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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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Form 10-Q



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Quarterly Report Pursuant to Section
13 or 15(d) of the Securities Exchange Act of 1934



For
the Quarterly Period Ended June 30, 2004



Commission File
No. 0-13442



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MENTOR GRAPHICS CORPORATION

(Exact
name of registrant as specified in its charter)



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|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|Oregon                                                         |  | 93-0786033                       
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification No.)
|                                                               | 
|8005 SW Boeckman Road                                          |  |                                  
|Wilsonville, Oregon                                            |  | 97070-7777                       
|(Address of principal executive offices)                       |  | (Zip Code)                       



Registrants
telephone number, including area code: (503) 685-7000



NO
CHANGE

(Former name, former address and former

fiscal year, if changed since last report)



---



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 whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act).    Yes  x    No ̈



Number of shares of common stock, no par value, outstanding as of August 2,
2004: 71,728,208



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##### Table of Contents

MENTOR GRAPHICS CORPORATION



Index to Form
10-Q



|                                                                                                  |  |            
|------------------------------------------------------------------------------------------------- |  | -----------
|                                                                                                  |  | Page Number
|PART I
FINANCIAL INFORMATION                                                                      |  |            
|                                                                                                  | 
|Item 1.
Financial Statements                                                                      |  |            
|                                                                                                  | 
|Condensed Consolidated Statements of Operations for the three months ended June 30, 2004 and 2003 |  | 3          
|                                                                                                  | 
|Condensed Consolidated Statements of Operations for the six months ended June 30, 2004 and 2003   |  | 4          
|                                                                                                  | 
|Condensed Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003                   |  | 5          
|                                                                                                  | 
|Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003   |  | 6          
|                                                                                                  | 
|Notes to Unaudited Condensed Consolidated Financial Statements                                    |  | 7-16       
|                                                                                                  | 
|Item 2.
Managements Discussion and Analysis of Results of Operations and Financial Condition     |  | 16-33      
|                                                                                                  | 
|Item 3.
Quantitative and Qualitative Disclosures About Market Risk                                |  | 33-34      
|                                                                                                  | 
|Item 4.
Controls and Procedures                                                                   |  | 34-35      
|                                                                                                  | 
|PART II
OTHER INFORMATION                                                                         |  |            
|                                                                                                  | 
|Item 4.
Submission of Matters to a Vote of Security Holders                                       |  | 35         
|                                                                                                  | 
|Item 6.
Exhibits and Reports on Form 8-K                                                          |  | 36         
|                                                                                                  | 
|SIGNATURES                                                                                        |  | 36         



2



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##### Table of Contents

PART I. FINANCIAL INFORMATION



Item 1. Financial Statements



Mentor Graphics Corporation

Condensed Consolidated Statements of Operations

(Unaudited)



|                                                                |  |      |         |   |      |   |         |  
|--------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|Three months ended June 30, In thousands, except per share data |  | 2004 |         |   | 2003 |  
|Revenues:                                                       |  |      |         |   |      |   |         |  
|System and software                                             |  | $    | 98,091  |   |      | $ | 87,791  |  
|Service and support                                             |  |      | 71,551  |   |      |   | 69,677  |  
|                                                                |  |      |         |   |      |   |         |  
|Total revenues                                                  |  |      | 169,642 |   |      |   | 157,468 |  
|                                                                |  |      |         |   |      |   |         |  
|Cost of revenues:                                               |  |      |         |   |      |   |         |  
|System and software                                             |  |      | 4,623   |   |      |   | 4,781   |  
|Service and support                                             |  |      | 19,079  |   |      |   | 20,758  |  
|Amortization of purchased technology                            |  |      | 2,504   |   |      |   | 2,269   |  
|                                                                |  |      |         |   |      |   |         |  
|Total cost of revenues                                          |  |      | 26,206  |   |      |   | 27,808  |  
|                                                                |  |      |         |   |      |   |         |  
|Gross margin                                                    |  |      | 143,436 |   |      |   | 129,660 |  
|                                                                |  |      |         |   |      |   |         |  
|Operating expenses:                                             |  |      |         |   |      |   |         |  
|Research and development                                        |  |      | 48,322  |   |      |   | 43,965  |  
|Marketing and selling                                           |  |      | 64,045  |   |      |   | 58,708  |  
|General and administration                                      |  |      | 18,748  |   |      |   | 17,160  |  
|Amortization of intangible assets                               |  |      | 790     |   |      |   | 931     |  
|Special charges                                                 |  |      | 3,863   |   |      |   |        |  
|Merger and acquisition related charges                          |  |      | 360     |   |      |   | 1,800   |  
|                                                                |  |      |         |   |      |   |         |  
|Total operating expenses                                        |  |      | 136,128 |   |      |   | 122,564 |  
|                                                                |  |      |         |   |      |   |         |  
|Operating income                                                |  |      | 7,308   |   |      |   | 7,096   |  
|Other income, net                                               |  |      | 1,990   |   |      |   | 1,925   |  
|Interest expense                                                |  |      | (4,571  | ) |      |   | (3,929  | )
|                                                                |  |      |         |   |      |   |         |  
|Income before income taxes                                      |  |      | 4,727   |   |      |   | 5,092   |  
|Provision for income taxes                                      |  |      | 37,523  |   |      |   | 1,018   |  
|                                                                |  |      |         |   |      |   |         |  
|Net income (loss)                                               |  | $    | (32,796 | ) |      | $ | 4,074   |  
|                                                                |  |      |         |   |      |   |         |  
|Net income (loss) per share:                                    |  |      |         |   |      |   |         |  
|Basic                                                           |  | $    | (.47    | ) |      | $ | .06     |  
|                                                                |  |      |         |   |      |   |         |  
|Diluted                                                         |  | $    | (.47    | ) |      | $ | .06     |  
|                                                                |  |      |         |   |      |   |         |  
|Weighted average number of shares outstanding:                  |  |      |         |   |      |   |         |  
|Basic                                                           |  |      | 70,090  |   |      |   | 67,389  |  
|                                                                |  |      |         |   |      |   |         |  
|Diluted                                                         |  |      | 70,090  |   |      |   | 69,522  |  
|                                                                |  |      |         |   |      |   |         |  



See accompanying notes to unaudited
consolidated financial statements.



3



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##### Table of Contents

Mentor Graphics Corporation

Condensed Consolidated Statements of Operations

(Unaudited)



|                                                              |  |      |         |   |      |   |         |  
|------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|Six months ended June 30, In
thousands, except per share data |  | 2004 |         |   | 2003 |  
|Revenues:                                                     |  |      |         |   |      |   |         |  
|System and software                                           |  | $    | 192,612 |   |      | $ | 179,603 |  
|Service and support                                           |  |      | 141,435 |   |      |   | 137,205 |  
|                                                              |  |      |         |   |      |   |         |  
|Total revenues                                                |  |      | 334,047 |   |      |   | 316,808 |  
|                                                              |  |      |         |   |      |   |         |  
|Cost of revenues:                                             |  |      |         |   |      |   |         |  
|System and software                                           |  |      | 9,185   |   |      |   | 9,596   |  
|Service and support                                           |  |      | 39,174  |   |      |   | 41,461  |  
|Amortization of purchased technology                          |  |      | 4,970   |   |      |   | 4,478   |  
|                                                              |  |      |         |   |      |   |         |  
|Total cost of revenues                                        |  |      | 53,329  |   |      |   | 55,535  |  
|                                                              |  |      |         |   |      |   |         |  
|Gross margin                                                  |  |      | 280,718 |   |      |   | 261,273 |  
|                                                              |  |      |         |   |      |   |         |  
|Operating expenses:                                           |  |      |         |   |      |   |         |  
|Research and development                                      |  |      | 96,705  |   |      |   | 86,841  |  
|Marketing and selling                                         |  |      | 127,751 |   |      |   | 117,897 |  
|General and administration                                    |  |      | 37,310  |   |      |   | 36,143  |  
|Amortization of intangible assets                             |  |      | 1,572   |   |      |   | 2,076   |  
|Special charges                                               |  |      | 3,863   |   |      |   | 1,363   |  
|Merger and acquisition related charges                        |  |      | 360     |   |      |   | 1,800   |  
|                                                              |  |      |         |   |      |   |         |  
|Total operating expenses                                      |  |      | 267,561 |   |      |   | 246,120 |  
|                                                              |  |      |         |   |      |   |         |  
|Operating income                                              |  |      | 13,157  |   |      |   | 15,153  |  
|Other income, net                                             |  |      | 3,220   |   |      |   | 2,412   |  
|Interest expense                                              |  |      | (9,026  | ) |      |   | (7,974  | )
|                                                              |  |      |         |   |      |   |         |  
|Income before income taxes                                    |  |      | 7,351   |   |      |   | 9,591   |  
|Provision for income taxes                                    |  |      | 37,969  |   |      |   | 1,918   |  
|                                                              |  |      |         |   |      |   |         |  
|Net income (loss)                                             |  | $    | (30,618 | ) |      | $ | 7,673   |  
|                                                              |  |      |         |   |      |   |         |  
|Net income (loss) per share:                                  |  |      |         |   |      |   |         |  
|Basic                                                         |  | $    | (.44    | ) |      | $ | .11     |  
|                                                              |  |      |         |   |      |   |         |  
|Diluted                                                       |  | $    | (.44    | ) |      | $ | .11     |  
|                                                              |  |      |         |   |      |   |         |  
|Weighted average number of shares outstanding:                |  |      |         |   |      |   |         |  
|Basic                                                         |  |      | 69,946  |   |      |   | 67,362  |  
|                                                              |  |      |         |   |      |   |         |  
|Diluted                                                       |  |      | 69,946  |   |      |   | 68,901  |  
|                                                              |  |      |         |   |      |   |         |  



See accompanying notes to unaudited
consolidated financial statements.



4



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##### Table of Contents

Mentor Graphics Corporation

Condensed Consolidated Balance Sheets

(Unaudited)



|                                                                                                     |  |                     |         |   |                         |   |         |  
|---------------------------------------------------------------------------------------------------- |  | ------------------- | ------- | - | ----------------------- | - | ------- | -
|In thousands                                                                                         |  | As of June 30, 2004 |         |   | As of December 31, 2003 |  
|Assets                                                                                               |  |                     |         |   |                         |   |         |  
|Current assets:                                                                                      |  |                     |         |   |                         |   |         |  
|Cash and cash equivalents                                                                            |  | $                   | 74,929  |   |                         | $ | 68,333  |  
|Short-term investments                                                                               |  |                     | 8,825   |   |                         |   | 2,991   |  
|Trade accounts receivable, net of allowance for doubtful accounts of $3,925 and $4,149, respectively |  |                     | 225,148 |   |                         |   | 223,670 |  
|Inventory, net                                                                                       |  |                     | 6,355   |   |                         |   | 5,489   |  
|Prepaid expenses and other                                                                           |  |                     | 24,947  |   |                         |   | 21,675  |  
|Deferred income taxes                                                                                |  |                     | 18,676  |   |                         |   | 18,787  |  
|                                                                                                     |  |                     |         |   |                         |   |         |  
|Total current assets                                                                                 |  |                     | 358,880 |   |                         |   | 340,945 |  
|                                                                                                     |  |                    
|Property, plant and equipment, net                                                                   |  |                     | 87,418  |   |                         |   | 91,350  |  
|Term receivables, long-term                                                                          |  |                     | 106,574 |   |                         |   | 98,207  |  
|Goodwill                                                                                             |  |                     | 292,060 |   |                         |   | 290,352 |  
|Intangible assets, net                                                                               |  |                     | 33,061  |   |                         |   | 35,929  |  
|Deferred income taxes                                                                                |  |                     | 26,470  |   |                         |   | 60,021  |  
|Other assets, net                                                                                    |  |                     | 22,122  |   |                         |   | 23,884  |  
|                                                                                                     |  |                     |         |   |                         |   |         |  
|Total assets                                                                                         |  | $                   | 926,585 |   |                         | $ | 940,688 |  
|                                                                                                     |  |                     |         |   |                         |   |         |  
|Liabilities and Stockholders Equity                                                                 |  |                     |         |   |                         |   |         |  
|Current liabilities:                                                                                 |  |                     |         |   |                         |   |         |  
|Short-term borrowings                                                                                |  | $                   | 11,024  |   |                         | $ | 6,910   |  
|Accounts payable                                                                                     |  |                     | 16,429  |   |                         |   | 18,105  |  
|Income taxes payable                                                                                 |  |                     | 37,404  |   |                         |   | 35,122  |  
|Accrued payroll and related liabilities                                                              |  |                     | 59,963  |   |                         |   | 80,484  |  
|Accrued liabilities                                                                                  |  |                     | 34,319  |   |                         |   | 37,719  |  
|Deferred revenue                                                                                     |  |                     | 104,056 |   |                         |   | 74,662  |  
|                                                                                                     |  |                     |         |   |                         |   |         |  
|Total current liabilities                                                                            |  |                     | 263,195 |   |                         |   | 253,002 |  
|                                                                                                     |  |                    
|Notes payable                                                                                        |  |                     | 285,799 |   |                         |   | 286,768 |  
|Other long-term liabilities                                                                          |  |                     | 21,158  |   |                         |   | 23,161  |  
|                                                                                                     |  |                     |         |   |                         |   |         |  
|Total liabilities                                                                                    |  |                     | 570,152 |   |                         |   | 562,931 |  
|                                                                                                     |  |                     |         |   |                         |   |         |  
|Commitments and contingencies (Note 13)                                                              |  |                     |         |   |                         |   |         |  
|Minority interest                                                                                    |  |                     |        |   |                         |   | 3,391   |  
|                                                                                                     |  |                    
|Stockholders equity:                                                                                |  |                     |         |   |                         |   |         |  
|Common stock                                                                                         |  |                     | 304,038 |   |                         |   | 294,180 |  
|Deferred compensation                                                                                |  |                     | (1,187  | ) |                         |   | (2,601  | )
|Retained earnings                                                                                    |  |                     | 29,649  |   |                         |   | 57,800  |  
|Accumulated other comprehensive income                                                               |  |                     | 23,933  |   |                         |   | 24,987  |  
|                                                                                                     |  |                     |         |   |                         |   |         |  
|Total stockholders equity                                                                           |  |                     | 356,433 |   |                         |   | 374,366 |  
|                                                                                                     |  |                     |         |   |                         |   |         |  
|Total liabilities and stockholders equity                                                           |  | $                   | 926,585 |   |                         | $ | 940,688 |  
|                                                                                                     |  |                     |         |   |                         |   |         |  



See accompanying notes to unaudited
consolidated financial statements.



