** **

**SECURITIES AND EXCHANGE COMMISSION**WASHINGTON,D.C. 20549

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**FORM 10-Q**

**x**                               QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESAND EXCHANGE ACT OF 1934

**For the Quarterly PeriodEnded September 30, 2006**

**OR**

**o**                                  TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF1934

**For the transition period from                        to**                              

**CommissionFile No. 0-27246**

**ZORANCORPORATION**

**(Exactname of registrant as specified in its charter)**

** **
| **Delaware**                       | **94-2794449**         |
|------------------------------------|------------------------|
| (State or other  jurisdiction      | (I.R.S. Employer       |
| of incorporation or  organization) | Identification Number) |

 

**1390 Kifer Road**

**Sunnyvale, California 94086**

(Address ofprincipal executive offices, including zip code)

**(408) 523-6500**

(Registrant’s telephonenumber, including area code)

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Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes o  No x

Indicate by check mark whetherregistrant is a large accelerated filer, an accelerated filer or anon-accelerated filer.  See definition of“accelerated and large accelerated filer” in Rule 12b-2 of the ExchangeAct.  (Check one):

Large accelerated filer  x   Accelerated filer   o   Non accelerated-filer  o

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act) Yes oNo x

As of November 9, 2006,there were outstanding 49,433,780 shares of the registrant’s Common Stock, parvalue $0.001 per share.

 

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**ZORAN CORPORATION ANDSUBSIDIARIES**

**FORM 10-Q**

**INDEX**

**For theQuarter Ended September 30, 2006**
|                                 | ** **                                                                                                                            | **Page** |
|---------------------------------|---------------------------------------------------------------------------------------------------------------------------------------|----------|
| ** **                      |
|                            | Explanatory  Note Regarding Restatements                                                                                              | ii       |
|                            |                                                                                                                                  |     |
|                            | **PART  I. FINANCIAL INFORMATION**                                                                                                    |     |
|                            |                                                                                                                                  |     |
| **Item 1.**                     | Financial Statements (Unaudited):                                                                                                     |     |
|                            |                                                                                                                                  |     |
|                            | Condensed  Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005,  as restated                                   | 1        |
|                            |                                                                                                                                  |     |
|                            | Condensed Consolidated Statements of Operations for  the Three Months and Nine Months Ended September 30, 2006 and 2005, as  restated | 2        |
|                            |                                                                                                                                  |     |
|                            | Condensed  Consolidated Statements of Cash Flows for the Nine Months Ended September 30,  2006 and 2005, as restated                  | 3        |
|                            |                                                                                                                                  |     |
|                            | Notes to Condensed Consolidated Financial Statements                                                                                  | 4        |
|                            |                                                                                                                                  |     |
| **Item 2.**                     | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                           | 25       |
|                            |                                                                                                                                  |     |
| **Item 3.**                     | Quantitative and Qualitative Disclosures About Market  Risk                                                                           | 35       |
| ** **                      |                                                                                                                                  |     |
| **Item 4.**                     | Controls and Procedures                                                                                                               | 36       |
| ** **                      |                                                                                                                                  |     |
|                            |                                                                                                                                  |     |
|                            |                                                                                                                                  |     |
| **PART  II. OTHER INFORMATION** |
|                            |                                                                                                                                  |     |
| **Item  1.**                    | Legal  Proceedings                                                                                                                    | 38       |
|                            |                                                                                                                                  |     |
| **Item  1A.**                   | Risk Factors                                                                                                                          | 39       |
| ** **                      |                                                                                                                                  |     |
| **Item 6.**                     | Exhibits                                                                                                                              | 52       |
| ** **                      |                                                                                                                                  |     |
| Signatures                      |                                                                                                                                  | 53       |
|                                 |                                                                                                                                       |          |  |

 

 

i

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**EXPLANATORY NOTE REGARDINGRESTATEMENTS**

In this Quarterly Reporton Form 10-Q for the quarter ended September 30, 2006 we have restated ourcondensed consolidated financial statements for the three and six months endedSeptember  30, 2005, and the relateddisclosures. The restatements reflected in this report include adjustmentsarising from an independent investigation of Zoran’s historical stock optionpractices and related accounting for option grants.  For more information on these matters,including a detailed discussion of the effect of the restatement, please referto Note 2, “Restatement of Condensed Consolidated Financial Statements” of theNotes to Condensed Consolidated Financial Statements.

ii

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**PART I. FINANCIAL INFORMATION**

**Item 1.Financial Statements (Unaudited):**

**ZORAN CORPORATION**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands, except share data)**

**(unaudited)**
| ** **                                                                                                                                                                                                                                                          | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                          | ** ** | ** **                   | ** ** | **(Restated) (1)**     | ** ** |
| ASSETS                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Current assets:                                                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                          |       | $                            | 86,551     |                        | $          | 78,856 |   |
| Short-term  investments                                                                                                                                                                                                                                             |       | 193,709                      |       | 70,490                      |       |
| Accounts  receivable, net                                                                                                                                                                                                                                           |       | 62,969                       |       | 70,174                      |       |
| Inventories                                                                                                                                                                                                                                                         |       | 45,247                       |       | 32,616                      |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                                                          |       | 7,643                        |       | 11,746                      |       |
| Total current  assets                                                                                                                                                                                                                                               |       | 396,119                      |       | 263,882                     |       |
| Property and  equipment, net                                                                                                                                                                                                                                        |       | 14,374                       |       | 16,057                      |       |
| Other assets and  investments                                                                                                                                                                                                                                       |       | 22,763                       |       | 20,799                      |       |
| Goodwill                                                                                                                                                                                                                                                            |       | 178,662                      |       | 182,662                     |       |
| Intangible  assets, net                                                                                                                                                                                                                                             |       | 81,338                       |       | 119,231                     |       |
|                                                                                                                                                                                                                                                                |       | $                            | 693,256    |                        | $          | 602,631 |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                                                                                          |       |                         |       |                        |       |
| Current  liabilities:                                                                                                                                                                                                                                               |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                    |       | $                            | 38,224     |                        | $          | 38,999 |   |
| Accrued expenses  and other liabilities                                                                                                                                                                                                                             |       | 52,214                       |       | 54,769                      |       |
| Total current  liabilities                                                                                                                                                                                                                                          |       | 90,438                       |       | 93,768                      |       |
| Other long-term  liabilities                                                                                                                                                                                                                                        |       | 12,282                       |       | 11,939                      |       |
| Commitments and  Contingencies (Note 12)                                                                                                                                                                                                                            |       |                         |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                                                                                          |       |                         |       |                        |       |
| Common stock,  $0.001 par value; 105,000,000 shares authorized at   September 30, 2006 and December 31, 2005; 49,403,869 shares issued and   outstanding as of September 30, 2006; and 45,426,912 shares issued and   outstanding as of December 31, 2005 |       | 49                           |       | 45                          |       |
| Additional paid-in  capital                                                                                                                                                                                                                                         |       | 803,464                      |       | 738,253                     |       |
| Deferred stock-based  compensation                                                                                                                                                                                                                                  |       | —                       |       | (593                        | )          |
| Accumulated  other comprehensive income                                                                                                                                                                                                                             |       | 3,548                        |       | 3,057                       |       |
| Accumulated  deficit                                                                                                                                                                                                                                                |       | (216,525                     | )          | (243,838                    | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                    |       | 590,536                      |       | 496,924                     |       |
|                                                                                                                                                                                                                                                                |       | $                            | 693,256    |                        | $          | 602,631 |   |

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(1) See Note 2, “Restatementof Condensed Consolidated Financial Statements” of the Notes to CondensedConsolidated Financial Statements.

The accompanying notesare an integral part of these unaudited condensed consolidated financialstatements.

1

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**ZORAN CORPORATION**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands, except per sharedata)**

**(unaudited)**
| ** **                                                                     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                     | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                     | ** ** | ** **                       | ** ** | **(Restated)(1)**               | ** ** | ** ** | ** ** | **(Restated)(1)** | ** ** |
| Revenues:                                                                      |       |                             |       |                            |       |   |   |   |   |
| Hardware product  revenues                                                     |       | $                                | 115,602    |                            | $          | 104,208 |   | $ | 323,007 |   | $ | 244,107 |   |
| Software and  other revenues                                                   |       | 13,777                           |       | 13,276                          |       | 40,755 |   | 42,340 |   |
| License revenues  related to litigation settlement                             |       | —                           |       | —                          |       | 35,792 |   | — |   |
| Total revenues                                                                 |       | 129,379                          |       | 117,484                         |       | 399,554 |   | 286,447 |   |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Costs and expenses:                                                            |       |                             |       |                            |       |   |   |   |   |
| Cost of hardware  product revenues                                             |       | 66,810                           |       | 53,909                          |       | 180,815 |   | 136,220 |   |
| Research and  development                                                      |       | 25,255                           |       | 23,682                          |       | 74,729 |   | 65,292 |   |
| Selling, general  and administrative                                           |       | 25,907                           |       | 22,275                          |       | 80,917 |   | 69,869 |   |
| Amortization of  intangible assets                                             |       | 12,423                           |       | 12,757                          |       | 37,893 |   | 37,518 |   |
| Amortization of  stock-based compensation resulting from business combinations |       | —                           |       | 344                             |       | — |   | 1,318 |   |
| In process  research and development                                           |       | —                           |       | —                          |       | — |   | 2,650 |   |
| Total costs and  expenses                                                      |       | 130,395                          |       | 112,967                         |       | 374,354 |   | 312,867 |   |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Operating income (loss)                                                        |       | (1,016                           | )          | 4,517                           |       | 25,200 |   | (26,420 | ) |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Interest income                                                                |       | 3,079                            |       | 646                             |       | 7,539 |   | 1,726 |   |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Other income (loss),  net                                                      |       | (281                             | )          | 32                              |       | 496 |   | (609 | ) |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Income (loss) before  income taxes                                             |       | 1,782                            |       | 5,195                           |       | 33,235 |   | (25,303 | ) |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Provision of (benefit  for) for income taxes                                   |       | (70                              | )          | 1,200                           |       | 5,921 |   | 1,200 |   |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Net income (loss)                                                              |       | $                                | 1,852      |                            | $          | 3,995 |   | $ | 27,314 |   | $ | (26,503 | ) |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Basic net income (loss)  per share                                             |       | $                                | 0.04       |                            | $          | 0.09 |   | $ | 0.57 |   | $ | (0.60 | ) |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Diluted net income  (loss) per share                                           |       | $                                | 0.04       |                            | $          | 0.09 |   | $ | 0.54 |   | $ | (0.60 | ) |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Shares used to compute  basic net income (loss) per share                      |       | 49,333                           |       | 44,877                          |       | 48,013 |   | 43,942 |   |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Shares used to compute diluted net income (loss) per share                     |       | 50,712                           |       | 46,622                          |       | 50,286 |   | 43,942 |   |

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(1) See Note 2, “Restatementof Condensed Consolidated Financial Statements” of the Notes to CondensedConsolidated Financial Statements.

The accompanying notesare an integral part of these unaudited condensed consolidated financialstatements.

