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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 March 31, 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



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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 ̈



34,196,990 shares of the
registrants common stock, $0.001 par value, were outstanding as of April 30, 2003.



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NUANCE
COMMUNICATIONS, INC. & SUBSIDIARIES



FORM 10-Q, MARCH 31, 2003



CONTENTS



|ITEM NUMBER                   |  | PAGE                                                                                 
|----------------------------- |  | -------------------------------------------------------------------------------------
|PART I: FINANCIAL INFORMATION |  |                                                                                      
|                             
|Item 1.                       |  | Financial Statements                                                                 
|                              |  | Condensed Consolidated Balance Sheets:                                               
|                              |  | March 31, 2003 and December 31, 2002                                                 
|                              |  | Condensed Consolidated Statements of Operations:                                     
|                              |  | Three months ended March 31, 2003 and 2002                                           
|                              |  | Condensed Consolidated Statements of Cash Flows:                                     
|                              |  | Three months ended March 31, 2003 and 2002                                           
|                              |  | Notes to Condensed Consolidated Financial Statements                                 
|                             
|Item 2.                       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations
|                             
|Item 3.                       |  | Quantitative and Qualitative Disclosures about Market Risk                           
|                             
|Item 4.                       |  | Controls and procedures                                                              
|                             
|PART II: OTHER INFORMATION    |  |                                                                                      
|                             
|Item 1.                       |  | Legal Proceedings                                                                    
|                             
|Item 6.                       |  | Exhibits and Reports on Form 8-K                                                     
|                             
|SIGNATURES                    |  | 36                                                                                   
|                             
|CERTIFICATIONS                |  | 37                                                                                   



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PART I:
FINANCIAL INFORMATION



ITEM 1: FINANCIAL STATEMENTS



NUANCE COMMUNICATIONS, INC. &
SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

Unaudited



|                                                                                                                                           |  | March 31, 2003 |          |   | December 31, 2002 |  
|------------------------------------------------------------------------------------------------------------------------------------------ |  | -------------- | -------- | - | ----------------- | -
|ASSETS                                                                                                                                     |  |                |          |   |                   |  
|Current assets:                                                                                                                            |  |                |          |   |                   |  
|Cash and cash equivalents                                                                                                                  |  | $              | 43,860   |   |                   | $
|Short-term investments                                                                                                                     |  |                | 76,976   |   |                   |  
|Accounts receivable, net of allowance for doubtful accounts of $ 733 and $ 670,
respectively                                               |  |                | 7,432    |   |                   |  
|Prepaid expenses and other current assets                                                                                                  |  |                | 5,278    |   |                   |  
|                                                                                                                                           |  |                |          |   |                   |  
|Total current assets                                                                                                                       |  |                | 133,546  |   |                   |  
|Property and equipment, net                                                                                                                |  |                | 5,878    |   |                   |  
|Intangible assets, net                                                                                                                     |  |                | 1,302    |   |                   |  
|Restricted cash                                                                                                                            |  |                | 12,393   |   |                   |  
|Long-term investments                                                                                                                      |  |                | 1,053    |   |                   |  
|Other assets                                                                                                                               |  |                | 451      |   |                   |  
|                                                                                                                                           |  |                |          |   |                   |  
|Total assets                                                                                                                               |  | $              | 154,623  |   |                   | $
|                                                                                                                                           |  |                |          |   |                   |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                       |  |                |          |   |                   |  
|Current liabilities:                                                                                                                       |  |                |          |   |                   |  
|Accounts payable                                                                                                                           |  | $              | 1,139    |   |                   | $
|Accrued liabilities                                                                                                                        |  |                | 8,067    |   |                   |  
|Current restructuring accrual                                                                                                              |  |                | 9,989    |   |                   |  
|Accrued vacation                                                                                                                           |  |                | 2,018    |   |                   |  
|Deferred revenue                                                                                                                           |  |                | 8,133    |   |                   |  
|Current portion of capital lease                                                                                                           |  |                | 41       |   |                   |  
|                                                                                                                                           |  |                |          |   |                   |  
|Total current liabilities                                                                                                                  |  |                | 29,387   |   |                   |  
|Long-term restructuring accrual                                                                                                            |  |                | 40,004   |   |                   |  
|Other long-term liabilities                                                                                                                |  |                | 27       |   |                   |  
|                                                                                                                                           |  |                |          |   |                   |  
|Total liabilities                                                                                                                          |  |                | 69,418   |   |                   |  
|                                                                                                                                           |  |                |          |   |                   |  
|Commitments (Note 8)                                                                                                                       |  |                |          |   |                   |  
|Stockholders Equity                                                                                                                       |  |                |          |   |                   |  
|Common stock, $.001 par value, 250,000,000 shares authorized; 34,193,540 Shares and
34,182,244 shares issued and outstanding, respectively |  |                | 34       |   |                   |  
|Additional paid-in capital                                                                                                                 |  |                | 328,342  |   |                   |  
|Deferred stock compensation                                                                                                                |  |                | (144     | ) |                   |  
|Accumulated other comprehensive income                                                                                                     |  |                | 144      |   |                   |  
|Accumulated deficit                                                                                                                        |  |                | (243,171 | ) |                   |  
|                                                                                                                                           |  |                |          |   |                   |  
|Total stockholders equity                                                                                                                 |  |                | 85,205   |   |                   |  
|                                                                                                                                           |  |                |          |   |                   |  
|Total liabilities and stockholders equity                                                                                                 |  | $              | 154,623  |   |                   | $
|                                                                                                                                           |  |                |          |   |                   |  



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



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NUANCE
COMMUNICATIONS INC. & SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

