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

                               -----------------

                                   FORM 10-K
                       FOR ANNUAL AND TRANSITION REPORTS
                    PURSUANT TO SECTIONS 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934

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

     For the fiscal year ended December 31, 2001

[_]  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: 000-31097

                               -----------------

                        SPEECHWORKS INTERNATIONAL, INC.
            (Exact name of registrant as specified in its charter)

                      Delaware                 04-3239151
                   (State or other
                     jurisdiction
                 of incorporation or        (I.R.S. Employer
                    organization)          Identification No.)

                 695 Atlantic Avenue              02111
                Boston, Massachusetts          (Zip Code)
                (Address of principal
                 executive offices)

                                (617) 428-4444
             (Registrant's telephone number, including area code)

                               -----------------

     Securities registered pursuant to Section 12(b) of the Exchange Act:
                                     None

     Securities registered pursuant to Section 12(g) of the Exchange Act:
                    Common Stock, $.001 Par Value Per Share
                               (Title of Class)

                               -----------------

   Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]

   Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.  [_]

   The aggregate market value of the registrant's voting stock held by
non-affiliates of the registrant (without admitting that any person whose
shares are not included in such calculation is an affiliate) on February 28,
2002, was $256,258,928 based on the last bid price as reported by The Nasdaq
Stock Market.

   As of February 28, 2002, the registrant had 32,437,839 shares of common
stock outstanding.

                      DOCUMENTS INCORPORATED BY REFERENCE

   The following documents (or parts thereof) are incorporated by reference
into the following parts of this Form 10-K: Certain information required in
Part III of this Annual Report on Form 10-K is incorporated from the
Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held
on May 23, 2002.

================================================================================

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                                    PART I

Item 1.  Business

Overview

   We are a leading provider of software products and professional services
that enable enterprises, carriers and voice portals to offer automated,
speech-activated services over any telephone. With our network-based speech
recognition solutions, consumers can direct their own calls, obtain information
and conduct transactions automatically, simply by speaking naturally over any
telephone, anytime. With our network-based text-to-speech ("TTS") solutions,
consumers can experience natural sounding synthesized speech that supports a
number of applications, including unified messaging. With our embedded
technologies in both speech recognition and TTS, we can enable automobile and
device manufacturers to support both speech recognition and TTS on the device
or in the automobile itself.

   For network-based speech applications, we currently offer the OpenSpeech
product suite, a line of speech recognition solutions for over-the-telephone
applications designed to meet industry standards, with specific tuning for high
performance over wireless networks. The OpenSpeech Product line includes the
OpenSpeech Recognizer; OpenSpeech DialogModules, building blocks that support
VoiceXML standards; OpenSpeech Platform Integration Kit, a 'get started'
toolkit for platform partners to accelerate support for VoiceXML; and
OpenSpeech Server, a standards-based client-server architecture. In addition to
the OpenSpeech line, we offer our legacy recognizer, SpeechWorks 6.5, and the
SpeechSite package. Our TTS, or speech synthesis network-based solution,
Speechify, allows callers to hear text read to them by a computer in a natural
sounding voice. Finally, we offer a speaker verification solution, called
SpeechSecure, which authenticates callers by their unique voiceprint. We
complement our suite of network-based products with a professional services
organization that offers a range of services, including application development
and project management.

   Suitable for incorporation in mobile devices, automobiles and set-top boxes,
we offer our embedded speech technology product, Speech2Go, a recognizer that
supports a 1,000 word vocabulary with a footprint under 8MB. Our embedded TTS
product, ETI-Eloquence, is highly flexible and features a footprint of
approximately 1MB.

   Since shipping our first products in 1996, we have received awards for our
product capabilities and our industry leadership, including Industry Week's
Technology of the Year Award and Frost & Sullivan's Market Strategy Leadership
Award. To date, we have licensed our software to more than 500 clients
worldwide in a variety of industries including retail, financial services,
pharmaceuticals, telecommunications, technology, distribution and travel. Our
clients include America Online, Amtrak, AT&T, Continental Airlines, CSFB,
e-Plus, E*TRADE, First Union Corporation, GMAC Commercial Mortgage, Hyundai
Securities, iBasis/Price Interactive, McKessonHBOC, NetByTel, Nortel Networks,
The Hartford Insurance, United Airlines, Yahoo and WorldCom.

Industry Background

   Businesses today share a common goal to improve operating efficiency and to
enhance their customer service. Those goals translate to a vision of
communicating information and completing transactions with customers anywhere,
anytime, using any communications device. Fueled by the rapid growth in
wireless communications technologies and services as well as an abundance of
internet content available for use in speech services, businesses aim to reach
the widest population possible and have made significant investments in their
infrastructure to do so. While there is an opportunity based on increased
mobile phone usage and device proliferation, wireless networks present an
incremental technical challenge for speech recognition compared to landline
networks due to limitations on existing cellular technology and signal
coverage. Businesses are now seeking to maximize the return on their
investments, improve their customer service responsiveness, and capitalize on
the substantial growth of the wireless telephone network as a new distribution
channel.

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The Internet Content Infrastructure

   In the past decade, the internet has emerged as a global communications
network and channel for business and has fundamentally changed the way
consumers and businesses obtain information, communicate, purchase goods and
transact business. Many businesses now define their strategy and assess their
ability to compete based on the quality and diversity of the information,
products or services they offer online. Increasingly, consumers are retrieving
information from online databases and buying goods and services--tickets,
stocks, books--without going to a business in person or even speaking with a
customer service representative over the telephone. International Data
Corporation (IDC) estimates that the internet will continue to grow as a medium
for commerce, with nearly one billion people, about 15% of the world's
population, using the internet by 2005. It is expected that this usage will
generate over $5 trillion in commerce being initiated over the internet by the
end of 2005, a 70% compound annual growth rate from $354 billion in commerce in
2000.

The Proliferation of the Telephone

   Despite the internet's growing acceptance, the telephone network is still
more widely and readily accessible. Telephones are simple to operate and use
the most natural form of communication, the human voice. In January 2002, the
International Telecommunications Union estimated that there are over 986
million telephone lines installed worldwide. In 2001, the Yankee Group
estimated that by December 2001 there would be approximately 800 million
wireless telephone subscribers worldwide, and projected this number will grow
to over 900 million subscribers worldwide by the end of 2002.

   To manage the growth in telephone-based interactions, businesses have made
significant investments in customer service infrastructures such as call
centers staffed with customer service representatives. IDC estimated that
worldwide spending on customer relationship management services, which includes
expenditures on call centers, exceeded $40 billion in 1999.

   In addition, new technologies are being used, primarily by communications
service providers, to provide internet information services such as e-mail,
news, stock quotes, weather and sports information to wireless subscribers.
With these technologies, businesses are looking to extend access to their
internet infrastructure to cellular telephones and other wireless handheld
devices such as personal digital assistants or PDAs.

Need for Enhanced Access to e-Business

   The growth of the internet as a global medium for communications and
commerce has been driven, in part, by the increased availability of personal
computers and easy to use, visual web browser interfaces. However, access to
the internet over a personal computer is dependent on consumers having access
to a computer and a working internet connection. Further, using a web browser
on a personal computer can be difficult and slow. Wireless access to the
internet over cellular telephones and other handheld devices has the potential
to resolve the mobility and internet connectivity issues presented by internet
access over a personal computer. However, while the number of these devices has
increased in recent years, display screens on these devices are small and the
ability to input information using portable keyboards is constrained, limiting
the usability and convenience of this solution. Therefore, the goal of anytime,
anywhere access to a wide variety of information services has not yet been
fully realized.

   Access to businesses and information over the telephone is somewhat easier
than access over the internet because of the greater availability of landline
and wireless telephones. Although businesses have made significant investments
in staffed call centers, consumers are frequently required to wait on hold for
extended periods due to the lack of call center capacity or are unable to speak
to a customer service representative due to

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the high cost of having customer service representatives available around the
clock. Businesses have attempted to alleviate this problem by automating call
center services using touch-tone technologies. However, the range of services
that can be automated using touch-tone is limited, and the interface itself can
be very frustrating for users. Touch-tone menus can be difficult to follow and
callers often dial "0" to wait for a human operator or hang up rather than use
such a system. This can result in poor customer service which may negatively
affect customer relations, and ultimately lead to the loss of business.

Speech-Activated Solutions for e-Business

   To conduct e-business in a truly mobile, device-independent fashion, the
ability to communicate and conduct transactions in a hands-free manner is
essential. Speech recognition technology allows businesses to leverage their
investment in their e-business and existing telephony infrastructures to offer
their customers quick and easy access to information and services over the most
readily available communications device--the telephone. For example, businesses
can offer their customers the ability to obtain information and complete
transactions using words and natural sentences such as:

 "I'd like to transfer $5,000 from my checking account to my savings account."

          "Is the 5 o'clock flight from New York to Boston on time?"

                     "When will my shipment be delivered?"

   Speech recognition and text-to-speech technologies allow callers who would
otherwise have to wait for a call center agent to be serviced automatically,
and those who might otherwise be frustrated by having to choose from many
touch-tone options, to speak directly to the e-business application, thereby
achieving their objective faster and easier. Speech-activated services also
constitute a key differentiator for companies seeking to provide a convenient,
flexible and robust interface for customers to conduct internet transactions
through a medium other than a personal computer or PDA.

   Although basic speech recognition technology has existed for decades, until
recently, it has not been widely used in telephone applications due to a number
of technical and commercial limitations. In order to provide high-quality,
speech-activated services to callers, businesses require a solution that:

  .  recognizes a large vocabulary with low error rates,

  .  allows users to speak in natural phrases or sentences and to interrupt an
     application prompt when they are ready with responses or new queries,

  .  allows automated services to speak to the user with a natural-sounding yet
     synthesized voice,

  .  provides high-level development and operations tools that are integrated
     in accepted platforms, including platforms based on new industry standards,

  .  includes professional services to assist in one or more phases of the
     deployment lifecycle, and

  .  is sufficiently cost-effective and scalable that it enables an attractive
     return on investment.

The SpeechWorks Solution

   In addition to enhancing existing telephony-based customer service
applications, our speech recognition and synthesis technologies enable our
clients to extend the reach of their e-business solutions beyond the web and
beyond screen-based interfaces to anyone with access to a wireless or landline
telephone.

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   Enterprises are building speech-activated services with our products that
will automate and enhance customer service by making it easier for customers to
retrieve information and conduct transactions without waiting on hold or
speaking to an agent. Examples of phrases that can be understood by
applications enabled by our software are: "What is my checking account
balance?" and "Buy 100 shares of General Electric at the market price." These
services can improve the caller's experience and save expensive customer
service representative costs and "on hold" telephone times.

   Communication carriers and their partners are building speech-activated
services with our products that we believe have the potential to change the way
people use the telephone for network services. Applications have been built,
and enabled by our software, that can understand phrases such as "Call Mike
Phillips at home" and "Forward this message to Bill O'Farrell." These services
can differentiate one carrier's service offering from another, thereby
increasing the ability of carriers to attract and retain users.

   In addition, a relatively new class of service providers, known as voice or
speech portals and unified messaging companies, is using our software to build
applications that can understand phrases such as: "What is the weather in
Paris?" and "What was the score of the Red Sox game today?" and read-back
e-mail or text-based messages in a natural sounding, intelligible voice.

   We complement our products with a professional services organization that
offers a range of services, including application development and project
management. We have designed these services to shorten time-to-market, reduce
project implementation risk, assist our partners and improve our clients'
competitive position. We are focused on developing and extending our products
and services to provide our partners and clients with a comprehensive means for
building, managing and delivering sophisticated e-business applications and
services that can be accessed over the telephone.

   Our solutions are designed to provide the following benefits to our clients:

   Lower operational costs. Our enterprise clients can decrease their telephone
expense by shortening the average customer call length and by answering common
customer questions with a speech application rather than requiring callers to
hold for a live agent or employee. Speech-enabled call routing, such as that
provided by our SpeechSite product, can increase customer service efficiency by
classifying call types and collecting pertinent information prior to
transferring calls to an appropriate representative. This means that the same
number of customer service representatives can answer a significantly higher
volume of calls. We believe that off-loading repetitive calls to a speech
application and routing the more challenging transactions to highly-trained
customer service representatives can also increase employee job satisfaction
and decrease staff turnover. Additionally, our solutions can support multiple
languages on a single system, thereby reducing the number of platforms and
telephone numbers required. We believe our efficient speech recognition engine
and our single system architecture obviate the need for dedicated recognition
servers, which can result in a lower total cost of ownership than many other
alternative architectures.

   Increased revenues. Companies that implement speech-activated solutions can
use the additional, ubiquitous access to their online services to differentiate
their e-business offering from their competition and thereby increase customer
loyalty and reduce customer turnover. Many e-business applications that were
difficult to use with touch-tone technology, such as stock trading and flight
booking, can be more readily provided over the telephone with our speech
solutions. Online brokerages, for example, have used our products to extend
their automated services to new users who are not online and to enable existing
online subscribers to conduct trades when they are unable to access the web
with a visual internet browser. Increased automation of incoming calls can free
up call center agents to take on cross-selling and other revenue-generating
activities. In some cases, the speech service itself can offer cross- and
up-sell to callers, thereby enabling revenue generation. Using our products,
carriers can offer new, revenue-generating services to wireless or landline
telephone users, such as speech-activated dialing and voice access to instant
messaging and information or voice portals.


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   Increased customer satisfaction and retention.  Our speech-activated
services provide our clients' customers with a variety of services that are
accessible from any telephone, 24 hours-a-day, seven days a week. A caller is
generally not required to wait on hold or navigate complex touch-tone menus.
Our clients can personalize an application's dialog to match their callers'
needs, for example "Would you like to ticket your regular trip to Chicago, Mrs.
Jones?" Our speech-activated solutions also include barge-in technology that
enables callers to interrupt an application prompt with responses or new
queries, thereby completing the transaction more efficiently. Customers that
are becoming accustomed to accessing account or other information on the web
can now benefit from easy telephone access to the same information or services.
Customers are ultimately given more control if they can choose how--web
browser, mobile device, or telephone--and when to retrieve information or
conduct transactions.

   Superior technology and architecture.  Our speech recognition technology
allows our clients' applications to recognize spoken words and phrases based in
part on a self-learning feedback loop that can be configured to automatically
adapt the system to user characteristics such as accents and pronunciations.
Natural language processing capabilities allow callers to speak in complete
phrases and sentences and can be configured to provide hints that alert novice
or first-time users to these capabilities. Taking advantage of dramatic
increases in host processing power, we offer speech recognition solutions that
operate in one integrated system. We also offer a client-server configuration
of our software, and software that functions within the emerging industry
standard, VoiceXML. Our speech synthesis technology enables callers to hear
dynamically-generated text read to them in a voice that sounds natural in
pronunciation, tone and cadence. These elements of our technology, integration
and architecture, enable our clients to develop and deploy speech-activated
applications reliably and cost-effectively.

   High level tools for rapid time to market.  We offer patented, high-level
building blocks, known as DialogModules(TM), that make it easy for developers
to build speech applications with proven and consistent call flows and user
interfaces. The availability of DialogModules tailored for specific situations
gives our clients the ability to more easily create and maintain applications
and achieve reductions in development cycle time and cost per deployed
application. DialogModules have been tightly integrated into well-known
toolkits from leading vendors such as InterVoice-BRITE, Aspect Communications,
Comverse Technology, Avaya and Intel so that developers can begin to build
applications quickly. We also offer operations and tuning tools that enable our
clients to evaluate and improve deployed applications, based on actual caller
experiences, quickly and easily.

Products

   We offer a comprehensive suite of speech recognition, synthesis and
verification products for over-the-telephone applications:

  OpenSpeech(TM) Product Line

   Our OpenSpeech product line is a speech recognition solution optimized for
VoiceXML, the emerging standard for speech services.

      OpenSpeech Recognizer:  Version 1.0 offers a number of new features that
   are designed to enhance performance as well as make it easier to integrate
   speech recognition with a variety of platforms and solutions. Our speech
   recognition performance metrics have been recently improved in connection
   with the Finite State Transducer (FST) technology licensed from AT&T as part
   of a relationship with AT&T.

      OpenSpeech Browser P.I.K.:  The OpenSpeech Browser Platform Integration
   Kit offers developers the capability to build a VoiceXML-based browser in
   C/C++. Key elements include: OpenVXI SpeechWorks open source VoiceXML
   interpreter; limited number of licenses to use two SpeechWorks products,
   OpenSpeech Recognizer 1.0 and Speechify (TTS); APIs to speech recognition
   and text-to-speech; and a prompting engine for VoiceXML.

      OpenSpeech Server:  OpenSpeech Server allows SpeechWorks OpenSpeech
   Recognizer to perform in a client-server environment. OpenSpeech Server
   enables a distributed architecture where calls to a speech client can be
   assigned to one of many speech recognition servers. The client handles the
   tasks of telephony and application processing with the platform code or the
   VoiceXML browser, and communication via

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   OpenSpeech Server software with the servers handling the tasks of speech
   recognition. OpenSpeech Server is positioned for organizations requiring the
   flexibility and scalability offered by a client-server
   architecture--typically telecommunication providers, carriers and
   application service providers.

      OpenSpeech DialogModules:  Our patented OpenSpeech(TM) DialogModules(TM)
   are pre-packaged reusable building blocks that accelerate application
   development in VoiceXML environments. Speech application developers use this
   patented technology to accelerate time-to-market and deliver a consistent
   user interface for high-quality, speech-enabled VoiceXML content. Through
   OpenSpeech(TM) DialogModules(TM), application developers are to spend more
   time building applications rather than writing low-level speech code, which
   is typically tedious to write and difficult to learn. As a result,
   developers can code applications more quickly.

SpeechWorks(R)

   SpeechWorks(R) is a complete solution for speech-enabled applications over
the telephone. Its award-winning architecture, based on research initially
conducted at the Massachusetts Institute of Technology, provides both the
recognition technology and the tools required to deploy state-of-the-art
applications quickly. Available in eighteen languages, the SpeechWorks solution
includes:

  .  SpeechWorks SMARTRecognizer(TM):  The SpeechWorks engine recognizes more
     than 70,000 words as well as complete phrases and sentences, supports
     multiple languages and dialects and through a self-learning feedback loop,
     continuously improves accuracy levels in deployed systems.

  .  SpeechWorks Dialog Modules(TM):  These applications building blocks
     represent frequently used functions (such as capturing a yes/no response
     or a date) as reusable software objects to simplify and speed development.

  .  SpeechWorks Tools:  Speech Works 6.5 includes a unique, graphical suite of
     Vocabulary Editors, Grammars, Natural language and Turning Tools. With
     them, customers can track system performance and caller responses, and
     automatically tune interface to improve, high levels of caller success.

   Speechify(TM)--Speechify Text-to-Speech (TTS) product delivers high voice
quality using concatenative synthesis technology licensed from AT&T. Speechify
provides natural sounding TTS available for use in applications such as e-mail
reading, call center applications for delivering rapidly changing information,
and conversion of other text input to audio formats such as stock quotes and
navigational information. Speechify is available in both male and female voices
in the following languages: US English, Continental French and Spanish.

   Eloquent ETI(TM)--Eloquent ETI Text-to-Speech provides high quality TTS
using formant technology. Leading ETI attributes include support for thirteen
languages, including US English, UK English, Castillian Spanish, Mexican
Spanish, Standard French, Canadian French, German, Brazilian Portuguese,
Italian, Finnish, Mandarin Chinese, Japanese and Korean. Our Eloquent ETI
product uses formant technology to create highly intelligible speech, which is
compact enough to be embedded in mobile and other handheld devices. An ability
to synthesize voices from adult to child, male and female is provided.

   SpeechWorks SpeechSite(TM)--SpeechSite brings the model of self-service to
the telephone by providing speech enabled auto-attendant service and
information retrieval 24 hours a day.

   SpeechSecure(TM)--SpeechSecure provides authentication of callers based on a
biometric comparison of their "voice print" to a previously recorded sample.
SpeechSecure is difficult to deceive. It can enhance callers' experience by
removing the need to touchtone PIN numbers while also increasing the level of
security for a speech-enabled application. This product was developed from
technology licensed from unrelated third parties.

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Additional Product Features

   Vocabularies--Our vocabularies allow developers to more quickly deploy
applications using pre-built repositories of .wav files. Vocabularies available
include:

  .  Stocks--Covers a recognition vocabulary of all stock symbols on the AMEX,
     NYSE and NASDAQ. Canadian and Singapore exchanges are also available.

  .  Name--Supplies a recognition vocabulary of 90,000 names, 12,000 of which
     have been pre-recorded for audio playback.

  .  Address--Uses the US Postal Service database of street mailing addresses
     as a recognition vocabulary. All states and most common street and city
     names have been pre-recorded and are available for playback. Non-recorded
     address information can be spelled-back for confirmation.

   Voice Enrollment--Allows callers to add a vocabulary item over the phone to
an application. One example is to assign a name to a phone number for voice
activated dialing.

   Natural language tools.  Natural language tools include a vocabulary editor
that enables developers to generate and maintain large vocabulary lists of
words that are recognized at specific times during a call. Developers can add
new words by typing them in or pointing to a text database. SpeechWorks 6.5
generates the pronunciations automatically using either its built-in dictionary
of 250,000 words or by following standard phonetic rules. The vocabulary editor
also allows the developer to specify synonyms and alternative pronunciations
for each of the vocabulary items. A grammar editor enables developers to build
and test complex natural language grammars. Another SpeechWorks tool, the
pronunciation editor, allows the developer to edit pronunciations of each
vocabulary item.

   Operations and tuning tools.  Operations and tuning tools enable developers
to review application performance data in an easily understood graphical form.
These tuning tools provide detailed reports regarding recognition performance
and user interface effectiveness, peak usage times and call duration, execution
results for DialogModules and potential problem areas.

   SpeechWorks Here(TM) Customer Programs--We offer a money-back guarantee and
provide our customers with marketing services that encourage high usage to
promote returns on investment.

Solutions and Support Services

   We recognize that many clients want more than a software-only solution. We
therefore complement our products with a high quality professional services
organization that offers a wide range of services. Our professional services
organization supports our clients with business and systems consulting, project
management and application development assistance. We have designed these
professional services to shorten time-to-market, assist our clients, reduce
project implementation risk and improve our clients' competitive position. We
believe that our ability to successfully deliver an integrated solution to our
clients provides us with a significant competitive advantage in the market for
speech-activated solutions for e-business.

   These solution services are provided by staff located in Boston, New York
and San Francisco as well as in our international offices in Canada, Mexico,
the United Kingdom, France, Japan, Australia and Singapore. We provide
dedicated teams of professionals who follow our speech application development
lifecycle to help our clients deploy their speech applications and seek caller
satisfaction. The primary solutions and support services we offer our clients
include the following:

      Rapid prototyping.  We offer a rapid prototyping process that allows
   potential clients to explore quickly and cost effectively the capabilities
   of over-the-telephone, speech-activated applications. In our rapid
   prototyping process, clients can experiment with speech recognition
   technology, user interfaces and the tools required to build speech-activated
   services. An application prototype helps potential clients experience
   real-world caller interactions and can serve as the foundation for a
   full-scale production system.

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      Speech application development lifecycle.  We have created a proprietary
   speech application development lifecycle, which is a disciplined project
   management process to promote successful implementation of our solutions.
   Our lifecycle approach is based on three primary phases: specification,
   development and deployment. In the specification phase, we assess the
   functional, design and integration requirements of the system and prepare a
   preliminary user interface specification. During the development and
   deployment phases, developers are trained to pay particular attention to the
   iterative testing and tuning of the application's user interface. In
   addition, this approach supports parallel development of database and
   telephony system integration requirements supporting efficient and timely
   deployments. We believe that our speech application development lifecycle
   has been an important reason for our success, and our clients' success.

      User interface design.  We employ a team of user interface engineers and
   human factors experts who study how people interact with computers to design
   the most effective interface for a client's specific application. This team
   follows a three-phase process: research, design and testing. In the research
   phase, our engineers seek to understand the needs and desires of our clients
   and their callers. In order to help make a caller's experience effective and
   enjoyable, in the design phase, our engineers consider the implications that
   our interface design may have on callers by taking into account call flow,
   functionality, and the application's personality. Then our interface
   engineers conduct usability tests and periodically monitor and improve call
   flow, prompts, and recognition accuracy.

      Training.  We offer training programs that provide clients with a review
   of our products and services and an introduction to the process of building
   speech applications. Our lectures and interactive workshops provide
   instruction on embedding our software in a production-quality, runtime
   environment and developing state-of-the-art natural language recognition
   capabilities.

      Maintenance and support.  We also offer our clients a range of
   maintenance and support programs. These support programs include telephone
   and e-mail support, web access to knowledge databases, technical support,
   software patches and upgrades, and varying service level options.
   Application consulting, user interface design and tuning services are also
   available to our clients.

      SpeechCare.  We provide our SpeechSite clients with a technical support
   and services package, SpeechCare, which consists of three services: voice
   prompt recording and management, operations and technical support, and
   software maintenance, patches and updates.

Technology

   Our core technologies consist of speech recognition and text-to-speech
synthesis or TTS. In addition, we have been helping to drive evolving standards
in a number of areas in the telephone-based speech recognition industry.