2

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**ZORAN CORPORATION**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**
| ** **                                                                        | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                        | ** ** | **September 30,**          | ** ** |
| ** **                                                                        | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| ** **                                                                        | ** ** | ** **                      | ** ** | **(Restated)(1)** | ** ** |
| Cash flows from  operating activities:                                            |       |                            |       |   |   |
| Net income (loss)                                                                 |       | $                               | 27,314     |   | $ | (26,503 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operations:   |       |                            |       |   |   |
| Depreciation                                                                      |       | 7,093                           |       | 7,727 |   |
| Amortization                                                                      |       | 37,930                          |       | 37,588 |   |
| Stock-based compensation expense                                                  |       | 13,729                          |       | 2,835 |   |
| In process research and development                                               |       | —                          |       | 2,650 |   |
| Changes in current assets and liabilities:                                        |       |                            |       |   |   |
| Accounts receivable                                                               |       | 7,205                           |       | (20,496 | ) |
| Inventories                                                                       |       | (12,631                         | )          | 22,915 |   |
| Prepaid expenses and other current assets and other  assets                       |       | 1,216                           |       | 738 |   |
| Accounts payable                                                                  |       | (775                            | )          | 3,238 |   |
| Accrued expenses and other liabilities, goodwill and  other long term liabilities |       | 1,787                           |       | 2,958 |   |
| Net cash provided by operating activities                                         |       | 82,868                          |       | 33,650 |   |
|                                                                              |       |                            |       |   |   |
| Cash flows from  investing activities:                                            |       |                            |       |   |   |
| Purchases of property and equipment                                               |       | (5,429                          | )          | (6,419 | ) |
| Purchases of investments                                                          |       | (309,477                        | )          | (15,723 | ) |
| Proceeds from sales and maturities of investments                                 |       | 187,654                         |       | 37,808 |   |
| Acquisition of Oren Semiconductor, Inc. net of cash  acquired                     |       | —                          |       | (27,567 | ) |
| Net cash used in investing activities                                             |       | (127,252                        | )          | (11,901 | ) |
|                                                                              |       |                            |       |   |   |
| Cash flows from  financing activities:                                            |       |                            |       |   |   |
| Proceeds from issuance of common stock                                            |       | 52,079                          |       | 5,598 |   |
| Net cash provided by financing activities                                         |       | 52,079                          |       | 5,598 |   |
|                                                                              |       |                            |       |   |   |
| Net increase in  cash and cash equivalents                                        |       | 7,695                           |       | 27,347 |   |
|                                                                              |       |                            |       |   |   |
| Cash and cash  equivalents at beginning of period                                 |       | 78,856                          |       | 37,435 |   |
|                                                                              |       |                            |       |   |   |
| Cash and cash  equivalents at end of period                                       |       | $                               | 86,551     |   | $ | 64,782 |   |

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(1) See Note 2, “Restatementof Condensed Consolidated Financial Statements” of the Notes to Condensed ConsolidatedFinancial Statements.

The accompanying notesare an integral part of these unaudited condensed consolidated financialstatements.

3

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**ZORAN CORPORATION**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

**1.****              Basis ofPresentation**

The accompanyingunaudited condensed consolidated financial statements of Zoran Corporation andits subsidiaries (“Zoran” or the “Company”) have been prepared in conformitywith accounting principles generally accepted in the United States ofAmerica.  However, certain information orfootnote disclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States of Americahave been condensed or omitted pursuant to the rules and regulations of theSecurities and Exchange Commission (“SEC”). In the opinion of management, the condensed consolidated financialstatements reflect all adjustments considered necessary, consisting only ofnormal recurring adjustments, considered necessary for a fair statement of theconsolidated financial position, operating results and cash flows for theperiods presented.  The results ofoperations for the interim periods presented are not necessarily indicative ofthe results that may be expected for the full fiscal year or in any futureperiod.  This Quarterly Report on Form10-Q should be read in conjunction with the audited consolidated financialstatements and notes thereto for the year ended December 31, 2006,included in the Company’s 2005 Annual Report on Form 10-K.

***Revenues***

Revenues for the nine month period ended September30, 2006 include $35.8 million in license payments related to the settlement oflitigation, net of  withholding tax andamounts paid to holders of rights under certain patents involved in thelitigation and amounts payable as legal fees. The license agreements providefor additional cash  royalty payments ofup to $30.0 million payable in eleven quarterly installments which are recordedas software and other revenues when actual cash payments are received, net ofamounts paid to holders of rights under certain patents involved in the litigationand amounts payable as legal fees. Accordingly, the Company recorded $1.5million and $2.5 million as software and other revenues during the three andnine month periods ended September 30, 2006 and as of September 30, 2006, up to$12.8 million in future royalty payments were payable to Zoran under theseagreements.

***RecentAccounting Pronouncements***

In September 2006, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFASNo. 157 establishes a common definition for fair value to be applied to US GAAPguidance requiring use of fair value, establishes a framework for measuringfair value, and expands disclosure about such fair value measurements. Thisstatement is effective for the Company’s fiscal year ending December 31, 2008.The company is currently evaluating whether the adoption of SFAS No. 157 willhave a material effect on its condensed consolidated financial statements.

In June 2006, the FASB published FIN 48, “Accounting forUncertainty in Income Taxes—an interpretation of FASB Statement No. 109”which clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with SFAS No. 109,Accounting for Income Taxes. This Interpretation prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.This Interpretation also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure, andtransition. This Interpretation is effective for the Company in fiscal yearsbeginning January 1, 2007. The impact of the provisions of thisInterpretation on the Company’s retained earnings is expected to be less than$5 million.

In February 2006, theFASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments,an amendment of FASB Statements No. 133 and 140” (“SFAS No.155”).  SFAS No. 155 permits fair value remeasurementfor hybrid financial instruments containing an embedded derivative whichotherwise requires bifurcation.  Thisstatement is effective for all financial instruments acquired or issued by theCompany after January 1, 2007.  The Companyanticipates that the adoption of SFAS No. 155 will not have a material impacton its condensed consolidated financial statements.

In December 2004, the FASB, issued SFASNo. 123(R),  “Share-Based Payment,”an Amendment of SFAS No. 123 (“SFAS No. 123(R)”).   SFAS No. 123(R) requires the Company tomeasure all employee stock-based compensation awards using a fair value methodand record such expense in its consolidated financial statements.  InMarch 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107,which provides the Staff’s views regarding interactions between SFAS No. 123(R)and certain SEC rules and regulations and provides interpretations of thevaluation of share-based payments for public companies. Effective January 1, 2006, theCompany adopted SFAS No. 123(R) on a modified prospective 

4

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basis.As a result, the Company began to include stock-based compensation costs in itsresults of operations beginning with the quarter ended March 31, 2006.  See Note 3 “Stock-Based Compensation”.

**2.****                   ****Restatement of Condensed Consolidated Financial Statements**

**Independent Investigation**

On July 3, 2006, theCompany announced that, at the recommendation of the Audit Committee, the Boardof Directors had created a special committee of independent directors (“SpecialCommittee”) to conduct a review of our historical stock option practices. As aresult of its investigation, the Special Committee found, among other things,that some of the original measurement dates used by the Company for option grantswere not adequately supported by contemporaneous records, and therefore themeasurement dates used by us for accounting purposes required adjustment. TheSpecial Committee concluded that the evidence did not establish that the errorswhich it identified resulted from fraud or intentional misconduct by ourcurrent senior management.

Based on the SpecialCommittee’s findings and its own review of the facts, the Board of Directorsconcluded that there was no fraud or intentional misconduct by any currentmember of senior management.  The Boardalso concluded that it has confidence in the integrity of the Company’s ChiefExecutive Officer, Dr. Levy Gerzberg, and the Company’s Chief FinancialOfficer, Mr. Karl Schneider.

Based on informationobtained from the Special Committee’s review and additional work undertaken bythe Company, management has concluded, and the Audit Committee has agreed, thatthe Company should restate certain previously filed financial statements, toreflect additional stock-based compensation expense with regard to certain paststock option grants. The corrections made in the restatements relate to optionscovering approximately 3.6 million shares. These adjustments, after tax,amounted to an additional stock-based compensation expense of $60,000 and$686,000 in the three months ended September 30, 2006 and 2005 and $420,000 and$1,403,000 in the nine months ended September 30, 2006 and 2005 respectively.There was no tax impact of these additional expenses due to full valuationallowance on our tax assets.

In connection with therestatement, the Company is recording additional non-cash adjustments that werepreviously considered to be immaterial relating to the timing of revenuerecognition, accrued expenses, amortization of premiums and discounts oninvestments and the amortization of stock-based compensation relating to abusiness combination in 2003.  TheCompany is also recording losses under Accounting Principles Board (“APB”)Opinion No. 18 (“APB No. 18”), “The Equity Method of Accounting forInvestments in Common Stock,” to record the losses on investment of the prior17% ownership of Oren Semiconductor, Inc. under the equity method of accountingwhich was subsequently acquired by Zoran in 2005.   These additional adjustments resulted in acumulative expense of $1.3 million, including $0.2 million of tax expense, forthe periods 2000 through 2005.

Through 2005, we appliedAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees” (“APB No. 25”), and its related interpretations, andprovided the required pro forma disclosures under Statement of FinancialAccounting Standards (“SFAS”) No. 123, “Accounting for Stock-BasedCompensation,” and SFAS No. 148 “Accounting for Stock-Based Compensation - Transitionand Disclosure.” Under APB No. 25, non-cash, stock-based compensation expensewas recognized for any option for which the exercise price was below the marketprice on the actual grant date. Because each of the options identified below(other than those which we have determined should be accounted for variably)was deemed to have an exercise price below the market price on the appropriatemeasurement date, we should have recognized a charge for each of those optionsunder APB No. 25, in an amount equal to the number of shares covered by suchoptions, multiplied by the difference between the exercise price and the marketprice on the appropriate measurement date. That expense should have beenamortized over the vesting periods of the options. Starting in 2006, we adoptedSFAS No. 123(R). As a result, for 2006, the additional stock-based compensationexpense required to be recorded for each of the options identified below wasequal to the incremental fair value of those options on the appropriatemeasurement date over the remaining vesting periods of those options.  We did not record such stock-basedcompensation expenses under APB No. 25 or SFAS No. 123(R) in ourpreviously issued financial statements, and that is the reason for therestatement in this report.  To correctour past accounting for stock options, we recorded additional pre-tax,non-cash, stock-based compensation expense of (a) $11.7 million for the periods1997 to 2005 under APB No. 25 and (b) $60,000 and $420,000 for the three monthsand nine months ended September 30, 2006 under SFAS No.123(R).  The fair value of the options is beingrecorded using the accelerated amortization method under FIN 28 over therespective vesting periods of the awards.

5

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Consistent with theaccounting literature and recent guidance from the Securities and ExchangeCommission (“SEC”), the Company has organized the grants with respect to whichan accounting adjustment is required into categories based on grant type andprocess by which the grant was finalized. Based on the relevant facts and circumstances, the Company applied thecontrolling accounting standards to determine the measurement date for everygrant within each category. The Company made accounting adjustments asrequired, resulting in stock-based compensation expense and related taxeffects.  The Company organized thegrants where adjustments were required as follows:

·                                          *Company-wide option grants where optionees were addedor grant amounts were changed after the option list was complete, or whereinsufficient contemporaneous documentation of the grant date exists.* For seven Company-wide refresh and retentiongrants made between 1998 and 2003, the Company determined that some employeeswho were omitted from the option grant list were added to the list after thestated grant date, and that the number of shares covered by option grants tosome employees was not finally determined until after the stated grantdate.  Further, in 2001 and 2002,insufficient contemporaneous documentation of the stated grant date existed.  As a result of these issues, the Companyrestated its historical financial statements to increase stock-basedcompensation expense by approximately $6.3 million, recognized over the vestingperiods of the relevant options.

