM is used for bitcell development and process qualification. The TDSRAM bit is designed to measure key process parameters and is intentionally more sensitive to variations and yield issues than a conventional SRAM design. The TDSRAM can also be used to measure defect densities during volume manufacturing. TDROM: The TDROM measures process excursion and design rule skews, making it ideally suited for process characterization and monitoring. The higher number of circuits built within a specific TDROM provide a more dramatic increase in spatial resolution than is possible with traditional test structures. 10 TDParametric: The TDParametric array is unique in its ability to measure the intrinsic electrical properties of the process. It produces a parametric response that provides a finer resolution of the measurement. TDParametric can be used, among other things, for via resistance measurements and FET matching effects measurements. Some of the specific use cases for the array family products are bitcell development, process qualification, systematic yield loss diagnosis, process characterization and process monitoring. Customers use results derived from the arrays to correlate yield and analyze failures electrically and physically. TestChip Advantage(TM) TestChip Advantage(TM) is a sophisticated analysis and data reduction software based on our yield management software. Engineers can extract answers from the wafer test data using this software, saving them invaluable time by automating tedious analysis setup and by providing customized novel viewing of the experiments that HPL provides for yield understanding and root cause yield loss assessment. Using the TestChip Advantage(TM) templates and database, we capture the knowledge and intent of the various experiments during the design phase. Yield engineers are able to access the wafer results (both historical and current) to analyze process issues and shifts prior to product yield loss. TestChip Advantage(TM) allows the customer to view results grouped by experiment type, by layer, and by figures of merit. Both bit map and parametric data are available with the ability to do statistical analysis of parameters over multiple wafers and lots. Trend Analysis is also available between wafers / lots including spatial analysis of failures within a die or across wafer. TestChip Advantage(TM) also enables the customer to do split lot analysis and to classify wafers based on different process equipment used. The software supports customization by the user using advanced data mining features. These capabilities allow fast wafer level analysis, all accessible from a user-friendly menu system, which in turn enables trend monitoring and identification of potential yield hits. SALES AND MARKETING We rely on our direct sales force, distributors and sales agents to market our products to the semiconductor and flat panel display manufacturing markets. Our direct sales efforts have focused primarily on licensing our software products and TestChip technologies to semiconductor IDMs, foundries and flat panel display manufacturers. Our direct sales force operates out of our headquarters in San Jose, California and our facilities in Bedford, Massachusetts; Austin, Texas; Plano, Texas; Yokohama, Japan; Hsin Chu, Taiwan; and Aix-en-Provence, France. Our sales and marketing personnel also focus on developing our relationships with industry partners, which include semiconductor original equipment manufacturers ("OEMs") who can bundle our products in their hardware. These joint-marketing relationships provide us with access to the customer bases of these OEMs. We intend to continue to expand our industry relationships in the future. RESEARCH AND DEVELOPMENT The market for DFM and yield optimization is characterized by rapid technological development and product innovation. We believe that timely development of new products and enhancements to existing products are necessary to maintain our competitive position. Accordingly, we devote a significant portion of our human and financial resources to research and development programs and seek to maintain close relationships with customers to remain responsive to their needs. 11 The complexity of DFM and yield optimization requires domain expertise in physical integrated circuit ("IC") design and fabrication as well as software development. Today, we employ a staff of software development engineers focused on the development of yield-optimization software products. Our team also encompasses a core group of engineers and technicians with extensive education, experience and expertise in the semiconductor domain. Virtually every discipline associated with the lifecycle of an IC is represented at our company, including device physics, product design, product engineering, yield engineering, failure analysis engineering, fab management, process engineering and testing. COMPETITION The worldwide market for productivity enhancement tools and systems for semiconductor companies is highly competitive and characterized by rapidly changing technologies. We face direct competition from semiconductor companies that have developed or have the ability to develop their own proprietary yield-optimization tools and systems, as well as third-party providers of yield-management software and services. The tools and systems against which our products and services most often compete are those that semiconductor companies have created in-house as part of a specific fabrication process or through a dedicated development group. We must overcome a tendency that some producers may have to resist outside solutions. The third-party providers that compete in the market for yield-optimization tools are, generally, divisions of larger semiconductor equipment OEMs, such as KLA-Tencor, or smaller private companies, such as Yield Dynamics. Additionally, PDF Solutions provides service-based solutions where HPL products can also be used. The success of our business or other businesses like ours might prompt increased competition. As a result, we must continue to improve existing products, develop new products and protect our innovations through intellectual property laws in order to continue to differentiate our product offerings. Significant factors in our target market's choice of productivity-enhancement software include its performance, ease of use, reliability, price, compatibility with existing systems, installed base and technical service and support. While price is an important competitive factor, we believe that customers will choose the most effective productivity software, even if it is more expensive, because of the added profitability from better production yield. INTELLECTUAL PROPERTY Our future success and competitive position depends heavily upon our continued ability to develop new proprietary technology while protecting our existing intellectual property. To protect our products and their underlying technology, and to prevent competitors from using our technology in their products, we use a combination of patents, trade secrets and copyrights. As of March 31, 2005, we held ten U.S. patents and five Taiwan patents, expiring at different times between 2013 and 2025, had two pending U.S. patents, and eight U.S. patent applications and twelve foreign patent applications in process. We expect that, if granted, the duration of these patents will be 20 years from the date of filing the application. We continue to vigilantly pursue U.S. and foreign patent filings. We have additional patent applications that we are developing internally and may file in the future. There is no assurance that any of our current or future patent applications will result in the issuance of patents, and our existing or future patents may be circumvented, declared invalid or challenged as to scope or ownership. For these and other reasons, we may not realize any competitive advantage from our existing patents and any patents that we may be granted in the future. Furthermore, our competitors may develop technologies that are similar or superior to our proprietary technologies or design around any patents that we may hold. To the extent that others are able to obtain patents that overlap with our technologies or processes, we may be required to license these patents. 12 If we are unable to license these patents or obtain licenses on acceptable terms, we may need to alter our products or discontinue selling them altogether. In addition, we have not secured patent protection in all foreign countries for all equivalent U.S. patents we hold and we cannot be certain that the steps we take to prevent misappropriation of our intellectual property abroad will be effective, or that the application of foreign laws to technology developed abroad will not adversely affect the validity or enforceability of our U.S. patents. Much of our intellectual property has not been patented or is not patentable. Accordingly, we have historically protected our non-patented intellectual property as a trade secret. Trade secret protection is in many ways inferior to patent protection. Others may reverse-engineer our non-patented technologies and lawfully use any underlying technology that is discovered in this process. We typically enter into confidentiality agreements with prospective customers, distributors and business partners prior to disclosing material proprietary information. These agreements prohibit unauthorized use and disclosure of our trade secrets and other proprietary information. We currently require all of our employees to enter into similar agreements. While we believe that these agreements provide a measure of protection of our intellectual property, they may be declared invalid or unenforceable, or we may not have the resources to seek enforcement in the event of a breach. Additionally, courts only protect trade secrets from misappropriation to the extent that we have taken reasonable steps to protect the confidentiality of these trade secrets. It is possible that a court would find our trade-secret protection practices inadequate and declare portions of our trade secrets unprotected from misappropriation. Much of our source code is written by programmers and engineers in the Republic of Armenia. We generally rely on U.S. and Armenian copyright law and international treaties for protection of our software source code, software object code, training materials and user manuals created by our employees. While U.S. copyright law protects the expression of an idea, it does not protect the idea itself from being copied. As a result, others may be able to glean valuable concepts and methods from our copyrighted material and lawfully use these ideas and methods in a competing product or venture by simply changing the manner of expression. In an effort to protect our software from misappropriation, we do not typically divulge our source code to customers or vendors. EMPLOYEES As of April 30, 2005, we employed approximately 218 employees worldwide with 75 in the United States, 120 in Armenia and 23 in four other locations around the world. None of our employees are represented by a labor union or are subject to a collective bargaining agreement. We believe that our relationship with our employees is good. DIRECTORS AND OFFICERS The following table sets forth the directors and officers of the Company, their ages and positions as of May 31, 2005:

~~Square~~Name ~~Expiration~~Age ofPosition ~~Location Footage Lease Term Uses~~ ------------------------------ ------------------ ---------- ----------------------------- -------------------------~~-------------~~ ~~Austin,~~Cary ~~Texas~~D. ~~25,140~~Vandenberg ~~February~~49 ~~2006~~President ~~Offices~~and ~~Bedford,~~Chief ~~Massachusetts~~Executive 12Officer Michael P. Scarpelli 38 Chief Financial Officer,~~050~~ ~~October~~Senior ~~2005~~Vice ~~Offices;~~President ~~research~~of Administration and ~~development~~Secretary ~~Chennai,~~Elias ~~India~~Antoun 248 Director,~~097~~ ~~March~~Chairman ~~2007~~of ~~Offices~~the ~~HsinChu,~~Board ~~Taiwan~~Lawrence ~~1,636~~Kraus ~~May~~42 ~~2006~~Director ~~Offices~~Dr. ~~Yokohama,~~Yervant ~~Japan~~Zorian ~~2,444~~49 ~~April~~Director ~~2006~~Dr. ~~Offices~~Victor ~~San~~Boksha ~~Jose,~~44 ~~California~~Vice ~~12,500~~President ~~December~~of ~~2005~~Business ~~Executive~~Development ~~offices~~Dean ~~Plano,~~Frazier ~~Texas~~45 ~~18,302~~Vice ~~March~~President ~~2006~~of ~~Offices~~Marketing ~~Yerevan,~~Brian ~~Armenia~~Gordon ~~18,772~~47 ~~December~~Vice ~~2004~~President ~~Offices;~~of ~~research~~Software ~~and~~Engineering ~~development~~Dr. Greg Yeric 47 Chief Technologist

13 CARY D. VANDENBERG. Mr. Vandenberg joined the Company in May 2003 as President and Chief Executive Officer. Prior to joining HPL, Mr. Vandenberg was Vice President of Strategic Business Development at Communicant Semiconductor Technologies AG, a European based semiconductor foundry. He worked at Communicant from July 2001 to May 2003 and during this period he was responsible for the design kit and modeling group, corporate partnerships, and the e-business strategy. Mr. Vandenberg has over 20 years of management experience in software and semiconductor companies including positions at Sequencia, Inc. (President & CEO), JENOPTIK INFAB Intrack, Inc. (President), and PROMIS Systems Corporation Ltd. (Vice President). Mr. Vandenberg holds a Bachelor of Science degree in commerce from Santa Clara University. MICHAEL P. SCARPELLI. Mr. Scarpelli has been our Chief Financial Officer, Treasurer, Senior Vice President of Administration and Secretary since July 2002. In these roles, he is principally responsible for the Company's worldwide finance function, legal, contracts, and facilities. Mr. Scarpelli joined the Company in January 2002 as Vice President of Corporate Development, responsible for the oversight of the Company's mergers and acquisitions function. Prior to joining HPL, Mr. Scarpelli was an auditor with PricewaterhouseCoopers LLP since 1989 and an audit partner since 1998. Mr. Scarpelli received his Bachelor of Arts degree in economics from the University of Western Ontario and is a Certified Public Accountant and a Chartered Accountant. ELIAS ANTOUN. Mr. Antoun is President and Chief Executive Officer of Genesis Microchip, Inc. and a member of its board of directors since November 2004. Mr. Antoun joined our Board of Directors in August 2000 and serves as a member of our audit and compensation committees. Prior to this, he was President and Chief Executive Officer of Pixim, Inc. of Mountain View, California, a semiconductor solutions provider for video imaging from March 2004 to November 2004. From February 2000 to August 2003, he was President and Chief Executive Officer of MediaQ, Inc., a provider of semiconductor solutions which was acquired by NVIDIA Corporation in August 2003. From March 1998 to January 2000, Mr. Antoun served as Executive Vice President, Consumer Products Division at LSI Logic. Mr. Antoun has served as the Chairman of the Board since July 2002. Mr. Antoun's term expires at the next election of directors. LAWRENCE KRAUS. Mr. Kraus is a co-founder of the Company and has served as a member of the board of directors of the Company's principal operating subsidiary, HPLI, since its formation in 1989. From February 2001 to September 2002, Mr. Kraus served as HPLI's Vice President of Strategic Marketing. Mr. Kraus previously served as HPLI's Director of Hardware Development from May 1989 to January 1995 and as the Vice President and General Manager of HPLI's hardware divisions until their sale to Credence Systems Corporation in June 1998. With the sale of the hardware divisions to Credence, Mr. Kraus joined Credence as a Director of Operations and served in that capacity until February 2001. Mr. Kraus is currently a manager of hardware development at Advantest America, Inc. Mr. Kraus was elected to our board of directors in August 2000 and his term expires at the next election of directors. DR. YERVANT ZORIAN. Dr. Zorian has served as Vice President and Chief Scientist at Virage Logic Corporation since June 2000. He previously was the Chief Technology Advisor at LogicVision and a Distinguished Member of the Technical Staff at Bell Laboratories, Lucent Technologies. Dr. Zorian has chaired several Institute of Electrical and Electronic Engineering ("IEEE") symposiums and workshops. He currently serves as the editor and chief emeritus of IEEE Design & Test of Computers and is the Vice President of IEEE Computer Society. He has authored four books, received several best paper awards and holds twelve U.S. patents in the area of test technology. Dr. Zorian is an honorary doctor of the National Academy of Science, Armenia, and is a Fellow of IEEE. Mr. Zorian was elected to our board of directors in August 2000 and his term expires at the next election of directors. 14 DR. VICTOR BOKSHA. Dr. Boksha joined HPL in November 2003 as the Vice President of Business Development and is currently focused on building new products and industry relationships in the emerging Design for Manufacturing ("DFM") market. Dr. Boksha is a semiconductor industry veteran, with an extensive background in lithography, RET and TCAD. He brings to HPL almost 25 years of technology and business experience in high-volume mask and wafer manufacturing, simulation, equipment design, advanced lithography development, yield improvement and venture investments. Recently, he worked with Cadence Design Systems on a new DFM business opportunity and also advised a leading silicon intellectual property provider on technology strategy. Previously he worked for OPC Technologies, which was acquired by Mentor Graphics, and brought RET capabilities to the Calibre product line. Prior to OPC, he worked for Technology Modeling Associates ("TMA"), which is currently part of Synopsys. He holds a M.Sc. degree in Management from MIT Sloan School and a Ph.D. degree in laser microlithography from Belarus Academy of Science. DEAN FRAZIER. Mr. Frazier joined HPL in March 2004 as the Vice President of Marketing. Mr. Frazier is responsible for worldwide marketing activities at HPL. He has over twenty years of semiconductor industry experience in IC design, semiconductor process development and EDA software. From 2002 to 2004, Mr. Frazier was a founder of EMASYS Corporation, a developer of business intelligence software for IC companies. He served as VP of Engineering & Operations for Chameleon Systems, a venture-funded fabless IC company, from 2001 to 2002; as Director of Design Technology for Chips & Technologies, which was acquired by Intel, from 1991 to 2000; and has held various marketing and engineering roles at Seattle Silicon (1987-1990) and Motorola (1982-1987). Mr. Frazier holds a Bachelor of Science degree in Chemical Engineering from Stanford University. BRIAN GORDON. Mr. Gordon joined HPL in September 2003 as the Vice President of Software Development and is responsible for the development of all software products at HPL. He has more than 20 years experience in the design, development and implementation of mission-critical enterprise software for manufacturing. From 1984 to 2003, Mr. Gordon was Chief Technology Officer at Camstar Systems, a leading provider of enterprise manufacturing performance management systems for semiconductor, electronics, life sciences, and other global industrial manufacturers. In this role he was the Chief Architect responsible for the design, development, delivery and support of all software products. Prior to Camstar, he was the founder of a successful consulting practice, developing manufacturing and accounting software for midrange customers. His work has been patented, and he has also published many technical articles. DR. GREG YERIC. Dr. Greg Yeric joined HPL in February 2002 through the acquisition of TestChip Technologies, where he had worked since September 1997. Dr. Yeric has been our Chief Technologist since August 2004, responsible for HPL's technical guidance for yield management, technology development IP, and DFM solutions. Over the last 8 years at HPL and TestChip, Dr. Yeric has been instrumental in the execution of technology development and yield enhancement programs across each technology node, from 0.35um through 45nm and over a spectrum of process technologies (CMOS, SOI, Mixed-Signal). Prior to joining HPL, he was with Motorola's Advanced Products Research and Development Laboratories and was a technologist driving CMOS process shrink initiatives with an emphasis on interconnect characterization and reliability, as well as developing CMOS platform process integration methodologies for logic, microprocessor, and NVM technologies from June 1993 to September 1997. He has a Ph.D. in Electrical Engineering from the University of Texas at Austin and is an author of numerous technical publications and a regular speaker at technical industry events. 15 ITEM 2. PROPERTIES The following table sets forth the Company's principal properties as of May 31, 2005. We believe that our existing facilities are adequate for our current needs

~~Fiscal~~Square ~~2003~~Expiration ~~High~~of ~~Low~~Location Footage Lease Term Uses ------------------------------ ---------------------------- ----------------------------- -------------- ---------------------- ~~First~~Austin, ~~Quarter~~Texas $25,140 ~~16.26~~February $2006 ~~9.59~~Offices ~~Second~~Bedford, ~~Quarter~~Massachusetts $12,050 ~~15.80~~October $2005 ~~13.10~~Offices; ~~Third~~research ~~Quarter~~and $development ~~0.11~~Chennai, $India ~~0.02~~2,097 ~~Fourth~~March ~~Quarter~~2007 $Offices ~~0.20~~HsinChu, $Taiwan ~~0.02~~1,636 May 2006 Offices Plano, Texas 18,302 March 2006 Offices San Jose, California 12,500 December 2005 Executive offices Yerevan, Armenia 18,772 December 2009 Offices; research and development Yokohama, Japan 2,444 April 2006 Offices

ITEM 3. LEGAL PROCEEDINGS Between July 31, 2002 and November 15, 2002, several class-action lawsuits were filed against the Company, certain current and former officers and directors of the Company, and our independent auditors in the United States District Court for the Northern District of California. The lawsuits were consolidated into a single action (the "Securities Class Action"), which alleged that the defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, Rule 10b-5 promulgated thereunder, and Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 by making a series of material misrepresentations as to the financial condition of the Company during the class period of July 31, 2001 to July 19, 2002. On March 11, 2005, the United States District Court for the Northern District of California granted final approval of the Securities Class Action settlement. On April 13, 2005, the period for appeals expired, and the settlement is now final. We issued 5,319,613 new shares of common stock on May 11, 2005, in consideration for the settlement of the Securities Class Action. Former shareholders of Covalar Technologies Group, Inc., which was acquired by us in February 2002, brought suit in the District Court of Dallas County, Texas, against our independent auditors and the managing underwriter in our initial public offering, in connection with claims relating to the acquisition (the "Covalar Action"). On April 26, 2004, the Company and our former President and Chief Executive Officer were named as defendants in this action. On July 13, 2004, we signed a settlement and release agreement with the plaintiffs in the Covalar Action contingent on the settlement of the Securities Class Action. Pursuant to this settlement agreement, we placed 2,000,000 shares in escrow in October 2004. On December 20, 2004, the court issued an order dismissing us without prejudice from the Covalar Action, pursuant to the Company's settlement agreement with the plaintiffs. On April 15, 2005, we authorized the release of 1,000,000 shares from escrow to the former Covalar shareholders. The remaining 1,000,000 shares will remain in escrow until October 2006. During this period, we have an option to acquire these shares at $1.00 per share. If we do not exercise our option by October 13, 2006, the shares will be released to the former shareholders. As part of our initial public offering, we signed an underwriting agreement, which contained provisions in favor of our underwriters. The managing underwriter was named as a defendant in the Covalar Action and the FabCentric Action described below. Subject to a reservation of rights, we have accepted the underwriter's request to indemnify the underwriter in connection with our initial public offering and to advance expenses in the Covalar Action. The underwriter's legal counsel submitted bills totaling $850,000 through December 31, 2003, which we had accrued. On April 11, 2005, we entered into a settlement 16 and release agreement with the underwriter for a total of $425,000, which is to be paid on or before August 11, 2005. Accordingly, during the three month period ended March 31, 2005, we reduced the accrual related to the Covalar Action. On May 22, 2003, five former shareholders of FabCentric, Inc., which we acquired in December 2001, sued us, our former President and Chief Executive Officer and former Chief Financial Officer, and our independent auditors in a lawsuit pending in Superior Court in the County of Santa Clara, California (the "FabCentric Action"). The plaintiffs subsequently added the managing underwriter in our initial public offering and our current Chief Financial Officer as defendants. This lawsuit alleges claims for fraud, negligent misrepresentation, breach of warranties and covenants, breach of contract, negligence, and violations of the California Corporations Code and seeks rescission or, alternatively, damages, costs and expenses. After several rounds of demurrers, the auditors and the underwriters filed answers to the fourth amended complaint in May 2005. Answers by the Company and our former CEO and CFO have been extended by stipulation. On February 17, 2005, we participated in a mediation session with the FabCentric plaintiffs. On February 23, 2005, the FabCentric plaintiffs agreed in principle to settle with us and our former CEO and CFO by participating in the HPL Parties' settlement in the Securities Class Action, in addition to receiving 2,100,000 shares of common stock from us, $500,000 in cash from our insurer, Twin City Fire Insurance Company ("Twin City"), and 25% of the net recovery, if any, from Twin City in the litigation described below. The parties are preparing the settlement documentation. The Company anticipates issuing the 2,100,000 new shares of common stock to the FabCentric plaintiffs along with an additional 336,387 shares to the plaintiffs in the Securities Class Action pursuant to an anti-dilution provision following the Superior Court's determination that the settlement was made in good faith. We were also a nominal defendant in consolidated stockholder derivative lawsuits filed between July 31, 2002 and December 31, 2002, in Superior Court in the County of Santa Clara, California. These lawsuits asserted derivative claims on behalf of us against our current and former officers and directors and our independent auditors. The consolidated complaint asserted claims for insider trading, breach of fiduciary duties, breach of contract, professional negligence and unjust enrichment, and sought damages suffered by the Company, treble damages for the sale of shares, costs and expenses of these actions and such other relief as the court may deem appropriate. On April 6, 2005, the Superior Court in the County of Santa Clara, California, approved the settlement of the derivative actions. Our contribution to plaintiffs' attorney's fees of $950,000, which was our only contribution to the settlement, was fully funded by our excess directors and officers liability insurance ("D&O") policies. Additionally, Twin City (our first-layer excess D&O carrier) filed a declaratory relief action on October 6, 2003, in Superior Court in the County of Santa Clara, California, against us, our former President and Chief Executive Officer, our former Chief Financial Officer, and other former and current officers and directors of the Company seeking a determination that no coverage is afforded the defendants under Twin City's policy, which follows form to the Company's primary D&O policy issued by Executive Risk Indemnity Inc. Executive Risk has already agreed to pay its policy limits for the Securities Class Action, exhausting the limits of the primary D&O policy. We filed a Second Amended Cross-Complaint on September 29, 2004, seeking a declaration that Twin City and our other excess D&O insurance carriers, National Union Fire Insurance Company ("National Union") and St. Paul Mercury Insurance Company ("St. Paul"), are obligated to indemnify us for losses in connection with the Securities Class Actions and related litigation and that Twin City has breached its insurance contract by not paying the defendants' defense expenses on a current basis. 17 On January 11, 2005, we argued cross-motions for summary adjudication, in the Twin City matter. The parties sought a declaration regarding whether exclusionary language in our D&O liability insurance application excluded coverage for insureds that did not have knowledge of Y. David Lepejian's unlawful conduct. The Superior Court, in a ruling issued on January 12, 2005, held that this exclusionary language did not preclude coverage for insureds who did not have knowledge of the unlawful conduct, including the Company. Twin City's motion to reconsider the Superior Court's January 12, 2005 ruling was denied on February 22, 2005 and an amended order was issued on March 9, 2005. We intend to continue to oppose the remaining claims made in the Third Amended Complaint filed by Twin City and to seek coverage under Twin City's policy. To date, Twin City has advanced or agreed to advance, subject to a reservation of rights, a total of $900,000 under a reservation of rights to fund our settlements of the Securities Class Action and the FabCentric Action. On December 21, 2004, National Union, our third-layer excess D&O carrier, paid $1,000,000 into escrow in exchange for a full policy release. St. Paul, our fourth-layer excess D&O carrier has similarly paid $125,000 into escrow in exchange for a full policy release The proceeds have now been used to settle the consolidated derivative action and for legal defense costs. As of December 31, 2004, we had accrued $9.1 million relating to the 9,756,000 new shares of common stock we had agreed to issue to settle the above actions. On March 31, 2005, we reduced the accrual to $8.4 million reflecting the estimated value of our common stock. Accordingly, there was a $730,000 reduction in legal settlement expenses in the three month period ended March 31, 2005. Following our dismissal from the FabCentric Action, the only remaining litigation in which we are a party will be our claim against Twin City discussed above. This matter is in the early stages of litigation and accordingly it may ultimately be resolved on a basis different than currently estimated. Because there could be many factors that enter into the ultimate resolution of this matter which are not within our control, we are not able to estimate the maximum potential financial exposure to litigate this matter or the potential financial benefit to us should it be resolved successfully. The resolution of the Twin City litigation could have a material effect on our financial condition, results of operations or cash flows. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 18 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES On September 30, 2002, our common stock was delisted from the Nasdaq National Market. Since that time, no established public trading market has existed for our common stock and shares of our common stock are neither listed on any national securities exchange nor presently traded on any public stock exchange or in any other public market. Although quotations for shares of our common stock may be obtained through the over-the-counter "pink sheets" maintained by Pink Sheets LLC (a centralized quotation service that collects and publishes market maker quotes for over-the-counter securities), because secondary market activity for shares of our common stock has been limited and sporadic, such quotations may not accurately reflect the price or prices at which purchasers or sellers would currently be willing to purchase or sell shares of our common stock. The following table shows the range of high and low closing bid prices for our common stock for the periods indicated, as reported in the Pink Sheets under the symbol "HPLA.PK." The quotations on the Pink Sheets reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. Fiscal 2005 High Low -------------------------- -------------- -------------- First Quarter $ 0.70 $ 0.14 Second Quarter $ 0.86 $ 0.45 Third Quarter $ 0.66 $ 0.51 Fourth Quarter $ 0.93 $ 0.55 Fiscal 2004 High Low ------------------------- -------------- -------------- First Quarter $ 0.25 $ 0.11 Second Quarter $ 0.26 $ 0.12 Third Quarter $ 0.30 $ 0.18 Fourth Quarter $ 0.36 $ 0.20 As of May 31, 2005 there were approximately 136 holders of record of our common stock and 38,768,065 shares of common stock outstanding. No dividends have been paid on our common stock since inception, and we do not anticipate paying any dividends in the foreseeable future. RECENT SALES OF UNREGISTERED SECURITIES In April, 2005 we issued 2,000,000 shares of common stock, pursuant to the settlement of the Covalar Action - see Item 3 Legal Proceedings. This offering was exempt from registration under Section 4(2) of the Act. In May 2005, we issued 5,319,613 shares of common stock pursuant to the settlement of the Securities Class Action - see Item 3 Legal Proceedings. These securities constituted exempted securities under Section 3(a)(10) of the Act and were not registered for issuance pursuant to Section 5 of the Act. ITEM 6. SELECTED FINANCIAL DATA The selected consolidated financial data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations", and the consolidated financial statements of HPL and the notes to the consolidated financial statements included elsewhere in this annual report on Form 10-K. The consolidated statement of operations data for 19 the years ending March 31, 2005, 2004 and 2003 and the consolidated balance sheet data at March 31, 2005 and 2004 are derived from the audited financial statements included elsewhere in this annual report on Form 10-K. The consolidated statement of operations data for the years ending March 31, 2002 and 2001 and the consolidated balance sheet data at March 31, 2003, 2002 and 2001 are derived from audited financial statements for the periods not included in this annual report on Form 10-K. Our historical results are not necessarily indicative of results to be expected in future periods. Statement of Operations Data:

~~Fiscal~~Years Ended March 31, 2005 2004 ~~High~~2003 ~~Low~~2002 2001 ------------- -------------- ------------- ------------- -------------- (in thousands, except per share data) Revenues: Software licenses $ 3,176 $ 4,799 $ 5,281 $ 1,614 $ 3,159 Consulting services, maintenance and other 6,593 7,902 10,311 2,899 1,156 ------------- -------------- ------------- ------------- ~~First~~-------------- ~~Quarter~~Total revenues 9,769 12,701 15,592 4,513 4,315 ------------- -------------- ------------- ------------- -------------- Cost of revenues: Software licenses 96 507 656 587 133 Consulting services, maintenance and other (1) 2,752 3,131 3,808 507 243 ------------- -------------- ------------- ------------- -------------- Total cost of revenues 2,848 3,638 4,464 1,094 376 ------------- -------------- ------------- ------------- -------------- Gross profit 6,921 9,063 11,128 3,419 3,939 ------------- -------------- ------------- ------------- -------------- Operating expenses: Research and development (1) 6,590 6,384 10,515 6,118 3,349 Sales, general and administrative (1) 8,264 13,604 19,788 9,285 4,329 Legal settlement expense 470 7,900 - - - Goodwill impairment - - 30,570 - - Stock-based compensation 45 315 1,047 3,547 2,369 Amortization of intangible assets 1,181 1,327 1,494 294 137 ------------- -------------- ------------- ------------- -------------- Total operating expenses 16,550 29,530 63,414 19,244 10,184 ------------- -------------- ------------- ------------- -------------- Loss from operations (9,629) (20,467) (52,286) (15,825) (6,245) Interest income and other income 138 252 617 1,104 62 Interest expense (3) (39) (149) (196) (252) ------------- -------------- ------------- ------------- -------------- Loss before income taxes (9,494) (20,254) (51,818) (14,917) (6,435) Provision for income taxes (71) 89 - - - ------------- -------------- ------------- ------------- -------------- Net loss $(9,423) ~~0.25~~$(20,343) $ ~~0.11~~(51,818) ~~Second~~$(14,917) ~~Quarter~~$(6,435) ============= ============== ============= ============= ============== Net loss per share basic and diluted $ (0.2630) $ (0.1265) ~~Third~~$ ~~Quarter~~(1.69) $ (0.3062) $ (0.37) Shares used in per share computations: Basic and diluted 31,332 31,145 30,645 24,038 17,496 ---------------------------------------------------------- (1) Excludes the following stock-based compensation charges: Cost of revenues $ - $ - $ 18 ~~Fourth~~$ ~~Quarter~~39 $ ~~0.36~~60 Research and development 15 113 414 692 296 Sales, general administrative 30 202 615 2,816 2,013 ------------- -------------- ------------- ------------- -------------- $ ~~0.20~~45 $ 315 $ 1,047 $ 3,547 $ 2,369 ============= ============== ============= ============= ==============

20 Consolidated Balance Sheet Data:

~~Years Ended~~ March 31, 2005 2004 2003 2002 2001 ~~2000~~ ------------- -------------- ------------- ------------- -------------- (in thousands) Cash, ~~except~~cash ~~per~~equivalents ~~share~~and ~~data)~~short-term ~~Revenues:~~investments ~~Software licenses~~ $ 43,~~799~~246 $ 510,~~281~~210 $ 121,~~614~~741 $ 347,~~159~~109 $ ~~3,039~~989 ~~Consulting~~Working ~~services,~~capital ~~maintenance~~(deficit) and other 7,902 10,311 2,899 1,156 665 ------------- -------------- ------------- ------------- -------------- Total revenues 12,701 15,592 4,513 4,315 3,704 ------------- -------------- ------------- ------------- -------------- Cost of revenues: Software licenses 507 656 587 133 9 Consulting services, maintenance and other (1) (3,131 3,808 507 243 259 ------------- -------------- ------------- ------------- -------------- Total cost of revenues 3,638 4,464 1,094 376 268 ------------- -------------- ------------- ------------- -------------- Gross profit 9,063 11,128 3,419 3,939 3,436 ------------- -------------- ------------- ------------- -------------- Operating expenses: Research and development (1635) ~~6,384 10,515 6,118~~ 3,~~349~~393 ~~2,851 Sales, general and administrative (1)~~ 13,~~604~~525 1935,~~788~~062 ~~9,285 4,329 3,155 Legal settlement expense~~ (7,~~900~~169) -Total ~~- - - Goodwill impairment - 30,570 - - - Stock-based compensation 315 1,047 3,547 2,369 580 Amortization of intangible~~ assets 134,~~327~~802 144,~~494~~865 ~~294 137 148 ------------- -------------- ------------- ------------- -------------- Total operating expenses 29~~60,~~530~~385 63101,~~414~~308 195,~~244~~455 ~~10,184 6,734~~ Long-~~------------~~term ~~-------------- ------------- ------------- -------------- Loss from operations (20~~debt,~~467)~~ ~~(52,286)~~less ~~(15,825)~~current ~~(6,245)~~portion ~~(3,298)~~13 ~~Interest~~39 ~~income~~130 ~~(expense)~~280 ~~and~~295 ~~other,~~Total ~~net~~stockholders' ~~213~~equity ~~468 908~~ (~~190~~deficit) ~~(248)~~$ ~~------------- -------------- ------------- ------------- -------------- Loss before income taxes (20~~16,~~254)~~938 ~~(51,818) (14,917) (6,435) (3,546) Provision for income taxes 89 - - - - ------------- -------------- ------------- ------------- -------------- Net loss~~ $ ~~(20~~26,~~343)~~042 $ ~~(51~~46,~~818)~~032 $ ~~(14~~82,~~917)~~316 $ (6,~~435~~748) $ (~~3,546) ============= ============== ============= ============= ============== Net loss per share-basic and diluted $ (0.65) $ (~~1~~.69~~) $Included ~~(0.62)~~in $working ~~(0.37)~~capital ~~$ (0.21) Shares used~~ in ~~per~~2005, ~~share~~2004 ~~computations: Basic~~ and ~~diluted~~2003 ~~31,145~~is ~~30,645~~a ~~24,038 17,496 17,068 _______________________________________________________________ (1) Excludes the following stock~~non-~~based~~cash ~~compensation~~liability ~~charges: Cost~~ of ~~revenues~~ $4,335,000 -relating $to 18advances $from 39our $former 60CEO $which 2were ~~Research~~reclassified ~~and~~to ~~development~~equity ~~113~~on ~~414~~the ~~692~~settlement ~~296~~of 96our ~~Sales,~~litigation ~~general administrative 202 615 2,816 2,013 482~~ -~~------------~~ ~~--------------~~See ~~-------------~~Item ~~------------- -------------- $ 315 $ 1,047 $~~ 3~~,547~~. $Legal ~~2,369 $ 580 ============= ============== ============= ============= ==============~~Proceedings.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with Item 1: Business; Item 6: Selected Financial Data; and Item 8: Financial Statements and Supplementary Data. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Forward-looking statements are often, though not always identified by words and phrases such as "expect", "believe", "should", and "will". Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under "Risk Factors" and elsewhere in this report. HPL undertakes no obligation to update any forward-looking statement to reflect events after the date of this report. OVERVIEW We provide comprehensive yield-optimization solutions to the semiconductor industry and flat-panel display manufacturers. We license our software products and sell related services through our direct sales force, distributors, and sales agents. In each of the last three fiscal years, a relatively small number of customers have accounted for a large portion of our revenues, and the composition of our major customers has changed from year to year. This is because we currently have a limited sales force, our products have a lengthy sales cycle and we recognize relatively large license revenues upon entering into perpetual licensing agreements. We had two, three, and three end customers that individually accounted for at least 10% of our revenues in the years ended March 31, 2005, 2004 and 2003, respectively. In the aggregate, these end customers accounted for 34%, 42%, and 61% of our revenues in the years ended March 31, 2005, 2004 and 2003, respectively. From July 2002 until today, as a result of our investigation into financial and accounting irregularities which ultimately lead to a restatement of our financial statements for the years ended March 31, 2001 and 2002, and the litigation discussed in the Liquidity and Capital Resources section below, we experienced a significant period of transition. In our year ended March 31, 2003, senior management was focused on determining the impact of the financial 21 restatement on our business going forward, integrating previously acquired businesses and cutting costs to reflect the level of sales activities we were experiencing. In our year ended March 31, 2004, we began to hire a new management team, filling five senior positions with the hiring of a new Chief Executive Officer, Senior Vice President of Sales, Vice President of Software Development, Vice President of Marketing and Vice President of Business Development. With the new management team in place, we have shifted our focus and resources in order to better integrate our yield analysis software capabilities with our TestChip solutions to better compete in the DFM market segment with our unique product offerings. This has resulted in a decrease in our revenue in the years ended March 31, 2005 and March 31, 2004 from the year ended March 31, 2003. In the year ended March 31, 2005 we experienced an operating loss of $9.4 million. At March 31, 2005, we have $3.2 million in cash and cash equivalents and short-term investments. As of March 31, 2005, we had an accumulated deficit of $107.5 million. Since going public in 2001, we have not achieved profitability on a quarterly or annual basis. As we continue to build our customer base and further develop new products, we expect to continue to incur net operating losses at least through our year ending March 31, 2006. We will need to generate significantly higher revenues in order to sustain our operations and to achieve and maintain profitability. Our ability to generate higher revenues may continue to be impacted by our previous litigation, the capital spending trends of our potential and current customers in the semiconductor industry, the time to market of our new products and our ability to compete in our market segment. See "Liquidity and Capital Resources" below. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses, and our related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, goodwill and identifiable, separately recorded intangible assets, litigation, contingent liabilities and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Our estimates then form the basis of judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies and the related judgments and estimates significantly affect the preparation of our consolidated financial statements: Revenue Recognition Revenue recognition rules are very complex, and certain judgments affect the application of our revenue policy. The amount and timing of our revenue is difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter. In addition to determining our results of operations for a given period, our revenue recognition determines the timing of certain expenses, such as commissions, royalties and other variable expenses. We derive revenues principally from the sale of software licenses, software maintenance contracts and consulting services. We offer two types of licenses: perpetual and time-based. Perpetual licenses have no expiration date, while time-based licenses require renewal. Our software product licenses provide a narrowly defined subset of features for a given customer. The customer may acquire additional licenses to extend the functionality of our products as its technologies and facilities change or if it wishes to use additional features of our software for its production process. Our licenses usually limit the number of people who can use the software at a given time. 22 Revenues from software licenses are generally recognized upon the execution of a binding agreement and delivery of the software, provided that: the fee is fixed or determinable; vendor-specific objective evidence exists to allocate a portion of the total license fee to any undelivered elements of the arrangement; collection is reasonably assured; and the agreement does not contain customer acceptance clauses. If customer acceptance clauses exist, revenues are recognized upon customer acceptance if all other revenue recognition criteria are met. If consulting or other services sold in connection with the software license are essential to the functionality of the software or involve significant production, customization or modification of software, we recognize revenue on either a percentage-of-completion or completed contract basis. For the percentage-of-completion method, we recognize revenues using labor hours incurred as the measure of progress against the total labor hours estimated for completion of the project. We consider a project completed after all contractual obligations are met. At times, an unbilled accounts receivable balance can exist which comprises revenue recognized in advance of contractual billings. We make provisions for estimated contract losses in the period in which the loss becomes probable and can be reasonably estimated. Estimates of total labor hours or expected losses on contracts are subject to judgment and actual amounts may differ significantly from those estimates. For contracts with multiple obligations (e.g., deliverable and undeliverable products, post-contract support and other services), we allocate revenues to the undelivered elements of the contract based on vendor specific objective evidence of their fair value. This objective evidence is the sales price of the element when sold separately or the renewal rate specified in the agreement for licensing arrangements with terms of one year or greater that include post-contract customer support and software updates. We recognize revenues allocated to undelivered products when the criteria for software license revenues set forth above are met. Revenues from time-based software licenses are generally recognized ratably over the period of the licenses. Determining whether objective evidence of fair value exists is subject to judgment and resulting fair values used in determining the value of the undelivered elements is also subject to judgment and estimates. Software maintenance revenues are recognized ratably over the term of the maintenance period, which is generally one year. Our software maintenance includes product maintenance updates, Internet-based technical support and telephone support. Revenues derived from our consulting services are recognized as the services are performed. Revenues derived from software development projects are recognized on a completed contract basis. We also derive revenues from the sale of software licenses, maintenance and post-contract support services through our distributors. Revenues from sales made through our distributors for which the distributors have return rights are recognized when the distributors have sold the software licenses or service to their customers and the criteria for revenue recognition under SOP 97-2, as amended, are met. Revenues from maintenance and post-contract support services sold through our distributors are recognized ratably over the contract period. Amounts invoiced to our customers in excess of recognized revenues are recorded as deferred revenues. The timing and amounts invoiced to customers can vary significantly depending on specific contract terms and can therefore have a significant impact on deferred revenues in any given period. Goodwill and Intangible Assets Consideration paid in connection with acquisitions is required to be allocated to the acquired assets, including certain identifiable intangible assets, goodwill, and liabilities acquired. Acquired assets and liabilities are 23 recorded based on our estimate of fair value, which requires significant judgments, including those with respect to future estimated cash flows and discount rates. For identifiable intangible assets that we separately record, we are required to estimate the useful life of the assets and recognize their cost as an expense over the useful lives. We use the straight-line method to amortize long-lived assets, except goodwill, which results in an equal amount of expense in each period. We assess the impairment of identifiable intangibles and long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Furthermore, we assess the impairment of goodwill at least annually. Factors we consider important which could trigger an impairment review include the following: o significant underperformance relative to historical or projected future operating results; o significant changes in the manner of our use of the acquired assets or the strategy for our overall business; o significant negative industry or economic trends; o significant decline in our stock price for a sustained period; o market capitalization relative to net book value; and o a current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. When one or more of the above indicators of impairment occurs we estimate the value of long-lived assets and intangible assets to determine whether there is an impairment. We measure any impairment based on the projected discounted cash flow method, which requires us to make several estimates including the estimated cash flows associated with the asset, the period over which these cash flows will be generated and a discount rate commensurate with the risk inherent in our current business model. These estimates are subjective and if we made different estimates, it could materially impact the estimated fair value of these assets and the conclusions we reached regarding an impairment. We identified triggering events in the second, third and fourth quarter of our year ended March 31, 2003 which required us to perform the first step of the analysis. The first and second steps of the two-step process are as follows: Step 1 - We compare the fair value of our reporting units to the carrying value, including goodwill. For each reporting unit where the carrying value, including goodwill, exceeds the unit's fair value, we proceed on to Step 2. If a unit's fair value exceeds the carrying value, no further analysis is performed and no impairment charge is necessary. We measure fair value by weighing equally our projected five year discounted cash flows with a terminal value discounted to the measurement date (the "Income Approach") and looking at comparable public companies and the multiples at which they trade, based on their trailing twelve months revenue and forward looking twelve months revenue compared to our comparable revenue to determine our market value (the "Market Approach"). Step 2 - We perform an allocation of the fair value of the reporting unit to our identifiable tangible and non-goodwill intangible assets and liabilities. This derives an implied fair value for the reporting unit's goodwill. We then compare the implied fair value of the reporting unit's goodwill with the carrying amount of the reporting unit's goodwill. If the carrying amount of the reporting unit's goodwill is greater than the implied fair value of its goodwill, an impairment charge would be recognized for the excess. At March 31, 2003, we performed Step 1 as of March 31, 2003 and determined that goodwill was impaired. We then performed Step 2 and determined that a $30.6 million impairment charge was required in the three months ended March 31, 2003. During 2004 and 2005, we continued to test for impairment on an annual basis and determined that there was no further impairment in goodwill. 24 Litigation Management's estimated range of liability related to some of the pending litigation is based on claims for which our management can estimate the amount and range of loss. As of March 31, 2005, we have settled the Securities Action, the Covalar Action and (in principal) the Fabcentric Action. These settlements require the Company to issue approximately 9,755,207 shares of HPL common stock which have been valued at $8.4 million in a manner consistent with our measurement of potential goodwill impairment. Accordingly, we have accrued this non-cash cost in our financial statements as of March 31, 2005. Income Taxes We are required to estimate our income taxes in each of the jurisdictions in which we operate as part of the process of preparing our consolidated financial statements. This process involves estimating our actual current tax exposure, together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We then assess the likelihood that our net deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. We currently have a full valuation allowance on our gross deferred tax assets. In the event our future taxable income is expected to be sufficient to utilize our deferred tax assets, an adjustment to the valuation allowance will be made, increasing income in the period in which such determination is made. Stock-based compensation We currently account for our employee stock option plans using the intrinsic value method described in Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations. Under APB Opinion No. 25, deferred stock compensation is recorded for the difference, if any, between an option's exercise price and the fair value of the underlying common stock on the grant date of the option. As currently permitted by SFAS No. 123, "Accounting for Stock-Based Compensation," we adopted the "disclosure only" alternative described in SFAS No. 123 for its employee stock plans. We currently account for stock issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force Consensus ("EITF") No. 96-18 "Accounting for Equity Instruments that Are Issued to Other than Employees For Acquiring, or in Conjunction with Selling, Goods or Services." Under SFAS No. 123 and EITF No. 96-18, stock options and warrants issued to non-employees are accounted for at their fair value calculated using the Black-Scholes option pricing model. Compensation expense resulting from employee and non-employee stock options are amortized to expense using an accelerated approach over the term of the options in accordance with Financial Accounting Standards Board Interpretation ("FIN") No. 28, "Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans." Pursuant to FAS 123(R), and commencing with fiscal 2007, we will be required to record compensation expense for all share-based payment transaction, as described below. RECENT ACCOUNTING PRONOUNCEMENTS In September 2004, the EITF delayed the effective date for the recognition and measurement guidance previously discussed under EITF Issue No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its Application to 25 Certain Investments" ("EITF 03-01") as included in paragraphs 10-20 of the proposed statement. The proposed statement will clarify the meaning of other-than-temporary impairment and our application to investments in debt and equity securities, in particular investments within the scope of FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and investments accounted for under the cost method. We will evaluate the impact of EITF 03-01 once the final guidance is issued. In December 2004, the FASB issued SFAS No. 123 (R), Share-Based Payment ("SFAS 123(R)"), an amendment of SFAS No. 123 and SFAS No. 95 Statement of Cash Flows. The statement eliminates the ability to account for share-based compensation transactions using APB No. 25 and requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements. SFAS No. 123(R) applies to all share-based payment transactions in which an entity acquires goods or services by issuing its shares, share options, or other equity instruments or by incurring liabilities based on the price of an entity's shares or that require settlement by the issuance of equity instruments. In March 2005, the SEC issued Staff Accounting Bulletin (SAB)107 ("SAB 107") which expresses views of the SEC staff regarding the application of SFAS No. 123(R). Among other things, SAB 107 provides interpretive guidance related to the interaction between SFAS No. 123(R) and certain SEC rules and regulations, as well as provides the SEC staff's views regarding the valuation of share-based payment arrangements for public companies. In April 2005, the SEC amended the compliance dates for SFAS 123(R) to provide that the provisions of this statement will be effective for fiscal years beginning after June 15, 2005. We will adopt SFAS 123(R) as of the beginning of our 2007 fiscal year. Although we are currently assessing the application of SFAS No. 123(R), we believe that the adoption of this statement will have a material impact on our results of operations, depending on the amount of stock options we grant in future periods. In December 2004, the FASB issued FASB Staff Position ("FSP") No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 ("FSP No. 109-2"). FSP No. 109-2 provides guidance under SFAS No. 109, Accounting for Income Taxes ("SFAS No. 109"), with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the "Jobs Act") on enterprises' income tax expense and deferred tax liability. FSP No. 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment of the Jobs Act to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS No. 109. The Jobs Act was enacted on October 22, 2004. We do not believe that the adoption of FSP No.109-2 will have a material effect on our financial position, results of operation or cash flows. In December 2004, the FASB issued SFAS No. 153, "Exchanges of Non-monetary Assets, an amendment of APB Opinion No. 20, Accounting for Non-monetary Transactions." The amendments made by this Statement are based on the principle that exchanges of non-monetary assets should be measured based on the fair value of the assets exchanged. This Statement also eliminates the exception for non-monetary exchanges of similar productive assets and replaces it with a broader exception for exchanges of non-monetary assets that do not have commercial substance. We are required to adopt the provisions of this Statement beginning April 1, 2006 for all non-monetary asset exchanges and will apply its provisions prospectively upon adoption. We do not believe this will have a material impact on our consolidated financial statements. 26 RESULTS OF OPERATIONS The following table sets forth statement of operations data for the periods indicated as a percentage of total revenues.