   Speech recognition.  The distinguishing features of our network-based speech
recognition technology include the following:

  .  Segment-based statistical models.  Our speech recognition system is based
     on work on segmental systems performed for many years at the Massachusetts
     Institute of Technology and other research groups. The segmental approach,
     unlike the frame-based, Hidden Markov Model approach, is able to take into
     account the entire phonetic segment. This allows our product to better
     account for the static and dynamic properties of individual speech sounds
     which increases accuracy and reduces the overall amount of computation
     needed for a given recognition task.

  .  Barge-in.  Barge-in technology allows callers to interrupt the outgoing
     prompts by speaking over them and allows our recognizer to understand what
     the user said when interrupting. We have developed

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     patented technologies to provide state-of-the-art barge-in performance. We
     believe that clients using our technology were the first to support
     barge-in functionality in large scale, production applications.

  .  Dynamic vocabularies.  Many traditional speech recognition engines require
     that the recognition vocabulary be defined and compiled at application
     development time. However, there are many applications where the necessary
     vocabulary must be generated while the application is running. We have
     therefore engineered our speech recognition engine to allow rapid, dynamic
     updates of recognition vocabularies.

  .  Automatic adaptation.  We have incorporated a process to support automatic
     adaptation of the recognition models of our engine. The result is that,
     through a fully automated process, the SpeechWorks engine is able to
     reduce error rates by 30-60% over time as it is used for some applications.

  .  Finite State Transducer (FST).  FST technology, licensed via the
     SpeechWorks/AT&T relationship and incorporated into the OpenSpeech
     Recognizer, allows vocabulary expansion beyond 1 million words.
     Transmission bandwidth, CPU loading, and recognition accuracy may be
     negatively affected and therefore must be considered when evaluating the
     feasibility of large vocabularies.

   Text-to-speech (TTS).  The ability to take plain text and convert it
automatically into speech utilizes two basic methods to build the voice output,
concatenative and formant synthesis. Concatenative TTS reads text by
reassembling tiny slices of pre-recorded speech in real time. Formant-based TTS
is synthetically generated according to preprogrammed pronunciation rules. We
offer products using both these technologies to meet our clients' needs.
Speechify uses concatenative technology, licensed from AT&T and enhanced by us,
to generate natural, human sounding speech. Our SpeechWorks ETI-Eloquence
product uses formant technology to create highly intelligible speech, which is
compact enough to be embedded in mobile devices.

   Standards.  We have been helping to drive evolving standards in a number of
areas in the telephone-based speech recognition industry. This includes
participation in the Enterprise Computer Telephony Forum, or ECTF, to define
the S.100 and S.300 APIs for speech recognition along with driving development
of standards for Dialog Application Components in the ECTF architecture. We are
an active participant in the World Wide Web Consortium, or W3C, Voice Browser
working group, which is developing standards such as VoiceXML for speech
applications and interfaces using web-based programming methods. We are among
the founding six members of Speech Application Language Tags Forum, an emerging
standard for multimodal applications.

Sales and Marketing

  Sales

   We sell our products and services both directly through a sales force and
indirectly through third-party value added resellers and system integrators.

   Sales Force.  As of December 31, 2001, we have a sales force in North
America that consists of three vice presidents, 9 regional sales directors, 16
sales engineers, and 38 sales representatives located in 12 states and Canada.
This sales force represents our products and services to enterprises, channel
partners and carriers in North America. We support the sales efforts of our
value added resellers and system integrators outside of North America with an
international sales force of 19 located throughout Europe, Asia Pacific, and
Latin America.

   Indirect Sales/Channel Partners.  As of December 31, 2001, we have a network
of over 150 resellers, OEMs, application service providers and systems
integration partners located in the United States, Canada, United Kingdom,
France, Germany, South Korea, Australia, Singapore and other countries that
distribute and implement our solutions around the globe. Our value added
resellers and system integrators have experience in interactive voice response
platforms, system integration of communication applications or hosting
expertise for interactive voice response applications. Our resellers increase
our coverage of global markets and fulfill the diverse application and service
opportunities for our software and services.

                                      10

<PAGE>

  Marketing

   Our marketing strategy is focused on educating prospects on the benefits of
speech services and assisting prospects and partners in identifying, evaluating
and deploying speech services. We also seek to build brand awareness of
SpeechWorks as a leading provider of software products and professional
services that enable enterprises and carriers to offer automated,
speech-activated services. In February 2002, Frost & Sullivan awarded us the
Award for Business Development Strategy that recognizes "the company's ability
to best perceive consumer needs, develop products and/or services that meet
consumer needs, successfully introduce products or services to the industry,
and identify new market segments to expand the existing customer base."

   Our strategic demand-generation campaigns use both traditional and
electronic media. Our print advertising focuses on targeted trade and business
publications, including telecommunications, internet and other categories. We
conduct both live seminars and web seminars and participate in a number of
trade shows and other industry events. We also provide speakers from our
company to represent us at a number of industry forums.

   Our marketing strategy also includes public relations efforts designed to
convey our message to appropriate audiences. We reinforce this through our
ongoing communications with a number of key industry analysts and press
representatives.

   To better assist our prospects in identifying high-yield speech services, we
introduced SpeechWorks Here S.T.E.P., Speech Technology Evaluation Process. A
sales and marketing process designed to serve prospects as they evaluate speech
solutions for their company, S.T.E.P. is a customized 5-step process that helps
companies select and deploy speech solutions.

  Competition

   A number of companies have developed, or are expected to develop, products
that compete with our products. Competitors in the speech recognition and TTS
software market include AT&T, Elan, Fonix, IBM, Lucent Technologies, Microsoft,
Nuance Communications, Philips Communications, Rhetorical, ScanSoft, and
Phonetic Systems. Furthermore, 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 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 clients.

   We believe that the principal competitive factors affecting our market
include the breadth and depth of solutions, product quality and performance,
core technology, product scalability and reliability, product features, client
service, the ability to implement solutions, the value of a given solution, the
creation of a base of referenceable clients and the strength and breadth of
reseller and developer relationships. Although we believe that our solutions
currently compete favorably with respect to these factors, particularly with
respect to product quality and performance, our market is relatively new and is
evolving rapidly.

   In addition, some of our competitors, in particular the larger ones, may be
able to offer products, systems, technologies or services which we do not
offer, along with their products and services which are competitive with ours.

Research and Development

   We have made substantial investments in research and development through
both internal development and technology licenses. The majority of our research
and development activity has been directed towards feature extensions to our
family of products. This development consists primarily of adding new
competitive product features and additional tools and products as we expand
into new markets.

   Our research and development expenses for 2001, 2000, and 1999 were $14.6
million, $9.1 million and $5.2 million, respectively. We expect that we will
continue to commit significant resources to research and development in the
future. All research and development expenses have been expensed as incurred.

                                      11

<PAGE>

   The market for our products and services is characterized by rapid
technological change, frequent new product introductions and enhancements,
evolving industry standards, and rapidly changing client requirements. The
introduction of products incorporating new technologies and the emergence of
new industry standards could render existing products obsolete and
unmarketable. Our future success will depend in part on our ability to
anticipate changes, enhance our current products, develop and introduce new
products that keep pace with technological advancements and address the
increasingly sophisticated needs of our clients.

Intellectual Property and Other Proprietary Rights

   We regard our patents, copyrights, service marks, trademarks, trade secrets
and other intellectual property as important to our success. We rely on a
combination of patent, trademark and copyright law, trade secret protection and
confidentiality and/or license agreements with our employees, consultants,
clients, partners and others to protect our proprietary rights. Our employees
execute confidentiality and assignment of invention agreements. Prior to
disclosing confidential information to third parties, we generally require them
to sign confidentiality or other agreements restricting the use and disclosure
of our confidential information.

   To date we have obtained six U.S. patents. We have twelve pending U.S.
patent applications and twenty-three pending patent applications outside of the
U.S., in the European Patent Office, Hong Kong, Australia, Canada, China,
Japan, Taiwan and Singapore. Additionally, we pursue registration of our key
trademarks and service marks in the U.S. and, in many cases, internationally.
However, effective patent, trademark, service mark, copyright and trade secret
protection may not be available or sought by us in every country in which our
products and services are sold.

   We license software technology from MIT under a nonexclusive license
agreement. This license agreement will terminate upon the expiration of MIT's
copyrights related to such technology. We do not anticipate that this will
restrict our ability to use or license the software technology or any
derivative works in any way. In June 2000, we entered into an agreement to
license certain speech technology from AT&T on a non-exclusive basis. The
technology includes AT&T speech recognition software and text-to-speech
software, as well as certain other technology related to computer processing of
the human voice, including large vocabulary recognition, natural language
understanding and dialog management.

   As part of the Eloquent acquisition in January 2001, we assumed obligations
of Eloquent under a license agreement between IBM and Eloquent. The license
provides us with nonexclusive access to certain text-to-speech technologies and
multi-language capabilities.

   We currently own a number of internet domain names, including
speechworks.com.

Employees

   As of December 31, 2001, we had 409 employees worldwide, including 122 in
research and development, 125 in service and support, 104 in sales and
marketing and 58 in finance and administration.

Item 2.  Properties

   Our principal offices are located at 695 Atlantic Avenue, in Boston,
Massachusetts, where we lease approximately 53,600 square feet under leases
that expire in September 2004. We also maintain regional sales and development
offices in New York, San Francisco, Montreal (Canada), Puebla (Mexico),
Singapore and Woking (England), as well as regional sales offices in Chicago,
Atlanta, Dallas, Reston (Virginia), Sydney (Australia), Paris (France), Tokyo
(Japan) and Seoul (South Korea). The leases for the development offices in New
York, San Francisco and Montreal expire at various times through 2016. The
leases for the regional sales offices are short-term. We believe that our
existing facilities are adequate for our current needs.

                                      12

<PAGE>

Item 3.  Legal Proceedings

   To our knowledge, we are not engaged in any legal proceeding that we expect
to have a material adverse effect on our business.

Item 4.  Submission of Matters to a Vote of Security Holders

   No matters were submitted to a vote of security holders during the fourth
quarter of the year ended December 31, 2001.

                     EXECUTIVE OFFICERS OF THE REGISTRANT

   The following table sets forth certain information concerning our executive
officers as of February 28, 2002:

<TABLE>
<CAPTION>
    Name                 Age Position
    ----                 --- --------
    <S>                  <C> <C>
    Stuart R. Patterson. 45  President, Chief Executive Officer and Director
    Richard J. Westelman 44  Chief Financial Officer
    Mark A. Holthouse... 46  Senior Vice President of Operations
    Michael S. Phillips. 40  Chief Technology Officer and Director
    Steven Chambers..... 39  Vice President of Worldwide Marketing
    Joseph Murphy....... 46  Vice President of Sales
    Howard A. Gross..... 44  Vice President of International
    William Ledingham... 40  Vice President of Product Development
    Charles Rutledge.... 37  Vice President of Customer Solutions
    Alan Schwartz....... 36  Vice President of Business Development
    Alexandra LaMaster.. 32  Vice President of People Strategy
    Doron Gorshein...... 37  Vice President and General Counsel
</TABLE>

   Stuart R. Patterson has served as our President since September 1997 and as
our Chief Executive Officer and a director since May 1998. Prior to joining us,
from May 1997 to September 1997, he served on the board of BBG New Media, Inc.,
a developer of high-end web sites, which was bought by Think New Ideas, Inc.,
now AnswerThink Consulting Group, in September 1997. From May 1996 to March
1997, he served as Vice President and Line of Business Manager at Voxware,
Inc., a developer of digital speech and audio technologies and solutions. From
August 1994 to May 1996, he served on the Advisory Board of Voxware. From
September 1987 to April 1996, he co-founded and served as the Chief Executive
Officer of Vicorp Interactive Systems, Inc., a developer of large-scale voice
and data applications based on open systems tools and platforms.

   Richard J. Westelman has served as our Chief Financial Officer since August
1998. Prior to joining us, from June 1996 to August 1998, he served as Chief
Financial Officer and Director of Dove Associates, a strategy consulting firm.
From January 1994 to June 1996, he served as Chief Financial Officer of Vicorp
Interactive Systems, Inc.

   Mark A. Holthouse has served as our Senior Vice President of Operations
since March 1996. In 1987, he co-founded Vicorp Interactive Systems, Inc., a
developer of large-scale voice and data applications based on open systems
tools and platforms. He served as Managing Director of Technology and
Operations of Vicorp from April 1987 to March 1996.

   Michael S. Phillips co-founded SpeechWorks and has served as our Chief
Technology Officer since September 1994 and as a director since May 1994. From
May 1987 to August 1994, he served as a research scientist in the Spoken
Language Systems Group at the Massachusetts Institute of Technology, a
non-profit think-tank dedicated to the development of a conversational
interface between computers and human spoken words.

                                      13

<PAGE>

   Steven Chambers has served as our Vice President of Worldwide Marketing
since September 1999. From October 1998 to July 1999, he served as Vice
President of Marketing at Arbortext, Inc., an XML-based information solutions
company. From October 1997 to October 1998, he was the Vice President of
Marketing for VDOnet, a company specializing in streaming media over the
internet. From November 1991 to October 1997, he served as Vice President of
Worldwide Marketing at PictureTel Corporation, a visual communications company.

   Joseph Murphy has served as our Vice President of Sales since August 1999.
From July 1998 to August 1999, he was Vice President of Sales at Rubric, Inc.,
a web-based marketing vendor. From August 1996 to June 1998, he was Director of
Sales at Genesys Telecommunications, Inc., a computer telephony integration and
enterprise interaction management software company. From January 1995 to April
1996, he served as Vice President of Worldwide Sales for GeoTel Communications,
a software company.

   Howard A. Gross joined us as our Vice President of International in February
2001. From June 1999 to February 2001, he was President and Chief Operating
Officer of IT Network, Inc., a provider of unbranded audio and text content for
wireless and wireline telephony and Internet companies. From June 1998 to June
1999, he was an independent consultant working with IT Network, Inc. From 1988
through 1998, he was with Brite Voice Systems, Inc. (now InterVoice-Brite),
where he held various positions, including Vice President and Managing
Director, Asia Pacific, Vice President Operations, and Vice President Corporate
and Legal Affairs.

   William Ledingham has served as our Vice President of Product Development
since July 1995. From 1989 to 1994, he held a number of marketing management
positions at Stratus Computer, a computer hardware company.

   Charles Rutledge has served as our Vice President of Customer Solutions
since November 1998. From 1993 to 1998, he was a manager with Andersen
Consulting (now Accenture) in their Financial Services practice.

   Alan Schwartz has served as our Vice President of Business Development since
July 2000. From March 1997 until July 2000, he held various positions at AT&T,
including New Market Development Director for AT&T Labs. From August 1995 to
March 1997, he worked as an attorney for the New York office of Debevoise &
Plimpton and from September 1994 to August 1995 he worked as an attorney for
the Toyko office of Nishimura & Partners.

   Alexandra LaMaster joined us in January 1999 as Director of People Strategy
and has served as our Vice President of People Strategy since November 2000.
From June 1995 to December 1998 she held various positions at The Open Group
(previously Open Software Foundation) including Human Resource Manager.

   Doron Gorshein joined us in November 2001 as our Vice President and General
Counsel. From May 1999 to October 2001 he held the position of Vice President
and Associate General Counsel at EchoStar Communications Corporation. From
September 1996 to April 1999, he was legal counsel at Voxware. Prior to that,
he held legal and business positions at ECI Telecom and Turner Broadcasting
System.


                                      14

<PAGE>

                                    PART II

Item 5.  Market for Registrant's Common Equity and Related Stockholder Matters

   Our common stock began trading on The Nasdaq Stock Market on August 1, 2000
under the symbol "SPWX." The following table sets forth, for the period
indicated, the high and low bid prices for the common stock, as reported by
Nasdaq, since the common stock commenced public trading. Such over-the-counter
market quotations reflect inter-dealer prices, without retail mark-up,
mark-down or commission and may not necessarily represent actual transactions:

<TABLE>
<CAPTION>
                                                        Common Stock
                                                       --------------
                                                        High    Low
          -                                            ------- ------
          <S>                                          <C>     <C>
          2001:
             Fourth Quarter........................... $ 11.65 $ 4.55
             Third Quarter............................ $ 15.40 $ 4.10
             Second Quarter........................... $ 18.13 $ 4.81
             First Quarter............................ $ 48.00 $ 6.31
          2000:
             Fourth Quarter........................... $ 99.50 $25.63
             Third Quarter (beginning August 1, 2000). $108.50 $44.98
</TABLE>

   On February 28, 2002, the last sale price of the common stock was $7.90.

Stockholders

   As of February 28, 2002, there were approximately 444 stockholders of record
of the 32,437,839 outstanding shares of common stock.

Dividends

   We have not paid dividends to our stockholders since our inception and we do
not plan to pay cash dividends in the foreseeable future. We currently intend
to retain earnings, if any, to finance our growth. Additionally, our credit
facility currently prohibits the payment of cash dividends on our capital stock.

Use of IPO Proceeds

   In August 2000, we completed our initial public offering of 5,462,500 shares
of common stock. The offering raised approximately $100 million, net of
offering expenses, for us. The following table sets forth our cumulative use of
the net offering proceeds as of December 31, 2001:

<TABLE>
        <S>                                                  <C>
        Purchase and installation of machinery and equipment $ 2,621,000
        Acquisition of other business.......................   5,379,000
        Repayment of indebtedness...........................     500,000
        Investment in unrelated third party.................     500,000
        Working capital.....................................          --
        Temporary investments:
        Cash and cash equivalents...........................  89,325,000
           All other purposes...............................          --
</TABLE>

                                      15

<PAGE>

   The foregoing use of net proceeds does not represent a material change in
the use of net proceeds described in our Registration Statement on Form S-1,
filed on April 19, 2000, File No. 333-35164.

Item 6.  Selected Consolidated Financial Data

   The following selected consolidated financial data should be read in
conjunction with our consolidated financial statements and related notes and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," included elsewhere in this Annual Report on Form 10-K. The
consolidated statement of operations data for the years ended December 31,
2001, 2000 and 1999 and the consolidated balance sheet data as of December 31,
2001 and 2000 have been derived from our audited consolidated financial
statements appearing elsewhere in this Annual Report on Form 10-K. The
consolidated statement of operations data for the years ended December 31, 1998
and 1997 and the consolidated balance sheet data as of December 31, 1999, 1998
and 1997 are derived from our audited consolidated financial statements not
included in this Annual Report on Form 10-K. There is no difference between
basic and diluted net loss per common share since potential shares of common
stock from the conversion of preferred stock and the exercise of options and
warrants are anti-dilutive for all periods presented.

                                      16

<PAGE>

                     SELECTED CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                              Years Ended December 31,
                                                                   ----------------------------------------------
                                                                     2001      2000      1999     1998     1997
                                                                   --------  --------  --------  -------  -------
                                                                        (in thousands, except per share data)
<S>                                                                <C>       <C>       <C>       <C>      <C>
Consolidated Statement of Operations Data:
Revenues:
   Product licenses............................................... $ 25,836  $ 16,356  $  3,680  $ 1,567  $   949
   Professional services..........................................   16,146    11,260     5,944    2,873      982
   Other revenues.................................................    3,052     2,681     4,387    1,410      111
   Non-cash stock compensation....................................   (1,093)     (273)       --       --       --
                                                                   --------  --------  --------  -------  -------
       Total revenues.............................................   43,941    30,024    14,011    5,850    2,042
                                                                   --------  --------  --------  -------  -------
Cost of revenues:.................................................
   Cost of product licenses.......................................      350       214       153       52       54
   Cost of professional services--non-cash stock
                             compensation.........................      617       538       139       --       --
                        --all other expenses......................   10,372     8,374     4,991    1,982      678
   Cost of other revenues.........................................    2,512     1,844     2,987      890       90
   Amortization of purchased technology...........................    1,131        --        --       --       --
                                                                   --------  --------  --------  -------  -------
       Total cost of revenues.....................................   14,982    10,970     8,270    2,924      822
                                                                   --------  --------  --------  -------  -------
Gross profit......................................................   28,959    19,054     5,741    2,926    1,220
                                                                   --------  --------  --------  -------  -------
Operating expenses:
   Selling and marketing--non-cash stock
                        compensation..............................    5,567     3,045       225       --       --
                   --all other expenses...........................   27,850    19,802     9,254    3,867    1,074
    Research and development--non-cash stock
                         compensation.............................      559       472        97       --       --
                       --all other expenses.......................   14,056     8,652     5,164    1,881    1,969
   General and administrative--non-cash stock
                         compensation.............................      425       398        47       --       --
                       --all other expenses.......................   24,555    17,300     6,693    3,157    1,057
   Amortization of intangible assets..............................    6,509     1,916        --       --       --
                                                                   --------  --------  --------  -------  -------
       Total operating expenses...................................   79,521    51,585    21,480    8,905    4,100
                                                                   --------  --------  --------  -------  -------
Loss from operations..............................................  (50,562)  (32,531)  (15,739)  (5,979)  (2,880)
Interest and other income, net....................................    3,758     3,244       276      219      360
                                                                   --------  --------  --------  -------  -------
Loss before income taxes..........................................  (46,804)  (29,287)  (15,463)  (5,760)  (2,520)
Provision for income taxes........................................       45       309        --       --       --
                                                                   --------  --------  --------  -------  -------
Net loss..........................................................  (46,849)  (29,596)  (15,463)  (5,760)  (2,520)
Accretion and deemed dividend on redeemable convertible
  preferred stock.................................................       --    (6,955)   (1,904)    (789)    (533)
                                                                   --------  --------  --------  -------  -------
       Net loss attributable to common stockholders............... $(46,849) $(36,551) $(17,367) $(6,549) $(3,053)
                                                                   ========  ========  ========  =======  =======
Basic and diluted net loss per common share....................... $  (1.46) $  (2.29) $  (3.28) $ (1.44) $ (0.83)
Shares used in computing basic and diluted net loss per
  common share....................................................   31,981    15,935     5,298    4,537    3,696
</TABLE>

                                      17

<PAGE>

<TABLE>
<CAPTION>
                                                          December 31,
                                         ---------------------------------------------
                                           2001     2000     1999      1998     1997
                                         -------- -------- --------  --------  -------
                                                         (in thousands)
<S>                                      <C>      <C>      <C>       <C>       <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents............... $ 55,534 $ 99,203 $ 11,474  $  4,486  $   426
Marketable securities...................   24,264   14,370       --        --       --
Working capital.........................   79,002  115,920   12,133     5,156    4,764
   Total assets.........................  124,788  144,374   20,566     9,162    6,437
Long-term debt, net of current portion..    1,201      292      833       161      414
Redeemable convertible preferred stock..       --       --   43,507    17,749    9,974
   Total stockholders' equity (deficit).  107,859  131,439  (28,248)  (11,457)  (4,948)
</TABLE>

                                      18

<PAGE>

Item 7.  Management's Discussion And Analysis Of Financial Condition And
       Results Of Operations

   You should read the following discussion in conjunction with our
consolidated financial statements and the related notes that are included
elsewhere in this Annual Report on Form 10-K.

                          FORWARD LOOKING STATEMENTS

   This Annual Report on Form 10-K contains a number of forward-looking
statements. These forward-looking statements are not historical facts but
rather are based on current expectations, estimates and projections about our
industry, our beliefs and our assumptions. Words such as "anticipate,"
"expect," "intend," "plan," "believe," "seek," "estimate" and variations of
these words and similar expressions, are intended to identify forward-looking
statements. These statements are not guarantees of future performance and are
subject to risks, uncertainties and other factors, some of which are beyond our
control, are difficult to predict and could cause actual results to differ
significantly from those expressed, implied or forecasted in the
forward-looking statements. These risks and uncertainties include, among
others, those described in Exhibit 99 to this Annual Report on Form 10-K and
elsewhere in this Annual Report on Form 10-K. All forward-looking statements
included in this Annual Report on Form 10-K are based on information available
to us on the date hereof, and we assume no obligation to update any such
forward-looking statements. Readers are cautioned not to place undue reliance
on these forward-looking statements, which reflect our management's view only
as of the date of this Annual Report on Form 10-K.

Overview

   We are a leading provider of software products and professional services
that enable enterprises, carriers and voice portals to offer automated,
speech-activated services over any telephone. With our speech recognition
solutions, consumers can direct their own calls, obtain information and conduct
transactions automatically, simply by speaking naturally over any telephone,
anytime. Our solutions are designed to help businesses build sustainable
customer relationships over the telephone, provide improved and cost-effective
customer service systems, increase the returns on their internet-related
investments and capitalize on a variety of new business opportunities.

   We currently offer two speech recognition solutions for over-the-telephone
applications, the SpeechWorks 6.5 platform and our OpenSpeech product line.
SpeechWorks 6.5 is a comprehensive set of software tools and core speech
recognition technologies that can be used to build state-of-the-art,
speech-activated services. With our SpeechWorks 6.5 platform, companies can
quickly design and deploy speech-activated applications, in multiple languages,
that enable their customers to buy travel tickets, trade stocks, update account
information, get health care referrals, update account records, send messages
and conduct a myriad of other transactions that extend web-based e-business to
any telephone.

   The OpenSpeech product line is a comprehensive set of software tools and
core speech recognition technologies that can be used to build
state-of-the-art, speech-activated services and is optimized for VoiceXML, the
new industry standard for speech. Benefits include: open, standards-based
architecture for ease of integration and investment protection, VoiceXML
support and performance and accuracy enhancements, particularly in wireless
environments.

