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# UNITED STATES 
SECURITIES AND
EXCHANGE COMMISSION 
WASHINGTON, D.C. 20549

# FORM 10-Q

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

# FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003

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 000-30203

# NUANCE COMMUNICATIONS,
INC.

(EXACT NAME OF
REGISTRANT AS SPECIFIED IN ITS CHARTER)

|DELAWARE                 | 94-3208477                          
|------------------------ | ------------------------------------
|(STATE OF INCORPORATION) | (IRS EMPLOYER IDENTIFICATION NUMBER)

1005 HAMILTON AVENUE
MENLO PARK, CALIFORNIA 94025
(650) 847-0000 
(ADDRESS AND TELEPHONE NUMBER OF PRINCIPAL EXECUTIVE OFFICES)

Indicate by check mark whether
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 such shorter period
that the registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES [X] NO [ ]

Indicate by check mark whether the
registrant is an accelerate filer (as defined in Rule 12b-2 of the Exchange Act) YES [X]
NO [ ]

34,490,376 shares of the
registrants common stock, $0.001 par value, were outstanding as of July 31, 2003.

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# NUANCE COMMUNICATIONS,INC. & SUBSIDIARIES

# FORM 10-Q, JUNE 30, 2003

# CONTENTS

|ITEM  NUMBER |                                                                                                        | PAGE
|------------ | ------------------------------------------------------------------------------------------------------ | ----
|             | PART I: FINANCIAL INFORMATION                                                                          |     
|             |                                                                                                        |     
|Item 1.      | Financial Statements                                                                                   |     
|             | Condensed Consolidated Balance Sheets:     June 30, 2003 and December 31,                              | 1   
|             | Condensed Consolidated Statements of Operations:     Three and six months ended June 30, 2003 and 2002 | 2   
|             | Condensed Consolidated Statements of Cash Flows:     Six months ended June 30, 2003 and 2002           | 3   
|             | Notes to Condensed Consolidated Financial Statements                                                   | 4   
|             |                                                                                                        |     
|Item 2.      | Management's Discussion and Analysis of      Financial Condition and Results of Operations             | 16  
|             |                                                                                                        |     
|Item 3.      | Quantitative and Qualitative Disclosures about Market Risk                                             | 35  
|             |                                                                                                        |     
|Item 4.      | Controls and procedures                                                                                | 35  
|             |                                                                                                        |     
|             | PART II: OTHER INFORMATION                                                                             |     
|             |                                                                                                        |     
|Item 1.      | Legal Proceedings                                                                                      | 36  
|             |                                                                                                        |     
|Item 4.      | Sbmission of matters to a vote of security holders                                                     | 36  
|             |                                                                                                        |     
|Item 6.      | Exhibits and Reports on Form 8-K                                                                       | 37  
|             |                                                                                                        |     
|SIGNATURES   | 38                                                                                                    
|             |                                                                                                        |     

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# PART
I:  FINANCIAL INFORMATION

# ITEM 1: FINANCIAL
STATEMENTS

# NUANCE COMMUNICATIONS,
INC. & SUBSIDIARIES 
CONDENSED CONSOLIDATED
BALANCE SHEETS 
(IN THOUSANDS, EXCEPT
SHARE AND PER SHARE AMOUNTS) (Unaudited)

|                                                                                                                                                                     | June 30,2003 | December 31,2002
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------ | ----------------
|ASSETS                                                                                                                                                               |              |                 
|Current assets:                                                                                                                                                      |              |                 
|Cash and cash equivalents                                                                                                                                            |              | $   25,388      
|Short-term investments                                                                                                                                               |              | 84,014          
|Accounts receivable, net of allowance for doubtful accounts of $662                  and $670, respectively                                                          |              | 11,280          
|Prepaid expenses and other current assets                                                                                                                            |              | 5,554           
|                                                                                                                                                                     |              |                 
|Total current assets                                                                                                                                                 |              | 126,236         
|Property and equipment, net                                                                                                                                          |              | 5,047           
|Intangible assets, net                                                                                                                                               |              | 1,199           
|Restricted cash                                                                                                                                                      |              | 12,503          
|Long-term investments                                                                                                                                                |              | 2,634           
|Other assets                                                                                                                                                         |              | 494             
|                                                                                                                                                                     |              |                 
|Total assets                                                                                                                                                         |              | $  148,113      
|LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                                                                 |             
|Current liabilities:                                                                                                                                                 |             
|Accounts payable                                                                                                                                                     |              | $     1,312     
|Accrued liabilities                                                                                                                                                  |              | 6,302           
|Current restructuring accrual                                                                                                                                        |              | 9,570           
|Accrued vacation                                                                                                                                                     |              | 2,153           
|Deferred revenue                                                                                                                                                     |              | 7,792           
|Current portion of capital lease                                                                                                                                     |              | 46              
|Total current liabilities                                                                                                                                            |              | 27,175          
|Long-term restructuring accrual                                                                                                                                      |              | 37,782          
|Other long-term liabilities                                                                                                                                          |              | 21              
|Total liabilities                                                                                                                                                    |              | 64,978          
|Commitments (Note 8)                                                                                                                                                 |              |                 
|Stockholders Equity                                                                                                                                                 |              |                 
|Common stock, $0.001 par value, 250,000 shares authorized;           
    34,488,526 shares and 34,182,244 shares issued and outstanding,   
           respectively |              | 34              
|Additional paid-in capital                                                                                                                                           |              | 328,712         
|Deferred stock compensation                                                                                                                                          |              | (48)            
|Accumulated other comprehensive income                                                                                                                               |              | 275             
|Accumulated deficit                                                                                                                                                  |              | (245,838)       
|Total stockholders equity                                                                                                                                           |              | 83,135          
|Total liabilities and stockholders equity                                                                                                                           |              | $   148,113     

The accompanying notes are an
integral part of these condensed consolidated financial statements.

1

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# NUANCE COMMUNICATIONS,
INC. & SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS 
(IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)

|                                                            | Three Months Ended | Six Months Ended
|----------------------------------------------------------- | ------------------ | ----------------
|                                                            |                    |                 
|                                                            |                    |                 
|Revenue:                                                    |                    |                 
|License                                                     |                    |                 
|Service                                                     |                    |                 
|Maintenance                                                 |                    |                 
|                                                            |                    |                 
|Total revenue                                               |                    |                 
|                                                            |                    |                 
|Cost of revenue:                                            |                    |                 
|License                                                     |                    |                 
|Service (1)                                                 |                    |                 
|Maintenance (1)                                             |                    |                 
|                                                            |                    |                 
|Total cost of revenue                                       |                    |                 
|                                                            |                    |                 
|Gross profit                                                |                    |                 
|                                                            |                    |                 
|Operating expenses:                                         |                    |                 
|Sales and marketing (1)                                     |                    |                 
|Research and development (1)                                |                    |                 
|General and administrative (1)                              |                    |                 
|Non-cash compensation expense (benefits)                    |                    |                 
|Restructuring charges (credits)                             |                    |                 
|Total operating expenses                                    |                    |                 
|Loss from operations                                        |                    |                 
|Interest and other income, net                              |                    |                 
|                                                            |                    |                 
|Loss before income taxes                                    |                    |                 
|Benefit from income taxes                                   |                    |                 
|                                                            |                    |                 
|Net loss                                                    |                    |                 
|                                                            |                    |                 
|Basic and diluted net loss per share                        |                    |                 
|Shares used to compute basic and diluted net loss per share |                    |                 
|(1) Excludes non-cash stock-based compensation as follows:  |                    |                 
|Service and maintenance cost of revenue                     |                    |                 
|Sales and marketing                                         |                    |                 
|Research and development                                    |                    |                 
|General and administrative                                  |                    |                 
|Total non-cash stock-based compensation                     |                    |                 

The accompanying notes are an
integral part of these consolidated financial statements.

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# NUANCE COMMUNICATIONS
INC. & SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)  (UNAUDITED)

|                                                                          | Six Months Ended
|------------------------------------------------------------------------- | ----------------
|                                                                          | June 30,        
|                                                                          | 2003            
|Cash flows from operating activities:                                     |                 
|Net loss                                                                  |                 
|Adjustments to reconcile net loss to net cash used in operating activites |                 
|Depreciation and amortization                                             |                 
|Non-cash stock-based compensation expense (benefit)                       |                 
|Provision for doubtful accounts                                           |                 
|Changes in operating assets and liabilities:                              |                 
|Accounts receivable                                                       |                 
|Prepaid expenses, other current assets and other assets                   |                 
|Accounts payable                                                          |                 
|Accrued liabilities                                                       |                 
|Restructuring accrual                                                     |                 
|Deferred revenue                                                          |                 
|Net cash used in operating activities                                     |                 
|Cash flows from investing activities:                                     |                 
|Purchase of investments                                                   |                 
|Maturities of investments                                                 |                 
|Purchase of property and equipment                                        |                 
|Increase in restricted cash                                               |                 
|Net cash used in investing activities                                     |                 
|Cash flows from financing activities:                                     |                 
|Repurchase of common stok                                                 |                 
|Issuance of common stock                                                  |                 
|Proceeds from exercise of stock options                                   |                 
|Proceeds from employee stock purchase plan                                |                 
|Net cash provided by financing activities                                 |                 
|Effect of exchange rate fluctuations on cash and cash equivalent          |                 
|Net decrease in cash and cash equivalents                                 |                 
|Cash and cash equivalents, beginning of period                            |                 
|Cash and cash equivalents, end of period                                  |                 
|Suplementary disclosures of cash flow information:                        |                 
|Cash paid during the priod for:                                           |                 
|Interest                                                                  |                 
|Income taxes                                                              |                 
|Suplementary disclosures of non-cash transactions:                        |                 
|Unrealized gain (loss) on available-for-sale securities                   |                 
|Issuance of escrow shares                                                 |                 

The accompanying notes are an
integral part of these condensed consolidated financial statements.

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# NUANCE COMMUNICATIONS,
INC. & SUBSIDIARIES   NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                                            (UNAUDITED)

# 1.     ORGANIZATION
AND OPERATIONS

Nuance Communications, Inc. (the
Company) was incorporated on July 15, 1994 in the State of California, and
subsequently reincorporated in March 2000 in the State of Delaware to develop, market and
support software that enables enterprises and telecommunications carriers to automate the
delivery of information and services over the telephone. The Companys software
platform consists of software servers that run on industry-standard hardware and perform
speech recognition, natural language understanding and voice authentication. The Company
sells its products through a combination of resellers, original equipment manufacturers,
system integrators and directly to end users.

# 2.     SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES

Reclassification

Amounts in the condensed consolidated
financial statements for the periods ended June 30, 2002 have been reclassified to conform
to the current periods presentation.

Basis of Presentation

The unaudited condensed consolidated
financial statements have been prepared by the Company in accordance with instructions to
Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures
normally included in annual financial statements prepared under accounting principles
generally accepted in the United States of America have been condensed or omitted pursuant
to these instructions and regulations. In the opinion of management, the financial
statements reflect all adjustments, consisting only of normal recurring adjustments
considered necessary for a fair presentation of the consolidated financial position as of
June 30, 2003 and December 31, 2002, the results of operations for the three and six
months ended June 30, 2003 and 2002 and cash flow for the six months ended June 30, 2003
and 2002. The results for the periods presented are not necessarily indicative of the
results to be expected for the full year or for any future periods. The accompanying
condensed consolidated financial statements should be read in conjunction with the audited
consolidated financial statements contained in the Companys Form 10-K filed with the
Securities and Exchange Commission on March 31, 2003.

Principles of
Consolidation

The condensed consolidated financial statements
include the accounts of the Company and its subsidiaries. All significant inter-company
transactions and balances have been eliminated.

Use of Estimates

The preparation of the consolidated
financial statements in conformity with accounting principles generally accepted in the
United States of America requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities, the disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the reported amounts
of revenue and expenses during the reporting period. Such estimates include, but are not
limited to: allowance for doubtful accounts, restructuring accrual, income taxes,
contingencies and percentage of completion estimates of certain revenue contracts. Actual
results could differ from those estimates.

Cash and Cash Equivalents

The Company considers all highly
liquid investments with maturity of three months or less, when purchased, to be cash
equivalents. Cash and cash equivalents consist of money market accounts, certificates of
deposit and deposits with banks. Cash and cash equivalents are recorded at cost which
approximates fair value.

Investments

The Companys investments are
comprised of U.S. Treasury notes, U.S. Government agency bonds, corporate bonds and
commercial paper. Investments with maturities of less than one year are considered to be
short-term. All investments are held in the Companys name at major financial
institutions. As of June 30, 2003, all of the Companys investments are classified as
available-for-sale and carried at fair value, which is determined based on quoted market
prices, with net unrealized gain or loss included in Accumulated other comprehensive
income in the accompanying condensed consolidated balance sheets.

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Property and Equipment

Property and equipment are stated at
cost and are depreciated using the straight-line method over the estimated useful lives of
the assets as follows:

| | Computer equipment and software | 2-3 years                                     
| | ------------------------------- | ----------------------------------------------
| | Furniture and fixtures          | 5 years                                       
| | Leasehold improvements          | Shorter of lease term or estimated useful life

Restricted Cash

The restricted cash represents
investments in certificates of deposit and interest thereon. The restricted cash secures
letters of credit required by landlords to meet rent deposit requirements for certain
leased facilities.

Goodwill and Intangible Assets

Intangible assets are carried at cost
less accumulated amortization. Amortization is computed using the straight-line method
over the estimated lives of the respective assets, generally 18 months to five years. The
Company adopted Statement of Financial Accounting Standards (SFAS) No.142,
Goodwill and Intangible Assets beginning on January 1, 2002. As of that date,
goodwill and intangible assets with indefinite lives are not amortized but are tested for
impairment annually using a fair value approach, or whenever there is an impairment
indicator; other intangible assets are valued and amortized over their estimated lives.
Goodwill is not subject to amortization. At June 30, 2003 and December 31, 2002, the
Company had no goodwill.

Impairment of Long-lived Assets

The Company continually monitors
events and changes in circumstances that could indicate carrying amounts of the long-lived
assets, including intangible assets, may not be recoverable. When such events or changes
in circumstances occur, the Company assesses the recoverability of long-lived assets by
determining whether the carrying value of such assets will be recovered through
undiscounted expected future cash flow. If the total of the future undiscounted net cash
flow is less than the carrying amount of these assets, the Company recognizes an
impairment loss based on the excess of the carrying amount over the fair value of the
assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets.

Revenue Recognition

Revenues are generated from licenses,
services and maintenance. All revenues generated from our worldwide operations are
reviewed at our corporate headquarters, located in the United States. The Company applies
the provisions of Statement of Position (SOP) 97-2, Software Revenue
Recognition, as amended by SOP 98-9 Modification of SOP 97-2, Software Revenue
Recognition, With Respect to Certain Transactions to all transactions involving the
sale of software products. The Company also recognizes some revenue based on SOP 81-1
Accounting for Performance of Construction-Type and Certain Production-Type
Contracts.

The Companys license revenue
consists of license fees for the software products. The license fees for the
Companys software products are calculated using two variables, one of which is the
estimated maximum number of simultaneous end-user connections or ports to an
application running on our software and the other of which is the value attributed to the
functional use of the software.

For licensed products requiring
significant customization, we generally recognize license revenue using the
percentage-of-completion method of accounting over the period that services are performed.
For all license and service agreements accounted for under the percentage-of-completion
method, we determine progress to completion based on actual direct labor hours incurred to
date as a percentage of the estimated total direct labor hours required to complete the
project. We periodically evaluate the actual status of each project to ensure that the
estimates to complete each contract remain accurate. A provision for estimated losses on
contracts is made in the period in which the loss becomes probable and can be reasonably
estimated. To date, these losses have not been significant. Costs incurred in advance of
billings are recorded as costs in excess of related billings on uncompleted contracts. If
the amount of revenue recognized exceeds the amounts billed to customers, the excess
amount is recorded as unbilled accounts receivable. If the amount billed exceeds the
amount of revenue recognized, the excess amount is recorded as deferred revenue. Revenue
recognized in any period is dependent on our progress toward completion of projects in
progress. Significant management judgment and discretion are used to estimate total direct
labor hours. Any changes in or deviation from these estimates could have a material effect
on the amount of revenue we recognize in any period.

For licensed products which do not
require significant customization of components, the Company recognizes revenue from the
sale of software licenses when:

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|. | persuasive evidence of an arrangement exists;                          
|- | -----------------------------------------------------------------------
|  |                                                                        
|. | the software and corresponding authorization codes have been delivered;
|  |                                                                        
|. | the fee is fixed and determinable;                                     
|  |                                                                        
|. | collection of the resulting receivable is probable.                    

The Company uses a signed contract
and purchase order or royalty report as evidence of an arrangement for license orders.