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Mentor Graphics Corporation

Condensed Consolidated Statements of Cash Flows

(Unaudited)



|                                                                                         |  |      |         |   |      |   |         |  
|---------------------------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|Six months ended June 30, In
thousands                                                   |  | 2004 |         |   | 2003 |  
|Operating Cash Flows:                                                                    |  |      |         |   |      |   |         |  
|Net income (loss)                                                                        |  | $    | (30,618 | ) |      | $ | 7,673   |  
|                                                                                         |  |     
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |  |      |         |   |      |   |         |  
|Depreciation and amortization of property, plant and equipment                           |  |      | 11,785  |   |      |   | 11,533  |  
|Amortization                                                                             |  |      | 9,028   |   |      |   | 12,508  |  
|Deferred income taxes                                                                    |  |      | 33,662  |   |      |   | (976    | )
|Changes in other long-term liabilities and minority interest                             |  |      | (1,855  | ) |      |   | (2,441  | )
|Write-down of assets                                                                     |  |      | 1,118   |   |      |   | 2,106   |  
|Gain on sale of investments                                                              |  |      |        |   |      |   | (1,491  | )
|                                                                                         |  |     
|Changes in operating assets and liabilities, net of effect of acquired businesses:       |  |      |         |   |      |   |         |  
|Trade accounts receivable                                                                |  |      | (3,123  | ) |      |   | (8,672  | )
|Prepaid expenses and other                                                               |  |      | (2,806  | ) |      |   | (3,053  | )
|Term receivables, long-term                                                              |  |      | (9,118  | ) |      |   | 5,052   |  
|Accounts payable and accrued liabilities                                                 |  |      | (24,529 | ) |      |   | (5,202  | )
|Income taxes payable                                                                     |  |      | 2,537   |   |      |   | (7,315  | )
|Deferred revenue                                                                         |  |      | 29,713  |   |      |   | 16,492  |  
|                                                                                         |  |      |         |   |      |   |         |  
|Net cash provided by operating activities                                                |  |      | 15,794  |   |      |   | 26,214  |  
|                                                                                         |  |      |         |   |      |   |         |  
|Investing Cash Flows:                                                                    |  |      |         |   |      |   |         |  
|Proceeds from sales and maturities of short-term investments                             |  |      | 9,954   |   |      |   | 3,857   |  
|Purchases of short-term investments                                                      |  |      | (15,788 | ) |      |   |        |  
|Purchases of property, plant and equipment                                               |  |      | (8,946  | ) |      |   | (8,962  | )
|Purchases of intangible assets                                                           |  |      | (2,704  | ) |      |   |        |  
|Proceeds from sale of investments                                                        |  |      |        |   |      |   | 1,491   |  
|Acquisitions of businesses and equity interests                                          |  |      | (5,745  | ) |      |   | (15,860 | )
|                                                                                         |  |      |         |   |      |   |         |  
|Net cash used in investing activities                                                    |  |      | (23,229 | ) |      |   | (19,474 | )
|                                                                                         |  |      |         |   |      |   |         |  
|Financing Cash Flows:                                                                    |  |      |         |   |      |   |         |  
|Proceeds from issuance of common stock                                                   |  |      | 11,015  |   |      |   | 3,992   |  
|Net increase in short-term borrowings                                                    |  |      | 4,069   |   |      |   | 2,351   |  
|Repayment of long-term notes payable                                                     |  |      | (1,000  | ) |      |   | (753    | )
|                                                                                         |  |      |         |   |      |   |         |  
|Net cash provided by financing activities                                                |  |      | 14,084  |   |      |   | 5,590   |  
|                                                                                         |  |      |         |   |      |   |         |  
|Effect of exchange rate changes on cash and cash equivalents                             |  |      | (53     | ) |      |   | 126     |  
|                                                                                         |  |      |         |   |      |   |         |  
|Net change in cash and cash equivalents                                                  |  |      | 6,596   |   |      |   | 12,456  |  
|Cash and cash equivalents at beginning of period                                         |  |      | 68,333  |   |      |   | 34,969  |  
|                                                                                         |  |      |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                               |  | $    | 74,929  |   |      | $ | 47,425  |  
|                                                                                         |  |      |         |   |      |   |         |  



See accompanying notes to unaudited
consolidated financial statements.



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MENTOR GRAPHICS CORPORATION

Notes to Unaudited Condensed Consolidated Financial Statements

(In thousands, except per share amounts)



|(1) | General - The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the
United States of America and reflect all material normal recurring adjustments. However, certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally
accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the condensed consolidated financial statements include
adjustments necessary for a fair presentation of the results of the interim periods presented. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included
in the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2003.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of
revenue and expenses during the reporting period. Actual results could differ from those estimates.



|(2) | Summary of Significant Accounting Policies 
|--- | --------------------------------------------



Principles of Consolidation



The condensed consolidated financial statements include the financial statements of the Company and its wholly owned and majority-owned subsidiaries. All
significant intercompany accounts and transactions are eliminated in consolidation.



The Company does not have off-balance sheet arrangements, financings or other relationships with unconsolidated entities or other persons, also known as special purpose entities. In the ordinary course of business,
the Company leases certain real properties, primarily field office facilities and equipment, as described in Note 13.



Revenue Recognition



The Company derives system and software revenue from the sale of licenses of software products and emulation hardware systems. The Company derives service
and support revenue from annual support contracts and professional services, which includes consulting services, training services and other services.



For the sale of licenses of software products and related service and support, the Company recognizes revenue in accordance with Statement of Position
(SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions. Revenue from perpetual license arrangements is recognized upon
shipment, provided persuasive evidence of an arrangement exists, fees are fixed or determinable and collection is probable. Product revenue from term license installment agreements is recognized upon shipment and start of the license term, provided
persuasive evidence of an arrangement exists, fees are fixed or determinable and collection is probable. The Company uses term license installment agreements as a standard business practice and has a history of successfully collecting under the
original payment terms without making concessions on payments, products or services. In a term license agreement where the Company provides the customer with rights to unspecified or unreleased future products, revenue is recognized ratably over the
license term.



The Company uses the residual method to
recognize revenue when a license agreement includes one or more elements to be delivered at a future date if evidence of the fair value of all undelivered elements exists. If an undelivered element of the arrangement exists under the license
arrangement, revenue is deferred based on vendor-specific objective evidence of the fair value of the undelivered element, as established by the price charged when such element is sold separately. If vendor-specific objective evidence of fair value
does not exist for all undelivered elements, all revenue is deferred until sufficient evidence exists or all elements have been delivered.



7



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##### Table of Contents

Revenue from annual maintenance and support arrangements is deferred and recognized ratably over the term
of the contract. Revenue from consulting and training is recognized when the services are performed.



For the sale of emulation hardware systems and related service and support, the Company recognizes revenue in accordance with SEC Staff Accounting
Bulletin (SAB) No. 104, Revenue Recognition, which supercedes SAB No. 101, Revenue Recognition in Financial Statements. Revenue is recognized when the title and risk of loss have passed to the customer, there is persuasive
evidence of an arrangement, delivery has occurred or services have been rendered, the sales price is fixed or determinable and collection is probable. When the terms of sale include customer acceptance provisions and compliance with those provisions
cannot be demonstrated until customer use, revenue is recognized upon acceptance. A limited warranty is provided on emulation hardware systems generally for a period of ninety days. The Company maintains an accrued warranty reserve to provide for
these potential future costs and evaluates its adequacy on a quarterly basis. Service and maintenance revenues are recognized over the service period.



Accounting for Stock-Based Compensation



Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, defines a fair value based method of
accounting for employee stock options and similar equity instruments. As is permitted under SFAS No. 123, the Company has elected to continue to account for its stock-based compensation plans under Accounting Principles Board (APB) Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations. The Company has computed, for pro forma disclosure purposes, the value of all stock-based awards granted during the three months and six months ended June 30, 2004
and 2003 using the Black-Scholes option pricing model as prescribed by SFAS No. 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation  Transition and Disclosure, using the following assumptions:



|                                      |  |                             |   |  |                          |   |  |      |   |  |      |  
|------------------------------------- |  | --------------------------- | - |  | ------------------------ | - |  | ---- | - |  | ---- | -
|                                      |  | Three months ended June 30, |   |  | Six months endedJune 30, |  
|Stock Option Plans                    |  | 2004                        |   |  | 2003                     |   |  | 2004 |   |  | 2003 |  
|Risk-free interest rate               |  | 3.7                         | % |  | 2.6                      | % |  | 3.4  | % |  | 2.7  | %
|Dividend yield                        |  | 0                           | % |  | 0                        | % |  | 0    | % |  | 0    | %
|Expected life (in years)              |  | 4.4                         |   |  | 4.1                      |   |  | 4.4  |   |  | 4.1  |  
|Volatility                            |  | 45                          | % |  | 71                       | % |  | 45   | % |  | 66   | %
|                                      |  |                            
|                                      |  | Three months endedJune 30,  |   |  | Six months endedJune 30, |  
|Employee Stock Purchase Plans (ESPPs) |  | 2004                        |   |  | 2003                     |   |  | 2004 |   |  | 2003 |  
|Risk-free interest rate               |  | 1.8                         | % |  | 1.7                      | % |  | 1.7  | % |  | 1.7  | %
|Dividend yield                        |  | 0                           | % |  | 0                        | % |  | 0    | % |  | 0    | %
|Expected life (in years)              |  | 1.25                        |   |  | 1.25                     |   |  | 1.25 |   |  | 1.25 |  
|Volatility                            |  | 45                          | % |  | 86                       | % |  | 45   | % |  | 86   | %



The Company used
expected volatility to estimate volatility for options granted during the three months and six months ended June 30, 2004, and considers expected volatility to be more representative of prospective trends. Expected volatility is based on the option
feature embedded in the Companys convertible subordinated debentures (see Note 5), which is comparable to employee stock options. For options granted during the three months and six months ended June 30, 2003, the Company used historical
volatility. Using the Black-Scholes methodology, weighted average fair value of options granted was $6.95 and $6.92 per share during the three months ended June 30, 2004 and 2003, respectively, and $6.91 and $5.80 per share during the six months
ended June 30, 2004 and 2003, respectively. The weighted average estimated fair value of purchase rights under the ESPPs was $1.86 and $1.73 during the three months ended June 30, 2004 and 2003, respectively, and $1.86 and $1.73 during the six
months ended June 30, 2004 and 2003, respectively.



Other than
with respect to options assumed through acquisitions, no stock-based employee compensation cost is reflected in net income, as all options granted under the Companys Stock Option Plans have an exercise price equal to the market value of the
underlying common stock on the date of grant and the ESPPs are considered noncompensatory under APB Opinion No. 25. The Company recorded compensation expense for amortization of deferred compensation related to unvested stock options assumed through



8



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##### Table of Contents

acquisitions of $374 and $511 for the three months ended June 30, 2004 and 2003, respectively, and $748
and $1,022 for the six months ended June 30, 2004 and 2003, respectively. If the Company had accounted for its stock-based compensation plans in accordance with SFAS No. 123, the Companys net income (loss) and net income (loss) per share would
approximate the pro forma disclosures below:



|                                                                                                                                                                                 |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------- | ------- | - | ------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                                                                                                 |  | Three months ended June 30, |         |   | Six months ended June 30, |  
|                                                                                                                                                                                 |  | 2004                        |         |   | 2003                      |   |        | 2004 |  |   | 2003    |  
|Net income (loss), as reported                                                                                                                                                   |  | $                           | (32,796 | ) |                           | $ | 4,074  |      |  | $ | (30,618 | ) |  | $ | 7,673   |  
|                                                                                                                                                                                 |  |                             |         |  
|Less: Total stock-based employee compensation expense determined under fair value based method, for all awards not previously included in net
income, net of related tax benefit |  |                             | (4,609  | ) |                           |   | (5,627 | )    |  |   | (9,384  | ) |  |   | (11,102 | )
|                                                                                                                                                                                 |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Pro forma net loss                                                                                                                                                               |  | $                           | (37,405 | ) |                           | $ | (1,553 | )    |  | $ | (40,002 | ) |  | $ | (3,429  | )
|                                                                                                                                                                                 |  |                             |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Basic net income (loss) per share  as reported                                                                                                                                  |  | $                           | (.47    | ) |                           | $ | .06    |      |  | $ | (.44    | ) |  | $ | .11     |  
|Basic net loss per share  pro forma                                                                                                                                             |  | $                           | (.53    | ) |                           | $ | (.02   | )    |  | $ | (.57    | ) |  | $ | (.05    | )
|Diluted net income (loss) per share  as reported                                                                                                                                |  | $                           | (.47    | ) |                           | $ | .06    |      |  | $ | (.44    | ) |  | $ | .11     |  
|Diluted net loss per share  pro forma                                                                                                                                           |  | $                           | (.53    | ) |                           | $ | (.02   | )    |  | $ | (.57    | ) |  | $ | (.05    | )



Reclassifications



Certain reclassifications
have been made in the accompanying condensed consolidated financial statements for 2003 to conform to the 2004 presentation.



|(3) | Net Income (Loss) Per Share  Basic net income (loss) per share is computed using the weighted average number of common shares outstanding during the period.
Diluted net income (loss) per share is computed using the weighted average number of common shares and dilutive potential common shares outstanding during the period. Dilutive common shares consist of employee stock options, purchase rights from
Employee Stock Purchase Plans and warrants using the treasury stock method and common shares issued assuming conversion of the convertible subordinated notes and convertible subordinated debentures, if dilutive.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The following provides the computation of basic and diluted net income
(loss) per share:



|                                                                                                          |  |                            |         |                           |      |   |        |  |   |         |   |  |   |       
|--------------------------------------------------------------------------------------------------------- |  | -------------------------- | ------- | ------------------------- | ---- | - | ------ |  | - | ------- | - |  | - | ------
|                                                                                                          |  | Three months endedJune 30, |         | Six months ended June 30,
|                                                                                                          |  | 2004                       |         |                           | 2003 |   | 2004   |  |   | 2003   
|Net income (loss)                                                                                         |  | $                          | (32,796 | )                         |      | $ | 4,074  |  | $ | (30,618 | ) |  | $ | 7,673 
|                                                                                                          |  |                            |         |                           |      |   |        |  |   |         |   |  |   |       
|Weighted average shares used to calculate basic net income (loss) per share                               |  |                            | 70,090  |                           |      |   | 67,389 |  |   | 69,946  |   |  |   | 67,362
|Employee stock options and employee stock purchase plan                                                   |  |                            |        |                           |      |   | 2,133  |  |   |        |   |  |   | 1,539 
|                                                                                                          |  |                            |         |                           |      |   |        |  |   |         |   |  |   |       
|Weighted average common and potential common shares used to calculate diluted net income (loss) per share |  |                            | 70,090  |                           |      |   | 69,522 |  |   | 69,946  |   |  |   | 68,901
|                                                                                                          |  |                            |         |                           |      |   |        |  |   |         |   |  |   |       
|Basic net income (loss) per share                                                                         |  | $                          | (.47    | )                         |      | $ | .06    |  | $ | (.44    | ) |  | $ | .11   
|                                                                                                          |  |                            |         |                           |      |   |        |  |   |         |   |  |   |       
|Diluted net income (loss) per share                                                                       |  | $                          | (.47    | )                         |      | $ | .06    |  | $ | (.44    | ) |  | $ | .11   
|                                                                                                          |  |                            |         |                           |      |   |        |  |   |         |   |  |   |       



Options and warrants
to purchase 11,494 and 10,090 shares of common stock for the three months ended June 30, 2004 and 2003, respectively and 11,373 and 11,383 for the six months ended June 30, 2004 and



9



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##### Table of Contents

2003, respectively, were not included in the computation of diluted earnings per share. The options and
warrants were anti-dilutive either because the Company incurred a net loss or because the exercise price was greater than the average market price of the common shares for the respective periods. The effect of the conversion of the Companys
convertible subordinated notes for the three months and six months ended June 30, 2004, was anti-dilutive. If the convertible subordinated notes had been dilutive, the Companys net income (loss) per share would have included additional
earnings of $2,648 and $5,296 as well as additional incremental shares of 7,413 for the three months and six months ended June 30, 2004. The shares issuable on conversion of the Companys convertible subordinated debentures have been excluded
from dilutive common shares, as the circumstances that allow for conversion were not met. If the circumstances had been met and such conversion had been dilutive, additional earnings of $759 and $1,437 and incremental shares of 4,700 would have been
included for the three months and six months ended June 30, 2004.