   SpeechSite, a packaged application based on the SpeechWorks 6.5 platform,
brings the web model of self-service to the telephone. SpeechSite answers and
directs telephone calls and delivers company information. Like a website,
SpeechSite can link to other services and deliver various types of information
to callers. However, SpeechSite uses a spoken interface rather than a visual
browser.

   In addition to these speech recognition solutions, we offer two
text-to-speech, or speech synthesis technologies, with our Speechify and
ETI-Eloquence products. Using Speechify or ETI-Eloquence, portals and

                                      19

<PAGE>

carriers can allow their callers to hear dynamically-generated text, such as
e-mails and news updates, read to them by a computer in a natural-sounding
voice.

   SpeechSecure is a speaker verification technology that provides enhanced
security and convenience to callers who access personal information and conduct
commerce over the telephone. The product recognizes and verifies an ID or
account number as a caller speaks, eliminating the need to remember a separate
password.

   We complement all of our products with a professional services organization
that offers a range of services including application development,
user-interface design consulting, project management, post-contract support and
training. We offer these services to shorten our customers time-to-market,
reduce project implementation risk and improve our clients' competitive
position. We believe that our ability to successfully deliver an integrated
solution to our clients that includes both software and professional services
provides us with an important competitive advantage.

   We also occasionally resell hardware products made by third parties,
including products such as voice-processing equipment that run our software, as
well as facilities management services that are provided by third-party call
centers. We only resell hardware or facilities management services when clients
expressly request that we do so and therefore, such revenue is considered other
revenue.

   We market our products and services primarily in North America, Europe, and
AsiaPacific. We sell our products and professional services to our enterprise
and carrier clients through our direct sales force, and indirectly through
value-added resellers and original equipment manufacturers ("OEMs"). We also
sell our products and services to service bureaus, application service
providers, and portals who use them to offer speech-enabled services to their
customers. We currently have relationships with over 150 value-added resellers
and OEMs. We are aggressively expanding our reseller and OEM relationships.
Total revenue from our resellers, OEMs and application service providers
accounted for 55.7% of our total revenue for 2001, 47.6% of our total revenue
for 2000 and 21.2% of our total revenue for 1999. We expect that revenue
derived from sales to resellers and OEMs will continue to increase as a
percentage of our total revenue for the foreseeable future as we focus on and
expand our distribution channels.

   In 2001, Intervoice-BRITE represented 19.3% of our total revenue. In 2000,
InterVoice-BRITE represented 16.1% of our total revenue. In 1999, United
Airlines represented 33.7% of our total revenue and InterVoice-BRITE
represented 10.9% of our total revenue.

   We began selling our products and services to clients outside the United
States in 1999, and these sales accounted for 9.4% of our total revenue for
2001, 13.8% of our total revenue for 2000 and 2.6% of our total revenue for
1999. We expect the portion of our total revenue derived from sales to clients
outside the United States to increase as we expand our international sales
efforts and distribution channels.

   Our cost of revenue consists of the cost of our product licenses, cost of
professional services, and cost of resold hardware and services, including
SpeechSite hardware, and amortization of purchased technology. Cost of product
licenses consists of royalties that we pay to Massachusetts Institute of
Technology and International Business Machines that is equal to a percentage of
our product license revenue for automated speech recognition and certain
text-to-speech products, respectively. This amount as a percentage of total
revenues was 1.4% in 2001, 1.3% in 2000 and 4.2% in 1999. Cost of professional
services revenue consists of our direct labor and related benefits costs, taxes
and project-specific travel expenses. Cost of other revenue consists of the
cost of third-party hardware, which we resell, and payments to the third-party
providers of outsourced facilities management services and SpeechSite hardware.
Amortization of purchased technology represents the write-off of technology
acquired in the purchase of Eloquent Technolgoy, Inc. ("ETI"). These
technologies are being amortized over their expected useful life of 60 months.

   Our selling and marketing expenses consist primarily of compensation and
related expenses, sales commissions and travel expenses, along with other
marketing expenses, including advertising, trade shows,

                                      20

<PAGE>

public relations, direct mail campaigns, seminars and other promotional
expenses. Our research and development expenses consist primarily of
compensation and related expenses for our personnel and, to a lesser extent,
independent contractors, who work on new products, enhancements to existing
products and the implementation of our products in new languages. Our general
and administrative expenses consist primarily of compensation for our
administrative, financial and information technology personnel, occupancy and
overhead expense, and company-wide professional fees, including recruiting,
legal and accounting fees, as well as increases to our allowance for doubtful
accounts. Our non-cash stock compensation charges result from non-cash charges
for options issued with exercise prices that are less than the fair market
value of our common stock on the date of grant and the fair value of warrants
issued to non-employees.

   We receive interest income by investing the proceeds that we raised in our
prior equity financings and our initial public offering. Interest expense is
incurred primarily from amounts we owe under our line of credit and capital
lease lines of credit.

   Due to our operating losses, we have recorded no provision or benefit for
U.S. federal or state income taxes in relation to these losses for any period
since our inception. During 2001 and 2000, we recorded a provision for income
taxes of $45,000 and $309,000, respectively, representing amounts owed in
foreign jurisdictions related to income of our foreign operations. As of
December 31, 2001, we had $47.3 million of net operating loss carryforwards for
federal income tax purposes, which expire beginning in 2011. Our ability to use
these net operating losses in future periods is not sufficiently assured and
therefore, these tax assets carry no value on the balance sheet.

Critical Accounting Policies and Significant Judgments and Estimates

   Our critical accounting policies and significant judgements and estimates
are as follows:

.. Revenue recognition;

.. Estimating valuation allowances, specifically the allowance for doubtful
             accounts;

.. Valuation of long-lived and intangible assets and goodwill;

.. Acquisition accounting; and

.. Stock compensation accounting.

   Revenue recognition.   We derive our revenue from three sources: product
licenses, professional services, including maintenance and support, and the
resale of hardware and facilities management services. We sell product licenses
either directly to clients or through third-party distribution channels. To
support the sale, installation and operation of our products, we also provide
professional services, consisting of developing custom software applications,
user interface design consulting, project management, training, maintenance and
technical support. We resell hardware products provided by third parties,
including products such as voice-processing equipment that run our software, as
well as facilities management services that are provided by third-party
call-centers. We expect the resale component of our total revenues to decrease
as a percentage of our total revenues over time. We only resell hardware or
facilities management services when clients expressly request that we do so and
therefore, such revenue is considered other revenue.

   Our typical customer arrangement includes a signed contract between the
customer and us in which we generally offer payment terms ranging from 30 to 90
days, no rights of return of delivered products and a limited warranty period
of 30 to 90 days based on agreed product specifications.

   We recognize revenue in accordance with Statement of Position 97-2 Software
Revenue Recognition ("SOP 97-2"), as amended by Statement of Position 98-9, and
the Securities and Exchange Commission's Staff Accounting Bulletin No. 101
Revenue Recognition in Financial Statements. We recognize revenue from the

                                      21

<PAGE>

licensing of software, provided that no significant obligations remain,
evidence of the arrangement exists, the fees are fixed or determinable, and
collectibility is reasonably assured, as follows:

  .  When we license our software and do not provide any professional services,
     we recognize the license revenue when we ship the software to the client.

  .  When OEM's license our software, we receive a royalty. We recognize the
     revenue from these royalties upon delivery to the third party when such
     information is available, or when the OEM notifies us of the sale.

  .  When we license software in connection with custom software applications
     developed by us, we recognize the revenue over the life of the development
     project, concurrent with any related services fees as described below.

   Typically, we do not consider professional services, other than the
development of custom software applications, to be essential to the
functionality of the other elements of our software arrangements. The other
professional services are limited and primarily include training and
feasibility studies. We recognize the revenue from professional services,
provided that evidence of the arrangement exists, the fees are fixed or
determinable and collectibility is reasonably assured, as follows:

  .  When we provide professional services for a fixed fee, we recognize
     revenue from the fees for such services and any related software licenses
     as we complete the project using the percentage-of-completion method. We
     determine the percentage-of-completion by comparing the labor hours we
     have incurred to date to our estimate of the total labor hours required to
     complete the project based on regular discussions with our project
     managers. This method is used because we consider expended labor hours to
     be the most available measure of progress on these projects. Adjustments
     to contract estimates are made in the periods in which facts resulting in
     a change become known. When the estimate indicates a loss, such loss is
     provided for in its entirety. Significant judgments and estimates are
     involved in determining the percent complete of each contract. Different
     assumptions could yield materially different results.

  .  When we provide services on a time and materials basis, we recognize
     revenue as we perform the services, based on actual time incurred.

  .  When we provide support and maintenance services, we recognize the revenue
     ratably over the term of the related contracts, typically one year.

   Our sales frequently include, under related contracts, software licenses,
related professional services and a maintenance and support arrangement. The
total contract value is attributed first to the maintenance and support
arrangement based on its fair value, equal to its stated list price as a fixed
percentage of the related software product's price. The remainder of the total
contract value is then attributed to the software license and related
professional services, with the effect that discounts inherent in the total
contract value are attributed to the software license and related professional
services. For revenue classification, we allocate the contract value remaining
after allocation to maintenance and support using the fair value of
professional services, based on the fee charged when services are sold
separately, and record that as professional services revenue; all remaining
amounts are recorded as product license revenue.

   Under our maintenance and support arrangements, we offer unspecified
upgrades and enhancements on software products only on a when-and-if-available
basis. Typically, we do not contract in advance for specified upgrades,
enhancements or additional software products. In arrangements where we agree to
provide additional products, specified upgrades or enhancements, we allocate
revenue from the entire arrangement among all elements of the order, including
future deliverables, based on the relative fair values when products are sold
separately, of each element of the arrangement. We defer recognition of revenue
allocated to the specified future deliverable until delivery has occurred and
any remaining contractual terms relating to that element have been met. In
situations where fair value does not exist for all elements to be delivered
under the arrangement, we defer all revenue from the arrangement until the
earlier of the date when all elements have been delivered or fair value exists
for all undelivered elements. We do not offer rights of return to our
customers. In situations where negotiated contracts require rights of return,
we do not recognize revenue until all significant obligations have been
delivered and accepted by the client.

                                      22

<PAGE>

   When we resell hardware, we recognize the revenue when we deliver the
hardware. We recognize the revenue from resold facilities management services
in the period that the services are provided.

   At the time of the transaction, we assess whether the fee associated with
our revenue transaction is fixed or determinable based on the payment terms
associated with the transaction. If a significant portion of a fee is due after
our normal payment terms, which are 30 to 90 days from the invoice date, we
account for the fee as not being fixed or determinable. In these cases, we
recognize revenue as the fees become due.

   We assess collection based on a number of factors, including past
transaction history with the customer and the credit-worthiness of the customer
by reviewing credit reports from Dun and Bradstreet, as well as bank and trade
references. We do not request collateral from our customers. If we determine
that collection of a fee is not reasonably assured, we defer the fee and
recognize revenue at the time collection becomes reasonably assured, which is
generally upon receipt of cash.

   Allowance for doubtful accounts.  Management must make estimates of any
uncollectibility of our accounts receivable resulting from the inability of our
customers to make payments. Management analyzes accounts receivable and
analyzes historical bad debts, customer concentrations, customer
credit-worthiness, current economic trends and changes in our customer payment
terms when evaluating the adequacy of the allowance for doubtful accounts. We
record the allowance for doubtful accounts on a specific identification basis.
If the financial condition of our customers deteriorates after entering into a
revenue arrangement resulting in an impairment of their ability to make
payments beyond that estimated by management, additional allowances may be
required. Significant judgments and estimates are involved in assessing the
collectibility of customer transactions. Different assumptions could yield
materially different results. Our accounts receivable balance was $12.7
million, net of allowance for doubtful accounts of $1.4 million, as of December
31, 2001.

   Long-lived assets.  We assess the impairment of identifiable intangibles,
long-lived assets and goodwill whenever events or changes in circumstances
indicate that the carrying value may not be recoverable. Factors we consider
important which could trigger an impairment review include the following:

  .  Significant underperformance relative to expected historical or projected
     future operating results;

  .  Significant changes in the manner of our use of the acquired assets or the
     strategy for our overall business; and

  .  Significant negative industry or economic trends.

   When we determine that the carrying value of intangibles, long-lived assets
and goodwill may not be recoverable based upon the existence of one or more of
the above indicators of potential impairment, we assess whether an impairment
has occurred based on whether net book value of the assets exceeds related
projected undiscounted cash flows from these assets, considering a number of
factors including past operating results, budgets, economic projections, market
trends and product development cycles. Net intangible assets, long-lived
assets, and goodwill amounted to $27.7 million as of December 31, 2001.

   Acquisition accounting.  In January 2001, we acquired Eloquent Technology,
Inc. (ETI) for total consideration of $18.8 million which was allocated to net
tangible assets and liabilities acquired of ($198,000), completed technology of
$5.7 millon and goodwill of $13.4 million. The fair value of the completed
technology was determined based on the discounted estimated future cash flows
from the sale of the completed technology, including the assumption that we
would generate enough revenue from the licensing of this technology to meet the
minimum royalty payments owed to IBM under a development and royalty agreement.
Actual results during the year ended December 31, 2001 were consistent with our
estimated cash flows. We estimated that the useful life of the acquired
technology would be five years. Significant judgments and estimates are
involved in determining the fair market value of assets acquired and their
useful lives. Different assumptions could yield materially different results.

                                      23

<PAGE>

   Stock compensation accounting.  In connection with the grant of certain
options to employees and directors through June 30, 2000, we recorded deferred
stock compensation within stockholders' equity of $10.7 million, 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.

   Additionally, on August 1, 2000, in connection with the sale of common stock
in private placements to Net2Phone and America Online (AOL), concurrent with
our initial public offering, we recorded deferred stock compensation within
stockholders' equity of $5.4 million. This amount represents the difference
between the price of the public offering of $20.00 per share and the price paid
by Net2Phone and AOL of $12.46 per share. This amount is presented as a
reduction of stockholders' equity and is being amortized to the statement of
operations over the three-year term of the concurrently entered arrangements.
In each reporting period, such amortization is reflected as a reduction of
revenues resulting from the arrangements; to the extent that the amortization
exceeds such revenues, the residual is reflected in operating expenses.

   On June 30, 2000, we issued a fully-vested warrant to purchase up to 765,422
shares of common stock to AOL in connection with a long-term marketing
arrangement. In accordance with EITF 96-18, the estimated value of this warrant
upon its issuance, utilizing the Black-Scholes valuation model, was $11.2
million, which is being amortized to selling and marketing stock compensation
expense over the three-year term of the agreement. The warrant, which has an
exercise price of $12.46 per share, becomes exercisable upon the earlier of
June 30, 2002 or in three equal installments upon the achievement of certain
performance targets. The warrant may be exercised at the option of the holder,
in whole or in part, at any time on or before the fifth anniversary from the
date that portion of the warrant becomes exercisable.

   Significant judgments and estimates were involved in determining the proper
valuation of deferred stock compensation related to employee stock options
because at the time of grant there was no available market for our common
stock. Significant judgments and estimates were involved in determining the
proper valuation of stock issued at below fair market values and warrants, as
well as their useful lives. Different assumptions would have yielded materially
different results.

Results of Operations

   The following table sets forth consolidated financial data for the periods
indicated as a percentage of our total revenue.
<TABLE>
<CAPTION>
                                                                   Year Ended
                                                                  December 31,
                                                                 -------------
                                                                 2001 2000 1999
                                                                 ---- ---- ----
<S>                                                              <C>  <C>  <C>
Revenues:
   Product licenses.............................................  59%  54%  27%
   Professional services........................................  37   38   42
   Other revenues...............................................   7    9   31
   Non-cash stock compensation..................................  (3)  (1)  --
                                                                 ---  ---  ---
       Total revenues........................................... 100% 100% 100%
                                                                 ===  ===  ===
Cost of revenues:
   Cost of product licenses.....................................   1%   1%   1%
   Cost of professional services--non-cash stock compensation...   1    2    1
                       --all other expenses.....................  24   28   36
   Cost of other revenues.......................................   6    6   21
   Amortization of purchased technology.........................   2   --   --
                                                                 ---  ---  ---
       Total cost of revenues...................................  34   37   59
          Gross profit..........................................  66   63   41
                                                                 ---  ---  ---
</TABLE>

                                      24

<PAGE>

<TABLE>
<CAPTION>
                                                                    Year Ended
                                                                   December 31,
                                                               ------------------
                                                               2001   2000   1999
                                                               ----   ----   ----
<S>                                                            <C>    <C>    <C>
Operating expenses:
   Selling and marketing--non-cash stock compensation.........   13     10      2
                   --all other expenses.......................   63     66     66
   Research and development--non-cash stock compensation......    1      2      1
                      --all other expenses....................   32     29     37
   General and administrative--non-cash stock compensation....    1      1     --
                      --all other expenses....................   56     58     48
   Amortization of intangible assets..........................   15      6
                                                               ----   ----   ----
       Total operating expenses...............................  181    172    154
                                                               ----   ----   ----
Loss from operations.......................................... (115)  (109)  (113)
Interest and other income, net................................    8     11      2
                                                               ----   ----   ----
Loss before income taxes...................................... (107)   (98)  (111)
Provision for income taxes....................................   --      1     --
                                                               ----   ----   ----
          Net loss............................................ (107)%  (99)% (111)%
                                                               ====   ====   ====
</TABLE>

Comparison of Years Ended December 31, 2001, 2000 and 1999

   Total revenues.  Our total revenues (net of non-cash stock compensation)
increased 46.4% to $43.9 million in 2001, from $30.0 million in 2000 and
increased 114.3% in 2000 from $14.0 million in 1999. Revenue from international
sales were $4.1 million in both 2001 and 2000, an increase of 1042.8% in 2000
from revenue of $362,000 in 1999. International revenues as a percentage of
total revenues were 9.4% in 2001, 13.8% in 2000 and 2.6% in 1999.

   Revenue from product licenses.  Revenue from the licensing of proprietary
software increased 58.0% to $25.8 million in 2001 from $16.4 million in 2000
and increased 344.5% in 2000 from $3.7 million in 1999. This growth in product
licenses revenue from 1999 to 2001 resulted from a growing market acceptance of
our speech activated solutions by enterprises, carriers and portals, our
expanded sales and marketing efforts, and the improved productivity of our
distribution channels, primarily OEMs. Revenue from product licenses
represented 58.8% of total revenue in 2001, 54.5% in 2000 and 26.3% in 1999.
Over the last six months of 2001 revenue from product licenses represented over
60% of our total revenues as a result of several larger license-only sales
recorded to resellers and OEMs.

   Revenue from professional services.  Revenue from fees we receive for
professional services increased 43.4% to $16.1 million in 2001 from $11.3
million in 2000 and increased 89.4% in 2000 from $5.9 million in 1999. The
growth in revenue from professional services resulted primarily from the
increased demand for custom speech applications from existing and new clients
over these years and the growing maintenance revenue from an increasing
installed license base.

   Other revenues.  Other revenues totaled $3.1 million, or 6.9% of total
revenue in 2001, $2.7 million, or 8.9% of total revenue in 2000 and $4.4
million, or 31.3% of total revenue in 1999. The increase in other revenues from
2000 to 2001 resulted primarily from several clients that requested us to
provide the hardware to host our software products sold to them. Other revenues
decreased from 1999 to 2000 due to fewer customers purchasing hardware as part
of the solution sold to them. We anticipate that resold hardware and facilities
management revenue will continue to decline as a percentage of total revenues
in the future.

   Non-cash stock compensation offset to revenues.  In connection with the sale
of common stock in private placements to Net2Phone and America Online, Inc.
("AOL"), concurrent with our initial public offering in August 2000, we
recorded deferred stock compensation within stockholders' equity of $5.4
million. This amount

                                      25

<PAGE>

represents the difference between the price of the public offering of $20.00
per share and the price paid by each of Net2Phone and AOL of $12.46 per share.
This amount is presented as a reduction of stockholders' equity and is being
amortized to the statement of operations over the three-year term of the
concurrently entered arrangements. In each quarterly reporting period, such
amortization is first reflected as a reduction of revenues resulting from the
arrangements; to the extent that the amortization exceeds such revenues, the
residual is reflected in operating expenses. For the year ended December 31,
2001, we recognized revenue from Net2Phone and AOL and, accordingly, the
related amortization of $1.1 million was recorded as a non-cash stock
compensation charge which reduced revenue. Amortization of deferred stock
compensation for Net2Phone and AOL of $722,000, which was in excess of revenue
recognized in each quarter, was recorded as selling and marketing stock
compensation expense. For the year ended December 31, 2000, we recognized
revenue from Net2Phone and AOL and, accordingly, the related amortization of
$273,000 was recorded as a non-cash stock compensation charge which reduced
revenue. Amortization of deferred stock compensation for Net2Phone and AOL of
$483,000, which was in excess of revenue recognized in each quarter was
recorded as selling and marketing stock compensation expense.

   Cost of product licenses revenues.  Cost of product licenses revenue
increased by 63.6% to $350,000 in 2001 from $214,000 in 2000 and increased
39.9% in 2000 from $153,000 in 1999. This cost represented 1.4% of product
licenses revenues in 2001, 1.3% in 2000 and 4.2% in 1999. The increase in the
percentage of product licenses revenues from 2000 to 2001 resulted from the
inclusion of additional royalties owed to IBM related to the licensing of
certain text-to-speech products developed by Eloquent Technology, Inc., which
we acquired in January 2001. The decrease in the percentage of product licenses
revenues from 1999 to 2000 reflects the decrease in the royalty rate owed to
MIT based on achieving a cumulative product license sales milestone. We
anticipate that the royalty rate in the future will be higher based on the
inclusion of IBM royalties, in addition to our MIT royalties.

   Cost of professional services revenuse.  Cost of professional services
revenue increased 23.9% to $10.4 million in 2001 from $8.4 million in 2000 and
increased 67.8% in 2000 from $5.0 million in 1999. The increased costs from
1999 to 2001 are due primarily to the hiring of additional project managers,
developers, user interface designers, speech scientists and technical support
staff to expand our professional services organization. This cost represented
64.2% of professional services revenue in 2001, 74.4% in 2000 and 84.0% in
1999. The decrease in cost of professional services as a percentage of related
revenue from 1999 to 2001 reflects improvements in margins as certain
lower-margin projects were completed and replaced with higher-margin projects.
Additionally, the higher cost of professional services as a percent of related
revenue in 1999 reflects costs associated with significant hiring in
anticipation of revenue growth in late 1999 and 2000 and client delays on
several large fixed-fee projects.

   Cost of other revenues.  Cost of resold hardware and resold facilities
management services increased 36.2% to $2.5 million in 2001 from $1.8 million
in 2000, and decreased 38.3% in 2000 from $3.0 million in 1999. The cost of
other revenues as a percent of other revenues increased to 82.3% in 2001 from
68.8% in 2000 and decreased from 68.1% in 1999. The increase in cost of other
revenues as a percentage of related revenues from 2000 to 2001 reflects lower
margins on hardware related arrangements. The decrease in cost of other
revenues from 1999 to 2000 reflects fewer shipments of hardware to customers
during 2000.

   Amortization of purchased technology.  On January 5, 2001, we acquired all
of the outstanding capital stock of Eloquent Technology, Inc., a supplier of
speech synthesis, or text-to-speech technology. The purchase price of $18.8
million has been allocated to net tangible assets and liabilities acquired of
($198,000), completed technology of $5.6 million and goodwill of $13.4 million.
These intangible assets are being amortized on a straight-line basis through
December 2005. The amortization of the purchased technology totaled $1.1
million in 2001. Effective in January 2002, Statements of Financial Accounting
Standards (SFAS) No. 142, Goodwill and Other Intangible Assets requires that we
discontinue amortizing acquired goodwill.

   Total operating expenses.  Our total operating expenses increased 54.2% to
$79.5 million in 2001 from $51.6 million in 2000 and increased 140.2% in 2000
from $21.5 million in 1999. These increases occurred in all

                                      26

<PAGE>

categories of operating expense over the three-year period as we grew our
organization. These increases included the addition of 92 employees in 2001,
119 employees in 2000 and 112 employees in 1999. As a percentage of total
revenues, our operating expenses were 181.0% in 2001, 171.8% in 2000 and 153.3%
in 1999. Non-cash charges are also included in 2001, 2000 and 1999 as noted
below.

   Selling and marketing.  Selling and marketing expenses consist primarily of
salaries, commissions and related travel costs for the selling and marketing
personnel, along with spending on marketing activities, including
advertisements, tradeshows, public relations activities and educational
seminars. These expenses increased 40.6% to $27.9 million in 2001 from $19.8
million in 2000 and increased 114.0% in 2000 from $9.3 million in 1999. Selling
and marketing expenses as a percentage of revenues, were 63.4% in 2001, 66.0%
in 2000 and 66.0% in 1999. The increases in selling and marketing expenses from
1999 to 2001 resulted primarily from our investment in sales and marketing
personnel. During this period, the number of sales personnel in North America
increased from 21 to 53 and the number of employees in marketing increased from
16 to 30. In addition, the cost of engineers devoted to technical sales
support, recorded as a selling expense, has increased steadily with increased
sales. The increase in selling and marketing expenses also reflects higher
commissions associated with higher sales and increased marketing activities,
including advertisements, tradeshows, public relations activities and
educational seminars during these years. We anticipate that selling and
marketing expenses will increase during 2002 at a slower rate than in 2001, and
that these expenses as a percentage of revenues will be less than 60% for 2002.