·                                          *Re-priced options. *In August 2002, after consideration of relevant information,the Compensation Committee rescinded its April 2002 grant, and its June 2002grant, to executives and other key employees.  The Company thereafter reissuedthe grants in August 2002.  At the time,in consultation with our external advisors, we determined that thesetransactions did not require variable accounting.  As a result of the Special Committee reviewof our historical stock option practices, we have reassessed the circumstancessurrounding these transactions with our external advisors, and have determinedthat the grants should have been accounted for variably.  As a result, the Company restated itshistorical financial statements to increase stock-based compensation expense bya cumulative net amount of approximately $3.8 million, recognized over thevesting periods of these options.

·                                          *Acquisition-related options*.  The Company determined a grant given toretain employees hired in connection with an acquisition in October 2000 shouldhave been accounted for variably.  As aresult, the Company restated its historical financial statements to increasestock-based compensation expense by approximately $0.3 million, recognized overthe vesting periods of these options.

·                                          *Improper measurement dates for non-refresh stockoption grants. *The Companyrevised the measurement dates for**certaingrants made to new hires and for promotional and other miscellaneousnon-refresh grants made between 1997 and 2003 as a result of approvals thatwere obtained subsequent to the stated grant dates or as a result ofadministrative delays or errors and a small number of stock option grants tonon-executives that were determined to have been established retrospectively.As a result, the Company restated its historical financial statements toincrease stock-based compensation expense by approximately $1.3 million,recognized over the vesting periods of these options.

In the aggregate, we haverecorded additional stock-based compensation expense for the periods 1997through 2005 of approximately $11.7 million on stock option grants made from1997 through 2003.

The incrementalimpact from recognizing stock-based compensation expense resulting from theinvestigation of past stock option grants is as follows (dollars in thousands):

|                                        | ** ** | **Expense  (Benefit)** | ** ** |
|----------------------------------------|------------|------------------------|------------|
| **Fiscal  Year**                       |       |                   |       |
| 1997                                   |       | $                      | 190        |   |
| 1998                                   |       | 223                    |       |
| 1999                                   |       | 123                    |       |
| 2000                                   |       | 120                    |       |
| 2001                                   |       | 1,385                  |       |
| 2002                                   |       | 3,182                  |       |
| 2003                                   |       | 5,299                  |       |
| Cumulative effect at December 27, 2003 |       | 10,522                 |       |
| 2004                                   |       | (1,476                 | )          |
| 2005                                   |       | 2,623                  |       |
|                                   |       | $                      | 11,669     |   |

 

6

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The cumulative effect ofall of the restatements through December 31, 2003 increased additional paid-incapital by $10.7 million from $703.8 million to $714.5 million, increasedaccumulated deficit by $9.0 million from $156.4 million to $165.4 million, anddecreased total stockholders’ equity by $0.7 million from $534.3 million to$533.6 million. All the restatements of financial statements, financial dataand related disclosures described in this report are collectively referred toin this report as the “restatements.”

In December 2006, theCompany amended options to purchase approximately 218,000 shares of commonstock held by Dr. Gerzberg and Mr. Schneider, to increase the exercise price ofthose options to the fair market value of the Company’s common stock on therevised measurement date so that these options are no longer subject to IRCSection 409A.

We have not amended, andwe do not intend to amend, any of our other previously filed Annual Reports onForm 10-K.  We have amended our QuarterlyReport for the period ended March 31, 2006 concurrent with the filing of ourAnnual Report on Form 10-K, and we do not intend to amend any of our otherpreviously filed Quarterly Reports on Form 10-Q for the periods affected by therestatements.  We presented restatedquarterly financial information for each of the quarters in 2006 and 2005 in “SelectedQuarterly Financial Information (Unaudited)” included in this report.

*Restatement and Impact on FinancialStatements*

Theincome statement impacts of the restatements are as follows (in thousands):
| ** **                                                                                                               | ** ** | **Cumulative  effect at  December  31, 2005** | ** ** | **Year  Ended  December  31, 2005** | ** ** | **Year  Ended  December  31, 2004** | ** ** | **Cumulative  effect at  December  31, 2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                               | ** ** | ** **                                              | ** ** | ** **                               | ** ** | ** **                               | ** ** | ** **                                              | ** ** |
| Net loss, as  previously reported                                                                                        |       |                                                    |       | $                                        | (26,971    | )                                        | $          | (47,354                                                 | )          |   |   |
| Additional compensation (expense) benefit resulting from improper  measurement dates for stock option grants, net of tax |       | $                                                       | (11,669    | )                                        | (2,623     | )                                        | 1,476      |                                                    | $          | (10,522 | ) |
| Other  adjustments, net of tax                                                                                           |       | (1,374                                                  | )          | (678                                     | )          | (2,230                                   | )          | 1,534                                                   |       |
| Total increase to net loss                                                                                               |       | (13,043                                                 | )          | (3,301                                   | )          | (754                                     | )          | (8,988                                                  | )          |
| Net  loss, as restated                                                                                                   |       |                                                    |       | (30,272                                  | )          | (48,108                                  | )          |                                                    |       |
|                                                                                                                          |            |                                                         |            |                                          |            |                                          |            |                                                         |            |  |  |  |  |

 

 
| ** **                                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                         | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** | **1998** | ** ** | **1997** | ** ** |
| ** **                                                                                         | ** ** | ** **                                 | ** ** |
| Stock based  compensation expense, as previously reported                                          |       | $                                          | (6,281     | ) | $ | (292 | ) | $ | (544 | ) | $ | (99 | ) | $ | — |   | $ | — |   | $ | — |   |
| Additional compensation expense resulting from improper measurement  dates for stock option grants |       | (5,299                                     | )          | (3,182 | ) | (1,385 | ) | (120 | ) | (123 | ) | (223 | ) | (190 | ) |
| Stock based  compensation expense, as restated                                                     |       | $                                          | (11,580    | ) | $ | (3,474 | ) | $ | (1,929 | ) | $ | (219 | ) | $ | (123 | ) | $ | (223 | ) | $ | (190 | ) |

 

 

7

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In addition, the Companyevaluated the impact of the restatements on its global tax provision. TheCompany and its subsidiaries file tax returns in multiple tax jurisdictionsaround the world. In certain jurisdictions, including, but not limited to, theUnited States and Israel, the Company is able to claim a tax deduction relativeto stock options. In those jurisdictions, where a tax deduction is claimed, theCompany has recorded deferred tax assets relative to the book compensation nowrecorded on the restated options.  Aswith our other deferred tax assets, the company recorded a full valuationallowance on all deferred tax assets relating to restated options.  The Company also believes that it should nothave taken a United States tax deduction of $0.6 million in prior years forstock option related amounts pertaining to certain executives under InternalRevenue Code (IRC) Section 162(m) which limits the deductibility ofcompensation above certain thresholds. The deferred tax asset and relatedvaluation allowance have been adjusted accordingly.  The cumulative tax effect of all componentsof the restatements for 1997 to 2005 is an increase in tax expense of $200,000.

On February 27, 2007, theCompany elected to: (i) participate in the Internal Revenue Service remediationprogram 2007-18 and pay to the IRS, on behalf of affected and eligibleemployees (not including executive officers), their IRC 409A tax liabilitiesand penalties; (ii) participate in any similar remediation program that may beoffered by any state for applicable state tax liabilities and penalties; (iii)act directly with any state not offering a similar remediation program toaddress any applicable tax liabilities and penalties on behalf of employees;and (iv) pay to such employees a “gross-up” payment to offset the associatedfederal and state income tax consequences.  The Company took this action because the vast majority of the holders ofstock options issued by the Company that are now subject to re-measurement as aresult of the Company’s option investigation were not involved in or aware ofthe stock option pricing determination. Employees who exercised such options in 2006, other than executiveofficers at the time of option grant or entering into this program, will participatein this program.  The Company estimatesthat the total cash payments needed to deal with the adverse tax consequencesof previously exercised discount priced options granted to non-officers will beapproximately $0.8 million, which is expected to be recorded in 2007.

In addition, the Companymay consider taking action to minimize the adverse tax consequences that may beincurred by the holders of unexercised discount options. Discount-priced stockoptions vesting after December 31, 2004 (“409A Affected Options”) subject U.S.option holders to a penalty tax under IRC Section 409A (and to similar penaltytaxes under California and other state tax laws, as applicable). The Companymay consider offering to amend the 409A Affected Options held by persons otherthan directors and executive officers to increase the exercise prices of thoseoptions to the market price of our common stock on the revised measurementdate. The amended options would not be subject to taxation under IRC Section409A. Under IRS regulations, the amendments for non-executives cannot beoffered until after this Report is filed and do not need to be completed untilDecember 31, 2007. The Company may also consider approving the payment ofbonuses to holders of those amended options to compensate them for theresulting increase in their option exercise price. The amount of these bonuseswould be effectively repaid to the Company if and when the options areexercised and the increased exercise price is paid (but there is no assurancethat the options will be exercised).  TheCompany has not estimated the expense of any such bonus payments.

The restatement adjustmentsdid not affect the Company’s previously reported cash and cash equivalents andinvestments balances. The following presents the effect of the restatementadjustments by financial statement line item for the Condensed ConsolidatedBalance Sheets as of December 31, 2005, and Statements of Operations andStatements of Cash Flows for the three and nine months ended September 30,2005.

8

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**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands, except share data)**
| ** **                                                                                                                                                        | ** ** | **December 31,  2005** | ** ** | **Adjustments** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                        | ** ** | **(As reported)**      | ** ** | **(Note 1)**    | ** ** | **(As restated)**      | ** ** |
| ASSETS                                                                                                                                                            |       |                        |       |            |       |                        |       |
| Current  assets:                                                                                                                                                  |       |                        |       |            |       |                        |       |
| Cash  and cash equivalents                                                                                                                                        |       | $                           | 78,856     |            | $          | —                      |       | $ | 78,856 |   |
| Short-term  investments                                                                                                                                           |       | 70,490                      |       | —          |       | 70,490                      |       |
| Accounts  receivable, net.                                                                                                                                        |       | 70,174                      |       | —          |       | 70,174                      |       |
| Inventories                                                                                                                                                       |       | 32,616                      |       | —          |       | 32,616                      |       |
| Prepaid  expenses and other current assets                                                                                                                        |       | 11,746                      |       | —          |       | 11,746                      |       |
| Total  current assets                                                                                                                                             |       | 263,882                     |       | —          |       | 263,882                     |       |
| Property  and equipment, net                                                                                                                                      |       | 16,057                      |       | —          |       | 16,057                      |       |
| Other  assets and investments                                                                                                                                     |       | 20,799                      |       | —          |       | 20,799                      |       |
| Goodwill                                                                                                                                                          |       | 184,254                     |       | (1,592          | )          | 182,662                     |       |
| Intangible  assets, net                                                                                                                                           |       | 119,231                     |       | —          |       | 119,231                     |       |
|                                                                                                                                                              |       | $                           | 604,223    |            | $          | (1,592                      | )          | $ | 602,631 |   |
|                                                                                                                                                              |       |                        |       |            |       |                        |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                        |       |                        |       |            |       |                        |       |
| Current  liabilities:                                                                                                                                             |       |                        |       |            |       |                        |       |
| Accounts  payable                                                                                                                                                 |       | $                           | 38,999     |            | $          | —                      |       | $ | 38,999 |   |
| Accrued  expenses and other liabilities                                                                                                                           |       | 53,937                      |       | 832             |       | 54,769                      |       |
| Total  current liabilities                                                                                                                                        |       | 92,936                      |       | 832             |       | 93,768                      |       |
| Other  long-term liabilities                                                                                                                                      |       | 11,939                      |       | —          |       | 11,939                      |       |
| Commitments  and Contingencies (Note 12)                                                                                                                          |       |                        |       |            |       |                        |       |
| Stockholders’  equity:                                                                                                                                       |       |                        |       |            |       |                        |       |
| Common  stock, $0.001 par value; 105,000,000 shares authorized at December 31,  2005;  45,426,912 shares issued and outstanding as of December 31, 2005 |       | 45                          |       | —          |       | 45                          |       |
| Additional  paid-in capital                                                                                                                                       |       | 727,597                     |       | 10,656          |       | 738,253                     |       |
| Deferred  stock-based compensation                                                                                                                                |       | (593                        | )          | —          |       | (593                        | )          |
| Accumulated  other comprehensive income                                                                                                                           |       | 3,094                       |       | (37             | )          | 3,057                       |       |
| Accumulated  deficit                                                                                                                                              |       | (230,795                    | )          | (13,043         | )          | (243,838                    | )          |
| Total  stockholders’ equity                                                                                                                                  |       | 499,348                     |       | (2,424          | )          | 496,924                     |       |
|                                                                                                                                                              |       | $                           | 604,223    |            | $          | (1,592                      | )          | $ | 602,631 |   |