(IN THOUSANDS, EXCEPT PER SHARE DATA)



|                                                            |  | Three Months Ended |       
|----------------------------------------------------------- |  | ------------------ | ------
|                                                            |  | March 31,          |       
|                                                            |  | 2003               |       
|Revenue:                                                    |  |                    |       
|License                                                     |  | $                  | 6,078 
|Service                                                     |  |                    | 2,811 
|Maintenance                                                 |  |                    | 2,674 
|                                                            |  |                    |       
|Total revenue                                               |  |                    | 11,563
|Cost of revenue                                             |  |                    |       
|License                                                     |  |                    | 12    
|Service (1)                                                 |  |                    | 2,194 
|Maintenance (1)                                             |  |                    | 894   
|                                                            |  |                    |       
|Total cost of revenue                                       |  |                    | 3,100 
|                                                           
|                                                            |  |                    |       
|Gross profit                                                |  |                    | 8,463 
|                                                            |  |                    |       
|                                                           
|Operating expenses:                                         |  |                    |       
|Sales and marketing (1)                                     |  |                    | 6,865 
|Research and development (1)                                |  |                    | 3,874 
|General and administrative (1)                              |  |                    | 3,398 
|Non-cash stock-based compensation expense                   |  |                    | 74    
|Restructuring charges (credits)                             |  |                    | (943  
|                                                            |  |                    |       
|Total operating expenses                                    |  |                    | 13,268
|                                                            |  |                    |       
|                                                           
|Loss from operations                                        |  |                    | (4,805
|Interest and other income, net                              |  |                    | 466   
|                                                            |  |                    |       
|Loss before income taxes                                    |  |                    | (4,339
|Provision (benefit) for income taxes                        |  |                    | (64   
|                                                            |  |                    |       
|                                                           
|Net loss                                                    |  | $                  | (4,275
|                                                            |  |                    |       
|                                                           
|Basic and diluted net loss per share                        |  | $                  | (0.13 
|                                                            |  |                    |       
|Shares used to compute basic and diluted net loss per share |  |                    | 34,169
|                                                            |  |                    |       
|                                                           
|(1) Excludes non-cash stock-based compensation as follows:  |  |                    |       
|                                                           
|Service and maintenance cost of revenue                     |  | $                  |      
|Sales and marketing                                         |  |                    | 74    
|Research and development                                    |  |                    |      
|General and administrative                                  |  |                    |      
|                                                            |  |                    |       
|Total non-cash stock-based compensation expense             |  | $                  | 74    
|                                                            |  |                    |       



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

(UNAUDITED)

(IN THOUSANDS)



|                                                                           |  | Three Months Ended March 31, |        
|-------------------------------------------------------------------------- |  | ---------------------------- | -------
|                                                                           |  | 2003                         |        
|Cash flows from operating activities:                                      |  |                              |        
|Net loss                                                                   |  | $                            | (4,275 
|Adjustments to reconcile net loss to net cash used in operating
activities |  |                              |        
|Depreciation and amortization                                              |  |                              | 1,125  
|Non-cash stock-based compensation expense                                  |  |                              | 74     
|Provision for doubtful accounts                                            |  |                              | 63     
|Write-off of purchased software                                            |  |                              |       
|Changes in operating assets and liabilities:                               |  |                              |        
|Accounts receivable                                                        |  |                              | 855    
|Prepaid expenses, other current assets and other assets                    |  |                              | (45    
|Accounts payable                                                           |  |                              | (452   
|Accrued liabilities                                                        |  |                              | 989    
|Restructuring accrual                                                      |  |                              | (2,692 
|Deferred revenue                                                           |  |                              | (821   
|                                                                           |  |                              |        
|Net cash used in operating activities                                      |  |                              | (5,179 
|                                                                           |  |                              |        
|Cash flows from investing activities:                                      |  |                              |        
|Purchase of investments                                                    |  |                              | (24,020
|Maturities of investments                                                  |  |                              | 29,701 
|Purchase of property and equipment                                         |  |                              | (574   
|Restricted cash                                                            |  |                              |       
|                                                                           |  |                              |        
|Net cash provided by (used in) investing activities                        |  |                              | 5,107  
|                                                                           |  |                              |        
|Cash flows from financing activities:                                      |  |                              |        
|Proceeds from exercise of stock options                                    |  |                              | 3      
|                                                                           |  |                              |        
|Net cash provided by financing activities                                  |  |                              | 3      
|                                                                           |  |                              |        
|Effect of exchange rate fluctuations on cash and cash equivalents          |  |                              | 159    
|                                                                           |  |                              |        
|Net increase (decrease) in cash and cash equivalents                       |  |                              | 89     
|Cash and cash equivalents, beginning of period                             |  |                              | 43,771 
|                                                                           |  |                              |        
|Cash and cash equivalents, end of period                                   |  | $                            | 43,860 
|                                                                           |  |                              |        
|Supplementary disclosures of cash flow information:                        |  |                              |        
|Cash paid during the period for:                                           |  |                              |        
|Interest                                                                   |  | $                            | 1      
|Income taxes                                                               |  | $                            | 309    
|Supplementary disclosures of non-cash transactions:                        |  |                              |        
|Unrealized loss on available-for-sale securities                           |  | $                            | 28     



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



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
March 31, 2003 and December 31, 2002, the results of operations and cash flows for the three months ended March 31, 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 intercompany 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 March 31, 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.



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



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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. 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 March 31, 2003 and December 31, 2002, the Company has 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.



The Company
recognizes 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.
| | - |  | ---------------------------------------------------



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



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.



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.



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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 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.



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 standard implementation services that are not
essential to the functionality of the software. When the Company performs consulting 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
insignificant for the three months ended March 31, 2003 and 2002, respectively. The Company is also exploring potential markets for complete speech solutions, delivered through combined product and services, which the Company expects to require
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 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. 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 required to later activate maintenance. Customers generally have the option to renew or decline maintenance agreements annually
during the contract term.



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 March 31, 2003 and December 31, 2002, deferred revenue was $8.1 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.



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 year-end exchange rates; revenues and expenses are translated at average exchange rates during the year. 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.



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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 March 31, 2003 and December 31, 2002, the cumulative foreign currency
translation losses are $4,000 and $159,000, net of taxes $2,000 and $93,000, respectively. As of March 31,2003 and December 31, 2002, the cumulative unrealized gains on investments are $148,000 and $176,000, net of taxes $87,000 and $103,000,
respectively. As of March 31, 2003 and December 31, 2002, the total cumulative other comprehensive income are $144,000 and $17,000. For the three months ended March 31, 2003 and 2002, the total comprehensive losses are $4,148 and $10,653,
respectively.