   Research and development.  Research and development expenses consist
primarily of labor costs and related travel for personnel involved in new
product development and enhancements. These expenses increased by 62.5% to
$14.1 million in 2001 from $8.7 million in 2000 and increased 67.5% in 2000
from $5.2 million in 1999. Research and development expenses as a percentage of
revenues were 32.0% in 2001, 28.8% in 2000 and 36.9% in 1999. The overall
increase in research and development expenses from 1999 to 2001 resulted from
increased hiring of software developers, quality assurance and testing
personnel and speech scientists to develop and enhance our products. The number
of personnel involved in research and development increased to 122 in 2001 from
86 in 2000 and 43 in 1999. We anticipate that research and development expenses
will increase slightly during 2002, and that these expenses as a percentage of
revenues will be less than 30% for 2002.

   General and administrative.  General and administrative expenses consist of
labor costs and related travel for personnel involved in supporting the
financial, legal, recruiting and system administration infrastructure, all
occupancy related and corporate overhead costs including costs associated with
being a public company. These expenses increased 41.9% to $24.6 million in 2001
from $17.3 million in 2000 and increased 158.5% in 2000 from $6.7 million in
1999. The increases in general and administrative expenses from 1999 to 2001
was primarily due to additional infrastructure necessary to support our growing
operations in the United States and internationally, an increase in
professional services fees incurred to support our growth, increased recruiting
costs, and the addition of senior level management to lead our growth. Due to
the overall slowdown in the economy during 2001, our rate of growth in our
corporate infrastructure also slowed. We anticipate that general and
administrative expenses will increase slightly during 2002, and that these
expenses as a percentage of revenue will be less than 40% for 2002.

   Non-cash stock compensation.  Non-cash stock compensation charges are being
recorded as a separate component of cost of professional services, selling and
marketing expenses, research and development expenses and general and
administrative expenses. In connection with the grant of certain options to
employees and directors through June 30, 2000, we recorded deferred stock
compensation within stockholders' equity of $10.7 million, representing the
difference between the estimated fair market value of the common stock for
accounting purposes and the option exercise price of these options at the date
of grant. Such amount is presented as a reduction of stockholders' equity and
is being amortized over the vesting period of the applicable options. We
recorded amortization of deferred stock compensation of $2.7 million in 2001,
$2.4 million in 2000 and $508,000 in 1999. We expect the amortization of
deferred stock compensation relating to employee stock options to be
approximately $2.7 million per year through 2002 and decreasing thereafter
through 2004.

                                      27

<PAGE>

   Sales and marketing expenses--non-cash stock compensation charges also
includes non-cash stock compensation of $3.7 million in 2001 and $1.6 million
in 2000 related to warrants issued to AOL, valued at $11.2 million, which is
being recognized as expense over the related three-year marketing agreement.
Additionally, sales and marketing expenses--non-cash stock compensation charges
include $722,000 in 2001 and $483,000 in 2000 of expense associated with common
stock issued at below fair market value to Net2Phone and AOL as further
described above in non-cash stock compensation offset to revenues.

   Amortization of intangible assets.  On January 5, 2001, we acquired all of
the outstanding capital stock of Eloquent Technology, Inc. ("ETI"), a supplier
of speech synthesis, or text-to-speech technology. The purchase price of $18.8
million has been allocated to net tangible assets and liabilities acquired of
($198,000), completed technology of $5.7 million and goodwill of $13.4 million.
Goodwill represents the amount by which the total purchase price exceeded the
fair value of acquired net tangible and intangible assets on the acquisition
date. The completed technology is being amortized on a straight-line basis
through December 2005, while the goodwill amortization was discontinued at the
end of 2001 as a result of a change in accounting rules. The amortization of
the goodwill totaled $2.7 million during 2001.

   On June 5, 2000, we entered into a development and license agreement with
AT&T Corp. to develop and sell products that use AT&T speech technology.
Pursuant to this agreement, in exchange for 1,045,158 shares of our common
stock, we received development and distribution licenses to AT&T's speech
software, text-to-speech software and certain other technology related to
computer processing of the human voice. In addition, the parties agreed to
collaborate in certain marketing efforts and additional technology development.
In connection with this agreement we recorded $11.5 million for the acquired
intellectual property and collaborative rights, equal to the fair value of the
common stock issued, which is being amortized over a three-year period.
Amortization expense for the acquired intellectual property and collaborative
rights was $3.8 million in 2001 and $1.9 million in 2000.

   Interest and other income, net.  Interest income was $3.9 million in 2001,
$3.6 million in 2000 and $549,000 in 1999. Interest expense was $44,000 in
2001, $131,000 in 2000 and $113,000 in 1999. The increase in interest income
from 1999 to 2001 was due to higher cash balances available for investing
during 2000 and 2001 as a result of the initial public offering proceeds. The
decrease in interest expense is primarily due to the reduction in debt payable
under our line of credit and capital equipment leases.

Liquidity and Capital Resources

   From inception through July 31, 2000, we funded our operations primarily
through private placements of convertible preferred stock totaling $60.0
million and, to a lesser extent, through bank borrowings and capital equipment
lease financing. In August 2000, we raised approximately $109.0 million, before
offering expenses, through completion of our initial public offering of common
stock and the concurrent private placement of common stock with AOL and
Net2Phone. As of December 31, 2001, we had cash and cash equivalents of
$55.5 million and marketable securities of $24.3 million. Our revolving line of
credit, which expires on November 30, 2002, provides for available borrowings
up to $5.0 million, based upon certain eligible accounts receivable. As of
December 31, 2001, there was $3.6 million available for borrowings under this
line of credit, with $1.4 million committed under the line of credit for
outstanding letters of credit. Any amounts borrowed under this facility, would
be due as of December 1, 2002. Under the financing arrangement, we are required
to comply with certain financial covenants related to total tangible net worth.
As of December 31, 2001, we were in compliance with these financial covenants.
Based on our financial projections, we believe that we will continue to meet
the financial covenants required in the financing agreement. Our operating
activities resulted in net cash outflows of $26.2 million in 2001,
$23.6 million in 2000 and $14.6 million in 1999. The operating cash outflows
for these periods resulted primarily from our significant investment in
research and development, sales and marketing and infrastructure.

   To date, our investing activities have consisted primarily of net purchases
of marketable securities of $9.9 million in 2001 and $14.4 million in 2000 and
capital expenditures for property and equipment, including $4.5 million in
2001, $3.8 million in 2000 and $3.1 million in 1999. Capital expenditures have
consisted

                                      28

<PAGE>

primarily of computer hardware, software and furniture and fixtures for our
growing employee base. We anticipate that investment in capital equipment will
continue, similar to the rate of increase as seen between 2000 and 2001 for the
next 12 months. In 2001, we paid $5.4 million, net of cash acquired, as part of
the purchase price of ETI and $500,000 was invested in another unrelated third
party. Total investing activities used cash of $10.4 million, excluding
marketable securities investments of $9.9 million, in 2001, used cash of $3.2
million, excluding marketable securities investments of $14.4 million, in 2000
and used cash of $3.5 million in 1999.

   In December 2001, we entered into an equipment line of credit with a bank.
Under this agreement, we obtained the right to borrow up to $6.0 million to
finance purchases of fixed assets. Borrowings under this line are
collateralized by the fixed assets purchased and bear interest at the annual
prime rate (4.75% at December 31, 2001), which is payable monthly over a period
of 36 months. During December 2001, we borrowed $1.8 million under this line
with monthly payments beginning in January 2002 and ending December 2004. Under
the financing agreement, we are obligated to comply with certain financial
covenants related to total tangible net worth. As of December 31, 2001, we were
in compliance with these financial covenants. Based on our financial
projections, we believe that we will continue to meet the financial covenants
required in the financing agreement.

   We had an equipment line of credit that we converted into a term loan in the
amount of $1.5 million. The term loan bears interest at an annual rate of prime
plus 0.75% (5.5% at December 31, 2001), and principal and interest under the
term loan are payable in 36 monthly installments through September 2002. As of
December 31, 2001, $292,000 was outstanding under this facility.

   Our financing activities generated cash of $2.9 million, $128.8 million and
$25.0 million in 2001, 2000 and 1999, respectively. Of these financing
activities, the issuance of convertible preferred stock and common stock
generated net proceeds of $1.6 million, $129.6 million and $23.9 million in the
same respective periods. We had proceeds from bank borrowings of $1.8 million,
none and $1.5 million during the same respective years. Repayment of bank
borrowings and capital leases was $500,000, $724,000 and $398,000 during 2001,
2000 and 1999, respectively.

   On August 4, 2000, we completed our initial public offering of 5.46 million
shares of common stock. The offering raised approximately $100 million, net of
offering expenses, for us. Concurrent with the initial public offering, we
completed two private placements of common stock that raised an additional $9.0
million. As of the date of the offering, all outstanding shares of our
preferred stock automatically converted into an aggregate of 16.4 million
shares of common stock.

   We believe that the net proceeds from our initial public offering and the
concurrent private placements, together with existing cash and cash equivalents
and marketable securities and borrowings available under our bank financing
agreements, will be sufficient to meet our working capital and capital
expenditure requirements for at least the next 12 months. In the event we
require additional financing, we believe that we would be able to obtain such
funding, however, there can be no assurances that we would be successful in
doing so or that we could do so on terms favorable to us.

Contractual Obligations

   The following table sets forth future payments that we are obligated to make
under existing long-term debt and operating lease commitments:

<TABLE>
<CAPTION>
                                                    Payments Due by Period
                                               --------------------------------
                                                        (in thousands)
                                                       Years   Years   Year 6
Contractual Obligation                  Total  Year 1 2 and 3 4 and 5 and later
----------------------                 ------- ------ ------- ------- ---------
<S>                                    <C>     <C>    <C>     <C>     <C>
Long-Term Debt........................ $ 2,093 $  892 $1,201  $   --   $    --
Operating Leases......................  23,447  3,369  6,785   2,818    10,475
                                       ------- ------ ------  ------   -------
   Total Contractual Cash Obligations. $25,540 $4,261 $7,986  $2,818   $10,475
                                       ======= ====== ======  ======   =======
</TABLE>

                                      29

<PAGE>

Other Commercial Commitments

   The following table sets forth other financial commitments under existing
banking arrangements. We currently have standby letters of credit at a bank
that are used as security deposits for various office leases. In the event of
default on these lease commitments, the landlord would be eligible to draw down
against their respective standby letter of credit. At December 31, 2001, we
were not in default on any of our leased facilities.

<TABLE>
<CAPTION>
                                         Amount of Commitment Expiration by Period
                                         -----------------------------------------
                                                      (in thousands)
                                                          Years   Years   Year 6
     Other Commercial Commitments Total  Year 1          2 and 3 4 and 5 and later
     ---------------------------- ------ ------          ------- ------- ---------
     <S>                          <C>    <C>             <C>     <C>     <C>
      Standby Letters of Credit.. $1,350  $164            $352     $47     $787
</TABLE>

Royalty Commitments

   Under the terms of the ETI acquisition, we assumed the royalty commitments
to IBM for the sale of software products developed under an agreement between
ETI and IBM. Under the terms of the agreement, the maximum amount of royalties
owed to IBM is $5.0M. As of December 31, 2001, we have reported the first two
years of minimum royalties, totaling $500,000, from this agreement. As of
December 31, 2001, we had remaining obligations of $4.5 million under the
assumed agreement. We are obligated to pay an annual minimum royalty of $50,000
to MIT for the sale of software products developed using their technology for
as long as MIT holds the copyright on the technology. The following table sets
forth the future minimum royalties owed to IBM and MIT under these agreement,
along with the royalty rates.

<TABLE>
<CAPTION>
                                      Amount of Minimum Royalty Commitment
                                                   by Period
                                      -----------------------------------
                                                 (in thousands)
       Royalty Commitments     Total  2002    2003  2004  2005  Thereafter
       -------------------     ------ ----    ----  ----  ----  ----------
       <S>                     <C>    <C>     <C>   <C>   <C>   <C>
       Royalty Rate--IBM......          11%     12%   12%   12%       12%
       Royalty Commitment--IBM $4,500 $200    $200  $200  $500    $3,400
       Royalty Rate--MIT......           1%      1%    1%    1%        1%
       Royalty Commitment--MIT $  250 $ 50    $ 50  $ 50  $ 50    $   50
</TABLE>

Recent Accounting Pronouncements

   In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statements of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other
Intangible Assets. SFAS 142 became effective for us on January 1, 2002 and
requires, among other things, the discontinuance of goodwill amortization. In
addition, the standard includes provisions for the reclassification of certain
existing recognized intangible assets into goodwill, the reassessment of the
useful lives of existing recognized intangible assets, the reclassification of
certain intangible assets out of previously reported goodwill and the
identification of reporting units for purposes of assessing potential future
impairments of goodwill. SFAS 142 also requires us to complete a transitional
goodwill impairment test within six months from the date of adoption. We are
currently assessing and have not yet determined the impact of SFAS 142 with
respect to any impairment of our goodwill. As of January 1, 2002, we ceased
amortizing goodwill. Quarterly amortization of goodwill for the year ended
December 31, 2001 was approximately $669,000.

   In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. The objectives of SFAS 144 are to address
significant issues relating to the implementation of FASB Statement No. 121,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of ("SFAS 121"), and to develop a single accounting model, based on
the framework established in SFAS 121, for long-lived assets to be disposed of
by sale, whether previously held and used or newly acquired. SFAS 144
supersedes SFAS 121; however, it retains the fundamental provisions of SFAS 121
for (1) the recognition and measurement of the impairment of long-lived assets
to be held and used and (2) the measurement of long-lived assets to be disposed
of by sale. SFAS 144 supersedes the accounting and reporting provisions of

                                      30

<PAGE>

Accounting Principles Board No. 30, Reporting the Results of
Operations--Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions ("APB
30"), for segments of a business to be disposed of. However, SFAS 144 retains
APB 30's requirement that entities report discontinued operations separately
from continuing operations and extends that reporting requirement to "a
component of an entity" that either has been disposed of or is classified as
"held for sale." SFAS 144 also amends the guidance of Accounting Research
Bulletin No. 51, Consolidated Financial Statements, to eliminate the exception
to consolidation for a temporarily controlled subsidiary. SFAS 144 is effective
for financial statements issued commencing with the first quarter of fiscal
2002, and, generally, its provisions are to be applied prospectively. We do not
expect the adoption of SFAS 144 to have a material impact on our financial
position or results of operations.

   In November 2001, the Emerging Issues Task Force (EITF), a committee of the
FASB, reached a consensus on EITF Issue 01-9, Accounting for Consideration
Given by a Vendor to a Customer or Reseller of the Vendor's Products ("EITF
01-9"). EITF 01-9 presumes that consideration, including equity instruments,
from a vendor to a customer or reseller of the vendor's products is a reduction
of the selling prices of the vendor's products and, therefore, should be
characterized as a reduction of revenue when recognized in the vendor's income
statement and could lead to negative revenue under certain circumstances.
Revenue reduction is required unless consideration relates to a separate
identifiable benefit and the benefit's fair value can be established. EITF 01-9
is applicable for us as of January 1, 2002. Upon adoption, reclassification of
all prior period amounts is required to conform to the current period
presentation. We have previously issued equity instruments to certain of our
customers. Upon adopting EITF 01-9 on January 1, 2002, we will be required to
reclassify the amortization of certain equity instruments issued to customers,
which exceed amounts previously recognized as an offset to revenue. The amounts
that will be reclassified from selling and marketing stock-based compensation
expense to a reduction of revenue for the years ended December 31, 2000 and
December 31, 2001 are $935,000 and $1,086,000, respectively. Based on the
amount of revenue we recognize in the future, we expect that a portion or
potentially all of the quarterly future amortization could be recorded against
revenue.

   During November 2001, the EITF reached consensus on Topic No. D-103, Income
Statement Characterization of Reimbursements Received for 'Out-of-Pocket'
Expenses Incurred ("Topic D-103"). The EITF concluded in Topic D-103 that
reimbursements received for out-of-pocket expenses incurred should be
characterized as revenue in the income statement with the offsetting cost
recorded as costs of revenue. Out-of-pocket expenses generally include, but are
not limited to, expenses related to airfare, mileage, hotel stays, out-of-town
meals, photocopies, and telecommunications and facsimile charges. Topic D-103
is applicable for us as of January 1, 2002. Upon adoption, reclassification of
all prior period amounts is required to conform to the current period
presentation. We do not expect the adoption of Topic D-103 to have a material
impact on our financial position or results of operations.

                                      31

<PAGE>

          CAUTIONARY STATEMENTS REGARDING FORWARD-LOOKING INFORMATION

   We undertake no obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.
Our actual results may differ significantly from the results discussed in
forward-looking statements. Important factors that could cause future results
to differ materially from such expectations include: the timing of sales of our
products and services; market acceptance of our speech-activated systems; our
reliance on a limited number of large orders for much of its revenue;
uncertainties related to current economic, political and national security
conditions; our ability to develop new products and services in the face of
rapidly evolving technology; our ability to effectively integrate operations of
any acquired companies; the uncertainties related to our planned international
operations; our ability to manage growth of its business; our ability to
protect our intellectual property; our reliance on resellers and original
equipment manufacturers for a significant portion of our sales; our ability to
respond to competitive developments; and our reliance on attracting, retaining
and motivating key technical and management personnel. These and other
important factors are detailed in our filings with the Securities and Exchange
Commission. As a result of these and other important factors, there can be no
assurances that we will not experience material fluctuations in future
operating results on a quarterly or annual basis.

We have a history of losses and we expect to continue to incur net losses for
the foreseeable future that may depress our common stock price.

   We had an accumulated deficit of $112.8 million at December 31, 2001, and we
expect to incur net losses for the foreseeable future. Net losses were $46.8
million for the year ended December 31, 2001, $29.6 million for the year ended
December 31, 2000 and $15.5 million for the year ended December 31, 1999. We
anticipate continuing to incur significant sales and marketing, research and
development and general and administrative expenses and, as a result, we will
need to generate higher revenues to achieve and sustain profitability. We
cannot be certain we will realize sufficient revenues to achieve profitability.
Moreover, if we were to achieve profitability, we may not be able to sustain or
increase our profitability on a quarterly or annual basis. Any additional
financing that we may require in the future may not be available at all or, if
available, may be on terms unfavorable to us. Failure to achieve or maintain
profitability may depress the market price of our common stock.

We expect our quarterly revenues and operating results to fluctuate. If our
quarterly operating results fail to meet the expectations of financial analysts
and investors, the trading price of our common stock may decline.

   Our revenues and operating results are likely to vary significantly from
quarter to quarter. A number of important factors are likely to cause these
variations, including:

    .  the timing of sales of our products and services, particularly in light
       of our dependence on a relatively small number of large orders,

    .  the timing of product implementations, particularly large client design
       projects,

    .  unexpected delays in introducing new products and services,

    .  variation in capital spending budgets of our clients and potential
       clients,

    .  increased expenses, whether related to sales and marketing, product
       development or administration,

    .  deferral of recognition of our revenue in accordance with applicable
       accounting principles due to the time required to complete projects,

    .  the mix of product license and services revenue,

    .  the mix of domestic and international sales, and

    .  costs related to possible acquisitions of technology or businesses.


                                      32

<PAGE>

   Because of the volatility of our quarterly results and the difficulty in
predicting our future performance, our operating results may fall below the
expectations of analysts or investors and, as a result, the price of our common
stock may decline.

The slowdown in the economy has affected the market for information technology
products, and our future financial results will depend in part upon whether
this slowdown continues.

   As a result of recent unfavorable economic conditions and reduced capital
spending, demand for our products and services may be adversely affected. Many
of our customers are in the telecommunications and airline industries, which
have been strongly affected by the current economic downturn. If the current
economic conditions continue or worsen, our business may be harmed.

Speech-activated systems are relatively new products, and our success will
depend on our ability to continue to educate prospective clients on the
commercial viability of the products. If our potential clients and their
customers do not accept speech-activated systems, our business will be harmed.

   Our business would be harmed if use of speech-activated, e-business
solutions does not continue to develop, or develops more slowly than we expect.
Our market is relatively new and rapidly evolving. Our future success depends
on the acceptance by current and future clients and their customers of
speech-activated services as an integral part of their businesses. The size of
our market will depend in part on consumer acceptance of automated speech
systems and the actual and perceived quality of these systems. The adoption of
speech-activated services could be hindered by the perceived costs of this new
technology, as well as the reluctance of enterprises that have invested
substantial resources in existing call centers, touch-tone-based systems or
internet-based infrastructures to replace or enhance their current systems with
this new technology. Accordingly, in order to achieve broad commercial
acceptance, we will have to educate prospective clients, including large,
established telecommunications companies, about the uses and benefits of
speech-activated services in general and our products in particular. If these
efforts fail, or if speech-activated software platforms do not achieve broad
commercial acceptance, our business could be significantly harmed and our
revenues could decline. In addition, the continued development of new and
evolving wireless technologies using a visual web browser interface could
adversely affect the demand for speech-activated services.

We currently rely on a limited number of large orders for a significant portion
of our revenues. As a result, our inability to secure additional significant
clients during a given period or the loss of one major client could cause our
quarterly results of operation to suffer. Our stock price may also be adversely
affected by unexpected quarterly revenue declines caused by delays in revenue
recognition.

   Due to the nature of our business, in any quarter we are dependent upon a
limited number of orders that are relatively large in relation to our overall
revenues. For example, one customer of ours accounted for 19.3% of our total
revenue in 2001 and 16.1% of our total revenue in 2000. Our speech-activated
products and services require significant expenditures by our clients and
typically involve lengthy sales cycles. We may spend significant time and incur
substantial expenses educating and providing information to prospective
clients. Any failure to complete a sale to a prospective client during a
quarter could result in revenues and operating results for the quarter that are
lower than expected.

   In addition, as a result of the significant time required to deliver or
perform a client order, we may be unable to recognize revenue related to a
client order until well after we receive the order. Our dependence on large
client orders and the delay in recognizing revenue relating to these orders
makes it difficult to forecast quarterly operating results. This could cause
our stock price to be volatile or to decline.

                                      33

<PAGE>

If we fail to develop new products and services in the face of our industry's
rapidly evolving technology, our future operating results may be adversely
affected.

   Our growth and future operating results will depend, in part, on our ability
to keep pace with:

    .  rapidly changing speech recognition and speech synthesis technology,

    .  evolving industry standards and practices,

    .  frequent new speech-activated service and product introductions and
       enhancements, and

    .  changing client requirements and preferences for their automated speech
       systems.

   Any delay or failure on our part in responding quickly, cost-effectively and
sufficiently to these developments could render our existing speech-activated
products and services noncompetitive or obsolete and have an adverse effect on
our competitive position. We may have to incur substantial expenditures to
modify or adapt our speech-activated products and services to respond to
technological changes. We must stay abreast of cutting-edge technological
developments and evolving service offerings to remain competitive and increase
the utility of our speech-activated services. We must be able to incorporate
new technologies into the speech-activated solutions we design and develop to
address the increasingly complex and varied needs of our client base. If we are
unable, for technological or other reasons, to develop and introduce new and
enhanced products and to respond to changing client requirements and
preferences in a timely manner, we may lose existing customers and fail to
attract new customers, which could result in a significant decline in our
revenues.

Development and commercial release of our new product line could impair our
ability to sell existing product lines, and result in a decrease in associated
services revenues.

   The release of our OpenSpeech/TM/ products could have a negative effect on
sales of our existing speech recognition products, including our SpeechWorks
product, and the prices we could charge for these products. Additionally, in
the event of such a negative effect, the maintenance and support revenues
associated with the sales of these products, as well as any potential
consulting services revenues that would have been otherwise associated with
certain sales of these products, may be delayed or impaired. We may also divert
sales and marketing resources from our current products in order to promote and
support our new Open Speech product line. This diversion of resources could
have a further negative effect on sales of our current products and services.

Our application software may contain defects, which could result in delayed or
lost revenue, expensive corrections, liability to our clients and claims
against us.

   We design, develop and implement highly technical speech-activated solutions
that are crucial to the operation of our clients' products and businesses.
Defects in the solutions we develop could result in delayed or lost revenue,
adverse client reaction and negative publicity about us or our products and
services or require expensive corrections. Also, due to the developing nature
of speech recognition technology and text-to-speech technology, our products
are not currently and may never be accurate in every instance. In addition,
third party technology that is included in our products could contain errors or
defects. Clients who are not satisfied with our products or services could
bring claims against us for substantial damages, which, even if unsuccessful,
would likely be time consuming and could result in costly litigation and
payment of damages. Such claims could have an adverse effect on our financial
results and competitive position.

Our current and potential competitors in the speech-activated solutions market,
some of whom have greater resources and experience than we do, may offer
products and services 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 in the speech recognition and
text-to-speech software market include AT&T, Elan, Fonix,

                                      34

<PAGE>

IBM, Lucent Technologies, Microsoft, Nuance Communications, Philips
Communications, Rhetorical, ScanSoft, and Phonetic Systems. Furthermore, we
expect consolidation in our industry, and other companies may enter our markets
by acquiring or entering into strategic relationships with our competitors.
Current and potential competitors 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/or larger client bases than
we do. Our present or future competitors may be able to develop
speech-activated products and services comparable or superior to those we
offer, adapt more quickly than we do to new technologies, evolving industry
trends and standards or client requirements, or devote greater resources to the
development, promotion and sale of their products and services than we do.
Accordingly, we may not be able to compete effectively in our markets,
competition may intensify and future competition may cause demand for and the
prices of our products to decline, which could adversely affect our sales and
profitability.