|(4) | Short-Term Borrowings  In July 2003, the Company renewed its syndicated, senior, unsecured credit facility that allows the Company to borrow up to $100,000. This
facility is a three-year revolving credit facility, which terminates on July 14, 2006. Under this facility, the Company has the option to pay interest based on LIBOR plus a spread of between 1.25% and 2.00% or prime plus a spread of between 0% and
0.75%, based on a pricing grid tied to a financial covenant. As a result, the Companys interest expense associated with borrowings under this credit facility will vary with market interest rates. In addition, commitment fees are payable on the
unused portion of the credit facility at rates between 0.35% and 0.50% based on a pricing grid tied to a financial covenant. The facility contains certain financial and other covenants, including financial covenants requiring the maintenance of
specified liquidity ratios, leverage ratios and minimum tangible net worth. The Company had no short-term borrowings against the credit facility at June 30, 2004 and December 31, 2003. The Companys credit facility prohibits the payment of
dividends.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Other short-term borrowings include
borrowings on multi-currency lines of credit, capital leases and other borrowings. Interest rates are generally based on the applicable countrys prime lending rate, depending on the currency borrowed. Other short-term borrowings of $11,024 and
$6,910 were outstanding under these facilities at June 30, 2004 and December 31, 2003, respectively.



|(5) | Long-Term Notes Payable  In August 2003, the Company issued $110,000 of Floating Rate Convertible Subordinated Debentures (Debentures) due 2023 in a private
offering pursuant to SEC Rule 144A. The Debentures have been registered with the SEC under the Securities Act of 1933. The Company pays interest on the Debentures quarterly in February, May, August and November, at a variable interest rate equal to
3-month LIBOR plus 1.65%. The effective interest rate was 2.80% for the six months ended June 30, 2004. The Debentures are convertible, under certain circumstances, into the Companys common stock at a conversion price of $23.40 per share, for
a total of 4,700 shares. These circumstances generally include (a) the market price of the Companys common stock exceeding 120% of the conversion price, (b) the market price of the Debentures declining to less than 98% of the value of the
common stock into which the Debentures are convertible, or (c) a call for redemption of the Debentures or certain other corporate transactions. The conversion price may also be adjusted based on certain future transactions. Some or all of the
Debentures may be redeemed by the Company for cash on or after August 6, 2007. Some or all of the Debentures may be redeemed at the option of the holder for cash on August 6, 2010, 2013 or 2018.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In June 2002 the Company issued $172,500 of 67/8% Convertible Subordinated Notes (Notes) due 2007 in a private offering pursuant to SEC Rule 144A. The Notes have
been registered with the SEC under the Securities Act of 1933. The Company pays interest on the Notes semi-annually in June and December. The Notes are convertible into the Companys common stock at a conversion price of $23.27 per share, for a
total of 7,413 shares. Some or all of the Notes may be redeemed by the Company for cash on or after June 20, 2005. The Notes rank pari passu with the Debentures.



Other long-term notes payable include multi-currency notes payable and capital leases. Interest rates are generally based on
the applicable countrys prime lending rate, depending on the currency borrowed. Other long-term notes payable of $3,299 and $4,268 were outstanding under these agreements at June 30, 2004 and December 31, 2003, respectively.



10



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##### Table of Contents

|(6) | Stock Repurchases -The board of directors has authorized the Company to repurchase shares in the open market. There were no repurchases in the six months ended June
30, 2004 and 2003. The Company considers market conditions, alternative uses of cash and balance sheet ratios when evaluating share repurchases.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(7) | Supplemental Cash Flow Information -The following provides additional information concerning supplemental disclosures of cash flow activities:
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------



|                                        |  |      |       |   |      |   |      
|--------------------------------------- |  | ---- | ----- | - | ---- | - | -----
|Six months ended June 30,               |  | 2004 |       |   | 2003
|Interest paid                           |  | $    | 8,106 |   |      | $ | 6,941
|Income tax paid (refunds received), net |  | $    | (95   | ) |      | $ | 844  



|(8) | Comprehensive Income (Loss)- The following provides a summary of comprehensive income:
|--- | --------------------------------------------------------------------------------------



|                                                           |  |      |         |   |      |   |       
|---------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------
|Six months ended June 30,                                  |  | 2004 |         |   | 2003
|Net income (loss)                                          |  | $    | (30,618 | ) |      | $ | 7,673 
|Change in unrealized gain (loss) on derivative instruments |  |      | 245     |   |      |   | 612   
|Change in accumulated translation adjustment               |  |      | (1,299  | ) |      |   | 2,706 
|                                                           |  |      |         |   |      |   |       
|Comprehensive income (loss)                                |  | $    | (31,672 | ) |      | $ | 10,991
|                                                           |  |      |         |   |      |   |       



|(9) | Special Charges For the six months ended June 30, 2004, the Company recorded special charges of $3,863. These charges primarily consisted of accruals for excess
leased facilities and costs incurred for employee terminations.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Excess leased facility costs of $1,267 primarily consist of adjustments to previously recorded non-cancelable lease payments for leases of facilities in North America and Europe. These adjustments are a result of
reductions to the estimated expected sublease income primarily due to the real estate markets in which these facilities are located remaining at depressed levels longer than originally anticipated. Non-cancelable lease payments on these excess
leased facilities should be expended over seven years. In addition, the Company recorded a $758 write-off of leasehold improvements for a facility lease in North America that was previously abandoned.



The Company rebalanced its workforce by 25 employees during the six months
ended June 30, 2004. The reduction impacted several employee groups. Employee severance costs of $1,463 included severance benefits, notice pay and outplacement services. Termination benefits were communicated to the affected employees prior to the
end of the quarter in which the employees were terminated. The majority of these costs should be expended during the next twelve months. There have been no significant modifications to the amount of these charges.



Other costs of $590 include other costs incurred to restructure the
organization other than employee rebalances and excess leased facility costs.



In addition, the Company reversed a portion of the remaining accrual related to the emulation litigation with Cadence Design Systems, Inc.



For the six months ended June 30, 2003, the Company recorded special charges of $1,363. These charges primarily consisted of
costs incurred for employee terminations. The Company rebalanced its workforce by 32 employees during the six months ended June 30, 2003. This reduction impacted several employee groups. Employee severance costs included severance benefits, notice
pay and outplacement services. Termination benefits were communicated to the affected employees prior to the end of the quarter in which the employees were terminated. The majority of these costs were expended during the six months of 2003. There
have been no significant modifications to the amount of these charges.



11



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##### Table of Contents

Accrued special charges are included in accrued liabilities and other long-term liabilities on the
consolidated balance sheets. The following table shows changes in accrued special charges during 2004:



|                                                |  |                                          |        |             |   |       |              |  |   |                                              |   |  |   |       
|----------------------------------------------- |  | ---------------------------------------- | ------ | ----------- | - | ----- | ------------ |  | - | -------------------------------------------- | - |  | - | ------
|                                                |  | AccruedSpecialCharges atDecember 31,2003 |        | 2004Charges |   |       | 2004Payments |  |   | Accrued Special Charges at June 30, 2004 (1)
|Emulation litigation settlement                 |  | $                                        | 1,536  |             | $ | (215  | )            |  | $ | (732                                         | ) |  | $ | 589   
|Employee severance and related costs            |  |                                          | 2,681  |             |   | 1,463 |              |  |   | (2,626                                       | ) |  |   | 1,518 
|Lease termination fees and other facility costs |  |                                          | 10,034 |             |   | 1,267 |              |  |   | (1,162                                       | ) |  |   | 10,139
|Other costs                                     |  |                                          |       |             |   | 590   |              |  |   | (165                                         | ) |  |   | 425   
|                                                |  |                                          |        |             |   |       |              |  |   |                                              |   |  |   |       
|Total                                           |  | $                                        | 14,251 |             | $ | 3,105 |              |  | $ | (4,685                                       | ) |  | $ | 12,671
|                                                |  |                                          |        |             |   |       |              |  |   |                                              |   |  |   |       

---

|(1) | Of the $12,671 total accrued special charges at June 30, 2004, $7,327 represents the long-term portion of accrued lease termination fees and other facility costs. The remaining
balance of $5,344 represents the short-term portion of accrued special charges.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(10) | Merger and Acquisition Related Charges During the six months ended June 30, 2004, the Company acquired (i) Project Technology Inc. and (ii) the remaining 49%
ownership interest of its Korean distributor, Mentor Korea Co. Ltd. (MGK) for a total ownership interest of 100%. The acquisitions were investments aimed at expanding the Companys product offerings and increasing revenue growth. The aggregate
purchase price including acquisition costs for these two acquisitions was $3,519. The aggregate excess of tangible assets acquired over liabilities assumed was $309. The minority interest recorded in connection with the original 51% ownership in MGK
was $3,383, less dividends paid in prior years to minority shareholders of $1,975, reducing the acquisition cost to be allocated by a total of $1,408. The purchase accounting allocations resulted in a charge for in-process research and development
(R&D) of $360, goodwill of $1,750, technology of $220 and other identified intangible assets of $90. The technology is being amortized to cost of goods sold over two years. The other identified intangible assets are being amortized to operating
expenses over three years.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The separate results
of operations for the acquisitions for the three months ended June 30, 2004 were not material compared to the Companys overall results of operations and accordingly pro-forma financial statements of the combined entities have been omitted.



During the six months ended June 30, 2003, the Company
acquired (i) the Technology Licensing Group business of Alcatel (Alcatel), (ii) Translogic Polska Sp z o.o. (Translogic), (iii) the distributorship, Mentor Italia S.r.l. (Mentor Italia) and (iv) the business and technology of DDE-EDA A/S (DDE). The
acquisitions were investments aimed at expanding the Companys product offerings and increasing revenue growth. The aggregate purchase price including acquisition costs for these four acquisitions was $13,022. The aggregate excess of tangible
assets acquired over liabilities assumed was $669. The purchase accounting allocations resulted in a charge for in-process research and development (R&D) of $1,650, goodwill of $6,583, technology of $3,580 and other identified intangible assets
of $540. The technology is being amortized to cost of goods sold over five years. The other identified intangible assets are being amortized to operating expenses over three years. In connection with the Alcatel acquisition, the Company concurrently
licensed software to Alcatel under term licenses and entered into an agreement to provide services. Payment for these arrangements was incorporated into the purchase price of the acquisition and resulted in a reduction of cash paid to Alcatel of
$3,804. The Company used an independent third party valuation firm to determine the fair value of the Alcatel acquisition.



In addition, during the three months ended June 30, 2003, the Company recorded a one-time charge to operations of $150 for the acquisition of the
in-process R&D of New Design Paradigm, Limited, a developer and marketer of engineering-design software systems for the automotive and aerospace industries.



12



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The separate results of operations for the acquisitions for the three months ended June 30, 2003 were not
material compared to the Companys overall results of operations and accordingly pro-forma financial statements of the combined entities have been omitted.



|(11) | Derivative Instruments and Hedging Activities  The Company is exposed to fluctuations in foreign currency exchange rates. To manage the volatility relating to
these exposures, exposures are aggregated on a consolidated basis to take advantage of natural offsets. For exposures that are not offset, the Company enters into short-term foreign currency forward and option contracts to partially offset these
anticipated exposures. The primary exposures that do not currently have natural offsets are the Japanese yen where the Company is in a long position and the Euro where the Company is in a short position. The Company formally documents all
relationships between foreign currency contracts and hedged items as well as its risk management objectives and strategies for undertaking various hedge transactions. All hedges designated as cash flow hedges are linked to forecasted transactions
and the Company assesses, both at inception of the hedge and on an ongoing basis, the effectiveness of the foreign exchange contracts in offsetting changes in the cash flows of the hedged items. The effective portions of the net gains or losses on
foreign currency contracts are reported as a component of accumulated other comprehensive income in stockholders equity. Accumulated other comprehensive income associated with hedges of forecasted transactions is reclassified to the
consolidated statement of operations in the same period as the forecasted transaction occurs. The Company discontinues hedge accounting prospectively when it is determined that a foreign currency contract is not highly effective as a hedge under the
requirements of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. Any gain or loss deferred through that date remains in accumulated other comprehensive income until the forecasted transaction occurs at which
time it is reclassified to the consolidated statement of operations. To the extent the transaction is no longer deemed probable of occurring, hedge accounting treatment is discontinued prospectively and amounts deferred are reclassified to other
income or expense.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The fair value of foreign
currency forward and option contracts, recorded in prepaid expenses and other in the consolidated balance sheet, was $1,351 and $11 at June 30, 2004 and December 31, 2003, respectively.



The following provides a summary of activity in accumulated other comprehensive income relating to the Companys
hedging program:



|                                                    |  |      |     |      |   |      |  
|--------------------------------------------------- |  | ---- | --- | ---- | - | ---- | -
|Six months ended June 30,                           |  | 2004 |     | 2003 |  
|Beginning balance                                   |  | $    |    |      | $ | (171 | )
|Favorable changes in fair value of cash flow hedges |  |      | 182 |      |   | 789  |  
|Net (gain) loss transferred to earnings             |  |      | 63  |      |   | (177 | )
|                                                    |  |      |     |      |   |      |  
|Net unrealized gain                                 |  | $    | 245 |      | $ | 441  |  
|                                                    |  |      |     |      |   |      |  



The remaining balance
in accumulated other comprehensive income at June 30, 2004 represents a net unrealized gain on foreign currency contracts relating to hedges of forecasted revenues and expenses expected to occur during 2004. These amounts will be transferred to the
consolidated statement of operations upon recognition of the related revenue and recording of the respective expenses. The Company expects substantially all of the balance in accumulated other comprehensive income to be reclassified to the
consolidated statement of operations within the next year. The Company transferred $194 deferred gain and a $285 deferred losses to system and software revenues relating to foreign currency contracts hedging revenues for the six months ended June
30, 2004 and 2003, respectively. The Company transferred a $257 deferred loss and a $462 deferred gain to operating expenses relating to foreign currency contracts hedging commission and other expenses for the six months ended June 30, 2004 and
2003, respectively.



The Company enters into foreign currency
contracts to offset the earnings impact relating to the variability in exchange rates on certain short-term monetary assets and liabilities denominated in non-functional currencies. These foreign exchange contracts are not designated as hedges.
Changes in the fair value of these contracts are recognized currently in earnings in other income, net to offset the remeasurement of the related assets and liabilities.



