Red Hat (RHT)

Accounting for Stock Options

Historically, we recognized stock option expense pursuant to Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and have elected to disclose the impact of expensing stock options pursuant to Statement of Financial Accounting Standards No. 123, Share-Based Payment (“SFAS 123”) in the notes to our Consolidated Financial Statements. Effective for fiscal 2007, we will adopt the provisions of Statement of Financial Accounting Standards No. 123R, Shared-Based Payments (“SFAS 123R”). Both SFAS 123 and SFAS 123R require us to make assumptions to determine the fair value of stock options, including the expected term of the options and the expected volatility of the underlying share price. Changes to such assumptions may have a significant impact on the value of our stock options, which could have a material effect on our consolidated financial statements. Additionally, we will be required to incorporate an estimate for forfeitures as we recognize the stock option expense over the requisite service period. Should our actual forfeitures differ from our estimates, our consolidated financial statements could be materially affected.

We plan to adopt SFAS 123R on a prospective basis beginning on March 1, 2006. Accordingly the consolidated results of operations for future periods will not be comparable to our historical consolidated results

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of operations. The adoption of SFAS 123R will have a material effect on our consolidated results of operations, increasing cost of revenue, sales and marketing expense, research and development expense and general and administration expense. We currently estimate the adoption of SFAS 123R will reduce diluted earnings per share by $0.10 in fiscal 2007; however the amount may change based on the number of options granted, the underlying share price at the time of grant, our estimate of forfeitures and our assumptions used to determine the options’ value, such as expected term and expected volatility. We will use the Black-Scholes-Merton option pricing model to determine the value of employee stock options and will use binomial or lattice models to determine certain assumptions used in the Black-Scholes-Merton pricing model, such as expected term. Expected volatility will be determined using a combination of historical volatility over a period equal to the expected term and implied volatility based on Red Hat options traded by the general public. For more information see discussion related to SFAS 123R at “Recent Accounting Pronouncements” in NOTE 2 to the Consolidated Financial Statements.