Year ended March 31, ------------------------------------------------------------------ 2005 2004 2003 ~~2002~~--------------- ~~2001~~-------------- ~~2000~~-------------- Revenues: Software licenses 33 % 38 % 34 % Consulting services, maintenance and other 67 % 62 % 66 % --------------- -------------- -------------- Total revenues 100 % 100 % 100 % --------------- -------------- ~~(in~~-------------- ~~thousands)~~Cost ~~Cash,~~of ~~cash~~revenues: ~~equivalents~~Software ~~and~~licenses ~~short-term~~1 ~~investments~~% $4 ~~10,210~~% $4 ~~21,741~~% $Consulting 47services,~~109~~ $maintenance ~~989~~and $other ~~178~~28 ~~Working~~% ~~capital~~25 ~~(deficit)~~% ~~3,393~~24 ~~13,525~~% ~~35,062~~--------------- ~~(7,169)~~-------------- ~~(2,090)~~-------------- Total ~~assets~~cost ~~44,865~~of ~~60,385~~revenues ~~101,308~~29 5% 29 % 28 % --------------- -------------- -------------- Gross profit 71 % 71 % 72 % --------------- -------------- -------------- Operating expenses: Research and development 67 % 50 % 67 % Sales,~~455~~ general and administrative 85 % 107 % 127 % Legal settlement expense 5~~,031~~ ~~Long~~% 62 % -~~term~~ ~~debt,~~% ~~less~~Goodwill ~~current~~impairment ~~portion~~- 39% ~~130~~- ~~280~~% ~~295~~196 ~~1,857~~% Stock based compensation 0 % 3 % 7 % Amortization of intangible assets 12 % 10 % 10 % --------------- -------------- -------------- Total ~~stockholders'~~operating ~~equity~~expenses ~~(deficit)~~169 $% ~~26,042~~232 $% ~~46,032~~407 $% ~~82,316~~--------------- $-------------- -------------- Loss from operations (~~6,748~~99)% $(161)% (~~2,727~~335)% =============== ============== ==============

Comparison of years ended March 31, 2005 and 2004 Revenues. Total revenues decreased to $9.8 million in the year ended March 31, 2005 from $12.7 million in the year ended March 31, 2004, or a decrease of 23%. Our sales cycle for the license of our software products has historically been very long, our products are new and our customers spend a significant amount of time evaluating our products. Customer purchase orders typically include integration and installation services, rights of return and acceptance criteria. As such, we defer a significant amount of our license revenue until integration and installation services are complete, rights of return lapse and final acceptance occurs. The amount of our license revenue is currently at levels that have resulted in no meaningful trend from period to period. Our ability to sell our products in the future may also be affected by declines in capital spending by potential customers in the semiconductor industry. Product sales were highly concentrated, with 34% of total revenues in the year ended March 31, 2005 coming from two customers and 42% of total revenues in the year ended March 31, 2004 coming from three customers. Software license revenue decreased to $3.2 million in the year ended March 31, 2005, from $4.8 million in the year ended March 31, 2004, or a decrease of 34%. Software license revenue in the year ended March 31, 2004 includes $2.2 million in deferred revenue from March 31, 2002 which was accepted in the year ended March 31, 2004. 27 Consulting services, maintenance and other revenues decreased to $6.6 million in the year ended March 31, 2005, down from $7.9 million in the year ended March 31, 2004, or a decrease of 17%. The decrease was principally due to a reduced level of orders from one of our largest customers, as we have shifted in focus from lower-margin, higher-volume services work to high-margin, lower-volume services work with this customer. Gross profit. As a percentage of revenues, gross profit remained constant at 71% year-over-year. Gross profit has been and will continue to be affected by a variety of factors, the most important of which is the relative mix of revenues among software licenses, maintenance fees and consulting services. Research and development. Research and development expenses represented 67% of revenues in the year ended March 31, 2005 compared to 50% of revenues in the year ended March 31, 2004. Actual costs increased slightly to $6.6 million in the year ended March 31, 2005, up from $6.4 million for the year ended March 31, 2004. This increase was primarily attributable to the development of new products. Salaries and related benefits of research and development engineers represent the single largest component of our research and development expenses. In the year ended March 31, 2005, salaries and related benefits comprised of $4.2 million of the total research and development expenses compared to $3.9 million in the year ended March 31, 2004. We expect our research and development costs to remain relatively stable for the foreseeable future. Sales, general and administrative. Sales, general and administrative expenses in the year ended March 31, 2005 were $8.3 million, or 85% of revenues, compared to $13.6 million, or 107% of revenues in the year ended March 31, 2004. The decrease in costs was primarily due to decreases in staff, professional fees and costs associated with litigation. Salary costs decreased to $4.7 million for the year ended March 31, 2005 compared to $6.2 million for the year ended March 31, 2004. Legal and professional fees associated with the litigation were approximately $800,000 and $2.7 million during years ended March 31, 2005 and 2004, respectively. The $800,000 is net of $492,000 in legal fees funded by D&O insurance proceeds and a reversal of $425,000 in legal accruals. We expect our legal fees to continue to decrease in future periods as the litigation proceedings are resolved. Legal settlement expense. At March 31, 2005, we were able to reasonably estimate the cost of the potential settlement of the Securities Action, the Covalar Action and the Fabcentric Action. As such, we increased the accrual by $470,000 bringing our total estimated legal settlement expense to $8.4 million from $7.9 million in the year ended March 31, 2004, which amount represents our estimate of the value of the common stock to be issued in connection with such settlements. At December 31, 2004, we had accrued $9.1 million for estimated potential settlement. Accordingly, there was a $730,000 reduction in legal settlement expenses in the three month period ended March 31, 2005. See "Liquidity and Capital Resource" below. Goodwill impairment. At March 31, 2005 and March 31, 2004 we performed an impairment test and determined that there was no impairment in goodwill. Future goodwill impairment tests may result in charges to earnings if the Company determines that goodwill has been impaired. Stock-based compensation. Stock-based compensation expense in the year ended March 31, 2005 was $45,000, compared with $315,000 in the year ended March 31, 2004. Stock-based compensation expense in the year ended March 31, 2005 decreased from the previous year primarily as a result of decreases in staff from prior acquisitions, which resulted in the reversal of previously expensed stock-based compensation which was not earned by the terminated employees, and that certain stock-based compensation expenses became fully amortized during fiscal 2005. 28 Amortization of intangible assets. Amortization of intangible assets was $1.2 million in the year ended March 31, 2005, compared to $1.3 million in the year ended March 31, 2004. Other intangible assets were fully amortized at March 31, 2005. Interest income and other income. Interest income for the year ended March 31, 2005 and 2004 was $138,000 and $252,000, respectively. This decrease was due to less interest income from lower average balances of cash, cash equivalents and short-term investments, during the year ended March 31, 2005. Interest Expense. Interest expense for the year ended March 31, 2005 and 2004 was $3,000 and $39,000, respectively. The decrease in interest expense was due to a reduction of interest paid on equipment and furniture under capital lease obligations. Provision for income taxes. In the years ended March 31, 2005 and 2004, we incurred net operating losses resulting in net deferred taxes. We have recorded valuation allowances for the full amount of our net deferred tax assets, because the future realization of the deferred tax assets was determined to be not likely as of March 31, 2005 and 2004. In the year ended March 31, 2005, the provision for income tax in the amount of $(71,000) was due to a tax benefit of $178,000 that resulted from a tax refund from the State of California net of a $107,000 provision for foreign income taxes. Comparison of years ended March 31, 2004 and 2003 Revenues. Total revenues decreased to $12.7 million in the year ended March 31, 2004 from $15.6 million in the year ended March 31, 2003, or a decrease of 19%. Product sales were highly concentrated, with 42% of total revenues in the year ended March 31, 2004 coming from three customers and 61% of total revenues in the year ended March 31, 2003 coming from four customers. Software license revenue decreased to $4.8 million in the year ended March 31, 2004, from $5.3 million in the year ended March 31, 2003, or a decrease of 9%. Software license revenue in the year ended March 31, 2004 includes $2.2 million in deferred revenue from March 31, 2002 which was accepted in the year ended March 31, 2004. Software license revenue in the year ended March 31, 2003 includes $4.6 million in revenue deferred as a result of our financial restatement in the year ended March 31, 2002 as customer acceptance was received in the period. Consulting services, maintenance and other revenues decreased to $7.9 million in the year ended March 31, 2004, down from $10.3 million in the year ended March 31, 2003, or a decrease of 23%. The decrease was due to customer delays in providing layout design specifications for custom services work and verifying silicon testing results as well as a shift in focus from low-margin, higher-volume services work to higher-margin, lower-volume services work. Gross profit. As a percentage of revenues, gross profit decreased slightly to 71% in the year ended March 31, 2004 from 72% in the year ended March 31, 2003. The modest decline was primarily due to the above variances in revenue from period to period and changes in cost of revenues. In addition, in the year ended March 31, 2004, we expensed $491,000 in deferred costs relating to the sale of a software license recognized in the period. This additional expense was partially offset by increased margins in our service business as a result of a shift in focus as noted above. Gross profit has been and will continue to be affected by a variety of factors, the most important of which is the relative mix of revenues among software licenses, maintenance fees and consulting services. 29 Research and development. Research and development expenses represented 50% of revenues in the year ended March 31, 2004 compared to 67% of revenues in the year ended March 31, 2003. Actual costs decreased to $6.4 million in the year ended March 31, 2004, down from $10.5 million for the year ended March 31, 2003. This decrease was primarily attributable to the cost-cutting measures commenced in September 2002 and continued through December 2003. Salaries and related benefits of research and development engineers represent the single largest component of our research and development expenses. Sales, general and administrative. Sales, general and administrative expenses in the year ended March 31, 2004 were $13.6 million, or 107% of revenues, compared to $19.8 million, or 127% of revenues in the year ended March 31, 2003. The decrease in costs was primarily due to decreases in staff, professional fees and costs associated with litigation and the restatement of our financial statements. Legal and professional fees associated with litigation and the restatement of our financial statements were approximately $2.7 million and $3.9 million during years ended March 31, 2004 and 2003, respectively. We expect the level of legal fees to decline significantly in fiscal 2005 as our pending legal matters are resolved. Legal settlement expense. In the year ended March 31, 2004, we were able to reasonably estimate the cost of the potential settlement of the Securities Action and the Covalar Action, and as such, we accrued $7.9 million, our estimate of the value of the common stock to be issued in connection with such settlement. The liability will be revalued quarterly until the effective date of the settlements. See "Liquidity and Capital Resources" below. Goodwill impairment. The Company operates within one reporting unit as defined by SFAS 142. Therefore, goodwill is not allocated within the Company, as it is considered enterprise goodwill. During the fourth quarter of the year ended March 31, 2003, the Company determined that there were indicators of impairment to the carrying value of goodwill, principally as a result of reducing its revenue forecast given the then current economic environment in the semiconductor industry. The Company performed its annual impairment review for goodwill and other intangible assets on March 31, 2003 and recorded a charge of $30.6 million relating to goodwill impairment, which is recorded as a component of operating income in the accompanying consolidated statement of operations. The amount of goodwill impairment was based on the fair value of the Company, representing its only reporting unit utilizing a valuation based on both the discounted cash flow and market approach. At March 31, 2004 we performed an impairment test and determined that there was no further impairment in goodwill. Future goodwill impairment tests may result in charges to earnings if the Company determines that goodwill has been further impaired. Stock-based compensation. Stock-based compensation expense in the year ended March 31, 2004 was $315,000, compared with $1.0 million in the year ended March 31, 2003. Stock-based compensation expense in the year ended March 31, 2004 decreased from the previous year primarily as a result of decreases in staff related to acquisitions, which resulted in the reversal of previously expensed stock-based compensation which was not earned by the terminated employees. Amortization of intangible assets. Amortization of intangible assets was $1.3 million in the year ended March 31, 2004, compared to $1.5 million in the year ended March 31, 2003. This decrease in amortization is due to certain intangible assets being fully amortized prior to fiscal 2004. Interest income and other income. Interest income for the year ended March 31, 2004 and 2003 was $252,000 and $617,000, respectively. This decrease was due to less interest income from lower average balances of cash, cash equivalents and short-term investments, during the year ended March 31, 2004. 30 Interest Expense. Interest expense for the year ended March 31, 2004 and 2003 was $39,000 and $149,000, respectively. The decrease in interest expense was due to a reduction of interest paid on equipment and furniture under capital lease obligations. Provision for income taxes. In the years ended March 31, 2004 and 2003, we incurred operating losses for which we have recorded valuation allowances for the full amount of our net deferred tax assets, because the future realization of the deferred tax assets was not likely as of March 31, 2004 and 2003. In the year ended March 31, 2004, the provision for income tax in the amount of $89,000 resulted from foreign income tax withholding. LIQUIDITY AND CAPITAL RESOURCES Our financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. Accordingly, the financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amount and classification of liabilities that might be necessary if we are unable to continue as a going concern. We have experienced net losses and negative cash flows since going public in July 2001 and, as of March 31, 2005, we had an accumulated deficit of $107.5 million. We expect to have a net operating loss in our year ending March 31, 2006. For the year ended March 31, 2005, cash used in operations and to fund capital expenditures was $7.2 million. Such conditions raise doubt about our ability to continue as a going concern and our independent registered public accounting firm has included a going concern uncertainty paragraph in their report, which is included in this Form 10-K. At March 31, 2005, we had approximately $3.2 million in cash and cash equivalents and short-term investments. Our current operating plan for the year ending March 31, 2006 projects that cash available from planned revenue combined with the $3.2 million on hand at March 31, 2005 will not be adequate to fund operations through March 31, 2006. Our future cash position will be adversely affected by slow or diminished revenue growth, research and development expenses, additional sales and marketing costs and higher general and administrative expenses, such as professional fees associated with the litigation. We need to raise additional capital or we will be forced to curtail or cease operations. There is no assurance that the Company will be able to raise such funds on terms acceptable to the Company, or at all. Net cash used in operating activities for the year ended March 31, 2005 was approximately $6.7 million, compared to $9.4 million used in operating activities for the year ended March 31, 2004 and $23.8 million used in operating activities in the year ended March 31, 2003. Our cash used in operations for the years ended March 31, 2005, 2004, and 2003 was primarily due to our net loss, adjusted for certain non-cash items including depreciation and amortization, legal settlement expense, goodwill impairment, stock-based compensation and deferred revenue. Net cash provided by investing activities was $5.2 million for the year ended March 31, 2005 compared to $3.7 million used in investing activities for the year ended March 31, 2004 and $7.1 million provided by investing activities for the year ended March 31, 2003. The cash provided by investing activities for the year ended March 31, 2005 consisted primarily of sale of marketable securities to fund current operations. The cash used in investing activities for the year ended March 31, 2004 consisted primarily of the purchase of marketable securities and the cash provided by investing activities for the year ended March 31, 2003 consisted primarily of proceeds from sale of marketable securities. Net cash used in financing activities was $50,000 for the year ended March 31, 2005, mainly due to the principal payments on capital lease obligations. Net cash used in financing activities was $1.8 million for the year 31 ended March 31, 2004, mainly due to the repayment of our $1.5 million secured convertible debenture in May 2003. Net cash provided by financing activities was $1.1 million for the year ended March 31, 2003, mainly due to the additional amount received from our former Chief Executive Officer in connection with fictitious sales transactions. Future payments due under debt and lease obligations as of March 31, 2005 are as follows (in thousands):

Capital Lease Operating Year ~~ended~~Ending March 31, ~~-----------------------------------------------------------~~Obligations ~~2004~~(1) ~~2003~~Leases ~~2002~~Total --------------- -------------- --------~~------~~ ~~Revenues: Software licenses 38 % 34 % 36 % Consulting services, maintenance and other 62 % 66 % 64 %~~ --------------- --~~------------~~ -------------- ~~Total revenues 100 % 100 % 100 %~~ ---~~------------~~ -------------- ---~~-----------~~ ~~Cost~~2006 of$ ~~revenues:~~27 ~~Software~~$ ~~licenses~~1,243 4$ %1,270 42007 % 13 %135 ~~Consulting~~148 ~~services,~~2008 ~~maintenance~~to ~~and~~2010 ~~other 25 % 24 % 11 %~~ -~~--------------~~ ~~--------------~~316 ~~--------------~~316 ~~Total cost of revenues 29 % 28 % 24 %~~ --------------- --~~------------~~ -------------- ~~Gross profit 71 % 72 % 76 %~~ ---~~------------~~ -------------- ---~~-----------~~ ~~Operating~~$ ~~expenses:~~40 ~~Research~~$ ~~and~~1,694 ~~development~~$ ~~50 % 67 % 136 % Sales~~1,734 general and administrative 107 % 127 % 206 % Legal settlement expense 62 % - % - % Goodwill impairment - % 196 % - % Stock based compensation 3 % 7 % 79 % Amortization of intangible assets 10 % 10 % 7 % --------------- -------------- -------------- Total operating expenses 232 % 407 % 428 % --------------- -------------- -------------- Loss from operations (161)% (335)% (352)% ================= ================= ================= (1) From Fiscal 2006 to Fiscal 2007, we are required to make interest payments totaling $1,400 for capital leases obligations; this interest component is included in the commitment schedule above.