13



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##### Table of Contents

In accordance with SFAS No. 133, the Company excludes changes in fair value relating to time value of
foreign currency contracts from its assessment of hedge effectiveness. The Company recorded income relating to time value in other income, net of $247 and $134 for the three months ended June 30, 2004 and 2003, respectively, and $385 and $273 for
the six months ended June 30, 2004 and 2003, respectively. The Company recorded expense related to time value in interest expense of $124 and $183 for the three months ended June 30, 2004 and 2003, respectively, and $238 and $331 for the six months
ended June 30, 2004 and 2003, respectively.



|(12) | Income Taxes - The provision for income taxes was $37,523 and $37,969 for the three months and six months ended June 30, 2004 compared to $1,018 and $1,918 for the
comparable periods of 2003. On a quarterly basis, the Company evaluates its expected income tax expense or benefit based on its year to date operations and records an adjustment in the current quarter. The net tax provision is the result of the mix
of profits earned by the Company and its subsidiaries in tax jurisdictions with a broad range of income tax rates. The provision for income taxes differs from tax computed at the federal statutory income tax rate primarily due to the impact of a
large one-time dividend declared by a foreign subsidiary as well as the impact of state taxes and the amortization of a deferred tax charge recorded in 2002, offset in part by the impact of the tax rate differential on earnings of foreign
subsidiaries. Tax expense of $36,650 was provided on the declaration of a $120,000 dividend from a foreign subsidiary and is reflected in the tax provision for the three months and six months ended June 30, 2004. The dividend was declared to
increase the Companys future flexibility to marshal the Companys foreign generated cash in the United States for operating and acquisition purposes, and to utilize United States deferred tax assets. Because the Company had sufficient net
operating loss and tax credit carryforwards to offset the tax liability for tax return purposes, the Company incurred a federal and state cash tax liability of approximately $3,000 as a result of the dividend and realized $33,650 of its deferred tax
assets.
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The Company has not provided for United
States income taxes on the undistributed earnings of foreign subsidiaries because they are considered permanently invested outside of the United States. Upon repatriation, some of these earnings would generate foreign tax credits which may reduce
the Federal tax liability associated with any future foreign dividend.



|(13) | Commitments and Contingencies 
|---- | -------------------------------



Leases



The Company leases a majority of its field office facilities under non-cancelable operating leases. In addition, the Company leases certain equipment used
in its research and development activities. This equipment is generally leased on a month-to-month basis after meeting a six-month lease minimum.



Indemnifications



The Companys license and services agreements include a limited indemnification provision for claims from third-parties relating to the
Companys intellectual property. Such indemnification provisions are accounted for in accordance with SFAS No. 5, Accounting for Contingencies. The indemnification is generally limited to the amount paid by the customer. At June 30,
2004, the Company is not aware of any material liabilities arising from these indemnifications.



Legal Proceedings



From time to time the Company is involved in various disputes and litigation matters that arise from the ordinary course of business. These include
disputes and lawsuits relating to intellectual property rights, licensing, contracts and employee relations matters. The Company believes that the outcome of current litigation, individually and in the aggregate, will not have a material affect on
the Companys results of operations.



|(14) | Segment Reporting- SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, requires disclosures of certain information
regarding operating segments, products and services, geographic areas of operation and major customers. To determine what information to report under SFAS No. 131, the Company reviewed the Chief Operating Decision Makers (CODM) method of
analyzing the operating segments to determine resource allocations and performance assessments. The Companys CODMs are the Chief Executive Officer and the President.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



14



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The Company operates exclusively in the electronic design automation (EDA) industry. The Company markets
its products and services worldwide, primarily to large companies in the military/aerospace, communications, computer, consumer electronics, semiconductor, networking, multimedia and transportation industries. The Company sells and licenses its
products through its direct sales force in North America, Europe, Japan and Pacific Rim, and through distributors where third parties can extend sales reach more effectively or efficiently. The Companys reportable segments are based on
geographic area.



All intercompany revenues and expenses are
eliminated in computing revenues and operating income (loss). The corporate component of operating income represents research and development, corporate marketing and selling, corporate general and administration, special charges and merger and
acquisition related charges. Corporate capital expenditures and depreciation and amortization are generated from assets allotted to research and development, corporate marketing and selling and corporate general and administration. Reportable
segment information is as follows:



|                        |  |                             |         |   |                           |   |         |      |  |   |          |   |  |   |          |  
|----------------------- |  | --------------------------- | ------- | - | ------------------------- | - | ------- | ---- |  | - | -------- | - |  | - | -------- | -
|                        |  | Three months ended June 30, |         |   | Six months ended June 30, |  
|                        |  | 2004                        |         |   | 2003                      |   |         | 2004 |  |   | 2003     |  
|Revenues                |  |                             |         |   |                           |   |         |      |  |   |          |   |  |   |          |  
|Americas                |  | $                           | 82,892  |   |                           | $ | 76,761  |      |  | $ | 147,922  |   |  | $ | 156,287  |  
|Europe                  |  |                             | 43,299  |   |                           |   | 46,840  |      |  |   | 87,120   |   |  |   | 89,260   |  
|Japan                   |  |                             | 28,358  |   |                           |   | 20,665  |      |  |   | 67,153   |   |  |   | 44,689   |  
|Pacific Rim             |  |                             | 15,093  |   |                           |   | 13,202  |      |  |   | 31,852   |   |  |   | 26,572   |  
|                        |  |                             |         |   |                           |   |         |      |  |   |          |   |  |   |          |  
|Total                   |  | $                           | 169,642 |   |                           | $ | 157,468 |      |  | $ | 334,047  |   |  | $ | 316,808  |  
|                        |  |                             |         |   |                           |   |         |      |  |   |          |   |  |   |          |  
|Operating income (loss) |  |                             |         |   |                           |   |         |      |  |   |          |   |  |   |          |  
|Americas                |  | $                           | 49,932  |   |                           | $ | 42,242  |      |  | $ | 82,761   |   |  | $ | 85,821   |  
|Europe                  |  |                             | 21,663  |   |                           |   | 24,262  |      |  |   | 42,927   |   |  |   | 46,047   |  
|Japan                   |  |                             | 18,273  |   |                           |   | 11,328  |      |  |   | 46,681   |   |  |   | 25,924   |  
|Pacific Rim             |  |                             | 10,641  |   |                           |   | 10,057  |      |  |   | 23,002   |   |  |   | 19,917   |  
|Corporate               |  |                             | (93,201 | ) |                           |   | (80,793 | )    |  |   | (182,214 | ) |  |   | (162,556 | )
|                        |  |                             |         |   |                           |   |         |      |  |   |          |   |  |   |          |  
|Total                   |  | $                           | 7,308   |   |                           | $ | 7,096   |      |  | $ | 13,157   |   |  | $ | 15,153   |  
|                        |  |                             |         |   |                           |   |         |      |  |   |          |   |  |   |          |  



The Company segregates
revenue into three categories of similar products and services. These categories include Integrated Circuit (IC) Design, Systems Design and Professional Services. The IC Design and Systems Design categories include both product and support revenue.
Revenue information is as follows:



|                               |  |                             |         |                           |   |         |  |      |         |  |   |        
|------------------------------ |  | --------------------------- | ------- | ------------------------- | - | ------- |  | ---- | ------- |  | - | -------
|                               |  | Three months ended June 30, |         | Six months ended June 30,
|                               |  | 2004                        |         | 2003                      |   | 2004    |  | 2003
|Revenues                       |  |                             |         |                           |   |         |  |      |         |  |   |        
|Integrated Circuit (IC) Design |  | $                           | 116,246 |                           | $ | 107,779 |  | $    | 231,988 |  | $ | 211,877
|Systems Design                 |  |                             | 46,639  |                           |   | 43,057  |  |      | 88,575  |  |   | 92,954 
|Professional Services          |  |                             | 6,757   |                           |   | 6,632   |  |      | 13,484  |  |   | 11,977 
|                               |  |                             |         |                           |   |         |  |      |         |  |   |        
|Total                          |  | $                           | 169,642 |                           | $ | 157,468 |  | $    | 334,047 |  | $ | 316,808
|                               |  |                             |         |                           |   |         |  |      |         |  |   |        



|(15) | Recent Accounting Pronouncements- In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on the remaining portions of EITF 03-01, The Meaning
of Other-Than-Temporary Impairment and Its Application to Certain Investments, effective for the first fiscal year or interim period beginning after June 15, 2004. EITF 03-01 provides new disclosure requirements for other-than-temporary
impairments on debt and equity investments. Investors are required to disclose quantitative information about: (i) the aggregate amount of unrealized losses, and (ii) the aggregate related fair values of investments with
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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unrealized losses, segregated into time periods during which the investment has been in an unrealized
loss position of less than 12 months and greater than 12 months. In addition, investors are required to disclose the qualitative information that supports their conclusion that the impairments noted in the qualitative disclosure are not
other-than-temporary. The adoption of this issue is not expected to have a material impact on the Companys financial position or results of operations.



Item 2. Managements Discussion and Analysis of Results of Operations and Financial Condition

(All numerical references in
thousands, except for percentages)



OVERVIEW



The Company



The Company is a supplier of electronic design automation (EDA) systems  advanced computer software, emulation hardware systems and
intellectual property designs and databases used to automate the design, analysis and testing of electronic hardware and embedded systems software in electronic systems and components. The Company markets its products and services worldwide,
primarily to large companies in the military/aerospace, communications, computer, consumer electronics, semiconductor, networking, multimedia and transportation industries. Through the diversification of the Companys customer base among these
various customer markets, the Company attempts to reduce its exposure to fluctuations within each market. The Company sells and licenses its products through its direct sales force and a channel of distributors and sales representatives. In addition
to its corporate offices in Wilsonville, Oregon, the Company has sales, support, software development and professional service offices worldwide.



Business Environment



Beginning in late 2000, the electronics industry experienced a broad economic downturn. As a result of this downturn, many of the Companys customers reduced
research and development (R&D) budgets, limited general investment in design tools and reduced engineering staff. Although the overall economy and the electronics industry have gradually recovered during 2003 and 2004, the Companys
customers have in general continued to limit EDA spending. Notwithstanding this general trend, customers still require new innovative EDA tools to solve leading edge design problems and increase productivity and speed time to market. The Company
attempts to fill those demands through its relatively young and diverse product portfolio. As a result, the Company had solid performance in 2003 and first half of 2004. Strength in system design in the military and aerospace segments helped drive
revenue growth for the Company in 2003. As customer demand expanded during this time, the Company was able to leverage its strength in system design relative to its major competitors. As the semiconductor industry began to stabilize in the second
half of 2003 and first half of 2004, newer integrated circuit (IC) design tool sales increased. For the Company, this resulted in growth in the second half of 2003 and first half of 2004, led by its physical verification product family.



The Companys management believes that EDA spending by semiconductor companies
generally lags their economic financial recovery by several quarters for two primary reasons. First, because of the importance of R&D to the future of semiconductor companies, customers try to moderate R&D spending reductions during
downturns in comparison to other expense items. As a result, R&D spending as a percentage of revenue increases. As revenues grow in the early stages of the recovery, customers constrain spending increases until R&D returns to more typical
percentage of revenue levels. Second, as a result of reduced engineering staff, customers may hold excess software licenses of established tools. Hiring must resume before additional software licenses will be required. The exception is for newer
software that customers have not previously purchased.



The Companys
management is not predicting a recovery of EDA spending in 2004. We believe that the Company will continue to grow revenue and earnings faster than the industry because of its heavy mix of relatively new products, many of which are in new types of
design methodologies that do not currently have a large EDA installed base. The Company will continue its strategy of attempting to develop best in class point tools with number one market share potential. This strategy is intended to create a
diversified product portfolio for the Company that solves customers critical design problems. The Companys management believes that this product strategy, in conjunction with a customer diversification strategy, has helped reduce the
impact of marketplace fluctuations in the past.



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License Model Mix



License model trends can have a material impact on various aspects of the Companys business. See Critical Accounting Estimates  Revenue
Recognition on pages 18-19 for a description of the types of product licenses sold by the Company. As the mix among perpetual licenses, fixed term licenses (term) with upfront revenue recognition and term licenses with ratable revenue
recognition (which include due and payable and cash based revenue recognition) shifts, revenues, earnings, cash flow and days sales outstanding (DSO) are either positively or negatively affected. The year ended December 31, 2003 marked the third
consecutive year in which, as a percentage of product revenue, term revenue increased while perpetual revenue decreased. This trend was primarily the result of two factors. First, the Companys customers are moving toward the term license
model, which provides the customer with greater flexibility for product usage, including the ability to share the products between multiple locations and reconfigure consumption at regular intervals from a fixed product list. As such, some of the
Companys customers have converted their existing installed base from perpetual to term licenses. Second, the weakness in the United States high-technology economy has disproportionately impacted the Companys smaller customers.
Historically these customers have purchased under the perpetual license model.



Under this recent shift from perpetual licenses to term licenses with upfront revenue recognition, which the Companys management views as a positive trend, the Company expects no measurable impact to earnings, but a negative impact on
cash flow and DSO. As customers move away from perpetual licenses and into term licenses, the renewability and repeatability of the Companys business is increased. This provides opportunity for increased distribution of newer products earlier
in their lifecycles.



Product Developments



During 2003 and 2004, the Company continued to execute its strategy of focusing on new
customer problem areas, as well as building upon its well-established product families. The Companys management believes that customers, faced with leading-edge design challenges, choose the best products in each category to build their design
environment. The Company generally has focused its internal development efforts on areas where it believes it can build a number one market position, or extend an existing number one market position.



New products delivered by the Company in the area of printed circuit board design included:
I/O Designer (tool that enable large and complex FPGAs to be efficiently incorporated into the design process), TeamPCB (a tool that allows multiple designers to simultaneously work on the same design without affecting each others work) and
advanced high-speed design and analysis software.



In the Design-to-Silicon
Division, the Company continued to extend the scope of the Calibre platform, obtaining significant new customer engagements and orders with its resolution enhancement technology. The Company also worked on developing new design-for-manufacturing
tools that are expected to debut later in 2004.



The Company launched its
Scalable Verification Environment featuring a suite of tools designed to solve the verification challenges that design engineers face. According to Collett International, an industry analysis firm, engineers spend approximately 62% of their design
effort verifying their designs. This dominance of verification in the design process has driven many customers to seek new solutions to enhance their verification abilities.



In 2004, the Company launched Catapult C Synthesis, a new tool that enables designers to work at a higher level of design abstraction. Using
C language rather than traditional hardware design languages can improve design quality as well as designer productivity.



The Companys management believes that the development and commercialization of EDA software tools is usually a multi-year process with limited customer adoption in
the first years of tool availability. Once tools are adopted, however, their life spans tend to be long and healthy. The Companys management believes that the Companys relatively young and diverse product lines are positioned for growth
over the long-term.



Q2 2004 Financial Performance



| |  | Total revenues were $169,642 and $334,047 for the three months and six months ended June 30, 2004, respectively, a 8% and 5% increase over the comparable periods of 2003, resulting
largely from strength in Scalable Verification and Design-to-Silicon product lines as well as favorable currency effects from strengthening of the Japanese yen, the Euro, the British pound sterling and other European currencies.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | Product revenues split by license model was 45% term with upfront revenue recognition, 39% perpetual and 16% term with ratable revenue recognition (which include due and payable and
cash based revenue recognition), compared to Q2 2003 product revenue splits of 35% term with upfront revenue recognition, 49% perpetual and 16% term with ratable revenue recognition.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Service and support revenues for the three months and six months ended June 30, 2004 were $71,551 and $141,435, respectively, a 3% increase over the comparable periods of 2003
service and support revenues of $69,677 and $137,205, respectively, resulting largely from favorable currency effects from strengthening of the Japanese yen, the Euro, the British pound sterling and other European currencies.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | By geography, revenues increased 8% for the three months ended June 30, 2004 and decreased 5% for the six months ended June 30, 2004 in the Americas as compared to the comparable
periods of 2003. Revenues increased for the three months ended June 30, 2004 as compared to the comparable period of 2003 primarily due to an increase in Scalable Verification product revenues primarily attributable to the Modelsim product line and
continued strength in Design-to-Silicon product revenues primarily attributable to the Calibre product line. Revenues decreased for the six months ended June 30, 2004 as compared to the comparable period of 2003 is primarily due to a decrease in
Integrated Systems Design product revenues due to a large term deal in the first six months of 2003. Revenues decreased 8% and 2% in Europe, increased 37% and 50% in Japan due to new term business and 14% and 20% in Pacific Rim for the three months
and six months ended June 30, 2004, respectively. The Americas contributed the largest share of revenues at nearly 49% and 44% for the three months and six months ended June 30, 2004.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Net loss for the three months and six months ended June 30, 2004 was $32,796 and $30,618 respectively, compared to a net income of $4,074 and $7,673 in the comparable periods of
2003. The decrease was primarily due to an increase in the tax provision due to the declaration of a $120,000 dividend from a foreign subsidiary for the three months ended June 30, 2004. This decrease is offset by increased revenues for the three
months and six months ended June 30, 2004 as compared to the comparable period of 2003.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Trade accounts receivable, net increased to $225,148 at June 30, 2004, up 1% from $223,670 at December 31, 2003. Average days sales outstanding increased from 100 days at December
31, 2003 to 119 days at June 30, 2004. The increase in days sales outstanding was primarily due to the decrease in revenue for the three months ended June 30, 2004 as compared to the three months ended December 31, 2003 and effect of annual support
renewals in the first half of 2004.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Cash generated by operating activities was $15,794 for the six months ended June 30, 2004 compared to $26,214 in the comparable period of 2003. At June 30, 2004, cash, cash
equivalents and short-term investments were $83,754, up 17% from $71,324 at December 31, 2003.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



CRITICAL ACCOUNTING ESTIMATES



The Companys discussion and analysis of its financial condition and results of operations are based upon the Companys consolidated financial statements, which have been prepared in accordance with accounting principles generally
accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities and contingencies as of the date of the financial
statements and the reported amounts of revenues and expenses during the reporting periods. The Company evaluates its estimates on an on-going basis. The Company bases its estimates on historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions. The Company believes the following are the critical accounting estimates and judgments used in the preparation of its consolidated financial statements.