 

----

(1)           The restated consolidated balance sheet for the fiscal year ended2005 reflects a $13.0 million increase to accumulated deficit and a $10.7million increase to additional paid-in capital primarily due to additionalstock-based compensation recorded in connection with this restatement tocorrect prior year stock option-related accounting errors as described aboveand to reflect the cumulative impact of other adjustments that were previouslyconsidered to be immaterial. The $1.6 million decrease to goodwill is theimpact of recording losses associated with our investment in Oren Semiconductorunder the equity method of accounting and $0.8 million increase to accruedexpenses and other liabilities relates to the accrual of royalty obligationsthat were previously not recorded at December 31, 2005. 

** **

9

 

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**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands, except per share data)**
| ** **                                                                     | ** ** | **Three months Ended  September 30, 2005** | ** ** | **Nine months Ended  September 30, 2005** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **As  previously  reported**                                   | ** ** | **Adjustments  (1)**                                          | ** ** | **As  restated** | ** ** | **As  previously  reported** | ** ** | **Adjustments  (1)** | ** ** | **As  restated** | ** ** |
| Revenues:                                                                      |       |                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Hardware product revenues                                                      |       | $                                                              | 104,208    |                                                          | $          | — |   | $ | 104,208 |   | $ | 244,107 |   | $ | — |   | $ | 244,107 |   |
| Software and other revenues                                                    |       | 13,276                                                         |       | —                                                        |       | 13,276 |   | 42,340 |   | — |   | 42,340 |   |
| Total revenues                                                                 |       | 117,484                                                        |       | —                                                        |       | 117,484 |   | 286,447 |   | — |   | 286,447 |   |
| Costs and  expenses:                                                           |       |                                                           |       |                                                          |       |   |   |   |   |   |   |   |   |
| Cost of hardware product revenues*                                             |       | 53,660                                                         |       | 249                                                           |       | 53,909 |   | 135,860 |   | 360 |   | 136,220 |   |
| Research and development*                                                      |       | 23,469                                                         |       | 213                                                           |       | 23,682 |   | 64,890 |   | 402 |   | 65,292 |   |
| Selling, general and administrative*                                           |       | 21,817                                                         |       | 458                                                           |       | 22,275 |   | 69,309 |   | 560 |   | 69,869 |   |
| Amortization of intangible assets                                              |       | 12,757                                                         |       | —                                                        |       | 12,757 |   | 37,518 |   | — |   | 37,518 |   |
| Amortization of stock-based compensation resulting  from business combinations |       | 344                                                            |       | —                                                        |       | 344 |   | 1,318 |   | — |   | 1,318 |   |
| In-process research and development                                            |       | —                                                         |       | —                                                        |       | — |   | 2,650 |   | — |   | 2,650 |   |
| Total costs and expenses                                                       |       | 112,047                                                        |       | 920                                                           |       | 112,967 |   | 311,545 |   | 1,322 |   | 312,867 |   |
| Operating income  (loss)                                                       |       | 5,437                                                          |       | (920                                                          | )          | 4,517 |   | (25,098 | ) | (1,322 | ) | (26,420 | ) |
| Interest income                                                                |       | 689                                                            |       | (43                                                           | )          | 646 |   | 1,796 |   | (70 | ) | 1,726 |   |
| Other income  (loss), net                                                      |       | 32                                                             |       | —                                                        |       | 32 |   | (391 | ) | (218 | ) | (609 | ) |
| Income (loss)  before income taxes                                             |       | 6,158                                                          |       | (963                                                          | )          | 5,195 |   | (23,693 | ) | (1,610 | ) | (25,303 | ) |
| Provision for  income taxes                                                    |       | 1,200                                                          |       | —                                                        |       | 1,200 |   | 1,200 |   | — |   | 1,200 |   |
| Net income  (loss)                                                             |       | $                                                              | 4,958      |                                                          | $          | (963 | ) | $ | 3,995 |   | $ | (24,893 | ) | $ | (1,610 | ) | $ | (26,503 | ) |
| Basic net loss  per share                                                      |       | $                                                              | 0.11       |                                                          | $          | (0.02 | ) | $ | 0.09 |   | $ | (0.57 | ) | $ | (0.03 | ) | $ | (0.60 | ) |
| Diluted net loss  per share                                                    |       | $                                                              | 0.11       |                                                          | $          | (0.02 | ) | $ | 0.09 |   | $ | (0.57 | ) | $ | (0.03 | ) | $ | (0.60 | ) |
| Shares used to  compute basic net loss per share                               |       | 44,877                                                         |       |                                                          |       | 44,877 |   | 43,942 |   |   |   | 43,942 |   |
| Shares used to compute  diluted loss per share                                 |       | 46,622                                                         |       |                                                          |       | 46,622 |   | 43,942 |   |   |   | 43,942 |   |

----

* includes thefollowing amounts related to employee equity awards
| Cost of hardware  product revenues   |   | $ | — |   | $ | 15  |   | $ | 15  |   | $ | — |   | $ | 30  |   | $ | 30    |   |
|--------------------------------------|--------|---|--------|--------|---|-----|--------|---|-----|--------|---|--------|--------|---|-----|--------|---|-------|--------|
| Research and  development            |   | $ | — |   | $ | 213 |   | $ | 213 |   | $ | — |   | $ | 436 |   | $ | 436   |   |
| Selling, general and  administrative |   | $ | 114    |   | $ | 458 |   | $ | 572 |   | $ | 114    |   | $ | 937 |   | $ | 1,051 |   |

(1) In addition to restating the consolidated financial statements inresponse to the Special Committee’s findings, the Company has recordedadditional non-cash adjustments that were considered to be immaterial to ourpreviously filed consolidated financial statements relating to the timingof revenue recognition, accrued expenses, amortization of premiumsand discounts on investments, additional expense related to optionsgranted to a consultant, and the amortization of stock-based compensation relatingto a business combination in 2003.  In addition, the Company isalso recording losses under APB Opinion No. 18 (“APB No. 18”), “TheEquity Method of Accounting for Investments in Common Stock,” to recordthe losses on investment of the prior 17% ownership of OrenSemiconductor, Inc. under the equity method of accounting which was subsequentlyacquired by Zoran in 2005.

10

 

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**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(in thousands)**
| ** **                                                                        | ** ** | **Nine Months Ended  September 30, 2005** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                        | ** ** | **As  previously  reported**                                  | ** ** | **Adjustments** | ** ** | **As  restated** | ** ** |
| Cash flows from operating activities:                                             | ** ** | ** **                                                    | ** ** | ** ** |   |   |   |
| Net loss                                                                          |       | $                                                             | (24,893    | ) | $ | (1,610 | ) | $ | (26,503 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operations:  | ** ** | ** **                                                    |       |   |   |   |   |
| Depreciation                                                                      |       | 7,727                                                         |       | — |   | 7,727 |   |
| Amortization                                                                      |       | 37,518                                                        |       | 70 |   | 37,588 |   |
| Stock-based compensation expense                                                  |       | 1,432                                                         |       | 1,403 |   | 2,835 |   |
| In-process research and development                                               |       | 2,650                                                         |       |   |   | 2,650 |   |
| Changes in assets and liabilities, net of effect of  acquisitions:                | ** ** | ** **                                                    |       |   |   |   |   |
| Accounts receivable.                                                              |       | (20,496                                                       | )          | — |   | (20,496 | ) |
| Inventory                                                                         |       | 22,915                                                        |       | — |   | 22,915 |   |
| Prepaid expenses and other current assets and other  assets                       |       | 650                                                           |       | 88 |   | 738 |   |
| Accounts payable                                                                  |       | 3,238                                                         |       | — |   | 3,238 |   |
| Accrued expenses and other liabilities, goodwill and  other long term liabilities |       | 2,909                                                         |       | 49 |   | 2,958 |   |
| Net cash provided by operating activities.                                        |       | 33,650                                                        |       | — |   | 33,650 |   |
| Cash flows from investing activities:                                             | ** ** | ** **                                                    |       |   |   |   |   |
| Purchases of property and equipment                                               |       | (6,419                                                        | )          | — |   | (6,419 | ) |
| Purchases of investments.                                                         |       | (15,723                                                       | )          | — |   | (15,723 | ) |
| Proceeds from sales and maturities ofinvestments                                  |       | 37,808                                                        |       | — |   | 37,808 |   |
| Acquisition of Oren Semiconductor, Inc., net of cash  acquired                    |       | (27,567                                                       | )          | — |   | (27,567 | ) |
| Net cash used in investing activities.                                            |       | (11,901                                                       | )          | — |   | (11,901 | ) |
| Cash flows from financing activities:                                             | ** ** | ** **                                                    |       |   |   |   |   |
| Proceeds from issuance of common stock                                            |       | 5,598                                                         |       | — |   | 5,598 |   |
| Net cash provided by financing activities                                         |       | 5,598                                                         |       | — |   | 5,598 |   |
| Net increase in cash and cash equivalents                                         |       | 27,347                                                        |       | — |   | 27,347 |   |
| Cash and cash equivalents at beginning of period                                  |       | 37,435                                                        |       | — |   | 37,435 |   |
|                                                                              |       |                                                          |       |   |   |   |   |
| Cash and cash  equivalents at end of period                                       |       | $                                                             | 64,782     |   | $ | — |   | $ | 64,782 |   |

 

**3.****                   ****Stock-Based Compensation**

Effective January 1, 2006, Zoran adopted SFAS 123(R), using themodified prospective application transition method, which establishesaccounting for stock-based awards exchanged for employee services.  Accordingly, stock-based compensation cost ismeasured at grant date, based on the fair value of the award, over therequisite service period.  The Companypreviously applied APB 

11

 

----

No. 25 and related interpretations andprovided the pro forma disclosures required by SFAS No. 123, “ Accountingfor Stock-Based Compensation” (“SFAS No. 123”).

***Periods Prior to the Adoption of SFAS 123(R)***

Prior to the adoption ofSFAS No. 123(R), the Company provided the disclosures required under SFAS No. 123,as amended by SFAS No. 148, “Accounting for Stock-Based Compensation —Transition and Disclosures.”