Between July 31, 2002 and November 15, 2002, several class-action lawsuits were filed against the Company, certain current and former officers and directors of the Company, and our independent auditors in the United States District Court for the Northern District of California. The lawsuits were consolidated into a single action (the "Securities Class Action"), which alleged that the defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, Rule 10b-5 promulgated thereunder, and Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 by making a series of material misrepresentations as to the financial condition of the Company during the class period of July 31, 2001 to July 19, 2002. On March 11, 2005, the United States District Court for the Northern District of California granted final approval of the Securities Class Action settlement. On April 13, 2005, the period for appeals expired, and the settlement is now final. We issued 5,319,613 new shares of common stock on May 11, 2005, in consideration for the settlement of the Securities Class Action. Former shareholders of Covalar Technologies Group, Inc., which was acquired by us in February 2002, brought suit in the District Court of Dallas County, Texas, against our independent auditors and the managing underwriter in our initial public offering, in connection with claims relating to the acquisition (the "Covalar Action"). On April 26, 2004, the Company and our former President and Chief Executive Officer were named as defendants in this action. On July 13, 2004, we signed a settlement and release agreement with the plaintiffs in the Covalar Action contingent on the settlement of the Securities Class Action. Pursuant to this settlement agreement, we placed 2,000,000 shares in escrow in October 2004. On December 20, 2004, the court issued an order dismissing us without prejudice from the Covalar Action, pursuant to the Company's settlement agreement with the plaintiffs. On April 15, 2005, we authorized the release of 1,000,000 shares from escrow to the former Covalar shareholders. The remaining 1,000,000 shares will remain in escrow until October 2006. During this period, we have an option to acquire these shares at $1.00 per share. If we do not exercise our option by October 13, 2006, the shares will be released to the former shareholders. As part of our initial public offering, we signed an underwriting agreement, which contained provisions in favor of our underwriters. The managing underwriter was named as a defendant in the Covalar Action and the FabCentric Action described below. Subject to a reservation of rights, we have accepted the underwriter's request to indemnify the underwriter in connection with our initial public offering and to advance expenses in the Covalar Action. The underwriter's legal counsel submitted bills totaling $850,000 through December 31, 2003, which we had accrued. On April 11, 2005, we entered into a settlement 32 and release agreement with the underwriter for a total of $425,000, which is to be paid on or before August 11, 2005. Accordingly, during the three month period ended March 31, 2005, we reduced the accrual related to the Covalar Action. On May 22, 2003, five former shareholders of FabCentric, Inc., which we acquired in December 2001, sued us, our former President and Chief Executive Officer and former Chief Financial Officer, and our independent auditors in a lawsuit pending in Superior Court in the County of Santa Clara, California (the "FabCentric Action"). The plaintiffs subsequently added the managing underwriter in our initial public offering and our current Chief Financial Officer as defendants. This lawsuit alleges claims for fraud, negligent misrepresentation, breach of warranties and covenants, breach of contract, negligence, and violations of the California Corporations Code and seeks rescission or, alternatively, damages, costs and expenses. After several rounds of demurrers, the auditors and the underwriters filed answers to the fourth amended complaint in May 2005. Answers by the Company and our former CEO and CFO have been extended by stipulation. On February 17, 2005, we participated in a mediation session with the FabCentric plaintiffs. On February 23, 2005, the FabCentric plaintiffs agreed in principle to settle with us and our former CEO and CFO by participating in the HPL Parties' settlement in the Securities Class Action, in addition to receiving 2,100,000 shares of common stock from us, $500,000 in cash from our insurer, Twin City Fire Insurance Company ("Twin City"), and 25% of the net recovery, if any, from Twin City in the litigation described below. The parties are preparing the settlement documentation. The Company anticipates issuing the 2,100,000 new shares of common stock to the FabCentric plaintiffs along with an additional 336,387 shares to the plaintiffs in the Securities Class Action pursuant to an anti-dilution provision following the Superior Court's determination that the settlement was made in good faith. We were also a nominal defendant in consolidated stockholder derivative lawsuits filed between July 31, 2002 and December 31, 2002, in Superior Court in the County of Santa Clara, California. These lawsuits asserted derivative claims on behalf of us against our current and former officers and directors and our independent auditors. The consolidated complaint asserted claims for insider trading, breach of fiduciary duties, breach of contract, professional negligence and unjust enrichment, and sought damages suffered by the Company, treble damages for the sale of shares, costs and expenses of these actions and such other relief as the court may deem appropriate. On April 6, 2005, the Superior Court in the County of Santa Clara, California, approved the settlement of the derivative actions. Our contribution to plaintiffs' attorney's fees of $950,000, which was our only contribution to the settlement, was fully funded by our excess directors and officers liability insurance ("D&O") policies. Additionally, Twin City (our first-layer excess D&O carrier) filed a declaratory relief action on October 6, 2003, in Superior Court in the County of Santa Clara, California, against us, our former President and Chief Executive Officer, our former Chief Financial Officer, and other former and current officers and directors of the Company seeking a determination that no coverage is afforded the defendants under Twin City's policy, which follows form to the Company's primary D&O policy issued by Executive Risk Indemnity Inc. Executive Risk has already agreed to pay its policy limits for the Securities Class Action, exhausting the limits of the primary D&O policy. We filed a Second Amended Cross-Complaint on September 29, 2004, seeking a declaration that Twin City and our other excess D&O insurance carriers, National Union Fire Insurance Company ("National Union") and St. Paul Mercury Insurance Company ("St. Paul"), are obligated to indemnify us for losses in connection with the Securities Class Actions and related litigation and that Twin City has breached its insurance contract by not paying the defendants' defense expenses on a current basis. 33 On January 11, 2005, we argued cross-motions for summary adjudication, in the Twin City matter. The parties sought a declaration regarding whether exclusionary language in our D&O liability insurance application excluded coverage for insureds who did not have knowledge of Y. David Lepejian's unlawful conduct. The Superior Court, in a ruling issued on January 12, 2005, held that this exclusionary language did not preclude coverage for insureds that did not have knowledge of the unlawful conduct, including the Company. Twin City's motion to reconsider the Superior Court's January 12, 2005 ruling was denied on February 22, 2005 and an amended order was issued on March 9, 2005. We intend to continue to oppose the remaining claims made in the Third Amended Complaint filed by Twin City and to seek coverage under Twin City's policy. To date, Twin City has advanced or agreed to advance, subject to a reservation of rights, a total of $900,000 under a reservation of rights to fund our settlements of the Securities Class Action and the FabCentric Action. On December 21, 2004, National Union, our third-layer excess D&O carrier, paid $1,000,000 into escrow in exchange for a full policy release. St. Paul, our fourth-layer excess D&O carrier has similarly paid $125,000 into escrow in exchange for a full policy release. The proceeds have now been used to settle the consolidated derivative action and for legal defense costs. As of December 31, 2004, we had accrued $9.1 million relating to the 9,756,000 new shares of common stock we had agreed to issue to settle the above actions. On March 31, 2005, we reduced the accrual to $8.4 million reflecting the estimated value of our common stock. Accordingly, there was a $730,000 reduction in legal settlement expenses in the three month period ended March 31, 2005. Following our dismissal from the FabCentric Action, the only remaining litigation in which we are party will be our claim against Twin City discussed above. This matter is in the early stages of litigation and accordingly it may ultimately be resolved on a basis different than currently estimated. Because there could be many factors that enter into the ultimate resolution of this matter which are not within our control, we are not able to estimate the maximum potential financial exposure to litigate this matter or the potential financial benefit to us should it be resolved successfully. The resolution of the Twin City litigation could have a material effect on our financial condition, results of operations or cash flows. RISK FACTORS RISKS ASSOCIATED WITH OUR BUSINESS We need to increase revenues or reduce costs or raise additional capital to fund our operating activities for the next twelve months. We currently are able to pay our debts and meet our obligations as they become due, but we believe that our existing capital resources will not be sufficient to satisfy our current and projected funding requirements through March 31, 2006. We intend to seek additional funding to support our future operations through public or private sales of our equity or debt securities. If we are unable to obtain additional funds to support our operations, we may need to reduce or curtail our operations, and you may lose your investment in our company. These factors raise substantial doubt as to our ability to continue as a going concern, and our independent registered public accounting firm has included a going concern uncertainty paragraph in their report, which is included in this Form 10-K 34 An investment in our securities is highly speculative. Our stock price has been highly volatile and there has been only limited trading volume (liquidity) in our common stock, which is currently traded on the over-the-counter market or the "pink sheets". Historically, our stock price has been subject to significant changes in value as we make material announcements regarding our company or results of operations and we expect this volatility will continue for the foreseeable future. In addition, the Company is investigating informal and formal restructuring alternatives which potentially may dilute shareholder equity. Accordingly, an investment in our securities is highly speculative and should not be made unless you are prepared to lose your entire investment. Our financial condition may raise concerns among our customers regarding our long-term stability. These concerns may adversely affect future sales. Customers who purchase our software products make a significant long-term investment in our technology. Our products often become an integral part of each installed fabrication facility and our customers look to us to provide continuing support, enhancements and new versions of our products. Because of the long-term nature of an investment in yield optimization software, customers are often concerned about the stability of their suppliers. Our current weak financial condition and the going-concern basis on which our financial statements have been prepared may cause current and potential customers concern over our stability and these concerns may cause us to lose sales. Any loss in sales could adversely affect our results of operations, further deepening concern among current and potential customers. Key employees Our employees are vital to our success, and our key management, engineering and other employees are difficult to replace. We generally do not have employment contracts with our key employees. Further, we do not maintain key person life insurance on any of our employees. The expansion of high technology companies worldwide has increased the demand and competition for qualified personnel. If we are unable to retain key personnel, or if we are not able to attract, assimilate or retain additional highly qualified employees to meet our needs in the future, our business and operations could be harmed. These factors could seriously harm our business. We currently have only three directors and believe we will have difficulty attracting qualified candidates to serve on our board. Our failure to add additional directors could adversely impact the management of our company, our compliance with securities laws and our future exchange listing eligibility. Since July 2002, we have had only three directors. We have begun searching for candidates to fill these vacancies. However, in light of our financial position, we believe we will have difficulty attracting qualified individuals to serve on our board. Our inability to attract and retain qualified independent directors may adversely affect the quality of our management and may make it more difficult for us to comply with corporate governance requirements of the securities exchanges, such as Nasdaq and those imposed by the Securities and Exchange Commission pursuant to the Sarbanes-Oxley Act of 2002. The semiconductor industry has experienced downturns in the past and any future downturns could adversely affect our revenues and operating results. Our business depends in part on the economic health of our customers: IDMs, or integrated device manufacturers, fabless semiconductor companies, and semiconductor equipment OEMs, or original equipment manufacturers. The semiconductor industry is prone to periods of oversupply resulting in significantly reduced capital expenditures. As a result of slowdowns, some semiconductor manufacturers have postponed or canceled capital expenditures for previously planned expansions or new fabrication facility construction projects, resulting in a substantial decline in worldwide semiconductor capital expenditures. 35 Current conditions and future downturns could affect the willingness of semiconductor companies to purchase our yield-optimization products and services or to purchase equipment from semiconductor equipment OEMs that have embedded our software in their products. Significant downturns could materially and adversely affect our business and operating results. In addition, we expect to continue increasing our investment in engineering, research and development, and marketing, which limits our ability to reduce expenses during such downturns. In any particular period, we derive a substantial portion of our revenues from a small number of customers, and our revenues may decline significantly if any major customer cancels or delays a purchase of our products. In each of the years ended March 31, 2005, 2004, and 2003, customers that individually accounted for at least 10% of our revenues together represented 34%, 42%, and 61% of our revenues, respectively, and in each of these years, there was substantial change among the companies that represented our largest customers. In the year ended March 31, 2005, sales to two customers accounted for 18% and 16%, respectively, of our revenues. Because we derive most of our revenues from a few customers and because our existing customers' needs for additional products are based on intermittent events, such as the introduction of new technologies or processes, building of new facilities or the need to increase capacity of existing facilities, our largest customers change from period to period. Delays or failures in selling new licenses to existing or new customers would cause significant period-to-period changes in our operating results, which may result in our failure to meet market expectations. We may also incur significant expense and devote management attention to the pursuit of potentially significant license revenues, but ultimately fail to secure these revenues. We must continually replace the revenues generated from the sale of licenses and one-time orders to maintain and grow our business. Over the past year, we have generated a significant amount of our revenues from sales of one-time customer orders. These licenses and orders produce large amounts of revenues in the periods in which the license fees are recognized and are not necessarily indicative of a commensurate level of revenues from the same customers in future periods. Achieving period-to-period growth will depend significantly on our ability to expand the number of users of our products within our customers' organizations, license additional software to our customers and attract new customers. We may not be successful in these sales efforts and, consequently, revenues in any future period may not match that of prior periods. We have a long and variable sales cycle, which can result in uncertainty and delays in generating additional revenues and results in potentially significant fluctuations in revenues from period to period. Because our yield optimization software and services are often unfamiliar to our prospective customers, it can take a significant amount of time and effort to explain the benefits of our products. This means that we may spend substantial time and management attention on potential licenses that are not consummated, thereby foregoing other opportunities. In addition, due to the nature of fabrication facility deployment and the extended time required to bring a fabrication facility to full capacity, capital expenditures vary greatly during this time. Accordingly, we may be unable to predict accurately the timing of any significant future sales of software licenses, which has significantly affected, and will continue to significantly affect quarterly operating results. In addition to the previously discussed risk resulting from our restatement of previously issued financial statements, factors that could cause our revenues and operating results to vary from period to period include: 36 o large sales unevenly spaced over time; o timing of new products and product enhancements by us and our competitors; o the cyclical nature of the semiconductor industry; o changes in our customers' development schedules, expenditure levels and product support requirements; and o incurrence of sales and marketing and research and development expenses that may not generate revenues until subsequent quarters. As a result, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and may not be accurate indicators of future performance. These factors may cause our operating results to be below market expectations in some future quarters, which could cause the market price of our stock to decline. We may not succeed in developing new products and our operating results may decline as a result. Our customers and competitors operate in rapidly evolving markets that are characterized by introduction of new technologies and more complex designs, shorter product life cycles and disaggregation of the industry into new subsectors. For example, ever smaller geometries are being used in semiconductors and new materials are being employed to enhance performance. We must continually create new software and add features and functionality to our existing software products to keep pace with these changes in the semiconductor industry. Specifically, we need to focus our research and development to: o interface with new semiconductor producing hardware and systems that others develop; o remain competitive with companies marketing third party yield management software and consulting services; o continue developing new software modules that are attractive to existing customers, many of which have purchased perpetual licenses and are under no ongoing obligation to make future purchases from us; and o attract new customers to our software. Maintaining and capitalizing on our current competitive strengths will require us to invest heavily in research and development, marketing, and customer service and support. Although we intend to devote substantial expenditures to product development, we may not be able to create new products in a timely manner that adequately meet the needs of our existing and potential customers. A failure to do so would adversely affect our competitive position and would result in lower sales and a decline in our profitability. Our competitors generally have greater resources and our failure to effectively compete against other companies could impair our growth and profitability. We target IDMs, fabless semiconductor companies, foundries and semiconductor equipment OEMs. The tools and systems against which our products and services most commonly compete are those that semiconductor companies have created in house. In order to grow our business, we must convince these producers of the benefit of an outside solution. The third party providers against whom we compete are, generally, divisions of larger semiconductor equipment OEMs, such as KLA-Tencor. These companies can compete on the basis of their greater financial, engineering and manufacturing resources, and their long-standing relationships with the same companies we are targeting. If we cannot compete successfully against these forms of competition, the growth of our business will be impaired. 37 Errors in our products or the failure of our products to conform to specifications could hurt our reputation and result in our customers demanding refunds or asserting claims against us for damages. Because our software products are complex, they could contain errors or "bugs" that can be detected at any point in a product's lifecycle. We have a team dedicated to detecting errors in our products prior to their release in order to enable our software developers to remedy any such errors. In the past we have discovered errors in some of our products and have experienced delays in the delivery of our products because of these errors. In addition, we have software engineers and developers who participate in the maintenance and support of our products and assist in detecting and remedying errors after our products are sold. These delays and replacements have principally related to new product releases. Detection of any significant errors may result in: o the loss of, or delay in, market acceptance and sales of our products; o the delay or loss of revenues; o diversion of development resources; o injury to our reputation; or o increased maintenance and warranty costs. Any of these problems could harm our business and operating results. If our products fail to conform to specifications, customers could demand a refund for the purchase price or assert claims for damages. Liability claims could require us to spend significant time and money in litigation or to pay significant damages. Any such claims, whether or not successful, could seriously damage our reputation and our business. We may incur non-cash charges resulting from acquisitions and equity issuances, which could harm our operating results. We have incurred $8.4 million in charges related to our estimated cost of settling the Securities Action, Covalar Action and Fabcentric Action based on the estimated value of the 9,755,207 shares of our stock we have agreed to issue in the year ended March 31, 2005. We may incur additional charges related to settling these matters as we revalue the accrual for issuances quarterly until the shares are actually issued. We incurred a $30.6 million goodwill impairment charge in the fourth quarter of our year ended March 31, 2003. We will continue to incur charges to reflect amortization and any future impairment of identified intangible assets acquired in connection with our acquisitions of FabCentric, Covalar and DYM, and we may make other acquisitions or issue additional stock or other securities in the future that could result in further accounting charges. In the future, we may incur additional impairment charges related to the goodwill already recorded, as well as goodwill arising out of any future acquisitions. Current and future accounting charges like these could result in significant losses and delay our achievement of net income. Terrorist activities and resulting military and other actions could adversely affect our business Terrorist attacks in New York, Pennsylvania and Washington, D.C. in September 2001 disrupted commerce throughout the United States and other parts of the world. The continued threat of terrorism within the United States and abroad, and the potential for military action and heightened security measures in response to such threats, may cause significant disruption to commerce throughout the world. To the extent that such disruptions result in delays or cancellations of customer orders, a general decrease in corporate spending, or our inability to effectively market, sell or operate our services and software, our business and results of operations could be materially and adversely affected. 38 RISKS RELATED TO OUR INTERNATIONAL OPERATIONS Our business could be harmed by political or economic instability in the Republic of Armenia. Some of our software products are largely developed, produced, delivered and supported from our facilities in the Republic of Armenia. Changes in the political or economic conditions in Armenia and the surrounding region, such as fluctuations in exchange rates, the imposition of currency transfer restrictions or limitations, or the adoption of burdensome trade or tax policies, procedures, rules, regulations or tariffs, could adversely affect our ability to develop new products and take advantage of Armenia's low labor and production costs, and to otherwise conduct business effectively in Armenia. Armenia voted for independence in 1991 and adopted its current constitution in 1995. Laws protecting property (including intellectual property) are not well established and may be difficult to enforce. In recent years, Armenia has suffered significant political and economic instability. Any future political and economic instability could interfere with our ability to retain or recruit employees, significantly increase the cost of our operations, or result in regulatory restrictions on our business, making it difficult for us to maintain our business in Armenia or disrupting our Armenian operations. Any significant increase in the costs of our Armenian operations (whether due to inflation, imposition of additional taxes or other causes) would diminish, and could eliminate their current cost-advantages. Furthermore, we cannot assure you that restrictive foreign relations laws or policies on the part of Armenia or the United States will not constrain our ability to operate effectively in both countries. If we lose or choose to terminate any part of our Armenian operation, replacements could be costly and we could experience delays in our product development, thereby harming our competitive position and adversely affecting our results of operations. Our expansion into international markets may result in higher costs and could reduce our operating margins due to the higher costs of international sales. Our current strategy for growth includes further expansion in Asia, Europe, and other international markets. To effectively further this strategy, we must find additional partners to sell our products in international markets and expand our direct international sales presence. We would likely incur higher sales costs by expanding our direct sales staff abroad, but we might not realize corresponding increases in revenues or profitability. Furthermore, we may be forced to share sales revenues with distributors or other sales partners abroad in order to successfully penetrate foreign markets. Even if we successfully expand our direct and indirect international sales efforts, we cannot be certain that we will be able to create or increase international market penetration or demand for our products. Problems with international business operations could adversely affect our sales. Sales to customers located outside the United States accounted for approximately 59%, 53%, and 36% of our revenues in the years ended March 31, 2005, 2004 and 2003, respectively. We anticipate that sales to customers located outside the United States will represent a significant portion of our total revenues in future periods. In addition, many of our customers rely on third party foundries operating outside of the United States. Accordingly, our operations and revenues are subject to a number of risks associated with foreign commerce, including the following: o managing foreign distributors; o maintaining relationships with foreign distributors; o staffing and managing foreign branch offices; o political and economic instability abroad; o foreign currency exchange fluctuations; o changes in tax laws and tariffs; o timing and availability of export licenses; o inadequate protection of intellectual property rights in some countries; and o obtaining governmental approvals for certain technologies. 39 Any of these factors could result in decreased sales to international customers and domestic customers that use foreign fabrication facilities. Our accounts receivable from international customers are generally outstanding longer than our domestic receivables and, as a result, we may need a proportionately greater amount of working capital to support our international sales. INTELLECTUAL PROPERTY RELATED RISKS Our success depends in part on our ability to protect our intellectual property, and any inability to do so could cause our business material harm. Our success depends in significant part on our intellectual property. While we have attempted to protect our intellectual property through patents, copyrights, or the maintenance of trade secrets, there can be no assurance that these measures will successfully protect our technology or that competitors will not be able to develop similar technology independently. It is possible, for example, that the claims we are allowed on any of our patents will not be sufficiently broad to protect our technology. In addition, patents issued to us could be challenged, invalidated or circumvented and the rights granted under those patents might not provide us with any significant competitive advantage. The laws of some foreign countries do not protect our intellectual property as effectively as the laws of the United States. Also, our source code developed in Armenia may not receive the same copyright protection that it would receive if it was developed in the United States. As we increase our international presence, we expect that it will become more difficult to monitor the development of competing products that may infringe on our rights as well as unauthorized use of our products. Our operating results would suffer if we were subject to a protracted intellectual property infringement claim or one with a significant damages award. Litigation regarding intellectual property rights frequently occurs in the software industry. We may be subject to infringement claims as the number of competitors in our industry segment grows. While we are unaware of any claims that our products infringe on the intellectual property rights of others, such claims may arise in the future. Regardless whether these claims have merit, they could: o be costly to defend; o divert senior management's time, attention and resources; o cause product shipment delays; and o require us to enter into costly licensing or royalty arrangements. Any of these potential results of intellectual property infringement claims could limit our ability to maintain our business and negatively affect our operating results. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK In the normal course of business, our financial position is subject to a variety of risks, including market risk associated with interest rate and foreign currency exchange movements. We regularly assess these risks and have established policies and business practices to protect against these and other exposures. As a result, we do not anticipate material potential losses in these areas. 40 Interest Rate Risk We invest excess cash in debt instruments of the U.S. Government and its agencies, and in high quality corporate issuers and, limit the amount of credit exposure to any one issuer. Our investments in fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates. We believe that a change in long-term interest rates would not have a material effect on our business, financial condition, results of operations or cash flow. Our cash and cash equivalents consist of cash and highly liquid money market instruments with original or remaining maturities of 90 days or less. Because of the short maturities of these instruments, a sudden change in market interest rates would not have a material impact on the fair value of the portfolio, but it may cause the amount of income we derive to vary from period to period. A hypothetical 10% increase in interest rates would not result in a material decrease in the fair value of our available-for-sale securities as of March 31, 2005. Foreign Exchange Risk Our sales are primarily denominated in U.S. dollars and, as a result, we have relatively little exposure to foreign currency exchange risk with respect to revenues. Our sales through our Japanese subsidiary, which represented approximately 11.4% of total revenues in the year ended March 31, 2005, are denominated in yen. A 10% adverse change in yen exchange rates would have had a 1.1% impact on revenues for the year ended March 31, 2005. Additionally, our exposure to foreign exchange rate fluctuations arises in part from inter-company accounts, which can be denominated in the functional currency of the foreign subsidiary. As exchange rates vary when the accounts are translated, results may vary from expectations and adversely impact earnings. The effect of foreign exchange rate fluctuations in the year ended March 31, 2005 was a loss of approximately $116,000 to the Company. While our sales are generally denominated in U.S. dollars, our international subsidiaries' books and records are maintained in the local currency. As a result, our financial statements are remeasured in U.S. dollars using a combination of current and historical exchange rates. The functional currencies of our foreign subsidiaries are their local currencies. We translate certain assets and liabilities to U.S. dollars at the current exchange rate as of the applicable balance sheet date. Revenues and expenses are translated at the average exchange rates prevailing during the period. Adjustments resulting from the translation of the foreign subsidiaries' financial statements are recorded as accumulated other comprehensive income (loss) in stockholders' equity. 41 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements

~~Capital~~Consolidated ~~Lease~~Financial ~~Operating~~Statements: ~~Year~~Report ~~Ending~~of Independent Registered Public Accounting Firm 43 Consolidated Statements of Operations for each of the three years in the period ended March 31, ~~Obligations~~2005 ~~(1)~~44 ~~Leases~~Consolidated ~~Total~~Balance ~~-------------------------------------~~Sheets ~~-----------------~~at ~~-----------------~~March ~~-----------------~~31, 2005 98and ~~1,356~~2004 ~~1,454~~45 ~~2006~~Consolidated 27Statements ~~1,048~~of ~~1,075~~Cash ~~2007~~Flows 13for 20each 33of ~~-----------------~~the ~~-----------------~~three ~~-----------------~~years $in ~~138~~the $period ~~2,424~~ended $March 231,~~562~~ ~~=================~~2005 ~~=================~~46 ~~=================~~Consolidated ~~-----------------------------------~~Statements of Stockholders' Equity (1Deficit) ~~From~~for ~~2004~~each toof ~~2007~~the three years in the period ended March 31, we2005 ~~are~~47 ~~required~~Notes to ~~make~~Consolidated ~~interest~~Financial ~~payments~~Statements ~~totaling~~48 ~~$8,000~~Financial ~~for~~Statement ~~capital~~Schedules: ~~leases~~All ~~obligations;~~schedules ~~this~~are ~~interest~~omitted ~~component~~because they are not applicable or the required information is ~~included~~shown in the ~~commitment~~Consolidated ~~schedule~~Financial ~~above~~Statements or Notes thereto. Supplementary Financial Data: Quarterly Financial Data (unaudited) for the two years ended March 31, 2005 67

42 Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of HPL Technologies, Inc.: In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of HPL Technologies and its subsidiaries at March 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended March 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. PricewaterhouseCoopers LLP San Jose, California June 27, 2005 43 HPL Technologies, Inc. Consolidated Statements of Operations (In thousands, except per share amounts)

~~Consolidated~~Year ~~Financial~~ended ~~Statements~~March 31, 2005 2004 2003 --------------- ---------------- ---------------- Revenues: ~~Report~~Software oflicenses ~~Independent~~$ ~~Registered~~3,176 ~~Public~~$ ~~Accounting~~4,799 ~~Firm~~$ 435,281 ~~Consolidated~~Consulting ~~Statements~~services, maintenance and other 6,593 7,902 10,311 --------------- ---------------- ---------------- Total revenues 9,769 12,701 15,592 --------------- ---------------- ---------------- Cost of ~~Operations~~revenues: ~~for~~Software ~~each~~licenses 96 507 656 Consulting services, maintenance and other (1) 2,752 3,131 3,808 --------------- ---------------- ---------------- Total cost of ~~the~~revenues ~~three~~2,848 ~~years~~3,638 in4,464 ~~the~~--------------- ~~period~~---------------- ~~ended~~---------------- ~~March~~Gross 31profit 6,921 ~~2004~~9,063 4411,128 ~~Consolidated~~--------------- ~~Balance~~---------------- ~~Sheets~~---------------- atOperating ~~March~~expenses: 31Research and development (1) 6,590 ~~2004~~6,384 10,515 Sales, general and ~~2003~~administrative (1) 8,264 13,604 19,788 Legal settlement expense (Note 16) 470 7,900 - Goodwill impairment - - 30,570 Stock-based compensation 45 ~~Consolidated~~315 ~~Statements~~1,047 Amortization of ~~Cash~~intangible ~~Flows~~assets ~~for~~1,181 ~~each~~1,327 of1,494 ~~the~~--------------- ~~three~~---------------- ~~years~~---------------- inTotal ~~the~~operating ~~period~~expenses ~~ended~~16,550 ~~March~~29,530 3163,414 ~~2004~~--------------- 46---------------- ~~Consolidated~~---------------- ~~Statements~~Loss offrom ~~Stockholders'~~operations ~~Equity~~(9,629) (~~Deficit~~20,467) ~~for~~(52,286) ~~each~~Interest ofincome ~~the~~and ~~three~~other ~~years~~income in138 ~~the~~252 ~~period~~617 ~~ended~~Interest ~~March~~expense 31(3) (39) (149) --------------- ---------------- ---------------- Loss before income taxes (9,494) ~~2004~~(20,254) 47(51,818) ~~Notes~~Provision tofor ~~Consolidated~~(benefit ~~Financial~~from) ~~Statements~~income 48taxes ~~Financial~~(71) ~~Statement~~89 ~~Schedules:~~- ~~All~~--------------- ~~schedules~~---------------- ~~are~~---------------- ~~omitted~~Net ~~because~~loss ~~they~~$ ~~are~~(9,423) ~~not~~$(20,343) ~~applicable~~$ or(51,818) ~~the~~=============== ~~required~~================ ~~information~~================ isNet ~~shown~~loss inper ~~the~~share ~~Consolidated~~basic ~~Financial~~and ~~Statements~~diluted: or$ ~~Notes~~(0.30) ~~thereto~~$ (0.65) ~~Supplementary~~$ ~~Financial~~( ~~Data~~1.69) =============== ================ ================ Shares used in per share calculations basic and diluted: ~~Quarterly~~31,332 ~~Financial~~31,145 ~~Data~~30,645 =============== ================ ================ ---------------------------------------------------------- (~~unaudited~~1) ~~for~~Excludes the ~~two~~following ~~years~~stock-based ~~ended~~compensation ~~March~~charges: 31Cost of revenues $ - $ - $ 18 Research and development 15 113 414 Sales, ~~2004~~general 69and administrative 30 202 615 --------------- ---------------- ---------------- $ 45 $ 315 $ 1,047 =============== ================ ================ The accompanying notes are an integral part of these consolidated financial statements.

44 HPL Technologies, Inc. Consolidated Balance Sheets (In thousands, except per share data)

~~Year ended~~ March 31, ~~----------------------------------------------------------~~2005 2004 ~~2003 2002~~ --------------- --------------- ----~~------------~~ ~~Revenues:~~ASSETS ~~Software~~Current ~~licenses~~assets: $Cash ~~4,799~~and $cash ~~5,281~~equivalents $ 1,~~614~~185 ~~Consulting~~$ ~~services~~2,408 ~~maintenance~~Short-term ~~and~~investments ~~other~~2,061 7,~~902~~802 ~~10,311~~Accounts 2receivable,~~899~~ ~~---------------~~net ~~---------------~~of ~~----------------~~allowances ~~Total~~of ~~revenues~~$100 12and $100,~~701~~ 15respectively 1,~~592~~311 42,~~513~~888 ~~---------------~~Unbilled ~~---------------~~accounts ~~----------------~~receivable ~~Cost~~102 of4 ~~revenues:~~Prepaid ~~Software~~expenses ~~licenses 507 656 587 Consulting services, maintenance~~ and other ~~(1)~~current ~~3,131~~assets 31,~~808~~187 ~~507~~940 --------------- --------------- -----~~-----------~~ Total ~~cost~~current ofassets ~~revenues~~5,846 314,~~638~~042 4Property and equipment,~~464~~ net 847 1,~~094~~308 ~~---------------~~Goodwill ~~---------------~~27,754 ~~----------------~~27,754 ~~Gross~~Other ~~profit~~intangible 9assets,~~063~~ ~~11,128~~net 3- 1,~~419~~181 Other assets 355 580 --------------- --------------- -----~~-----------~~ ~~Operating~~Total ~~expenses:~~assets ~~Research~~$ ~~and development (1) 6~~34,~~384~~802 ~~10,515~~$ 644,~~118~~865 ~~Sales,~~=================================== ~~general~~LIABILITIES ~~and~~AND ~~administrative~~STOCKHOLDERS' ~~(1)~~EQUITY ~~13,604~~Current ~~19,788~~liabilities: ~~9,285~~Accounts ~~Legal~~payable ~~settlement~~$ ~~expense~~901 ~~(Note~~$ ~~16) 7~~2,~~900~~085 -Accrued -liabilities ~~Goodwill~~6,867 ~~impairment - 30~~6,~~570~~579 -Deferred ~~Stock-based~~revenue ~~compensation 315~~ 1,~~047~~687 31,~~547~~894 ~~Amortization~~Capital oflease ~~intangible~~obligations ~~assets~~- ~~1,327~~current ~~1,494~~portion ~~294~~26 91 --------------- --------------- -----~~-----------~~ Total ~~operating~~current ~~expenses~~liabilities 299,~~530~~481 6310,~~414~~649 ~~19,244~~Capital ~~---------------~~lease ~~---------------~~obligations ~~----------------~~net ~~Loss~~of ~~from~~current ~~operations~~portion $13 ~~(20,467)~~39 $Legal ~~(52,286)~~settlement $liability (~~15,825)~~Note ~~Interest income (expense~~16) ~~and~~8,370 ~~other~~7,900 ~~net~~Other ~~213~~liabilities ~~468~~- ~~908~~235 --------------- --------------- -----~~-----------~~ ~~Loss~~Total ~~before~~liabilities ~~income taxes $ (20~~17,~~254)~~864 ~~$ (51~~18,~~818)~~823 ~~$ (14,917) Provision for income taxes 89~~ - - --------------- --------------- ---~~-------------~~ ~~Net~~Contingencies ~~loss~~and $Commitments (~~20,343)~~Notes $9 ~~(51,818~~and 16) $Stockholders ~~(14,917)~~equity ~~===============~~: ~~===============~~Preferred ~~================~~stock, ~~Net~~$0.001 ~~loss~~par ~~per~~value, ~~share~~10,000 -shares ~~basic~~authorized, ~~and~~no ~~diluted:~~shares $issued ~~(0.65)~~and $outstanding ~~(1.69)~~at $March ~~(0.62)~~31, ~~===============~~2005 ~~===============~~and ~~================~~2004 ~~Shares~~- ~~used~~- inCommon ~~per~~stock, ~~share~~$0.001 ~~calculations~~par -value; ~~basic~~75,000 ~~and~~shares ~~diluted:~~authorized; 31,~~145~~447 ~~30,645~~and 2431,~~038~~275 ~~===============~~shares ~~===============~~issued ~~================~~and ~~(1)~~outstanding ~~Excludes~~at ~~the~~March ~~following~~31, ~~stock-based~~2005 ~~compensation~~and ~~charges:~~2004 ~~Cost~~32 of32 ~~revenues~~Additional $ paid-in $capital 18124,181 $124,205 39Deferred ~~Research~~stock-based ~~and~~compensation ~~development~~(19) ~~113~~(129) ~~414~~Accumulated ~~692~~deficit ~~Sales~~(107,470) ~~general~~(98,047) ~~and~~Accumulated ~~administrative~~other ~~202~~comprehensive ~~615~~gain ~~2,816~~(loss) 214 (19) --------------- -------------------- Total stockholders' equity 16,938 26,042 ----------------------------------- $Total ~~315~~liabilities and stockholders' equity $ 134,~~047~~802 $ 344,~~547~~865 =============== =============== =====~~===========~~ The accompanying notes are an integral part of these consolidated financial statements.