Products delivered with acceptance criteria
or return rights are not recognized as revenue until all criteria are achieved. If
undelivered products or services exist that are essential to the functionality of the
delivered product in an arrangement, delivery is not considered to have occurred. Delivery
is accomplished through electronic distribution of the authorization codes or
keys. The software was previously delivered to the customer either
electronically or on a CD-ROM. Occasionally the customer will require that we secure their
acceptance of the system in addition to the delivery of the keys. Such acceptance, when
required, typically consists of a demonstration to the customer that, upon implementation,
the software performs in accordance with specified system parameters, such as recognition
accuracy or task completion rates. In absence of such acceptance, the Company will defer
revenue recognition until signed acceptance is obtained.

The Company assesses whether the fee
is fixed and determinable based on the payment terms associated with the transaction. The
Company assesses collectibility of the transaction based on a number of factors, including
the customers past payment history and its current financial position. If the
Company determines that collection of a fee is not probable, the Company defers
recognition of the revenue until the time collection becomes reasonably assured, which is
generally upon receipt of the cash payment.

The Company uses the residual method
to recognize revenue when a license agreement includes one or more elements to be
delivered at a future date if vendor specific objective evidence of the fair value of all
undelivered elements exists. Vendor-specific objective evidence of fair value is based on
the price generally charged when the element is sold separately, or if not yet sold
separately, is established by authorized management. In situations where vendor-specific
objective evidence of fair value for an undelivered elements does not exist, the entire
amount of revenue from the arrangement is deferred and recognized when vender-specific
objective evidence of fair value can be established for all undelivered elements or when
all such elements are delivered. In situations where the only undelivered element is
maintenance and vendor specific objective evidence of fair value for maintenance does not
exist, the entire amount of revenue from the arrangement is recognized ratably over the
maintenance period. As a general rule, license revenue from resellers is recognized when
product has been sold through to an end user and such sell-through has been reported to
the Company. However, certain reseller agreements include time-based provisions by which
the Company recognizes revenue, in these instances, there is no right of returns possible.

The timing of license revenue
recognition is affected by whether the Company performs consulting services in the
arrangement and the nature of those services. In the majority of cases, the Company either
performs no consulting services or the Company performs services that are not essential to
the functionality of the software. When the Company performs consulting and implementation
services that are essential to the functionality of the software, the Company recognizes
both license and consulting revenue utilizing contract accounting based on the percentage
of the consulting services that have been completed. This calculation is done in
conformity with SOP 81-1, however judgment is required in determining the percentage of
the project that has been completed. Such contracts were significant for the three and six
months ended June 30, 2003 and 2002, respectively. The Company has also explored the
markets for complete speech solutions and delivering through combined product and
services, where the Company is required to use the contract accounting based upon
percentage of completion. This method of accounting is subject to certain judgments by the
Company regarding amount of revenue allocated to percentage of work completed. Typically,
the Company would recognize revenue based upon the proportional level of effort expended,
combined with the value of the technology delivered, to complete certain milestones
defined in the customer contract or statement of work.

Service revenue consists of revenue
from providing implementation, consulting, training and other revenue. Other revenue
consists primarily of reimbursements for consulting out-of-pocket expenses incurred, in
accordance with the Emerging Issues Task Force (EITF) Issue No. 01-14,
Income Statement Characterization of Reimbursements Received for
Out-of-Pocket Expenses Incurred. For services revenue, we generally
require a signed contract, statement of work and purchase order prior to recognizing any
services revenue. The Companys consulting service contracts are bid either on a
fixed-fee basis or on a time-and-materials basis. For a fixed-fee contract, the Company
recognizes revenue using the percentage of completion method. For time-and-materials
contracts, the Company recognizes revenue as services are performed. Training service
revenue is recognized as services are performed. Losses on service contracts, if any, are
recognized as soon as such losses become known.

Maintenance revenue consists of fees
for providing technical support and software upgrades and updates. The Company generally
requires a signed contract and purchase order prior to recognizing any maintenance
revenue. The Company recognizes all maintenance revenue ratably over the contract term.
Customers have the option to purchase or decline maintenance agreements at the time of the
license purchase. If maintenance is declined, a reinstatement fee is generally required
when the customer decides to later activate maintenance. Customers generally have the
option to renew or decline maintenance agreements annually during the contract term.

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The Companys standard payment
terms are net 30 to 90 days from the date of invoice. Thus, a significant portion of our
accounts receivable balance at the end of a quarter is primarily comprised of revenue from
that quarter.

The Company records deferred revenue
primarily as a result of payments from customers received in advance of recognition of
revenue. As of June 30, 2003 and December 31, 2002, deferred revenue was $7.8 million and
$9.0 million, respectively. The deferred revenue amount includes unearned license fees,
which will be recognized as revenue when the appropriate criteria have been met, prepaid
maintenance and prepaid or unearned professional services that will be recognized as
revenue as the services are performed, or in some cases, when an identified time period
has expired and the customer or resellers right to certain licenses has been
forfeited.

Cost of license revenue consists
primarily of license fees payable on third-party software products, amortization of
software costs, documentation and media costs. Cost of service revenue consists of
compensation and related overhead costs for employees or third parties engaged in
consulting and training. Cost of maintenance revenue consists of compensation and related
overhead costs for employees engaged in technical support.

Foreign Currency Translation

The functional currency of the
Companys foreign subsidiaries is deemed to be the local countrys currency.
Consequently, assets and liabilities recorded in foreign currencies are translated at
period-end exchange rates; revenues and expenses are translated at average exchange rates
during the period. The effects of foreign currency translation adjustments are included in
stockholders equity as a component of Accumulated other comprehensive
income in the accompanying condensed consolidated balance sheets. The effects of
foreign currency transactions are included in Interest and other income, net
in the accompanying condensed consolidated statements of operations.

Accumulated Other Comprehensive Income

Comprehensive income includes net
loss and all non-owner changes to stockholders equity, which for the Company, is
foreign currency translation and changes in unrealized gains and losses on investments. As
of June 30, 2003 and December 31, 2002, the cumulative foreign currency translation
gain (loss) is $190,000 and $(159,000), net of taxes $112,000 and $(93,000), respectively.
As of June 30, 2003 and December 31, 2002, the cumulative unrealized gains on investments
are $85,000 and $176,000, net of taxes $50,000 and $103,000, respectively. As of June 30,
2003 and December 31, 2002, the total cumulative other comprehensive income are
$275,000 and $17,000. For the three and six months ended June 30, 2003, the total
comprehensive losses are $2.5 million and $6.7 million, respectively. For the three and
six months ended June 30, 2002, the total comprehensive losses are $9.2 million and $19.9
million, respectively.

Stock-Based Compensation

The Company accounts for stock-based
compensation in accordance with the provisions of APB No. 25, Accounting for Stock
Issued to Employees, and comply with the disclosure provisions of SFAS No. 123
as amended by SFAS No.148, Accounting for Stock-Based Compensation 
Transition and Disclosures. Deferred compensation recognized under APB No. 25 is
amortized to expense using the graded vesting method. The Company adopted the disclosure-only
provisions of SFAS No.123 and No.148, and accordingly, no expense has been recognized
for options granted to employees under the various Plans. The Company amortizes deferred stock-based
compensation on the graded vesting method over the vesting periods of the applicable stock
purchase rights and stock options, generally four years. The graded vesting method
provides for vesting of portions of the overall awards at interim dates and results in
greater vesting in earlier years than the straight-line method. Had compensation expense
been determined based on the fair value at the grant date for awards, consistent with the
provisions of SFAS 123, the Companys pro forma net loss and net loss per share
would be as follows (in thousands, except per share data):

|                                                                                                       | Three Months Ended | Six Months Ended
|------------------------------------------------------------------------------------------------------ | ------------------ | ----------------
|                                                                                                       |                    |                 
|                                                                                                       |                    |                 
|Net loss, as reported                                                                                  |                    |                 
|Add: Stock-based employee compensation expense (benefit)           included in net loss                |                    |                 
|Less: Total stock-based employee compensation expense under           fair value method for all awards |                    |                 
|Pro forma net loss                                                                                     |                    |                 
|Basic and diluted net loss per share - as reported                                                     |                    |                 
|Basic and diluted net loss per share - pro forma                                                       |                    |                 

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# 3.     RECENT
ACCOUNTING PRONOUNCEMENTS

On January 1, 2003, the Company
adopted SFAS No. 146, Accounting for Costs Associated with Exit or Disposal
Activities, (SFAS No. 146), which nullifies Emerging Issues Task
Force (EITF) 94-3,Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring) (EITF 94-3). SFAS No. 146 requires that a liability
be recognized for restructuring costs only when the liability is incurred, that is, when
it meets the definition of a liability in the Financial Accounting Standards Boards
(FASBs) conceptual framework. SFAS No. 146 also establishes fair
value as the objective for initial measurement of liabilities related to exit or disposal
activities and is effective for exit or disposal activities that are initiated after
December 31, 2002. The adoption of SFAS No. 146 did not have a material impact
on our results of operations, financial position or cash flows.

On January 1, 2003, the Company
adopted Financial Interpretation 45, Guarantors Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others
(FIN 45). FIN 45 requires certain guarantees to be recorded at fair value
and requires a guarantor to make disclosures, even when the likelihood of making any
payments under the guarantee is remote. For those guarantees and indemnifications that do
not fall within initial recognition and measurement requirements of FIN 45, the
Company must continue to monitor the conditions that are subject to the guarantees and
indemnifications, as required under existing generally accepted accounting principles, to
identify if a loss has been incurred. If the Company determines that it is probable that a
loss has been incurred, any such estimable loss would be recognized. The initial
recognition and measurement requirements do not apply to the Companys product
warranties or to the provisions contained in the majority of the Companys software
license agreements that indemnify licensees of the Companys software from damages
and costs resulting from claims alleging that the Companys software infringes the
intellectual property rights of a third party. The Company has provided disclosures as
required by FIN 45 in Note 6 to its condensed consolidated financial statements. The
adoption of the liability recognition provisions did not have a material impact on its
financial position or results of operations.

In December 2002, the FASB issued
SFAS 148, Accounting for Stock-Based Compensation  Transition and
Disclosure, an amendment to FASB Statement 123. SFAS 148 provides alternative
methods of transition for a voluntary change to the fair value based method of accounting
of stock-based employee compensation. In addition, SFAS 148 amends the disclosure
requirements of SFAS 123, Accounting for Stock-Based Compensation, to
require prominent disclosures in both annual and interim financial statements about the
method of accounting for stock-based employee compensation and the effect of the method
used on reported results. The Company adopted the disclosure provisions of SFAS 148
effective for the year ended December 31, 2002.

In January 2003, the EITF published
EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables, (EITF
00-21), which requires companies to determine whether an arrangement involving
multiple deliverables contains more than one unit of accounting. In applying EITF 00-21,
revenue arrangements with multiple deliverables should be divided into separate units of
accounting if the deliverables in the arrangement meet certain criteria. Arrangement
consideration should be allocated among the separate units of accounting based on their
relative fair values. This issue is effective for revenue arrangements entered into in
fiscal periods beginning after June 15, 2003. The Company adopted EITF 00-21 on July 1, 2003
and adoption of EITF 00-21 did not have any material impact to our consolidated financial
position, results of operations or cash flows.

In January 2003, the FASB issued
Interpretation 46, Consolidation of Variable Interest Entities. In general, a
variable interest entity is a corporation, partnership, trust, or any other legal
structure used for business purposes that either (a) does not have equity investors with
voting rights or (b) has equity investors that do not provide sufficient financial
resources for the entity to support its activities. Interpretation 46 requires a variable
interest entity to be consolidated by a company if that company is subject to a majority
of the risk of loss from the variable interest entitys activities or entitled to
receive a majority of the entitys residual returns or both. The consolidation
requirements of Interpretation 46 apply immediately to variable interest entities created
after January 31, 2003. The consolidation requirements apply to older entities in the
first fiscal year or interim period beginning after June 15, 2003. Certain of the
disclosure requirements apply in all financial statements issued after January 31, 2003,
regardless of when the variable interest entity was established. The Company does not
believe the adoption of the Interpretation will have a material impact on its financial
statements.

# 4.     NET LOSS PER SHARE

Net loss per share is calculated
under SFAS No. 128, Earnings Per Share. Basic net loss per share is computed
using the weighted average number of shares of common stock outstanding. Diluted net loss
per share is equal to basic net loss per share for all periods

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presented since potential
common shares from stock options and warrants are anti-dilutive due to the reported net
loss. Shares subject to repurchase resulting from early exercises of options that have not
vested are excluded from the calculation of basic and diluted net loss per share. During
the three and six months ended June 30, 2003 and 2002, the Company had securities
outstanding which could potentially dilute basic earnings per share in the future, but
were excluded in the computation of diluted loss per share in such periods, as their
effect would have been anti-dilutive due to the net loss reported in such periods. The
total number of shares excluded from diluted net loss per share was 9,751,000 shares and
9,394,000 shares, respectively, for the three months and six months ended June 30, 2003.
The total number of shares excluded from diluted net loss per share was 6,216,000 shares
and 6,920,000 shares, respectively, for the three months and six months ended June 30,
2002.

The following table presents the
calculation of basic and diluted net loss per share (in thousands, except per share data):

|                                                                             | Three Months Ended | Six Months Ended
|---------------------------------------------------------------------------- | ------------------ | ----------------
|                                                                             |                    |                 
|                                                                             |                    |                 
|Net loss                                                                     |                    |                 
|                                                                             |                    |                 
|Basic and diluted shares:                                                    |                    |                 
|Weighted average shares of common stock outstanding                          |                    |                 
|Less: weighted average shares of common stock
subject to repurchase          |                    |                 
|Weighted average shares used to compute basic and diluted net loss per share |                    |                 
|Basic and diluted net loss per share - as reported                           |                    |                 

# 5.     INTANGIBLE ASSETS

Information regarding the Companys intangible assets follows (in thousands):

|                     | As of June 30, 2003
|-------------------- | -------------------
|                     |                    
|Purchased Technology |                    
|Patents Purchased    |                    
|Total                |                    

|                     | As of December 31, 2002
|-------------------- | -----------------------
|                     |                        
|Purchased Technology |                        
|Patents Purchased    |                        
|Warrant - GM Onstar  |                        
|Total                |                        

Purchased technology and patents purchased are amortized to cost of license revenue.  In total, the Company amortized $169,000 and
$37,000 from the purchased technology and the patents purchased, respectively, for the six months ended June 30, 2003; The warrant
GM On-star was fully amortized as of December 31, 2002.

As of June 30, 2003, total estimated amortization of the purchased technology and the patent for each of the five fiscal years and
thereafter is as follows (in thousands):

|Year Ended December 31,   |   | Amortization Expense
|------------------------- | - | --------------------
|2003 (remaining 6 months) | $ | 207                 
|2004                      |   | 413                 
|2005                      |   | 413                 
|2006                      |   | 116                 
|2007                      |   | 50                  
|Total                     | $ | 1,199               

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# 6.     GUARANTEES

Guarantee

As of June 30, 2003, our financial
guarantee consists of standby letters of credit outstanding and it includes the restricted
cash requirement collateralizing our lease obligation. The maximum amount of potential
future payment under the arrangement at June 30, 2003 was $10.9 million. Related to this
maximum exposure, $10.9 million with its interest totaling $12.5 million was presented as
Restricted cash on our balance sheet at June 30, 2003.

Warranty

The Company does not maintain a
general warranty reserve for estimated costs of product warranties at the time revenue is
recognized due to the effectiveness of our extensive product quality program and
processes.

Indemnifications to customers

The Company defends and indemnifies its customers
for damages and reasonable costs incurred in any suit or claim brought against them
alleging that our products sold to our customers infringe any U.S. patent, copyright,
trade secret or similar right. If a product becomes the subject of an infringement claim,
we may, at our option: (i) replace the product with another non-infringing product
that provides substantially similar performance; (ii) modify the infringing product
so that it no longer infringes but remains functionally equivalent; (iii) obtain the
right for the customer to continue using the product at our expense and for the reseller
to continue selling the product; (iv) take back the infringing product and refund to
customer the purchase price paid less depreciation amortized on a straight line basis. The Company
has not been required to make material payments pursuant to these provisions
historically. The Company has not identified any losses that are probable under these provisions
and, accordingly, the Company has not recorded a liability related to these indemnification
provisions.

Indemnifications to Officers and Directors

Our corporate by-laws require that we
indemnify our officers and directors, as well as those who act as directors and officers
of other entities at our request, against expenses, judgments, fines, settlements and
other amounts actually and reasonably incurred in connection with any proceedings arising
out of their services to Nuance. In addition, we have entered into separate
indemnification agreements with each director and each board-appointed officer of Nuance
which provides for indemnification of these directors and officers under similar
circumstances and under additional circumstances. The indemnification obligations are more
fully described in the by-laws and the indemnification agreements. We purchase insurance
to cover claims or a portion of the claims made against our directors and officers. Since
a maximum obligation is not explicitly stated in our by-laws or in our indemnification
agreements and will depend on the facts and circumstances that arise out of any future
claims, the overall maximum amount of the obligations cannot be reasonably estimated.
Historically, we have not made payments related to these obligations, and the estimated
fair value for these obligations is zero on the balance sheet as of June 30, 2003.