The pro forma effect ofrecognizing compensation expense pursuant to SFAS No. 123 for the three andnine month periods ended September 30, 2005 was as follows (in thousands exceptper-share amounts):

|                                                                                | ** ** | **Three Months  Ended  September  30, 2005** | ** ** | **Nine Months  Ended  September  30, 2005** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **(Restated)**                                         | ** ** | **(Restated)**                                        | ** ** |
|                                                                           |       |                                                   |       |                                                  |       |
|                                                                           |       |                                                   |       |                                                  |       |
| Net income  (loss) attributable to common stockholders                         |       | $                                                      | 3,995      |                                                  | $          | (26,503 | ) |
|                                                                           |       |                                                   |       |                                                  |       |
| Add:   Stock-based compensation expense included in loss                       |       | 1,144                                                  |       | 2,835                                                 |       |
|                                                                           |       |                                                   |       |                                                  |       |
|                                                                           |       |                                                   |       |                                                  |       |
| Total stock-based compensation expense determined  under the fair value method |       | (6,172                                                 | )          | (21,339                                               | )          |
|                                                                           |       |                                                   |       |                                                  |       |
| Pro forma net  loss attributable to common stockholders                        |       | $                                                      | (1,033     | )                                                     | $          | (45,007 | ) |
|                                                                           |       |                                                   |       |                                                  |       |
|                                                                           |       |                                                   |       |                                                  |       |
| Pro forma net  loss per share attributable to common stockholders:             |       |                                                   |       |                                                  |       |
| Basic                                                                          |       | $                                                      | (0.02      | )                                                     | $          | (1.02 | ) |
| Diluted                                                                        |       | $                                                      | (0.02      | )                                                     | $          | (1.02 | ) |
|                                                                           |       |                                                   |       |                                                  |       |
|                                                                           |       |                                                   |       |                                                  |       |
| Net income  (loss) per share as restated attributable to common stockholders:  |       |                                                   |       |                                                  |       |
| Basic                                                                          |       | $                                                      | 0.09       |                                                  | $          | (0.60 | ) |
| Diluted                                                                        |       | $                                                      | 0.09       |                                                  | $          | (0.60 | ) |

 

For purposes of this proforma disclosure, the expense recognized was estimated using the acceleratedamortization method under FIN 28 over the respective vesting periods of theawards. Due to the valuation allowance provided on our deferred tax assets, theCompany has not recorded any tax benefits attributable to pro forma stock-basedcompensation.

***Impact ofAdoption of SFAS No. 123(R)***

During the three and nine month periods endedSeptember 30, 2006, the Company recorded stock-based compensation expense forawards granted prior to but not yet vested as of January 1, 2006 as if the fairvalue method required for pro forma disclosure under SFAS No. 123 were ineffect for expense recognition purposes adjusted for estimated forfeitures. Forthese awards, the Company has continued to recognize compensation expense usingthe accelerated amortization method. For stock-based awards granted after January1, 2006, the Company recognized compensation expense based on the grant datefair value required under SFAS No. 123(R). For these awards, the Companyrecognized compensation expense using a straight-line amortization method. AsSFAS No. 123(R) requires that stock-based compensation expense be based onawards that are ultimately expected to vest, estimated stock-based compensationfor the three and nine month periods ended September 30, 2006 has been reducedfor estimated forfeitures.  The adoptionof SFAS No. 123(R) 

12

 

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resulted in a one-time benefit of $314,000related to unvested awards for which compensation expense had already beenrecorded.

The following tablesummarizes stock-based compensation expense related to employee stock options,employee stock purchases and restricted stock unit grants for the three andnine month periods ended September 30, 2006 as recorded in accordance with SFASNo. 123(R) (in thousands):

|                                      | ** ** | **Three Months Ended  September 30, 2006** | ** ** | **Nine Months Ended  September 30, 2006** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Cost of hardware  product revenues   |       | $                                                              | 129        |                                                          | $          | 420 |   |
| Research and  development            |       | 1,236                                                          |       | 4,290                                                         |       |
| Selling, general  and administrative |       | 2,405                                                          |       | 9,019                                                         |       |
| Total costs and  expenses            |       | $                                                              | 3,770      |                                                          | $          | 13,729 |   |

 

**The effect of recording stock-based compensation expense onbasic and diluted net income per share was $0.07 for the three months endedSeptember 30, 2006 and $0.26 and $0.25 per share for the nine months endedSeptember 30, 2006.**

***ValuationAssumptions***

For purposes of thedisclosure requirements of SFAS No. 123 and the requirements of SFAS No. 123(R),the Company estimates the fair value of stock options using the Black-Scholesvaluation model using the following weighted-average assumptions:
| ** **                    | ** ** | **Stock Option Plans**                     | ** ** |
|-------------------------------|------------|------------------------------------------------------|------------|
| ** **                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
| ** **                    | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Average expected term (years) |       | 5.7                                                  |       | 3.8 |   | 5.7 |   | 3.9 |   |
| Expected volatility           |       | 68                                                   | %          | 66 | % | 71 | % | 69 | % |
| Risk-free interest rate       |       | 4.8                                                  | %          | 4.0 | % | 4.8 | % | 3.8 | % |
| Dividend  yield               |       | 0                                                    | %          | 0 | % | 0 | % | 0 | % |

 
| ** **                    | ** ** | **Employee Stock Purchase Plans**                    | ** ** |
|-------------------------------|------------|------------------------------------------------------|------------|
| ** **                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
| ** **                    | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Average expected term (years) |       | 1.25                                                 |       | 1.25 |   | 1.25 |   | 1.25 |   |
| Expected volatility           |       | 58                                                   | %          | 45 | % | 58 | % | 47 | % |
| Risk-free interest rate       |       | 2.3                                                  | %          | 3.7 | % | 2.3 | % | 3.3 | % |
| Dividend  yield               |       | 0                                                    | %          | 0 | % | 0 | % | 0 | % |

 

*Expected Term:*  The expected term represents the period thatthe Company’s stock-based awards are expected to be outstanding and wasdetermined based on the Company’s historical experience with similar awards,giving consideration to the contractual terms of the stock-based awards andvesting schedules.

*Expected Volatility*:  For the three and nine months ended September 30, 2006,the Company modified its volatility assumption to use implied volatility for optionsgranted during the quarter.  Previously,the Company used only historical volatility in deriving its volatilityassumption.  Management believes thatimplied volatility appropriately reflects the market’s expectations of futurevolatility.

*Risk-Free Interest Rate*:  Management bases its assumptions regardingthe risk-free interest rate on U.S. Treasury zero-coupon issues with anequivalent remaining term.

13

 

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*Expected Dividend:*TheCompany has not paid and does not anticipate paying any dividends in the nearfuture.

*Estimated Pre-vestingForfeitures:*When estimatingforfeitures, the Company considers voluntary termination behavior based onactual historical information.

***Stock Option Activity***

The following is asummary of stock option activities:

|                               | ** ** | **Shares Underlying   Outstanding Options** | ** ** | **Weighted Average   Exercise Price** | ** ** |
|-------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------|------------|
| Balances, December 31,  2005  |       | 12,955,585                                                 |       | $                                                    | 16.32      |   |
| Granted                       |       | 361,565                                                    |       | $                                                    | 21.15      |   |
| Exercised                     |       | (3,653,935                                                 | )          | $                                                    | 13.59      |   |
| Canceled                      |       | (1,452,153                                                 | )          | $                                                    | 23.54      |   |
| Balances, September 30,  2006 |       | 8,211,062                                                  |       | $                                                    | 16.47      |   |

 

Significantoption groups outstanding as of September 30, 2006 and the related weightedaverage exercise price and contractual life information, are as follows:
| ** **               | ** ** | **Options Outstanding**                                                  | ** ** | **Options Exercisable**                                       | ** ** |
|--------------------------|------------|-------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| **Exercise Prices** | ** ** | **Shares   Underlying   Options at  September 30,  2006** | ** ** | **Weighted  Average  Remaining  Contractual   Life  (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate   Intrinsic value   (‘000)** | ** ** | **Shares   Underlying   Options at  September 30,  2006** | ** ** | **Weighted  Average  Remaining  Contractual   Life  (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate   Intrinsic  value   (‘000)** | ** ** |
| $0.00 to $9.99           |       | 603,285                                                                       |       | 5.21                                                               |       | $ | 6.24 |   | $ | 5,937 |   | 479,201 |   | 4.86 |   | $ | 6.39 |   | $ | 4,641 |   |
| $10.00 to $11.99         |       | 1,378,400                                                                     |       | 7.66                                                               |       | $ | 10.56 |   | 7,613 |   | 1,378,400 |   | 7.66 |   | $ | 10.56 |   | 7,613 |   |
| $12.00 to $14.99         |       | 1,640,680                                                                     |       | 6.58                                                               |       | $ | 13.00 |   | 5,048 |   | 1,362,710 |   | 6.11 |   | $ | 12.86 |   | 4,388 |   |
| $15.00 to $19.99         |       | 2,384,373                                                                     |       | 7.32                                                               |       | $ | 17.11 |   | 103 |   | 1,942,286 |   | 7.14 |   | $ | 17.11 |   | 78 |   |
| $20.00 to $25.99         |       | 1,809,728                                                                     |       | 6.92                                                               |       | $ | 24.04 |   | — |   | 1,564,350 |   | 6.51 |   | $ | 24.21 |   | — |   |
| $26.00 to $46.53         |       | 394,596                                                                       |       | 4.04                                                               |       | $ | 28.59 |   | — |   | 385,631 |   | 3.91 |   | $ | 28.61 |   |   |   |
|                     |       |                                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                    |       | 8,211,062                                                                     |       | 6.83                                                               |       | $ | 16.47 |   | $ | 18,701 |   | 7,112,578 |   | 6.58 |   | $ | 16.49 |   | $ | 16,720 |   |

 

The weighted average grant date fair value ofoptions, as determined under SFAS No. 123(R), granted during the three monthsand nine months ended September 30, 2006 was $8.82 and $11.48 per share,respectively.

The aggregate intrinsicvalue in the table above represents the total pretax intrinsic value, based onthe Company’s closing stock price of $16.08 as of September 30, 2006, whichwould have been received by the option holders had all option holders exercisedtheir options as of that date.  The totalnumber of shares of common stock underlying in-the-money options exercisable asof September 30, 2006 was 3.4 million.

The total intrinsic valueof options exercised during the three months and nine months ended September30, 2006 was $0.4 million and $40.6 million, respectively.  The total cash received from employees as aresult of employee stock option exercises during the three months and ninemonths ended September 30, 2006 was approximately $0.5 million and $49.7million, respectively.  In connectionwith these exercises, there was no tax benefit realized by the Company due tothe Company’s current loss position.

As of September 30, 2006,the total unrecognized compensation cost related to stock options not yetrecognized was $12.0 million after estimated forfeitures which are expected tobe recognized over an estimated amortization period of four years.

The Company settles employee stock optionexercises with newly issued common shares.

14

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 ***StockOption Plans***

As of September 30, 2006,the Company had outstanding options for the purchase of 8.2 million shares ofcommon stock held by employees and directors under the Company’s 2005 EquityIncentive Plan (the “2005 Plan”), 2005 Outside Directors Equity Plan, 2002Stock Option Plan, 1995 Outside Directors Stock Option Plan, the 1993 StockOption Plan and other various plans the Company assumed as a result ofacquisitions.  As of September 30, 2006,3,951,103 shares remained available for future grants and awards. Options andstock appreciation rights granted under the 2005 Plan must have exercise pricesper share not less than the fair market value of Zoran common stock on the dateof grant and may not be repriced without stockholder approval.  Such awards will vest and become exercisableupon conditions established by the Compensation Committee and may not have aterm exceeding 10 years.