Revenue Recognition



The Company reports revenue in two categories based upon how the revenue is generated: (i)
system and software and (ii) services and support.



System
and software revenue - System and software revenues are derived from the sale of licenses of software products and emulation hardware systems.



The Company licenses software using two different license types:



| | 1. | Term licenses are for a specified time period, typically three years with payments spread over the license term, and do not provide the customer with the right to use the product
after the
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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end of the term. The Company generally recognizes product revenue from term installment license
agreements upon shipment and start of the license term. The Company uses these agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products
or services. If the Company no longer had a history of collecting without providing concessions on term agreements, then revenue would be required to be recognized as the payments become due and payable over the license term. This change would have
a material adverse impact on the Companys near-term results of operations. In a situation in which a risk of concession may exist on a term license agreement, revenue is recognized on a due and payable basis. In a term license agreement where
the Company provides the customer with rights to unspecified or unreleased future products, revenue is recognized ratably over the license term.



| | 2. | Perpetual licenses provide the customer with the right to use the product in perpetuity and typically do not provide for extended payment terms. The Company recognizes product
revenue from perpetual license agreements upon delivery to the customer when the likelihood of product return is remote. If the agreement provides for customer payment terms that are different than the standard payment terms in the customers
jurisdiction, product revenue is recognized as payments become due and payable.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Service and support revenue- Service and support revenues consist of revenues from support contracts and professional services, which include consulting services, training services and other services. The
Company records service revenue as the services are provided to the customer. Support revenue is recognized over the support term. For multi-element arrangements that include support, support is allocated based on vendor specific objective evidence
(VSOE) of the fair value of support. For term licenses, VSOE is established by the price charged when such support is offered as optional during the license term. For perpetual licenses, VSOE is established by the price charged when such support is
sold separately.



The Company determines whether software product revenue
recognition is appropriate based upon the evaluation of whether the following four criteria have been met:



|1. | Persuasive evidence of an arrangement exists  An agreement signed by the customer and the Company.
|-- | ---------------------------------------------------------------------------------------------------



|2. | Delivery has occurred  The software has been shipped, the customer is in possession of the software or the software has been made available to the customer through electronic
delivery.
|-- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|3. | Fee is fixed and determinable  The amount of the fee and the due date have been fixed at execution of the arrangement without the possibility of future adjustments or
concessions.
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|4. | Collectibility is probable  The customer is expected to pay for products or services without the Company providing future concessions to the customer.
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------



Valuation of Trade Accounts Receivable



The Company maintains allowances for doubtful accounts on trade accounts receivable and
term receivables, long-term for estimated losses resulting from the inability of its customers to make required payments. The Company evaluates the collectibility of its trade accounts receivable based on a combination of factors. The Company
regularly analyzes its customer accounts. When it becomes aware of a specific customers inability to meet its financial obligations, such as in the case of bankruptcy or deterioration in the customers operating results or financial
position, a specific reserve for bad debt is recorded to reduce the related receivable to the amount believed to be collectible. The Company also records unspecified reserves for bad debt for all other customers based on a variety of factors
including length of time the receivables are past due, the financial health of the customers, the current business environment and historical experience. If circumstances related to specific customers change, estimates of the recoverability of
receivables would be adjusted resulting in either additional selling expense or a reduction in selling expense in the period such determination was made.



Valuation of Deferred Tax Assets



Deferred tax assets are recognized for deductible temporary differences, net operating loss carryforwards and credit carryforwards if it is more likely than not that the
tax benefits will be realized. The Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for valuation allowances. The Company has recorded a valuation allowance to reduce its
deferred tax assets to the amount that is more likely than not to be realized. In the event the Company was to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to
the deferred tax asset would increase either income or contributed capital, or decrease goodwill, in the period such determination was made. Also, if the Company was to determine that it would not be able to realize all or part of its net deferred
tax asset in the future, an adjustment to increase the valuation allowance on such net deferred tax assets would be charged to expense in the period such determination was made.



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Goodwill, Intangible Assets and Long-Lived Assets



The Company reviews long-lived assets and the related intangible assets for impairment
whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable. Recoverability of an asset is determined by comparing its carrying amount, including any associated intangible assets, to the forecasted
undiscounted net cash flows of the operation to which the asset relates. If the operation is determined to be unable to recover the carrying amount of its assets, then intangible assets are written down first, followed by the other long-lived assets
of the operation, to fair value. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the assets. Goodwill and intangible assets with indefinite lives are tested for impairment annually and
whenever there is an impairment indicator using a fair value approach. In the event that, in the future, it is determined that the Companys goodwill, intangible or other long-lived assets have been impaired, an adjustment would be made that
would result in a charge for the write-down in the period that determination was made.



Inventory



The Company purchases and commits to
purchase inventory based upon forecasted shipments of its emulation hardware systems. The Company evaluates, on a quarterly basis, the need for inventory reserves based on projections of systems expected to ship within six months. Reserves for
excess and obsolete inventory are established to account for the differences between forecasted shipments and the amount of purchased and committed inventory.



Restructuring Charges



The Company has recorded restructuring charges in connection with its plans to better align the cost structure with projected operations in the future. In accordance with
Statement of Financial Accounting Standards (SFAS) No. 146, Accounting for Costs Associated with Exit or Disposal Activities, the Company records liabilities for costs associated with exit or disposal activities when the liability is
incurred. Prior to January 1, 2003, in accordance with Emerging Issues Task Force (EITF) No. 94-3, the Company accrued for restructuring costs when management made a commitment to an exit plan that specifically identified all significant actions to
be taken.



The Company has recorded restructuring charges in connection with
employee rebalances based on estimates of the expected costs associated with severance benefits. If the actual cost incurred exceeds the estimated cost, additional special charges will be recognized. If the actual cost is less than the estimated
cost, a benefit to special charges will be recognized.



The Company has also
recorded restructuring charges in connection with excess leased facilities to offset future rent, net of estimated sublease income that could be reasonably obtained, of the abandoned office space and to write-off leasehold improvements on abandoned
office space. The Company worked with external real estate experts in each of the markets where properties are located to obtain assumptions used to determine the best estimate of the net loss.



The Companys estimates of expected sublease income could change based on factors that
affect the Companys ability to sublease those facilities such as general economic conditions and the real estate market. If the real estate markets worsen and the Company is not able to sublease the properties as expected, additional
adjustments may be required, which would result in additional special charges in the period such determination was made. Likewise, if the real estate market strengthens and the Company is able to sublease the properties earlier or at more favorable
rates than projected, a benefit to special charges will be recognized.



RESULTS OF OPERATIONS



REVENUES AND GROSS MARGINS



System and Software



System and software revenues are derived from the sale of licenses of software products and
emulation hardware systems. System and software revenues for the three months and six months ended June 30, 2004 totaled $98,091 and $192,612, respectively, representing an increase of $10,300 or 12% and $13,009 or 7% over the comparable



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periods of 2003. The increase in software product revenue was attributable to (i) an increase in Scalable Verification
product revenues primarily attributable to the Modelsim product line and (ii) continued strength in the Design-to-Silicon product revenues primarily attributable to the Calibre product line. This increase was offset by a decrease in Integrated
Systems Design product revenues due to a large term deal in the six months ended June 30, 2003. In addition, system and software revenues were favorably impacted by approximately 2% by the strengthening of foreign currencies for the three months and
six months ended June 30, 2004.



System and software gross margins were 93% for
the three months and six months ended June 30, 2004, compared to 92% for the comparable periods of 2003. Gross margin was favorably impacted for the three and six months ended June 30, 2004 due to a greater mix of higher margin software product
revenue versus lower margin emulation hardware system revenue.



Amortization of
purchased technology to system and software cost of goods sold was $2,504 and $4,970 for the three months and six months ended June 30, 2004, respectively, compared to $2,269 and $4,478 in the comparable periods of 2003. The increase in amortization
of purchased technology is primarily attributable to acquisitions in the second quarter of 2003. Purchased technology costs are amortized over two to five years to system and software cost of revenues.



Service and Support



Service and support revenues consist of revenues from support contracts and professional
services, which include consulting services, training services and other services. Service and support revenues for the three months and six months ended June 30, 2004 totaled $71,551 and $141,435, respectively, representing an increase of $1,874 or
3% and $4,230 or 3% over the comparable periods of 2003. The increases in service and support revenues for the three and six months ended June 30, 2004 were primarily attributable to the strengthening of foreign currencies.



Service and support gross margins for the three months and six months ended June 30, 2004
were 73% and 72%, respectively, compared to 70% for the comparable periods of 2003. Service and support gross margin increased for the three and six months ended June 30, 2004 compared to the same period in 2003 primarily due to higher revenue
resulting from the strengthening of foreign currencies and lower costs resulting from headcount reductions.



Geographic Revenues Information



|                            |  |      |         |        |    |    |      |   |        
|--------------------------- |  | ---- | ------- | ------ | -- | -- | ---- | - | -------
|Three months ended June 30, |  | 2004 |         | Change |    |    | 2003
|Americas                    |  | $    | 82,892  |        | 8  | %  |      | $ | 76,761 
|Europe                      |  |      | 43,299  |        | (8 | )% |      |   | 46,840 
|Japan                       |  |      | 28,358  |        | 37 | %  |      |   | 20,665 
|Pacific Rim                 |  |      | 15,093  |        | 14 | %  |      |   | 13,202 
|                            |  |      |         |        |    |    |      |   |        
|Total                       |  | $    | 169,642 |        |    |    |      | $ | 157,468
|                            |  |      |         |        |    |    |      |   |        



|                          |  |      |         |        |    |    |      |   |        
|------------------------- |  | ---- | ------- | ------ | -- | -- | ---- | - | -------
|Six months ended June 30, |  | 2004 |         | Change |    |    | 2003
|Americas                  |  | $    | 147,922 |        | (5 | )% |      | $ | 156,287
|Europe                    |  |      | 87,120  |        | (2 | )% |      |   | 89,260 
|Japan                     |  |      | 67,153  |        | 50 | %  |      |   | 44,689 
|Pacific Rim               |  |      | 31,852  |        | 20 | %  |      |   | 26,572 
|                          |  |      |         |        |    |    |      |   |        
|Total                     |  | $    | 334,047 |        |    |    |      | $ | 316,808
|                          |  |      |         |        |    |    |      |   |        



Revenues in the Americas increased for
the three months ended June 30, 2004 as compared to the three months ended June 30, 2003 due to an increase in Scalable Verification product revenues. Revenues in the Americas decreased for the six months ended June 30, 2004 as compared to the six
months ended June 30, 2003 due to a large term deal in the six months ended June 30, 2003. Revenues outside the Americas represented 51% and 56% of total revenues for the three months and six months ended June 30, 2004, respectively, compared to 51%
for the



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comparable periods of 2003. The effects of exchange rate differences from the European currencies to the United States
dollar positively impacted European revenues by approximately 3% for the three and six months ended June 30, 2004. Exclusive of currency effects, lower revenue for the three and six months ended June 30, 2004 compared to the comparable periods of
2003 was due to lower emulation hardware systems sales. The effects of exchange rate differences from the Japanese yen to the United States dollar positively impacted Japanese revenues by approximately 8% for the three months and six months ended
June 30, 2004. Exclusive of currency effects, higher revenues in Japan were primarily attributable to higher software product sales and an increase in service and support revenue. Revenues in the Pacific Rim increased for the three and six months
ended June 30, 2004 as compared to the comparable periods of 2003 primarily as a result of higher software product and support sales. Since the Company generates approximately half of its revenues outside of the U.S. and expects this to continue in
the future, revenue results should continue to be impacted by the effects of future foreign currency fluctuations.



OPERATING EXPENSES



|                                       |  |                             |        |                           |     |    |      |   |        |  |        |         |  |      |    |  |   |        
|-------------------------------------- |  | --------------------------- | ------ | ------------------------- | --- | -- | ---- | - | ------ |  | ------ | ------- |  | ---- | -- |  | - | -------
|                                       |  | Three months ended June 30, |        | Six months ended June 30,
|                                       |  | 2004                        |        | Change                    |     |    | 2003 |   | 2004   |  | Change |         |  | 2003
|Research and development               |  | $                           | 48,322 |                           | 10  | %  |      | $ | 43,965 |  | $      | 96,705  |  | 11   | %  |  | $ | 86,841 
|Marketing and selling                  |  | $                           | 64,045 |                           | 9   | %  |      | $ | 58,708 |  | $      | 127,751 |  | 8    | %  |  | $ | 117,897
|General and administration             |  | $                           | 18,748 |                           | 9   | %  |      | $ | 17,160 |  | $      | 37,310  |  | 3    | %  |  | $ | 36,143 
|Amortization of intangible assets      |  | $                           | 790    |                           | (15 | )% |      | $ | 931    |  | $      | 1,572   |  | (24  | )% |  | $ | 2,076  
|                                       |  |                             |        |                           |     |   
|Special charges                        |  | $                           | 3,863  |                           | 100 | %  |      | $ |       |  | $      | 3,863   |  | 183  | %  |  | $ | 1,363  
|Merger and acquisition related charges |  | $                           | 360    |                           | (80 | )% |      | $ | 1,800  |  | $      | 360     |  | (80  | )% |  | $ | 1,800  



Research and Development



R&D costs increased for the three months and six months ended
June 30, 2004 over the comparable period of 2003 primarily attributable to higher R&D headcount, including headcount in the systems design and embedded system product lines and due to a weaker United States dollar during 2004 that increased
R&D expenses by approximately 2% and 3% for the three months and six months ended June 30, 2004, respectively.



Marketing and Selling



Marketing and selling costs increased for the three months and six months ended June 30, 2004 over the comparable period of 2003 primarily due to higher headcount and due
to a weaker United States dollar during 2004 that increased marketing and selling expenses by approximately 3% and 4% for the three months and six months ended June 30, 2004, respectively.