Other Indemnifications

As is customary in our industry and
as provided for in local law in the U.S. and other jurisdictions, many of our standard
contracts provide remedies to others with whom we enter into contracts, such as defense,
settlement, or payment of judgment for intellectual property claims related to the use of
our products. From time to time, we indemnify our suppliers, contractors, lessors, lessees
and others with whom we enter into contracts, against combinations of loss, expense, or
liability arising from various trigger events related to the sale and the use of our
products and services, the use of their goods and services, the use of facilities, the
state of the assets and businesses that we sell and other matters covered by such
contracts, usually up to a specified maximum amount. In addition, from time to time we
also provide protection to these parties against claims related to undiscovered
liabilities, additional product liability or environmental obligations. In our experience,
claims made under such indemnifications are rare and the associated estimated fair value
of the liability is not material.

# 7.     RESTRUCTURING

Fiscal Year 2001

In April 2001, with Board of
Directors approval, the Company implemented a restructure plan to align our expenses with
revised anticipated demand and create a more efficient organization. In connection with
the restructuring plan, the Company recorded a restructuring charge of $34.1 million for
lease loss and severance costs and an asset impairment charge of $20.9 million on tenant
improvements during the quarter ended June 30, 2001. The Company decreased the asset
impairment charge by $0.5 million in the quarter ended December 31, 2001.

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In connection with the restructuring
plan, the Company decided not to occupy a new leased facility. This decision has resulted
in a lease loss of $32.6 million for the year ended December 31, 2001, comprised of a
sublease loss, broker commissions and other facility costs. To determine the sublease
loss, the loss after the Companys cost recovery efforts from subleasing the
building, certain assumptions were made related to the (1) time period over which the
building will remain vacant (2) sublease terms and (3) sublease rates. The Company
established the reserves at the low end of the range of estimable cost against outstanding
commitments, net of estimated future sublease income. These estimates were derived using
the guidance provided in SAB No. 100, Restructuring and Impairment Charges,
and EITF No. 94-3, Liability Recognition for Certain Employee Termination Benefits
and Other Costs to Exit an Activity (Including Certain Costs Incurred in a
Restructuring)". The lease loss was increased in August 2002 as described below and
will continue to be adjusted in the future upon triggering events (change in estimate of
time to sublease, actual sublease rates, etc.). The Company recorded $1.5 million in costs
for the year ended December 31, 2001 associated with severance and related benefits. The
Company reduced headcount by approximately 80 employees, with reductions ranging between
10% and 20% across all functional areas and affecting several locations.

Fiscal Year 2002

In January 2002, with Board of
Directors approval, the Company implemented a restructuring plan to reduce the
Companys workforce by approximately 8%, or 33 employees. The restructuring was
primarily to realign the sales and professional services organizations. The Company
recorded a restructuring charge of $1.3 million for the three months ended March 31, 2002,
consisting primarily of payroll and related expenses associated with reducing headcount.
This amount was paid out as of December 31, 2002.

In August 2002, with Board of
Directors approval, the Company implemented a restructuring plan to reduce the
Companys worldwide workforce by approximately 21%, or 81 employees, to realign the
Companys expense structure with near term market opportunities. In connection with
the reduction of workforce, the Company recorded a charge of $2.6 million primarily for
severance and related employee termination costs. As of December 31, 2002, approximately
$1.9 million of this amount was paid out, with the remainder to be paid by the end of
third quarter 2003. The plan also included the consolidation of facilities through the
closing of certain international offices that resulted in a charge of $1.6 million. In
addition, the Company recorded an increase in the Companys previously reported real
estate restructuring accrual related to the new leased facility the Company does not
occupy and which has not been subleased as a result of continued declines in local
sub-lease rates in San Mateo County, California. This additional charge of $31.8 million
was resulted from an analysis of the time period by which the San Mateo property will
remain vacant, sub-lease terms and sub-lease rates, altogether reflecting continued
softening of the local real estate market.

The restructuring charges and quarter
end balances for the quarter ended June 30, 2003 are as follows (in thousands):

|                                                     | Lease Loss | Severance & Related | Asset Write Down | Total Restructuring
|---------------------------------------------------- | ---------- | ------------------- | ---------------- | -------------------
|2001 Plan                                            |            |                     |                  |                    
|Total charges for the year ending December 31, 2001  |            |                     | $                | 32,615             
|Amount utilized in the year ending December 31, 2001 |            |                     |                  | (3,572             
|Accrual balance at December 31, 2001                 |            |                     | $                | 29,043             
|Total charges for the year ending December 31, 2002  |            |                     | $                | 31,829             
|Amount utilized in the year ended December 31, 2002  |            |                     |                  | (9,342             
|Balance at December 31, 2002                         |            |                     | $                | 51,530             
|Total charges for
the quarter ended March 31, 2003   |            |                     | $                | --                 
|Amount utilized
in the quarter ended March 31, 2003  |            |                     |                  | (2,320             
|Balance at March 31, 2003                            |            |                     | $                | 49,210             
|Total charges for
the quarter ended June 30, 2003    |            |                     | $                | --                 
|Amount utilized
in the quarter ended June 30, 2003   |            |                     |                  | (2,416             
|Balance at June 30, 2003                             |            |                     | $                | 46,794             
|Current restructuring accrual                        |            |                     | $                | 9,012              
|Long-term restructuring accrual                      |            |                     | $                | 37,782             
|Q1 2002 Plan                                         |            |                     |                  |                    
|Total charges for the year ending December 31, 2002  |            |                     | $                | --                 
|Amount utilized in the year ending December 31, 2002 |            |                     |                  | --                 
|Balance at December 31, 2002                         |            |                     |                  | --                 
|Current restructuring accrual                        |            |                     |                  | --                 
|Long-term restructuring accrual                      |            |                     | $                | --                 
|Q3 2002 Plan                                         |            |                     |                  |                    
|Total charges for the year ending December 31, 2002  |            |                     | $                | 1,560              
|Amount utilized in the year ending December 31, 2002 |            |                     |                  | (1,046             
|Balance at December 31, 2002                         |            |                     |                  | 514                
|Total charges for the quarter ended March 31, 2003   |            |                     | $                | --                 
|Amount utilized in the quarter ended March 31, 2003  |            |                     |                  | (361               
|Balance at March 31, 2003                            |            |                     |                  | 153                
|Total charges for the quarter ended June 30, 2003    |            |                     | $                | --                 
|Amount utilized in the quarter ended June 30, 2003   |            |                     |                  | (36                
|Balance at June 30, 2003                             |            |                     | $                | 117                
|Current restructuring accrual                        |            |                     | $                | 117                
|Long-term restructuring accrual                      |            |                     | $                | --                 
|Balance at June 30, 2003 (All restructuring plans)   |            |                     |                  |                    
|Total restructuring accrual: Current                 |            |                     | $                | 9,129              
|Total restructuring accrual: Long-term               |            |                     | $                | 37,782             

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The Company expects the total cash outlay for the restructuring  plans to be $71.4 million,  of which $24.0 million was paid through
June 30, 2003 and $47.4  million  remains  accrued at June 30, 2003.  The Company  expects $9.1 million of the lease loss to be paid
out over the next twelve months and remaining  $37.8 million to be paid out over the remaining life of the lease of  approximately 9
years.  The  Company  expects the  remaining  $0.4  million of employee  severance  and related  benefits  accrual to be paid out by
September 30, 2003.

In February 2003, the Company  received cash and recorded an asset  impairment  credit of $0.9 million related to a refund of tenant
improvement  costs for the building the Company does not occupy,  following  the  landlord's  reconciliation  of tenant  improvement
costs. This credit was recorded on the Restructuring Charges (Credits) line of the Condensed  Consolidated  Statements of Operation,
where the original asset impairment charge of $20.4 million was recognized for the year ended December 31, 2001.

# 8.     COMMITMENTS

Operating leases

The Company leases its facilities  under  non-cancelable  operating  leases with various  expiration  dates through July 2012. As of
June 30, 2003,  future  minimum  lease  payments  under these  agreements  (excluding  sublease  income),  including  the  Company's
unoccupied facilities lease and lease loss portion of the restructuring charges, are as follows (in thousands):

|Year Ended December 31,             |   | Operating leases
|----------------------------------- | - | ----------------
|2003 (remaining 6 months)           | $ | 4,876           
|2004                                |   | 9,142           
|2005                                |   | 8,319           
|2006                                |   | 8,610           
|2007                                |   | 8,871           
|Thereafter                          |   | 43,774          
|Total future minimum lease payments | $ | 83,592          

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In May 2000, the Company entered into a lease for a new headquarters facility. The lease has
an eleven-year term, which began in August 2001, and provides for monthly rent payments
starting at approximately $600,000. An $11.0 million certificate of deposit secures a
letter of credit required by the landlord for a rent deposit. In conjunction with the
April 2001 and August 2002 restructuring plans, the Company decided not to occupy this new
leased facility, as well as close certain international offices and have recorded a lease
loss of $65.8 million related to future lease commitments, net of expected sublease
income. The future minimum lease payments table referenced above does not include
estimated sublease income as there are no sublease commitments.

Capital leases

In June 2002, the Companys
Canadian subsidiary entered into a lease for certain equipment for approximately $138,000,
which is accounted for as a capital lease. This lease bears interest at a rate of 11.2%,
and expires in August 2004. Future minimum lease payments under the agreement, as of June
30, 2003, are as follows (in thousands):

|Year Ended December 31,                    |   | Capital leases
|------------------------------------------ | - | --------------
|2003 (remaining 6 months)                  | $ | 25            
|2004                                       |   | 33            
|Total minimum lease payments               | $ | 58            
|Amount representing interst (11.2%)        |   | (4)           
|Present value of minimum lease payments    | $ | 54            
|Current portion of long-term capital lease |   | (46)          
|Long-term portion                          | $ | 8             

# 9.     LITIGATION

On January 16, 2001, Nuance filed an
opposition proceeding in the European community against a Community Trade Mark application
for NUANCE, owned by Nuance Global Traders, Ltd. The opposition is still pending. The
parties have agreed upon a settlement which will become final upon, among other things,
completion of final settlement documents.

Beginning in March 2001, a number of
putative shareholder class actions were filed against the Company and certain of its
present and former officers and directors in the United States District Court for the
Northern District of California (the Federal Actions). The actions have been
consolidated as In re Nuance Communications Inc. Securities Litigation, Master File No.
C-01-20320-JW. Lead plaintiffs were appointed and a consolidated complaint was filed on
behalf of a purported class of persons who purchased the Companys stock during the
period January 31, 2001 through March 15, 2001, alleging false and misleading statements
and insider trading in violation of the federal securities laws, specifically Section
10(b), 20(a) and 20A of the Securities Exchange Act of 1934, and seek unspecified damages.
In April 2003, the court granted in part and denied in part defendants most recent
motion to dismiss. No trial date has been set. The parties have reached an agreement to
settle this litigation which settlement will become final upon, among other things,
completion of formal settlement papers, and final approval by the Court. The settlement is
to be covered by the Companys insurance policies. In the event that final settlement
does not occur, and litigation against the Company continues, the Company
believes it has meritorious defenses and intends to defend the case vigorously.

In May and June 2001, putative
shareholder derivative actions were filed in California Superior Court, San Mateo County,
against various of the Companys present and former officers and the Companys
directors (the Derivative Actions). The putative derivative complaints contain
allegations similar to the Federal Actions, and claim that the defendants engaged in
breaches of fiduciary duty and insider trading. The Company appears to be named as nominal
defendant, against whom no recovery is sought. All proceedings in the putative derivative
actions have been stayed by agreement of the parties. An agreement has been reached to
settle these actions, which settlement will become final upon, among other things,
completion of formal settlement papers and Court approval of the settlement.

In August 2001, the first of several
putative shareholder class actions were filed against various of the underwriters for the
Companys initial public offering (IPO), the Company and certain of its
present and former officers and directors in the United States District Court for the
Southern District of New York. Those complaints have been consolidated and a consolidated
amended complaint filed, captioned In re Nuance Communications Inc. Initial Public
Offering Sec. Litig., No. 01-CV-7344. The complaint generally alleges that various
investment bank underwriters engaged in improper activities related to the allocation of
shares in the Companys IPO, that were not disclosed in the registration statements
for the Companys IPO or secondary offerings. The consolidated action is part of a
larger coordinated proceeding, In re Initial Public Offering Securities Litigation, 21 MC
92, involving more than 40 underwriters and 250 issuers. In October 2002, the individual
defendants were dismissed from the action without prejudice pursuant to stipulation. In
February 2003, the court issued a ruling on an omnibus motion to dismiss filed by
defendants in the coordinated proceeding, denying the motion as to the claims against the
Company. No trial date has been set. A proposal has been made for the settlement and
release of claims against the issuer defendants in the case, including the Company.
The settlement is contingent upon a number of conditions, including completion of formal
settlement papers and approval of the Court. In the event that settlement does not occur,
and litigation against Nuance continues, the Company believes it has meritorious
defenses and intends to defend the case vigorously.

Should the respective settlements not
proceed as anticipated, an unfavorable resolution of these litigations could have a
material adverse effect on the Companys business, results of operations, or
financial condition.

# 10.     STOCK-BASED
COMPENSATION

The Company accounts for its
stock-based awards to employees using the intrinsic value method in accordance with APB
No. 25. Accordingly, the Company records deferred stock compensation equal to the
difference between the grant price and fair value of the Companys common stock on
the date of grant. In connection with the grant of stock options prior to our initial
public offering, the Company recorded deferred stock compensation of approximately $8.7
million within stockholders equity, representing the difference between the
estimated fair value of the common stock for accounting purposes and the option exercise
price of these options at the date of grant. This amount is presented as a reduction of
stockholders equity and is being amortized over the vesting period of the applicable
options in a manner consistent with FASB Interpretation No. 28.

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For the three and six months ended
June 30, 2003, the Company recorded amortization of deferred compensation of 57,000 and
$133,000. Also for the three and six months ended June 30, 2003, the Company reversed excess amortization of deferred stock compensation due to
termination of employees of ($145,000) and ($147,000), resulting in net benefit of deferred
compensation of ($88,000) and ($14,000), respectively, in the Compny's Condensed Consolidated Statements of
Operations. Also for the three and six months ended June 30, 2003, the Company reversed $38,000 and $39,000
of deferred stock compensation and additional paid-in-capital, representing unamortized deferred stock compensation relating to
forfeitures of stock options by terminated employees. For the three and six months ended June 30, 2002, the Company
recorded amortization of deferred stock compensation of $221,000 and $382,000
respectively, relating to approximately 3,152,000 stock options granted at a weighted
average exercise price of $8.58. For the six months ended June 30, 2002, the Company
reversed approximately $62,000

In connection with the SpeechFront
acquisition, the Company recorded deferred compensation expense of $97,000 and $387,000
for the three and six months ended June 30, 2002. SpeechFront related deferred
compensation was fully amortized as of December 31, 2002.

The Company expects to amortize
non-cash compensation of $40,000 in the remaining 6 months of 2003 and $8,000 in 2004.

# 11.     SHORT-TERM
INVESTMENTS

All our investments are classified as
available for sale at June 30, 2003 and December 31, 2002. Available-for-sale investments
with original maturities of greater than three months are classified as short-term
investments, as these investments generally consist of highly marketable securities that
are intended to be available to meet current cash requirements. Investment securities
classified as available-for-sale are reported at market value, and net unrealized gains or
losses are recorded in cumulative other comprehensive income (loss), a separate component
of stockholders equity, until realized. Realized gains and losses on non-equity
investments are computed based upon specific identification and are included in interest
income and other, net. For all periods presented, realized gains and losses on
available-for-sale investments were not material. Management evaluates investments on a
regular basis to determine if an other-than-temporary impairment has occurred.

Our investments in publicly held
companies are generally considered impaired when a decline in the fair value of an
investment as measured by quoted market prices is less than its carrying value, and such a
decline is not considered temporary. For the six months ended June 30, 2003 and year ended
December 31, 2002, the Company has incurred no such impairment.

# 12.     SEGMENT REPORTING

The Company has three operating
segments: licenses, services and maintenance. Revenue and cost of revenue for the segments
are identical to those presented on the accompanying condensed consolidated statements of
operations. The Company does not track expenses nor derive profit or loss based on these
segments. The Company also does not track assets by segments.

Sales of licenses, as well as
services and maintenance through June 30, 2003 occurred through resellers and direct sales
representatives located in the Companys headquarters in Menlo Park, California, and
in other locations. These sales were supported through the Menlo Park location. The
Company does not separately report costs by region internally.