Stock-Based Compensation



The Company accounts for stock-based employee compensation arrangements in
accordance with the provisions and related interpretations of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and has elected to follow the disclosure only alternative prescribed
by Financial Accounting Standards Boards SFAS No. 123, Accounting for Stock-Based Compensation. Under APB 25, stock-based compensation is based on the difference, if any, on the date of grant, between the fair value of the Companys stock
and the exercise price. Unearned compensation is amortized using the graded vesting method and expensed over the vesting period of the respective options.



Since the Company continues to account for its stock-based awards to employees using the intrinsic value method in accordance
with APB No. 25, SFAS No. 123 requires the disclosure of pro forma net income (loss) as if the Company had adopted the fair value method. Under SFAS No. 123, the fair value of stock-based awards is calculated through the use of option pricing
models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Companys stock option awards. The Companys
calculations were made using the Black-Scholes option pricing model, which requires subjective assumptions, including expected time to exercise, which greatly affects the calculated values and the resulting pro forma compensation cost may not be
representative of that to be expected in future periods.



The
following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. For purposes
of SFAS 123 pro forma disclosures, the estimated fair value of the options is amortized to expense over the options vesting period (in thousands):



|                                                                                              |  | March 31, 2003 |        |   | March 31, 2002 |  
|--------------------------------------------------------------------------------------------- |  | -------------- | ------ | - | -------------- | -
|Net loss, as reported                                                                         |  | $              | (4,275 | ) |                | $
|Add: Stock-based employee compensation expense included in net income                         |  |                | 74     |   |                |  
|Less: Total stock-based employee compensation expense under fair value method for all
awards, |  |                | (3,613 | ) |                |  
|Pro forma net loss                                                                            |  | $              | (7,814 | ) |                | $
|Basic and diluted net loss per shareas reported                                              |  | $              | (0.13  | ) |                | $
|Basic and diluted net loss per sharepro forma                                                |  | $              | (0.23  | ) |                | $



Reclassifications and
Disclosures



Certain prior period amounts have been
classified to conform to current period presentation. These reclassifications had no significant impact on the financial statements for the periods presented



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3. RECENT ACCOUNTING
PRONOUNCEMENTS



On January 1, 2003, the Company adopted SFAS
No. 146, which nullifies EITF 94-3. SFAS 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) conceptual framework. SFAS 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 Company does not expect the adoption of SFAS 146 to have a material impact on our results of operation, financial position or cash flows, although SFAS 146 may impact the timing of recognition of costs associated with future
restructuring, exit or disposal activities.



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 that upon issuance of
a guarantee, the guarantor must disclose, and may recognize a liability for, the fair value of the obligation it assumes under that guarantee. The initial recognition and measurement requirement of FIN 45 is effective for guarantees issued or
modified after December 31, 2002. As of March 31, 2003, guarantees that were issued or modified by the Company after December 31, 2002 were not material. The disclosure requirements of FIN 45 are applicable to our restricted cash, effective for this
report and all future quarterly and annual reports. As of March 31, 2003 and December 31, 2002, the restricted cash was $12.4 million and $12.4 million, respectively. The restricted cash secures letters of credit required by landlords to meet rent
deposit requirements for certain leased facilities and is invested in certificates of deposit. (See Note 6)



In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure. SFAS No. 148 amends SFAS No. 123 Accounting for Stock-Based
Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123
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 transition guidance and annual
disclosure requirements became effective for fiscal years ending after December 15, 2002. The Company has adopted the annual disclosure provisions of SFAS 148 in our financial reports beginning with year ended December 31, 2002 and the Company has
adopted the interim disclosure provisions for financial reports with quarter ended March 31, 2003. The Company continues to account for stock-based compensation under the provisions of Accounting Principles Board Opinion No. 25 Accounting for
Stock Issued to Employees using the intrinsic value method. Accordingly, the adoption of SFAS No. 148 does not have a material effect on the Companys financial position, results of operations, or cash flows.



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 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. The
total number of shares excluded from diluted net loss per share was 9,075,000 shares and 7,779,000 shares, respectively, for the three months ended March 31, 2003 and March 31, 2002.



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



|                                                                             |  | Three Months Ended March 31, |       
|---------------------------------------------------------------------------- |  | ---------------------------- | ------
|                                                                             |  | 2003                         |       
|Net loss                                                                     |  | $                            | (4,275
|Basic and diluted shares:                                                    |  |                              |       
|Weighted average shares of common stock outstanding                          |  |                              | 34,192
|Less: Weighted average shares of common stock subject to repurchase          |  |                              | (23   
|                                                                             |  |                              |       
|Weighted average shares used to compute basic and diluted net loss per
share |  |                              | 34,169
|                                                                             |  |                              |       
|Basic and diluted net loss per share                                         |  | $                            | (0.13 
|                                                                             |  |                              |       



5. INTANGIBLE ASSETS



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



|                     |  | As of March 31, 2003
|-------------------- |  | --------------------
|                     |  | Gross Amount        
|Purchased Technology |  | $                   
|Patents Purchased    |  |                     
|                     |  |                     
|Total                |  | $                   
|                     |  |                     



|                     |  | As of December 31, 2002
|-------------------- |  | -----------------------
|                     |  | Gross Amount           
|Purchased Technology |  |                        
|Patents Purchased    |  | $                      
|WarrantGM Onstar    |  |                        
|                     |  |                        
|Total                |  | $                      
|                     |  |                        



Purchased technology and
patents purchased are amortized as Research and Development expense.



In total, the Company amortized $104,000 from the purchased technology and the patents purchased for the quarter ended March 31, 2003; the Company amortized $271,000 from the purchased technology and the warrant  GM On-star for
the quarter ended March 31, 2002. The warrant GM On-star was fully amortized as of December 31, 2002. As of March 31, 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 9 months) |  | $                   
|2004                      |  |                     
|2005                      |  |                     
|2006                      |  |                     
|2007                      |  |                     
|                          |  |                     
|Total                     |  | $                   
|                          |  |                     



6. GUARANTEE



As of March 31, 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 was $11.0 million.



The Company does not maintain a general warranty reserve for estimated costs
of product warranties at the time revenue is recognized due to our extensive product quality program and processes and because our customer service inventories utilized to correct product failures are carried at zero cost.



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.