*** ******RestrictedShares and Restricted Stock Units***

Restricted shares and restricted stock units aregranted under the 2005 Plan. On January 6, 2006, the Company filed a Tender OfferStatement with the Securities and Exchange Commission and commenced an offer tocurrent employees to exchange outstanding options with exercise prices pershare that were more than the greater of $20.00 and the closing sale price ofZoran common stock on the offer expiration date of February 6, 2006.  The exchange offer was approved by Zoran’sstockholders at their 2005 annual meeting. On February 6, 2006, the Companyaccepted for exchange options to purchase an aggregate of 1,060,536 shares ofZoran common stock having an exercise price greater than $22.48. Subject to theterms and conditions of the exchange, the Company granted 197,433 restrictedshares of common stock or restricted stock units in exchange for the tenderedoptions.  The shares of restricted stockand restricted stock units granted as part of this exchange vest over a periodof two years.  None of the directors orexecutive officers was eligible for participation in the exchange offer.  This exchange was accounted as a modificationunder SFAS No. 123(R).  As of September 30, 2006, there was$0.4 million of total unrecognized stock-based compensation expense related torestricted shares and restricted stock units. This cost is expected to berecognized over the vesting period of two to four years.

The following is asummary of restricted shares and restricted stock units activities:

 

|                              | ** ** | **Outstanding   restricted shares   and stock units** | ** ** | **Weighted-  average grant-   date fair value** | ** ** |
|------------------------------|------------|--------------------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| Balances, December 31,  2005 |       | 65,333                                                                         |       | $                                                                   | 13.59      |   |
| Granted                      |       | 197,433                                                                        |       | $                                                                   | 21.56      |   |
| Released                     |       | (64,986                                                                        | )          | $                                                                   | 19.56      |   |
| Forfeited                    |       | (7,085                                                                         | )          | $                                                                   | 21.56      |   |
| Balances, September 30, 2006 |       | 190,695                                                                        |       | $                                                                   | 19.50      |   |

 

***EmployeeStock Purchase Plan***

The Company’s 1995 Employee Stock Purchase Plan(“ESPP”) was adopted by the Company’s Board of Directors in October 1995,and approved by its stockholders in December 1995.  The ESPP enables employees to purchase sharesthrough payroll deductions at approximately 85% of the lesser of the fair valueof common stock at the beginning of a 24-month offering period or the end ofeach six-month segment within such offering period.  The ESPP is intended to qualify as an “employeestock purchase plan” under Section 423 of the U.S. Internal RevenueCode.  There were no purchases during thequarter ended September 30, 2006.  As ofSeptember 30, 2006, 2,311,447 shares were reserved and available for issuanceunder this plan.

**3.****             ****Comprehensive Income (Loss)**

Thefollowing table presents the calculation of comprehensive income (loss) asrequired by SFAS 130 (“Reporting Comprehensive Income”).  The components of comprehensive income(loss), net of tax, are as follows (in thousands):

15

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** **
| ** **                                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                            | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                            | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                            | ** ** | ** **                       | ** ** | **(restated)**                  | ** ** | ** ** | ** ** | **(restated)** | ** ** |
| Net income (loss)                                     |       | $                                | 1,852      |                            | $          | 3,995 |   | $ | 27,314 |   | $ | (26,503 | ) |
| Change in  unrealized gain (loss) on investments, net |       | 1,060                            |       | 217                             |       | 491 |   | 1,794 |   |
| Total comprehensive income (loss)                     |       | $                                | 2,912      |                            | $          | 4,212 |   | $ | 27,805 |   | $ | (24,709 | ) |

The components ofaccumulated other comprehensive income (loss) are unrealized gain (loss) onmarketable securities.

**4.****             ****Short-term investments**

The Company’s portfolio of short-term investmentsat September 30, 2006 was as follows (in thousands):

 
| ** **                         | ** ** | **Cost** | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
|------------------------------------|------------|----------|------------|-----------------------|------------|------------------------|------------|----------------------------|------------|
| Corporate debt                     |       | $        | 88,160     |                  | $          | 16                     |       | $                          | (203       | ) | $ | 87,973 |   |
| U.S. government  securities        |       | 40,265   |       | 20                    |       | (72                    | )          | 40,213                     |       |
| Auction rate securities            |       | 47,100   |       | —                |       | —                 |       | 47,100                     |       |
| Foreign bonds                      |       | 10,016   |       | 1                     |       | (6                     | )          | 10,011                     |       |
| Municipal debt                     |       | 3,000    |       | —                |       | —                 |       | 3,000                      |       |
| Total fixed income  securities     |       | 188,541  |       | 37                    |       | (281                   | )          | 188,297                    |       |
| Publicly traded equity  securities |       | 1,619    |       | 3,793                 |       | —                 |       | 5,412                      |       |
| Total                              |       | $        | 190,160    |                  | $          | 3,830                  |       | $                          | (281       | ) | $ | 193,709 |   |

 

The Company’s portfolio of marketable securities atDecember 31, 2005 was as follows (in thousands):

 
| ** **                         | ** ** | **Cost** | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
|------------------------------------|------------|----------|------------|-----------------------|------------|------------------------|------------|----------------------------|------------|
| Corporate debt                     |       | $        | 26,211     |                  | $          | —                 |       | $                          | (151       | ) | $ | 26,060 |   |
| U.S. government  securities        |       | 20,000   |       | —                |       | (151                   | )          | 19,849                     |       |
| Auction rate securities            |       | 15,125   |       | —                |       | —                 |       | 15,125                     |       |
| Foreign bonds                      |       | 4,474    |       | —                |       | (6                     | )          | 4,468                      |       |
| Total fixed income  securities     |       | 65,810   |       | —                |       | (308                   | )          | 65,502                     |       |
| Publicly traded equity  securities |       | 1,623    |       | 3,365                 |       | —                 |       | 4,988                      |       |
| Total                              |       | $        | 67,433     |                  | $          | 3,365                  |       | $                          | (308       | ) | $ | 70,490 |   |

 

The following tablesummarizes the contractual maturities of the Company’s fixed income securitiesat September 30, 2006 (in thousands):

 

|                                | ** ** | **Cost** | ** ** | **Estimated  Fair  Value** | ** ** |
|--------------------------------|------------|----------|------------|----------------------------|------------|
| Less than 1 year               |       | $        | 85,409     |                       | $          | 85,239 |   |
| Due in 1 to 2 years            |       | 38,126   |       | 38,096                     |       |
| Due in 2 to 5 years            |       | 17,906   |       | 17,862                     |       |
| Greater than 5 years*          |       | 47,100   |       | 47,100                     |       |
| Total fixed income  securities |       | $        | 188,541    |                       | $          | 188,297 |   |

----

*Comprised of auction rate securities which have resetdates of 90 days or less but final expiration dates over 5 years.

 

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**5.  Inventories**

Inventories are stated at the lower of cost (first in,first out) or market and consisted of the following (in thousands):

|                                      | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Purchased parts and  work in process |       | $                      | 21,642     |                  | $          | 14,904 |   |
| Finished goods                       |       | 23,605                 |       | 17,712                |       |
|                                 |       | $                      | 45,247     |                  | $          | 32,616 |   |

 

**6.   Goodwill and Other Intangible Assets**

In accordance with SFAS 142, goodwill is not amortized.  The Company monitors the recoverability ofgoodwill recorded in connection with acquisitions, by reporting unit, annually,or sooner if events or changes in circumstances indicate that the carryingamount may not be recoverable.  TheCompany performed the annual analysis as of September 30, 2006 and concludedthat goodwill was not impaired, as the fair value of each reporting unitexceeded its carrying value, including goodwill.

***Componentsof Acquired Intangible Assets****(in thousands):*

 
| ** **                    | ** ** | ** **        | ** ** | **September 30, 2006** | ** ** | **December 31, 2005 (restated)** | ** ** |
|-------------------------------|------------|-------------------|------------|----------------------------------|------------|-------------------------------------------------|------------|
| ** **                    | ** ** | **Life  (Years)** | ** ** | **Gross  Carrying  Amount**      | ** ** | **Accumulated  Amortization**                   | ** ** | **Net  Balance** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Balance** | ** ** |
| Amortized intangible  assets: |       |              |       |                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Purchased  technology         |       | 2-3               |       | $                                | 195,505    |                                            | $          | (133,612 | ) | $ | 61,893 |   | $ | 195,505 |   | $ | (105,088 | ) | $ | 90,417 |   |
| Patents                       |       | 3-5               |       | 40,265                           |       | (27,120                                         | )          | 13,145 |   | 40,265 |   | (19,978 | ) | 20,287 |   |
| Customer base                 |       | 3-5               |       | 13,860                           |       | (8,968                                          | )          | 4,892 |   | 13,860 |   | (7,123 | ) | 6,737 |   |
| Tradename and  others         |       | 3-5               |       | 3,350                            |       | (1,942                                          | )          | 1,408 |   | 3,350 |   | (1,560 | ) | 1,790 |   |
| Total                         |       |              |       | $                                | 252,980    |                                            | $          | (171,642 | ) | $ | 81,338 |   | $ | 252,980 |   | $ | (133,749 | ) | $ | 119,231 |   |

 

Estimated future intangibleamortization expense, based on current balances, as of September 30, 2006 is asfollows (in thousands):

 
| Remaining three months of  2006 |   | $      | 12,169 |   |
|---------------------------------|--------|--------|--------|--------|
| Year ending December  31, 2007  |   | 43,224 |   |
| Year ending December  31, 2008  |   | 23,315 |   |
| Year ending December  31, 2009  |   | 1,820  |   |
| Year ending December  31, 2010  |   | 810    |   |
|                            |   | $      | 81,338 |   |

 

Goodwill by reporting units was as follows (inthousands):

 
| ** ** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------|------------|------------------------|------------|-----------------------|------------|
| ** ** | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** ** | ** ** | ** **             | ** ** | **(restated)**        | ** ** |
| ** ** | ** ** | ** **             | ** ** | ** **            | ** ** |
| Consumer   |       | $                      | 173,023    |                  | $          | 176,623 |   |
| Imaging    |       | 5,639                  |       | 6,039                 |       |
|       |       | $                      | 178,662    |                  | $          | 182,662 |   |

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**7.    Income Taxes**

The provision for income taxes reflects the effectivetax rate applied to earnings, excluding charges for amortization of intangibleassets for the interim periods and a one-time charge of $4.3 million relatingto the MediaTek settlement.  In addition,the Company recognized a benefit of $0.7 million related to the closure of adomestic income tax audit and a benefit of $1.4 million related to theexpiration of the statute of limitations on a previously accrued domesticreserve.  The effective tax rate differsfrom the U.S. statutory rate due to utilization of previously unbenefittedoperating losses and State of Israel tax benefits on foreign earnings.  The provision is due primarily to domesticincome offset by previously unbenefitted purchased NOLs which when utilizedreduce goodwill and not tax expense

**8.   SegmentReporting**

SFAS No. 131 establishesstandards for the reporting by public business enterprises of information aboutoperating segments, products and services, geographic areas, and majorcustomers.  The method for determiningwhat information to report is based on the manner in which management organizesthe operating segments within the Company for making operational decisions andassessments of financial performance. The Company’s chief operating decision-maker is considered to be theChief Executive Officer.