Revenues are based on the country in
which the end-user is located. The following is a summary of license, service and
maintenance revenue by geographic region (in thousands):

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|                     | Three Months Ended | Six Months Ended
|-------------------- | ------------------ | ----------------
|                     |                    |                 
|                     |                    |                 
|License Revenue:     |                    |                 
|United States        |                    |                 
|Canada               |                    |                 
|Europe               |                    |                 
|Asia                 |                    |                 
|Australia            |                    |                 
|Latin America        |                    |                 
|Total                |                    |                 
|Service Revenue:     |                    |                 
|United States        |                    |                 
|Canada               |                    |                 
|Europe               |                    |                 
|Asia                 |                    |                 
|Australia            |                    |                 
|Latin America        |                    |                 
|Total                |                    |                 
|Maintenance Revenue: |                    |                 
|United States        |                    |                 
|Canada               |                    |                 
|Europe               |                    |                 
|Asia                 |                    |                 
|Australia            |                    |                 
|Latin America        |                    |                 
|Total                |                    |                 
|Total revenue:       |                    |                 
|United States        |                    |                 
|Canada               |                    |                 
|Europe               |                    |                 
|Asia                 |                    |                 
|Australia            |                    |                 
|Latin America        |                    |                 
|Total revenue        |                    |                 

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# ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

The following discussion should be
read in conjunction with the condensed consolidated financial statements and related notes
included elsewhere in this report. The results shown herein are not necessarily indicative
of the results to be expected for any future periods.

The section entitled
Managements Discussion and Analysis of Financial Condition and Results of
Operations set forth below contains forward-looking statements within the meaning of
Section 27A of the Securities Act and Section 21E of the Exchange Act, including but not
limited to our expectations for results during the current fiscal year, statements
regarding revenue and expense trends and cash positions, statements regarding our sales
and marketing, hiring activities, product development and our outlook for the Company, as
well as our expectations, beliefs, intentions or strategies regarding the future. Words
such as anticipates, expects, intends,
may, will, plans, believes,
seeks and estimates and other similar expressions are intended to
identify forward-looking statements. These statements are not guarantees of future
performance and actual actions or results may differ materially. These statements are
based on information available to us on the date hereof, and the Company assumes no
obligation to update any such forward-looking statements. These statements involve risks
and uncertainties and actual results could differ materially from those anticipated in
these forward-looking statements as a result of a number of factors, including, but not
limited to, those set forth in Company Risk Factors and elsewhere in this
Report on Form 10-Q and in other reports or documents filed by us from time to time with
the Securities and Exchange Commission. For example, see Company Risk
FactorsOur ability to accurately forecast our quarterly sales is limited, our costs
are relatively fixed in the short term and we expect our business to be affected by
seasonality. As a result, our quarterly operating results may fluctuate, We
are exposed to general economic conditions, which may continue to harm our business,
If we are unable to effectively manage our operations and resources in accordance
with market and economic conditions, our business could be harmed and Our products
can have a long sales and implementation cycle and, as a result, our quarterly operating
results may fluctuate and We depend upon resellers for a significant portion
of our sales. The loss of key resellers or a decline in resellers sales of our
products could limit our ability to sustain and grow revenue. The following
discussion should be read in conjunction with the condensed consolidated financial
statements and related notes included elsewhere in this report. The results shown herein
are not necessarily indicative of the results to be expected for the full year or any
future periods.

# OVERVIEW

We develop, market and support speech
software products for automating interactions over the telephone for a range of industries
and applications. Our products and services include: speech recognition software, which is
used to recognize what a person says, deliver responses and information and perform
transactions; text-to-speech synthesis software, which converts text, for example, from a
database, email or web page into an audio signal to deliver speech over the telephone;
voice authentication software, which is used to provide secure access to information by
verifying the identity claims of speakers by the unique qualities of their voices;
grammars, which define the dictionary of possible caller responses for use in
applications; and a standards-based software platform designed as a foundation for speech
application deployment and management. In June 2003, we added our Nuance Call Steering
application, a packaged application designed to accurately and cost-effectively route
phone calls to the correct customer care destinations. We plan to add additional
applications for key industries which, like Nuance Call Steering, will be designed to
leverage the features inherent in our engines and platform while reducing deployment time
and cost.

We seek to actively support both
emerging industry standards as well as proprietary development environments. Our software
is designed to work with Voice Extensible Markup Language (VoiceXML), the
recognized industry standard language for the creation of voice-driven products and
services. We also offer a range of consulting, support and education services that enable
our customers and channel partners to develop and maintain voice-driven applications that
use our software products.

We sell our products both directly
through our sales force and indirectly through third-party resellers. We sell our products
to customers in the United States, Canada, the United Kingdom and other countries in
Europe, China and other countries in Asia, Australia, Central America and Latin America.
We anticipate that markets outside of the United States will continue to represent a
meaningful portion of total future revenue.

# OVERVIEW OF OPERATION

Our growth and profitability are
heavily dependent upon global economic conditions and demand for information technology.
Our growth has traditionally been fueled by the telecommunications and financial services
industries. Both industries have sustained dramatic slowdowns over the past several
quarters. Information technology spending remains depressed and may continue to lag for
the foreseeable future.

In response to the challenging
business environment, we have evolved and continue to evolve our strategic direction in a
way that we believe will improve our business performance. Our strategic objectives
include

|. | focusing resources on geographic and industry targets believed to have the highest
potential for revenue,                                                                                                
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                          
|. | evolving  our voice  platform  and  developing  and  supporting  applications  designed to  increase  the speed and ease of
         deployment and reduce the total cost of ownership of speech systems,
|  |                                                                                                                                                                                                          
|. | developing and strengthening a multi-channel selling model,                                                                                                                                              
|  |                                                                                                                                                                                                          
|. | developing  advanced speech  technologies  that deliver  customer value and maintain our leadership  position in the speech
         industry.                                                           

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Some specific  operating  changes have already been  accomplished,  such as the  restructuring  actions taken in the first and third
quarters  of 2002,  the  release of the Nuance  Voice  Platform  product in the first  quarter of 2003 and the  release of our first
application  product,  Nuance Call Steering 1.0 in the second quarter of 2003. We plan to introduce  certain new applications in the
future.  Other operating  activities,  including new products and changes to selling and delivery channels,  will continue to evolve
over the  remainder of this and next fiscal year.  We are making these  strategic  shifts  because we believe that they will enhance
our business  performance,  however,  some of the actions we are taking, such as the introduction of new products,  present inherent
risks.  We believe  that these new  products  will make speech  systems  faster and easier to deploy,  and will create value for our
customers.  The success of these products  depends upon certain market factors such as information  technology  spending  generally,
market acceptance of packaged software applications and industry adoption of VoiceXML and related standards.

In addition,  we are  responding to customers'  requests to work more directly with them and provide them greater access to Nuance's
speech expertise across all levels of their speech  solutions.  We believe that increasing our direct  relationships  with end users
and delivering more complete solutions will allow us to reap greater value from these sales  transactions.  However,  this new sales
and delivery model may also present  increased costs and risks such as increased  liability for complete  solution  delivery,  costs
and risks of subcontractors,  and delays in recognition of revenue due to project timelines for solutions  deployment.  Further,  we
may experience  periodic variation in our consulting  services revenues when long-term  consulting  projects come to completion.  In
addition,  while we are actively working to manage potential channel conflicts and maintain strong reseller  relationships,  certain
reseller  relationships  may be  adversely  affected  by our  introduction  of our own  platform  product  and/or our  direct  sales
activities, which may have an unfavorable impact on revenue from certain resellers.

We are committed to a multi-channel sales approach and reseller partners have been and will continue to be instrumental in
delivering speech engines, applications and services to our end customers. We are actively working to maintain and build strong
relationships with existing resellers as well as new resellers. We will continue to focus efforts on fostering a strong reseller
channel, particularly to leverage complementary capabilities in order to speed and ease deployment of speech solutions. We may
encounter difficulties or delays in finding reseller partners having such complementary capabilities and/or establishing reseller
partner relationships with such entities.

In addition, competition exists in the speech technology market. We believe that our business and technology has the ability to
compete effectively, however, the market is relatively new and susceptible to change. Our competitors may be able to develop
superior technologies or may combine with each other to leverage complimentary technologies or relationships. Current and
potential competitors may be larger and may be able to invest greater resources in competitive efforts and/or may establish
relationships among themselves or with third parties to increase their technological and/or selling and marketing abilities.

# CODE OF BUSINESS CONDUCT AND ETHICS

We maintain a code of business conduct and ethics for directors, officers and employees, and will promptly disclose any
waivers of the code for directors or executive officers. Our code of business practices
addresses conflicts of interest; confidentiality; compliance with laws, rules and
regulations (including insider trading laws); and related matters.

# RESULTS OF OPERATIONS

The following table sets forth, for the periods indicated, the percentage of net revenue represented by certain items in our
statements of operations for the three and six months ended June 30, 2003 and 2002.

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|                                         | Three Months Ended | Six Months Ended
|---------------------------------------- | ------------------ | ----------------
|                                         |                    |                 
|                                         |                    |                 
|Revenue:                                 |                    |                 
|License                                  |                    |                 
|Service                                  |                    |                 
|Maintenance                              |                    |                 
|Total revenue                            |                    |                 
|Cost of revenue:                         |                    |                 
|License                                  |                    |                 
|Service                                  |                    |                 
|Maintenance                              |                    |                 
|Total cost of revenue                    |                    |                 
|Gross profit                             |                    |                 
|Operating expenses:                      |                    |                 
|Sales and marketing (1)                  |                    |                 
|Research and development (1)             |                    |                 
|General and administrative (1)           |                    |                 
|Non-cash compensation expense (benefits) |                    |                 
|Restructuring charges (credits)          |                    |                 
|Total operating expenses                 |                    |                 
|Loss from operations                     |                    |                 
|Interest and other income, net           |                    |                 
|Loss before income taxes                 |                    |                 
|Benefit from income taxes                |                    |                 
|Net loss                                 |                    |                 

# COMPARISON OF THREE AND
SIX MONTHS ENDED JUNE 30, 2003 AND 2002

# Revenue

Total revenue for the three months
ended June 30, 2003 was $12.9 million, compared with $11.4 million in the three months
ended June 30, 2002, an increase of 14%. Total revenue for the six months ended June 30,
2003 was $24.5 million, compared with $20.4 million in the six months ended June 30, 2002,
an increase of 20%.

License revenue for the three months
ended June 30, 2003 was $6.2 million, compared with $7.6 million in the three months ended
June 30, 2002, a decrease of 18%. License revenue for the six months ended June 30, 2003
was $12.3 million, compared with $13.5 million in the six months ended June 30, 2002, a
decrease of 9%. For the three months ended June 30, 2003, we released our first
application product on schedule, Nuance call Steering 1.0. This follows our release of the
Nuance Voice Platform product in the first quarter of 2003. These new releases have helped
our revenue generation. Comparing to the quarter ended June 30, 2003, we have closed a greater number of
transactions in the quarter ended June 30, 2002. License revenue represented 48% and 50% of total revenue for the three and
six months ended June 30, 2003, respectively, and 67% and 66% of total revenue for the
three and six months ended June 30, 2002, respectively.

Service revenue for the three months
ended June 30, 2003 was $3.6 million, compared with $1.6 million for the three months
ended June 30, 2002, an increase of 127%. Service revenue for the six months ended June
30, 2003 was $6.4 million, compared with $2.8 million for the six months ended June 30,
2002, an increase of 127%. Service revenues grew primarily from a large multi-quarter
contract. Service revenue represented 28% and 26% of total revenue for the three and six
months ended June 30, 2003 and 14% of total revenue both for the three and six months
ended June 30, 2002, respectively.

Maintenance revenue for the three
months ended June 30, 2003 was $3.1 million, compared with $2.1 million for the three
months ended June 30, 2002, representing an increase of 43%. Maintenance revenue for the
six months ended June 30, 2002 was $5.7 million, compared with $4.1 million for the six
months ended June 30, 2002, an increase of 39%. The increased maintenance revenue was due
primarily to an increase in the support contract renewal rate and a one-time benefit from
some retroactive back support revenue for which the services had already been delivered.
Maintenance revenue represented 24% of total revenue both for the three and six months
ended June 30, 2003, respectively, and 19% and 20% of total revenue for the three and six
months ended June 30, 2002, respectively.

# Cost of Revenue

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Cost of license revenue consists
primarily of third-party royalties, media and documentation costs. Cost of license
revenues were $0.1 million and $0.2 million for the three and six months ended June 30,
2003, respectively, a decrease of 60% and 39%, respectively from $0.2 million and $0.3
million for three and six months ended June 30, 2002. The decrease was primarily due to
the write off of purchased software for the six months ended June 30, 2002. During 2001,
we purchased $550,000 of third-party software to complement our core platform product
line. At December 31, 2001, we assessed the remaining carrying value of this software in
relation to recovery of future revenues and wrote off $275,000. In 2002, we wrote off
$118,000 and $204,000 for the three and six months ended June 30, 2002. We wrote off the
remaining amount during the third quarter of 2002. Cost of license revenue as a percentage
of license revenue was 1% and 2% in the three and six months ended June 30, 2003,
respectively, compared with 3% and 2% for the three and six months ended June 30, 2002,
respectively.

Cost of service revenue for the three
months ended June 30, 2003 was $2.3 million, compared with $1.4 million in the quarter
ended June 30, 2002, representing an increase of 63%. Cost of service revenue for the six
months ended June 30, 2003 was $4.5 million, compared with $3.4 million in the six months
ended June 30, 2002, an increase of 31%. The increase was due to additional capacity, in
the form of third party services, temporarily employed to fulfill a large multi-quarter
contract . Also, there is an increase of professional service personnel by approximately 6
employees, or 20%, at June 30, 2003 compared with the headcount at June 30, 2002. Cost of
service revenue as a percentage of service revenue was 63% and 70% in the three and six
months ended June 30, 2003, respectively, compared with 87% and 120% for the three and six
months ended June 30, 2002, respectively. We provide consulting services both through the
use of our own employees as well as through the use of contracted third party services.
Cost of service revenue may fluctuate and may vary based on the need to contract third
party services.

Cost of maintenance revenue was $0.9
million for the three months ended June 30, 2003 and 2002. Cost of maintenance revenue was
$1.8 million for the six months ended June 30, 2003 and 2002. It remains flat period over
period. Cost of maintenance revenue as a percentage of maintenance revenue was 29% and 31%
in the three and six months ended June 30, 2003, respectively, compared with 41% and 43%
for the three and six months ended June 30, 2002, respectively. Cost of maintenance
revenue run rates are expected to remain constant in absolute dollars but are expected to
vary slightly as a percentage of total revenue in the third quarter of 2003. However, this
will depend upon our revenue growth, among other factors. Accordingly, there can be no
assurance that we will be successful in maintaining our cost of maintenance revenues as a
percentage of total revenues.

# Operating Expenses

We have reduced costs and expenses to
better align resources with revenue opportunities anticipated in the current information
technology market. In January 2002 and August 2002, we announced restructuring plans to
reduce our workforce by approximately 8% and 21%, respectively. Most of the savings
resulting from the workforce reduction is reflected in sales and marketing expense. We
have also reduced variable costs across the Company as a result of discretionary spending
controls.

Sales and Marketing  Sales and
marketing expenses primarily consist of compensation and related costs for sales,
marketing and business development personnel and promotional expenditures, including
public relations, advertising, trade shows and marketing collateral materials. Sales and
marketing expenses for the three months ended June 30, 2003 were $7.3 million, compared
with $12.3 million in the three months ended June 30, 2002, representing a decrease of
41%. Sales and marketing expenses for the six months ended June 30, 2003 were $14.4
million, compared with $21.4 million in the six months ended June 30, 2002, a decrease of
33%. The decrease was primarily attributable to the reduction of the global customer team
and marketing workforce. The global customer team was decreased by 74 persons,
approximately 50%, from 149 persons at June 30, 2002 to 75 persons at June 30, 2003 and
the marketing force was decreased by 10 persons, approximately 28%, from 36 at June 30,
2002 to 26 at June 30, 2003. These two factors resulted in lower payroll and related
overhead costs. We recognize significant benefits from cost restructuring actions we took
in the third quarter of 2002. As a percentage of total revenue, sales and marketing
expenses were 57% and 59% for the three and six month periods ended June 30, 2003,
respectively, and 108% and 104% in the three and six month periods ended June 30, 2002,
respectively.

Research and Development 
Research and development expenses primarily consist of compensation and related costs for
research and development personnel and contractors. Research and development expenses for
the three months ended June 30, 2003 were $4.0 million, compared with $3.5 million in the
three months ended June 30, 2002, representing an increase of 14%. Research and
development expenses for the six months ended June 30, 2003 were $7.8 million, compared
with $7.2 million in the six months ended June 30, 2002, an increase of 9%. This increase
reflects our continuing efforts to develop and deliver enhancements to our core speech
engine products, to develop and deliver our new Nuance Voice Platform product and Nuance
Call Steering Application product. As a percentage of total revenue, research and
development expenses were 31% and 32% in the three and six months ended June 30, 2003
respectively, and 31% and 35% in the three and six months ended June 30, 2002,
respectively. We anticipate that research and development expenses will increase nominally
in absolute dollars and will vary as a percentage of total revenue from period to period.