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



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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 second 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 stemmed 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 March 31, 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 |   |                     | $ | 1,516  |                  |  | $ | 20,424              |  
|Amount utilized in the year ending December 31, 2001 |  |            | (3,572 | ) |                     |   | (1,416 | )                |  |   | (20,424             | )
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Accrual balance at December 31, 2001                 |  | $          | 29,043 |   |                     | $ | 100    |                  |  | $ |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|                                                    
|Total charges for the year ending December 31, 2002  |  | $          | 31,829 |   |                     | $ |       |                  |  | $ |                    |  
|Amount utilized in the year ended December 31, 2002  |  |            | (9,342 | ) |                     |   | (100   | )                |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Balance at December 31, 2002                         |  |            | 51,530 |   |                     |   |       |                  |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Current restructuring accrual                        |  |            | 9,298  |   |                     |   |       |                  |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Long-term restructuring accrual                      |  | $          | 42,232 |   |                     | $ |       |                  |  | $ |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Q1 2002 Plan                                         |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Total charges for the year ending December 31, 2002  |  | $          |       |   |                     | $ | 1,319  |                  |  | $ |                    |  
|Amount utilized in the year ending December 31, 2002 |  |            |        |   |                     |   | (1,319 | )                |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|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  |   |                     | $ | 2,567  |                  |  | $ |                    |  
|Amount utilized in the year ending December 31, 2002 |  |            | (1,046 | ) |                     |   | (1,926 | )                |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Balance at December 31, 2002                         |  |            | 514    |   |                     |   | 641    |                  |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|                                                    
|Total charges for the quarter ended March 31, 2003   |  | $          |       |   |                     | $ |       |                  |  | $ |                    |  
|Amount utilized in the quarter ended March 31, 2003  |  |            | (361   | ) |                     |   | (11    | )                |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Balance at March, 31, 2002                           |  |            | 153    |   |                     |   | 630    |                  |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|                                                    
|Current restructuring accrual                        |  |            | 153    |   |                     |   | 630    |                  |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Long-term restructuring accrual                      |  | $          |       |   |                     | $ |       |                  |  | $ |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|                                                    
|Total restructuring accrual: Current                 |  | $          | 9,359  |   |                     | $ | 630    |                  |  | $ |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Total restructuring accrual: Long-term               |  | $          | 40,004 |   |                     | $ |       |                  |  | $ |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  



The Company expects the
total cash outlay for the restructuring plans to be $71.4 million, of which $21.4 million was paid through March 31, 2003 and $50.0 million remains accrued at March 31, 2003. The Company expects $9.4 million of the lease loss to be paid out over the
next twelve months and the remaining $40.0 million to be paid out over the remaining life of the lease of approximately 10 years. The Company expects the remaining $0.6 million of employee severance and related benefits accrual to be paid out by
June 30, 2003.



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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 March 31, 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):



|Fiscal Year Ending December 31, |  | Operating Leases
|------------------------------- |  | ----------------
|2003 (remaining 9 months)       |  | $               
|2004                            |  |                 
|2005                            |  |                 
|2006                            |  |                 
|2007                            |  |                 
|Thereafter                      |  |                 
|                                |  |                 
|Total minimum lease payments    |  | $               
|                                |  |                 



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 March 31, 2003, are as
follows (in thousands):



|Fiscal Year Ending December 31,            |  | Capital Leases |    
|------------------------------------------ |  | -------------- | ---
|2003 (remaining 9 months)                  |  | $              | 34 
|2004                                       |  |                | 30 
|                                           |  |                |    
|Total minimum lease payments               |  | $              | 64 
|Amount representing interest (11.2%)       |  |                | (4 
|                                           |  |                |    
|Present value of minimum lease payments    |  | $              | 60 
|Current portion of long-term capital lease |  |                | (41
|                                           |  |                |    
|Long-term portion                          |  | $              | 19 
|                                           |  |                |    



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 are currently engaged in settlement negotiations.



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,



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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.



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.



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.



10. STOCK COMPENSATION



Deferred Stock 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 will be amortized over the vesting period of the applicable
options in a manner consistent with FASB Interpretation No. 28. The Company recorded amortization of deferred stock compensation of $74,000 and $161,000 for the quarter ended March 31, 2003 and 2002, respectively, relating to approximately 3,152,000
stock options granted at a weighted average exercise price of $8.58. For the quarter ended March 31, 2003 and 2002, the Company reversed approximately $2,000 and $89,000 of deferred stock compensation and additional paid-in-capital, which
represented the unamortized amortization of deferred stock compensation relating to employees terminated under restructuring plans.



In connection with the SpeechFront acquisition, the Company recorded $290,000 for the quarters ended March 31, 2003 2002. SpeechFront related deferred
compensation is fully amortized as of December 31, 2002.



The
Company expects to amortize non-cash compensation of $137,000 in the remaining 9 months of 2003 and $8,000 in 2004, respectively.



11. SHORT-TERM INVESTMENTS



All our investments are classified as available for sale at March 31, 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 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 quarter ended March 31, 2003 and year ended December 31, 2002, the Company has incurred no such impairment.



12. SEGMENT REPORTING



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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 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 March 31, 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):



|                    |  | March 31, 2003 |        | March 31, 2002
|------------------- |  | -------------- | ------ | --------------
|License Revenue     |  |                |        |               
|United States       |  | $              | 3,733  |               
|Europe              |  |                | 626    |               
|Asia                |  |                | 453    |               
|Australia           |  |                | 14     |               
|Canada              |  |                | 1,250  |               
|Latin America       |  |                | 2      |               
|                    |  |                |        |               
|Total               |  | $              | 6,078  |               
|                    |  |                |        |               
|Service Revenue     |  |                |        |               
|United States       |  | $              | 1,951  |               
|Europe              |  |                | 170    |               
|Asia                |  |                | 30     |               
|Canada              |  |                | 646    |               
|Latin America       |  |                | 14     |               
|                    |  |                |        |               
|Total               |  | $              | 2,811  |               
|                    |  |                |        |               
|Maintenance Revenue |  |                |        |               
|United States       |  | $              | 1,846  |               
|Europe              |  |                | 417    |               
|Asia                |  |                | 65     |               
|Australia           |  |                |       |               
|Canada              |  |                | 235    |               
|Latin America       |  |                | 111    |               
|                    |  |                |        |               
|Total               |  | $              | 2,674  |               
|                    |  |                |        |               
|Total Revenue       |  | $              | 11,563 |               
|                    |  |                |        |               
|United States       |  | $              | 7,530  |               
|Europe              |  |                | 1,213  |               
|Asia                |  |                | 548    |               
|Australia           |  |                | 14     |               
|Canada              |  |                | 2,131  |               
|Latin America       |  |                | 127    |               
|                    |  |                |        |               
|Total Revenue       |  | $              | 11,563 |               
|                    |  |                |        |               