If the standards we have selected to support are not adopted as the industry
standards for speech-activated software, businesses might not use our
speech-activated software platform for delivery of applications and services,
and our revenues could be negatively affected.

   The market for speech-activated services software is new and emerging and
industry software standards have not yet been fully established. We may not be
competitive unless our products support changing industry software standards.
The emergence of industry standards other than those we have selected to
support, 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 clients and potential clients may not purchase our products, and our
revenues could be adversely affected. Multiple standards in the marketplace
could also make it difficult for us to design our products to support all
applicable standards, which could also result in decreased sales of our
products.

We have and intend to continue expanding our international operations. Because
of the risks involved with operating a business in foreign countries, we may
not be successful and our business could be harmed.

   Our international sales represented 9.4% of our revenue in 2001, 13.8% in
2000 and 2.6% in 1999. We have recently expanded our direct and indirect
international sales force with the expectation of increasing international
revenues. We have limited experience in international operations and
international product and service sales, and there can be no assurance we will
be successful in growing our international business. 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,

    .  difficulties in establishing and maintaining an effective international
       reseller network,

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

    .  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.


                                      35

<PAGE>

In order to increase our international sales, we must 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.

   In order to expand our international sales, we intend to continue to invest
significant resources to create and refine different speech recognition and
synthesis models for particular languages and dialects. These speech processing
models are required to create versions of our products that understand or
reproduce the local language or dialect. 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. In addition, we are
required to invest resources to develop these versions of our products in
advance of the receipt of revenues. We may be unable to recognize revenues
sufficient to render these products profitable.

Growth in our operations may strain our resources, management information
systems and controls, which may reduce our chances of achieving profitability.

   We have recently experienced significant growth. From December 31, 2000 to
December 31, 2001 the number of our employees increased from 317 to 409. We
intend to continue to expand our business operations in the future. We will
need to expand our management, operational, financial and human resources, as
well as management information systems and controls, to support our anticipated
future growth. If we are successful, this growth may place a strain on the
ability of our management team to execute our business plan. In addition, we
will be required to make significant investments in personnel, management
systems and resources. The expansion of these systems will place a significant
burden on our management team and our information technology staff, and these
systems may not be effective once implemented. If we do not manage this growth,
our business will suffer.

We rely on our intellectual property rights, and if we are unable to protect
these rights, we may face increased competition. Protection of our intellectual
property rights is uncertain and may be costly.

   Intellectual property rights are important in our industry. We rely on a
combination of patent, copyright, trademark and trade secret laws, as well as
confidentiality, assignment of rights to inventions, and/or license agreements
with our employees, consultants and corporate or strategic partners to protect
our intellectual property rights. These legal protections afford only limited
protection and may be time-consuming and expensive to obtain and maintain.
Further, despite our efforts, we may be unable to prevent third parties from
unauthorized use of our intellectual property. Monitoring unauthorized use of
our intellectual property is difficult, and we cannot be certain that the steps
we have taken will be effective to prevent unauthorized use.

   Litigation may be necessary to enforce our intellectual property rights and
trade secrets. These lawsuits, regardless of their success, would likely be
time consuming and expensive to resolve and would divert management's time and
attention away from our business.

We may undertake strategic acquisitions or investments in the future and any
difficulties from integrating such acquisitions or investments could damage our
ability to attain or maintain profitability. The anticipated benefits of
strategic acquisitions or investments may never be realized.

   We may acquire or make significant investments in businesses and
technologies that complement or augment our existing business and technologies.
Integrating any newly acquired businesses or technologies could be expensive
and time-consuming and could divert management's time and attention away from
our on-going business. We may not be able to integrate any acquired business,
products, employees or technology successfully and our failure to do so could
harm our business. We cannot guarantee that we will realize any anticipated
benefits from such acquisitions or investments. Moreover, we may need to raise
additional funds through public or private debt or equity financing to acquire
or make significant investments in any businesses or technologies, which may
result in dilution for stockholders and the incurrence of indebtedness. We may
not be able to operate acquired businesses profitably.

                                      36

<PAGE>

Some of our customers and partners are newly formed businesses or businesses
that are not yet profitable. if these companies fail or experience financial
difficulties, our business could be negatively affected.

   Some of our customers and partners are financed by investments from venture
capital investors. Given the current general economic conditions and investment
climate, these companies could face difficulties in securing additional
financing to fund their operations. If these companies are not yet profitable
or self-sustaining based on their operations, they could be unable to satisfy
their commitments to us. Even if they are able to meet current obligations to
us, they may not be able to buy additional products and services from us. If
these companies cannot meet their current obligations to us or fail, our
business could be significantly harmed and our revenue could decline.

We may expend significant resources to defend against claims of infringement by
third parties, and if we are not successful we may lose significant rights or
be required to enter into disadvantageous license or royalty arrangements.

   Currently, in the software industry there are frequent assertions of patent
infringement by owners of patents, and assertions of other violations of
intellectual property rights such as trademarks, copyrights, and trade secrets.
In addition, there are a large number of patents in the speech processing area.
Although we do not believe that we are infringing on any patent rights, the
holders of patents may claim that we are doing so. If any claim was made
against us, our business could be harmed, particularly if we are unsuccessful
in defending such claim. If we are forced to defend any claim, whether it is
with or without merit or is determined in our favor, then we may face costly
litigation, diversion of technical and management personnel, delays in future
product releases or injunctions preventing us from selling our products and
services. We may also be required to enter into costly and burdensome royalty
and licensing agreements. Any royalty or licensing agreements, if required, may
not be available on terms acceptable to us, or at all.

Our products incorporate technology we license from others. Our inability to
maintain these licenses could have a material adverse effect on our business.

   Some of the technology included in or operating in conjunction with our
products is licensed by us from others. For example, we currently license
certain text-to-speech technology from IBM, text-to-speech and other technology
relating to computer processing of the human voice from AT&T and software and
technology from MIT. Certain of these license agreements are for limited terms.
If for any reason these license agreements terminate, we may be required to
seek alternative vendors and may be unable to obtain similar technology on
favorable terms or at all. If we are unable to obtain alternative license
agreements, we could be required to modify some features of our products, which
could adversely affect sales of our products and services.

We rely on resellers and original equipment manufacturers for a significant
portion of our sales. The loss of one or more significant resellers or original
equipment manufacturers could limit our ability to sustain and grow our
revenues.

   In 2001, 55.7% of our revenues were attributable to our resellers and
original equipment manufacturers, or OEMs, especially InterVoice-BRITE, which
accounted for 19.3% of our revenues in 2001. We intend to increase our sales
through resellers in the future. As a result, we are dependent upon the
continued success and viability of our resellers and OEMs, as well as their
continued interest in selling our products. The loss of a key reseller or OEM
or our failure to develop and sustain new reseller and OEM relationships could
limit our ability to sustain and grow our revenues.

   Our contracts with our resellers and OEMs generally do not require them to
purchase our products. Our resellers and OEMs are independent companies over
which we have limited control. Our resellers and OEMs could cease to market our
products or devote significant resources to the sale of our products. Any
failure of our resellers or OEMs to successfully market and sell our products
could result in revenues that are lower than anticipated. In addition, our
resellers and OEMs possess confidential information concerning our products and
operations. Although we have nondisclosure agreements with our resellers and
OEMs, a reseller or OEM could use our confidential information in competition
with us, which could adversely affect our competitive position and revenues.

                                      37

<PAGE>

We rely upon the continued service and performance of a relatively small number
of senior management and key technical personnel. Moreover, competition for
qualified personnel is intense. We may not be able to retain or recruit
necessary personnel, which could impact the management and development of our
business.

   Our future success depends on our retention of a small number of senior
management and key technical personnel, such as Stuart R. Patterson, our
President and Chief Executive Officer, and Michael S. Phillips, our Chief
Technology Officer and co-founder. We do not have key person life insurance
policies covering any of our employees. The loss of services of any of our
executive officers or key personnel could have a negative effect on our ability
to grow our business.

   We need to attract and retain managerial and highly skilled technical
personnel for whom there is intense competition. If we are unable to attract
and retain managerial and qualified technical personnel, our operations could
suffer and we may never achieve profitability.

Our business will be harmed if we fail to hire or retain qualified sales
personnel, or if newly hired sales people fail to develop the necessary sales
skills or develop these skills more slowly than we anticipate.

   Our financial success depends to a large degree on the ability of our direct
and indirect sales force to increase sales. Therefore, our ability to increase
revenue in the future depends considerably upon our success in recruiting,
training and retaining additional direct and indirect sales personnel and the
success of the sales force. Also, it may take a new salesperson a number of
months before he or she becomes a productive member of our sales force.

Item 7a.  Quantitative and Qualitative Disclosures About Market Risk

   A portion of our business is conducted outside the United States through our
foreign subsidiaries and branches. We have foreign currency exposure related to
our operations in international markets where we transact business in foreign
currencies and accordingly are subject to exposure from adverse movements in
foreign currency exchange rates. Currently, we do not engage in any foreign
currency hedging transactions. The functional currency of our foreign
subsidiaries is the local currency. Substantially all of our revenues are
invoiced and collected in U.S. dollars. Net realized gains and losses resulting
from foreign currency transactions are included in the consolidated statement
of operations as other income or expense and have not been material to date.

   We are exposed to market risk related to changes in interest rates
associated with our cash equivalents and marketable securities of $70.1 million
at December 31, 2001. Cash equivalents and marketable securities are recorded
on the balance sheet at market value, with any unrealized gain or loss recorded
in comprehensive income or loss. We believe that the effect of any reasonably
possible near-term changes in interest rates would not have a material impact
on the fair market value of these instruments due to their short maturity.

                                      38

<PAGE>

Item 8.  Financial Statements and Supplementary Data

                  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                                              Page
                                                                                              -----
<S>                                                                                           <C>
Report of Independent Accountants............................................................    40

Consolidated Balance Sheet as of December 31, 2001 and 2000..................................    41

Consolidated Statement of Operations for the years ended December 31, 2001, 2000 and 1999....    42

Consolidated Statement of Changes in Redeemable Convertible Preferred Stock and Stockholders'
  Equity for the years ended December 31, 2001, 2000 and 1999................................    43

Consolidated Statement of Cash Flows for the years ended December 31, 2001, 2000 and 1999....    44

Notes to Consolidated Financial Statements................................................... 45-62
</TABLE>

                                      39

<PAGE>

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders
of SpeechWorks International, Inc.:

   In our opinion, the consolidated financial statements listed in the
accompanying index present fairly, in all material respects, the financial
position of SpeechWorks International, Inc. and its subsidiaries at December
31, 2001 and 2000, and the results of their operations and their cash flows for
each of the three years in the period ended December 31, 2001 in conformity
with accounting principles generally accepted in the United States of America.
In addition, in our opinion, the financial statement schedule listed in the
index appearing under Item 14 (a) (2) on page 64 presents fairly, in all
material respects, the information set forth therein when read in conjunction
with the related consolidated financial statements. These financial statements
and financial statement schedule are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements and financial statement schedule based on our audits. We conducted
our audits of these statements in accordance with auditing standards generally
accepted in the United States of America, which require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

/S/  PRICEWATERHOUSECOOPERS LLP

Boston, Massachusetts
January 28, 2002

                                      40

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

                          CONSOLIDATED BALANCE SHEET

<TABLE>
<CAPTION>
                                                                                            December 31,
                                                                                        --------------------
                                                                                           2001       2000
                                                                                        ---------   --------
                                                                                        (in thousands, except
                                                                                         share information)
<S>                                                                                     <C>         <C>
                                     A S S E T S
                                     ------
Current assets:
   Cash and cash equivalents........................................................... $  55,534   $ 99,203
   Marketable securities...............................................................    24,264     14,370
   Accounts receivable, net of allowance for doubtful accounts of $1,428 and $600,
     respectively......................................................................    12,669     12,502
   Prepaid expenses and other current assets...........................................     2,263      2,488
                                                                                        ---------   --------
       Total current assets............................................................    94,730    128,563
Fixed assets, net......................................................................     6,719      5,337
Intangible assets, net.................................................................    20,978      9,581
Other assets...........................................................................     2,361        893
                                                                                        ---------   --------
       Total assets.................................................................... $ 124,788   $144,374
                                                                                        =========   ========

         L I A B I L I T I E S  A N D  S T O C K H O L D E R S'  E Q U I T Y
         ------------------------------------
Current liabilities:
   Accounts payable.................................................................... $   2,074   $    640
   Accrued compensation................................................................     3,574      4,639
   Accrued expenses....................................................................     3,063      2,991
   Deferred revenue....................................................................     6,125      3,873
   Current portion of notes payable....................................................       892        500
                                                                                        ---------   --------
       Total current liabilities.......................................................    15,728     12,643
Notes payable, net of current portion..................................................     1,201        292
                                                                                        ---------   --------
       Total liabilities...............................................................    16,929     12,935
                                                                                        ---------   --------
Commitments (Note 10)..................................................................
Stockholders' equity:
   Preferred stock, $0.001 par value; 10,000,000 shares authorized; zero shares issued
     and outstanding...................................................................        --         --
   Common stock, $0.001 par value; 100,000,000 shares authorized; 32,347,954 and
     30,583,333 shares issued and outstanding, respectively............................        32         31
   Additional paid-in capital..........................................................   234,563    219,519
   Deferred stock compensation.........................................................   (13,889)   (22,151)
   Accumulated other comprehensive loss................................................       (46)        (8)
   Accumulated deficit.................................................................  (112,801)   (65,952)
                                                                                        ---------   --------
       Total stockholders' equity......................................................   107,859    131,439
                                                                                        ---------   --------
       Total liabilities and stockholders' equity...................................... $ 124,788   $144,374
                                                                                        =========   ========
</TABLE>

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

                                      41

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

                     CONSOLIDATED STATEMENT OF OPERATIONS

<TABLE>
<CAPTION>
                                                                            Year Ended December 31,
                                                                     ------------------------------------
                                                                        2001          2000        1999
                                                                      --------      --------    --------
                                                                     (in thousands, except per share data
<S>                                                                  <C>           <C>         <C>
Revenues:
   Product licenses................................................. $ 25,836      $ 16,356    $  3,680
   Professional services............................................   16,146        11,260       5,944
   Other revenues...................................................    3,052         2,681       4,387
   Non-cash stock compensation......................................   (1,093)         (273)         --
                                                                      --------      --------    --------
       Total revenues...............................................   43,941        30,024      14,011
                                                                      --------      --------    --------
Cost of revenues:
   Cost of product licenses.........................................      350           214         153
   Cost of professional services--non-cash stock compensation.......      617           538         139
    --all other expenses............................................   10,372         8,374       4,991
Cost of other revenues..............................................    2,512         1,844       2,987
Amortization of purchased technology................................    1,131            --          --
                                                                      --------      --------    --------
       Total cost of revenues.......................................   14,982        10,970       8,270
                                                                      --------      --------    --------
Gross profit........................................................   28,959        19,054       5,741
                                                                      --------      --------    --------
Operating expenses:
   Selling and marketing--non-cash stock compensation...............    5,567         3,045         225
    --all other expenses............................................   27,850        19,802       9,254
   Research and development--non-cash stock compensation............      560           472          97
    --all other expenses............................................   14,056         8,652       5,164
   General and administrative--non-cash stock compensation..........      425           398          47
    --all other expenses............................................   24,555        17,300       6,693
   Amortization of intangible assets................................    6,508         1,916          --
                                                                      --------      --------    --------
       Total operating expenses.....................................   79,521        51,585      21,480
                                                                      --------      --------    --------
Loss from operations................................................  (50,562)      (32,531)    (15,739)
Interest income.....................................................    3,927         3,554         549
Interest expense....................................................      (44)         (131)       (113)
Other expenses, net.................................................     (125)         (179)       (160)
                                                                      --------      --------    --------
Loss before income taxes............................................  (46,804)      (29,287)    (15,463)
Provision for income taxes..........................................       45           309          --
                                                                      --------      --------    --------
Net loss............................................................  (46,849)      (29,596)    (15,463)
Accretion and deemed dividend on redeemable convertible preferred
  stock.............................................................       --        (6,955)     (1,904)
                                                                      --------      --------    --------
Net loss attributable to common stockholders........................ $(46,849)     $(36,551)   $(17,367)
                                                                      ========      ========    ========
Basic and diluted net loss per common share.........................   $(1.46)       $(2.29)     $(3.28)
Shares used in computing basic and diluted net loss per common share   31,981        15,935       5,298
</TABLE>

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

                                      42

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

     CONSOLIDATED STATEMENT OF CHANGES IN REDEEMABLE CONVERTIBLE PREFERRED
                        STOCK AND STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                                         Redeemable
                                                                        Convertible        Common
                                                                      Preferred Stock      Stock
                                                                     -----------------  ------------ Additional
                                                                                                Par   Paid-In
                                                                     Shares    Amount   Shares Value  Capital
                                                                     -------  --------  ------ ----- ----------

<S>                                                                  <C>      <C>       <C>    <C>   <C>
Balance at December 31, 1998........................................   6,570  $ 17,749   4,784  $ 5   $    486
Issuance of preferred stock.........................................       6        25
Issuance of preferred stock, including related issuance costs of $24   2,671    23,829
Issuance of common stock upon exercise of employee stock options....                       801    1         79
Repayment of notes receivable from stockholders.....................
Accrual of cumulative dividends on redeemable convertible
 preferred stock....................................................             1,904
Deferred compensation related to employee stock option grants.......                                     5,413
Amortization of deferred stock compensation.........................
Net loss............................................................
                                                                     -------  --------  ------  ---   --------
Balance at December 31, 1999........................................   9,247    43,507   5,585    6      5,978
Issuance of preferred stock, including related issuance costs of $74   2,545    20,001
Accrual of cumulative dividends on redeemable convertible
 preferred stock....................................................             1,765
Issuance of common stock upon initial public offering, net of
 issuance costs of $1,820...........................................                     5,463    6     99,777
Sale of common stock in private placement...........................                       722    1      8,999
Accretion of redeemable convertible preferred stock to redemption
 value..............................................................             5,190
Conversion of redeemable convertible preferred stock to common
 stock in connection with the initial public offering............... (11,792)  (70,463) 16,415   16     70,447
Issuance of common stock upon warrant exercises.....................                       431   --         85
Issuance of common stock upon acquiring intellectual property and
 collaborative rights...............................................                     1,045    1     11,494
Issuance of common stock upon exercise of employee stock options....                       922    1        767
Deferred compensation related to employee stock option grants,
 issuance of warrants and issuance of common stock at less than
 fair market value..................................................                                    21,972
Amortization of deferred stock compensation.........................
Unrealized gain on marketable securities............................
Foreign currency translation adjustment.............................
Net loss............................................................

Comprehensive loss..................................................
                                                                     -------  --------  ------  ---   --------
Balance at December 31, 2000........................................      --        --  30,583   31    219,519
Issuance of common stock upon acquisition of Eloquent
 Technology, Inc....................................................                       300   --     13,457
Issuance of common stock upon warrant exercises.....................                       727   --         --
Issuance of common stock upon exercise of employee stock options
 and under the employee stock purchase plan.........................                       738    1      1,587
Amortization of deferred stock compensation.........................
Unrealized gain on marketable securities............................
Foreign currency translation adjustment.............................
Net loss............................................................

Comprehensive loss..................................................
                                                                     -------  --------  ------  ---   --------
Balance at December 31, 2001........................................      --  $     --  32,348  $32   $234,563
                                                                     =======  ========  ======  ===   ========
</TABLE>
<TABLE>
<CAPTION>


                                                                                     Notes      Accumulated
                                                                       Deferred    Receivable      Other
                                                                        Stock         From     Comprehensive Accumulated
                                                                     Compensation Stockholders     Loss        Deficit
                                                                     ------------ ------------ ------------- -----------

<S>                                                                  <C>          <C>          <C>           <C>
Balance at December 31, 1998........................................   $     --       $(12)        $ --       $ (11,936)
Issuance of preferred stock.........................................
Issuance of preferred stock, including related issuance costs of $24                                                (24)
Issuance of common stock upon exercise of employee stock options....
Repayment of notes receivable from stockholders.....................                    12
Accrual of cumulative dividends on redeemable convertible
 preferred stock....................................................                                             (1,904)
Deferred compensation related to employee stock option grants.......     (5,413)
Amortization of deferred stock compensation.........................        508
Net loss............................................................                                            (15,463)
                                                                       --------       ----         ----       ---------
Balance at December 31, 1999........................................     (4,905)        --           --         (29,327)
Issuance of preferred stock, including related issuance costs of $74                                                (74)
Accrual of cumulative dividends on redeemable convertible
 preferred stock....................................................                                             (1,765)
Issuance of common stock upon initial public offering, net of
 issuance costs of $1,820...........................................
Sale of common stock in private placement...........................
Accretion of redeemable convertible preferred stock to redemption
 value..............................................................                                             (5,190)
Conversion of redeemable convertible preferred stock to common
 stock in connection with the initial public offering...............
Issuance of common stock upon warrant exercises.....................
Issuance of common stock upon acquiring intellectual property and
 collaborative rights...............................................
Issuance of common stock upon exercise of employee stock options....
Deferred compensation related to employee stock option grants,
 issuance of warrants and issuance of common stock at less than
 fair market value..................................................    (21,972)
Amortization of deferred stock compensation.........................      4,726
Unrealized gain on marketable securities............................                                  4
Foreign currency translation adjustment.............................                                (12)
Net loss............................................................                                            (29,596)

Comprehensive loss..................................................
                                                                       --------       ----         ----       ---------
Balance at December 31, 2000........................................    (22,151)        --           (8)        (65,952)
Issuance of common stock upon acquisition of Eloquent
 Technology, Inc....................................................
Issuance of common stock upon warrant exercises.....................
Issuance of common stock upon exercise of employee stock options
 and under the employee stock purchase plan.........................
Amortization of deferred stock compensation.........................      8,262
Unrealized gain on marketable securities............................                                 12
Foreign currency translation adjustment.............................                                (50)
Net loss............................................................                                            (46,849)

Comprehensive loss..................................................
                                                                       --------       ----         ----       ---------
Balance at December 31, 2001........................................   $(13,889)      $ --         $(46)      $(112,801)
                                                                       ========       ====         ====       =========
</TABLE>
<TABLE>
<CAPTION>


                                                                         Total
                                                                     Stockholders'
                                                                        Equity     Comprehensive
                                                                       (Deficit)       Loss
                                                                     ------------- -------------

<S>                                                                  <C>           <C>
Balance at December 31, 1998........................................   $(11,457)
Issuance of preferred stock.........................................
Issuance of preferred stock, including related issuance costs of $24        (24)
Issuance of common stock upon exercise of employee stock options....         80
Repayment of notes receivable from stockholders.....................         12
Accrual of cumulative dividends on redeemable convertible
 preferred stock....................................................     (1,904)
Deferred compensation related to employee stock option grants.......         --
Amortization of deferred stock compensation.........................        508
Net loss............................................................    (15,463)     $(15,463)
                                                                       --------      ========
Balance at December 31, 1999........................................    (28,248)
Issuance of preferred stock, including related issuance costs of $74        (74)
Accrual of cumulative dividends on redeemable convertible
 preferred stock....................................................     (1,765)
Issuance of common stock upon initial public offering, net of
 issuance costs of $1,820...........................................     99,783
Sale of common stock in private placement...........................      9,000
Accretion of redeemable convertible preferred stock to redemption
 value..............................................................     (5,190)
Conversion of redeemable convertible preferred stock to common
 stock in connection with the initial public offering...............     70,463
Issuance of common stock upon warrant exercises.....................         85
Issuance of common stock upon acquiring intellectual property and
 collaborative rights...............................................     11,495
Issuance of common stock upon exercise of employee stock options....        768
Deferred compensation related to employee stock option grants,
 issuance of warrants and issuance of common stock at less than
 fair market value..................................................         --
Amortization of deferred stock compensation.........................      4,726
Unrealized gain on marketable securities............................          4      $      4
Foreign currency translation adjustment.............................        (12)          (12)
Net loss............................................................    (29,596)      (29,596)
                                                                                     --------
Comprehensive loss..................................................                 $(29,604)
                                                                       --------      ========
Balance at December 31, 2000........................................    131,439
Issuance of common stock upon acquisition of Eloquent
 Technology, Inc....................................................     13,457
Issuance of common stock upon warrant exercises.....................         --
Issuance of common stock upon exercise of employee stock options
 and under the employee stock purchase plan.........................      1,588
Amortization of deferred stock compensation.........................      8,262
Unrealized gain on marketable securities............................         12      $     12
Foreign currency translation adjustment.............................        (50)          (50)
Net loss............................................................    (46,849)      (46,849)
                                                                                     --------
Comprehensive loss..................................................                 $(46,887)
                                                                       --------      ========
Balance at December 31, 2001........................................   $107,859
                                                                       ========
</TABLE>

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

                                      43

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

                     CONSOLIDATED STATEMENT OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                   Year Ended December 31,
                                                                                ----------------------------
                                                                                  2001        2000        1999
                                                                                --------    --------    --------
                                                                                       (in thousands)
<S>                                                                             <C>         <C>         <C>
Cash flows from operating activities:
Net loss....................................................................... $(46,849)   $(29,596)   $(15,463)
Adjustments to reconcile net loss to net cash used in operating activities:
   Depreciation and amortization...............................................    3,060       1,891         785
   Amortization of intangible assets...........................................    7,639       1,916          --
   Stock compensation expense..................................................    8,262       4,726         508
   Provision for doubtful accounts.............................................    1,224         540         (15)
   Transaction (gains) losses, net.............................................      125         (33)          4
   Changes in operating assets and liabilities, net of effects of acquisition:
       Accounts receivable.....................................................   (1,397)     (8,967)     (1,080)
       Prepaid expenses and other current assets...............................      215      (2,039)       (286)
       Other assets............................................................     (988)       (330)       (347)
       Accounts payable........................................................    1,444        (200)       (557)
       Accrued compensation....................................................   (1,065)      3,535         594
       Accrued other expenses..................................................     (133)      2,030         688
       Deferred revenue........................................................    2,257       2,946         610
                                                                                --------    --------    --------
          Net cash used in operating activities................................  (26,206)    (23,581)    (14,559)
                                                                                --------    --------    --------
Cash flows from investing activities:
   Purchases of fixed assets...................................................   (4,509)     (3,777)     (3,100)
   Cash paid to acquire business including acquisition costs, net of cash
     acquired..................................................................   (5,377)                     --
   Cash paid for investment in third party.....................................     (500)         --          --
   Purchases of restricted investments.........................................                   --        (573)
   Maturities of restricted investments........................................       --         573          --
   Maturities of short-term investments........................................       --          --         200
   Purchases of marketable securities..........................................  (89,431)    (14,366)         --
   Maturities of marketable securities.........................................   79,549          --          --
                                                                                --------    --------    --------
          Net cash used in investing activities................................  (20,268)    (17,570)     (3,473)
                                                                                --------    --------    --------
Cash flows from financing activities:
   Principal payments on capital lease obligations.............................       --        (183)       (231)
   Proceeds from notes payable.................................................    1,801          --       1,500
   Principal payments on notes payable.........................................     (500)       (541)       (167)
   Proceeds from issuance of redeemable convertible preferred stock, net of
     issuance costs............................................................       --      19,927      23,830
   Proceeds from issuance of common stock under employee stock plans
     and warrants..............................................................    1,588         853          80
   Proceeds from sale of common stock, net of issuance costs...................       --     108,783          --
   Repayment of notes receivable from stockholders.............................       --          --          12
                                                                                --------    --------    --------
          Net cash provided by financing activities............................    2,889     128,839      25,024
                                                                                --------    --------    --------
   Effects of changes in exchange rates on cash................................      (84)         41          (4)
          Net (decrease) increase in cash and cash equivalents.................  (43,669)     87,729       6,988
Cash and cash equivalents, beginning of year...................................   99,203      11,474       4,486
                                                                                --------    --------    --------
Cash and cash equivalents, ending of year...................................... $ 55,534    $ 99,203    $ 11,474
                                                                                ========    ========    ========
</TABLE>

Supplemental disclosure of cash flow information (Note 15)

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

                                      44

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.   Business

   SpeechWorks International, Inc. (the "Company") was incorporated in May 1994
and began operations in September 1994 under the name Applied Language
Technologies, Inc. In October 1998, the Company's stockholders voted to change
its name to SpeechWorks International, Inc. The Company is a leading provider
of software products and professional services that enable enterprises,
carriers and voice portals to offer automated, speech-activated services over
any telephone. The Company, which operates in one reportable segment, markets
its products on a worldwide basis to companies in telecommunications, financial
services and travel industries, as well as to governmental agencies.