General and Administrative 
General and administrative expenses primarily consist of compensation and related costs
for administrative personnel, legal services, accounting services, insurance and other
general corporate expenses. General and administrative expenses for the three months ended
June 30, 2003 were $3.0 million, compared with $4.0 million in the three months ended June
30, 2002, representing a decrease of 25%. General and administrative expenses for the six
months ended June 30, 2003 were $6.1 million, compared with $6.9 million in the six months
ended June 30, 2002, a decrease of 11%. The decrease was primarily in the reduction in
professional services and decreased cost as a result of head count reduction in the Q3
2002 restructure plan. Headcount for general and administrative personnel decreased by
approximately 3 employees, a reduction of approximately 5%, from 61 at June 30, 2002 to 58
at June 30, 2003. As a percentage of total revenue, general and administrative expenses
were 23% and 25% in the three and six months ended June 30, 2003, respectively, and 35%
and 34% in the three and six months ended June 30, 2002. We anticipate that general and
administrative expenses will decline slightly in absolute dollars and will vary as a
percentage of total revenue from period to period.

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Non-Cash Compensation Expense
(Benefits)  In connection with the grant of stock options prior to our initial
public offering, we recorded deferred stock compensation of approximately $8.7 million
within stockholders equity, representing the difference between the estimated fair
value of the common stock for accounting purposes and the option exercise price of these
options at the date of grant. This amount is presented as a reduction of
stockholders equity and is amortized over the vesting period of the applicable
options in a manner consistent with FASB Interpretation No. 28. For the three and six months ended
June 30, 2003, the Company recorded amortization of deferred compensation of 57,000 and
$133,000. Also for the three and six months ended June 30, 2003, the Company reversed excess amortization of deferred stock compensation due to
termination of employees of ($145,000) and ($147,000), resulting in net benefit of deferred
compensation of ($88,000) and ($14,000), respectively, in the Compny's Condensed Consolidated Statements of
Operations. Also for the three and six months ended June 30, 2003, the Company reversed $38,000 and $39,000
of deferred stock compensation and additional paid-in-capital, representing unamortized deferred stock compensation relating to
forfeitures of stock options by terminated employees. For the three and six months ended June 30, 2002, the Company
recorded amortization of deferred stock compensation of $221,000 and $382,000 respectively, relating to approximately 3,152,000 stock options granted at a weighted
average exercise price of $8.58. For the six months ended June 30, 2002, the Company
reversed approximately $62,000

In connection with the SpeechFront
acquisition, the Company recorded deferred compensation expense of $97,000 and $387,000
for the three and six months ended June 30 2002. SpeechFront related deferred compensation
was fully amortized as of December 31, 2002.

In December 2000, we issued a warrant
to a customer to purchase 100,000 shares of common stock at an exercise price of $138.50
per share subject to certain anti-dilution adjustments. The warrant was exercisable at the
option of the holder, in whole or part, at any time between January 17, 2001 and August
2002. In January 2001, we valued the warrant at $526,000, utilizing the Black-Scholes
valuation model using the following assumptions: risk-free interest rate of 5.5%, expected
dividend yields of zero, expected life of 1.5 years and expected volatility of 80%. We
amortized $205,000 for the six months ended June 30, 2002 related to this warrant. We
reduced the warrant expense by $18,000 for the performance we delivered to this customer.
The warrant expired unexercised in August 2002.

We expect to amortize non-cash
compensation of $40,000 in the remaining 6 months of 2003 and $8,000 in 2004,
respectively.

Restructuring Charges
(Credits)

Fiscal Year 2001

In April 2001, with Board of
Directors approval, we implemented a restructure plan to align our expenses with revised
anticipated demand and create a more efficient organization. In connection with the
restructuring plan, we recorded a restructuring charge of $34.1 million for lease loss and
severance costs and an asset impairment charge of $20.9 million on tenant improvements
during the quarter ended June 30, 2001. We decreased the asset impairment charge by $0.5
million in the quarter ended December 31, 2001.

In connection with the restructuring
plan, we decided not to occupy a new leased facility. This decision has resulted in a
lease loss of $32.6 million for the year ended December 31, 2001, comprised of a sublease
loss, broker commissions and other facility costs. To determine the sublease loss, the
loss after our cost recovery efforts from subleasing the building, certain assumptions
were made related to the (1) time period over which the building will remain vacant
(2) sublease terms and (3) sublease rates. We established the reserves at the low end of
the range of estimable cost against outstanding commitments, net of estimated future
sublease income. These estimates were derived using the guidance provided in SAB No. 100,
Restructuring and Impairment Charges, and EITF No. 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity
(Including Certain Costs Incurred in a Restructuring)". The lease loss was increased
in August 2002 as described below and will continue to be adjusted in the future upon
triggering events (change in estimate of time to sublease, actual sublease rates, etc.).
We recorded $1.5 million in costs for the year ended December 31, 2001 associated with
severance and related benefits. We reduced headcount by approximately 80 employees, with
reductions ranging between 10% and 20% across all functional areas and affecting several
locations.

Fiscal Year 2002

In January 2002, with Board of
Directors approval, we implemented a restructuring plan to reduce our workforce by
approximately 8%, or 33 employees. The restructuring was primarily to realign the sales
and professional services organizations. We recorded a restructuring charge of $1.3
million for the three months ended March 31, 2002, consisting primarily of payroll and
related expenses associated with reducing headcount. This amount was paid out as of
December 31, 2002.

In August 2002, with Board of
Directors approval, we implemented a restructuring plan to reduce our worldwide workforce
by approximately 21%, or 81 employees, to realign our expense structure with near term
market opportunities. In connection with the reduction of workforce, we recorded a charge
of $2.6 million primarily for severance and related employee termination costs. As of
December 31, 2002, approximately $1.9 million of this amount was paid out, with the
remainder to be paid by the end of third quarter 2003. The plan also included the
consolidation of facilities through the closing of certain international offices that
resulted in a charge of $1.6 million. In addition, we recorded an increase in our
previously reported real estate restructuring accrual related to the new leased facility
we do not occupy and which has not been subleased as a result of continued declines in
local sub-lease rates in San Mateo County, California. This additional charge of $ 31.8
million was resulted from an analysis of the time period by which the San Mateo property
will remain vacant, sub-lease terms and sub-lease rates, altogether reflecting continued
softening of the local real estate market.

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The restructuring charges and quarter
end balances for the quarter ended June 30, 2003 are as follows (in thousands):

|                                                     | Lease Loss | Severance & Related | Asset Write Down | Total Restructuring
|---------------------------------------------------- | ---------- | ------------------- | ---------------- | -------------------
|2001 Plan                                            |            |                     |                  |                    
|Total charges for the year ending December 31, 2001  |            |                     | $                | 32,615             
|Amount utilized in the year ending December 31, 2001 |            |                     |                  | (3,572             
|Accrual balance at December 31, 2001                 |            |                     | $                | 29,043             
|Total charges for the year ending December 31, 2002  |            |                     | $                | 31,829             
|Amount utilized in the year ended December 31, 2002  |            |                     |                  | (9,342             
|Balance at December 31, 2002                         |            |                     | $                | 51,530             
|Total charges for
the quarter ended March 31, 2003   |            |                     | $                | --                 
|Amount utilized
in the quarter ended March 31, 2003  |            |                     |                  | (2,320             
|Balance at March 31, 2003                            |            |                     | $                | 49,210             
|Total charges for
the quarter ended June 30, 2003    |            |                     | $                | --                 
|Amount utilized
in the quarter ended June 30, 2003   |            |                     |                  | (2,416             
|Balance at June 30, 2003                             |            |                     | $                | 46,794             
|Current restructuring accrual                        |            |                     | $                | 9,012              
|Long-term restructuring accrual                      |            |                     | $                | 37,782             
|Q1 2002 Plan                                         |            |                     |                  |                    
|Total charges for the year ending December 31, 2002  |            |                     | $                | --                 
|Amount utilized in the year ending December 31, 2002 |            |                     |                  | --                 
|Balance at December 31, 2002                         |            |                     |                  | --                 
|Current restructuring accrual                        |            |                     |                  | --                 
|Long-term restructuring accrual                      |            |                     | $                | --                 
|Q3 2002 Plan                                         |            |                     |                  |                    
|Total charges for the year ending December 31, 2002  |            |                     | $                | 1,560              
|Amount utilized in the year ending December 31, 2002 |            |                     |                  | (1,046             
|Balance at December 31, 2002                         |            |                     |                  | 514                
|Total charges for the quarter ended March 31, 2003   |            |                     | $                | --                 
|Amount utilized in the quarter ended March 31, 2003  |            |                     |                  | (361               
|Balance at March 31, 2003                            |            |                     |                  | 153                
|Total charges for the quarter ended June 30, 2003    |            |                     | $                | --                 
|Amount utilized in the quarter ended June 30, 2003   |            |                     |                  | (36                
|Balance at June 30, 2003                             |            |                     | $                | 117                
|Current restructuring accrual                        |            |                     | $                | 117                
|Long-term restructuring accrual                      |            |                     | $                | --                 
|Balances at June 30, 2003 (All restructuring plans)  |            |                     |                  |                    
|Total restructuring accrual: Current                 |            |                     | $                | 9,129              
|Total restructuring accrual: Long-term               |            |                     | $                | 37,782             

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We expect the total cash outlay for
the restructuring plans to be $71.4 million, of which $24.0 million was paid through
June 30, 2003 and $47.4 million remains accrued at June 30, 2003. We expect $9.1 million
of the lease loss to be paid out over the next twelve months and the remaining $37.8
million to be paid out over the remaining life of the lease of approximately 10 years. We
expect the remaining $0.4 million of employee severance and related benefits accrual to be
paid out by September 30, 2003.

In February 2003, we received cash
and recorded an asset impairment credit of $0.9 million related to a refund of tenant
improvement costs for the building we do not occupy, following the landlords
reconciliation of tenant improvement costs. This credit was recorded on the Restructuring
Charges (Credits) line of the Condensed Consolidated Statements of Operation, where the
original asset impairment charge of $20.4 million was recognized for the year ended
December 31, 2001.

# Interest and Other
Income, Net

Interest and other income, net,
consists primarily of interest earned on cash and cash equivalents and short-term and
long-term investments. Interest and other income, net was $253,000 and $719,000 in the
three and six months ended June 30, 2003, respectively; $654,000 and $1,521,000 in the
three and six months ended June 30, 2002, respectively, a decrease of 61% and 53% in the
three and six month period, respectively. This decrease was due to a reduction in interest
income, resulting from lower cash and investment balances and a decline in interest rates.

# Provision for Income
Taxes

We have incurred operating losses for
all periods from inception through June 30, 2003 and therefore have not recorded a
provision for U.S. federal income taxes for any period through June 30, 2003. We recorded
income tax expense relating to foreign royalties taxes of $15,000 and $55,000 for the
three months ended June 30, 2003 and 2002, respectively, $63,000 and $92,000 for the six
months ended June 30, 2003 and 2002, respectively. The income tax expense has been reduced
by foreign tax credits. For the six months ended June 30, 2003, the benefit for income
taxes totaled $1.6 million, primarily due to technology tax credits from our Canadian
operations and the one-time credits of $1.4 million associated with certain international
VAT and income tax liabilities from Europe. We do not expect the tax credits to be
substantial in future quarters.

# LIQUIDITY AND CAPITAL
RESOURCES

From inception to our initial public
offering, we financed our operations primarily from private sales of convertible preferred
stock totaling $70.0 million through March 31, 2000 and, to a lesser extent, from bank
financing. On April 18, 2000, we raised approximately $80 million through the completion
of our initial public offering of common stock. On October 2, 2000, we raised
approximately $144 million through the completion of our follow-on public offering.

As of June 30, 2003, we had cash and
cash equivalents of $25.4 million, short-term and long-term investments totaling
approximately $86.6 million.

Our operating activities used cash of
$15.3 million and $25.5 million for the six months ended June 30, 2003 and 2002,
respectively. The negative operating cash flows in the quarter ended June 30, 2003 and
2002 both resulted principally from our net losses and lease payments for a building we do
not occupy.

Our investing activities used cash of
$4.0 million and $10.5 million for the six months ended June 30, 2003 and 2002,
respectively. The use of cash for investing activities relates primarily to purchases of
investments, offset by the maturities of certain portion of investment.

Our financing activities generated
cash of $559,000 and $2.0 million for the six months ended June 30, 2003 and 2002,
respectively. Net cash provided by financing activities related primarily to the proceeds
from the sale of common stock through the exercise of stock options and through employee
stock purchase plan.

Contractual obligations

The following table summarizes our
obligations and commercial commitments to make future payments under contracts as of June
30, 2003 (in thousands):

|Contractual Obligations       | Total    | 2003 (remaining 6 months) | 2004    | 2005    | 2006    | 2007    | Thereafter
|----------------------------- | -------- | ------------------------- | ------- | ------- | ------- | ------- | ----------
|Operating leases              | $ 83,592 | $ 4,876                   | $ 9,142 | $ 8,319 | $ 8,610 | $ 8,871 | $ 43,774  
|Capital leases                | 58       | 25                        | 33      | --      | --      | --      | --        
|Total Contractual Obligations | $ 83,650 | $ 4,901                   | $ 9,175 | $ 8,319 | $ 8,610 | $ 8,871 | $ 43,774  

|Other Commercial Commitments | Total    | Less than 1 year | 1-3 years | 4-5 years | After 5 years |  | 
|---------------------------- | -------- | ---------------- | --------- | --------- | ------------- |  | 
|Standby Letters of Credit    | $ 10,943 | $      --        | $      -- | $      -- | $ 10,943      |  | 

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Our capital  requirements depend on numerous factors. We may continue to report significant  quarterly operating losses resulting in
future  negative  operating  cash flows.  We do not plan to spend more than $2 million on capital  expenditures  in the  remaining 6
months of 2003. We believe that our cash, cash  equivalents and our short-term and long-term  investments will be sufficient to fund
our  activities  for at least the next 12  months.  Thereafter,  we may need to raise  additional  funds in order to fund more rapid
expansion,  including  increases in employees and office  facilities;  to develop new or enhance existing  products or services;  to
respond  to  competitive  pressures;  or to acquire or invest in  complementary  businesses,  technologies,  services  or  products.
Additional  funding may not be available on favorable terms or at all. In addition,  we may, from time to time,  evaluate  potential
acquisitions of other businesses,  products and technologies.  We may also consider additional equity or debt financing, which could
be dilutive to existing investors.

The  restricted  cash secures our letters of credit of  approximately  $10.9 million and is invested with a bank, as required by our
landlords to meet rent deposits  requirements  for our leases on facilities.  As of June 30, 2003, $10.9 million and its accumulated
interest totaled $12.5 million and is presented as Restricted cash on our balance sheet.

# CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The  preparation  of financial  statements in  accordance  with  accounting  principles  generally  accepted in the United States of
America  requires  that  management  make a number of  assumptions  and  estimates  that affect the  reported  amounts of assets and
liabilities at the date of the financial  statements and the reported  amounts of revenue and expenses during the periods  presented
in our  consolidated  financial  statements and  accompanying  notes.  Management  bases its estimates on historical  experience and
various other  assumptions  believed to be reasonable.  Such estimates  include  uncollectible  accounts  receivable,  restructuring
accrual for leases,  taxes and  contingencies.  Although these estimates are based on management's  best knowledge of current events
and actions that may impact us in the future, actual results may differ from these estimates and assumptions.

Our critical accounting policies are those that affect our financial statements materially and involve a significant level of
judgment by management. Those policies are as follows:

|. | revenue recognition;                      
|- | ------------------------------------------
|  |                                           
|. | restructuring and impairment charges;     
|  |                                           
|. | valuation allowance for doubtful accounts;
|  |                                           
|. | income taxes;                             
|  |                                           
|. | valuation of long-lived assets.           

Revenue Recognition

Revenues are generated from licenses,
services and maintenance. All revenues generated from our worldwide operations are
reviewed at our corporate headquarters, located in the United States. We apply the
provisions of Statement of Position (SOP) 97-2, Software Revenue
Recognition, as amended by SOP 98-9 Modification of SOP 97-2, Software Revenue
Recognition, With Respect to Certain Transactions to all transactions involving the
sale of software products. We also recognize some revenue based on SOP 81-1
Accounting for Performance of Construction-Type and Certain Production-Type
Contracts.

Our license revenue consists of
license fees for the software products. The license fees for our software products are
calculated using two variables, one of which is the estimated maximum number of
simultaneous end-user connections or ports to an application running on our
software and the other of which is the value attributed to the functional use of the
software.