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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 subject to general economic conditions, which could harm our business, If we do not manage our operations in accordance with changing economic conditions, our resources may be strained which
could harm our chances of achieving profitability, We depend upon resellers for a significant portion of our sales. The loss of key resellers or a decline in their resale of our products and services could limit our ability to sustain
and grow our revenue, 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, Our current and potential competitors, some of whom have greater resources and experience than we do, may market or develop products, services and/or technologies that may cause demand for and the prices
of our products to decline, and Sales to customers outside the United States account for a significant portion of our revenue, which exposes us to risks inherent in international 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 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 2003, we plan to add certain applications for key industries which 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 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 (primarily Hong Kong) 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. We intend to continue to support sales and marketing activities with respect to international licensing of our software and provision of our services



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, developing a new voice platform and applications designed to increase the speed and ease of deployment and reduce the total cost of ownership of speech
systems, developing and strengthening a hybrid (direct and



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indirect) selling model, and
developing advanced speech technologies that deliver customer value and maintain our leadership position in the speech industry.



Some specific operating changes have already been accomplished, such as the restructuring actions taken in the first and third quarters of 2002 and the
release of our software platform in early 2003. Other operating activities, including new products and changes to selling and delivery channels, will continue to evolve over the 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. For instance, we have recently introduced a new software platform and plan to
introduce certain new applications. 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 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. In addition, while we are actively working to maintain productive reseller relationships, certain reseller relationships may be adversely affected by Nuances direct sales activities, which may have an unfavorable impact on revenue
from certain resellers.



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 strong relationships with many existing resellers as well as to develop new reseller relationships. 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 have may be larger and 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 months ended March 31, 2003 and 2002.



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|                                     |  | Three Months Ended March 31, |   
|------------------------------------ |  | ---------------------------- | --
|                                     |  | 2003                         |   
|Revenue:                             |  |                              |   
|License                              |  | 53                           | % 
|Service                              |  | 24                           |   
|Maintenance                          |  | 23                           |   
|                                     |  |                              |   
|Total Revenue                        |  | 100                          |   
|Cost of revenue                      |  |                              |   
|License                              |  |                             |   
|Service                              |  | 19                           |   
|Maintenance                          |  | 8                            |   
|                                     |  |                              |   
|Total cost of revenue                |  | 27                           |   
|                                     |  |                              |   
|Gross profit                         |  | 73                           |   
|                                     |  |                              |   
|Operating expenses                   |  |                              |   
|Sales and marketing                  |  | 59                           |   
|Research and development             |  | 34                           |   
|General and administrative           |  | 29                           |   
|Non-cash compensation                |  | 1                            |   
|Restructuring charges                |  | (8                           | ) 
|                                     |  |                              |   
|Total operating expenses             |  | 115                          |   
|                                     |  |                              |   
|Loss from operations                 |  | (42                          | ) 
|Interest and other income, net       |  | 4                            |   
|                                     |  |                              |   
|Loss before income taxes             |  | (38                          | ) 
|Provision (benefit) for income taxes |  | (1                           | ) 
|                                     |  |                              |   
|Net loss                             |  | (37                          | )%
|                                     |  |                              |   



COMPARISON OF THREE
MONTHS ENDED MARCH 31, 2003 AND 2002



Revenue



Total revenue for the three months ended March 31, 2003 was
$11.6 million, compared with $9.1 million in the three months ended March 31, 2002, an increase of 27%.



License revenue for the three months ended March 31, 2003 was $6.1 million, compared with $5.9 million in the three months ended March 31, 2002, an increase of 3%. This increase is primarily due to 34%
growth in the Unites States and Canada enterprise marketplace. License revenue represented 53% and 64% of total revenue for the three months ended March 31, 2003 and 2002, respectively.



Service revenue for the three months ended March 31, 2003 was $2.8 million, compared with $1.2 million for the three months
ended March 31, 2002, an increase of 133%. This increase in service revenue was due primarily to heightened consulting demand, particularly strong in the telecommunications marketplace. Service revenue represented 24% and 14% of total revenue for
the three months ended March 31, 2003 and 2002, respectively.



Maintenance revenue for the three months ended March 31, 2003 was $2.7 million, compared with $2.0 million for the three months ended March 31, 2002, representing an increase of 35%. The increased maintenance revenue was due to the
relative increase in license revenue combined with a sustained high level of contract renewals. Maintenance revenue represented 23% and 22% of total revenue for the three months ended March 31, 2003 and 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 revenue for the three months ended March 31, 2003 was $12,000, compared with $86,000 in the three months ended March 31, 2002, a decrease of 86%. The
decrease was primarily due to the write off of the software inventory for the quarter ended March 31, 2002. During 2001, we purchased $550,000 of third-party software to complement our core platform product line. For the year ended December 31,
2001, we evaluated the third party software and wrote-off $275,000 of excess inventory caused by lower-than-expected demand. In 2002, we continued to assess the remaining carrying value of the inventory in relation to recovery of future revenues and
wrote off $86,000 for the quarter ended March 31, 2002. We wrote off the remaining amount during the year ended December 31, 2002. We anticipate that cost of license revenue will slightly increase in absolute dollars, but will vary as a percentage
of total revenue from period to period.



Cost of service revenue
for the three months ended March 31, 2003 was $2.2 million, compared with $2.0 million in the quarter ended March 31, 2002, representing an increase of 10%. This was due to additional capacity, in the form of third party services, temporarily
employed to meet peak cycles stemming from increased consulting service demand. Also, there is an increase of professional service personnel by approximately 3 employees, approximately 10%, in the three months ended March 31, 2003 compared with the
quarter ended March 31, 2002. Cost of service revenue as a percentage of service revenue was 79% and 167% in the three months ended March 31, 2003 and 2002, respectively. While we anticipate that cost of service revenue will increase slightly in
absolute dollars, it will vary as a percentage of total revenue from period to period.