2.   Summary of Significant Accounting Policies

  Principles of Consolidation

   The consolidated financial statements reflect the operations of the Company
and its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated.

  Cash and Cash Equivalents and Marketable Securities

   The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents; all other
securities are classified as marketable securities. All investments are
classified as available for sale and are carried at fair value, with unrealized
gains and losses included in other comprehensive income or loss, which is a
separate component of stockholders' equity, until realized. The Company
recognizes realized gains and losses on a specific identification basis. The
Company invests excess cash primarily in commercial paper, municipal notes and
bonds, money market funds of major financial institutions and U.S. government
agencies and corporate debt securities.

  Concentration of Credit Risk and Major Customers

   Financial instruments that potentially expose the Company to concentrations
of credit risk are primarily comprised of cash investments and trade accounts
receivable. The Company places its excess cash in marketable investment grade
securities. There are no significant concentrations in any one issuer of
securities. The Company places its cash, cash equivalents and investments with
financial institutions with high credit standing. The Company provides credit
to customers in the normal course of business and management believes its
credit policies reflect normal industry terms and business risk. The Company
performs on-going credit evaluations of its customers' financial condition and
does not require collateral since management does not anticipate nonperformance
by the counterparties. When events indicate a change in a customer's ability to
make payments, the Company records a reserve for potential credit losses and
such losses have been within management's expectations.

   At December 31, 2001, 15% of the Company's accounts receivable was due from
one customer. At December 31, 2000, 13% of the Company's accounts receivable
were due from one customer.

   Revenue from one customer represented 19% and 16% of total revenues during
the years ended December 31, 2001 and 2000, respectively. Revenue from two
customers represented 34% and 11% of total revenues during the year ended
December 31, 1999.

  Fair Value of Financial Instruments

   Financial instruments, including cash, cash equivalents, accounts
receivable, accounts payable, accrued expenses and long-term debt, are carried
in the consolidated financial statements at amounts that approximate their fair
value as of December 31, 2001 and 2000.

                                      45

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Long-Lived Assets and Impairment of Long-Lived Assets

   Fixed assets are recorded at cost and depreciated using the straight-line
method over their estimated useful lives. Leasehold improvements are amortized
over the shorter of the useful life of the improvement or the remaining term of
the lease. Fixed assets held under capital leases are stated at the lower of
the fair market value of the related asset or the present value of the minimum
lease payments at the inception of the lease and are amortized on a
straight-line basis over either the life of the related asset or the term of
the lease. Repairs and maintenance costs are charged to expense as incurred.

   Intangible assets result from the Company's purchase of speech technology
from AT&T Corp. (Note 7) and from the Company's acquisition of Eloquent
Technology, Inc. (Note 6). Acquisition-related intangible assets consist of
completed technology and goodwill, which is the amount by which the cost of
acquired net assets exceeded the fair values of those net assets on the
acquisition date. Intangible assets are recorded at cost or fair value, if
recorded in connection with an acquisition, net of accumulated amortization.
Intangible assets are amortized on a straight-line basis over their estimated
useful lives.

   The Company periodically evaluates its long-lived assets for events and
circumstances that indicate a potential impairment. Recoverability of these
assets is assessed based on undiscounted expected cash flows from these assets,
considering a number of factors, including past operating results, budgets and
economic projections, market trends and product development cycles. An
impairment in the carrying value of each asset is assessed when the
undiscounted expected cash flows derived from the asset are less than its
carrying value. The amount of the impairment would equal the difference between
the estimated fair value of the asset and its carrying value. Through December
31, 2001, the Company has not recognized an impairment loss on its long-lived
assets.

  Revenue Recognition

   The Company recognizes revenue in accordance with Statement of Position
97-2, Software Revenue Recognition ("SOP 97-2"), as amended by Statement of
Position 98-9, and the Securities and Exchange Commission's Staff Accounting
Bulletin No. 101 Revenue Recognition in Financial Statements. Revenue from the
sale of licenses to end users, value-added resellers and system integrators to
use the Company's software products is recognized upon delivery, provided that
no significant obligations remain, evidence of the arrangement exists, the fees
are fixed or determinable, and collectibility is reasonably assured. Revenue
from royalties on sales of the Company's products by resellers to third parties
is recognized upon delivery to the third party when such information is
available, or when notified by the reseller that such royalties are due as a
result of a sale, provided that collectibility is reasonably assured.

   Professional services revenue primarily consists of fees for custom
development services, user-interface design consulting, project management
consulting services, and support and maintenance services provided to end
users, value added resellers, system integrators and OEMs. Revenue relating to
the development of custom software applications and nonrecurring platform
development work for third parties, including fees for licenses to use the
Company's software products in the related development effort and thereafter in
conjunction with the delivered custom application, as well as revenue relating
to consulting services provided on a fixed-fee basis, are recognized using the
percentage-of-completion method of accounting, provided that collection of the
related receivable is reasonably assured. In applying this method, the Company
measures each project's percentage-of-completion by the ratio of labor hours
incurred to date to estimated total labor hours to complete the project. This
method is used because management considers expended labor hours to be the best
available measure of progress on these projects. Adjustments to contract
estimates are made in the periods in which the facts requiring such revisions
become known. When the estimate indicates a loss, such loss is provided for in
its entirety. When services are provided on a time and materials basis, revenue
is recognized as the services are rendered. Revenue

                                      46

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

related to maintenance and support arrangements is recognized ratably over the
contract period. The Company does not consider professional services, other
than the development of custom software applications, to be essential to the
functionality of the other elements of its software arrangements. These other
professional services are limited and primarily include training and
feasibility studies.

   Other revenue primarily consists of resold hardware sales and other resold
facilities management services provided to end users. Resold hardware revenue
is recognized upon delivery, provided that evidence of the arrangement exists,
the fees are fixed or determinable, collectibility is reasonably assured and no
significant post-delivery obligations remain relating to the sale. Revenues
from resold facilities management services are recognized in the period in
which the services are provided.

   The Company's sales frequently include, under related contracts, software
licenses, related professional services and a maintenance and support
arrangement. The total contract value is attributed first to the maintenance
and support arrangement based on its fair value, equal to its stated list price
as a fixed percentage of the related software product's price. The remainder of
the total contract value is then attributed to the software license and related
professional services, with the effect that discounts inherent in the total
contract value are attributed to the software license and related professional
services. For revenue classification, the Company allocates the contract value
remaining after allocation to maintenance and support using the fair value of
professional services, based on the fee charged when services are sold
separately, and records that as professional services revenue; all remaining
amounts are recorded as product license revenue.

   Under its maintenance and support arrangements, the Company offers
unspecified upgrades and enhancements on software products only on a
when-and-if-available basis. Typically, the Company does not contract in
advance for specified upgrades, enhancements or additional software products.
In arrangements where the Company agrees to provide additional products,
specified upgrades or enhancements, the Company allocates revenue from the
entire arrangement among all elements of the order, including future
deliverables, based on the relative fair values, based on the fee charged when
products are sold separately, of each element of the arrangement. The Company
defers recognition of revenue allocated to the specified future deliverable
until delivery has occurred and any remaining contractual terms relating to
that element have been met. In situations where fair value does not exist for
all elements to be delivered under the arrangement, the Company defers all
revenue from the arrangement until the earlier of the date when all elements
have been delivered or fair value exists for all undelivered elements. The
Company does not offer rights of return to its customers. In situations where
negotiated contracts require rights of return, the Company does not recognize
revenue until all significant obligations have been delivered and accepted by
the client.

   In some customer arrangements the Company is able to invoice the customer in
advance of providing services under a milestone billing plan, or in advance of
providing maintenance and support. In these situations, the Company records the
invoiced amount as deferred revenue. The Company recognizes deferred revenue as
revenue as the related services are provided.

  Research and Development and Capitalized Software Development Costs

   Costs incurred in the research and development of new software products and
enhancements to existing products, other than certain software development
costs that qualify for capitalization, are expensed as incurred. Software
development costs incurred subsequent to the establishment of technological
feasibility, but prior to general release of the product, are capitalized and
amortized to cost of software license revenues over the estimated useful life
of the related products. In the years ended December 31, 2001, 2000 and 1999,
costs eligible for capitalization were not material.

                                      47

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Accounting for Stock Compensation

   The Company accounts for stock-based awards to employees using the intrinsic
value method as prescribed in Accounting Principles Board ("APB") Opinion No.
25, Accounting for Stock Issued to Employees, and related interpretations.
Accordingly, compensation expense is recorded for options issued to employees
in fixed amounts to the extent that the fixed exercise prices are less than the
fair market value of the Company's common stock on the date of grant. The
difference between the fair value of the Company's common stock and the
exercise price of the stock option is recorded as deferred stock compensation,
as a reduction of stockholders' equity. Deferred stock compensation is
amortized to compensation expense over the vesting period of the underlying
stock option. The Company follows the disclosure provisions of Statement of
Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based
Compensation (Note 9). All stock-based awards to nonemployees are accounted for
at their fair value in accordance with SFAS No. 123 and related interpretations.

  Advertising Expense

   The Company expenses advertising costs as incurred. During the years ended
December 31, 2001, 2000 and 1999, advertising expense totaled $1,626,000,
$1,598,000 and $1,334,000, respectively.

  Income Taxes

   Deferred tax assets and liabilities are determined based on the difference
between the financial statement and tax bases of assets and liabilities using
enacted tax rates in effect in the years in which the differences are expected
to reverse. A valuation allowance against deferred tax assets is recorded if,
based upon the weight of available evidence, it is more likely than not that
some or all of the deferred tax assets will not be realized. The Company does
not provide for U.S. income taxes on the undistributed earnings of its foreign
subsidiaries, which the Company considers to be permanent investments.

  Comprehensive Income (Loss)

   Comprehensive income (loss) consists of net income (loss) and other
comprehensive income (loss), which includes foreign currency translation
adjustments and unrealized gains and losses on certain investments. For the
purposes of comprehensive income (loss) disclosures, the Company does not
record tax provisions or benefits for the net changes in foreign currency
translation adjustment, as the Company intends to permanently reinvest
undistributed earnings in its foreign subsidiaries.

  Foreign Currency Translation

   The functional currency of the Company's foreign subsidiaries is the local
currency. Substantially all of the Company's revenues are invoiced and
collected in U.S. dollars. Assets and liabilities of foreign subsidiaries that
are denominated in foreign currencies are remeasured into U.S. dollars at rates
of exchange in effect at the balance sheet date. Revenue and expense amounts
are remeasured using the average exchange rates for the period. Net unrealized
gains and losses resulting from foreign currency remeasurement are included in
other comprehensive income (loss), which is a separate component of
stockholders' equity. Net realized gains and losses resulting from foreign
currency transactions are included in the consolidated statement of operations
as other income or expense.

  Net Loss Per Common Share

   Basic net loss per common share is computed by dividing net loss
attributable to common stockholders by the weighted average number of common
shares outstanding. Diluted net loss per share is computed by dividing

                                      48

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

the net loss attributable to common stockholders by the weighted average number
of shares of common stock and potential common stock outstanding during the
period, if dilutive. There is no difference between basic and diluted net loss
per share for all periods presented since potential common shares from the
conversion of redeemable convertible preferred stock and the exercise of
options and warrants were anti-dilutive for all periods presented.

   The following table sets forth the potential common stock excluded from the
calculation of diluted net loss per share:

<TABLE>
<CAPTION>
                                               Year ended December 31,
                                            ------------------------------
                                              2001      2000       1999
                                            --------- --------- ----------
     <S>                                    <C>       <C>       <C>
     Options to purchase common stock...... 6,616,476 5,692,249  4,836,202
     Warrants to purchase common stock.....   255,141 1,044,088    807,237
     Redeemable convertible preferred stock        --        -- 13,870,477
                                            --------- --------- ----------
                                            6,871,617 6,736,337 19,513,916
                                            ========= ========= ==========
</TABLE>

  Use of Estimates

   The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Components particularly subject to estimation include
estimates of costs to complete custom software development arrangements,
amounts recorded as accounts receivable allowances, recoverability of
intangible assets, including goodwill, and the income tax valuation allowance.
Actual results could differ from those estimates and would impact future
results of operations and cash flows.

  Reclassifications

   Certain amounts in the prior years' financial statements have been
reclassified to conform to current year presentation. These reclassifications
had no effect on reported net loss.

  Recent Accounting Pronouncements

   In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statements of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other
Intangible Assets. SFAS 142 is effective for the Company on January 1, 2002 and
requires, among other things, the discontinuance of goodwill amortization. In
addition, the standard includes provisions for the reclassification of certain
existing recognized intangible assets into goodwill, the reassessment of the
useful lives of existing recognized intangible assets, the reclassification of
certain intangible assets out of previously reported goodwill and the
identification of reporting units for purposes of assessing potential future
impairments of goodwill. SFAS 142 also requires the Company to complete a
transitional goodwill impairment test within six months from the date of
adoption. The Company is currently assessing and has not yet determined the
impact of SFAS 142 with respect to any impairment of its goodwill. As of
January 1, 2002, the Company will cease amortizing goodwill. Quarterly
amortization of goodwill for the year ended December 31, 2001 was approximately
$669,000.

   In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. The objectives of SFAS 144 are to address
significant issues relating to the implementation of

                                      49

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to Be Disposed Of ("SFAS 121"), and to develop a single
accounting model, based on the framework established in SFAS 121, for
long-lived assets to be disposed of by sale, whether previously held and used
or newly acquired. SFAS 144 supersedes SFAS 121; however, it retains the
fundamental provisions of SFAS 121 for (1) the recognition and measurement of
the impairment of long-lived assets to be held and used and (2) the measurement
of long-lived assets to be disposed of by sale. SFAS 144 supersedes the
accounting and reporting provisions of Accounting Principles Board No. 30,
Reporting the Results of Operations--Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions ("APB 30"), for segments of a business to be disposed
of. However, SFAS 144 retains APB 30's requirement that entities report
discontinued operations separately from continuing operations and extends that
reporting requirement to "a component of an entity" that either has been
disposed of or is classified as "held for sale." SFAS 144 also amends the
guidance of Accounting Research Bulletin No. 51, Consolidated Financial
Statements, to eliminate the exception to consolidation for a temporarily
controlled subsidiary. SFAS 144 is effective for financial statements issued
commencing with the first quarter of fiscal 2002 and, generally, its provisions
are to be applied prospectively. The Company does not expect the adoption of
SFAS 144 to have a material impact on its financial position or results of
operations.

   In November 2001, the Emerging Issues Task Force (EITF), a committee of the
FASB, reached a consensus on EITF Issue 01-9, Accounting for Consideration
Given by a Vendor to a Customer or Reseller of the Vendor's Products ("EITF
01-9"). EITF 01-9 presumes that consideration, including equity instruments,
from a vendor to a customer or reseller of the vendor's products is a reduction
of the selling prices of the vendor's products and, therefore, should be
characterized as a reduction of revenue when recognized in the vendor's income
statement and could lead to negative revenue under certain circumstances.
Revenue reduction is required unless consideration relates to a separate
identifiable benefit and the benefit's fair value can be established. EITF 01-9
is applicable for the Company as of January 1, 2002. Upon adoption,
reclassification of all prior period amounts is required to conform to the
current period presentation. The Company has previously issued equity
instruments to certain of its customers. Upon adopting EITF 01-9 on January 1,
2002, the Company will be required to reclassify the amortization of certain
equity instruments issued to customers, which exceed amounts previously
recognized as an offset to revenue. The amounts that will be reclassified from
selling and marketing stock-based compensation expense to a reduction of
revenue for the years ended December 31, 2000 and December 31, 2001 are
$935,000 and $1,086,000, respectively. Based on the amount of revenue the
Company recognizes in the future, it expects that a portion, or potentially
all, of the quarterly future amortization could be recorded against revenue.

   During November 2001, the EITF reached consensus on Topic No. D-103, Income
Statement Characterization of Reimbursements Received for 'Out-of-Pocket'
Expenses Incurred ("Topic D-103"). The EITF concluded in Topic D-103 that
reimbursements received for out-of-pocket expenses incurred should be
characterized as revenue in the income statement with the offsetting costs
recorded as costs of revenue. Out-of-pocket expenses generally include, but are
not limited to, expenses related to airfare, mileage, hotel stays, out-of-town
meals, photocopies, and telecommunications and facsimile charges. Topic D-103
is applicable for the Company as of January 1, 2002. Upon adoption,
reclassification of all prior period amounts is required to conform to the
current period presentation. The Company does not currently expect the adoption
of Topic D-103 to have a material impact on its financial position or results
of operations.

                                      50

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


3.  Investments

   Cash equivalents consist of the following:

<TABLE>
<CAPTION>
                                              December 31,
                                             ---------------
                                              2001    2000
                                             ------- -------
                                             (in thousands)
                   <S>                       <C>     <C>
                   Commercial paper......... $    -- $62,545
                   Municipal notes and bonds      --  16,481
                   Money market funds.......  45,857   9,494
                   U.S. government agencies.      --   4,997
                   Corporate debt securities      --   3,003
                                             ------- -------
                                             $45,857 $96,520
                                             ======= =======
</TABLE>

   Marketable securities at amortized cost, including accrued interest, and at
fair value as of December 31, 2001 and 2000, consist of the following:

<TABLE>
<CAPTION>
                                         2001              2000
                                   ----------------- -----------------
                                   Amortized  Fair   Amortized  Fair
                                     Cost     Value    Cost     Value
                                   --------- ------- --------- -------
                                             (in thousands)
         <S>                       <C>       <C>     <C>       <C>
         Commercial paper.........  $ 7,912  $ 7,912  $11,345  $11,338
         Corporate debt securities   16,336   16,352    3,021    3,032
                                    -------  -------  -------  -------
                                    $24,248  $24,264  $14,366  $14,370
                                    =======  =======  =======  =======
</TABLE>

   Gross realized and unrealized gains and losses on marketable securities for
the years ended December 31, 2001 and 2000 were immaterial. All marketable
securities held at December 31, 2001 and 2000 matured within one year.

4.  Accounts Receivable

   Accounts receivable consist of the following:

<TABLE>
<CAPTION>
                                                    December 31,
                                                   ---------------
                                                    2001    2000
                                                   ------- -------
                                                   (in thousands)
             <S>                                   <C>     <C>
             Accounts receivable.................. $11,252 $10,191
             Unbilled accounts receivable.........   2,845   2,911
                                                   ------- -------
                                                    14,097  13,102
             Less--allowance for doubtful accounts   1,428     600
                                                   ------- -------
                                                   $12,669 $12,502
                                                   ======= =======
</TABLE>

   Unbilled accounts receivable are primarily revenues earned under percentage
of completion accounting that have not yet been billed under the terms of the
arrangement.

                                      51

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


5.  Fixed Assets

   Fixed assets consist of the following:

<TABLE>
<CAPTION>
                                                    Estimated   December 31,
                                                   useful life --------------
                                                     (years)    2001    2000
                                                   ----------- ------- ------
                                                               (in thousands)
   <S>                                             <C>         <C>     <C>
   Software, computer and office equipment........      3      $ 9,961 $6,448
   Leasehold improvements.........................      5        2,050  1,232
   Furniture and fixtures.........................      5        1,080    969
                                                               ------- ------
                                                                13,091  8,649
   Less--accumulated depreciation and amortization               6,372  3,312
                                                               ------- ------
                                                               $ 6,719 $5,337
                                                               ======= ======
</TABLE>

   Depreciation and amortization expense for the years ended December 31, 2001,
2000 and 1999 was $3,060,000, $1,891,000 and $785,000, respectively.

6.  Acquisitions

   On January 5, 2001, the Company acquired all of the outstanding capital
stock of Eloquent Technology, Inc. ("ETI"), a supplier of speech synthesis, or
text-to-speech technology. In connection with the acquisition, the Company paid
$5,250,000 in cash and issued 299,873 shares of its common stock valued at
$13,457,000. Additionally, the Company incurred acquisition-related costs of
$132,000, which are included in the total purchase price for accounting
purposes. The acquisition was accounted for using the purchase method of
accounting. Accordingly, the fair market values of the acquired assets and
assumed liabilities have been included in the Company's consolidated financial
statements as of the acquisition date, and the results of operations of ETI
have been included in the Company's consolidated financial statements
thereafter. The purchase price of $18,839,000 has been allocated to net
tangible assets and liabilities acquired of ($198,000), completed technology of
$5,653,000 and goodwill of $13,384,000. The intangible assets are being
amortized on a straight-line basis through December 2005. In 2001, the Company
recorded amortization expense for completed technology of $1,131,000 and
amortization expense for goodwill of $2,677,000.

   The Company's pro forma statement of operations for periods prior to the
acquisition reflecting the Company and ETI on a combined basis would not differ
materially from the Company's reported results.

   In connection with this acquisition, the Company assumed the terms of a
development and royalty agreement between ETI and IBM. Under this agreement,
IBM funded development of certain of ETI's products, and the Company is
obligated to pay royalties of between 10% and 12% of revenue received from such
funded products. Total maximum royalties payable under the term of this
agreement are $5.0 million (See Note 10).

7.  Intangible Assets

   On June 5, 2000, the Company entered into a development and license
agreement with AT&T Corp. to develop and sell products that use AT&T speech
technology. Pursuant to this agreement, in exchange for 1,045,158 shares of the
Company's common stock, the Company received development and distribution
licenses to AT&T's speech software, text-to-speech software and certain other
technology related to computer processing of the human voice. In addition, the
parties agreed to collaborate in certain marketing efforts and additional

                                      52

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

technology development. In connection with this agreement, the Company recorded
$11,497,000 of acquired intellectual property and collaborative rights, equal
to the fair value of the common stock issued, which is being amortized on a
straight-line basis through June 2003. Amortization expense for the acquired
intellectual property and collaborative rights for the years ended December 31,
2001 and 2000 was $3,832,000 and $1,916,000, respectively.