For licensed products requiring
significant customization, we generally recognize license revenue using the
percentage-of-completion method of accounting over the period that services are performed.
For all license and service agreements accounted for under the percentage-of-completion
method, we determine progress to completion based on actual direct labor hours incurred to
date as a percentage of the estimated total direct labor hours required to complete the
project. We periodically evaluate the actual status of each project to ensure that the
estimates to complete each contract remain accurate. A provision for estimated losses on
contracts is made in the period in which the loss becomes probable and can be reasonably
estimated. To date, these losses have not been significant. Costs incurred in advance of
billings are recorded as costs in excess of related billings on uncompleted contracts. If
the amount of revenue recognized exceeds the amounts billed to customers, the excess
amount is recorded as unbilled accounts receivable. If the amount billed exceeds the
amount of revenue recognized, the excess amount is recorded as deferred revenue. Revenue
recognized in any period is dependent on our progress toward completion of projects in
progress. Significant management judgment and discretion are used to estimate total direct
labor hours. Any changes in or deviation from these estimates could have a material effect
on the amount of revenue we recognize in any period.

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For licensed products which do not
require significant customization of components, we recognize revenue from the sale of
software licenses when:

|. | persuasive evidence of an arrangement exists;                          
|- | -----------------------------------------------------------------------
|  |                                                                        
|. | the software and corresponding authorization codes have been delivered;
|  |                                                                        
|. | the fee is fixed and determinable;                                     
|  |                                                                        
|. | collection of the resulting receivable is probable.                    

We use a signed contract and purchase
order or royalty report as evidence of an arrangement for license orders.

Products delivered with acceptance
criteria or return rights are not recognized as revenue until all criteria are achieved.
If undelivered products or services exist that are essential to the functionality of the
delivered product in an arrangement, delivery is not considered to have occurred. Delivery
is accomplished through electronic distribution of the authorization codes or
keys. The software was previously delivered to the customer either
electronically or on a CD-ROM. Occasionally the customer will require that we secure their
acceptance of the system in addition to the delivery of the keys. Such acceptance, when
required, typically consists of a demonstration to the customer that, upon implementation,
the software performs in accordance with specified system parameters, such as recognition
accuracy or task completion rates. In absence of such acceptance, we will wait and not
recognize revenue until signed acceptance is obtained.

We assess whether the fee is fixed
and determinable based on the payment terms associated with the transaction. We assess
collectibility of the transaction based on a number of factors, including the
customers past payment history and its current financial position. If we determine
that collection of a fee is not probable, we defer recognition of the revenue until the
time collection becomes reasonably assured, which is generally upon receipt of the cash
payment.

We use the residual method to
recognize revenue when a license agreement includes one or more elements to be delivered
at a future date if vendor specific objective evidence of the fair value of all
undelivered elements exists. Vendor-specific objective evidence of fair value is based on
the price generally charged when the element is sold separately, or if not yet sold
separately, is established by authorized management. In situations where vendor-specific
objective evidence of fair value for an undelivered elements does not exist, the entire
amount of revenue from the arrangement is deferred and recognized when vender-specific
objective evidence of fair value can be established for all undelivered elements or when
all such elements are delivered. In situations where the only undelivered element is
maintenance and vendor specific objective evidence of fair value for maintenance does not
exist, the entire amount of revenue from the arrangement is recognized ratably over the
maintenance period. As a general rule, license revenue from resellers is recognized when
product has been sold through to an end user and such sell-through has been reported to
us. However, certain reseller agreements include time-based provisions by which we
recognize revenue, in these instances, there is no right of returns possible.

The timing of license revenue
recognition is affected by whether we perform consulting services in the arrangement and
the nature of those services. In the majority of cases, we either perform no consulting
services or we perform services that are not essential to the functionality of the
software. When we perform consulting and implementation services that are essential to the
functionality of the software, we recognize both license and consulting revenue utilizing
contract accounting based on the percentage of the consulting services that have been
completed. This calculation is done in conformity with SOP 81-1, however judgment is
required in determining the percentage of the project that has been completed. Such
contracts were significant for the three and six months ended June 30, 2003 and 2002,
respectively. We have also explored the markets for complete speech solutions and
delivering through combined product and services, where we are required to use the
contract accounting based upon percentage of completion. This method of accounting is
subject to certain judgments by us regarding amount of revenue allocated to percentage of
work completed. Typically, we would recognize revenue based upon the proportional level of
effort expended, combined with the value of the technology delivered, to complete certain
milestones defined in the customer contract or statement of work.

Service revenue consists of revenue
from providing implementation, consulting, training and other revenue. Other revenue
consists primarily of reimbursements for consulting out-of-pocket expenses incurred, in
accordance with the Emerging Issues Task Force (EITF) Issue No. 01-14,
Income Statement Characterization of Reimbursements Received for
Out-of-Pocket Expenses Incurred. For services revenue, we generally
require a signed contract, statement of work and purchase order prior to recognizing any
services revenue. Our consulting service contracts are bid either on a fixed-fee basis or
on a time-and-materials basis. For a fixed-fee contract, we recognize revenue using the
percentage of completion method. For time-and-materials contracts, we recognize revenue as
services are performed. Training service revenue is recognized as services are performed.
Losses on service contracts, if any, are recognized as soon as such losses become known.

Maintenance revenue consists of fees
for providing technical support and software upgrades and updates. We generally require a
signed contract and purchase order prior to recognizing any maintenance revenue. We
recognize all maintenance revenue ratably over the contract term. Customers have the
option to purchase or decline maintenance agreements at the time of the license purchase.
If maintenance is declined, a reinstatement fee is generally required when the customer
decides to later activate maintenance. Customers generally have the option to renew or
decline maintenance agreements annually during the contract term.

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Our standard payment terms are net 30
to 90 days from the date of invoice. Thus, a significant portion of our accounts
receivable balance at the end of a quarter is primarily comprised of revenue from that
quarter.

We record deferred revenue primarily
as a result of payments from customers received in advance of recognition of revenue. As
of June 30, 2003 and December 31, 2002, deferred revenue was $7.8 million and $9.0
million, respectively. The deferred revenue amount includes unearned license fees, which
will be recognized as revenue when the appropriate criteria have been met, prepaid
maintenance and prepaid or unearned professional services that will be recognized as
revenue as the services are performed, or in some cases, when an identified time period
has expired and the customer or resellers right to certain licenses has been
forfeited.

Cost of license revenue consists
primarily of license fees payable on third-party software products, amortization of
software costs, documentation and media costs. Cost of service revenue consists of
compensation and related overhead costs for employees or third parties engaged in
consulting and training. Cost of maintenance revenue consists of compensation and related
overhead costs for employees engaged in technical support.

Restructuring and
Impairment Charges

Through June 30, 2003, we have
accrued for restructuring costs when management approved and committed to a firm plan.
Historically the main components of our restructuring plans have been related to workforce
reductions, lease losses as a result of a decision not to occupy certain leased property
and asset impairments. Workforce-related charges were accrued based on an estimate of
expected benefits that would be paid out to the employees. To determine the sublease loss,
after our cost recovery efforts from subleasing the building, certain assumptions were
made related to the (1) time period over which the building would remain vacant (2)
sublease terms and (3) sublease rates. We established the reserves at the low end of the
range of estimable cost against outstanding commitments, net of estimated future sublease
income. These estimates were derived using the guidance provided in SAB No. 100,
Restructuring and Impairment Charges, and EITF No. 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity
(Including Certain Costs Incurred in a Restructuring)". These reserves were based
upon managements estimate of the time required to sublet the property and the amount
of sublet income that might be generated between the date the property was not occupied
and expiration of the lease for each of the unoccupied property. These estimates were
reviewed and revised quarterly and may result in a substantial increase or decrease to
restructuring expense should different conditions prevail than were anticipated in
original management estimates. As of June 30, 2003, and the date of this filing, we
believe our estimates remain materially correct. Asset impairments primarily reflected
write-offs of tenant improvements and fixtures associated with abandoned lease space. SFAS
No.146  Accounting for Costs Associated with Exit or disposal Activities
requires that a liability for a cost associated with an exit or disposal activity be
recognized when the liability is incurred and is effective in January 2003.

Valuation Allowance for
Doubtful Accounts

We perform ongoing credit evaluations
of our customers and adjust credit limits based upon payment history and the
customers current creditworthiness, as determined by our review of their current
credit information. We continuously monitor collections and payments from our customers
and maintain a provision for estimated credit losses based on a percentage of our accounts
receivable, our historical experience and any specific customer collection issues that we
have identified. While such credit losses have historically been within our expectations
and appropriate reserves have been established, we cannot guarantee that we will continue
to experience the same credit loss rates that we have experienced in the past. Material
differences may result in the amount and timing of revenue and or expenses for any period
if management made different judgments or utilized different estimates.

Income Taxes

In preparing our consolidated
financial statements, we are required to estimate our income taxes in each of the
jurisdictions in which we operate. This process involves estimating actual current tax
exposures together with assessing tax credits and 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,
which are included within the consolidated balance sheet. We then assess the likelihood
that 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. To the
extent we establish a valuation allowance or increase this allowance in a period, we
include an expense within the tax provision in our Consolidated Statement of Operations.

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Significant management judgment is
required in determining our provision for income taxes, income tax credits, our deferred
tax assets and liabilities and any valuation allowance recorded against our net deferred
tax assets. We have recorded a valuation allowance due to uncertainties related to our
ability to utilize some of our deferred tax assets, primarily consisting of the
utilization of certain net operating loss carry forwards and foreign tax credits before
they expire. The valuation allowance is based on estimates of taxable income by the
jurisdictions in which we operate and the period over which deferred tax assets will be
recoverable. In the event that actual results differ from these estimates or we adjust
these estimates in future periods, we may need to establish an additional valuation
allowance, which could impact our financial position and results of operations.

Valuation of Long-lived Assets

We have assessed the recoverability
of long-lived assets, including intangible assets other than goodwill, by determining
whether the carrying value of such assets will be recovered through undiscounted future
cash flows according to the guidance of SFAS No. 144 Accounting for the Impairment
of Disposal of Long Lived Assets. SFAS No. 144 supercedes SFAS No. 121
Accounting for the impairment or Disposal of Long-lived Assets in 2002. We
assess the realizability of long-lived assets, including intangibles in accordance with
the provisions of SFAS No. 144. We assess the impairment of goodwill in accordance with
SFAS No. 142 Goodwill and Other Intangible Assets, which became effective for
the year ended December 31, 2002. For assets to be held and used, including acquired
intangibles, we initiate our review annually or whenever events or changes in
circumstances indicate that the carrying amount of a long-lived asset may not be
recoverable. Recoverability of an asset is measured by comparison of its carrying amount
to the expected future undiscounted cash flows (without interest charges) that the asset
is expected to generate. Any impairment to be recognized is measured by the amount by
which the carrying amount of the asset exceeds its fair value. Significant management
judgment is required in the forecasting of future operating results which are used in the
preparation of projected discounted cash flows and should different conditions prevail,
material write downs of net intangible assets and/or goodwill could occur.

It is reasonably possible that the
estimates of anticipated future gross revenue, the remaining estimated economic life of
the products and technologies, or both, could differ from those used to assess the
recoverability of these costs and result in a write-down of the carrying amount or a
shortened life of acquired intangibles in the future. As of June 30, 2003, we have no
goodwill balance and no impairment of intangibles was recorded.

# FACTORS THAT AFFECT
FUTURE RESULTS

OUR ABILITY TO ACCURATELY FORECAST
OUR QUARTERLY SALES IS LIMITED, OUR SHORT TERM COSTS ARE RELATIVELY FIXED, AND WE EXPECT
OUR BUSINESS TO BE AFFECTED BY SEASONALITY. AS A RESULT, OUR QUARTERLY OPERATING RESULTS
MAY FLUCTUATE.

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Our quarterly operating results have
varied significantly in the past and we expect that they will vary significantly from
quarter to quarter in the future. As a result, our quarterly operating results are
difficult to predict. These quarterly variations are caused by a number of factors,
including:

 general economic downturn and
global economic and political conditions;

 delays or cancellations in orders by
customers who are reducing spending or adjusting project plans;

 delays in customer orders due
to the complex nature of large telephony systems and the associated implementation
projects;

 timing of product deployments
and completion of project phases, particularly for large orders and large solution
projects;

 delays in recognition of
software license revenue in accordance with applicable accounting principles;

 our ability to develop,
introduce, ship and support new and enhanced products, such as new versions of our
software platform and application(s), that respond to changing technology trends in a
timely manner and our ability to manage product transitions;

 rate of market adoption for
speech technology generally and our products in particular such as our new software
platform and applications;

 changes in our selling model
including focus of certain sales representatives on direct sales to end user customers and
resulting potential for channel conflict;

 unexpected customer
non-renewal of maintenance contracts, or renewal at lower rates than anticipated;

 the amount and
timing of expenses; and

 the utilization rate of our
professional services personnel.

Due to these factors, because the
market for our software is relatively new and rapidly changing, and because our business
model is evolving, our ability to accurately forecast our quarterly sales is limited. In
addition, most of our costs are relatively fixed in the short term, even as we endeavor to
manage these costs. If we have a shortfall in revenue in relation to our expenses, we may
be unable to reduce our expenses quickly enough to avoid lower quarterly operating
results. We do not know whether our business will grow rapidly enough to absorb our
expenses, even as we endeavor to manage these costs. As a result, our quarterly operating
results could fluctuate significantly and unexpectedly from quarter to quarter.

We also expect to experience
seasonality in the sales of our products. For example, we anticipate that sales may be
lower in the first and third quarters of each year due to patterns in the capital
budgeting and purchasing cycles of our current and prospective customers. We also expect
that sales may decline during summer months. These seasonal variations in our sales may
lead to fluctuations in our quarterly operating results. It is difficult for us to
evaluate the degree to which this seasonality may affect our business.

WE DEPEND UPON RESELLERS FOR A
SIGNIFICANT PORTION OF OUR SALES. THE LOSS OF KEY RESELLERS, OR A DECLINE IN
RESELLERS RESALE OF OUR PRODUCTS AND SERVICES, COULD LIMIT OUR ABILITY TO SUSTAIN
AND GROW OUR REVENUE.

In 2000, 72% of our revenue was
achieved by indirect sales through resellers. The percentage of revenue through indirect
sales increased to 75% in 2001, 74% in 2002 and 62% for the six months ended June 30,
2003. Though this percentage may vary or decrease in the future, we intend to continue to
rely on resellers for a substantial portion of our sales in the future. As a result, we
are dependent upon the viability and financial stability of our resellers, as well as upon
their continued interest and success in selling our products. In addition, some of our
resellers are thinly capitalized or otherwise experiencing financial difficulties. The
loss of a key reseller or our failure to develop new and viable reseller relationships
could limit our ability to sustain and grow our revenue. Significant expansion of our
internal sales force to replace the loss of a key reseller would require increased
management attention and higher expenditures.

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Our contracts with resellers
generally do not require a reseller to purchase our products or services. We cannot
guarantee that any of our resellers will continue to market our products or devote
significant resources to doing so. In addition, while we are actively working to manage
potential channel conflicts and maintain strong reseller relationships, certain reseller
relationships may be adversely affected by our introduction of our own platform product
and /or our direct sales activities, which may have an unfavorable impact on revenue from
certain resellers. In addition, we will, from time to time, terminate or adjust some of
our relationships with resellers in order to address changing market conditions, improve
our business, adapt to our business strategy, resolve disputes, or for other reasons. Any
such termination or adjustment could have a negative impact on our relationships with
resellers and our business and result decreased sales through resellers or threatened or
actual litigation. Finally, our resellers possess confidential information concerning our
products and services, product release schedules and sales, marketing and reseller
operations. Although we have nondisclosure agreements with our resellers, we cannot
guarantee that any reseller would not use our confidential information in competition with
us or otherwise. If our resellers do not successfully market and sell our products or
services for these or any other reasons, our sales could be adversely affected and our
revenue could decline.

SPEECH SOFTWARE PRODUCTS
GENERALLY, AND OUR PRODUCTS AND SERVICES IN PARTICULAR, MAY NOT ACHIEVE WIDESPREAD
ACCEPTANCE, WHICH COULD REQUIRE US TO MODIFY OUR SALES AND MARKETING EFFORTS AND COULD
LIMIT OUR ABILITY TO SUCCESSFULLY GROW OUR BUSINESS.

The market for speech software
products is relatively new and rapidly changing. In addition, some of our products are new
to the market or will be new to the market once released. Our ability to increase revenue
in the future depends on the acceptance by our customers, resellers and end users of
speech software solutions generally and our products and services in particular. The
adoption of speech software products could be hindered by the perceived costs and
deployment risks of this relatively new technology, as well as the reluctance of
enterprises that have invested substantial resources in existing call centers or
touch-tone-based systems to replace their current systems with this new technology.
Accordingly, in order to achieve commercial acceptance, we may have to educate prospective
customers, including large, established enterprises and telecommunications companies,
about the uses and benefits of voice interface software in general and our products in
particular. This may require shifts in our sales and marketing efforts and strategies to
achieve such education. If these efforts fail or prove excessively costly or otherwise
unmanageable, or if speech software generally do not achieve commercial acceptance, our
business could be harmed.

The continued development of the
market for our products will depend upon the following factors, among others:

 widespread and successful deployment
of speech software applications;

 customer demand for services
and solutions having a voice user interface;

 acceptance by businesses of
the benefits of speech technology;

 demand for new uses and
applications of speech software technology, including adoption of voice user interfaces by
companies that operate web-based and touch tone IVR self service solutions;

 adoption of industry standards
for speech software and related technologies; and

 continuing improvements in
hardware and telephony technology that may reduce the costs of speech software solutions.