45 HPL Technologies, Inc. Consolidated Statements of Cash Flows (In thousands)

~~March 31,~~ ------------------------------------------- 2005 2004 2003 -------------- ----------------------------- ~~ASSETS~~Cash ~~Current~~flows ~~assets~~from operating activities: ~~Cash~~Net ~~and~~loss ~~cash~~$ ~~equivalents~~(9,423) $ 4(20,~~708~~343) $ 17(51,~~350~~818) ~~Short-term~~Adjustments ~~investments~~to 5reconcile net loss to net cash used in operating activities: Depreciation and amortization 2,~~502~~121 42,~~391~~598 ~~Accounts~~3,218 ~~receivable~~Legal settlement expense 470 7,900 ~~net~~- Goodwill impairment - - 30,570 Forgiveness of ~~allowances~~note 150 150 150 Loss on disposal of ~~$100~~property & equipment 17 - - Stock-based compensation 45 315 1,047 Changes in assets and ~~$100~~liabilities, ~~respectively~~net 2of effects from acquisitions: Accounts receivable 1,~~888~~577 (1,~~560~~328) (47) Unbilled accounts receivable 4(98) ~~619~~615 164 Prepaid expenses and other current assets ~~940~~(247) 32,~~206~~266 ~~--------------~~687 ~~---------------~~Other ~~Total current~~ assets ~~14,042~~75 ~~27,126~~1 ~~Property~~15 ~~and~~Accounts ~~equipment~~payable (1,184) ~~net~~743 (1,~~308~~398) ~~2,316~~Accrued ~~Goodwill~~liabilities ~~27,754~~288 27(175) (1,~~704~~068) Other ~~intangible~~liabilities ~~assets,~~(235) ~~net~~(279) ~~1,181~~(225) ~~2,508~~Deferred ~~Other~~revenue ~~assets~~(207) ~~580~~(1,881) ~~731~~(5,054) -------------- ----------------------------- ~~Total~~Net ~~assets~~cash $used ~~44,865~~in $operating ~~60,385~~activities ~~============== =============== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 2,085 $ 1,342 Accrued liabilities~~ (6,~~579~~651) 6(9,~~754~~418) ~~Deferred revenue 1~~(23,~~894~~759) ~~3,667 Capital lease obligations~~ - ~~current portion 91 338 Convertible debenture~~ - ~~1,500~~ -------------- --------------------------- ~~Total~~Cash ~~current~~flows ~~liabilities~~from ~~10,649~~investing ~~13,601~~activities: ~~Capital~~Acquisition ~~lease~~of ~~obligations~~property and equipment (506) (263) (397) Proceeds on disposal of property and equipment 10 - ~~net~~- Issuance of ~~current~~notes ~~portion~~receivable 39- ~~130~~- ~~Deferred~~(450) ~~revenue~~Acquisitions, net of cash acquired - ~~108~~- ~~Legal~~(2,012) ~~settlement~~Purchase ~~liability~~of short-term investments (~~Note~~538) 16(15,681) 7(22,~~900~~378) Sale of short-term ~~Other~~investments ~~liabilities~~6,279 ~~235~~12,263 ~~514~~32,319 -------------- ----------------------------- ~~Total~~Net ~~liabilities~~cash 18provided by (used in) investing activities 5,~~823~~245 14(3,~~353~~681) 7,082 -------------- ----------------------------- ~~Contingencies~~Cash ~~and~~flows ~~Commitments~~from ~~(Notes~~financing ~~8, 9 and 16) Stockholders' equity~~ activities: ~~Preferred~~Repayments ~~stock,~~of ~~$0.001~~convertible ~~par~~debenture ~~value,~~- 10(1,~~000~~500) ~~shares~~- ~~authorized,~~Issuance noof ~~shares~~common ~~issued~~stock ~~and~~41 ~~outstanding~~9 at166 ~~March~~Principal ~~31,~~payments ~~2004~~on ~~and~~capital ~~2003~~lease -obligations -(91) ~~Common~~(338) ~~stock,~~(397) ~~$0.001~~Amounts ~~par~~received ~~value;~~from ~~75,000~~HPL's ~~shares~~former ~~authorized;~~Chief ~~31,275~~Executive ~~and~~Officer ~~30,810~~- ~~shares~~- ~~issued and outstanding at March 31~~1,300 ~~2004~~------------------------------------------- ~~and~~Net ~~2003~~cash 32provided 31by ~~Additional~~(used ~~paid-~~in) ~~capital~~financing ~~124~~activities (50) (1,~~205~~829) ~~124~~1,~~590~~069 ~~Deferred stock~~-~~based~~------------------------------------------ ~~compensation~~Effect ~~(129)~~of ~~(887)~~exchange ~~Accumulated~~rate ~~deficit~~changes ~~(98,047)~~on ~~(77,704)~~cash ~~Accumulated~~and ~~other~~cash ~~comprehensive~~equivalents ~~gain~~233 (~~loss~~14) ~~(19)~~160 2 -------------- ----------------------------- ~~Total~~Net ~~stockholders'~~decrease ~~equity~~in 26cash and cash equivalents (1,~~042~~223) 46(14,~~032~~942) (15,448) Cash and cash equivalents at beginning of period 2,408 17,350 32,798 -------------- ----------------------------- ~~Total~~Cash ~~liabilities~~ and ~~stockholders'~~cash ~~equity~~equivalents at end of period $ 441,~~865~~185 $ 602,~~385~~408 $ 17,350 ============== ============================= Supplemental disclosures of cash flow information: Interest paid $ 5 $ 187 $ 22 Income taxes paid $ 21 $ 10 $ 1,749 Income taxes refunded $ 180 $ 1,237 $ - Supplemental disclosure of non-cash investing and financing activities: Acquisition of property and equipment under capital lease obligations $ - $ 172 $ 391 Issuance of common stock and options assumed in connection with acquisitions $ - $ - $14,178 The accompanying notes are an integral part of these consolidated financial statements.

46 HPL Technologies, Inc. Consolidated Statements of Stockholders' Equity (In thousands)

~~Year~~Accumulated ~~ended~~Common ~~March~~Stock ~~31,~~Additional Deferred other Total -------------- paid-in stock-based Accumulated comprehensive stockholders' Shares Amount capital compensation deficit income equity ------- -------- --------- ------------~~-------~~ ~~2004 2003 2002~~ -----------~~-------~~ ------------~~------~~ -------------~~-----~~ ~~Cash~~Balances ~~flows~~as ~~from~~of ~~operating~~March ~~activities:~~31, ~~Net~~2002 ~~loss~~29,400 $ ~~(20~~29 $ 112,~~343)~~369 $ (514,~~818~~017) $ (1425,~~917~~886) ~~Adjustments~~$ ~~to reconcile net loss to net cash provided by~~ (~~used in~~179) ~~operating~~$ ~~activities: Depreciation and amortization 2~~82,~~598~~316 ~~3,218~~Components ~~779~~of ~~Legal~~comprehensive ~~settlement~~loss: ~~expense~~Net ~~7,900~~loss - - ~~Goodwill~~- ~~impairment~~ - 30(51,~~570~~818) - ~~Forgiveness~~(51,818) ofUnrealized ~~note~~gain ~~150~~on ~~150~~available ~~- Allowance~~ for ~~doubtful~~sale ~~accounts~~securities - - ~~(63)~~- ~~Accreted interest expense~~ - - 2569 ~~Stock-based~~69 ~~compensation~~Foreign ~~315~~currency ~~1,047~~translation ~~3,547~~adjustment ~~Loss~~- on- ~~disposal~~- of- ~~property~~- ~~and~~112 ~~equipment~~112 - - ------- ~~Changes~~Total incomprehensive ~~assets~~loss ~~and liabilities~~(51,637) ~~net~~--------- Exercise of ~~effects~~stock ~~from~~options ~~acquisitions:~~for ~~Accounts~~cash ~~receivable~~443 (1~~,328)~~ ~~(47)~~165 ~~1,806~~- ~~Unbilled~~- ~~accounts~~- ~~receivable~~166 ~~615~~Issuance ~~164~~of ~~(393)~~common ~~Prepaid~~stock ~~expenses~~ and ~~other~~options ~~current~~assumed ~~assets~~in ~~2,266~~connection ~~687~~with ~~(2,472)~~acquisitions ~~Other~~967 ~~assets~~ 1 1514,177 (6438) ~~Accounts~~- ~~payable~~- ~~743 (1~~14,~~398)~~140 ~~(261)~~Stock-based ~~Accrued~~compensation ~~liabilities~~- ~~(175)~~- (12,~~068~~121) ~~607~~3,168 ~~Other~~- ~~liabilities~~- ~~(279) (225) (344) Deferred revenue (~~1,~~881)~~047 ~~(5,054) (662)~~ ------- -------- --------- ------------ ----------- ------------- ~~Net cash provided by (used in) operating activities (9,418) (23,759) (12,412)~~ -----------~~-------------------------------------------------~~ ~~Cash~~Balances ~~flows~~as ~~from~~of ~~investing~~March ~~activities:~~31, ~~Acquisition~~2003 of30,810 ~~property~~31 ~~and~~124,590 ~~equipment~~ (~~263~~887) (~~397~~77,704) ~~(633)~~2 ~~Issuance~~46,032 Components of ~~notes~~comprehensive ~~receivable~~loss: Net loss - - - - (~~450~~20,343) - (320,~~045~~343) ~~Repayment~~Unrealized ofgain ~~notes~~on ~~receivable~~available -for -sale ~~2,745~~securities ~~Acquisitions,~~- ~~net~~- of- ~~cash~~- ~~acquired~~ - (~~2,012~~7) (~~12,095~~7) ~~Purchase~~Foreign ofcurrency ~~short~~translation adjustment -~~term~~ ~~investment~~- ~~(13,381)~~- - - (~~22,378~~14) (~~20,666~~14) ~~Sales of short~~-~~term investments 12,263 32,319 6,306~~ -------- Total comprehensive loss (20,364) --------- Exercise of stock options for cash 68 - 9 - - - 9 Issuance of common stock and options assumed in connection with acquisitions 397 1 49 - - - 50 Stock-based compensation - - (443) 758 - - 315 ------- -------- ---------~~------~~ ~~Net cash provided by (used in) investing activities (1,381) 7,082 (27,388)~~ ------------ ----------- ------------ ------------~~------------~~ ~~Cash~~Balances ~~flows~~as ~~from~~of ~~financing~~March ~~activities:~~31, ~~Repayments~~2004 of31,275 ~~convertible~~32 ~~debenture~~124,205 (1129) (98,~~500~~047) -(19) -26,042 ~~Proceeds~~Components ~~from issuance~~ of ~~notes~~comprehensive ~~payable~~loss: ~~and~~Net ~~line~~loss ~~of credit~~ - - ~~84 Repayments of notes payable and line of credit~~ - - (~~284~~9,423) ~~Issuance~~- of(9,423) ~~common~~Unrealized ~~stock~~gain 9on ~~166~~available ~~69,048~~for ~~Principal~~sale ~~payments~~securities on- ~~capital~~- ~~lease~~- ~~obligations~~- ~~(338)~~- (~~397~~16) (~~144~~16) ~~Amounts~~Foreign ~~received~~currency ~~from~~translation ~~HPL's~~adjustment ~~former~~- ~~Chief~~- ~~Executive~~- ~~Officer~~- - ~~1,300~~249 ~~3,035~~249 ---------~~-------------------------------------------------~~ ~~Net~~Total ~~cash~~comprehensive ~~provided~~loss by (~~used in) financing activities (1~~9,~~829~~190) ~~1,069 71,739~~ ---------~~-------------------------------------------------~~ ~~Effect~~xercise of ~~exchange~~stock ~~rate~~options ~~changes~~for on cash ~~and~~172 ~~cash~~- ~~equivalents~~41 ~~(14)~~- ~~160~~- ~~(130)~~- 41 Stock-based compensation - - (65) 110 - - 45 ------- -------- ---------- ------------ -----------~~-----~~ ~~Net increase (decrease) in cash and cash equivalents (12,642) (15,448) 31,809 Cash and cash equivalents at beginning of period 17,350 32,798 989~~ ------------ -----------~~-----------------------------------~~ ~~Cash~~Balances ~~and~~as ~~cash~~of ~~equivalents~~March at31, ~~end~~2005 of31,447 ~~period~~$ 32 $ 4124,~~708~~181 $ 17(19) $ (107,~~350~~470) $ 32214 $ 16,~~798~~938 ======== ======== =========== ============ =========== ============ ~~Supplemental~~=========== ~~disclosures~~The ofaccompanying ~~cash~~notes ~~flow~~are ~~information:~~an ~~Interest~~integral ~~paid~~part ~~$ 187 $ 22 $ 202 Income taxes paid $ 10 $ 1,749 $ 793 Income taxes refunded $ 1,237 - - Supplemental disclosure~~ of ~~non-cash~~these ~~investing~~consolidated ~~and~~financial financing activities: Acquisition of property and equipment under capital lease obligations $ 172 $ 391 $ 461 Issuance of common stock and options assumed in connection with acquisitions - $ 14,178 $ 33,592statements.

47 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. NATURE OF OPERATIONS AND GOING CONCERN HPL Technologies, Inc. ("HPL" or the "Company") is engaged in the sale, support and providing of services related to the yield optimization software it designs for companies involved in the design, fabrication and testing of semiconductors and flat panel displays. The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business; and, accordingly, the financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amount and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The Company has experienced net losses and negative cash flows since going public in July 2001 and, as of March 31, 2005, had an accumulated deficit of $107.5 million. The Company expects to have a net operating loss in the year ending March 31, 2006. For the year ended March 31, 2005, cash used in operations and to fund capital expenditures was $7.2 million. Management's plans for the Company to continue as a going concern include increases in revenues and raising additional capital or debt financing. At March 31, 2005, the Company had approximately $3.2 million in cash and cash equivalents and short-term investments. The Company's current operating plan for the year ending March 31, 2006 projects that cash available from planned revenue combined with the $3.2 million on hand at March 31, 2005 will not be adequate to fund operations through March 31, 2006. There is no assurance that equity or debt financing would be available to the Company or, if available, under terms that would be acceptable to the Company. NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of consolidation The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries after the elimination of intercompany balances and transactions. Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements. These estimates may affect the amounts of assets and liabilities reported in the balance sheet, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expense during the periods presented. Actual amounts may differ from those estimates. Revenue recognition The Company recognizes revenue in accordance with the provisions of Statement of Position ("SOP") 97-2, "Software Revenue Recognition," as amended by SOP 98-4, SOP 98-9 and Staff Accounting Bulletin No. 104, "Revenue Recognition in Financial Statements" issued by the Securities and Exchange Commission. The Company's revenues are primarily derived from three sources: 48 (i) software license revenue, derived primarily from sales to end users; (ii) maintenance revenue, derived primarily from providing post-contract customer support and software updates to end users; and (iii) consulting services revenues derived from providing design and test services, training and consulting services to end users. If the consulting or other services sold in connection with a software license are essential to the functionality of the software, the Company recognizes revenue on either a percentage-of-completion or completed contract basis. For the percentage-of-completion method, the Company recognizes revenues using labor hours incurred as the measure of progress against the total labor hours estimated for completion. The Company considers a project completed after all contractual obligations are met. Unbilled accounts receivable comprises revenue recognized in advance of contractual billings. Provisions for estimated contract losses are recognized in the period in which the loss becomes probable and can be reasonably estimated. When the services sold are not essential to the functionality of the software, the Company recognizes revenues from software licenses upon delivery of the software and execution of a binding agreement with the customer, provided that the fee is fixed or determinable, collection is reasonably assured and there are no customer acceptance clauses. When customer acceptance clauses exist, revenues are recognized upon customer acceptance. For contracts with multiple obligations (e.g., deliverable and undeliverable products, post-contract support and other services), the Company allocates revenues to the undelivered element of the contract based on vendor specific objective evidence of their fair value. This objective evidence is the sales price of the elements when sold separately or the renewal rate specified in the agreement for licensing arrangements with terms of one year or more that include post-contract customer support and software updates. The Company recognizes revenues allocated to undelivered products when all of the other criteria for revenue recognition have been met. Revenues for time-based software licenses for periods of one year or less are recognized ratably over the term of the contract. When the contract term is greater than one year and there is a stated renewal rate, which is substantive, in the arrangement for maintenance and post-contract support services, the Company recognizes the license fee upon delivery of the software assuming all other revenue recognition criteria have been met. Revenues from maintenance and post-contract support services are recognized ratably over the contractual period. Payments for maintenance and support services are generally made in advance and are non-refundable. Revenues from training and consulting services are recognized as the related services are performed. Customer advances and billed amounts due from customers in excess of revenue recognized are recorded as deferred revenue. The Company also derives revenues from the sale of its software licenses, maintenance and post-contract support services through distributors. Revenues from sales made through distributors which have return rights are recognized when the distributors have sold the software licenses or service to their customers and the criteria for revenue recognition under SOP 97-2, as amended, are met. Revenues from maintenance and post-contract support services sold through distributors are recognized ratably over the contractual period. Revenues derived from software development projects are recognized on a completed contract basis. Deferred revenue includes advance payments received for maintenance and support services and license revenues received or due under the terms of the contracts for which customer acceptance has not been received. Cost of revenues Cost of revenues consists primarily of expenses directly related to the cost of media on which a product is delivered, third party software royalties, product fulfillment costs, and direct customer service, consulting and support costs such as salaries and related expenses. Software development costs 49 Costs related to the research, design and development of software products are generally expensed as incurred. Software development costs are capitalized beginning when a product's technological feasibility has been established through the time of general release of the product. Based on the Company's product development process, technological feasibility is established upon the completion of a working model. Costs eligible for capitalization, incurred after achieving technological feasibility and before general release of its product, were not material in the years ended March 31, 2005, 2004 and 2003. Accordingly, all software development costs have been charged to research and development expense in the accompanying consolidated statements of operations. Cash, cash equivalents and short-term investments The Company invests its excess cash in debt instruments of the US Government and its agencies, and high-quality corporate issuers. The Company considers all highly liquid investments with an original or remaining maturity of three months or less at the date of purchase to be cash equivalents. Short-term investments are classified as securities available-for-sale and are reported at fair value based on quoted market prices as of the balance sheet date. Realized gains or losses and declines in value judged to be other than temporary, if any, are determined on the specific identification method and are reflected in other income or loss. Net unrealized gains or losses, net of tax, are recorded directly in stockholders' equity as accumulated other comprehensive income(loss). Property and equipment Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, as follows: Computers and equipment 3 years Furniture, fixtures and other 3 to 7 years Computers and equipment acquired under capital leases are amortized over the shorter of the lease term or the useful life of the asset. Leasehold improvements are amortized using the straight-line method over the shorter of the remaining lease term or the estimated useful life of the improvement. Repair and maintenance costs are expensed as incurred. When property and equipment are retired or otherwise disposed of, the cost and accumulated depreciation are relieved from the accounts and the net gain or loss is included in the determination of income or loss. Depreciation expense totaled $940,000, $1.3 million and $1.7 million for the years ended March 31, 2005, 2004 and 2003, respectively. Goodwill and intangible assets Goodwill is stated at fair value and intangible assets are stated at cost less accumulated amortization. Intangible assets are amortized on a straight line basis over the estimated useful life. Goodwill is not amortized, but rather is subject to at least an annual assessment for impairment. Intangible assets acquired in business combinations consist primarily of purchased technology and customer backlog and are being amortized on a straight-line basis over their estimated useful life which ranges from six months to three years. Amortization expense totaled $1.2 million, $1.3 million and $1.5 million for the years ended March 31, 2005, 2004 and 2003, respectively. 50 The Company periodically reviews the carrying value of acquired intangible assets, including goodwill, to determine whether impairment may exist. Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets," requires that goodwill and certain intangible assets be assessed for impairment using fair value measurement techniques. Specifically, goodwill impairment is determined using a two-step process. The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill. The Company has one reporting unit. The Company measures fair value by weighing equally its projected five year discounted cash flows with a terminal value discounted to the measurement date (the "Income Approach") and looking at comparable public companies and the multiples they trade at based on their trailing twelve months revenue and forward looking twelve months revenue compared to our comparable revenue to determine our market value (the "Market Approach"). If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired and the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting unit's goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit's goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. That is, the fair value of the reporting unit is allocated to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the purchase price paid to acquire the reporting unit. The impairment test for other intangible assets not subject to amortization consists of a comparison of the fair value of the intangible asset with its carrying value. If the carrying value of the intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. For intangible assets subject to amortization, to the extent the fair value of the intangible asset, determined based upon the estimated future cash inflows on a discounted basis attributable to the asset, less estimated future cash outflows on a discounted basis, are less than the carrying amount, an impairment loss is recognized. The determination of impairment of goodwill and other intangible assets requires significant judgment and management estimates. Long-lived assets The Company monitors events and changes in circumstances that could indicate the carrying amounts of long-lived assets may not be recoverable. When such events or changes in circumstances are present, the Company assesses the recoverability of long-lived assets by determining whether the carrying value of the assets will be recovered through non-discounted expected future cash flows. If the assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Foreign currency translation The functional currencies for the Company's international subsidiaries are the local currencies. These international subsidiaries' financial statements are translated to United States dollars using period-end rates of exchange for assets and liabilities, and the average rates of exchange for the year for revenues and expenses. Translation gains (losses) are recorded in accumulated other comprehensive income (loss) in stockholders' equity (deficit). Net gains and losses resulting from foreign exchange transactions are included in the expense line item to which they relate. The net loss for the year ended March 31, 2005 was $116,000. The amount for the year ended March 31, 2004 and 2003 was not significant. 51 Income taxes Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. A valuation allowance is recorded to reduce deferred tax assets to an amount whose realization is more likely than not. Advertising expense Advertising costs are included in sales, general and administrative expenses and are expensed as incurred. Advertising expense totaled $1,300, $13,000, $18,000 for the years ended March 31, 2005, 2004 and 2003, respectively. Stock-based compensation The Company accounts for its employee stock option plans using the intrinsic value method described in Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations. Under APB Opinion No. 25, deferred stock compensation is recorded for the difference, if any, between an option's exercise price and the fair value of the underlying common stock on the grant date of the option. As permitted by SFAS No. 123, "Accounting for Stock-Based Compensation," the Company has adopted the "disclosure only" alternative described in SFAS No. 123 for its employee stock plans. The Company accounts for stock issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force Consensus ("EITF") No. 96-18, "Accounting for Equity Instruments that Are Issued to Other than Employees For Acquiring, or in Conjunction with Selling, Goods or Services." Under SFAS No. 123 and EITF No. 96-18, stock options and warrants issued to non-employees are accounted for at their fair value calculated using the Black-Scholes option pricing model. Compensation expense resulting from employee and non-employee stock options is amortized to expense using an accelerated approach over the term of the options in accordance with Financial Accounting Standards Board Interpretation ("FIN") No. 28, "Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans." In December 2002, the FASB issued SFAS 148, "Accounting for Stock Based Compensation - Transition and Disclosure" which provides for two additional transition methods for entities that voluntarily adopt the fair value method of recording expenses when accounting for stock based compensation. We have chosen not to voluntarily adopt the fair value method of accounting for employee stock option grants at this time. If compensation cost had been determined in accordance with SFAS No.123, net loss and net loss per share would have been changed to the pro forma amounts indicated below: 52

Accumulated Total Additional Deferred other stockholders' Common Stock paid-in stock-based Accumulated comprehensive equity Shares Amount capital compensation deficit gain(loss) (deficit) ------ ------- --------- ------------- --------- ----------- ----------- Balances as of March 31, ~~2001 17,828 $ 18 5,715 (1,512) (10,969)~~ - ~~$ (6,748) Components of comprehensive loss: Net loss~~ - - - - ~~(14,917)~~ - ~~(14,917) Unrealized loss on available for sale securities~~ - - - - - ~~(49) (49) Foreign currency translation adjustment~~ - - - - - ~~(130) (130)~~ -------- ~~Total comprehensive loss (15,096)~~ -------- ~~Issuance of stock options to employees~~ - - ~~3,863 (3,863)~~ - - - ~~Issuance of stock options to non~~-~~employees~~ - - ~~162~~ - - - ~~162 Stock~~-~~based compensation~~ - -2005 -2004 ~~3,385~~2003 - - ~~3,385 Issuance of common stock in public offering and exercise options 9,387 9 69,039~~ - - - ~~69,048 Issuance of common stock and options assumed in connection with acquisitions 2,185 2 33,590 (2,027)~~ - - ~~31,565~~ ------ --~~---~~ --------- ---~~----------~~ --------- -----~~------~~ ~~---------~~Net ~~Balances~~loss, as ofreported ~~March 31, 2002 29,400~~ $ ~~29 $ 112,369~~ (49,~~017~~423) ~~(25,886) (179)~~ $ ~~82,316 Components of comprehensive loss: Net loss - - - -~~ (5120,~~818~~343) -$ (51,818) ~~Unrealized~~Add: ~~gain on available for sale securities~~ Stock-based -employee -compensation -expense -included 69in 69reported ~~Foreign~~net ~~currency translation adjustment - - - - - 112 112 --------- Total comprehensive~~ loss ~~(51,637)~~45 ~~---------~~315 ~~Exercise of stock options for cash 443~~ 1,047 ~~165~~Deduct: Stock-based -employee -compensation ~~166~~determined ~~Issuance~~under offair ~~common~~value ~~stock~~based ~~and~~method ~~options~~for ~~assumed~~all inawards ~~connection with acquisition 967 1 14,177~~ (38542) ~~- - 14,140 Stock-based compensation - -~~ (~~2,121~~251) ~~3,168 - -~~ (1,~~047~~045) ------- ------ --~~-------~~ ------------- --------- -----~~------~~ ~~---------~~Pro ~~Balances~~forma asnet ~~of March 31~~loss, ~~2003~~fair ~~30,810~~value $method 31for $all ~~124,590~~stock-based $awards ~~(887)~~ $ (779,~~704~~920) $ ~~2 $ 46,032 Components of comprehensive loss: Net loss - - - -~~ (20,~~343~~279) -$ (2051,~~343~~816) ~~Unrealized~~=============== ~~gain~~============ on============== ~~available~~Basic ~~for~~and ~~sale~~diluted ~~securities~~net -loss -per -share: -As -reported ~~(7)~~$ (70.30) ~~Foreign~~$ ~~currency translation adjustment - - - - -~~ (140.65) $ (141.69) ~~---------~~Pro ~~Total~~forma ~~comprehensive~~net loss ~~(20~~,~~364)~~ ~~---------~~fair ~~Exercise~~value ofmethod ~~stock options~~ for ~~cash~~all ~~68 - 9 - - - 9 Issuance of common~~ stock ~~in connection with acquisitions 397 1 49~~ - ~~- - 50 Stock-~~based ~~compensation~~awards ~~- - (443) 758 - - 315 ------ ------ --------- ------------- --------- ----------- --------- Balances as of March 31, 2004 31,275~~ $ ~~32 $ 124,205 $~~ (~~129~~0.32) $ (~~98,047~~0.65) $ (191.69) ~~$ 26,042 ====== ====== ========= ============= =========== =========== =========~~