General and Administration



General and administration costs increased for the three months and six months ended June
30, 2004 as compared to the comparable period of 2004 primarily attributable to higher headcount and a weaker United States dollar during 2004 that increased general and administration expenses by approximately 2% and 3% for the three months and six
months ended June 30, 2004, respectively. These increases were offset by no emulation litigation related costs due to the settlement of the emulation litigation with Cadence Design System, Inc. in 2003.



Amortization of Intangible Assets



Amortization of intangible assets decreased for the three months and six months ended June
30, 2004 as compared to the comparable period of 2003 due to complete amortization of intangible assets related to certain prior year acquisitions.



Special Charges



For the six months ended June 30, 2004, the Company recorded special charges of $3,863. These charges primarily consisted of accruals for excess leased facilities and costs incurred for employee terminations.



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Excess leased facility costs of $1,267 primarily consist of adjustments to previously recorded non-cancelable lease
payments for leases of facilities in North America and Europe. These adjustments are a result of reductions to the estimated expected sublease income primarily due to the real estate markets in which these facilities are located remaining at
depressed levels longer than originally anticipated. Non-cancelable lease payments on these excess leased facilities should be expended over seven years. In addition, the Company recorded a $758 write-off of leasehold improvements for a facility
lease in North America that was previously abandoned.



The Company rebalanced
its workforce by 25 employees during the six months ended June 30, 2004. The reduction impacted several employee groups. Employee severance costs of $1,463 included severance benefits, notice pay and outplacement services. Termination benefits were
communicated to the affected employees prior to the end of the quarter in which the employees were terminated. The majority of these costs should be expended during the next twelve months. There have been no significant modifications to the amount
of these charges.



Other costs of $590 include other costs incurred to
restructure the organization other than employee rebalances and excess leased facility costs.



In addition, the Company reversed a portion of the remaining accrual related to the emulation litigation with Cadence Design Systems, Inc.



For the six months ended June 30, 2003, the Company recorded special charges of $1,363. These charges primarily consisted of costs incurred
for employee terminations. The Company rebalanced its workforce by 32 employees during the six months ended June 30, 2003. This reduction impacted several employee groups. Employee severance costs of $1,350 included severance benefits, notice pay
and outplacement services. Termination benefits were communicated to the affected employees prior to the end of the quarter in which the employees were terminated. The majority of these costs were expended during the first half of 2003. There have
been no significant modifications to the amount of these charges.



Merger
and Acquisition Related Charges



During the six months ended June 30,
2004, the Company acquired (i) Project Technology Inc. and (ii) the remaining 49% ownership interest of its Korean distributor, Mentor Korea Co. Ltd. (MGK) for a total ownership interest of 100%. The acquisitions were investments aimed at expanding
the Companys product offerings and increasing revenue growth. The aggregate purchase price including acquisition costs for these two acquisitions was $3,519. The aggregate excess of tangible assets acquired over liabilities assumed was $309.
The minority interest recorded in connection with the original 51% ownership in MGK was $3,383, less dividends paid in prior years to minority shareholders of $1,975, reducing the acquisition cost to be allocated by a total of $1,408. The purchase
accounting allocations resulted in a charge for in-process research and development (R&D) of $360, goodwill of $1,750, technology of $220 and other identified intangible assets of $90. The technology is being amortized to cost of goods sold over
two years. The other identified intangible assets are being amortized to operating expenses over three years.



During the six months ended June 30, 2003, the Company acquired (i) the Technology Licensing Group business of Alcatel (Alcatel), (ii) Translogic Polska Sp z o.o. (Translogic), (iii) the distributorship, Mentor Italia
S.r.l. (Mentor Italia) and (iv) the business and technology of DDE-EDA A/S (DDE). The acquisitions were investments aimed at expanding the Companys product offerings and increasing revenue growth. The aggregate purchase price including
acquisition costs for these four acquisitions was $13,022. The aggregate excess of tangible assets acquired over liabilities assumed was $669. The purchase accounting allocations resulted in a charge for in-process research and development (R&D)
of $1,650, goodwill of $6,583, technology of $3,580 and other identified intangible assets of $540. The technology is being amortized to cost of goods sold over five years. The other identified intangible assets are being amortized to operating
expenses over three years. In connection with the Alcatel acquisition, the Company concurrently licensed software to Alcatel under term licenses and entered into an agreement to provide services. Payment for these arrangements was incorporated into
the purchase price of the acquisition and resulted in a reduction of cash paid to Alcatel of $3,804. The Company used an independent third party valuation firm to determine the fair value of the Alcatel acquisition.



In addition, during the three months ended June 30, 2003, the Company recorded a one-time
charge to operations of $150 for the acquisition of the in-process R&D of New Design Paradigm, Limited, a developer and marketer of engineering-design software systems for the automotive and aerospace industries.



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Other Income, Net



Other income, net totaled $1,990 and $3,220 for the three months and six months ended June 30, 2004, respectively, compared to $1,925 and $2,412 for the comparable
periods in 2003. Interest income was $1,860 and $3,492 for the three months and six months ended June 30, 2004, respectively, compared to $1,216 and $2,663 for comparable periods of 2003. Interest income includes income relating to time value of
foreign currency contracts of $247 and $385 for the three months and six months ended June 30, 2004, respectively, compared to $134 and $273 for the comparable periods in 2003. Other income, net was favorably impacted by a foreign currency gain of
$255 and $129 in the three months and six months ended June 30, 2004, respectively, compared to a loss of $92 and $825 for the comparable periods of 2003. These variances were partially offset by a net gain on sale of investment of $1,491 in the
three and six months ended June 30, 2003.



Interest Expense



Interest expense was $4,571 and $9,026 for the three months and six
months ended June 30, 2004, respectively, compared to $3,929 and $7,974 for comparable periods in 2003. Interest expense increased primarily as a result of the issuance of the Companys convertible subordinated notes in August 2003. Interest
expense is primarily attributable to of the Companys convertible subordinated notes and debentures issued in June 2002 and August 2003, respectively. The Company recorded interest expense relating to the time value of foreign currency
contracts of $124 and $238 for the three months and six months ended June 30, 2004, respectively, compared to $183 and $331 for the comparable period of 2003.



Provision for Income Taxes



The provision for income taxes was $37,523 and $37,969 for the three months and six months ended June 30, 2004 compared to $1,018 and $1,918 for the comparable periods of
2003. On a quarterly basis, the Company evaluates its expected income tax expense or benefit based on its year to date operations and records an adjustment in the current quarter. The net tax provision is the result of the mix of profits earned by
the Company and its subsidiaries in tax jurisdictions with a broad range of income tax rates. The provision for income taxes differs from tax computed at the federal statutory income tax rate primarily due to the impact of a large one-time dividend
declared by a foreign subsidiary as well as the impact of state taxes and the amortization of a deferred tax charge recorded in 2002, offset in part by the impact of the tax rate differential on earnings of foreign subsidiaries. Tax expense of
$36,650 was provided on the declaration of a $120,000 dividend from a foreign subsidiary and is reflected in the tax provision for the three months and six months ended June 30, 2004. The dividend was declared to increase the Companys future
flexibility to marshal the Companys foreign generated cash in the United States for operating and acquisition purposes, and to utilize United States deferred tax assets. Because the Company had sufficient net operating loss and tax credit
carryforwards to offset the tax liability for tax return purposes, the Company incurred a federal and state cash tax liability of approximately $3,000 as a result of the dividend and realized $33,650 of its deferred tax assets.



The Company has not provided for United States income taxes on the undistributed earnings of
foreign subsidiaries because they are considered permanently invested outside of the United States. Upon repatriation, some of these earnings would generate foreign tax credits which may reduce the Federal tax liability associated with any future
foreign dividend.



Under SFAS No. 109, Accounting for Income Taxes,
deferred tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are
expected to reverse. SFAS No. 109 provides for the recognition of deferred tax assets without a valuation allowance if realization of such assets is more likely than not. Based on the weight of available evidence, the Company has provided a
valuation allowance against certain deferred tax assets. A portion of the valuation allowance for deferred tax assets relates to the difference between financial and tax reporting of employee stock option exercises, for which subsequently recognized
tax benefits will be applied directly to increase contributed capital. A portion of the valuation allowance for deferred tax assets relates to certain of the tax attributes acquired from IKOS, for which subsequently recognized tax benefits will be
applied directly to reduce goodwill. The remainder of the valuation allowance was based on the historical earnings patterns within individual taxing jurisdictions that make it uncertain that the Company will have sufficient income in the appropriate
jurisdictions to realize the full value of the assets. The Company will continue to evaluate the realizability of the deferred tax assets on a quarterly basis.



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The Company recently settled an examination with the Internal Revenue Service for its U.S. federal income tax returns for
the years 2000 and 2001. The results of this exam have been reflected in the deferred tax asset balances and taxes payable balances as of June 30, 2004. There was no impact on tax expense because, as a result of audit findings, an additional
assessment of tax liability for the audit period had been adequately provided for in previous periods. See Factors that may affect future results and financial condition below. In addition, the Company is currently under examination by
the IRS for its 2002 federal income tax returns and will be for 2003 when the Company files that return. The Company is subject to income taxes in the United States and in numerous foreign jurisdictions and in the ordinary course of our business,
there are many transactions and calculations where the ultimate tax determination is uncertain.



Effects of Foreign Currency Fluctuations



More than half of the Companys revenues and approximately two-fifths of its expenses were generated outside of the United States for the first six months of 2004. For 2004 and 2003, approximately one-fourth of European and all
Japanese revenues were subject to exchange rate fluctuations as they were booked in local currencies. Most large European revenue contracts are denominated and paid to the Company in the United States dollar while the Companys European
expenses, including substantial research and development operations, are paid in local currencies causing a short position in the Euro and the British pound sterling. In addition, the Company experiences greater inflows than outflows of Japanese yen
as all Japanese-based customers contract and pay the Company in local currency. While these exposures are aggregated on a consolidated basis to take advantage of natural offsets, substantial exposure remains. For exposures that are not offset, the
Company enters into short-term foreign currency forward and option contracts to partially offset these anticipated exposures. The option contracts are generally entered into at contract strike rates that are different than current market rates. As a
result, any unfavorable currency movements below the strike rates will not be offset by the foreign currency option contract and could negatively affect operating results. These contracts address anticipated future cash flows for 90-day to one-year
periods and do not hedge 100% of the potential exposures related to these currencies. As a result, the effects of currency fluctuations could have a substantial effect on the Companys overall results of operations.



Foreign currency translation adjustment, a component of accumulated other comprehensive
income reported in the stockholders equity section of the consolidated balance sheets, decreased to $24,622 at June 30, 2004 from $25,922 at December 31, 2003. This reflects the decrease in the value of net assets denominated in foreign
currencies as a result of the strengthening of the United States dollar since year-end 2003.



LIQUIDITY AND CAPITAL RESOURCES



Cash, Cash Equivalents and Short-Term Investments



Total cash, cash equivalents and short-term investments at June 30, 2004 were $83,754 compared to $71,324 at December 31, 2003. Cash provided by operations was $15,794 in the first six months of 2004 compared to $26,214 during the same
period in 2003. The decrease in cash flows from operating activities was primarily due to payment of payroll and related liabilities in the first six months of 2004. This decrease was partially offset by an increase in deferred revenue.



Cash used for investing activities, excluding short-term investments, was $17,395 and
$23,331 in the first six months of 2004 and 2003, respectively. Cash used for investing activities included capital expenditures of $8,946 in the first six months of 2004 compared to $8,962 during the same period in 2003. Acquisition of businesses
and equity interests was $5,745 for the six months ended June 30, 2004 compared to $15,860 for the comparable period in 2003. Purchases of intangible assets were $2,704 for the six months ended June 30, 2004. There were no purchases of intangible
assets for the six months ended June 30, 2003.



Cash provided by financing
activities was $14,084 and $5,590 in the first six months of 2004 and 2003, respectively. Cash and short-term investments were positively impacted by proceeds from issuance of common stock upon exercise of stock options and employee stock plan
purchases of $11,015 and $3,992 during the six months ended June 30, 2004 and 2003, respectively. Cash provided by financing activities for the six months ended June 30, 2004 included proceeds from short-term borrowings, net of $4,069 compared to
$2,351 for the comparable period in 2003.



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Trade Accounts Receivable, net



Trade accounts receivable, net increased to $225,148 at June 30, 2004 from $223,670 at December 31, 2003. Excluding the current portion of
term receivables of $120,506 and $119,627, average days sales outstanding were 55 days and 46 days at June 30, 2004 and December 31, 2003, respectively. Average days sales outstanding in total accounts receivable increased from 100 days at December
31, 2003 to 119 days at June 30, 2004. The increase in days sales outstanding was primarily due to the decrease in revenue for the three months ended June 30, 2004 as compared to the three months ended December 31, 2003. In the quarters where term
contract revenue is recorded, only the first twelve months of the receivable is reflected in current trade accounts receivable. In the following quarters, the amount due in the next twelve months is reflected in current trade accounts receivable
without the corresponding revenue.



Inventory, Net



Inventory, net increased $866 from December 31, 2003 to June 30, 2004. The increase was
primarily due to purchases based on forecasted shipments of next generation emulation hardware systems.



Prepaid Expenses and Other



Prepaid expenses and other increased $3,272 from December 31, 2003 to June 30, 2004. The increase was primarily due to renewals of maintenance contracts and prepayments for benefits and sales commissions. The increase was partially offset
by the receipt of an income tax refund of $1,494.



Term Receivables,
Long-Term



Term receivables, long-term increased to $106,574 at June
30, 2004 compared to $98,207 at December 31, 2003. The balances were attributable to multi-year, multi-element term license sales agreements. Balances under term agreements that are due within one year are included in trade accounts receivable and
balances that are due in more than one year are included in term receivables, long-term. The Company uses term agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making
concessions on payments, products or services. The increase was attributable to new term agreements closed in the first half of 2004, primarily in Japan.



Accrued Payroll and Related Liabilities



Accrued payroll and related liabilities decreased $20,521 from December 31, 2003 to June 30, 2004. The decrease was primarily due to payments of the 2003 annual and
fourth quarter incentive compensation.



Deferred Revenue



Deferred revenue consists primarily of prepaid annual software
support contracts. Deferred revenue increased $29,394 from December 31, 2003 to June 30, 2004. The increase was primarily due to annual contract renewals in the first six months of 2004, higher renewal rates and support contracts moving from
quarterly to annual billing cycles.



Capital Resources



Expenditures for property and equipment decreased to $8,946 for the
first six months of 2004 compared to $8,962 for the same period in 2003. Expenditures in the first six months of 2004 and 2003 did not include any individually significant projects. In the first six months of 2004, the Company acquired (i) Project
Technology Inc., (ii) a minority equity interest in M2000, a French company and (iii) remaining 49% minority interest in MGK, which together resulted in total net cash payments of $4,680. Additionally, the Company paid $1,065 relating to holdbacks
on prior year acquisitions. The Company also paid $2,704 related to purchases of technology from (i) Atair and (ii) LSI Logic in the first six months of 2004. In the first six months of 2003, the Company acquired (i) the Technology Licensing Group
business of Alcatel, (ii) Translogic, (iii) the distributorship, Mentor Italia and (iv) the business and technology of DDE, which resulted in total net cash payments of $13,022. Additionally, the Company paid $4,070 relating to a holdback on a prior
year acquisition.