Cost of maintenance revenue for the three months ended March 31, 2003 was $0.9 million, compared with $0.9 million in the three months ended March 31, 2002. Cost of maintenance revenue as a percentage of maintenance revenue
was 33% and 45% in the three months ended March 31, 2003 and 2002, respectively. We anticipate cost of maintenance revenue to vary nominally in absolute dollars, but will vary as a percentage of total revenue from period to period.



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. 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 March 31, 2003 were $6.9 million, compared with $9.0 million in the three months ended March 31, 2002, representing a decrease of
23%. The decrease was primarily attributable to the reduction of the global customer team and marketing workforce. The global customer team was decreased by 45 persons, approximately 29%, from 157 persons at March 31, 2002 to 112 persons at March
31, 2003 and the marketing force was decreased by 6 persons, approximately 19%, from 32 at March 31, 2002 to 26 at March 31, 2003. These two factors resulted in lower payroll and related overhead costs. As a percentage of total revenue, sales and
marketing expenses were 59% and 99% for the three month periods ended March 31, 2003 and 2002, respectively. We anticipate that sales and marketing expenses will rise slightly but will vary as a percentage of total revenue from period to period.



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 March 31, 2003 were $3.9 million, compared with $3.7 million in the
three months ended March 31, 2002, representing an increase of 5%. This increase was attributable to our continuing effort to develop and deliver the Nuance Voice Platform product and Nuance Call Steering Application product. As a percentage of
total revenue, research and development expenses were 34% and 41% in the three months ended March 31, 2003 and 2002, respectively. We anticipate that research and development expenses will increase nominally in absolute dollars, but 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 March 31, 2003 were $3.4 million, compared with $3.0 million in the three months ended March 31, 2002, representing an increase of 13%. This increase was primarily due to transition expenses
associated with the new and former CEO, increasing insurance premiums, audit and tax services, and other professional services. As a percentage of total revenue, general and administrative expenses were 29% and 33% in the three months ended march
31, 2003 and 2002, respectively. We anticipate that general and administrative expenses will remain relatively constant in absolute dollars, but will vary as a percentage of total revenue from period to period.



Non-Cash Stock-Based Compensation  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 will be amortized over the vesting period of the applicable options in a manner consistent with
FASB Interpretation No. 28. We recorded amortization of deferred stock compensation of $74,000 and



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$162,000 for the quarter ended
March 31, 2003 and 2002, respectively, relating to approximately 3,152,000 stock options granted at a weighted average exercise price of $8.58. For the quarter ended March 31, 2003 and 2002, we reversed approximately $2,000 and $89,000 of deferred
stock compensation and additional paid-in-capital, which represented the unamortized amortization of deferred stock compensation relating to employees terminated under restructuring plans.



In connection with our November 2000 SpeechFront acquisition, we recorded deferred stock compensation of $4.1 million. This
amount was part of the purchase agreement and was payable to the founders in common stock, approximately 38,710 shares, contingent upon their continued employment. Of that amount, $1.7 million of stock, approximately 16,590 shares, related to
retention of the founders of SpeechFront, and was released from the escrow account on the eighteen-month anniversary of the acquisition date, which was May 2002. The remaining $2.4 million of stock, approximately 22,120 shares, also related to
retention of the founders and was released from the escrow account on the twelve-month anniversary of the acquisition date, which was November 2001. By May 2002, the SpeechFront founders had been issued all 38,710 shares of common stock. These
amounts have been amortized over 18 months and 12 months, respectively. We recorded deferred compensation of $290,000 for the quarter ended March 31, 2002. SpeechFront related deferred compensation is 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 is 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 in the three months ended March 31, 2002 related to this warrant. We reduced the warrant expense by $18,000 for the performance we delivered to this customer in the three months ended March 31, 2002. The warrant expired
unexercised in August 2002.



We expect to amortize non-cash
compensation of $136,000 in the remaining 9 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 restructuring 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 second quarter of 2003. The plan also included the consolidation of facilities through the closing of excess 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 stemmed from the analysis of the time period of which the San Mateo property will remain vacant, sub-lease terms and sub-lease rates, reflecting continued softening of the local real estate market.



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The restructuring charges and
quarter end balances for the quarter ended March 31, 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 |   |                     | $ | 1,516  |                  |  | $ | 20,424              |  
|Amount utilized in the year ending December 31, 2001 |  |            | (3,572 | ) |                     |   | (1,416 | )                |  |   | (20,424             | )
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Accrual balance at December 31, 2001                 |  | $          | 29,043 |   |                     | $ | 100    |                  |  | $ |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|                                                    
|Total charges for the year ending December 31, 2002  |  | $          | 31,829 |   |                     | $ |       |                  |  | $ |                    |  
|Amount utilized in the year ended December 31, 2002  |  |            | (9,342 | ) |                     |   | (100   | )                |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Balance at December 31, 2002                         |  |            | 51,530 |   |                     |   |       |                  |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Current restructuring accrual                        |  |            | 9,298  |   |                     |   |       |                  |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Long-term restructuring accrual                      |  | $          | 42,232 |   |                     | $ |       |                  |  | $ |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|                                                    
|Q1 2002 Plan                                         |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Total charges for the year ending December 31, 2002  |  | $          |       |   |                     | $ | 1,319  |                  |  | $ |                    |  
|Amount utilized in the year ending December 31, 2002 |  |            |        |   |                     |   | (1,319 | )                |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|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  |   |                     | $ | 2,567  |                  |  | $ |                    |  
|Amount utilized in the year ending December 31, 2002 |  |            | (1,046 | ) |                     |   | (1,926 | )                |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Balance at December 31, 2002                         |  |            | 514    |   |                     |   | 641    |                  |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|                                                    
|Total charges for the quarter ended March 31, 2003   |  | $          |       |   |                     | $ |       |                  |  | $ |                    |  
|Amount utilized in the quarter ended March 31, 2003  |  |            | (361   | ) |                     |   | (11    | )                |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Balance at March, 31, 2002                           |  |            | 153    |   |                     |   | 630    |                  |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|                                                    
|Current restructuring accrual                        |  |            | 153    |   |                     |   | 630    |                  |  |   |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Long-term restructuring accrual                      |  | $          |       |   |                     | $ |       |                  |  | $ |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|                                                    
|Total restructuring accrual: Current                 |  | $          | 9,359  |   |                     | $ | 630    |                  |  | $ |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  
|Total restructuring accrual: Long-term               |  | $          | 40,004 |   |                     | $ |       |                  |  | $ |                    |  
|                                                     |  |            |        |   |                     |   |        |                  |  |   |                     |  