Concentration of credit risk Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash, cash equivalents and short-term investments and accounts receivable. Cash, cash equivalents and short-term investments are managed by financial institutions that management believes are credit worthy. The Company performs ongoing credit evaluations of its customers' financial condition, generally requires no collateral from its customers and maintains allowances for probable credit losses. The Company applies judgment as to its ability to collect outstanding receivables based primarily on management's evaluation of the customer's financial condition and past collection history and records a specific allowance when required in management's judgment. In addition, the Company records a general allowance based on the length of time other receivables are past due. At March 31, 2005, receivables from the Company's Japanese distributor and one domestic customer accounted for 29% and 10% of accounts receivable and unbilled receivables combined, respectively. At March 31, 2004, receivables from two domestic, two international customers, and the Company's Japanese distributor accounted for 21%, 14%, 18%, 18% and 11% of accounts receivable and unbilled receivables combined, respectively. Accumulated other comprehensive income (loss) Accumulated other comprehensive income (loss) consists of gains and losses that are not recorded in the statements of operations but instead are recorded directly to stockholders' equity. The Company's components of accumulated other comprehensive income (loss) include net unrealized gain (loss) on available-for-sale securities and the cumulative foreign currency translation adjustment. Net loss per share Basic net loss per share is computed by dividing the net loss for the period by the weighted average number of shares of common stock outstanding 53 during the period. Diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of shares and potential shares of common stock outstanding during the period. The calculation of diluted net loss per share excludes shares of potential common stock if their effect is anti-dilutive. Potential common stock consists of shares of common stock that are incremental common shares issuable upon the exercise of stock options and warrants, computed using the treasury stock method, and shares issuable upon conversion of the convertible debenture, computed using the if-converted method. The following table presents the calculation of net loss per common share--basic and diluted (in thousands, except for per share data):

Years ended March 31, --------------------------------------------- 2005 2004 2003 ~~2002~~ -------------- -------------- -------------- Numerator: Net loss, as$ ~~reported~~(9,423) $ (20,343) $ (51,818) $-------------- ~~(14,917)~~-------------- ~~Add: Stock~~-~~based~~------------- ~~employee~~Denominator: ~~compensation~~Weighted ~~expense~~average ~~included~~common inshares ~~reported~~outstanding--basic ~~net~~and ~~loss~~diluted ~~315 1~~31,~~047~~332 331,~~547~~145 ~~Deduct: total stock-based compensation determined under fair value based method for all awards (251) (1~~30,~~045)~~645 ~~(4,944)~~ ----------- ------------------ -------------- ~~Pro~~Net ~~forma net~~ loss, ~~fair~~per ~~value~~common ~~method for all stock~~share-~~based~~-basic ~~awards~~and diluted $ (~~20,279~~0.30) $ (~~51,816~~0.65) $ (~~16,314~~1.69) ============== ============== ============== ~~Basic and diluted net loss per share: As reported $ (0.65) $ (1.69) $ (0.62) Pro forma net loss, fair value method for all stock-based awards $ (0.65) $ (1.69) $ (0.68)~~

The total number of shares excluded from the calculation of diluted net loss per share is detailed in the table below (in thousands):

~~Years ended~~ March 31, --------------------------------------------- 2005 2004 2003 ~~2002~~ ------------- -------------- -------------- ~~Numerator:~~Outstanding ~~Net~~stock ~~loss~~options $6,771 ~~(20~~6,~~343)~~730 ~~$ (51~~1,~~818)~~136 $Convertible debenture (~~14,917~~Note 8) -~~------------~~ -~~-------------~~ 1,032 Shares issuable under warrants -~~-----------~~ ~~Denominator:~~138 ~~Weighted~~138 ~~average~~Shares ~~common~~contingently ~~shares~~issuable ~~outstanding~~upon -legal ~~basic~~settlement ~~and~~(Note ~~diluted~~16) 319,~~145~~756 307,~~645~~000 ~~24,038~~- ------------- -------------- ------------- ~~Net loss per common share~~-~~-basic~~ ~~and~~Total ~~diluted~~16,527 $13,868 ~~(0.65)~~2,306 ~~$ (1.69) $ (0.62)~~ ============== ============== ==============

Reclassifications Certain amounts in the 2004 financial statements have been reclassified to conform with the 2005 presentation. Certain auction rate securities have been reclassified from cash equivalents to short-term investments. Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the securities in excess of 90 days. Auction rate securities have interest rate resets through a modified Dutch auction, at predetermined short-term intervals, usually every 7, 28 or 35 days. They trade at par and are callable at par on any interest payment date at the option of the issuer. Interest paid during a given period is based upon the interest rate determined during the prior auction. Although these securities are issued and rated as long-tem bonds, they are priced and traded as short-term instruments because of the liquidity provided through the interest rate reset. Based on the Company s ability either to liquidate the holdings or to roll the investment over to the next reset period, the Company had historically classified some or all of these instruments as cash equivalents if the period between interest rate resets was 90 days or less. The Company accounts for our marketable securities in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Such investments are classified as available for sale and are reported at fair 54 value in the Company s balance sheets. The short-term nature and structure, the frequency with which the interest rate resets and the ability to sell auction rate securities at par and at our discretion indicates that such securities should more appropriately be classified as short-term investments with the intent of meeting the Company s short-term working capital requirements. Based upon the Company s re-evaluation of these securities, the Company reclassified as short-term investments any auction rate securities previously classified as cash equivalents for each of the periods presented in the consolidated balance sheets. This resulted in a reclassification from cash and cash equivalents to short-term investments of $2.3 million on the March 31, 2004 consolidated balance sheet. In addition, purchases of short-term and long-term investments and sales of short-term investments included in the consolidated statements of cash flows have been revised to reflect the purchase and sale of auction rate securities during the periods presented. This resulted in a decrease in cash used in investing activities by $2.3 million for the year ended March 31, 2004. These reclassifications had no impact on the previously reported net income or cash flows from operations. RECENT ACCOUNTING PRONOUNCEMENTS In September 2004, the EITF delayed the effective date for the recognition and measurement guidance previously discussed under EITF Issue No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-01") as included in paragraphs 10-20 of the proposed statement. The proposed statement will clarify the meaning of other-than-temporary impairment and its application to investments in debt and equity securities, in particular investments within the scope of FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and investments accounted for under the cost method. The Company will evaluate the impact of EITF 03-01 once the final guidance is issued. In December 2004, the FASB issued SFAS No. 123 (R), Share-Based Payment ("SFAS 123(R)"), an amendment of SFAS No. 123 and SFAS No. 95 Statement of Cash Flows. The statement eliminates the ability to account for share-based compensation transactions using APB No. 25 and requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements. SFAS No. 123(R) applies to all share-based payment transactions in which an entity acquires goods or services by issuing its shares, share options, or other equity instruments or by incurring liabilities based on the price of an entity's shares or that require settlement by the issuance of equity instruments. In March 2005, the SEC issued Staff Accounting Bulletin (SAB) 107 ("SAB 107") which expresses views of the SEC staff regarding the application of SFAS No. 123(R). Among other things, SAB 107 provides interpretive guidance related to the interaction between SFAS No. 123(R) and certain SEC rules and regulations, as well as provides the SEC staff's views regarding the valuation of share-based payment arrangements for public companies. In April 2005, the SEC amended the compliance dates for SFAS 123(R) to provide that the provisions of this statement will be effective for fiscal years beginning June 15, 2005. The Company will adopt SFAS 123(R) as of the beginning of its 2007 fiscal year. Although the Company is currently assessing the application of SFAS No. 123(R), it believes that the adoption of this statement will have a material impact on its results of operations, depending on the amount of stock options it grants in future periods. In December 2004, the FASB issued FASB Staff Position ("FSP") No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 ("FSP No. 109-2"). FSP No. 109-2 provides guidance under SFAS No. 109, Accounting for Income Taxes ("SFAS No. 109"), with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the "Jobs Act") on enterprises' income tax expense and deferred tax liability. FSP No. 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment of the Jobs Act to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of 55 applying SFAS No. 109. The Jobs Act was enacted on October 22, 2004. The Company does not believe that the adoption of FSP No.109-2 will have a material effect on its financial position, results of operation or cash flows. In December 2004, the FASB issued SFAS No. 153, "Exchanges of Non-monetary Assets, an amendment of APB Opinion No. 20, Accounting for Non-monetary Transactions." The amendments made by this Statement are based on the principle that exchanges of non-monetary assets should be measured based on the fair value of the assets exchanged. This Statement also eliminates the exception for non-monetary exchanges of similar productive assets and replaces it with a broader exception for exchanges of non-monetary assets that do not have commercial substance. The Company is required to adopt the provisions of this Statement beginning April 1, 2006 for all non-monetary asset exchanges and will apply its provisions prospectively upon adoption. The Company does not believe this statement will have a material impact on its consolidated financial statements. NOTE 3. BUSINESS COMBINATIONS Defect & Yield Management, Inc. On April 10, 2002, the Company acquired all of the outstanding common and preferred shares of Defect & Yield Management, Inc. ("DYM"), a defect analysis and yield optimization software company offering software solutions to semiconductor companies. The results of DYM have been included in the consolidated financial statements from April 10, 2002, the acquisition date. In connection with the acquisition, the Company issued 967,260 shares of its common stock, paid $2.0 million in cash and assumed options to purchase up to 82,740 shares of the Company's common stock. In June 2003, as part of an earn-out, the Company issued to the former DYM shareholders an additional 396,826 shares in the aggregate, valued at $50,000. The transaction was accounted for using the purchase method of accounting. The acquisition of DYM provides the Company access to an installed customer base, complementary technology and a highly skilled workforce.

~~March~~The ~~31,~~aggregate ~~--------------------------------------------~~purchase ~~2004~~price ~~2003~~was ~~2002~~approximately ~~------------- -------------- -------------- Outstanding stock options 6,730~~ $17.1~~,136~~ 7million,~~782~~ ~~Convertible~~summarized ~~debenture~~as follows (~~Note~~in 8thousands): --Cash ~~1,032~~$ 12,~~032~~000 ~~Shares~~Fair ~~issuable~~market ~~under~~value ~~warrants~~of ~~138~~common ~~138~~stock ~~138~~13,474 ~~Contingent~~Fair ~~shares~~market ~~issuable~~value toof ~~former~~options ~~Covalar~~assumed ~~stockholders~~704 --Acquisition --related ~~600~~costs ~~Shares~~943 ~~issuable upon legal settlement (Note 17) 7,000~~ -- -- ------------ ~~-------------- -------------~~ Total ~~13,868~~$ 217,~~306~~121 ~~9,552~~ ============ ==~~============ =============~~

~~Fair~~The ~~market~~allocation ~~value~~ of ~~common~~the ~~stock~~purchase price to assets acquired and liabilities assumed is as follows (in thousands): Tangible assets acquired $ ~~8,032~~665 ~~Fair~~Intangible ~~market~~assets ~~value~~acquired of1,300 ~~options~~Deferred ~~assumed~~compensation ~~223~~38 ~~Acquisition~~Goodwill ~~related~~16,545 ~~costs~~Liabilities ~~250~~assumed (1,427) --------------~~---~~ Total ~~consideration~~ $ 817,~~505~~121 ==============~~===~~ The Company has included the results of operations of DYM since April 10, 2002, the date of acquisition.

56 NOTE 4. GOODWILL IMPAIRMENT The Company operates within one reporting unit as defined by SFAS 142. Therefore, goodwill is not allocated within the Company as it is considered enterprise goodwill. During the fourth quarter of the year ended March 31, 2003, the Company determined that there were indicators of impairment to the carrying value of goodwill, principally as a result of reducing its revenue forecast given the then current economic environment in the semiconductor industry and the litigation the Company was undergoing. The Company performed its annual impairment review for goodwill and other intangible assets and recorded a charge of $30.6 million relating to goodwill, which is recorded as a component of operating income in the accompanying consolidated statement of operations for the year ended March 31, 2003. The amount of goodwill impairment was based on the fair value of the Company, representing its only reporting unit utilizing a valuation based on both the Income Approach and Market Approach. The Company performed an impairment test at March 31, 2005 and March 31, 2004 and determined that there was no impairment. Future goodwill impairment tests may result in charges to earnings if the Company determines that goodwill has been impaired. NOTE 5. PROPERTY AND EQUIPMENT Property and equipment consists of the following (in thousands):

~~Tangible~~March ~~assets~~31, ~~acquired~~------------------------------- 2005 2004 -------------- --------------- Computers, equipment and other $ ~~685~~3,261 ~~Intangible~~$ ~~assets~~3,635 ~~acquired~~Furniture ~~660~~and ~~Deferred~~fixtures ~~compensation~~642 ~~106~~485 ~~Goodwill~~Leasehold 10improvements 639 633 Equipment and furniture under capital lease obligations 345 752 -------------- --------------- 4,~~750~~887 ~~Liabilities~~5,505 ~~assumed~~Less: Accumulated depreciation (34,~~696~~040) (4,197) -------------- --------------- ~~Total~~$ 847 $ 81,~~505~~308 ============== ===============

At March 31, 2005 and 2004, accumulated depreciation of the property and equipment under capital leases was $311,000 and $599,000, respectively. NOTE 6. INTANGIBLE ASSETS Intangible assets consist of the following (in thousands):

March 31, ~~2004~~2005 ------------------ -------------------- --------------------- ----------------- Amortization Gross Carrying Accumulated Net Carrying Period Amount Amortization Amount ------------------ --------------------- --------------------- -----------------~~----~~ Existing ~~technology~~Technology 3 years $ 2,760 $ (12,~~935~~760) $ ~~825~~- Modular ~~library~~Library 3 years 1,220 (~~864~~1,220) ~~356~~- --- ------------------ --- ----------------- --- ------------------ $ 3,980 $ (23,~~799~~980) $ ~~1,181~~- === ================== === ================= === ==================

March 31, ~~2003~~2004 ------------------ -------------------- --------------------- ----------------- Amortization Gross Carrying Accumulated Net Carrying Period Amount Amortization Amount ------------------ --------------------- --------------------- -----------------~~----~~ Existing ~~technology~~Technology 3 years $ 2,760 $ (1,~~015~~935) $ ~~1,745~~825 Modular ~~library~~Library 3 years 1,220 (~~457~~864) ~~763~~356 --- ------------------ --- ----------------- --- ------------------ $ 3,980 $ (12,~~472~~799) $ 21,~~508~~181 === ================== === ================= === ==================

57 NOTE 7. ACCRUED LIABILITIES Accrued liabilities consist of the following (in thousands):

~~Payment~~March ~~Due~~31, ~~by Fiscal Year Total 2005 2006 2007 2008 2009~~ --------------------------------- 2005 2004 -------------- ----------------~~---------------------------~~ ~~Capital~~Payroll ~~Lease~~and ~~Obligations~~related expenses $ ~~138~~807 $ 98888 $Professional 40fees $383 -563 $Other -accrued $expenses -1,342 ~~Operating~~1,037 ~~Lease~~Amounts ~~Obligations~~received $from ~~2,460~~HPL's $former ~~1,392~~Chief $Executive ~~1,068~~Officer $(see -Note $11) -4,335 $4,335 - --------------------------------~~----------------------------------------------------------~~ ~~Total~~ $ 26,~~598~~867 $ 16,~~490~~579 ~~$ 1,108 $ - $ - $ -~~ ============== ================~~============================================================~~

NOTE 8. CONVERTIBLE DEBENTURE In February 2000, the Company issued a $1.5 million convertible debenture. The debenture bore interest at the rate of 8% per annum. This debenture was convertible at any time at the option of the holder to common stock of the Company, at a conversion price of $1.45 per share. The debenture, if not converted, was due on February 15, 2005. The note provided that if the Company completes its initial public offering, the holder had the right to demand repayment. The debenture was repaid in full on May 13, 2003, along with accrued interest of $164,000. NOTE 9. COMMITMENTS The Company leases its facilities under operating lease agreements that expire at various dates through December 31, 2010. Rent expense for all operating leases for the years ended March 31, 2005, 2004 and 2003 was $1.1 million, $1.1 million, and $1.5 million, respectively. Minimum future lease payments under non-cancelable operating leases and future minimum payments under capital lease agreements at March 31, 2005 are included in the table below (in thousands):

~~2004~~Payments ~~2003~~Due ~~2002~~by Fiscal Year ------------ -------------~~-----~~ ------------ -----------~~-------~~ ------------ -------------~~-----~~ ~~Weighted~~Total ~~Weighted~~2006 ~~Weighted~~2007 ~~Average~~2008 ~~Average~~2009 ~~Average~~2010 ~~Shares Exercise Shares Exercise Shares Exercise Years ended March 31, (000's) Price (000's) Price (000's) Price~~ ------------~~-------------------------~~ -------------- ------------~~---~~ -----------~~---~~ -------------- -------------- ~~--------------~~Capital ~~Outstanding~~Lease atObligations ~~beginning of year 1,490~~ $ 4.40 ~~8,650~~ $ ~~2.18~~27 ~~7,431~~ $ ~~0.22~~13 ~~Granted~~$ ~~and~~- ~~assumed~~$ ~~upon~~- ~~acquisitions~~$ ~~7,296~~- ~~0.24~~Operating ~~238~~Lease ~~10.40~~Obligations 21,~~222~~694 ~~7.81 Exercised (68) 0.14 (443) 0.38 (759) 0.15 Forfeited (~~1,~~987)~~243 ~~1.59~~135 ~~(6,955)~~115 ~~2.10~~115 ~~(244)~~86 ~~0.10~~--- -------- --- --------- --- -------- --- ------- --- -------- ~~Outstanding~~-- at---------- ~~end~~Total of$ ~~year 6~~1,~~730~~734 ~~0.77~~$ 1,~~490~~270 ~~4.40~~$ ~~8,650~~148 ~~2.18~~$ 115 $ 115 $ 86 ===========~~===~~ ============~~===~~ ===========~~===~~ ==========~~====~~ ===========~~===~~ ============~~== Options exercisable at end of year 840 873 3,195 Shares available for grant 4,399~~

Guarantees and Indemnifications The Company includes standard intellectual property indemnification clauses in its software license agreements. Pursuant to these provisions, HPL holds harmless and agrees to defend the indemnified party, generally HPL's business partners and customers, in connection with certain patent, copyright or 58 trade secret infringement claims by third parties with respect to HPL's products. The term of the indemnification provisions is generally for the term of the license agreement and the applicable statute of limitations. The Company believes the estimated fair value of these obligations is minimal. HPL has recorded no liabilities for these obligations as of March 31, 2005 and has never had to make a payment under such indemnification provisions. The Company generally warrants that its software products will perform in all material respects in accordance with its standard published specifications in effect at the time of delivery of the licensed products to the customer for a period of 90 days following delivery. If necessary, HPL would provide for the estimated cost of product warranties based on specific warranty claims and claim history. The Company has incurred no significant expense under its product warranties to date and, as a result, the Company believes the estimated fair value of these warranties is minimal. The Company has recorded no liabilities for these warranties as of March 31, 2005. NOTE 10. CAPITAL STOCK Common stock The Company has reserved the following shares of authorized but unissued common stock for future issuance (in thousands): March 31, 2005 2004 ---------- --------- Warrants - 138 Stock option plans 10,731 10,903 Employee stock purchase plans 1,097 947 Legal settlement (Note 16) 9,756 - ----------- --------- 21,584 11,988 =========== ========= Stock option plans In May 2001, the Company adopted its 2001 Equity Incentive Plan (the "Plan") and reserved a total of 12,750,000 shares of its common stock for issuance to directors, employees and consultants under the Plan. Options granted under the Plan expire 10 years from the date of grant and generally vest over a four-year period. Under the Plan, eligible employees and consultants who own less than ten percent of voting power of all classes of stock, can receive options to purchase shares of the Company's common stock at a price no less than 100% and 85% of the fair value on the grant date for incentive stock options and non-statutory stock options, respectively. Those eligible employees and consultants who own more than ten percent of voting power of all classes of stock can receive options to purchase shares of the Company's common stock at a price no less than 110% of the fair value on the grant date for incentive stock options and nonqualified stock options. In connection with the acquisitions of FabCentric and Covalar in the year ended March 31, 2002, the Company assumed the options granted under the FabCentric and Covalar option plans totaling 441,665 HPL options. These options have similar terms as the Company's Plan. In connection with the acquisition of DYM in the year ended March 31, 2003, the Company assumed the options granted under the DYM option plan totaling 82,740 HPL options. These options have similar terms as the Company's Plan. 59 The following table summarizes information with respect to stock option activity:

~~Options~~2005 ~~Outstanding~~2004 ~~Options~~2003 ~~Exercisable~~ ------------------------------ --------------------- --------- ------------------------------ Weighted ~~Average~~ Weighted Weighted ~~Number~~Average ~~Remaining~~ Average ~~Number~~ Average ~~Outstanding~~Shares ~~Contractual~~Exercise ~~Life~~Shares Exercise ~~Exercisable~~Shares Exercise ~~Range~~Years ofended ~~Exercise~~March ~~Prices~~31, (000's) Price (~~Years~~000's) Price (000's) Price ------------------------------------- ------- ------- ------- -------- ----------- --- -------------- --------------- ---------------- ~~$0.04--~~Outstanding at beginning of year 6,730 $ 0.2077 ~~309~~1,490 $ 4.3640 8,650 $ 02.0818 ~~309~~Granted $and ~~0.08~~assumed $upon acquisitions 974 0.~~24--~~38 $7,296 0.24 ~~5,070~~238 910.4640 Exercised (172) 0.24 --(68) 0.0014 $(443) 0.~~25--~~38 $6Forfeited (761) 1.5015 (1,~~160~~988) ~~8.44~~ 1.4959 ~~431~~(6,955) 2.6210 ~~$9.59~~-- ~~$12.86 177 7.36 11.29 92 11.56 $12.98~~-- ~~$12.98 6 7.92 12.98 4 12.98 $13.87~~---------- ~~$13.87 8 7.92 13.87 4 13.87~~ -------------- --------------- Outstanding at end of year 6,~~730~~771 80.9968 $6,730 0.77 ~~840~~1,490 ~~$ 2~~4.7840 ============== =============== ==== ========== ====== ======== ======= ======= ============== Options exercisable at end of year 2,592 840 873 Shares available for grant 4,092 4,399 9,997

The following table summarizes information regarding options outstanding and exercisable as of March 31, 2005:

~~Stock~~ Options ~~Employee~~Outstanding ~~Stock~~Options ~~Purchase~~Exercisable ~~Plan~~ --------------------------------------------------- --------------------------------- ~~Years~~Weighted ~~ended~~Average ~~March~~Weighted ~~31,~~Weighted ~~2004~~Number ~~2003~~Remaining ~~2002~~Average ~~2002~~Number Average Outstanding Contractual Life Exercise Exercisable Exercise Range of Exercise Prices (000's) (Years) Price (000's) Price -------------------------------------------- -------------- ----------- -------- ----- ----------- -- ------------- ---------------- $0.04 -- ~~Expected~~$0.22 ~~volatility~~538 ~~85%~~5.26 ~~85%~~$ ~~85%~~0.14 ~~85%~~308 ~~Weighted~~$ ~~average~~0.08 ~~risk~~$0.23 ~~free~~-- ~~interest~~$0.24 ~~rate~~4,286 28.~~47%~~46 30.~~90%~~24 31,595 0.~~96%~~24 3$0.~~50%~~25 ~~Expected~~-- ~~life~~$0.29 51,001 ~~years~~8.95 50.28 ~~years~~167 50.27 ~~years~~$0.30 -- $0.597 ~~years~~508 ~~Expected~~8.33 ~~dividend~~0.53 ~~yield~~165 0.35 $0.98 -- $3.97 222 6.09 3.47 197 3.46 $3.98 -- $13.87 216 6.35 10.18 161 10.24 -------------- --------------- 6,771 8.12 $ 0.68 2,592 $ 1.10 ============== =================== ================ =============== ================