In August 2003, the Company issued $110,000 of Floating Rate
Convertible Subordinated Debentures (Debentures) due 2023 in a private offering pursuant to SEC Rule 144A for general corporate purposes and to fund the purchase of 1,750 shares of the Companys stock. The Debentures have been registered with
the SEC for resale under the Securities Act of 1933. Interest on the Debentures is payable quarterly at a variable interest rate equal to 3-month



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LIBOR plus 1.65%. The effective interest rate for the first six months of 2004 was 2.80%. The Company pays interest on
the Debentures quarterly in February, May, August and November. The Debentures are convertible, under certain circumstances, into the Companys common stock at a conversion price of $23.40 per share, for a total of 4,700 shares. These
circumstances generally include (a) the market price of the Companys common stock exceeding 120% of the conversion price, (b) the market price of the Debentures declining to less than 98% of the value of the common stock into which the
Debentures are convertible, or (c) a call for redemption of the Debentures or certain other corporate transactions. Some or all of the Debentures may be redeemed by the Company for cash on or after August 6, 2007. Some or all of the Debentures may
be redeemed at the option of the holder for cash on August 6, 2010, 2013 or 2018.



In June 2002, the Company issued $172,500 of 6-7/8% Convertible Subordinated Notes (Notes) due 2007 in a private offering pursuant to SEC Rule 144A to fund the purchase of Innoveda. The Notes have been registered with the SEC
under the Securities Act of 1933. The Company pays interest on the Notes semi-annually in June and December. The Notes are convertible into the Companys common stock at a conversion price of $23.27 per share, for a total of 7,413 shares. Some
or all of the Notes may be redeemed by the Company for cash on or after June 20, 2005.



In July 2003, the Company renewed its syndicated, senior, unsecured credit facility that allows the Company to borrow up to $100,000. This facility is a three-year revolving credit facility, which terminates on July 14, 2006. Under this
facility, the Company has the option to pay interest based on LIBOR plus a spread of between 1.25% and 2.00% or prime plus a spread of between 0% and 0.75%, based on a pricing grid tied to a financial covenant. As a result, the Companys
interest expense associated with borrowings under this credit facility will vary with market interest rates. In addition, commitment fees are payable on the unused portion of the credit facility at rates between 0.35% and 0.50% based on a pricing
grid tied to a financial covenant. The facility contains certain financial and other covenants, including financial covenants requiring the maintenance of specified liquidity ratios, leverage ratios and minimum tangible net worth. The Company had no
short-term borrowings against the credit facility at June 30, 2004.



The
Companys primary ongoing cash requirements will be for product development, operating activities, capital expenditures, debt service and acquisition opportunities that may arise. The Companys primary sources of liquidity are cash
generated from operations and borrowings under the revolving credit facility. The Company anticipates that current cash balances, anticipated cash flows from operating activities, including the effects of financing customer term receivables, and
amounts available under existing credit facilities will be sufficient to meet its working capital needs on a short-term and long-term basis. The Companys sources of liquidity could be adversely affected by a decrease in demand for the
Companys products or a deterioration of the Companys financial ratios.



Off-Balance Sheet Arrangements



The Company does not
have off-balance sheet arrangements, financings or other relationships with unconsolidated entities or other persons, also known as special purpose entities. In the ordinary course of business, the Company leases certain real properties, primarily
field office facilities, and equipment.



Outlook for Third Quarter 2004



Revenues for the third quarter are expected to be in the range of
$165,000-$170,000. Earnings per share are expected to range between $.01 and $.06.



FACTORS THAT MAY AFFECT FUTURE RESULTS AND FINANCIAL CONDITION



The statements contained under Outlook for Third Quarter 2004 above and other statements contained in this report that are not statements of historical fact, including without limitation, statements containing the words
believes, expects, projections and words of similar import, constitute forward-looking statements that involve a number of risks and uncertainties that are difficult to predict. Moreover, from time to time, the
Company may issue other forward-looking statements. Forward-looking statements regarding financial performance in future periods, including the statements above under Outlook for Third Quarter 2004, do not reflect potential impacts of
mergers or acquisitions or other significant transactions or events that have not been announced as of the time the statements are made. Actual outcomes and results may differ materially from what is expressed or forecast in forward-looking
statements. The Company disclaims any obligation to update forward-looking statements to reflect future events or revised expectations. The following discussion highlights factors that could cause actual results to differ materially from the results
expressed or implied by the Companys forward-looking statements. Forward-looking statements should be considered in light of these factors.



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Weakness in the United States and international economies may materially adversely affect the Company.



United States and international economies can experience an economic downturns, which may
have an adverse affect on the Companys results of operations. Weakness in these economies may adversely affect the timing and receipt of orders for the Companys products and the Companys results of operations. Revenue levels are
dependent on the level of technology capital spending, which include expenditures for EDA, software and other consulting services, in the United States and abroad. In addition, demand for the Companys products and services may be adversely
affected by mergers and company restructurings in the electronics industry worldwide which could result in decreased or delayed capital spending patterns.



The Company is subject to the cyclical nature of the integrated circuit and electronics systems industries and any future downturns may, materially adversely affect
the Company.



Purchases of the Companys products and services are
highly dependent upon new design projects initiated by integrated circuit manufacturers and electronics systems companies. The integrated circuit industry is highly cyclical and is subject to constant and rapid technological change, rapid product
obsolescence, price erosion, evolving standards, short product life cycles and wide fluctuations in product supply and demand. The integrated circuit and electronics systems industries regularly experience significant downturns, often connected
with, or in anticipation of, maturing product cycles of both companies in these industries and their customers products and a decline in general economic conditions. These downturns cause diminished product demand, production overcapacity,
high inventory levels and accelerated erosion of average selling prices. During such downturns, the number of new design projects generally decreases, which can adversely affect demand for the Companys products.



Fluctuations in quarterly results of operations due to the timing of significant orders
and the mix of licenses used to sell the Companys products could hurt the Companys business and the market price of the Companys common stock.



The Company has experienced, and may continue to experience, varied quarterly operating results. Various factors affect the Companys
quarterly operating results and some of these are not within the Companys control, including the timing of significant orders and the mix of licenses used to sell the Companys products. The Company receives a majority of its software
product revenue from current quarter order performance, of which a substantial amount is usually booked in the last few weeks of each quarter. A significant portion of the Companys revenue comes from multi-million dollar contracts, the timing
of the completion of and the terms of delivery of which can have a material impact on revenue recognition for a given quarter. If the Company fails to receive expected orders in a particular quarter, particularly large orders, the Companys
revenues for that quarter could be adversely affected and the Company could fail to meet investors expectations which could adversely affect the Companys stock price.



The Company uses fixed-term license agreements as a standard business practice. These multi-year, multi-element term license agreements are
typically three years in length, with payments spread over the license term and with customers the Company believes are credit-worthy. These agreements increase the risk associated with collectibility from customers that can arise for a variety of
reasons including ability to pay, product dissatisfaction, disagreements and disputes. If the Company is unable to collect under any of these multi-million dollar agreements, the Companys results of operations could be adversely affected.



The Company uses these fixed-term license agreements as a standard business
practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. If the Company no longer had a history of collecting without providing concessions on term
agreements, then revenue would be required to be recognized as the payments become due and payable over the license term. This change would have a material impact on the Companys results. In a situation in which a risk of concession may exist
on a term license agreement, revenue is recognized on a due and payable basis.



The Companys revenue is also affected by the mix of licenses entered into where the Company recognizes software product revenue as payments become due and payable or ratably over the license term as compared to revenue recognized at
the beginning of the license term. The Company recognizes revenue ratably over the license term when the customer is provided with rights to unspecified or unreleased future products. A shift in the license mix toward increased ratable or due and
payable revenue recognition would result in increased deferral of software product revenue to future periods and would decrease current revenue, possibly resulting in the Company not meeting revenue expectations.



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The accounting rules governing software revenue recognition have been subject to authoritative interpretations that have
generally made it more difficult to recognize software product revenue at the beginning of the license period. These new and revised standards and interpretations could adversely affect the Companys ability to meet revenue projections and
affect the Companys stock price.



The gross margin on the Companys
software products is greater than that for the Companys hardware products, software support and professional services. Therefore, the Companys gross margin may vary as a result of the mix of products and services sold. Additionally, the
margin on software products varies year to year depending on the amount of third-party royalties due to third parties from the Company for the mix of products sold. The Company also has a significant amount of fixed or relatively fixed costs, such
as professional service employee costs and purchased technology amortization, and costs which are committed in advance and can only be adjusted periodically. As a result, a small failure to reach planned revenue would have a great negative effect on
resulting earnings. If anticipated revenue does not materialize as expected, the Companys gross margins and operating results would be materially adversely affected.



Forecasting the Companys tax rates is complex and subject to uncertainty.



Forecasts of the Companys income tax position and resultant effective tax rate are
complex and subject to uncertainty as the Companys income tax position for each year combines the effects of a mix of profits (losses) earned by the Company and its subsidiaries in tax jurisdictions with a broad range of income tax rates as
well as benefits from available deferred tax assets and costs resulting from tax audits. In order to forecast the Companys global tax rate, pre-tax profits and losses by jurisdiction are estimated and tax expense by jurisdiction is calculated.
If the mix of profits and losses or effective tax rates by jurisdiction are different than those estimates, the Companys actual tax rate could be materially different than forecast.



Outcome of Internal Revenue Service and other tax authorities examinations could have a material adverse affect on the Company.



The Internal Revenue Service and other tax authorities regularly examine
the Companys income tax returns. Significant judgment is required in determining our provision for income taxes. In determining the adequacy of our income taxes, the Company assesses the likelihood of adverse outcomes resulting from the
Internal Revenue Service and other tax authorities examinations. The ultimate outcome of these examinations cannot be predicted with certainty. Should the Internal Revenue Service or other tax authorities assess additional taxes as a result of
examinations, the Company may be required to record charges to operations in future periods that could have a material impact on the results of operations, financial position or cash flows in the applicable period or periods recorded.



Limitations on the Effectiveness of Controls.



The Company does not expect that its disclosure controls or internal control over financial
reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control systems objectives will be met. Further, the design of a control
system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute
assurance that all control issues and instances of fraud, if any, within the Company have been detected.



The lengthy sales cycle for the Companys products and services and delay in customer consummation of projects makes the timing of the Companys revenue difficult to predict.



The Company has a lengthy sales cycle that generally extends between three and six months.
The complexity and expense associated with the Companys products and services generally requires a lengthy customer evaluation and approval process. Consequently, the Company may incur substantial expenses and devote significant management
effort and expense to develop potential relationships that do not result in agreements or revenue and may prevent the Company from pursuing other opportunities. In addition, sales of the Companys products and services may be delayed if
customers delay approval or commencement of projects because of customers budgetary constraints, internal acceptance review procedures, timing of budget cycles or timing of competitive evaluation processes.



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Any loss of the Companys leadership position in certain portions of the EDA market could have a material adverse
affect on the Company.



The industry in which the Company competes is
characterized by very strong leadership positions in specific portions of the EDA market. For example, one company may enjoy a large percentage of sales in the physical verification portion of the market while another will have a similarly strong
position in mixed-signal simulation. These strong leadership positions can be maintained for significant periods of time as the software is difficult to master and customers are disinclined to make changes once their employees, as well as others in
the industry, have developed familiarity with a particular software product. For these reasons, much of the Companys profitability arises from niche areas in which it is the strong leader. Conversely, it is difficult for the Company to achieve
significant profits in niche areas where other companies are the leaders. If for any reason the Company loses its leadership position in a niche, the Company could be materially adversely affected.



Intense competition in the EDA industry could materially adversely affect the Company.



Competition in the EDA industry is intense, which can lead to, among
other things, price reductions, longer selling cycles, lower product margins, loss of market share and additional working capital requirements. The Companys success depends upon the Companys ability to acquire or develop and market
products and services that are innovative and cost-competitive and that meet customer expectations.



The Company currently competes primarily with two large companies: Cadence Design Systems, Inc. and Synopsys, Inc. The Company also competes with numerous smaller companies, a number of which have combined with other
EDA companies. The Company also competes with manufacturers of electronic devices that have developed, or have the capability to develop, their own EDA products internally.



The Company may acquire other companies and may not successfully integrate them or the companies the Company has recently acquired.



The industry in which the Company competes has seen significant
consolidation in recent years. During this period, the Company has acquired numerous businesses, and it is frequently in discussions with potential acquisition candidates and may acquire other businesses in the future. For example, the Company is
frequently engaged in acquisition discussions with several companies. While the Company expects to carefully analyze all potential transactions before committing to them, the Company cannot assure that any transaction that is completed will result
in long-term benefits to the Company or its shareholders or that the Companys management will be able to manage the acquired businesses effectively. In addition, growth through acquisition involves a number of risks. If any of the following
events occurs after the Company acquires another business, it could materially adversely affect the Company:



| |  | difficulties in combining previously separate businesses into a single unit;
| | - | ----------------------------------------------------------------------------



| |  | the substantial diversion of managements attention from day-to-day business when evaluating and negotiating acquisition transactions and then integrating the acquired
business;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the discovery after the acquisition has been completed of liabilities assumed with the acquired business;
| | - | ---------------------------------------------------------------------------------------------------------



| |  | the failure to realize anticipated benefits, such as cost savings and revenue enhancements;
| | - | -------------------------------------------------------------------------------------------



| |  | the failure to retain key personnel of the acquired business;
| | - | -------------------------------------------------------------



| |  | difficulties related to assimilating the products of an acquired business in, for example, distribution, engineering and customer support areas;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  | unanticipated costs;
| | - | --------------------



| |  | adverse effects on existing relationships with suppliers and customers; and
| | - | ---------------------------------------------------------------------------



| |  | failure to understand and compete effectively in markets in which we have limited previous experience.
| | - | ------------------------------------------------------------------------------------------------------



Acquired businesses may not perform as projected, which could result in impairment of acquisition-related intangible assets. Additional
challenges include integration of sales channels, training and education of the sales force for new



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product offerings, integration of product development efforts, integration of systems of internal controls and
integration of information systems. Accordingly, in any acquisition there will be uncertainty as to the achievement and timing of projected synergies, cost savings and sales levels for acquired products. All of these factors can impair the
Companys ability to forecast, meet revenue and earnings targets and manage effectively the Companys business for long-term growth. The Company cannot assure that it can effectively meet these challenges.



Risks of international operations and the effects of foreign currency fluctuations can
adversely impact the Companys business and operating results.



The
Company realizes more than half of the Companys revenue from customers outside the United States and approximately two-fifths of the Companys expenses are generated outside of the United States. Significant changes in exchange rates can
have an adverse effect on the Company. For further discussion of foreign currency effects, see Effects of Foreign Currency Fluctuations discussion above. In addition, international operations subject the Company to other risks including
longer receivables collection periods, changes in a specific countrys or regions economic or political conditions, trade protection measures, import or export licensing requirements, loss or modification of exemptions for taxes and
tariffs, limitations on repatriation of earnings and difficulties with licensing and protecting the Companys intellectual property rights.



Delay in production of components or the ordering of excess components for the Companys Mentor Emulation Division hardware products could materially adversely
affect the Company.



The success of the Companys Mentor Emulation
Division depends on the Companys ability to:



| |  | procure hardware components on a timely basis from a limited number of suppliers;
| | - | ---------------------------------------------------------------------------------



| |  | assemble and ship systems on a timely basis with appropriate quality control;
| | - | -----------------------------------------------------------------------------



| |  | develop distribution and shipment processes;
| | - | --------------------------------------------



| |  | manage inventory and related obsolescence issues; and
| | - | -----------------------------------------------------



| |  | develop processes to deliver customer support for hardware
| | - | ----------------------------------------------------------



The Companys inability to be successful in any of the foregoing could materially adversely affect the Company.