The Company’s productsare based on highly integrated application-specific integrated circuits, orASICs, and system-on-a-chip, or SOC, solutions. The Company also licenses certain software and other intellectualproperty.  During the first quarter of2006, the Company reorganized its operating structure to bring together itsconsumer electronic product lines under a single operating group, inrecognition of the accelerating convergence of consumer products and theCompany’s strategy of sharing technology among its various product lines.  The new Consumer group combines the formerDigital Versatile Disc (DVD), Digital Television (DTV) and Mobile productgroups whose operations were previously reported separately.  The Company will continue to report theoperations of its Imaging group as a separate operating segment.

The Consumer groupprovides products for use in DVD players, recordable DVD players, standard andhigh definition digital television products, digital camera products andmultimedia mobile phone products.  TheImaging group provides products used in digital copiers, laser and inkjetprinters as well as multifunction peripherals.

The chief operatingdecision maker allocates resources to and evaluates operating segmentperformance based on net revenues and operating expenses of thesesegments.  The accounting policies of theoperating segments are the same as those described in the summary of accountingpolicies.  No reportable segments havebeen aggregated.

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Informationabout reported segment income or loss is as follows for the three and ninemonths ended September 30, 2006 and 2005 (in thousands):

 
| ** **           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **           | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **           | ** ** | ** **                                           | ** ** | **(restated)**                                      | ** ** | ** ** | ** ** | **(restated)** | ** ** |
| Net revenues:        |       |                                                 |       |                                                |       |   |   |   |   |
| Consumer             |       | $                                                    | 109,681    |                                                | $          | 95,825 |   | $ | 342,997 |   | $ | 220,911 |   |
| Imaging              |       | 19,698                                               |       | 21,659                                              |       | 56,557 |   | 65,536 |   |
|                 |       | $                                                    | 129,379    |                                                | $          | 117,484 |   | $ | 399,554 |   | $ | 286,447 |   |
|                 |       |                                                      |       |                                                     |       |   |   |   |   |
| Operating expenses:  |       |                                                 |       |                                                |       |   |   |   |   |
| Consumer             |       | $                                                    | 102,806    |                                                | $          | 85,690 |   | $ | 289,781 |   | $ | 226,300 |   |
| Imaging              |       | 15,166                                               |       | 14,176                                              |       | 46,680 |   | 45,081 |   |
|                 |       | $                                                    | 117,972    |                                                | $          | 99,866 |   | $ | 336,461 |   | $ | 271,381 |   |
|                 |       |                                                      |       |                                                     |       |   |   |   |   |
| Contribution margin: |       |                                                 |       |                                                |       |   |   |   |   |
| Consumer             |       | $                                                    | 6,875      |                                                | $          | 10,135 |   | $ | 53,216 |   | $ | (5,389 | ) |
| Imaging              |       | 4,532                                                |       | 7,483                                               |       | 9,877 |   | 20,455 |   |
|                 |       | $                                                    | 11,407     |                                                | $          | 17,618 |   | $ | 63,093 |   | $ | 15,066 |   |

 

A reconciliation of the totals reported for theoperating segments to the applicable line items in the consolidated financialstatements for the three and nine months ended September 30, 2006 and 2005 isas follows (in thousands):

 
| ** **                                                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended   September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                             | ** ** | **2005**                                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                               | ** ** | ** **                                           | ** ** | **(restated)**                                            | ** ** | ** ** | ** ** | **(restated)** | ** ** |
| Contribution margin  from operating segments                             |       | $                                                    | 11,407     |                                                      | $          | 17,618 |   | $ | 63,093 |   | $ | 15,066 |   |
| Amortization of  intangibles                                             |       | 12,423                                               |       | 12,757                                                    |       | 37,893 |   | 37,518 |   |
| Amortization of stock  compensation resulting from business combinations |       | —                                               |       | 344                                                       |       | — |   | 1,318 |   |
| In process research and  development                                     |       | —                                               |       | —                                                    |       | — |   | 2,650 |   |
| Total operating income (loss)                                            |       | $                                                    | (1,016     | )                                                         | $          | 4,517 |   | $ | 25,200 |   | $ | (26,420 | ) |

 

Zoran maintainsoperations in Canada, China, Germany, Israel, Japan, Korea, Taiwan, UnitedKingdom and the United States.  Activitiesin Israel and the United States consist of corporate administration, productdevelopment, logistics and worldwide sales management.  Other foreign operations consist of sales,product development and technical support.

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The geographic distribution of total revenues for the three and ninemonths ended September 30, 2006 and 2005 was as follows (in thousands):
| ** **                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended   September 30,** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                             | ** ** | **2005**                                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Revenue from unaffiliated  customers originating from:** |       |                                                 |       |                                                      |       |   |   |   |   |
| China                                                      |       | $                                                    | 49,728     |                                                      | $          | 46,330 |   | $ | 136,281 |   | $ | 114,879 |   |
| Japan                                                      |       | 29,544                                               |       | 31,415                                                    |       | 84,539 |   | 83,128 |   |
| Korea                                                      |       | 7,369                                                |       | 7,267                                                     |       | 22,687 |   | 15,611 |   |
| Taiwan                                                     |       | 21,809                                               |       | 19,519                                                    |       | 103,897 |   | 34,851 |   |
| United States                                              |       | 10,103                                               |       | 5,598                                                     |       | 28,298 |   | 17,978 |   |
| North America  (excluding United States)                   |       | 26                                                   |       | 63                                                        |       | 64 |   | 1,175 |   |
| Other                                                      |       | 10,800                                               |       | 7,292                                                     |       | 23,788 |   | 18,825 |   |
| **Total revenues**                                         |       | $                                                    | 129,379    |                                                      | $          | 117,484 |   | $ | 399,554 |   | $ | 286,447 |   |

 

For the three months and nine months ended September30, 2006, one customer accounted for 14% and 11% of total revenues,respectively.  For the same periods of2005, no customer accounted for more than 10% of total revenues.

As of September 30, 2006,three customers accounted for approximately 14%, 11% and 11% of total netaccounts receivable, respectively and as of December 31, 2005 one customer accounted for approximately 14% ofthe net accounts receivable balance.

** 9. Employee Benefit Plans**

Under Israeli law, theCompany is required to make severance payments to its retired or dismissedIsraeli employees and Israeli employees leaving its employment in certain othercircumstances. The Company’s severance pay liability to its Israeli employees,which is calculated based on the salary of each employee multiplied by theyears of such employee’s employment, is reflected in the Company’s balancesheet in other long-term liabilities on an accrual basis, and is partiallyfunded by the purchase of insurance policies in the name of the employees. Thesurrender value of the insurance policies is recorded in other non-currentassets. The severance pay expenses for the three and nine months endedSeptember 30, 2006 were $367,000 and $922,000 respectively.  The severance pay expenses for the three andnine months ended September 30, 2005 were $63,000 and $125,000 respectively.

**10.  Acquisition**

**OrenSemiconductor, Inc.**

On June 10,2005, Zoran completed the acquisition of Oren Semiconductor, Inc. (“Oren”),a privately-held provider of demodulator ICs for the global high definitiontelevision market.  Prior to thisacquisition, Zoran had made investments in Oren that represented a 17%ownership interest with a net book value of $3.4 million at the time ofacquisition.  Under the terms of theacquisition agreement, Zoran acquired the remaining 83% of Oren’s outstandingstock by means of a merger of Oren with a wholly-owned subsidiary of Zoran, inconsideration for which Zoran paid an aggregate of $28.4 million in cashand issued 1,188,061 shares of Zoran common stock valued at $12.9 million,for total consideration of $41.3 million, to the other stockholders of Oren andto employees holding Oren options.  Aspart of the restatement, the Company considered the requirements underAccounting Principles Board Opinion No. 18 (“APB No. 18”), “The Equity Methodof Accounting for Investments in Common Stock,” to record the gains or losseson investment of the prior 17% ownership under the equity method of accounting.  Based on the Company’s analysis, the priorfinancial results of the Company were restated to record the loss oninvestment.

The primary purpose ofthe acquisition was to obtain Oren’s demodulator ICtechnology for the global high definition television market.  This technology was combined with Zoran’sdigital television technology to deliver a complete and cost-effective systemsolution for digital television makers. As of September 30, 2006, there have been nomaterial variations from the underlying assumptions that were used in theoriginal computation of the value of the acquired entity.

Thetransaction was accounted for under SFAS No. 141, “Business Combinations,”using the purchase method of accounting. The Company incurred approximately $375,000 for acquisition-relatedexpenses consisting of financial advisory, legal and other consulting services.  The Company completed a valuation analysisand purchase price allocation. The results of operations of Oren have beenincluded in the consolidated financial statements from the date of acquisition.The acquisition resulted in goodwill of approximately

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$33.9 million.In accordance with SFAS 142, “Goodwilland Other Intangible Assets”, goodwill will not be amortized and will be testedfor impairment at least annually.  TheCompany does not expect goodwill to be deductible for tax purposes.

Allocation of the purchase price is as follows(restated) (in thousands):

| Net liabilities acquired             |   | $      | (941   | )      |
|--------------------------------------|--------|--------|--------|--------|
| In process research and  development |   | 2,650  |   |
| Intangible assets                    |   | 9,100  |   |
| Goodwill                             |   | 33,897 |   |
|                                 |   | $      | 44,706 |   |

 

Tangible assets were valued at estimates of their current fair values.  The purchase price exceeded the netassets acquired resulting in the recognition of goodwill and other intangibleassets.  The amounts allocated tointangible assets include purchased technology totaling $7.0 million, tradename and other intangible assets totaling $1.25 million and customer basetotaling $850,000 which are being amortized over their estimated useful livesof five years.

Approximately $2.7 million of the purchase price wasallocated to in-process research and development which had not yet reachedtechnological feasibility and had no alternative future use.  Accordingly, this amount was immediatelyexpensed upon the acquisition date.  Thisamount was determined using management’s estimates including consultation withan independent appraiser.  The value ofthe in-process research and development was determined using a discounted cashflow method and factors including projected financial results, relative risk ofsuccessful development, time-value of money and level of completion.

**Pro Forma Financial Information**

Thefollowing unaudited pro forma financial information presents the combinedresults of operations of Zoran and Oren as if the acquisition had occurred asof the beginning of the period presented, after giving effect to certain adjustments,including amortization of intangibles. The unaudited pro forma financialinformation does not necessarily reflect the results of operations that wouldhave occurred had the combined companies constituted a single entity duringsuch periods, and is not necessarily indicative of results which may beobtained in the future.

 

|                                              | ** ** | **Year Ended  December 31,** | ** ** |
|----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                   | ** ** | **2005**                               | ** ** |
| ** **                                   | ** ** | **(restated)**                         | ** ** |
|                                         |       |                                   |       |
| **In thousands except for per  share data:** |       |                                   |       |
| Pro forma revenues                           |       | $                                      | 396,737    |   |
|                                         |       |                                        |       |
| Pro forma net loss                           |       | $                                      | (33,024    | ) |
|                                         |       |                                        |       |
| Pro forma net loss per  share:               |       |                                   |       |
| Basic                                        |       | $                                      | (0.75      | ) |
|                                         |       |                                        |       |
| Diluted                                      |       | $                                      | (0.75      | ) |

 

**11.   NetIncome (Loss) Per Share**

Basic net income (loss)per share is calculated by dividing net income available to common stockholdersby the weighted average number of common shares outstanding during theperiod.  Diluted net income per share is calculated by using the weightedaverage number of common shares outstanding during the period increased toinclude the number of additional shares of common stock that would have beenoutstanding if the dilutive potential shares of common stock had beenissued.  The dilutive effect of outstanding options and restricted stockfor the three and nine month periods ended September 30, 2006 is reflected indiluted net income per share by application of the treasury stock method, whichincludes consideration of stock-based compensation required by SFAS No. 123(R).