Pro forma information regarding net loss per share is required by SFAS No. 123, as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123. The weighted average fair value of options granted for the years ended March 31, 2005, 2004 and 2003 was $0.22, $0.15, and $6.05 respectively. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option pricing model and the following weighted average assumptions: 60 Stock Options ------------------------------------------- Years ended March 31, 2005 2004 2003 ----------------------------------- ------------- ------------- ------------- Expected volatility 85% 85% 85% Weighted average risk free interest rate 3.37% 2.47% 3.90% Expected life 5 years 5 years 5 years Expected dividend yield - - - Employee stock purchase plans The 2001 Employee Stock Option Purchase Plan and the 2001 Foreign Employee Stock Purchase Plan (the "ESPP") were adopted by the Company's Board of Directors on May 22, 2001. A total of 660,000 shares of common stock may be purchased under the ESPP. Subject to the terms of the ESPP, the number of shares of common stock reserved and available for issuance pursuant to the ESPP will automatically increase on March 1 of each year until and including March 1, 2011 by a number of shares equal to the lesser of (i) 150,000, (ii) one percent of the number of shares of all classes of common stock outstanding on that date of, or (iii) a lesser number determined by the Board of Directors or a committee appointed by the Board of Directors. Qualified employees can elect to have up to 15 percent (30 percent for the Company's employees in the Republic of Armenia) of their annual earnings withheld, up to $25,000 in any calendar year, or portion of a calendar year, included in an offering period. No more than 1,500 shares can be purchased on any purchase date by an individual employee. The purchase price of the stock is 85% of the lower of the fair market value at the beginning of the twenty-four month offering period or at the end of each six-month purchase period. No shares were issued in the years ended March 31, 2005, 2004 and 2003, as the Company suspended the plans on July 19, 2002. Deferred stock-based compensation In connection with the granting of stock options to employees, in the year ended March 31, 2005, 2004 and 2003, the Company has not recorded deferred stock-based compensation as the grant prices were equal to the market prices on the date of grant which is the deemed fair value of the Company's common stock for accounting purposes. In connection with the acquisition of DYM in the year ended March 31, 2003, the Company recorded deferred compensation totaling $38,000. These amounts are included as a component of stockholders' equity and, in accordance with the method described in FIN No. 28, are being amortized on an accelerated basis by charging to operations over the vesting period of the options, which is generally four years. Accordingly, this resulted in an expense of $45,000, $315,000, and $1,047,000 for the years ended March 31, 2005, 2004 and 2003, respectively. NOTE 11. RELATED PARTY In the fourth quarter of fiscal 2002 and the first quarter of fiscal 2003, the Company provided a loan to an officer of the Company for an aggregate sum of $750,000 pursuant to his employment arrangement. On January 1, 2005, the balance due on the loan was $300,000. The loan is collateralized by a second deed of trust on the officer's home and bears interest at a rate equal to the higher of: (i) 6%, or (ii) the short-term "applicable federal rate" (assuming semi-annual compounding) as periodically published by the Internal Revenue Service. The employment arrangement provides that 20% of the principal sum and accrued interest will be forgiven annually over a period of five years, commencing on the first anniversary of the officer's employment, provided that he remains continuously employed by the Company during that time. 61 During fiscal 2003 and 2002, the former President and Chief Executive Officer of the Company had deposited approximately $4,335,000 into the Company's bank accounts which amounts were purported to have represented proceeds from the payment of accounts receivable related to fictitious sales transactions. As part of the former President and Chief Executive Officer's settlement in the derivative actions in April 2005, he released the Company from any claim to these funds, extinguishing and liability the Company may have had with regards to these funds. Accordingly, in the first quarter of fiscal 2006, the amount has been reclassified from accrued liabilities to additional paid-in-capital as part of shareholders' equity. NOTE 12. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value of financial instruments has been determined using available market information. However, considerable judgment is necessarily required in interpreting market data to develop estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company would realize in a current market exchange. Cash, cash equivalents, accounts receivable, notes receivable and accounts payable are carried at cost, which approximates their fair value because of the short maturities of these instruments. The Company's short-term investments are reported at fair value. The following is a summary of cash, cash equivalents and short-term investments (in thousands): March 31, 2005 ---------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Estimated Cost Gains (Losses) Fair Value ------------ ------------- ------------ ------------ Checking and savings $ 1,178 $ -- $ -- $ 1,178 Money market funds 7 -- -- 7 Corporate debt securities 2,067 -- (6) 2,061 ------------ ------------- ------------ ------------ $ 3,251 $ -- $ (6) $ 3,246 ============ ============= ============ ============ Included in: Cash and cash equivalents $ 1,185 Short-term investments 2,061 ------------ $ 3,246 ============ March 31, 2004 ---------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Estimated Cost Gains (Losses) Fair Value ------------ ------------- ------------ ------------ Checking and savings $ 2,160 $ -- $ -- $ 2,160 Money market funds 248 -- -- 248 Municipal bonds - taxable 2,300 -- -- 2,300 Corporate debt securities 3,867 9 -- 3,876 US Government agencies 1,625 1 -- 1,626 ------------ ------------- ------------ ------------ $ 10,200 $ 10 $ -- $ 10,210 ============ ============= ============ =========== Included in: Cash and cash equivalents $ 2,408 Short-term investments 7,802 ------------ $ 10,210 ============ 62 NOTE 13. EMPLOYEE BENEFIT PLAN The Company has a 401(k) Profit Sharing Plan (the "Profit Sharing Plan") qualified under Section 401(k) of the Internal Revenue Code of 1986. Each eligible employee may elect to contribute up to the maximum IRS annual deferral amount. The Company, at the discretion of its board of directors, may match employee contributions to the Profit Sharing Plan or make contributions to the Profit Sharing Plan for all eligible employees. The Company has elected not to make matching or other contributions to the Profit Sharing Plan for the years ended March 31, 2005, 2004, and 2003. NOTE 14. INCOME TAXES The Company's deferred tax assets (liabilities) consist of the following (in thousands): March 31, ------------------------------ 2005 2004 -------------- --------------- Deferred tax assets: Net operating loss and credit carry forwards $ 26,502 $ 24,772 Other accruals 9,521 8,137 -------------- --------------- Gross deferred tax assets 36,024 32,909 Valuation allowance (36,024) (32,479) -------------- --------------- Net deferred tax assets $ -- $ 430 ============== =============== Deferred tax liabilities: Intangible assets -- (430) -------------- --------------- Net deferred tax liabilities $ -- $ (430) ============== =============== Based on the available objective evidence, management believes it is more likely than not that the net deferred tax assets at March 31, 2005 and 2004 will not be fully realizable. Accordingly, the Company has applied a full valuation allowance against its net deferred tax assets as of March 31, 2005 and 2004. The net change in valuation allowance for the years ended March 31, 2005 and 2004 was an increase of $1.5 million and an increase of $6.7 million respectively. Reconciliation of the statutory federal income tax to the Company's effective tax is as follows: March 31 ------------------------------------------ 2005 2004 2003 -------------- ----------- ------------ Tax at federal statutory rate (34.0)% (34.0)% (34.0)% State, net of federal benefit (2.9) (2.4) (3.8) Other (3.3) 0.1 (0.2) Option compensation 0.1 0.6 0.8 Valuation allowance 39.3 36.1 37.4 -------------- ----------- ------------ Provision for income taxes (0.8)% 0.4% 0.2% ============== =========== ============ At March 31, 2005, the Company had approximately $65.0 million of Federal and $15.0 million of State net operating loss carryforwards available to reduce future taxable income which will begin to expire in 2012 for Federal and 2010 for state tax purposes, respectively. The Company has research credit carryforwards of approximately $3.0 million and $1.0 million for Federal and state income tax purposes, respectively. If not utilized, the Federal carryforward will expire in various amounts beginning in 2009. The California credit can be carried forward indefinitely. 63 The Internal Revenue Code limits the use of net operating loss and tax credit carryforwards in certain situations where changes occur in the stock ownership of a company. In the event the Company has had a change in ownership, utilization of the carryforwards could be restricted. NOTE 15. SEGMENT AND GEOGRAPHIC INFORMATION The Company has determined that it has one reportable business segment: the sale of yield optimization software used in the design, fabrication and testing of semiconductors and flat panel displays. The Company has a facility in the Republic of Armenia, which has fixed assets with a net book value of $235,000 as of March 31, 2005, and $166,000 as of March 31, 2004. The following is a geographic breakdown of the Company's revenues by customer location for the following periods (in thousands): Years ended March 31, ------------------------------------------- 2005 2004 2003 ------------- ------------- -------------- United States $ 3,993 $ 5,557 $ 9,869 Japan 2,486 3,352 2,820 Rest of Asia 2,936 2,120 1,672 Europe 354 1,672 1,231 ------------- ------------- -------------- $ 9,769 $ 12,701 $ 15,592 ============= ============= ============== For the year ended March 31, 2005, the Company derived revenue from two customers which comprised of 18% and 16% of the Company's total revenues, respectively. For the year ended March 31, 2004, the Company derived revenue from three customers which comprised 18%, 12% and 12% of the Company's total revenues, respectively. For the year ended March 31, 2003, the Company derived revenue from three customers which comprised 29%, 17% and 15% of the Company's total revenues, respectively. NOTE 16. CONTINGENCIES Between July 31, 2002 and November 15, 2002, several class-action lawsuits were filed against the Company, certain current and former officers and directors of the Company, and the Company's independent auditors in the United States District Court for the Northern District of California. The lawsuits were consolidated into a single action (the "Securities Class Action"), which alleged that the defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, Rule 10b-5 promulgated thereunder, and Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 by making a series of material misrepresentations as to the financial condition of the Company during the class period of July 31, 2001 to July 19, 2002. On March 11, 2005, the United States District Court for the Northern District of California granted final approval of the Securities Class Action settlement. On April 13, 2005, the period for appeals expired, and the settlement is now final. The Company issued 5,319,613 new shares of common stock on May 11, 2005, in consideration for the settlement of the Securities Class Action. 64 Former shareholders of Covalar Technologies Group, Inc., which was acquired by the Company in February 2002, brought suit in the District Court of Dallas County, Texas, against the Company's independent auditors and the managing underwriter in the Company's initial public offering, in connection with claims relating to the acquisition (the "Covalar Action"). On April 26, 2004, the Company and the Company's former President and Chief Executive Officer were named as defendants in this action. On July 13, 2004, the Company signed a settlement and release agreement with the plaintiffs in the Covalar Action contingent on the settlement of the Securities Class Action. Pursuant to this settlement agreement, the Company placed 2,000,000 shares in escrow in October 2004. On December 20, 2004, the court issued an order dismissing the Company without prejudice from the Covalar Action, pursuant to the Company's settlement agreement with the plaintiffs. On April 15, 2005, the Company authorized the release of 1,000,000 shares from escrow to the former Covalar shareholders. The remaining 1,000,000 shares will remain in escrow until October 2006. During this period, the Company has an option to acquire these shares at $1.00 per share. If the Company does not exercise its option by October 13, 2006, the shares will be released to the former shareholders. As part of the Company's initial public offering, the Company signed an underwriting agreement, which contained a provision in favor of its underwriters. The managing underwriter was named as a defendant in the Covalar Action and the FabCentric Action described below. Subject to a reservation of rights, the Company accepted the underwriter's request to indemnify the underwriter in connection with the Company's initial public offering and to advance expenses in the Covalar Action. The underwriter's legal counsel submitted bills totaling $850,000 through December 31, 2003, which the Company had accrued. On April 11, 2005, the Company entered into a settlement and release agreement with the underwriter for a total of $425,000, which is to be paid on or before August 11, 2005. Accordingly, during the three month period ended March 31, 2005, the Company reduced the accrual related to the Covalar Action. On May 22, 2003, five former shareholders of FabCentric, Inc., which was acquired by the Company in December 2001, sued the Company, the Company's former President and Chief Executive Officer and former Chief Financial Officer, and the Company's independent auditors in a lawsuit pending in Superior Court in the County of Santa Clara, California (the "FabCentric Action"). The plaintiffs subsequently added the managing underwriter in the Company's initial public offering and the Company's current Chief Financial Officer as defendants. This lawsuit alleges claims for fraud, negligent misrepresentation, breach of warranties and covenants, breach of contract, negligence, and violations of the California Corporations Code and seeks rescission or, alternatively, damages, costs and expenses. After several rounds of demurrers, the auditors and the underwriters filed answers to the fourth amended complaint in May 2005. Answers by the Company and the Company's former CEO and CFO have been extended by stipulation. On February 17, 2005, the FabCentric plaintiffs and the Company participated in a mediation session. On February 23, 2005, the FabCentric plaintiffs agreed in principle to settle with the Company and the Company's former CEO and CFO by participating in the HPL Parties' settlement in the Securities Class Action, in addition to receiving 2,100,000 shares of common stock from the Company, $500,000 in cash from the Company's insurer, Twin City Fire Insurance Company ("Twin City"), and 25% of the net recovery, if any, from Twin City in the litigation described below. The parties are preparing the settlement documentation. The Company anticipates issuing the 2,100,000 new shares of common stock to the FabCentric plaintiffs along with an additional 336,387 shares to the plaintiffs in the Securities Class Action pursuant to an anti-dilution provision following the Superior Court's determination that the settlement was made in good faith. The Company was also a nominal defendant in consolidated stockholder derivative lawsuits filed between July 31, 2002 and December 31, 2002, in Superior Court in the County of Santa Clara, California. These lawsuits asserted derivative claims on behalf of the Company against certain current and former officers and directors of the Company and the Company's independent auditors. 65 The consolidated complaint asserted claims for insider trading, breach of fiduciary duties, breach of contract, professional negligence and unjust enrichment, and sought damages suffered by the Company, treble damages for the sale of shares, costs and expenses of these actions and such other relief as the court may deem appropriate. On April 6, 2005, the Superior Court in the County of Santa Clara, California, approved the settlement of the derivative actions. The Company's contribution to plaintiffs' attorney's fees of $950,000, which was the Company's only contribution to the settlement, was fully funded by its excess directors and officers liability insurance ("D&O") policies. Additionally, Twin City (the Company's first-layer excess D&O insurance carrier) filed a declaratory relief action on October 6, 2003, in Superior Court in the County of Santa Clara, California, against the Company, its former President and Chief Executive Officer, its former Chief Financial Officer, and other former and current officers and directors of the Company seeking a determination that no coverage is afforded the defendants under Twin City's policy, which follows form to the Company's primary D&O policy issued by Executive Risk Indemnity Inc. Executive Risk has already agreed to pay its policy limits for the Securities Class Action, exhausting the limits of the primary D&O policy. The Company filed a Second Amended Cross-Complaint on September 29, 2004, seeking a declaration that Twin City and the Company's other excess D&O insurance carriers, National Union Fire Insurance Company ("National Union") and St. Paul Mercury Insurance Company ("St. Paul"), are obligated to indemnify the Company for losses in connection with the Securities Class Actions and related litigation and that Twin City has breached its insurance contract by not paying the defendants' defense expenses on a current basis. On January 11, 2005, the Company argued cross motions for summary adjudication in the Twin City matter. The parties sought a declaration regarding whether exclusionary language in the Company's D&O liability insurance application excluded coverage for insureds that did not have knowledge of Y. David Lepejian's unlawful conduct. The Superior Court, in a ruling issued on January 12, 2005, held that this exclusionary language did not preclude coverage for insureds who did not have knowledge of the unlawful conduct, including the Company. Twin City's motion to reconsider the Superior Court's January 12, 2005 ruling was denied on February 22, 2005 and an amended order was issued on March 9, 2005. The Company intends to continue to oppose the remaining claims made in the Third Amended Complaint filed by Twin City and to seek coverage under Twin City's policy. To date, Twin City has advanced or agreed to advance, subject to a reservation of rights, a total of $900,000 under a reservation of rights to fund settlements of the Securities Class Action and the FabCentric Action. On December 21, 2004, National Union, the Company's third-layer excess D&O carrier, paid $1,000,000 into escrow in exchange for a full policy release. The Company has dismissed National Union from its coverage action. St. Paul, the Company's fourth-layer excess D&O carrier has similarly paid $125,000 subsequent to December 31, 2004 into escrow in exchange for a full policy release and the Company has dismissed St. Paul from its coverage action. The proceeds were used to settle the consolidated derivative action and for legal defense costs. As of March 31, 2004, the Company had accrued $7.9 million relating to its estimated value of the shares to be issued to settle the above actions. In the three month period ended June 30, 2004, the Company increased the accrual by $1.2 million to $9.1 million based on new information in the period. On March 31, 2005, the Company reduced the accrual to $8.4 million reflecting the estimated value of the Company common stock to be issued in the settlement which the Company measured in a manner consistent with the measurement of potential goodwill impairment. For the year ended March 31, 2005, the legal settlement expense was $470,000. Following the Company's dismissal from the FabCentric Action, the only remaining litigation in which the Company is a party will be its claim against 66 Twin City discussed above. This matter is in the early stages of litigation and accordingly it may ultimately be resolved on a basis different than currently estimated. Because there could be many factors that enter into the ultimate resolution of this matter which are not within the Company's control, the Company is not able to estimate the maximum potential financial exposure to litigate this matter or the potential financial benefit to the Company should it be resolved successfully. The resolution of the Twin City litigation could have a material effect on the Company's financial condition, results of operations or cash flows. Supplementary Financial Data Quarterly Data (Unaudited)

~~March~~For ~~31,~~the ~~2004~~Quarters Ended ---------------------------------------------------------------- ~~Gross~~(in ~~Gross~~thousands, ~~Amortized~~except ~~Unrealized~~per ~~Unrealized~~share ~~Estimated~~amounts) ~~Cost~~March ~~Gains~~31, ~~(Losses)~~December ~~Fair~~31, ~~Value~~September 30, June 30, Year ended March 31, 2005 2005 2004 2004 2004 ------------ ------------- ------------ ------------ ~~Checking and savings $ 2,160 $~~ -- $ -- ~~$ 2,160 Money market funds 248~~ -- -- ~~248 Municipal bonds~~ - ~~taxable 2,300~~ -- -- ~~2,300 Corporate debt securities 3,867 9~~ -- ~~3,876 US Government agencies 1,625 1~~ -- ~~1,626~~ -------------- ---------------- --------------- -------------- Revenues $ 101,~~200~~961 $ 102,857 $ --1,790 $ 103,~~210~~161 ~~============~~Gross ~~=============~~profit ~~============~~1,534 ~~============~~1,977 ~~Included~~1,029 ~~in:~~2,381 ~~Cash~~Net ~~and~~loss ~~cash~~(1,714) ~~equivalents~~(1,826) $(3,262) 4(2,~~708~~621) ~~Short-term~~Net ~~investments~~loss ~~5,502~~per share--~~----------~~basic and diluted: $ (0.05) $ (0.07) $ (0.10) $ (0.08) Shares used in computing per share amounts--basic and diluted: 31,~~210~~424 ~~============~~31,354 31,275 31,275

March 31, 2003 ----------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Estimated Cost Gains (Losses) Fair Value ------------ ------------- ------------ ------------- Checking and savings $ 567 $ -- $ -- $ 567 Money market funds 10,914 -- -- 10,914 Commercial paper 5,870 -- (1) 5,869 Municipal bonds - taxable 1,145 -- -- 1,145 Corporate debt securities 1,713 1 9 1,723 US Government agencies 1,512 11 1,523 ----------- ------------- ------------ ------------- $ 21,721 $ 12 $ 8 $ 21,741 ============ ============= ============ ============= Included in: Cash and cash equivalents $ 17,350 Short-term investments 4,391 ------------- $ 21,741 =============

March 31, ------------------------------ 2004 2003 -------------- --------------- Deferred tax assets: Net operating loss and credit carry forwards $ 24,772 $ 22,321 Other accruals 8,137 4,466 -------------- --------------- Gross deferred tax assets 32,909 26,787 Valuation allowance (32,479) (25,811) -------------- --------------- Net deferred tax assets $ 430 $ 976 ============== =============== Deferred tax liabilities: Intangible assets (430) (948) Change of accounting methods -- (28) -------------- --------------- Net deferred tax liabilities $ (430) $ (976) ============== ===============

March 31 ------------------------------------------ 2004 2003 2002 -------------- ----------- ------------ Tax at federal statutory rate (34.0)% (34.0)% (34.0)% State, net of federal benefit (2.4) (3.8) (5.8) Other 0.1 (0.2) (4.6) Option compensation 0.6 0.8 9.5 Valuation allowance 36.1 37.2 34.9 -------------- ----------- ------------ Provision for income taxes 0.4% 0.0% 0.0% ============== =========== ============

Years ended March 31, ------------------------------------------- 2004 2003 2002 ------------- ------------- -------------- United States $ 5,941 $ 9,948 $ 3,181 Japan 3,339 2,820 666 France 419 365 643 Rest of the world 3,002 2,459 23 ------------- ------------- -------------- $ 12,701 $ 15,592 $ 4,513 ============= ============= ==============

For the Quarters Ended ---------------------------------------------------------------- (in thousands, except per share amounts) March 31, December 31, September 30, June 30, Year ended March 31, 2003 2003 2002 2002 2002 ------------------------------------------------------------------ -------------- ---------------- --------------- -------------- Revenues $ 3,582 $ 5,248 $ 4,483 $ 2,279 Gross profit (loss) 2,018 3,806 3,635 1,669 Net loss (34,526) (2,756) (6,886) (7,650) Net loss per share--basic and diluted: $ (1.12) $ (0.09) $ (0.22) $ (0.25) Shares used in computing per share amounts--basic and diluted: 30,796 30,784 30,777 30,410

Included in the net loss for the quarter ended March 31, 2005 is a non-cash charge reversal of $730,000 related to the revaluation of the legal settlement accrual. Included in the net loss for the quarter ended June 30, 2004 is a non-cash charge of $1.2 million related to the legal settlement estimated expense. Included in the net loss for the quarter ended March 31, 2004 is a non-cash charge of $7.9 million related to the legal settlement estimated expense. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES CEO and CFO Certifications 67 Filed as an exhibit to this Annual Report on Form 10-K are certifications of the Chief Executive Officer and the Chief Financial Officer. The certifications are required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002. This section of the Annual Report on Form 10-K contains the information concerning the controls evaluation referred to in the Section 302 certifications and this information should be read in conjunction with the Section 302 certifications for a more complete understanding of the topics presented. Disclosure Controls and Internal Controls Disclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, or the Exchange Act, such as this Annual Report on Form 10-K, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Internal controls are procedures which are designed with the objective of providing reasonable assurance that our transactions are properly authorized, our assets are safeguarded against unauthorized or improper use and our transactions are properly recorded and reported, all to permit the preparation of our financial statements in conformity with generally accepted accounting principles. With the participation of the principal executive officer and the principal financial officer, our management has evaluated of our disclosure controls and procedures (as defined in the Securities Exchange Act of 1934, Rules 13a-15(e), as of the end of the period covered by this report. Based on that evaluation, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report to ensure that material information relating to HPL and its consolidated subsidiaries is made know to them. Additionally, there were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the fiscal quarter ended March 31, 2005, that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting. 68 PART III. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information concerning our directors and executive officers required by this Item is incorporated by reference to the section in Item 1 of this report entitled "Directors and Officers." Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Securities Exchange Act of 1934 requires the Company's officers and directors and persons who own more than 10% of the Company's Common Stock (collectively, "Reporting Persons") to file reports of ownership and changes in ownership with the SEC on a periodic basis. Reporting Persons are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file. Based solely on a review of the copies of such forms provided to the Company, we believe that with respect to the year ended March 31, 2005, all of the Reporting Persons complied with the applicable filing requirements. Code of Ethics We have adopted a code of ethics that applies to our directors, officers and employees. A copy of the code of ethics is available on our website at www.hpl.com. Any waiver of or amendments to our code of ethics will be posted to our website. ITEM 11. EXECUTIVE COMPENSATION Summary Compensation Table The following table sets forth certain summary information concerning the compensation paid by the Company over the last three fiscal years to its Chief Executive Officers and the four most highly compensated executive officers of the Company for the year ended March 31, 2005 ("named executive officers").