We expect the total cash
outlay for the restructuring plans to be $71.4 million, of which $21.4 million was paid through March 31, 2003 and $50.0 million remains accrued at March 31, 2003. We expect $9.4 million of the lease loss to be paid over the next twelve months and
the remaining $40.0 million to be paid out over the remaining life of the lease of approximately 10 years. We expect the remaining $0.6 million of employee severance and related benefits accrual to be paid out by June 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
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 $466,000 and $867,000 in the three months ended March 31, 2003 and 2002, respectively, a decrease of 46%. 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 March 31, 2003 and therefore have not recorded a provision for U.S. federal income taxes for any period through March 31, 2003. We recorded income tax expense relating to foreign royalties taxes of $48,000 and $37,000 for the three
months ended March 31, 2003 and 2002, respectively. The income tax expense has been reduced by tax credits associated with research and development activities from our Canadian technology center. These tax credits, which result in cash payments to
us, are based on qualified salaries paid and capital equipment purchases. As of March 31, 2003,



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foreign income taxes balance
is in the credit of $112,000. It is made of tax credit of $150,000 from Canadian subsidiary and tax expense of 38,000 from other foreign subsidiaries. The credits are related to qualified expenditures made in 1999, 2000 and 2001. 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 March 31, 2003, we had cash and cash equivalents of $43.9 million,
short-term and long-term investments totaling approximately $78.0 million.



Our operating activities used cash of $5.2 million and $11.8 million for the three months ended March 31, 2003 and 2002, respectively. The negative operating cash flows in the quarter ended March 31, 2003 and 2002 both resulted
principally from our net losses and lease payments for a building we do not occupy.



Our investing activities provided cash of $5.1 million for the three months ended March 31, 2003 and used cash of $4.6 million for the three months ended March 31, 2002. For the three months ended March 31, 2003, cash is
generated from the proceeds of maturities from certain portion of investments, offset by the purchases of investments. For the three months ended March 31, 2002, 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 $6,000 and $300,000 for the three months ended March 31, 2003 and 2002, respectively. Net cash provided by financing activities for the three months ended March 31, 2002 related primarily to the proceeds from
the sale of common stock through the exercise of stock options.



Contractual obligations



The following
table summarizes our obligations and commercial commitments to make future payments under contracts as of March 31, 2003 (in thousands):



|Contractual Obligations       |  | Total |        | 2003 (remaining 9 months) |   | 2004      |  | 2005      |       | 2006          |   | 2007  |  | Thereafter
|----------------------------- |  | ----- | ------ | ------------------------- | - | --------- |  | --------- | ----- | ------------- | - | ----- |  | ----------
|Operating leases              |  | $     | 85,799 |                           | $ | 7,246     |  | $         | 9,073 |               | $ | 8,287 |  | $         
|Capital leases                |  |       | 64     |                           |   | 34        |  |           | 30    |               |   |      |  |           
|                              |  |       |        |                           |   |           |  |           |       |               |   |       |  |           
|Total Contractual Obligations |  | $     | 85,863 |                           | $ | 7,280     |  | $         | 9,103 |               | $ | 8,287 |  | $         
|                              |  |       |        |                           |   |           |  |           |       |               |   |       |  |           
|Other Commercial Commitments  |  | Total |        | Less than 1 year          |   | 1-3 years |  | 4-5 years |       | After 5 years |   |       |  |           
|Standby Letters of Credit     |  | $     | 12,393 |                           | $ |          |  | $         |      |               | $ |      |  | $         
|                              |  |       |        |                           |   |           |  |           |       |               |   |       |  |           



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 9 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 $12.4 million invested with a bank, as required by our landlords to meet rent deposits requirements for our leases on facilities.



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



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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 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 our software products. The
license fees for our software products are calculated using two variables, one 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.



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 is 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. 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 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.



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 standard implementation services that are not essential to the
functionality of the software. When we perform consulting 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 insignificant for 2002. We are also
exploring



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potential markets for complete
speech solutions, delivered through combined product and services, which we expect to require 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, 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 consulting, training and other revenue. Other revenue consists primarily of reimbursements for consulting out-of-pocket expenses incurred, in accordance with the 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. 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 required to later activate maintenance. Customers generally have the option to renew or decline maintenance agreements annually during the contract term.



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 March 31, 2003 and
December 31, 2002, deferred revenue was $8.1 million and $9.0 million, respectively. The deferred revenue amount includes unearned license, 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.



Restructuring and Impairment Charges



Through March 31, 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 March 31, 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



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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.



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 March 31, 2003, we have no goodwill balance and no impairment of intangibles was recorded.



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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.



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;
|- |  | -------------------------------------------------------------------------



| |  | 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, that respond to changing technology
trends in a timely manner and our ability to manage product transitions;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | rate of market adoption for our new products such as our software platform and applications products;
|- |  | -----------------------------------------------------------------------------------------------------



| |  | changes in our selling model including focus of certain sales representatives on direct sales to end user customers;
|- |  | --------------------------------------------------------------------------------------------------------------------



| |  | 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 have experienced seasonality in the sales of our product and expect such seasonality to continue. 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 THEIR 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, and was 74% in 2002. 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. We cannot guarantee that any of our resellers will continue to market our products or devote significant resources to doing so. 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, 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 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
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.
|- |  | --------------------------------------------------------------------------------------------------------------------



In addition, new sales and delivery models present increased
costs and risks such as liability for complete solution delivery, costs and risks of subcontractors, and delays in recognition of revenue due to project timeliness for solutions development.



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 a lengthy 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



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recognition may occur and may cause license and services revenue and operating results to vary
significantly from period to period.



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 $71.2 million for the year ended December 31, 2002. As of December 31, 2002, we had an accumulated deficit of
approximately $238.9 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 year
ended December 31, 2002, five customers made up 32% of our total revenue, and one customer, acting as a reseller, accounted for approximately 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 several 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 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. We anticipate that revenue from markets outside the United States will continue
to represent a significant 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;
|- |  | -------------------------------------------------------------------------------------------



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



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| |  | 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, the trading price of our common stock declined rapidly and significantly during 2002.