OUR PRODUCTS CAN HAVE A LONG SALES
AND IMPLEMENTATION CYCLE AND, AS A RESULT, OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE.

The sales cycles for our products
have typically ranged from three to twelve months, depending on the size and complexity of
the order, the amount of services to be provided by us and whether the sale is made
directly by us or indirectly through a reseller, a voice application service provider or a
systems integrator.

Purchase of our products requires a
significant expenditure by a customer. Accordingly, the decision to purchase our products
typically requires significant pre-purchase evaluation. We may spend significant time
educating and providing information to prospective customers regarding the use and
benefits of our products. During this evaluation period, we may expend substantial sales,
technical, marketing and management resources. Because of this lengthy evaluation cycle,
we may experience a delay between the time we incur these expenditures and the time we
generate revenues, if any, from such expenditures.

After purchase, it may take
substantial time and resources to implement our software and to integrate it with our
customers existing systems. If we are performing services that are essential to the
functionality of the software, in connection with its implementation, we recognize
software revenue based on the percentage completed using contract accounting. In cases
where the contract specifies milestones or acceptance criteria, we may not be able to
recognize either software or service revenue until these conditions are met. We have in
the past and may in the future experience unexpected delays in recognizing revenue.
Consequently, the length of our sales and implementation cycles and the varying order
amounts for our products make it difficult to predict the quarter in which revenue
recognition may occur and may cause license and services revenue and operating results to
vary significantly from period to period.

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WE HAVE A HISTORY OF LOSSES. WE
EXPECT TO CONTINUE TO INCUR LOSSES AND WE MAY NOT ACHIEVE OR MAINTAIN PROFITABILITY.

We have incurred losses since our
inception, including a net loss of approximately $6.9 million for the six months ended
June 30, 2003. As of June 30, 2003, we had an accumulated deficit of approximately $245.8
million. We expect we could have net losses and negative cash flow for at least the next
12 months. We expect to spend significant amounts to develop or enhance our products,
services and technologies and to enhance delivery capabilities. As a result, we will need
to generate significant increases in revenue to achieve profitability. Even if we achieve
profitability, we may not be able to sustain or increase profitability on a quarterly or
annual basis.

WE DEPEND ON A LIMITED NUMBER OF
CUSTOMER ORDERS FOR A SUBSTANTIAL PORTION OF OUR REVENUE DURING ANY GIVEN PERIOD. THE LOSS
OF, OR DELAYS IN, A KEY ORDER COULD SUBSTANTIALLY REDUCE OUR REVENUE IN ANY GIVEN PERIOD
AND HARM OUR BUSINESS

We derive a significant portion of
our revenue in each period from a limited number of customers. For example, for the six
months ended June 30, 2003, five customers made up 39% of our total revenue. Two customers
accounted for, individually, approximately 11% and 10% of our total revenue.

We expect that a limited number of
customers and customer orders will continue to account for a substantial portion of our
revenue in any given period. Generally, customers who make large purchases from us are not
expected to make subsequent, equally large purchases in the short term, and therefore we
must attract new customers in order to maintain or increase our revenues. As a result, if
we do not acquire a major customer, if a contract is delayed, cancelled or deferred, or if
an anticipated sale is not made, our business could be harmed.

OUR CURRENT AND POTENTIAL
COMPETITORS, SOME OF WHOM HAVE GREATER RESOURCES AND EXPERIENCE THAN WE DO, MAY MARKET OR
DEVELOP PRODUCTS, SERVICES AND TECHNOLOGIES THAT MAY CAUSE DEMAND FOR, AND THE PRICES OF,
OUR PRODUCTS TO DECLINE.

A number of companies have developed,
or are expected to develop, products that compete with our products. Competitors with
respect to speech technologies include SpeechWorks International and Scansoft, which have
recently announced their agreement to merge, IBM, Microsoft and others. With respect to
our software platform, there are many vendors, including some of our reseller partners,
who market and sell platforms for voice systems. We expect additional competition from
other companies, our competitors may combine with each other, and other companies may
enter our markets by acquiring or entering into strategic relationships with our
competitors. Current and potential competitors may have established, or may establish,
cooperative relationships among themselves or with third parties to increase the abilities
of their advanced speech and language technology products, platforms and applications to
address the needs of our prospective customers.

Many of our current and potential
competitors have longer operating histories, significantly greater financial, technical,
product development and marketing resources, greater name recognition and larger customer
bases than we do. Our present or future competitors may be able to develop products
comparable or superior to those we offer, adapt more quickly than we do to new
technologies, evolving industry trends and standards or customer requirements, or devote
greater resources to the development, promotion and sale of their products than we do.
Accordingly, we may not be able to compete effectively in our markets, competition may
intensify and future competition may cause us to reduce prices and/or otherwise harm our
business.

SALES TO CUSTOMERS OUTSIDE THE
UNITED STATES ACCOUNT FOR A SIGNIFICANT PORTION OF OUR REVENUE, WHICH EXPOSES US TO RISKS
INHERENT IN INTERNATIONAL OPERATIONS

International sales represented
approximately 35%, 42% and 47% of our total revenue in 2002, 2001 and 2000, respectively
and represented 38% of our total revenue for the 6months ended June 30, 2003. We
anticipate that revenue from markets outside the United States will continue to represent
a meaningful portion of our total revenue. We are subject to a variety of risks associated
with conducting business internationally, any of which could harm our business. These
risks include:

 difficulties and costs of
staffing and managing foreign operations;

 the difficulty in establishing
and maintaining an effective international reseller network;

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 the burden of complying with a wide
variety of foreign laws, particularly with respect to tax, intellectual property and
license requirements;

 longer sales
cycles;

 political and economic
instability outside the United States;

 import or export licensing and
product certification requirements;

 tariffs, duties, price
controls or other restrictions on foreign currencies or trade barriers imposed by foreign
countries;

 potential adverse tax
consequences, including higher marginal rates;

 unfavorable fluctuations in
currency exchange rates; and

 limited ability to enforce
agreements, intellectual property rights and other rights in some foreign countries.

# WE ARE EXPOSED TO
GENERAL ECONOMIC CONDITIONS, WHICH MAY CONTINUE TO HARM OUR BUSINESS.

As a result of recent unfavorable
economic conditions and reduced capital spending, it is possible that our sales will
decline. This economic downturn became particularly acute following the events of
September 11, 2001. We experienced a decline in revenues during 2001 due in part to delays
in purchases by our customers and to prevailing economic conditions. If unfavorable
economic conditions continue or worsen in the United States or internationally, we may
experience a material adverse impact on our business, operating results and financial
condition.

# OUR STOCK PRICE MAY BE
VOLATILE DUE TO FACTORS OUTSIDE OF OUR CONTROL.

Since our initial public offering on
April 13, 2000, our stock price has been extremely volatile. During that time, the stock
market in general, The Nasdaq National Market and the securities of technology companies
in particular have experienced extreme price and trading volume fluctuations. These
fluctuations have often been unrelated or disproportionate to the operating performance of
individual companies. The following factors, among others, could cause our stock price to
fluctuate:

 actual or anticipated
variations in operating results;

 announcements of operating
results and business conditions by our customers and suppliers;

 announcements by our
competitors relating to new customers, technological innovation or new services;

 announcements of new product
lines and/or shifts in business focus of sales and distribution models;

 increases in our plans for, or
rate of, capital expenditures for infrastructure, information technology and other similar
capital expenditures

 economic developments in our
industry as a whole;

 general market and economic
conditions;

 general decline in information
technology and capital spending plans.

These broad market fluctuations may
materially adversely affect our stock price, regardless of our operating results. Our
stock price may fluctuate due to variations in our operating results. For example, our
stock price steadily declined throughout 2002. As a result, the trading price of our
common stock declined rapidly and significantly.

WE MAY INCUR A VARIETY OF COSTS TO
ENGAGE IN FUTURE ACQUISITIONS OF COMPANIES, PRODUCTS OR TECHNOLOGIES, AND THE ANTICIPATED
BENEFITS OF THOSE ACQUISITIONS MAY NEVER BE REALIZED.

As a part of our business strategy,
we may make acquisitions of, or significant investments in, complementary companies,
products or technologies. For instance, in November 2000 we acquired SpeechFront, a
Canadian company. For the year ended December 31, 2001, the Company evaluated the carrying
value of the assets related to the SpeechFront acquisition and recorded an asset
impairment. In February 2001, we acquired non-exclusive intellectual property rights from
a third-party. For the year ended December 31, 2001, the Company performed an impairment
analysis and decided that asset was impaired and was subsequently written down to its
estimated fair value. Any future acquisitions of companies or technologies would be
accompanied by risks such as:

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 difficulties in assimilating
the operations and personnel of acquired companies;

 diversion of our
managements attention from ongoing business concerns;

 our potential inability to
maximize our financial and strategic position through the successful incorporation of
acquired technology and rights into our products and services;

 additional expense associated
with impairments of acquired assets such as, goodwill or acquired workforce;

 maintenance of uniform
standards, controls, procedures and policies; and

 impairment of existing relationships
with employees, suppliers and customers as a result of the integration of new management
personnel.

We cannot guarantee that we will be
able to successfully integrate any business, products, technologies or personnel that we
might acquire in the future, For example, the SpeechFront assets and text to speech
technology we acquired have been impaired (see notes to the consolidated financial
statements). Our inability to integrate successfully any business products, technologies
or personnel we may acquire in the future could harm our business.

OUR FAILURE TO RESPOND TO AND
SUCCESSFULLY MANAGE RAPID CHANGE IN THE MARKET FOR SPEECH SOFTWARE COULD CAUSE US TO LOSE
REVENUE AND HARM OUR BUSINESS

The speech software industry is
relatively new and rapidly changing. Our success will depend substantially upon our
ability to enhance our existing products and to develop and introduce, on a timely and
cost-effective basis, new products and features that meet changing end-user requirements,
gain commercial acceptance and incorporate technological advancements such as products
that speed deployment and accelerate customers return on investment. If we are
unable to develop new products and enhanced functionalities or technologies to adapt to
these changes, we may be unable to retain existing customers or attract new customers,
which could harm our business. In addition, as we develop new products, sales of existing
products may decrease. If we cannot offset a decline in revenue from existing products
with sales of new products, our business would suffer.

Commercial acceptance of any new
products and technologies we may introduce will depend, among other things, on:

 the ability of our services,
products and technologies to meet and adapt to the needs of our target markets;

 the performance and price of our
products and services and our competitors products and services; and

 our ability to deliver speech
solutions, customer service and professional services directly and through our resellers.

# OUR PRODUCTS MAY
INFRINGE THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS, AND RESULTING CLAIMS AGAINST US
COULD BE COSTLY AND REQUIRE US TO ENTER INTO DISADVANTAGEOUS LICENSE OR ROYALTY
ARRANGEMENTS

The software industry and the field
of speech and voice technologies are characterized by the existence of a large number of
patents and frequent litigation based on allegations of patent infringement and the
violation of intellectual property rights. Although we attempt to avoid infringing known
proprietary rights of third parties we may be subject to legal proceedings and claims for
alleged infringement by us or our licensees of third-party proprietary rights, such as
patents, trade secrets, trademarks or copyrights, from time to time in the ordinary course
of business. Any claims relating to the infringement of third-party proprietary rights,
even if not successful or meritorious, could result in costly litigation, divert resources
and managements attention or require us to enter into royalty or license agreements
which are not advantageous to us. In addition, parties making these claims may be able to
obtain injunctions, which could prevent us from selling our products. Furthermore, former
employers of our employees may assert that these employees have improperly disclosed
confidential or proprietary information to us. Any of these results could harm our
business. We may be increasingly subject to infringement claims as the number and features
of our products grow.

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OUR PRODUCTS ARE NOT 100% ACCURATE
AND WE COULD BE SUBJECT TO CLAIMS RELATED TO THE PERFORMANCE OF OUR PRODUCTS. ANY CLAIMS,
WHETHER SUCCESSFUL OR UNSUCCESSFUL, COULD RESULT IN SIGNIFICANT COSTS AND COULD DAMAGE OUR
REPUTATION.

Speech recognition, natural language
understanding and authentication technologies, including our own, are not 100% accurate.
Our customers, including several financial institutions, use our products to provide
important services to their customers, including transferring funds to accounts and buying
and selling securities. Any misrecognition of voice commands or incorrect authentication
of a users voice in connection with these financial or other transactions could
result in claims against us or our customers for losses incurred. Although our contracts
typically contain provisions designed to limit our exposure to liability claims, a claim
brought against us for misrecognition or incorrect authentication, even if unsuccessful,
could be time-consuming, divert managements attention, result in costly litigation
and harm our reputation. Moreover, existing or future laws or unfavorable judicial
decisions could limit the enforceability of the limitation of liability, disclaimer of
warranty or other protective provisions contained in our contracts.

# ANY SOFTWARE DEFECTS IN
OUR PRODUCTS COULD HARM OUR BUSINESS AND RESULT IN LITIGATION.

Complex software products such as
ours may contain errors, defects and bugs. With the planned release of any product, we may
discover these errors, defects and bugs and, as a result, our products may take longer
than expected to develop. In addition, we may discover that remedies for errors or bugs
may be technologically unfeasible. Delivery of products with undetected production defects
or reliability, quality, or compatibility problems could damage our reputation. Errors,
defects or bugs could also cause interruptions, delays or a cessation of sales to our
customers. We could be required to expend significant capital and other resources to
remedy these problems. In addition, customers whose businesses are disrupted by these
errors, defects and bugs could bring claims against us which, even if unsuccessful, would
likely be time-consuming and could result in costly litigation and payment of damages.

# WE ARE CURRENTLY ENGAGED
IN VARIOUS SECURITIES LITIGATIONS, WHICH, IF RESOLVED UNFAVORABLY, COULD ADVERSELY AFFECT
OUR BUSINESS,RESULTS OF OPERATIONS OR FINANCIAL OPERATIONS

We have been sued in various
shareholder lawsuits in state court in California and federal district court in California
and New York (See Part II Item 1 Legal Proceedings). If the
respective settlements to not proceed as anticipated, an unfavorable resolution of these
lawsuits could have a material adverse effect on our business, results of operations,
and/or financial condition.

INTERNATIONAL SALES OPPORTUNITIES
MAY REQUIRE US TO DEVELOP LOCALIZED VERSIONS OF OUR PRODUCTS. IF WE ARE UNABLE TO DO SO,
WE MAY BE UNABLE TO GROW OUR REVENUE AND EXECUTE OUR BUSINESS STRATEGY.

International sales opportunities may
require investing significant resources in creating and refining different language models
for each particular language or dialect. These language models are required to create
versions of our products that allow end users to speak the local language or dialect and
be understood and authenticated. If we fail to develop localized versions of our products,
our ability to address international market opportunities and to grow our business will be
limited. We must also expend resources to develop localized versions of our products, and
we may not be able to recognize adequate revenues from these localized versions of our
products to make them profitable.

IF WE ARE UNABLE TO EFFECTIVELY
MANAGE OUR OPERATIONS AND RESOURCES IN ACCORDANCE WITH MARKET AND ECONOMIC CONDITIONS, OUR
BUSINESS COULD BE HARMED.

Our operations have changed
significantly due to volatility in our business and may continue to change in the future.
We experienced significant growth in the past; however, in April 2001, we reduced our
workforce by approximately 20%. Additionally, during the quarter ended March 31, 2002, we
implemented a restructuring plan to reduce our workforce by approximately another 8% and
in August 2002 we reduced our work force by approximately 20%. We may be required to
expand or contract our business operations and workforce in the future to adapt to the
market environment, and as a result may need to expand or contract our management,
operational, sales, marketing, financial and human resources, as well as management
information systems and controls, to align and support any such growth or contraction. Our
failure to successfully manage these types of changes would place a burden on our
business, our operations and our management team, and could negatively impact sales,
customer relationships and other aspects of our business performance and could cause our
business to suffer. In addition, a significant portion of our restructuring accrual is
represented by a lease loss created by our decision to not occupy our Pacific Shores
facility. The accrual assumptions are based upon estimates of real estate market
conditions which are subject to wide fluctuations and could decline further, which may
result in additional restructuring accrual.

WE RELY ON THE SERVICES OF OUR KEY
PERSONNEL, WHOSE KNOWLEDGE OF OUR BUSINESS AND TECHNICAL EXPERTISE WOULD BE DIFFICULT TO
REPLACE.