Long-term Compensation ------------------ Annual Compensation Securities Name and ----------------------------------- Underlying All Other Principal Position(s) Year Salary Bonus/Commission Options (#) Compensation ------------------------------------------ ---------------- ---------------- ----------------- --------------- --- ------------- Cary D. Vandenberg (1) ~~2004~~2005 $ ~~244~~275,~~856~~000 $ ~~100,000~~-- ~~925,000~~-- $ -- President and 2004 244,856 100,000 925,000 -- Chief Executive Officer 2003 -- -- -- -- Michael P. Scarpelli (2) Chief Financial Officer, ~~2004~~2005 ~~250~~251,~~000~~200 ~~50,000~~-- ~~450,000~~-- ~~186~~177,000 Senior Vice President- ~~2003~~2004 ~~242~~250,~~466~~000 50,000 --450,000 ~~187~~186,~~225~~000 Administration, and ~~2002~~2003 56242,~~250~~466 ~~-- 325~~50,000 -- 187,225 Secretary ~~William~~Brian ~~Lamkin~~Gordon ~~III~~(3) ~~2004~~2005 98175,~~830~~000 420,~~840~~697 ~~350,000~~-- -- ~~Senior~~ Vice President- ~~Sales~~of &Software ~~Global Customer Support Brian Gordon(4)~~ 2004 101,522 -- 350,000 -- ~~Vice President of Software~~ Engineering Y.Dean ~~David~~Frazier ~~Lepejian~~ (54) ~~2003~~2005 70175,~~037 8,025 Former President and 2002 174,980 9,066 Chief Executive Officer Thomas A. Tomasetti(6) 2003 -- 229,~~000 ~~Former President and Chief Executive Officer~~ --~~--------------------------------~~ -71- ~~(1) Mr. Vandenberg joined the Company in May 2003 (2) Mr. Scarpelli joined the Company in January 2002 as our~~ Vice President of ~~Corporate~~Marketing Development. In July 2002, Mr. Scarpelli was appointed Chief Financial Officer of the Company. Mr. Scarpelli was awarded the bonus as part of an executive retention bonus arrangement. The amounts in "All Other Compensation" relate to the forgiveness of $150,000 in principal and accrued interest of $36,000 and $37,225 in 2004 ~~and 2003~~7,965 ~~respectively~~-- ~~on a $750~~350,000 ~~loan~~-- ~~Mr.~~Victor ~~Scarpelli~~Boksha ~~received as part of his original employment agreement with the Company. All of Mr. Scarpelli's options granted in fiscal 2002 were cancelled in fiscal 2003.~~ (~~3) Mr. Lamkin joined the Company in September 2003. (4) Mr. Gordon joined the Company in September 2003. (~~5)~~"All~~ ~~Other~~2005 ~~Compensation"~~150,000 ~~for~~11,715 ~~Mr.~~-- ~~Lepejian~~Vice ~~consists~~President of ~~premiums~~Business ~~paid~~2004 ~~by the Company for his term life insurance policy. Mr. Lepejian was terminated as an employee and officer of the Company on July 19~~54,038 ~~2002.~~-- ~~(6) Mr. Tomasetti served as our interim President and Chief Executive Officer from August 2002 through March 2003 pursuant to a consulting agreement between the Company and The Brenner Group~~250,000 ~~his~~-- ~~employer. "All Other Compensation" represents the consulting fees we paid to The Brenner Group.~~Development

69 -------------------------------------------------------------------------------- (1) Mr. Vandenberg joined the Company in May 2003. (2) Mr. Scarpelli was awarded the bonus payable in 2003 and 2004 as part of an executive retention arrangement. The amounts in "All Other Compensation" relate to the forgiveness of $150,000 in principal and accrued interest of $27,000, $36,000, and $37,225 in 2005, 2004 and 2003, respectively on a $750,000 loan Mr. Scarpelli received as part of his original employment agreement with the Company. All of Mr. Scarpelli's options granted in fiscal 2002 were cancelled in fiscal 2003. (3) Mr. Gordon joined the Company in September 2003. (4) Mr. Frazier joined the Company in March 2004. (5) Mr. Boksha joined the Company in November 2003. Fiscal 2005 Stock Option Grants The Company granted no stock options in fiscal 2005 to the named executive officers. Aggregated Option Exercises in Last Fiscal Year The following table sets forth certain information with respect to the exercise of options during the last fiscal year and the value of options held by the named executive officers as of the end of fiscal 2005. No options were exercised in the last fiscal year.

Number of Shares Underlying Value of Unexercised Unexercised Options in-the-money Options Shares at Fiscal Year-End (#) at Fiscal Year-End (1) ($) Acquired on Value --------------------------------- ---------------------------------- Name Exercise (#) Realized ($) Exercisable Unexercisable Exercisable Unexercisable ------------------------------ -------------- -------------- --------------- ----------------- --------------- ------------------ YCary D. ~~David~~Vandenberg ~~Lepejian~~-- ~~50,000~~ $ -- --346,875 --578,125 $ --166,500 $ --277,500 ~~Cary~~Michael DP. ~~Vandenberg~~Scarpelli -- -- --168,750 ~~925~~281,250 81,000 --135,000 --Dean ~~Michael~~Frazier ~~P. Scarpelli~~ -- -- --87,500 ~~450~~263,000 37,625 113,090 Brian Gordon -- -- ~~William~~131,250 ~~Lamkin~~218,750 ~~III~~63,000 --105,000 Greg Yeric -- -- ~~350~~134,~~000~~828 --160,963 --51,970 ~~Brian~~75,000 ~~Gordon~~Victor --Boksha -- -- ~~350~~78,~~000~~125 --171,875 --36,719 ~~--------------------~~80,781 (1) The value of the in-the-money options represents the difference between (A) $0.2172, our closing stock price on March 31, ~~2004~~2005 (the last trading day of fiscal ~~2004~~2005), and (B) the respective exercise price for each option, multiplied by the number of shares of Common Stock underlying each respective option.

70 Employment Arrangements In December 2001, we entered into an employment agreement, which is terminable at-will, with Michael Scarpelli, our Chief Financial Officer. This agreement provided for an annual base salary of $225,000, an annual bonus payable at the discretion of the board and a loan of $750,000. The loan bears interest at a rate equal to the higher of: (i) 6%, or (ii) the short-term "applicable federal rate" as periodically published by the Internal Revenue Service. The employment arrangement provides that 20% of the principal sum and accrued interest will be forgiven annually over a period of five years, commencing on the first anniversary of the officer's employment, provided that he remains continuously employed by the Company during that time. The agreement further provides that if Mr. Scarpelli is terminated without "cause" (as defined), or there is a "corporate transaction" (as defined), all outstanding principal and interest on the loan will be immediately forgiven. This agreement was subsequently amended in August 2002 to provide Mr. Scarpelli with: (1) an increase in annual base salary to $250,000; (2) a retention bonus of $100,000, payable 50% on January 18, 2003 and 50% on July 18, 2003, so long as Mr. Scarpelli remains an employee of the Company through each respective payment date, and (3) certain severance benefits. Currently, Mr. Scarpelli is entitled to receive severance payments equal to six months' of base salary if his employment is terminated without cause (as defined), provided, however, that this severance benefit will increase to 18 months' base salary if a "corporate transaction" (as defined) occurs on or before June 12, 2006 and Mr. Scarpelli's employment is subsequently terminated without cause. Additionally, Mr. Scarpelli is entitled to receive a one-time bonus equal to nine months' base salary if the Company completes a "corporate transaction" on or before June 12, 2006. In April 2003, we entered into an employment agreement, which is terminable at-will, with Cary D. Vandenberg, our President and Chief Executive Officer. This agreement provided for an annual base salary of $275,000 and an annual bonus payable in an amount and at the discretion of the board. In addition, if Mr. Vandenberg's employment is terminated without "cause", or if he resigns for "good reason" (each as defined), then he will be entitled to receive severance payments equal to one year of base salary, one year of COBRA benefits coverage, and acceleration of vesting of one-half of his stock option awards (to the extent that the options are then not fully vested). Additionally, Mr. Vandenberg is entitled to receive a one-time bonus equal to six months' base salary if the Company completes a "corporate transaction" on or before June 12, 2006. In August 2003, we entered into an employment agreement, which is terminable at-will, with Brian Gordon, our Vice President of Software Engineering. This agreement provided Mr. Gordon with an annual base salary of $175,000, an annual target bonus of $25,000 based upon individual performance, and an annual target bonus of $15,000 based on overall company performance. In addition, if Mr. Gordon's employment is terminated without cause, then he will be entitled to receive a severance payment equal to three months base pay. In March 2004, we entered into an employment agreement, which is terminable at-will, with Dean Frazier, our Vice President of Marketing. This agreement provides for an annual base salary of $175,000 and an annual target bonus of $40,000 based on individual performance. In addition, if Mr. Frazier's employment is terminated without cause, then he will be entitled to receive severance payments equal to three months of base salary and three months of COBRA benefits coverage. Compensation Committee Interlocks and Insider Participation The Compensation Committee currently consists of Messrs Antoun and Zorian. No member of the Compensation Committee or executive officer of the Company has a relationship that would constitute an interlocking relationship with any executive officers or directors of another entity. 71 Director Compensation Each non-employee director of the Company receives $10,000 annually and $500 for each meeting of the board of directors, or any committee of the board of directors, he attends. In addition, each non-employee director is eligible to receive an annual option grant to purchase up to 7,500 shares of Common Stock, at an exercise price equal to the fair market value of the stock on the date of grant. Options to purchase a total of 37,500 shares of common stock were granted to our directors in fiscal 2004, 15,000 of which related to fiscal 2003 awards issued in fiscal 2004. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The following table sets forth certain information, as of May 31, 2005 (unless otherwise indicated below), with respect to the beneficial ownership of the outstanding Common Stock by: (i) each stockholder known by the Company to be the beneficial owner of more than 5% of the outstanding Common Stock; (ii) each director or nominee; (iii) each of the named executive officers; and (iv) all current executive officers and directors as a group. Unless otherwise indicated below, each stockholder has sole voting and sole investment power with respect to all shares beneficially owned, subject to community property laws, if applicable.

Shares Beneficially Owned and Shares Underlying Options Exercisable Within 60 days of May 31, ~~2004~~2005 Name and Address -------------------------------------------------------- Percent of Beneficial Owner + Shares (#) Options (#) Total (#) of Class (1) -------------------------------------- ----------------~~-----~~ ----------------~~---~~ ------------------ ---------------- --~~------------~~ Synopsys, Inc. ~~6,239,128 -- 6,239,128 19.95%~~ 700 East Middlefield Road Mountain View, CA 94043 ~~----------------------------------------------------------- ------------------- ------------------ ---------------- -------------- Lawrence Kraus 3~~6,~~924~~239,~~250~~128 -- 36,~~924~~239,~~250~~128 1215.556% Y.Lawrence ~~David~~Kraus ~~Lepejian(2)~~ 3,~~614~~924,~~000~~250 --7,500 3,~~614~~931,~~000~~750 119.569% ~~1357 Lakeshore Circle - Bldg. #12 San Jose, CA 95131~~ Dr. Yervant Zorian 782,500 --15,000 ~~782~~797,500 2.500% Elias Antoun 400,000 85100,170 ~~485~~500,170 1.552% Cary D. Vandenberg -- --423,958 --423,958 --1.1% Michael P. Scarpelli -- --206,250 --206,250 0.5% Brian Gordon -- ~~William~~160,417 ~~Lamkin~~160,417 ~~III~~0.4% --Greg --Yeric -- --156,446 ~~Brian~~156,446 ~~Gordon~~0.4% --Dean --Frazier -- 113,020 113,020 0.3% Victor Boksha -- 98,958 98,958 0.2% All directors and executive officers as a group (7 persons) 5,106,750 851,~~170~~281,719 56,~~191~~388,~~920~~469 16.600% -74- ------------------------------------------------------------- + Unless indicated otherwise, the address of each beneficial owner is HPL Technologies, Inc. 2033 Gateway Place, Suite 400, San Jose, California 95110. (1) Applicable percentage of ownership is based on approximately 31,274,623 shares of Common Stock outstanding as of June 30, 2004, together with applicable stock options for such stockholder. Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission. Shares of common stock subject to options currently exercisable or exercisable within 60 days of May 31, 2004 are deemed outstanding for computing the percentage of ownership of the person holding such stock options, but are not deemed outstanding for computing the percentage of any other person. (2) Mr. Lepejian has served notice of exercise of a stock option to purchase up to 2,670,000 shares of common stock previously issued by HPLI. The Company has refused to issue the shares as the options were cancelled on his termination from employment. 884,000 shares of Mr. Lepejian's total shares were represented to have been sold by Mr. Lepejian to a third party in December 2002. However, the certificates are still registered in Mr. Lepejian's name and we have no support for such sales.

(1) Applicable percentage of ownership is based on approximately 38,768,065, shares of Common Stock outstanding as of May 31, 2005, together with applicable stock options for such stockholder. Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission. Shares of common stock subject to options currently exercisable or exercisable within 60 days of May 31, 2005 are deemed outstanding for computing the percentage of ownership of the person holding such stock options, but are not deemed outstanding for computing the percentage of any other person. Equity Compensation Plan Information The Company maintains the 2001 Equity Incentive Plan (the "2001 Plan"), the 2001 Employee Stock Purchase Plan (the "ESPP") and the 2001 Foreign Employee Stock Purchase Plan (the "Foreign ESPP"), pursuant to which it may grant equity awards to eligible persons. The following table sets forth certain information regarding the 2001 Plan, the ESPP and the Foreign ESPP as of March 31, 2005. 72

Number of securities remaining available for Number of securities to be Weighted-average future issuance under issued upon exercise of exercise price of equity compensation plans outstanding options, outstanding options, (excluding securities Plan category warrants and rights (1) warrants and rights (1) reflected in first column) (2) --------------------------------------- ---------------------------- --------------------------- --------------------------------- Equity compensation plans approved by security holders 6,~~503~~638,~~473~~818 $ 0.6561 5,~~346~~189,~~294~~347 Equity compensation plans not approved by security holders -- -- -- ---------------------------- --------------------------- --------------------------------- Total 6,~~503~~638,~~473~~818 $ 0.6561 5,~~346~~189,~~294~~347 ---------------------------- --------------------------- --------------------------------- ~~-----------------------~~ (1) The Company has assumed certain stock option awards in connection with three acquisitions completed through the end of fiscal 2003. A total of 524,405 shares of Company common stock ~~underly~~underlie the assumed options, with a weighted-average exercise price of approximately $4.28 per share. No further awards will be made under the plans governing the assumed awards. Statistics regarding the assumed options are not included in the above table. (2) At March 31, ~~2004~~2005, 4,~~399~~092,~~139~~192 and ~~947~~1,097,155 shares of Common Stock were available for future issuance under the 2001 Plan and the ESPPs, respectively. The ESPPs contain an evergreen provision that provides for an annual share increase on March 1 of each year, until and including March 1, 2011, equal to the least of: (i) 150,000, (ii) 1% of the number of shares of Common Stock outstanding on that date, or (iii) a lesser number determined by the administrator.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The following table presents the fees for audit and other services provided by our principal accounting firm, PricewaterhouseCoopers LLP, for the years ended March 31, 2005 and 2004 (in thousands). No other types of services including tax or other advisory services, were provided by our principal accounting firm during that time. Type of Fees 2005 2004 ------------------------ ----------------- ---------------- Audit Fees (1) $ 271 $ 282 =============== =============== (1) Audit Fees include professional services rendered by PricewaterhouseCoopers LLP, the member firms of PricewaterhouseCoopers, and their respective affiliates (collectively, "PricewaterhouseCoopers") for the audit of HPL's annual financial statements and review of financial statements or services that are normally provided in connection with statutory and regulatory filings or engagements for that fiscal year. 73 Audit Committee's Pre-Approval Policies and Procedures On June 25, 2003, our Board of Directors adopted a new Audit Committee Charter that, among other things, requires the Audit Committee to pre-approve the rendering by our independent auditor of audit or permitted non-audit services. The Chair of the Audit Committee may pre-approve the rendering of services on behalf of the Committee, provided the matter is then presented to the full Committee at the next scheduled meeting. Our Audit Committee approved the audit fees for audit of our consolidated financial statements for the year ended March 31, 2005 prior to the commencement of the audit. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Financial Statements: Financial Statements for the three years ended March 31, 2005 are included in Item 8. All schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (b) Exhibits: The following exhibits are incorporated by reference or filed as part of this report.

Exhibit Description Number ------------ ---------------------------------------------------------------------------------------------------------------------- 3.1 Amended and Restated Certificate of Incorporation of Registrant. (1) 3.2 Bylaws of Registrant. (1) 4.1 Form of Common Stock Certificate. (1) 10.1 2001 Amended and Restated Equity Incentive Plan. (1) 10.2 2001 Amended and Restated Employee Stock Purchase Plan. (1) 10.3 HPL Technologies, Inc. 2001 Foreign Subsidiary Employee Stock Purchase Plan, as amended. (2) 10.4 Form of Officer and Director Indemnification Agreement. (1) 10.5 Employment Offer Letter from HPL Technologies, Inc. to Michael P. Scarpelli, dated December 4, 2001. (3) 74 10.6 Employment Amendment Letter from HPL Technologies, Inc. to Michael P. Scarpelli, dated August 6, 2002. (1) 10.7 Employment Amendment Letter from HPL Technologies, Inc. to Cary D. Vandenberg, dated April 23, 2003. (5) 10.8 Employment Offer Letter from HPL Technologies, Inc. to ~~William Lamkin III, dated August 22, 2003. (6) 10.9 Employment Offer Letter from HPL Technologies, Inc. to~~ Brian Gordon, dated August 26, 2003. (6) ~~-77-~~ 10.109 Real property lease dated August 19, 1998 by and between Heuristic Physics Laboratories, Inc. and Spieker Properties, L.P., (San Jose, California). (1) 10.1110 Industrial Lease Agreement, dated as of November 17, 2000, between Research Interchange One L.P., a Texas Limited Partnership and Testchip Technologies, Inc., a Texas Corporation. (4) 10.1211 First Amendment, dated as of March 28, 2001, to Industrial Lease Agreement, dated as of November 17, 2000, between Research Interchange One L.P., a Texas Limited Partnership and Testchip Technologies, Inc., a Texas Corporation. (4) 10.1312 Second Amendment, dated June 6, 2001, to Industrial Lease Agreement, dated as of November 17, 2000, between Research Interchange One L.P., a Texas Limited Partnership and Testchip Technologies, Inc., a Texas Corporation. (4) 10.1413 Third Amendment, dated October 1, 2001, to Industrial Lease Agreement, dated as of November 17, 2000, between Research Interchange One L.P., a Texas Limited Partnership and Testchip Technologies, Inc., a Texas Corporation. (4) 10.1514 Lease Agreement, dated June 1, 2000, between Jackson-Shaw Technology Center II, LTD and Testchip Technologies, Inc. (4) 10.1615 Amendment, dated August 7, 2000, to Lease Agreement, dated June 1, 2000, between Jackson-Shaw Technology Center, II, LTD. and Testchip Technologies. (4) 10.1716 Modification and Ratification of Lease, dated October 31, 2001, between Jackson-Shaw Technology Center II, LTD. and Testchip Technologies. (4) 21.1 Subsidiaries of the registrant. 23.1 Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm. 24.1 Powers of Attorney. (Contained on Signature Page) 31.1 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 75 ------------------------------------------------------------------------------- (1) Incorporated by reference from our Registration Statement on Form S-1 filed with the Commission May 29, 2001, as amended (Registration No. 333-61810). (2) Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended September 30, 2001. (3) Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended December 31, 2001. ~~-78-~~ (4) Incorporated by reference from our Annual Report on Form 10-K for the year ended March 31, 2003. (5) Incorporated by reference from our Annual Report on Form 10-Q for the quarter ended June 30, 2003. (6) Incorporated by reference from our Annual Report on Form 10-Q for the quarter ended September 30, 2003. (c) Not Applicable

76 SIGNATURE Pursuant to the requirements of Section 13 or 15(d) 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. HPL Technologies, Inc. Dated: June 29, 2005 By: /s/ Cary D Vandenberg -------------------------------------------- Cary D. Vandenberg President and Chief Executive Officer 77 POWERS OF ATTORNEY AND SIGNATURES KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Cary D. Vandenberg and Michael P. Scarpelli as his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this report, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent or his substitute may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Signature Title Date ---------------------------------------- ------------------------------------------------------ ---------------------------------- /s/ Cary D. Vandenberg President and Chief Executive Officer ~~July~~June 14 29, ~~2004~~2005 ---------------------------------------- Cary D. Vandenberg (Principal Executive Officer) /s/ Michael P. Scarpelli Chief Financial Officer ~~July~~June 1429, ~~2004~~2005 ---------------------------------------- Michael P. Scarpelli (Principal Financial and Accounting Officer) /s/ Elias Antoun Director ~~July~~June 1429, ~~2004~~2005 ---------------------------------------- Elias Antoun /s/ Lawrence Kraus Director ~~July~~June 1429, ~~2004~~2005 ---------------------------------------- Lawrence Kraus /s/ Dr. Yervant Zorian Director ~~July~~June 1429, ~~2004~~2005 ---------------------------------------- Dr. Yervant Zorian

78 EXHIBIT INDEX

~~EXHIBIT INDEX~~ Exhibit Number Description ------------ --------------------------------------------------------------------------------------------------------------------- 3.1 Amended and Restated Certificate of Incorporation of Registrant. (1) 3.2 Bylaws of Registrant. (1) 4.1 Form of Common Stock Certificate. (1) 10.1 2001 Amended and Restated Equity Incentive Plan. (1) 10.2 2001 Amended and Restated Employee Stock Purchase Plan. (1) 10.3 HPL Technologies, Inc. 2001 Foreign Subsidiary Employee Stock Purchase Plan, as amended. (2) 10.4 Form of Officer and Director Indemnification Agreement. (1) 10.5 Employment Offer Letter from HPL Technologies, Inc. to Michael P. Scarpelli, dated December 4, 2001. (3) 10.6 Employment Amendment Letter from HPL Technologies, Inc. to Michael P. Scarpelli, dated August 6, 2002. (1) 10.7 Employment Amendment Letter from HPL Technologies, Inc. to Cary D. Vandenberg, dated April 23, 2003. (5) 10.8 Employment Offer Letter from HPL Technologies, Inc. to ~~William Lamkin III, dated August 22, 2003. 10.9 Employment Offer Letter from HPL Technologies, Inc. to~~ Brian ~~Gorden~~Gordon, dated August 26, 2003. (6) 10.109 Real property lease dated August 19, 1998 by and between Heuristic Physics Laboratories, Inc. and Spieker Properties, L.P., (San Jose, California). (1) 10.1110 Industrial Lease Agreement, dated as of November 17, 2000, between Research Interchange One L.P., a Texas Limited Partnership and Testchip Technologies, Inc., a Texas Corporation. (4) 10.1211 First Amendment, dated as of March 28, 2001, to Industrial Lease Agreement, dated as of November 17, 2000, between Research Interchange One L.P., a Texas Limited Partnership and Testchip Technologies, Inc., a Texas Corporation. (4) 10.1312 Second Amendment, dated June 6, 2001, to Industrial Lease Agreement, dated as of November 17, 2000, between Research Interchange One L.P., a Texas Limited Partnership and Testchip Technologies, Inc., a Texas Corporation. (4) 10.1413 Third Amendment, dated October 1, 2001, to Industrial Lease Agreement, dated as of November 17, 2000, between Research Interchange One L.P., a Texas Limited Partnership and Testchip Technologies, Inc., a Texas Corporation. (4) ~~-82-~~ 10.1514 Lease Agreement, dated June 1, 2000, between Jackson-Shaw Technology Center II, LTD and Testchip Technologies, Inc. (4) 79 10.1615 Amendment, dated August 7, 2000, to Lease Agreement, dated June 1, 2000, between Jackson-Shaw Technology Center, II, LTD. and Testchip Technologies. (4) 10.1716 Modification and Ratification of Lease, dated October 31, 2001, between Jackson-Shaw Technology Center II, LTD. and Testchip Technologies. (4) 21.1 Subsidiaries of the registrant. 23.1 Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm. 24.1 Powers of Attorney. (Contained on Signature Page) 31.1 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. -------------------------------------------------------------------------------- (1) Incorporated by reference from our Registration Statement on Form S-1 filed with the Commission May 29, 2001, as amended (Registration No. 333-61810). (2) Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended September 30, 2001. (3) Incorporated by reference from our Quarterly Report on Form 10-Q for the quarter ended December 31, 2001. (4) Incorporated by reference from our Annual Report on Form 10-K for the year ended March 31, 2002. (5) Incorporated by reference from our Annual Report on Form 10-Q for the quarter ended June 30, 2003. (6) Incorporated by reference from our Annual Report on Form 10-Q for the quarter ended September 30, 2003.

80 Exhibit 21.1 SUBSIDIARIES OF THE REGISTRANT Subsidiary Name Jurisdiction of Incorporation ------------------------------------- --------------------------------------- Heuristic Physics Laboratories, Inc. California FabCentric, Inc. California HPL International Ltd. Cayman Island HPLA Limited Liability Company Armenia HPL Japan KK Japan HPL Technologies Private Limited India HPL Texas, Inc. Delaware TestChip Technologies, Inc. Texas Defect & Yield Management, Inc. Delaware HPL, Taiwan Inc. Taiwan 81 Exhibit 23.1 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 333-66962 and No. 333-87144) of HPL Technologies, Inc. of our report dated June 27, 2005, relating to the financial statements, which appears in this Form 10-K. /s/ PricewaterhouseCoopers LLP ---------------------------------------- PricewaterhouseCoopers LLP San Jose, California June 28, 2005 82 Exhibit 31.1 I, Cary D. Vandenberg, certify that: 1. I have reviewed this annual report on Form 10-K of HPL Technologies, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial data; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Date: June 29, 2005 By: /s/ Cary D. Vandenberg ---------------- --------------------------------- Cary D. Vandenberg President and Chief Executive Officer 83 Exhibit 31.2 I, Michael P. Scarpelli, certify that: 1. I have reviewed this annual report on Form 10-K of HPL Technologies, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial data; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Date: June 29, 2005 By: /s/ Michael P. Scarpelli --------------- --------------------------------- Michael P. Scarpelli Chief Financial Officer 84 Exhibit 32.1 CERTIFICATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 I, Cary D. Vandenberg, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Annual Report of HPL Technologies, Inc. on Form 10-K for the fiscal year ended March 31, 2004 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Annual Report on Form 10-K fairly presents in all material respects the financial condition and results of operations of HPL Technologies, Inc. Date: June 29, 2005 /s/ Cary D. Vandenberg ------------------------------------- Cary D. Vandenberg President and Chief Executive Officer A signed original of this written statement required by Section 906 has been provided to HPL Technologies, Inc. and will be retained by HPL Technologies, Inc. and furnished to the Securities and Exchange Commission upon request. 85 Exhibit 32.2 CERTIFICATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 I, Michael P. Scarpelli, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Annual Report of HPL Technologies, Inc. on Form 10-K for the fiscal year ended March 31, 2004 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Annual Report on Form 10-K fairly presents in all material respects the financial condition and results of operations of HPL Technologies, Inc. Date: June 29, 2005 /s/ Michael P. Scarpelli ----------------------------- Michael P. Scarpelli Chief Financial Officer A signed original of this written statement required by Section 906 has been provided to HPL Technologies, Inc. and will be retained by HPL Technologies, Inc. and furnished to the Securities and Exchange Commission upon request. 86

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