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.



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Any future acquisitions of companies or technologies would be accompanied by risks such as:



| |  | 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.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------



For instance, in November 2000 we acquired SpeechFront, a Canadian company.
For the year ended December 31, 2001, we 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.



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.



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.



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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). We
believe that the allegations against us are without merit and intend to continue to defend the litigations vigorously. An unfavorable resolution of the 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 reduced 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 March 2003, our Chief Executive Officer, Ronald Croen, resigned from his position as CEO. In addition, in January 2002 Graham Smith resigned from his position with Nuance as Chief Financial Officer. Other than Charles
Berger, our CEO, 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



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markets for our products and services or to compete more effectively, we could lose market share and our
business could suffer.



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.



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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 March
31, 2003, we had cash and cash equivalents, short-term investments and long-term investments of $121.9 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



(a) Evaluation of disclosure controls and procedures



Based on their evaluation, as of a date within 90 days of the filing of this Quarterly Report Form 10-Q, the Companys Chief Executive Officer and Chief Financial Officer have concluded that the Companys disclosure
controls and procedures (as defined in Rules 13a-14(c) and 15d-14 (c) under the Securities Exchange Act of 1934 (the Exchange Act)) are effective to ensure that information required to be disclosed by he Company in reports that it files
or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods in Securities and Exchange Commission rules and forms.



(b) Changes in internal controls



There have been no significant changes to the Companys internal controls or in other factors that could significantly
affect these controls subsequent to the date of their evaluation. There were no significant deficiencies or material weakness, and therefore there were no corrective actions.



In accordance with Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley
Act of 2002 (the Act), we are required to disclose the non-audit services approved by our Audit Committee to be performed by Deloitte & Touche LLP, our external auditor. Non-audit services are defined in the Act as services other
than those provided in connection with an audit or a review of the financial statements of a company. The Audit Committee has approved the engagement of Deloitte & Touche LLP for services related to local statutory audits, quarterly services and
certain taxation matters.



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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 are currently engaged in settlement
negotiations.



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.



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.



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.



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.                                                                                                        
|              
|10.1***        |  | Executive Employee Agreement by and between the Company and Ronald A. Croen dated as
of January 1, 2003.                                              
|              
|10.2***        |  | Executive Employee Agreement by and between the Company and Charles W. Berger dated as of March 31,
2003.                                             
|              
|99.1           |  | 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.
|              
|99.2           |  | Certification of the Chief Financial 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 effective by
|- |  | ------------------------------------------------------------------------------------------------------------------------------



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| |  | 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.
|-- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|*** |  | Confidential treatment to be requested for a portion of this agreement; Confidential portion filed separately with the Securities and Exchange Commission
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



(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: |  | May 15, 2003 |  |                                         
|      |  |              |  |                                         



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CERTIFICATION PURSUANT TO SECTION 302(a) OF THE SARBANES  OXLEY ACT OF 2002



I, Charles W. Berger, Chief Executive Officer of Nuance Communications, Inc. (the Company), certify that:



(1) I have reviewed this quarterly report of the Company on Form 10-Q (the Report);



(2) Based on my knowledge, the Report does not contain any untrue statements
of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the Report;



(3) Based on my knowledge, the financial statements, and other financial
information included in the Report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in the Report;



(4) The Companys other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15b-14) for the Company and we have:



a. Designed such disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries
is made known to us by others in the Company particularly during the period in which the Report is being prepared;



b. Evaluated the effectiveness of the Companys disclosure controls and procedures as of a date within 90 days prior to the filing date of the Report
(the Evaluation Date); and



c. Presented in the
Report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;



(5) The Companys other certifying officer and I have disclosed, based on our most recent evaluation, to the Companys auditors and the Audit
Committee of the Companys Board of Directors:



a. All
significant deficiencies in the design or operation of internal controls which could adversely affect the Companys ability to record, process, summarize, and report financial data and have identified for the Companys auditors any
material weaknesses in internal controls; and



b. Any fraud,
whether or not material, that involves management or other employees who have a significant role in the Companys internal controls; and



(6) The Companys other certifying officer and I have indicated in the Report whether or not there were significant changes in internal controls or
in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.



|
|
|
|





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CERTIFICATION PURSUANT TO SECTION 302(a) OF THE SARBANES  OXLEY ACT OF 2002



I, Karen Blasing, Chief Financial Officer of Nuance Communications, Inc. (the Company), certify that:



(1) I have reviewed this quarterly report of the Company on Form 10-Q (the Report);



(2) Based on my knowledge, the Report does not contain any untrue statements
of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the Report;



(3) Based on my knowledge, the financial statements, and other financial
information included in the Report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in the Report;



(4) The Companys other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15b-14) for the Company and we have:



a. Designed such disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries
is made known to us by others in the Company particularly during the period in which the Report is being prepared;



b. Evaluated the effectiveness of the Companys disclosure controls and procedures as of a date within 90 days prior to the filing date of the Report
(the Evaluation Date); and



c. Presented in the
Report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;



(5) The Companys other certifying officer and I have disclosed, based on our most recent evaluation, to the Companys auditors and the Audit
Committee of the Companys Board of Directors:



a. All
significant deficiencies in the design or operation of internal controls which could adversely affect the Companys ability to record, process, summarize, and report financial data and have identified for the Companys auditors any
material weaknesses in internal controls; and



b. Any fraud,
whether or not material, that involves management or other employees who have a significant role in the Companys internal controls; and



(6) The Companys other certifying officer and I have indicated in the Report whether or not there were significant changes in internal controls or
in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.



|
|
|
|



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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.                                                                                                        
|              
|10.1***        |  | Executive Employee Agreement by and between the Company and Ronald A. Croen dated as of January 1,
2003.                                              
|              
|10.2***        |  | Executive Employee Agreement by and between the Company and Charles W. Berger dated as of March 31,
2003.                                             
|              
|99.1           |  | 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.
|              
|99.2           |  | Certification of the Chief Financial 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 effective 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.
|-- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|*** |  | Confidential treatment to be requested for a portion of this agreement; Confidential portion filed separately with the Securities and Exchange Commission
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------