The Company occasionally commits to purchase component parts from suppliers based on sales
forecasts of the Companys Mentor Emulation Division products. If the Company cannot change or be released from these non-cancelable purchase commitments, or if orders for the Companys products do not materialize as anticipated, the
Company could incur significant costs related to the purchase of excess components which could become obsolete before the Company can use them. Additionally, a delay in production of the components could materially adversely affect the
Companys operating results.



The Companys failure to obtain
software or other intellectual property licenses or adequately protect the Companys proprietary rights could materially adversely affect the Company.



The Companys success depends, in part, upon the Companys proprietary technology. Some of the Companys products include software or other intellectual
property licensed from third parties, and the Company may have to seek new licenses or renew existing licenses for software and other intellectual property in the future. The Companys failure to obtain software or other intellectual property
licenses or rights on favorable terms, or the need to engage in litigation over these licenses or rights, could materially adversely affect the Company.



The Company generally relies on patents, copyrights, trademarks, trade secret laws, licenses and restrictive agreements to establish and protect the Companys
proprietary rights in technology and products. Despite precautions the Company may take to protect the Companys intellectual property, the Company cannot assure that third parties will not try to challenge, invalidate or circumvent these
safeguards. The Company also cannot assure that the rights granted under the Companys patents will provide it with any competitive advantages, that patents will be issued on any of the Companys pending applications or that future patents
will be sufficiently broad to protect the Companys technology. Furthermore, the laws of foreign countries may not protect the Companys proprietary rights in those countries to the same extent as United States law protects these rights in
the United States.



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The Company cannot assure you that the Companys reliance on licenses from or to, or restrictive agreements with,
third parties, or that patent, copyright, trademark and trade secret protections, will be sufficient for success and profitability in the industries in which it competes.



Future litigation proceedings may materially adversely affect the Company.



Future litigation matters may have a material adverse effect on the Company. Any future
litigation may result in injunctions against future product sales and substantial unanticipated legal costs and divert the efforts of management personnel, any and all of which could materially adversely affect the Company.



Errors or defects in the Companys products and services could expose us to liability
and harm the Companys reputation.



The Companys customers use
the Companys products and services in designing and developing products that involve a high degree of technological complexity and have unique specifications. Because of the complexity of the systems and products with which the Company works,
some of the Companys products and designs can be adequately tested only when put to full use in the marketplace. As a result, the Companys customers or their end users may discover errors or defects in the Companys software or the
systems we design, or the products or systems incorporating the Companys designs and intellectual property may not operate as expected. Errors or defects could result in:



| |  | loss of current customers and loss of, or delay in, revenue and loss of market share;
| | - | -------------------------------------------------------------------------------------



| |  | failure to attract new customers or achieve market acceptance;
| | - | --------------------------------------------------------------



| |  | diversion of development resources to resolve the problems resulting from errors or defects; and
| | - | ------------------------------------------------------------------------------------------------



| |  | increased service costs.
| | - | ------------------------



The Companys failure to attract and retain key employees may harm the Company.



The Company depends on the efforts and abilities of the Companys senior management, the Companys research and development staff and a number of other key
management, sales, support, technical and services personnel. Competition for experienced, high-quality personnel is intense, and the Company cannot assure that it can continue to recruit and retain such personnel. The failure by the Company to hire
and retain such personnel would impair the Companys ability to develop new products and manage the Companys business effectively.



Terrorist attacks and other acts of violence or war may materially adversely affect the markets on which the Companys securities trade, the markets in which the
Company operates, the Companys operations and the Companys profitability.



Terrorist attacks may negatively affect the Companys operations and investment in the Companys business. These attacks or armed conflicts may directly impact the Companys physical facilities or those
of the Companys suppliers or customers. Furthermore, these attacks may make travel and the transportation of the Companys products more difficult and more expensive and ultimately affect the Companys sales.



Any armed conflict entered into by the United States could have an impact on the
Companys sales and the Companys ability to deliver products to the Companys customers. Political and economic instability in some regions of the world may also result from an armed conflict and could negatively impact the
Companys business. The Company currently has operations in Pakistan, Egypt and Israel, countries that maybe particularly susceptible to this risk. The consequences of any armed conflict are unpredictable, and the Company may not be able to
foresee events that could have an adverse effect on the Companys business.



More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the United States and worldwide financial markets and economy. They also could result in or exacerbate
economic recession in the United States or abroad. Any of these occurrences could have a significant impact on the Companys operating results, revenues and costs and may result in volatility of the market price for the Companys
securities.



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The Companys articles of incorporation, Oregon law and the Companys shareholder rights plan may have
anti-takeover effects.



The Companys board of directors has the
authority, without action by the shareholders, to designate and issue up to 1,200,000 shares of incentive stock in one or more series and to designate the rights, preferences and privileges of each series without any further vote or action by the
shareholders. Additionally, the Oregon Control Share Act and the Business Combination Act limit the ability of parties who acquire a significant amount of voting stock to exercise control over the Company. These provisions may have the effect of
lengthening the time required for a person to acquire control of the Company through a proxy contest or the election of a majority of the board of directors. In February 1999, the Company adopted a shareholder rights plan which has the effect of
making it more difficult for a person to acquire control of the Company in a transaction not approved by the Companys board of directors. The potential issuance of incentive stock, the provisions of the Oregon Control Share Act and the
Business Combination Act and the Companys shareholder rights plan may have the effect of delaying, deferring or preventing a change of control of the Company, may discourage bids for the Companys common stock at a premium over the market
price of the Companys common stock and may adversely affect the market price of, and the voting and other rights of the holders of, the Companys common stock.



Item 3. Quantitative And Qualitative Disclosures About Market Risk

(All numerical references in thousands, except for rates and
percentages)



INTEREST RATE RISK



The Company is exposed to interest rate risk primarily through its investment portfolio,
short-term borrowings and long-term notes payable. The Company does not use derivative financial instruments for speculative or trading purposes.



The Company places its investments in instruments that meet high credit quality standards, as specified in the Companys investment policy. The policy also limits
the amount of credit exposure to any one issuer and type of instrument. The Company does not expect any material loss with respect to its investment portfolio.



The table below presents the carrying value and related weighted-average fixed interest rates for the Companys investment portfolio. The carrying value
approximates fair value at June 30, 2004. In accordance with the Companys investment policy, all investments mature in twelve months or less.



|                                                      |  |                 |        |                             |      |  
|----------------------------------------------------- |  | --------------- | ------ | --------------------------- | ---- | -
|Principal (notional) amounts in United States dollars |  | Carrying Amount |        | Average Fixed Interest Rate |     
|Cash equivalents  fixed rate                         |  | $               | 44,624 |                             | 1.35 | %
|Short-term investments  fixed rate                   |  |                 | 8,825  |                             | 1.19 | %
|                                                      |  |                 |        |                             |      |  
|Total fixed rate interest bearing instruments         |  | $               | 53,449 |                             | 1.32 | %
|                                                      |  |                 |        |                             |      |  



The Company had convertible
subordinated notes of $172,500 outstanding with a fixed interest rate of 6 7/8% at June 30, 2004. For fixed rate debt, interest rate changes affect the fair value of the notes but do not affect earnings or cash flow.



The Company had floating rate convertible subordinated debentures of $110,000 outstanding
with a variable interest rate of 3-month LIBOR plus 1.65% at June 30, 2004. For variable interest rate debt, interest rate changes affect earnings and cash flow. If the interest rates on the variable rate borrowings were to increase or decrease by
1% for the year and the level of borrowings outstanding remained constant, annual interest expense would increase or decrease by approximately $1,100.



At June 30, 2004, Company had a three-year revolving credit facility, which terminates on July 14, 2006, which allows the Company to borrow up to $100,000. Under this
facility, the Company has the option to pay interest based on LIBOR plus a spread of between 1.25% and 2.00% or prime plus a spread of between 0% and 0.75%, based on a pricing grid tied to a financial covenant. As a result, the Companys
interest expense associated with borrowings under this credit facility will vary with market interest rates. The Company had no short-term borrowings against the credit facility at June 30, 2004.



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The Company had other long-term notes payable of $3,299 and short-term borrowings of $11,024 outstanding at June 30, 2004
with variable rates based on market indexes. For variable rate debt, interest rate changes generally do not affect the fair market value, but do affect future earnings or cash flow. If the interest rates on the variable rate borrowings were to
increase or decrease by 1% for the year and the level of borrowings outstanding remained constant, annual interest expense would increase or decrease by approximately $143.



FOREIGN CURRENCY RISK



The Company transacts business in various foreign currencies and has established a foreign currency hedging program to hedge certain foreign currency forecasted
transactions and exposures from existing assets and liabilities. Derivative instruments held by the Company consist of foreign currency forward and option contracts. The Company enters into contracts with counterparties who are major financial
institutions and believes the risk related to default is remote. The Company does not hold or issue derivative financial instruments for trading purposes.



The Company enters into foreign currency option contracts for forecasted revenues and expenses between its foreign subsidiaries. These instruments provide the Company the
right to sell/purchase foreign currencies to/from third parties at future dates with fixed exchange rates. As of June 30, 2004, the Company had options outstanding to sell Japanese yen with contract values totaling approximately $41,351 at a
weighted average contract rate of 113.66 and had options outstanding to buy the Euro with contract values totaling $26,945 at a weighted average contract rate of 1.26.



The Company enters into foreign currency forward contracts to protect against currency exchange risk associated with expected future cash
flows and existing assets and liabilities. For further discussion of foreign currency effects, see Effects of Foreign Currency Fluctuations discussion under Item 2. Managements Discussion and Analysis of Results of Operations
and Financial Condition above.



The table provides information as of June
30, 2004 about the Companys foreign currency forward contracts. The information provided is in United States dollar equivalent amounts. The table presents the notional amounts, at contract exchange rates, and the weighted average contractual
foreign currency exchange rates.



|                       |  |                 |         |                               |        |                   |    
|---------------------- |  | --------------- | ------- | ----------------------------- | ------ | ----------------- | ---
|                       |  | Notional Amount |         | WeightedAverage Contract Rate |        | Contract Currency
|Forward Contracts:     |  |                 |         |                               |        |                   |    
|Japanese yen           |  | $               | 55,201  |                               | 106.25 |                   | JPY
|Euro                   |  |                 | 37,504  |                               | 1.22   |                   | USD
|Canadian dollar        |  |                 | 5,302   |                               | 1.38   |                   | CAD
|Taiwan dollar          |  |                 | 2,627   |                               | 33.73  |                   | TWD
|British pound sterling |  |                 | 1,453   |                               | 1.82   |                   | USD
|Norway krona           |  |                 | 1,092   |                               | 6.93   |                   | NOK
|Other                  |  |                 | 3,913   |                               |       |                   |    
|                       |  |                 |         |                               |        |                   |    
|Total                  |  | $               | 107,092 |                               |        |                   |    
|                       |  |                 |         |                               |        |                   |    



Item 4. Controls and Procedures



The Company
maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Companys Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the
SECs rules and forms, and that such information is accumulated and communicated to the Companys management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required
disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control
objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.



The Company carried out an evaluation, under the supervision and with the participation of the Companys management, including the Companys Chief Executive
Officer and the Companys Chief Financial Officer, of the effectiveness of the design and operation of the Companys disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, the
Companys Chief Executive Officer and Chief Financial Officer concluded that the Companys disclosure controls and procedures were effective.



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Internal Control Over Financial Reporting



There has been no change in the Companys internal control over financial reporting
that occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Companys internal control over financial reporting.



PART II. OTHER INFORMATION



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



The 2004 Annual Meeting of Shareholders of the Company was held pursuant to notice at 5:00 p.m. Pacific time on May 19, 2004 at the Companys offices in Wilsonville, Oregon to consider and vote upon



|           |  |                                                                                                                                                        
|---------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------
|Proposal 1 |  | To elect directors to serve for the ensuing year and until their successors are elected                                                                
|Proposal 2 |  | To amend the Companys 1989 Employee Stock Purchase Plan to increase the number of shares reserved for issuance under the plan.                        
|Proposal 3 |  | To approve the Companys Foreign Subsidiary Employee Stock Purchase Plan                                                                               
|Proposal 4 |  | To amend the Companys 1982 Stock Option Plan to increase the number of shares reserved for issuance under the plan.                                   
|Proposal 5 |  | To amend Article III of the Companys 1987 Restated Articles of Incorporation, as amended, to increase the number of authorized shares of Common Stock.



The results of the voting on these
proposals was as follows:



Proposal 1



|                       |  |            |  |          
|---------------------- |  | ---------- |  | ---------
|Election of Directors  |  | For        |  | Withheld 
|Marsha B. Congdon      |  | 65,279,400 |  | 1,836,328
|Gregory K. Hinckley    |  | 65,279,400 |  | 1,836,328
|Kevin C. McDonough     |  | 65,279,400 |  | 1,836,328
|Walden C. Rhines       |  | 65,279,400 |  | 1,836,328
|Fontaine K. Richardson |  | 65,279,400 |  | 1,836,328
|Sir Peter Bonfield     |  | 65,279,325 |  | 1,836,403
|James R. Fiebiger      |  | 65,279,310 |  | 1,836,418
|Patrick B. McManus     |  | 65,279,210 |  | 1,836,518



|           |  |            |  |            |  |             |  |                 
|---------- |  | ---------- |  | ---------- |  | ----------- |  | ----------------
|           |  | For        |  | Against    |  | Abstentions |  | Broker Non-Votes
|Proposal 2 |  | 50,242,401 |  | 6,399,028  |  | 702,457     |  | 9,771,842       
|Proposal 3 |  | 50,460,687 |  | 6,181,019  |  | 702,180     |  | 9,771,842       
|Proposal 4 |  | 31,705,939 |  | 24,932,487 |  | 705,460     |  | 9,771,842       
|Proposal 5 |  | 61,648,470 |  | 5,286,076  |  | 181,182     |  |                



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Item 6. Exhibits and Reports on Form 8-K.

(All numerical references in thousands)



|(a) | Exhibits
|--- | --------



|      |  |                                                                                                                                                                                             
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.A.  |  | 1987 Restated Articles of Incorporation, as amended.                                                                                                                                        
|      | 
|10.A. |  | 1982 Stock Option Plan.                                                                                                                                                                     
|      | 
|31.1  |  | Certification of Chief Executive Officer of Registrant Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                      
|      | 
|31.2  |  | Certification of Chief Financial Officer of Registrant Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                      
|      | 
|32    |  | Certification of Chief Executive Officer and Chief Financial Officer of Registrant Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.



|(b) | Reports on Form 8-K
|--- | -------------------



On April 22, 2004, the Company filed a current report on Form 8-K to report under Item 9 and 12 that on April 22, 2004, the Company had announced
financial results for the first quarter of 2004 and provided outlook for the second quarter of 2004 and the full year of 2004.



On April 26, 2004, the Company filed an amended current report on Form 8-K/A to furnish information inadvertently omitted from the current report filed on
April 22, 2004.



SIGNATURES



Pursuant to the requirements 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.



|                      |  |                            
|--------------------- |  | ---------------------------
|Dated: August 6, 2004 |  | MENTOR GRAPHICS CORPORATION
|                      |  | (Registrant)               
|                      | 
|                      |  | /s/ Gregory K. Hinckley    
|                      |  | Gregory K. Hinckley        
|                      |  | President                  



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