   Intangible assets consist of the following:

<TABLE>
<CAPTION>
                                           Estimated   December 31,
                                          useful life ---------------
                                            (years)    2001    2000
                                          ----------- ------- -------
                                                      (in thousands)
           <S>                            <C>         <C>     <C>
           AT&T Technology...............      3      $11,497 $11,497
           ETI Technology................      5        5,653      --
           ETI Goodwill..................      5       13,384      --
                                                      ------- -------
                                                       30,534  11,497
           Less--accumulated amortization               9,556   1,916
                                                      ------- -------
                                                      $20,978 $ 9,581
                                                      ======= =======
</TABLE>

8.  Stockholders' Equity

  Preferred Stock

   The Company has authorized up to 10,000,000 shares of preferred stock,
$0.001 par value, for issuance. Each series of preferred stock shall have
rights, preferences, privileges and restrictions, including voting rights,
dividend rights, conversion rights, redemption privileges and liquidation
preferences, as shall be determined by the Board of Directors upon the issuance
of the preferred stock.

  Common Stock

   Each share of common stock entitles the holder to one vote on all matters
submitted to a vote of the Company's stockholders. Common stockholders are not
entitled to receive dividends unless declared by the Board of Directors.

  Deferred Stock Compensation

   In connection with the sale of common stock in private placements to
Net2Phone and America Online (AOL), concurrent with the Company's initial
public offering, the Company recorded deferred stock compensation within
stockholders' equity of $5,446,000. This amount represents the difference
between the price of the public offering of $20.00 per share and the price paid
by each of Net2Phone and AOL of $12.46 per share. This amount is presented as a
reduction of stockholders' equity and is being amortized to the statement of
operations over the three-year term of the concurrently entered arrangements.
In each reporting period, such amortization is reflected first as a reduction
of revenues resulting from the arrangements; to the extent that the
amortization exceeds such revenues, the residual is reflected in operating
expenses. For the year ended December 31, 2001, the Company recognized revenue
from Net2Phone and AOL and, accordingly, the related amortization of
$1,093,000, was recorded as a non-cash stock compensation charge that reduced
revenue. Amortization of deferred stock compensation for Net2Phone and AOL of
$722,000, which was in excess of revenue recognized during the year, was
recorded as selling and marketing stock compensation expense. For the year ended

                                      53

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 31, 2000, the Company recognized revenue from Net2Phone and AOL and,
accordingly, the related amortization of $273,000 was recorded as a non-cash
stock compensation charge that reduced revenue. Amortization of deferred stock
compensation for Net2Phone and AOL of $483,000, which was in excess of revenue
recognized during the year, was recorded as selling and marketing stock
compensation expense.

  Warrants

   On June 30, 2000, the Company issued a fully-vested warrant to purchase up
to 765,422 shares of common stock to AOL in connection with a long-term
marketing arrangement. In accordance with EITF 96-18, the value ascribed to
this warrant upon its issuance, utilizing the Black-Scholes valuation model,
was $11,220,000, which is being amortized to selling and marketing stock
compensation expense over the three-year term of the agreement. The Company
recognized $3,740,000 and $1,558,000 of stock compensation expense during the
years ended December 31, 2001 and 2000, respectively. The warrant, which has an
exercise price of $12.46 per share, becomes exercisable upon the earlier of
June 30, 2002 or in three equal installments upon the achievement of certain
performance targets. The warrant may be exercised at the option of the holder,
in whole or in part, at any time on or before the fifth anniversary from the
date that portion of the warrant becomes exercisable. As of December 31, 2000,
in accordance with the original terms of the warrant, AOL exercised a portion
of their warrant for the purchase of 510,281 shares of common stock in a
cashless exercise, resulting in the Company issuing 365,248 shares of common
stock. As of December 31, 2001, the remaining warrant to purchase up to 255,141
shares of common stock was not exercisable.

   On May 31, 2000, the Company issued to a Series E preferred investor a
warrant to purchase 47,710 shares of common stock at an exercise price of $7.86
per share, subject to certain anti-dilution adjustments. The warrant was
exercisable at the option of the holder, in whole or part, at any time on or
before May 31, 2002. The fair value ascribed to this warrant upon its issuance,
utilizing the Black-Scholes valuation model, was $330,630. On January 24, 2001,
the warrant was exercised in full in a cashless exercise resulting in the
Company issuing 37,020 shares of common stock.

   In November 1998, in connection with the acquisition of the name
"SpeechWorks," the Company issued a warrant to an unrelated third party to
purchase 30,000 shares of the Company's common stock at a price of $2.83 per
share, subject to certain anti-dilution adjustments. This warrant was
exercisable at the option of the holder, in whole or in part, at any time on or
before November 30, 2003. The value ascribed to this warrant upon its issuance,
utilizing the Black-Scholes valuation model, was not significant. On October
19, 2000, the warrant was exercised in full for proceeds to the Company of
approximately $85,000.

   In January 1997, the Company issued to a customer a warrant to purchase
741,237 shares of the Company's common stock at a price of $2.05 per share,
subject to certain anti-dilution adjustments. This warrant was exercisable at
the option of the holder, in whole or in part, at any time on or before January
31, 2002, subject to a maximum of three exercises. The value ascribed to this
warrant upon its issuance, utilizing the Black-Scholes valuation model, was not
significant. On February 6, 2001, the warrant was exercised in full in a
cashless exercise resulting in the Company issuing 690,052 shares of common
stock.

   In connection with a leasing agreement entered in 1996, the Company issued a
warrant to purchase 36,000 shares of its common stock at a price of $0.67 per
share. The warrant was subject to certain anti-dilution adjustments and was
exercisable, in whole or in part, on or before October 31, 2002. The value
ascribed to this warrant upon its issuance, utilizing the Black-Scholes
valuation model, was not significant. On October 31, 2000, the warrant was
exercised in full in a cashless exercise resulting in the Company issuing
35,686 shares of common stock.

                                      54

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Reserved Shares

   At December 31, 2001, the Company had 6,871,617 shares of its common stock
reserved for issuance upon the exercise of outstanding options issued under the
Company's stock option plans and upon exercise of outstanding common stock
warrants.

9.  Stock Option Plans

   During April 2000, the Company's Board of Directors approved the 2000
Employee, Director and Consultant Stock Plan (the "2000 Plan"), which was
approved by the Company's stockholders in May 2000. The 2000 Plan provides for
the grant of incentive stock options ("ISOs") as well as non-qualified options
to employees, directors and other individuals providing services to the
Company. The Compensation Committee of the Board of Directors determines the
term of each option, exercise price, number of shares for which each option is
granted, whether restrictions will be imposed on the shares subject to options
and the rate at which each option is exercisable. The exercise price for ISOs
cannot be less than the fair market value per share of the underlying common
stock on the date granted. The exercise price for ISOs granted to holders of
more than 10% of the voting stock of the Company cannot be less than 110% of
the fair market value per share of the underlying common stock on the grant
date. The term of ISOs and non-qualified options cannot exceed ten years. The
term of ISOs granted to holders of more than 10% of the voting stock of the
Company cannot exceed five years. Options granted under the 2000 Plan typically
vest over 4 years. A maximum of 5,000,000 shares of common stock have been
authorized for issuance under the 2000 Plan. As of December 31, 2001, 3,166,704
options have been issued and remain outstanding, with an additional 1,677,841
still available for grant.

   During May 2000, the Company's Board of Directors and stockholders approved
the 2000 Employee Stock Purchase Plan (the "Purchase Plan"), which became
effective upon completion of the Company's initial public offering. The plan
authorizes the issuance of up to a total of 200,000 shares of common stock to
participating employees. Under the Purchase Plan, the Company makes two
offerings each fiscal year, at the end of which employees may purchase shares
of the Company's common stock through payroll deductions made over the term of
each offering period. The per-share purchase price at the end of each offering
period is equal to the lesser of 85% of the closing price of the Company's
common stock at the beginning or end of the offering period. The first plan
period began September 1, 2000 and ended on February 28, 2001, with future
offering periods ending on August 31 and February 28 of each subsequent year.
In 2001, there were 85,129 shares issued under the Purchase Plan.

   During August 1995, the Company adopted the Amended and Restated 1995 Stock
Option Plan (the "1995 Plan"). The 1995 Plan provides for the grant of
incentive stock options as well as non-qualified options to employees,
directors and other individuals providing services to the Company. The
Compensation Committee of the Board of Directors determines the term of each
option, exercise price, number of shares for which each option is granted,
whether restrictions will be imposed on the shares subject to options and the
rate at which each option is exercisable. The exercise price for ISOs cannot be
less than the fair market value per share of the underlying common stock on the
date granted. The exercise price for ISOs granted to holders of more than 10%
of the voting stock of the Company cannot be less than 110% of the fair market
value per share of the underlying common stock on the grant date. The term of
ISOs and non-qualified options cannot exceed ten years. The term of ISOs
granted to holders of more than 10% of the voting stock of the Company cannot
exceed five years. Options granted under the 1995 Plan typically vest over 4
years. A maximum of 3,645,254 shares of common stock have been authorized for
issuance under the 1995 Plan. As of December 31, 2001, 3,332,328 options have
been issued and remain outstanding, with an additional 312,926 still available
for grant.

                                      55

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   A summary of the status of options granted under the Company's stock option
plans as of December 31, 2001, 2000 and 1999 and changes during the years then
ended is presented below:

<TABLE>
<CAPTION>
                                                        2001             2000             1999
                                                  ---------------- ---------------- ----------------
                                                         Weighted-        Weighted-        Weighted-
                                                  Number  average  Number  average  Number  average
                                                    of   exercise    of   exercise    of   exercise
                                                  shares   price   shares   price   shares   price
                                                  ------ --------- ------ --------- ------ ---------
                                                                    (in thousands)
<S>                                               <C>    <C>       <C>    <C>       <C>    <C>
Outstanding at beginning of year................. 5,692   $ 6.77   4,836   $ 1.51   3,397    $0.36
   Granted....................................... 2,062    10.64   2,103    15.71   2,795     2.51
   Exercised.....................................  (655)    1.21    (922)    0.83    (801)    0.10
   Canceled......................................  (483)   18.79    (325)    3.14    (555)    1.47
                                                  -----   ------   -----   ------   -----    -----
Outstanding at end of year....................... 6,616   $ 7.65   5,692   $ 6.77   4,836    $1.51
                                                  =====   ======   =====   ======   =====    =====
Options exercisable at December 31............... 2,857   $ 4.60   1,821   $ 1.62   1,423    $0.51
Options available for future grant at December 31 1,991            3,570            5,547
Weighted-average fair value of options granted
  during the year ended December 31..............         $ 9.86           $12.69            $0.65
</TABLE>

   The following table summarizes information about stock options outstanding
at December 31, 2001:

<TABLE>
<CAPTION>
                                  Options outstanding    Options exercisable
                                  -------------------- -----------------------
                                   Weighted
                                    average   Weighted                Weighted
                                   remaining  average                 average
     Range of          Number     contractual exercise     Number     exercise
   exercise prices  Outstanding      life      price    exercisable    price
 ----------------- -------------- ----------- -------- -------------- --------
                   (in thousands) (in years)           (in thousands)
 <S>               <C>            <C>         <C>      <C>            <C>
 $ 0.01--$   0.67      1,044          5.9     $  0.43        982      $  0.41
   0.83-    1.50         477          7.3        1.00        264          .98
   2.05-    2.17         729          7.6        2.16        339         2.16
   4.00-    4.13       1,005          7.7        4.03        550         4.05
   4.80-    6.62       1,013          9.3        6.60        147         6.62
   6.69-    8.00       1,178          8.6        7.82        353         7.97
   8.32-   18.00         681          9.0       13.46        151        14.25
  19.00-   92.25         489          8.9       38.85         71        50.56
                       -----                               -----
 $ 0.01-$ 92.25        6,616          8.0     $  7.65      2,857      $  4.60
                       =====                               =====
</TABLE>

   In connection with the grant of certain stock options to employees through
June 30, 2000, the Company recorded deferred stock compensation within
stockholders' equity of $10,719,000, 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. Such amount is presented
as a reduction of stockholders' equity and is being amortized over the vesting
period of the applicable options. Subsequent to June 30, 2000, no options have
been issued with exercise prices less than fair value on the date of grant;
accordingly, no additional deferred stock compensation has been recorded. The
Company recorded amortization of deferred stock compensation for the years
ended December 31, 2001, 2000 and 1999 of $2,707,000, $2,411,000 and $508,000,
respectively. Had compensation expense for all stock awards been determined
based on the fair value at the date of grant, consistent with the method
prescribed by SFAS No. 123, the Company's net loss attributable to common

                                      56

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

stockholders and net loss per common share for the years ended December 31,
2001, 2000 and 1999 would have increased to the pro forma amounts indicated
below:

<TABLE>
<CAPTION>
                            2001                  2000                  1999
                    --------------------  --------------------  --------------------
                      Net loss   Net loss   Net loss   Net loss   Net loss   Net loss
                    attributable   per    attributable   per    attributable   per
                     to common    common   to common    common   to common    common
                    stockholders  share   stockholders  share   stockholders  share
                    ------------ -------- ------------ -------- ------------ --------
                                  (in thousands, except per share data)
<S>                 <C>          <C>      <C>          <C>      <C>          <C>
As reported........   $(46,849)   $(1.46)   $(36,551)   $(2.29)   $(17,367)   $(3.28)
Pro forma..........   $(57,059)   $(1.78)   $(41,565)   $(2.61)   $(17,719)   $(3.34)
</TABLE>

   For this purpose, the fair value of options at the date of grant was
estimated using the Black-Scholes valuation model after the Company's initial
registration filing and the minimum value method before the Company's initial
registration filing with the following weighted-average assumptions:

<TABLE>
<CAPTION>
                                                2001  2000 1999
                                                ----  ---- ----
                <S>                             <C>   <C>  <C>
                Dividend yield.................   --   --   --
                Expected volatility............  139% 100%  --
                Risk-free interest rate........ 4.85% 6.1% 5.4%
                Expected option life (in years) 6.17  6.4  7.5
</TABLE>

   The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options. The Company's employee stock options have
characteristics significantly different from those of traded options such as
vesting restrictions and extremely limited transferability. In addition, the
assumptions used in option valuation models are highly subjective, particularly
the assumption of expected stock price volatility of the underlying stock.
Changes in these subjective assumptions can materially affect the fair value
estimate.

10.  Commitments

  Operating Leases

   The Company leases its primary office space under noncancelable operating
leases, which expire through September 30, 2004. Under the terms of the lease
relating to its main facility, the Company is required to maintain an
irrevocable standby letter of credit stating the lessor as the beneficiary. The
letter of credit must be in the amount of $80,000 through December 31, 2001,
with such amount being reduced by $40,000 each succeeding year through the
expiration of the lease. During 1999, the Company leased additional office
space under a noncancelable operating lease, which expires in 2004. Under the
terms of the lease, the Company is required to maintain an irrevocable letter
of credit stating the lessor as beneficiary. The letter of credit must be in
the amount of $313,500 through September 2002, with such amount reduced by
$100,000 after September 2002 and an additional $100,000 after September 2003.

   During 2000, the Company leased office space in New York under a
noncancelable operating lease, which expires in 2016. Under the terms of the
lease, the Company is required to maintain an irrevocable letter of credit,
stating the lessor as beneficiary, in the amount of $711,000 through 2016.

   During 1999, the Company leased office space in Montreal, Canada under a
noncancelable operating lease, which expires in 2010. Additional office space
in Montreal, Canada was leased as an addendum to the 1999 lease during 2000.
Under the terms of the lease, the Company is required to maintain an
irrevocable letter of credit

                                      57

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

stating the lessor as beneficiary. The letter of credit must be in the amount
of $216,000 through November 2001, with such amount reduced by $24,000 each
succeeding year through expiration of the lease.

   Rent expense under operating leases was $4,339,000, $2,951,000 and
$1,050,000 for the years ended December 31, 2001, 2000 and 1999, respectively.

   Future minimum lease obligations under operating leases as of December 31,
2001 are as follows:

<TABLE>
<CAPTION>
                Year                             (in thousands)
                ----                             --------------
                <S>                              <C>
                2002............................    $ 3,369
                2003............................      3,711
                2004............................      3,074
                2005............................      1,545
                2006............................      1,273
                Thereafter......................     10,475
                                                    -------
                   Total minimum lease payments.    $23,447
                                                    =======
</TABLE>

  Royalty Agreement

   In August 1994, the Company entered into a license agreement, last amended
in July 1996, under which the Company obtained a nonexclusive right to use
certain software technology through the term of the licensor's copyrights on
such technology. In exchange, the Company is required to pay royalties on net
sales of licensed product. These royalties begin at 5% of licensed product
sales and decrease as a percentage of sales based on cumulative life to date
sales. In addition, the Company was required to pay annual minimum royalties
totaling $80,000 and $90,000 for the years ended December 31, 2000 and 1999,
respectively, and $50,000 annually thereafter. Any payments that exceed these
minimums can be used to offset future royalties payable under the agreement.

   In January 2001, in connection with the acquisition of ETI, the Company
assumed the terms of a development and royalty agreement between ETI and IBM.
Under this agreement, IBM funded development of certain of ETI's products, and
the Company is obligated to pay royalties of between 10% and 12% of revenue
received from such funded products. Total maximum royalties payable under the
term of this agreement are $5.0 million. The agreement requires the Company to
make minimum royalty payments of $200,000 in 2002, 2003 and 2004 and $500,000
in 2005. As of December 31, 2001, the Company's remaining obligation under the
assumed agreement was approximately $4.5 million.

   Under the terms of these royalty agreements, the Company recorded royalty
expense totaling $350,000, $214,000 and $93,000 during the years ended December
31, 2001, 2000 and 1999, respectively. Also, in 1999, cost of product license
revenue included a $60,000 payment to a client as a royalty for the resale of
an application originally developed for that client.

11.  Notes Payable and Line of Credit

   In December 2001, the Company entered into an equipment line of credit with
a bank. Under this agreement, the Company obtained the right to access up to
$6,000,000 to finance purchases of fixed assets. Borrowings under this line are
collateralized by the fixed assets purchased and bear interest at an annual
rate of prime (4.75% at December 31, 2001), which is payable monthly over a
period of 36 months. During December

                                      58

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

2001, the Company borrowed $1,801,000 under this line. In accordance with the
terms of the equipment line of credit, principal payments of $600,000 are due
in each of the years ended December 31, 2002 and 2003 and $601,000 is due
during the year ended December 31, 2004. Under the financing agreement, the
Company is obligated to comply with certain financial covenants related to
total tangible net worth; the Company was in compliance as of December 31, 2001.

   In March 1999, the Company entered into an equipment financing agreement
with a bank. Under this agreement, the Company entered into two lines of credit
under which the Company obtained the right to access up to $1,500,000 to
finance purchases of fixed assets. Borrowings under these lines are
collateralized by the fixed assets purchased and bear interest at an annual
rate of prime plus 0.75% (5.5% at December 31, 2001) which is payable monthly.
Borrowings made between March 1999 and May 1999 and between June 1999 and
November 1999 converted into term loans on May 31, 1999 and November 30, 1999,
respectively, at which point monthly payments of principal plus interest became
due over a period of 36 months. During 1999, the Company borrowed the entire
$1,500,000 available under these lines. At December 31, 2001, $292,000 was
outstanding under the resulting notes payable; maturing in 2002. Under the
financing agreement, the Company is obligated to comply with certain financial
covenants related to total tangible net worth; the Company was in compliance as
of December 31, 2001.

   Also in March 1999, the Company entered into a revolving line of credit with
the same bank, which as modified on December 1, 2001 provides for available
borrowings of up to $5,000,000. The revolving line of credit expires on
November 30, 2002. Amounts available for borrowing are based upon certain
eligible accounts receivable. Borrowings under the revolving line of credit
bear interest at the bank's prime rate (4.75% at December 31, 2001), and all
outstanding borrowings are due December 1, 2002. At December 31, 2001, no
amounts were outstanding under the revolving line of credit and $3,650,000 was
available for borrowing, with $1,350,000 committed under this line of credit
for outstanding letters of credit. Under the financing agreement, the Company
is obligated to comply with certain financial covenants related to total
tangible net worth; the Company was in compliance as of December 31, 2001.

12.  Segment Reporting

   The Company operates in a single segment and has no organizational structure
dictated by product lines, geography or customer type.

   The following table presents total revenue, including non-cash stock
compensation, and long-lived assets, excluding intangible assets, information
by geographic area as of and for the years ended December 31, 2001, 2000 and
1999:

<TABLE>
<CAPTION>
                                   Total Revenue       Long-Lived Assets
                              ----------------------- --------------------
                               2001    2000    1999    2001   2000   1999
                              ------- ------- ------- ------ ------ ------
                                             (in thousands)
      <S>                     <C>     <C>     <C>     <C>    <C>    <C>
      United States.......... $39,817 $25,887 $13,649 $7,636 $5,065 $3,499
      Canada.................      --      --      --    660    673     --
      Other foreign countries   4,124   4,137     362    784    492    460
                              ------- ------- ------- ------ ------ ------
                              $43,941 $30,024 $14,011 $9,080 $6,230 $3,959
                              ======= ======= ======= ====== ====== ======
</TABLE>

   Revenue classification above is based on the country in which the sale
originates.

                                      59

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


13.  Income Taxes

   During the year ended December 31, 2000, the Company changed from the cash
receipts and disbursements accounting method to the accrual accounting method
for federal and state income tax purposes. As a result of taxable losses
generated in the United States, the Company has not recorded any domestic
provision for income taxes for the years ended December 31, 2001, 2000 and 1999
but has recorded a foreign income tax provision for the years ended December
31, 2001 and 2000 related to income from its foreign operations. The following
shows net income and loss from U.S. and foreign operations for the years ended
December 31, 2001, 2000 and 1999:

<TABLE>
<CAPTION>
                                                   December 31,
                                           ----------------------------
        Profit (loss) before income taxes:   2001      2000      1999
        ---------------------------------- --------  --------  --------
                                                  (in thousands)
        <S>                                <C>       <C>       <C>
        United States..................... $(47,555) $(32,279) $(15,463)
        Foreign...........................      751     2,992        --
                                           --------  --------  --------
           Total loss before income taxes. $(46,804) $(29,287) $(15,463)
                                           ========  ========  ========
</TABLE>

   The following is a reconciliation between the amount of the Company's income
taxes utilizing the U.S. federal statutory rate and the Company's actual
provision for income taxes for the years ended December 31, 2001, 2000 and 1999:

<TABLE>
<CAPTION>
                                                     December 31,
                                              --------------------------
                                                2001     2000     1999
                                              --------  -------  -------
                                                    (in thousands)
      <S>                                     <C>       <C>      <C>
      At U.S. federal statutory rate......... $(15,886) $(9,958) $(5,328)
      State taxes, net of federal effect.....   (1,374)  (1,576)  (1,045)
      Effect of change in valuation allowance    8,483    8,870    6,416
      Foreign rate differential..............    6,369    3,024       --
      Amortization...........................    2,799       --
      Other..................................     (346)     (51)     (43)
                                              --------  -------  -------
         Provision for income taxes.......... $     45  $   309  $    --
                                              ========  =======  =======
</TABLE>

   The Company's net deferred tax assets consist of the following:

<TABLE>
<CAPTION>
                                                      December 31,
                                                   ------------------
                                                     2001      2000
                                                   --------  --------
                                                     (in thousands)
          <S>                                      <C>       <C>
          Gross deferred tax assets...............
          Net operating loss carryforwards........ $ 19,539  $ 17,041
          Tax credit carryforwards................    1,890     1,144
          Accrued expenses........................    3,772     1,177
          Deferred compensation...................    2,266        --
          Other...................................      815        64
                                                   --------  --------
             Total gross deferred tax assets......   28,282    19,426
                                                   --------  --------
          Gross deferred tax liabilities..........
          Purchased technology....................   (1,821)       --
          Deferred tax asset valuation allowance..  (26,461)  (19,426)
                                                   --------  --------
             Total gross deferred tax liabilities.  (28,282)  (19,426)
                                                   --------  --------
          Net deferred tax asset.................. $     --  $     --
                                                   ========  ========
</TABLE>

                                      60

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   At December 31, 2001 and 2000, the Company provided a valuation allowance
for the full amount of its net deferred tax assets since, based on the weight
of available evidence, management could not conclude that it is more likely
than not that these future benefits will be realized. At December 31, 2001, the
Company has federal and state net operating loss carryforwards of $47,300,000
and $52,300,000, respectively, available to reduce future income, which expire
at various dates through 2021. Approximately $1,419,000 of the net operating
losses is due to the exercise of non-qualified stock options and disqualifying
dispositions of incentive stock options for which the benefit will be charged
to additional paid in capital when recognized. The Company also has federal and
state research and development credit carryforwards of $1,094,000 and $704,000,
respectively, available to reduce future income tax liabilities, which expire
at various dates through 2021. Under the Internal Revenue Code, certain
substantial changes in the Company's ownership could result in an annual
limitation on the amount of net operating loss and tax credit carryforwards
which can be utilized in future years to offset future taxable income and tax
liabilities.

14.  401(k) Savings Plan

   The Company has established a retirement savings plan under Section 401(k)
of the Internal Revenue Code (the "401(k) Plan"). The 401(k) Plan covers
substantially all employees of the Company who meet minimum age and service
requirements, and allows participants to defer a portion of their annual
compensation on a pre-tax basis. Company contributions to the 401(k) Plan may
be made at the discretion of the Board of Directors. The Company has not made
any contributions to the 401(k) Plan through December 31, 2001.

15.  Supplemental Cash Flow Information

   During the years ended December 31, 2001, 2000 and 1999, the Company made
cash payments for interest totaling $44,000, $126,000 and $113,000,
respectively.