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We rely upon the continued service
and performance of a relatively small number of key technical and senior management
personnel. Our future success will be impacted by our ability to retain these key
employees. We cannot guarantee that we will be able to retain all key personnel. For
example, in April 2003, our President, Chief Executive Officer and Chairman, Ronald Croen,
existed his position as President and CEO. In addition, in January 2002 Graham Smith
resigned from his position with Nuance as Chief Financial Officer. Other than Charles
Berger, none of our key technical or senior management personnel are bound by employment
agreements to remain at the Company, and, as a result, any of these employees could leave
with little or no prior notice. If we lose any of our key technical and senior management
personnel, replacement of such personnel could be difficult and costly, and if we are
unable to successfully and swiftly replace such personnel and effectively transition to
new management personnel, our business could be harmed. We do not have key personnel life
insurance policies covering any of our employees.

IF THE STANDARDS WE HAVE SELECTED
TO SUPPORT ARE NOT ADOPTED AS THE STANDARDS FOR SPEECH SOFTWARE, CUSTOMERS MIGHT NOT USE
OUR SPEECH SOFTWARE PRODUCTS FOR DELIVERY OF APPLICATIONS AND SERVICES.

The market for speech software is
relatively new and emerging and industry standards are still being established. We may not
be competitive unless our products support changing industry standards. The emergence of
industry standards, whether through adoption by official standards committees or
widespread usage, could require costly and time-consuming redesign of our products. If
these standards become widespread and our products do not support them, our customers and
potential customers may not purchase our products. Multiple standards in the marketplace
could also make it difficult for us to ensure that our products will support all
applicable standards, which could in turn result in decreased sales of our products.

Our V-Builder applications-building
tool and our Nuance Voice Platform software are each designed to work with the recently
emerged VoiceXML standard. There are currently other, similar standards in development,
some of which may become more widely adopted than VoiceXML. If VoiceXML is not widely
accepted by our target customers or if another competing standard were to become widely
adopted, then sales of our products could decline and our business would be harmed. In
that case, we may find it necessary to redesign our existing products or design new
products that are compatible with alternative standards that are widely adopted or that
replace VoiceXML. This design or redesign could be costly and time-consuming.

# ANY INABILITY TO
ADEQUATELY PROTECT OUR PROPRIETARY TECHNOLOGY COULD HARM OUR ABILITY TO COMPETE

Our future success and ability to
compete depends in part upon our proprietary technology and our trademarks, which we
attempt to protect with a combination of patent, copyright, trademark and trade secret
laws, as well as with our confidentiality procedures and contractual provisions. These
legal protections afford only limited protection and may be time-consuming and expensive
to obtain and/or maintain. Further, despite our efforts, we may be unable to prevent third
parties from infringing upon or misappropriating our intellectual property.

Although we have filed multiple U.S.
patent applications, we have currently only been issued a small number of patents. There
is no guarantee that more patents will be issued with respect to our current or future
patent applications. Any patents that are issued to us could be invalidated, circumvented
or challenged. If challenged, our patents might not be upheld or their claims could be
narrowed. Our intellectual property may not be adequate to provide us with competitive
advantage or to prevent competitors from entering the markets for our products.

Additionally, our competitors could
independently develop non-infringing technologies that are competitive with, equivalent
to, and/or superior to our technology. Monitoring infringement and/or misappropriation of
intellectual property can be difficult, and there is no guarantee that we would detect any
infringement or misappropriation of our proprietary rights. Even if we do detect
infringement or misappropriation of our proprietary rights, litigation to enforce these
rights could cause us to divert financial and other resources away from our business
operations. Further, we license our products internationally, and the laws of some foreign
countries do not protect our proprietary rights to the same extent as do the laws of the
United States.

THIRD PARTIES COULD OBTAIN
LICENSES FROM SRI INTERNATIONAL RELATING TO SPEECH SOFTWARE TECHNOLOGIES AND DEVELOP
TECHNOLOGIES TO COMPETE WITH OUR PRODUCTS, WHICH COULD CAUSE OUR SALES TO DECLINE.

Upon our incorporation in 1994, we
received a license from SRI International to a number of patents and other proprietary
rights, including rights in software, relating to speech software technologies developed
by SRI International. This license was exclusive until December 1999, when we chose to
allow the exclusivity to lapse. As a result, SRI International may have, or may in the
future, license these patents and proprietary rights to our competitors. If a license from
SRI International were to enable third parties to enter the markets for our products and
services or to compete more effectively, we could lose market share and our business could
suffer.

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# CERTAIN STOCKHOLDERS MAY
DISAGREE WITH HOW NUANCE USES THE PROCEEDS FROM ITS PUBLIC OFFERINGS.

Management retains broad discretion
over the use of proceeds from our April 2000 initial public offering and September 2000
secondary public offering. Stockholders may not deem these uses desirable and our use of
the proceeds may not yield a significant return or any return at all. Because of the
number and variability of factors that determine our use of the net proceeds from these
offerings, we cannot guarantee that these uses will not vary substantially from our
currently planned uses.

OUR CHARTER AND BYLAWS AND
DELAWARE LAW CONTAIN PROVISIONS WHICH MAY DELAY OR PREVENT A CHANGE OF CONTROL OF NUANCE.

Our Shareholder Rights Plan as well
as provisions of our charter and bylaws may make it more difficult for a third party to
acquire, or discourage a third party from attempting to acquire, control of Nuance. These
provisions could limit the price that investors might be willing to pay in the future for
shares of our common stock. These provisions include:

 the companys Shareholder
Rights Plan adopted in December 2002;

 the division of the board of
directors into three separate classes;

 the elimination of cumulative
voting in the election of directors;

 prohibitions on our
stockholders from acting by written consent and calling special meetings;

 procedures for advance
notification of stockholder nominations and proposals; and

 the ability of the board of
directors to alter our bylaws without stockholder approval.

In addition, our board of directors
has the authority to issue up to 5,000,000 shares of preferred stock and to determine the
price, rights, preferences, privileges and restrictions, including voting rights, of those
shares without any further vote or action by the stockholders. The issuance of preferred
stock, while providing flexibility in connection with possible financings or acquisitions
or other corporate purposes, could have the effect of making it more difficult for a third
party to acquire a majority of our outstanding voting stock.

Since the completion of our initial
public offering on April 13, 2000, we have been subject to the anti-takeover provisions of
the Delaware General Corporation Law, including Section 203, which may deter potential
acquisition bids for our company. Under Delaware law, a corporation may opt out of Section
203. We do not intend to opt out of the provisions of Section 203.

OUR FACILITIES ARE LOCATED NEAR
KNOWN EARTHQUAKE FAULT ZONES, AND THE OCCURRENCE OF AN EARTHQUAKE OR OTHER NATURAL
DISASTER COULD CAUSE DAMAGE TO OUR FACILITIES AND EQUIPMENT, WHICH COULD REQUIRE US TO
CURTAIL OR CEASE OPERATIONS.

Our facilities are located in the San
Francisco Bay Area near known earthquake fault zones and are vulnerable to damage from
earthquakes. In October 1989, a major earthquake that caused significant property damage
and a number of fatalities struck this area. We are also vulnerable to damage from other
types of disasters, including fire, floods, power loss, communications failures and
similar events. If any disaster were to occur, our ability to operate our business at our
facilities could be seriously, or potentially completely, impaired.

# WE RELY ON A CONTINUOUS
POWER SUPPLY TO CONDUCT OUR OPERATIONS, AND AN ENERGY CRISIS COULD DISRUPT OUR OPERATIONS
AND INCREASE OUR

# EXPENSES

We currently do not have backup
generators or alternate sources of power in the event of a blackout, and our current
insurance does not provide coverage for any damages we, or our customers, may suffer as a
result of any interruption in our power supply. If blackouts interrupt our power supply,
we would be temporarily unable to continue operations at our facilities. Any such
interruption in our ability to continue operations at our facilities could damage our
reputation, harm our ability to retain existing customers and to obtain new customers, and
could result in lost revenue, any of which could substantially harm our business and
results of operations.

INFORMATION THAT WE MAY PROVIDE TO
INVESTORS FROM TIME TO TIME IS ACCURATE ONLY AS OF THE DATE WE DISSEMINATE IT AND WE
UNDERTAKE NO OBLIGATION TO UPDATE THE INFORMATION.

From time to time, we may publicly
disseminate forward-looking information or guidance in compliance with Regulation FD
promulgated by the Securities and Exchange Commission. This information or guidance
represents our outlook only as of the date that we disseminated it, and we undertake no
obligation to provide updates to this information or guidance in our filings with the
Securities and Exchange Commission or otherwise.

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# ITEM 3. QUANTITATIVE AND
QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discusses our exposure
to market risk related to changes in interest rates, equity prices and foreign currency
exchange rates. This discussion contains forward-looking statements that are subject to
risks and uncertainties. Actual results could vary materially as a result of a number of
factors including those set forth in the risk factors section of this Quarterly Report on
Form 10-Q.

# Market Risk

The following section describes our
exposure to market risk related to changes in foreign currency exchange rates and interest
rates. This section contains forward-looking statements that are subject to risks and
uncertainties. Actual results could vary materially as a result of a number of factors
including those set forth in the risk factors section of this quarterly Report on Form
10-Q.

# Foreign Currency
Exchange Rate Risk

To date, all of our recognized
revenues have been denominated in U.S. dollars and primarily from customers in the United
States, and our exposure to foreign currency exchange rate changes has been immaterial. We
expect, however, that future product license and services revenues derived from
international markets may be denominated in the currency of the applicable market. As a
result, our operating results may become subject to significant fluctuations based upon
changes in the exchange rates of certain currencies in relation to the U.S. dollar.
Furthermore, to the extent that we engage in international sales denominated in U.S.
dollars, an increase in the value of the U.S. dollar relative to foreign currencies could
make our products less competitive in international markets. Although we will continue to
monitor our exposure to currency fluctuations, and when appropriate, may use financial
hedging techniques to minimize the effect of these fluctuations, we cannot assure you that
exchange rate fluctuations will not adversely affect our financial results in the future.

# Interest Rate Risk

As of June 30, 2003, we had cash and
cash equivalents, short-term investments and long-term investments of $112.0 million. Any
decline in interest rates over time would reduce our interest income from our short-term
and long-term investments. Based upon our balance of cash and cash equivalents, short-term
investments and long-term investments, an absolute reduction in interest rates of 0.5%
would cause a corresponding decrease in our annual interest income by approximately $0.6
million.

# ITEM 4. CONTROLS AND
PROCEDURES

Evaluation of disclosure controls and
procedures. Our management evaluated, with the participation of our Chief Executive
Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and
procedures as of the end of the period covered by this Quarterly Report on Form 10-Q.
Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have
concluded that our disclosure controls and procedures are effective to ensure that
information we are required to disclose in reports that we file or submit under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in Securities and Exchange Commission rules and forms.

Changes in internal control over
financial reporting. There was no change in our internal control over financial reporting
that occurred during the period covered by this Quarterly Report on Form 10-Q that has
materially affected, or is reasonably likely to materially affect, our internal control
over financial reporting.

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# PART II: OTHER
INFORMATION

# ITEM 1. LEGAL PROCEEDINGS

On January 16, 2001, Nuance filed an
opposition proceeding in the European community against a Community Trade Mark application
for NUANCE, owned by Nuance Global Traders, Ltd. The opposition is still pending. The
parties have agreed upon a settlement which will become final upon, among other things,
completion of final settlement documents.

Beginning in March 2001, a number of
putative shareholder class actions were filed against the Company and certain of its
present and former officers and directors in the United States District Court for the
Northern District of California (the Federal Actions). The actions have been
consolidated as In re Nuance Communications Inc. Securities Litigation, Master File No.
C-01-20320-JW. Lead plaintiffs were appointed and a consolidated complaint was filed on
behalf of a purported class of persons who purchased the Companys stock during the
period January 31, 2001 through March 15, 2001, alleging false and misleading statements
and insider trading in violation of the federal securities laws, specifically Section
10(b), 20(a) and 20A of the Securities Exchange Act of 1934, and seek unspecified damages.
In April 2003, the court granted in part and denied in part defendants most recent
motion to dismiss. No trial date has been set. The parties have reached an agreement to
settle this litigation which settlement will become final upon, among other things,
completion of formal settlement papers, and final approval by the Court. The settlement is
to be covered by the Companys insurance policies. In the event that final settlement
does not occur, and litigation against the Company continues, the Company
believes it has meritorious defenses and intends to defend the case vigorously.

In May and June 2001, putative
shareholder derivative actions were filed in California Superior Court, San Mateo County,
against various of the Companys present and former officers and the Companys
directors (the Derivative Actions). The putative derivative complaints contain
allegations similar to the Federal Actions, and claim that the defendants engaged in
breaches of fiduciary duty and insider trading. The Company appears to be named as nominal
defendant, against whom no recovery is sought. All proceedings in the putative derivative
actions have been stayed by agreement of the parties. An agreement has been reached to
settle these actions, which settlement will become final upon, among other things,
completion of formal settlement papers and Court approval of the settlement.

In August 2001, the first of several
putative shareholder class actions were filed against various of the underwriters for the
Companys initial public offering (IPO), the Company and certain of its
present and former officers and directors in the United States District Court for the
Southern District of New York. Those complaints have been consolidated and a consolidated
amended complaint filed, captioned In re Nuance Communications Inc. Initial Public
Offering Sec. Litig., No. 01-CV-7344. The complaint generally alleges that various
investment bank underwriters engaged in improper activities related to the allocation of
shares in the Companys IPO, that were not disclosed in the registration statements
for the Companys IPO or secondary offerings. The consolidated action is part of a
larger coordinated proceeding, In re Initial Public Offering Securities Litigation, 21 MC
92, involving more than 40 underwriters and 250 issuers. In October 2002, the individual
defendants were dismissed from the action without prejudice pursuant to stipulation. In
February 2003, the court issued a ruling on an omnibus motion to dismiss filed by
defendants in the coordinated proceeding, denying the motion as to the claims against the
Company. No trial date has been set. A proposal has been made for the settlement and
release of claims against the issuer defendants in the case, including the Company.
The settlement is contingent upon a number of conditions, including completion of formal
settlement papers and approval of the Court. In the event that settlement does not occur,
and litigation against Nuance continues, the Company believes it has meritorious
defenses and intends to defend the case vigorously.

Should the respective settlements not
proceed as anticipated, an unfavorable resolution of these litigations could have a
material adverse effect on the Companys business, results of operations, or
financial condition.

# ITEM 4. SUBMISSION OF
MATTERS TO A VOTE OF SECURITY HOLDERS

The Company held its Annual Meeting
of Stockholders on May 22, 2003. At the meeting, the following proposals received the
votes listed below:

Proposal I:     Election of Class III directors to serve
a three-year term ending in 2006.

|                  | Votes for: | Votes against:
|----------------- | ---------- | --------------
|Charles Berger    | 18,355,272 | 7,440,310     
|Gary Morgenthaler | 25,469,757 | 325,825       

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The Companys Board of Directors
is currently comprised of eight (8) members who are divided into three classes with
overlapping three-year terms. The term for Class I directors (Ronald Croen, Irwin
Federman and Vinton Cerf) will expire at the meeting of stockholders to be held in 2004.
The term for Class II directors (Curtis Carlson, Alan Herzig and Philip Quigley) will
expire at the meeting of stockholders to be held in 2005

Proposal
II:     Approval of Ratification of the appointment of Deloitte & Touche LLP as
independent auditors of the Company for the 2003 fiscal year

|Votes for:     | 25,761,872
|-------------- | ----------
|Votes against: | 25,861    
|Abstentions:   | 7,850     

# ITEM 6. EXHIBITS AND
REPORTS ON FORM 8-K:

(a) Exhibits

|Exhibit Index Exhibit number | Description                                                                                                                                             
|---------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1*                         | Restated Certificate of Incorporation
of the Company, as currently in effect.                                                                           
|                             |                                                                                                                                                         
|3.2**                        | Bylaws of the Company, as currently in effect.                                                                                                          
|                             |                                                                                                                                                         
|31.1                         | Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 302(a)of the Sarbanes-Oxley Act of 2002.
|                             |                                                                                                                                                         
|31.2                         | Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 302(a)of the Sarbanes-Oxley Act of 2002.
|                             |                                                                                                                                                         
|32.1                         | Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  
|                             |                                                                                                                                                         
|32.2                         | Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  

---

* Incorporated by reference to the
registrants Registration Statement on Form S-1 (File no. 333-96217) as declared
effectively by the Securities and Exchange Commission on February 2, 2000.

** Incorporated by reference to the
registrants Annual Report on Form 10K for the fiscal year ended December 31, 2002,
as filed with the Securities and Exchange Commission on March 31, 2003.

(a) Reports on Form 8-K

None.

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# SIGNATURES

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

|                      |  | NUANCE COMMUNICATIONS, INC.                                                                        
|--------------------- |  | ---------------------------------------------------------------------------------------------------
|                      |  | (Registrant)                                                                                       
|                      |  |                                                                                                    
|                      |  |                                                                                                    
|                      |  |                                                                                                    
|                      |  |                                                                                                    
|Date: August 13, 2003 |  | By:           /s/ KAREN BLASING                                                                    
|                      |  | Karen BlasingVice President and
Chief Financial Officer(Principal Financial and Accounting Officer)
|                      |  |                                                                                                    

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Table of Contents

## End of Filing