   During 2001, warrant holders exercised warrants for the purchase of 788,947
shares of the Company's common stock in cashless exercises, resulting in the
Company issuing 727,072 shares of common stock.

   During 2001, in exchange for common stock and cash, the Company acquired
Eloquent Technology, Inc. as follows:

<TABLE>
<CAPTION>
                                                      (in thousands)
                                                      --------------
           <S>                                        <C>
           Fair value of assets acquired and goodwill    $ 19,057
           Common stock issued.......................     (13,457)
           Cash paid.................................      (5,377)
                                                         --------
              Liabilities assumed....................    $    223
                                                         ========
</TABLE>

   During 2000, the Company issued 1,045,158 shares of its common stock, valued
at $11,497,000, to AT&T in exchange for intellectual property and collaborative
rights.

   During 2000, in connection with the Company's initial public offering, all
outstanding shares of preferred stock automatically converted into an aggregate
16,415,158 shares of the Company's common stock.

   During 2000, warrant holders exercised warrants for the purchase of 546,281
shares of the Company's common stock in cashless exercises, resulting in the
Company issuing 400,934 shares of common stock.

                                      61

<PAGE>

                        SPEECHWORKS INTERNATIONAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


16.  Quarterly Results (Unaudited)

   The following information has been derived from unaudited consolidated
financial statements that, in the opinion of management, include all recurring
adjustments necessary for a fair presentation of such information.

<TABLE>
<CAPTION>
                                                                                     Three Months Ended
                                                        --------------------------------------------------------------------
                                                        Dec. 31,  Sept. 30, June 30,  Mar. 31,  Dec. 31, Sept. 30, June 30,
                                                          2001      2001      2001      2001      2000     2000      2000
                                                        --------  --------- --------  --------  -------- --------- --------
<S>                                                     <C>       <C>       <C>       <C>       <C>      <C>       <C>
Revenues:
  Product licenses..................................... $  7,030  $  6,908  $  5,806  $  6,092  $ 6,120   $ 4,853  $  2,776
  Professional services................................    4,361     3,744     3,673     4,368    3,642     3,096     2,364
  Other revenues.......................................      353       848       899       952      793       674       892
  Non-cash stock compensation..........................     (264)     (288)     (229)     (312)    (273)       --        --
                                                        --------  --------  --------  --------  -------   -------  --------
   Total revenues......................................   11,480    11,212    10,149    11,100   10,282     8,623     6,032
                                                        --------  --------  --------  --------  -------   -------  --------
Cost of revenue:
  Cost of product licenses.............................       78       145        73        54       59        44        66
  Cost of professional services--non-cash stock
                    compensation.......................      155       154       154       154      154       156       135
                  --all other expenses.................    2,476     2,386     2,575     2,935    2,478     2,346     1,856
  Cost of other revenues...............................      312       697       752       751      477       558       659
  Amortization of purchased technology.................      282       283       283       283       --        --        --
                                                        --------  --------  --------  --------  -------   -------  --------
   Total cost of revenues..............................    3,303     3,665     3,837     4,177    3,168     3,104     2,716
                                                        --------  --------  --------  --------  -------   -------  --------
    Gross profit.......................................    8,177     7,547     6,312     6,923    7,114     5,519     3,316
                                                        --------  --------  --------  --------  -------   -------  --------
Operating expenses:
  Selling and marketing--non-cash stock compensation...    1,401     1,377     1,436     1,353    1,392     1,201       259
              --all other expenses.....................    7,530     7,048     6,959     6,313    5,737     5,793     4,478
  Research and development--non-cash stock
                    compensation.......................      140       140       140       140      140       140       120
                 --all other expenses..................    3,259     3,580     3,865     3,352    2,676     2,160     2,006
  General and administrative--non-cash stock
                    compensation.......................      107       106       106       106      106       107       150
                 --all other expenses..................    6,400     6,223     6,389     5,543    5,858     4,482     3,652
  Amortization of intangible assets....................    1,627     1,627     1,627     1,627      958       958        --
                                                        --------  --------  --------  --------  -------   -------  --------
       Total operating expenses........................   20,464    20,101    20,522    18,434   16,867    14,841    10,665
                                                        --------  --------  --------  --------  -------   -------  --------
Loss from operations...................................  (12,287)  (12,554)  (14,210)  (11,511)  (9,753)   (9,322)   (7,349)
Interest and other income, net.........................      782       620       897     1,459    1,805     1,334        97
                                                        --------  --------  --------  --------  -------   -------  --------
Loss before income taxes...............................  (11,505)  (11,934)  (13,313)  (10,052)  (7,948)   (7,988)   (7,252)
Provision (benefit) for income taxes...................       22        42       (45)       26      309        --        --
                                                        --------  --------  --------  --------  -------   -------  --------
Net loss...............................................  (11,527)  (11,976)  (13,268)  (10,078)  (8,257)   (7,988)   (7,252)
Accretion and deemed dividend on redeemable convertible
 preferred stock.......................................       --        --        --        --       --      (300)   (6,055)
                                                        --------  --------  --------  --------  -------   -------  --------
Net loss attributable to common stockholders........... $(11,527) $(11,976) $(13,268) $(10,078) $(8,257)  $(8,288) $(13,307)
                                                        ========  ========  ========  ========  =======   =======  ========
Basic and diluted net loss per common share............ $  (0.36) $  (0.37) $  (0.41) $  (0.32) $ (0.27)  $ (0.39) $  (2.12)
Shares used in computing basic and diluted net loss per
 common share..........................................   32,320    32,153    32,031    31,408   30,180    21,419     6,281
</TABLE>
<TABLE>
<CAPTION>


                                                        Mar. 31,
                                                          2000
                                                        --------
<S>                                                     <C>
Revenues:
  Product licenses..................................... $ 2,607
  Professional services................................   2,158
  Other revenues.......................................     322
  Non-cash stock compensation..........................      --
                                                        -------
   Total revenues......................................   5,087
                                                        -------
Cost of revenue:
  Cost of product licenses.............................      45
  Cost of professional services--non-cash stock
                    compensation.......................      93
                  --all other expenses.................   1,694
  Cost of other revenues...............................     150
  Amortization of purchased technology.................      --
                                                        -------
   Total cost of revenues..............................   1,982
                                                        -------
    Gross profit.......................................   3,105
                                                        -------
Operating expenses:
  Selling and marketing--non-cash stock compensation...     193
              --all other expenses.....................   3,794
  Research and development--non-cash stock
                    compensation.......................      72
                 --all other expenses..................   1,810
  General and administrative--non-cash stock
                    compensation.......................      35
                 --all other expenses..................   3,308
  Amortization of intangible assets....................      --
                                                        -------
       Total operating expenses........................   9,212
                                                        -------
Loss from operations...................................  (6,107)
Interest and other income, net.........................       8
                                                        -------
Loss before income taxes...............................  (6,099)
Provision (benefit) for income taxes...................      --
                                                        -------
Net loss...............................................  (6,099)
Accretion and deemed dividend on redeemable convertible
 preferred stock.......................................    (600)
                                                        -------
Net loss attributable to common stockholders........... $(6,699)
                                                        =======
Basic and diluted net loss per common share............ $ (1.19)
Shares used in computing basic and diluted net loss per
 common share..........................................   5,644
</TABLE>

                                      62

<PAGE>

Item 9.  Changes in and Disagreements With Accountants on Accounting and
       Financial Disclosure

   Not applicable.

                                   PART III

Item 10.  Directors and Executive Officers of the Registrant

Directors

   The response to this item is incorporated by reference from the discussion
responsive thereto under the captions "Management" and "Compliance with Section
16(a) of the Securities Exchange Act of 1934" in the Company's Proxy Statement
for the 2002 Annual Meeting of Stockholders and under the caption "Executive
Officers of the Registrant" in Part I of this Annual Report on Form 10-K.

Item 11.  Executive Compensation

   The response to this item is incorporated by reference from the discussion
responsive thereto under the caption "Executive Compensation" in the Company's
Proxy Statement for the 2002 Annual Meeting of Stockholders.

Item 12.  Security Ownership of Certain Beneficial Owners and Management

   The response to this item is incorporated by reference from the discussion
responsive thereto under the caption "Security Ownership of Certain Beneficial
Owners and Management" in the Company's Proxy Statement for the 2002 Annual
Meeting of Stockholders.

Item 13.  Certain Relationships and Related Transactions

   The response to this item is incorporated by reference from the discussion
responsive thereto under the caption "Certain Relationships and Related
Transactions" and "Executive Compensation--Employment Agreements, Termination
of Employment and Change of Control Arrangements" in the Company's Proxy
Statement for the 2002 Annual Meeting of Stockholders.

                                      63

<PAGE>

                                    PART IV

Item 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-k

Item 14(a).  The following documents are filed as part of this annual report on
Form 10-K.

Item 14(a)(1)  Financial Statements.

   The following consolidated financial statements are filed as part of this
report under "Item 8-Financial Statements and Supplementary Data":

<TABLE>
<CAPTION>
                                                                                Page
                                                                                -----
<S>                                                                             <C>

Report of Independent Accountants..............................................    40

Consolidated Balance Sheet as of December 31, 2001 and 2000....................    41

Consolidated Statement of Operations for the years ended December 31, 2001,
 2000 and 1999.................................................................    42

Consolidated Statement of Changes in Redeemable Convertible Preferred Stock and
  Stockholders' Equity for the years ended December 31, 2001, 2000 and 1999....    43

Consolidated Statement of Cash Flows for the years ended December 31, 2001,
 2000 and 1999.................................................................    44

Notes to Consolidated Financial Statements..................................... 45-62
</TABLE>

Item 14(a)(2)  List of Schedules

   Schedule II--Valuation and Qualifying Accounts for the three years ended
December 31, 2001. All other schedules to the consolidated financial statements
are omitted, as the required information is either inapplicable or presented in
the consolidated financial statements.

                                      64

<PAGE>

Item 14(a)(3)  Exhibits

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
Exhibit
Number                                         Description of Exhibit
-------                                        ----------------------
<C>     <S>

2.1(1)  Agreement and Plan of Merger dated as of December 19, 2000 among SpeechWorks International,
          Inc., Eloquent Technology, Inc., SpeechWorks Acquisition Sub, Inc. and the sole shareholder of
          Eloquent Technology, Inc., incorporated herein by reference to Exhibit 2.1 to the Registrant's
          Current Report on Form 8-K, filed on January 19, 2001, File No. 000-31097.

   3.1  Restated Certificate of Incorporation of SpeechWorks International, Inc., incorporated herein by
          reference to Exhibit 4.2 of the Registrant's Registration Statement on Form S-8, filed on
          August 9, 2000, File No. 333-43398.

   3.2  Amended and Restated Bylaws of SpeechWorks International, Inc., incorporated herein by
          reference to Exhibit 3.3 to the Registrant's Registration Statement on Form S-1, filed on
          April 19, 2000, File No. 333-35164.

   4.1  Form of Common Stock Certificate, incorporated herein by reference to Exhibit 4.1 to the
          Registrant's Registration Statement on Form S-1, filed on April 19, 2000, File No. 333-35164.

 +10.1  License Agreement, dated August 3, 1994, between the Registrant and MIT, as amended,
          incorporated herein by reference to Exhibit 10.1 to the Registrant's Registration Statement on
          Form S-1, filed on April 19, 2000, File No. 333-35164.

  10.2  Fourth Amended and Restated Registration Rights Agreement, dated as of April 11, 2000, among
          the Registrant and the investors party thereto, incorporated herein by reference to Exhibit 10.2 to
          the Registrant's Registration Statement on Form S-1, filed on April 19, 2000, File
          No. 333-35164.

  10.3  Lease Agreement, dated February 21, 1997, between the Registrant and Landman Omnibus V
          Limited Partnership, incorporated herein by reference to Exhibit 10.3 to the Registrant's
          Registration Statement on Form S-1, filed on April 19, 2000, File No. 333-35164.

  10.4  Sublease Agreement, dated April 1, 1998, between the Registrant and Exchange Applications, Inc.,
          incorporated herein by reference to Exhibit 10.4 to the Registrant's Registration Statement on
          Form S-1, filed on April 19, 2000, File No. 333-35164.

  10.5  Amended and Restated 1995 Option Plan, incorporated herein by reference to Exhibit 10.5 to the
          Registrant's Registration Statement on Form S-1, filed on April 19, 2000, File No. 333-35164.

  10.6  2000 Employee, Director and Consultant Stock Plan, incorporated herein by reference to Exhibit
          10.6 to the Registrant's Registration Statement on Form S-1, filed on April 19, 2000, File
          No. 333-35164.

  10.7  2000 Employee Stock Purchase Plan, incorporated herein by reference to Exhibit 10.7 to the
          Registrant's Registration Statement on Form S-1, filed on April 19, 2000, File No. 333-35164.

  10.8  Form of Incentive Stock Option Agreement entered into by the named executive officers,
          incorporated herein by reference to Exhibit 10.9 to the Registrant's Registration Statement on
          Form S-1, filed on April 19, 2000, File No. 333-35164.

  10.9  Employment Agreement, dated June 21, 2000, between the Registrant and Richard J. Westelman,
          incorporated herein by reference to Exhibit 10.10 to the Registrant's Registration Statement on
          Form S-1, filed on April 19, 2000, File No. 333-35164.

+10.10  Development and License Agreement, dated June 5, 2000, between the Registrant and AT&T,
          incorporated herein by reference to Exhibit 10.11 to the Registrant's Registration Statement on
          Form S-1, filed on April 19, 2000, File No. 333-35164.
</TABLE>

                                      65

<PAGE>

<TABLE>
<CAPTION>
Exhibit
Number                                          Description of Exhibits
------                                          -----------------------
<C>       <S>

 10.11    First Amendment to the Fourth Amended and Restated Registration Rights Agreement, incorporated
            herein by reference to Exhibit 10.12 to the Registrant's Registration Statement on Form S-1, filed
            on April 19, 2000, File No. 333-35164.

 10.12    Second Amendment to the Fourth Amended and Restated Registration Rights Agreement,
            incorporated herein by reference to Exhibit 10.13 to the Registrant's Registration Statement on
            Form S-1, filed on April 19, 2000, File No. 333-35164.

+10.13    Software License and Professional Services Agreement, dated June 30, 2000, between AOL and the
            Registrant, incorporated herein by reference to Exhibit 10.14 to the Registrant's Registration
            Statement on Form S-1, filed on April 19, 2000, File No. 333-35164.

+10.14    Master Software License Agreement, dated September 1, 2000 between Net2Phone and the
            Registrant, incorporated herein by reference to Exhibit 10.14 to the Registrant's Annual Report on
            Form 10-K, filed March 16, 2001.

 10.15    Third Amendment to the Fourth Amended and Restated Registration Rights Agreement, incorporated
            herein by reference to Exhibit 10.15 to the Registrant's Annual Report on Form 10-K, filed
            March 16, 2001.

 10.16    Fourth Amendment to the Fourth Amended and Restated Registration Rights Agreement,
            incorporated herein by reference to Exhibit 10.16 to the Registrant's Annual Report on
            Form 10-K, filed March 16, 2001.

 10.17    Silicon Valley Bank Loan Arrangement with SpeechWorks International, Inc., dated March 26, 1999,
            between Silicon Valley Bank and the Registrant, as modified by the Third Loan Modification
            Agreement dated August 6, 2001, the Fourth Loan Modification Agreement dated November 13,
            2001 and the Fifth Loan Modification Agreement dated December 28, 2001, incorporated herein
            by reference to Exhibit 10.17 to the Registrant's Annual Report on Form 10-K, filed March 16,
            2001.

 10.18    Fifth Amendment to the Fourth Amended and Restarted Registration Rights Agreement, dated as of
            January 5, 2001, among the Registrant and the investors party thereto, incorporated herein by
            reference to Exhibit 10.1 to the Registrant's Current Report on Form 10-Q, filed May 14, 2001.

 10.19(1) Silicon Valley Bank Loan Arrangement with SpeechWorks International, Inc., dated March 26, 1999,
            between Silicon Valley Bank and the Registrant, as modified by the Third Loan Modification
            Agreement dated August 6, 2001, the Fourth Loan Modification Agreement dated November 13,
            2001 and the Fifth Loan Modification Agreement dated December 28, 2001.

  21.1    List of Subsidiaries

  23.1    Consent of PricewaterhouseCoopers LLP.
</TABLE>
--------
(1) Certain schedules to this agreement were omitted by the Registrant. The
    Registrant agrees to furnish any schedule to this agreement supplementally
    to the Securities and Exchange Commission upon written request.
 + Confidential Treatment granted as to certain portions.

                                      66

<PAGE>

                                                                    Schedule II

                        SPEECHWORKS INTERNATIONAL, INC.

                       VALUATION AND QUALIFYING ACCOUNTS
                                (in thousands)

<TABLE>
<CAPTION>
                                      Balance at                        Balance
                                     beginning of                      at end of
          Description           Year    period    Additions Deductions  period
          -----------           ---- ------------ --------- ---------- ---------
<S>                             <C>  <C>          <C>       <C>        <C>
Allowance for doubtful accounts 1999     $ 75      $   --     $  15     $   60
Allowance for doubtful accounts 2000     $ 60      $  540     $  --     $  600
Allowance for doubtful accounts 2001     $600      $1,108     $ 280     $1,428
</TABLE>

                                      67

<PAGE>

                                  SIGNATURES

   Pursuant to the requirements of Section13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.

                                               SPEECHWORKS INTERNATIONAL, INC.

                                               By:   /s/  STUART R. PATTERSON
                                                   -----------------------------
                                                        Stuart R. Patterson
                                                    Chief Executive Officer and
                                                             President

   Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated below and on the dates indicated.

          Signature                       Title                  Date
          ---------                       -----                  ----
  /s/  STUART R. PATTERSON    Chief Executive Officer,      March 20, 2002
-----------------------------   President and Director
     Stuart R. Patterson        (principal executive
                                officer)

  /s/  RICHARD J. WESTELMAN   Chief Financial Officer
-----------------------------   (principal financial and
    Richard J. Westelman        accounting officer)         March 20, 2002

  /s/  MICHAEL S. PHILLIPS    Chief Technology Officer and
-----------------------------   Director
     Michael S. Phillips                                    March 20, 2002

  /s/  WILLIAM J. O'FARRELL   Chairman of the Board
-----------------------------
    William J. O'Farrell                                    March 20, 2002

      /s/  AXEL BICHARA       Director
-----------------------------
        Axel Bichara                                        March 20, 2002

     /s/  RICHARD BURNES      Director
-----------------------------
       Richard Burnes                                       March 20, 2002

      /s/  ROBERT FINCH       Director
-----------------------------
        Robert Finch                                        March 20, 2002

  /s/  JOHN C. FREKER, JR.    Director
-----------------------------
     John C. Freker, Jr.                                    March 20, 2002

                                      68

<PAGE>

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
Exhibit
Number                                         Description of Exhibit
-------                                        ----------------------
<C>     <S>

2.1(1)  Agreement and Plan of Merger dated as of December 19, 2000 among SpeechWorks International,
          Inc., Eloquent Technology, Inc., SpeechWorks Acquisition Sub, Inc. and the sole shareholder of
          Eloquent Technology, Inc., incorporated herein by reference to Exhibit 2.1 to the Registrant's
          Current Report on Form 8-K, filed on January 19, 2001, File No. 000-31097.

   3.1  Restated Certificate of Incorporation of SpeechWorks International, Inc., incorporated herein by
          reference to Exhibit 4.2 of the Registrant's Registration Statement on Form S-8, filed on
          August 9, 2000, File No. 333-43398.

   3.2  Amended and Restated Bylaws of SpeechWorks International, Inc., incorporated herein by
          reference to Exhibit 3.3 to the Registrant's Registration Statement on Form S-1, filed on
          April 19, 2000, File No. 333-35164.

   4.1  Form of Common Stock Certificate, incorporated herein by reference to Exhibit 4.1 to the
          Registrant's Registration Statement on Form S-1, filed on April 19, 2000, File No. 333-35164.

 +10.1  License Agreement, dated August 3, 1994, between the Registrant and MIT, as amended,
          incorporated herein by reference to Exhibit 10.1 to the Registrant's Registration Statement on
          Form S-1, filed on April 19, 2000, File No. 333-35164.

  10.2  Fourth Amended and Restated Registration Rights Agreement, dated as of April 11, 2000, among
          the Registrant and the investors party thereto, incorporated herein by reference to Exhibit 10.2 to
          the Registrant's Registration Statement on Form S-1, filed on April 19, 2000, File
          No. 333-35164.

  10.3  Lease Agreement, dated February 21, 1997, between the Registrant and Landman Omnibus V
          Limited Partnership, incorporated herein by reference to Exhibit 10.3 to the Registrant's
          Registration Statement on Form S-1, filed on April 19, 2000, File No. 333-35164.

  10.4  Sublease Agreement, dated April 1, 1998, between the Registrant and Exchange Applications, Inc.,
          incorporated herein by reference to Exhibit 10.4 to the Registrant's Registration Statement on
          Form S-1, filed on April 19, 2000, File No. 333-35164.

  10.5  Amended and Restated 1995 Option Plan, incorporated herein by reference to Exhibit 10.5 to the
          Registrant's Registration Statement on Form S-1, filed on April 19, 2000, File No. 333-35164.

  10.6  2000 Employee, Director and Consultant Stock Plan, incorporated herein by reference to Exhibit
          10.6 to the Registrant's Registration Statement on Form S-1, filed on April 19, 2000, File
          No. 333-35164.

  10.7  2000 Employee Stock Purchase Plan, incorporated herein by reference to Exhibit 10.7 to the
          Registrant's Registration Statement on Form S-1, filed on April 19, 2000, File No. 333-35164.

  10.8  Form of Incentive Stock Option Agreement entered into by the named executive officers,
          incorporated herein by reference to Exhibit 10.9 to the Registrant's Registration Statement on
          Form S-1, filed on April 19, 2000, File No. 333-35164.

  10.9  Employment Agreement, dated June 21, 2000, between the Registrant and Richard J. Westelman,
          incorporated herein by reference to Exhibit 10.10 to the Registrant's Registration Statement on
          Form S-1, filed on April 19, 2000, File No. 333-35164.

+10.10  Development and License Agreement, dated June 5, 2000, between the Registrant and AT&T,
          incorporated herein by reference to Exhibit 10.11 to the Registrant's Registration Statement on
          Form S-1, filed on April 19, 2000, File No. 333-35164.
</TABLE>

<PAGE>

<TABLE>
<CAPTION>
Exhibit
Number                                          Description of Exhibits
------                                          -----------------------
<C>       <S>

 10.11    First Amendment to the Fourth Amended and Restated Registration Rights Agreement, incorporated
            herein by reference to Exhibit 10.12 to the Registrant's Registration Statement on Form S-1, filed
            on April 19, 2000, File No. 333-35164.

 10.12    Second Amendment to the Fourth Amended and Restated Registration Rights Agreement,
            incorporated herein by reference to Exhibit 10.13 to the Registrant's Registration Statement on
            Form S-1, filed on April 19, 2000, File No. 333-35164.

+10.13    Software License and Professional Services Agreement, dated June 30, 2000, between AOL and the
            Registrant, incorporated herein by reference to Exhibit 10.14 to the Registrant's Registration
            Statement on Form S-1, filed on April 19, 2000, File No. 333-35164.

+10.14    Master Software License Agreement, dated September 1, 2000 between Net2Phone and the
            Registrant, incorporated herein by reference to Exhibit 10.14 to the Registrant's Annual Report on
            Form 10-K, filed March 16, 2001.

 10.15    Third Amendment to the Fourth Amended and Restated Registration Rights Agreement, incorporated
            herein by reference to Exhibit 10.15 to the Registrant's Annual Report on Form 10-K, filed
            March 16, 2001.

 10.16    Fourth Amendment to the Fourth Amended and Restated Registration Rights Agreement,
            incorporated herein by reference to Exhibit 10.16 to the Registrant's Annual Report on
            Form 10-K, filed March 16, 2001.

 10.17    Silicon Valley Bank Loan Arrangement with SpeechWorks International, Inc., dated March 26, 1999,
            between Silicon Valley Bank and the Registrant, as modified by the Third Loan Modification
            Agreement dated August 6, 2001, the Fourth Loan Modification Agreement dated November 13,
            2001 and the Fifth Loan Modification Agreement dated December 28, 2001, incorporated herein
            by reference to Exhibit 10.17 to the Registrant's Annual Report on Form 10-K, filed March 16,
            2001.

 10.18    Fifth Amendment to the Fourth Amended and Restarted Registration Rights Agreement, dated as of
            January 5, 2001, among the Registrant and the investors party thereto, incorporated herein by
            reference to Exhibit 10.1 to the Registrant's Current Report on Form 10-Q, filed May 14, 2001.

 10.19(1) Silicon Valley Bank Loan Arrangement with SpeechWorks International, Inc., dated March 26, 1999,
            between Silicon Valley Bank and the Registrant, as modified by the Third Loan Modification
            Agreement dated August 6, 2001, the Fourth Loan Modification Agreement dated November 13,
            2001 and the Fifth Loan Modification Agreement dated December 28, 2001.

  21.1    List of Subsidiaries

  23.1    Consent of PricewaterhouseCoopers LLP.
</TABLE>
--------
(1) Certain schedules to this agreement were omitted by the Registrant. The
    Registrant agrees to furnish any schedule to this agreement supplementally
    to the Securities and Exchange Commission upon written request.
 + Confidential Treatment granted as to certain portions.

                                      2