 

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The following table provides a reconciliation of thecomponents of the basic and diluted net income (loss) per share computations(in thousands, except per share data):
| ** **                                                   | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                   | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                   | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                   | ** ** | ** **                       | ** ** | **(restated)**                  | ** ** | ** ** | ** ** | **(restated)** | ** ** |
| Net income (loss)                                            |       | $                                | 1,852      |                            | $          | 3,995 |   | $ | 27,314 |   | $ | (26,503 | ) |
|                                                         |       |                             |       |                            |       |   |   |   |   |
| Weighted average shares  outstanding                         |       | 49,333                           |       | 44,877                          |       | 48,013 |   | 43,942 |   |
| Effect of dilutive  options, ESPP and restricted stock units |       | 1,379                            |       | 1,745                           |       | 2,273 |   | — |   |
| Dilutive weighted  average shares                            |       | 50,712                           |       | 46,622                          |       | 50,286 |   | 43,942 |   |
|                                                         |       |                             |       |                            |       |   |   |   |   |
| Net income (loss) per  share: (1)                            |       |                             |       |                            |       |   |   |   |   |
| Basic                                                        |       | $                                | 0.04       |                            | $          | 0.09 |   | $ | 0.57 |   | $ | (0.60 | ) |
| Diluted                                                      |       | $                                | 0,04       |                            | $          | 0.09 |   | $ | 0.54 |   | $ | (0.60 | ) |

----

(1)    Net income for the three and nine monthperiods ended September 30, 2006 includes $4.0 million and $13.5 million,respectively, of stock-based compensation expense.  The effect of recording stock-basedcompensation expense on basic and diluted net income per share was $0.08 pershare for the three months ended September 30, 2006 and $0.28 and $0.27 pershare, respectively, for the nine months ended September 30, 2006.

Options to purchase 4,475,000 and 7,412,000 shares ofcommon stock were excluded from the computation of diluted net income (loss)per share for the three months ended September 30, 2006 and 2005, respectively,as these shares would have had an anti-dilutive effect.

Options to purchase 2,571,000 shares of common stockwere excluded from the computation of diluted net income (loss) per share forthe nine months ended September 30, 2006 as these shares would have had ananti-dilutive effect.

Options to purchase 10,025,000 shares and 65,000restricted stock units were excluded from the computation of diluted net income(loss) per share for the nine months ended September 30, 2005 as these shareswould have had an anti-dilutive effect

**12.**          Legal Proceedings

*U.S. Attorney andSEC Investigations: *On July 3, 2006, Zoran disclosed in a press releasethat it received a grand jury subpoena from the office of the U.S. attorney forthe Northern District of California requesting documents from 1995 through thepresent referring to, relating to or involving stock options, and also receivedan informal inquiry from the SEC requesting documents related to Zoran’s stockoption grants.  Zoran intends tocooperate fully in all government investigations.  These inquiries likely will require theCompany to expend significant management time and incur significant legal andother expenses, and could result in civil and criminal actions seeking, amongother things, injunctions against the Company and its officers and directors andthe payment of significant fines and penalties by the Company and its officersand directors, which may adversely affect its results of operations and cashflow.  The Company cannot predict howlong it will take to or how much more time and resources it will have to expendto resolve these government inquiries, nor can it predict the outcome of theseinquiries. Also, there can be no assurance that other inquiries, investigationsor actions will not be started by other United States federal or stateregulatory agencies or by foreign governmental agencies.

*Late SEC Filings and Nasdaq Delisting Proceedings*Due to the Special Committee investigation and theresulting restatements, the Company did not file on time its Quarterly Reportson Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006or its Annual Report on Form 10-K for the year ended December 31, 2006. As aresult, the Company received Nasdaq Staff Determination letters dated August14, 2006, November 15, 2006, and March 20, 2007 stating that the Company  was not in compliance with the filingrequirements of Marketplace Rule 4310(c)(14) and, therefore, that the Company’sstock was subject to delisting from the Nasdaq Global Select Market.  A hearing before a Nasdaq ListingQualifications Panel was held on September 27, 2006 and a decision to grant theCompany’s request for continued listing on Nasdaq subject to certain conditions

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*occurredon December 28, 2006.  The Company hasappealed this decision, and the Nasdaq Listing Council has determined to staythe December 28, 2006 Panel decision, and any future Panel determinations tosuspend Zoran’s securities from trading, pending further action from theListing Council.  On March 2, 2007, theCompany provided the Listing Council with an additional submission for itsconsideration regarding continued listing. The Listing Council will review the matter on the basis of the writtenrecord.*

*Shareholder Class Actionsand Derivative Litigation Relating to Historical Stock Option Practices:*****As discussed further below,certain persons and entities identifying themselves as shareholders ofZoran have filed class action complaints against the Company and derivativeactions purporting to assert claims on behalf of and in the name of the Companyagainst various of the Company’s current and former directors and officersrelating to its historical accounting for stock options.

*Zucker v. Zoran Corporation, et al..*  On August 10, 2006, a securities class actioncomplaint was filed against Zoran and certain of its officers and directors inthe United States District Court, Northern District of California, allegingviolations of federal securities laws. The Court selected Middlesex Pension Fund as lead plaintiff and approvedlead plaintiff’s selection of counsel for the class.  Plaintiff filed an amended complaint onFebruary 1, 2007 and a second amended complaint on February 20, 2007.  On March 8, 2007, Defendants filed a motionto dismiss.  On March 20, 2007, leadplaintiff filed a notice voluntarily dismissing the action with prejudice as tothe lead plaintiff.

*NCEA-IBEW Pension Fund (The Decatur Plan) v. Galil,et al.*  On June 12,2006, a purported shareholder derivative action was filed by the Decatur Planagainst Zoran as a nominal defendant and certain of its  officers and directors in the United StatesDistrict Court, Northern District of California, alleging, inter alia,violations of federal and state securities laws and breaches of fiduciaryduty.  On December 4, 2006, Decatur Planfiled a notice of voluntary dismissal.

*Pfeiffer v. Zoran Corporation et al.*  On September 7, 2006, a purported shareholderderivative action was filed by Milton Pfeiffer against Zoran as a nominaldefendant and certain of its officers and directors in the United StatesDistrict Court, Northern District of California, alleging, inter alia,violations of federal securities laws and breaches of fiduciary duties.

*Gerald del Rosario v. Aharon et al.** *OnSeptember 26, 2006, a purported shareholder derivative action was filed byGerald del Rosario against Zoran as a nominal defendant and certain of itscurrent and former officers and directors in the United States District Court,Northern District of California, alleging, inter alia, violations of federalsecurities laws and breaches of fiduciary duty. On December 8, 2006, the Court issued an order consolidating the *Del Rosario* action with the *Pfeiffer*action.  The Court selected del Rosarioas lead plaintiff and approved lead plaintiff’s selection of counsel for theconsolidated derivative action. Plaintiffs filed a consolidated amended complaint on March 14, 2007.

*Barone v. Gerzberg et al.; Durco v. Gerzberg et al.* On October 23, 2006,two purported shareholder derivative actions were filed by Moshe Barone andJohn Durco against Zoran as a nominal defendant and certain of its current andformer officers and directors in the California Superior Court of Santa ClaraCounty, alleging, inter alia, violations of state securities laws and breachesof fiduciary duty.  On January 24, 2007the Court consolidated the *Barone*and *Durco*actions, appointed Messrs. Barone and Durco as co-leadplaintiffs and approved their selection of counsel for the consolidatedderivative action.  Co-Lead Plaintiffsfiled a consolidated amended complaint on March 26, 2007.

On February 20, 2007, the Company filed a complaintagainst ArcSoft Inc. in the California Superior Court for the County of Alameda,seeking, payment of $4 million in principal, together with accrued interestthen in the amount of approximately $525,000, under four separate convertiblepromissory notes.  On February 28, 2007,the Company filed an application with the Court seeking to attach assets ofArcSoft as security for the payment of its obligations under the notes.  The notes represent amounts loaned by theCompany to ArcSoft in 2004 in connection with a transaction involving thetransfer to ArcSoft of rights related to a software product then underdevelopment and related agreements regarding the continued development andcommercialization of the product.  OnMarch 28, 2007, ArcSoft filed an answer denying liability under the notes andasserting various affirmative defenses. ArcSoft also filed a cross complaint alleging fraud in the inducement ofthe business arrangement, fraudulent and negligent misrepresentation, breach ofcontract and of the implied covenant of good faith and fair dealing, and unjustenrichment and seeking monetary damages of more than $6.9 million.  The hearing on our application for anattachment is currently scheduled for May 14, 2007.

*Indemnification Obligations***.** Subject to certain limitations, theCompany is obligated to indemnify its current and former directors, officersand employees in connection with the investigation of the Company’s historicalstock option practices and related government inquiries and litigation. Theseobligations arise under the terms of the Company’s certificate of incorporation,its bylaws, applicable contracts, and Delaware and California law. Theobligation to indemnify generally means that the Company is required to pay orreimburse the individuals’ reasonable legal expenses and possibly damages andother liabilities incurred in connection with these matters. The Company iscurrently paying or reimbursing legal expenses being incurred in connectionwith these matters by a number of its current and former directors, officersand employees.

*Other Legal Matters.*The Company is named from time to time as a party to lawsuits in the normalcourse of its business. Litigation, in general, and intellectual property andsecurities litigation in particular, can be expensive and disruptive to normalbusiness operations. Moreover, the results of legal proceedings are difficultto predict.

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**13.****                SubsequentEvents**

On February 27, 2007, the Company elected to: (i)participate in the Internal Revenue Service remediation program 2007-18 and payto the IRS, on behalf of affected and eligible employees (not includingexecutive officers), their IRC 409A tax liabilities and penalties; (ii)participate in any similar remediation program that may be offered by any statefor applicable state tax liabilities and penalties; (iii), act directly withany state not offering a similar remediation program to address any applicabletax liabilities and penalties on behalf of employees; and (iv) pay to suchemployees a “gross-up” payment to offset the associated federal and stateincome tax consequences.   The Companytook this action because the vast majority of the holders of stock optionsissued by the Company that are now subject to re-measurement as a result of theCompany’s option investigation were not involved in or aware of the stockoption pricing determination.  Employeeswho exercised such options in 2006, other than executive officers at the timeof option grant or entering into this program, will participate in thisprogram.  The Company estimates that thetotal cash payments needed to deal with the adverse tax consequences of previouslyexercised discount priced options granted to non-officers will be approximately$0.8 million, which is expected to be recorded in 2007.

In addition, the Companymay consider taking action to minimize the adverse tax consequences that may beincurred by the holders of unexercised discount options. Discount-priced stockoptions vesting after December 31, 2004 (“409A Affected Options”) subject U.S.option holders to a penalty tax under IRC Section 409A (and to similar penaltytaxes under California and other state tax laws, as applicable). The Companymay consider offering to amend the 409A Affected Options held by persons otherthan directors and executive officers to increase the exercise prices of thoseoptions to the market price of our common stock on the revised measurementdate. The amended options would not be subject to taxation under IRC Section409A. Under IRS regulations, the amendments for non-executives cannot beoffered until after this Report is filed and do not need to be completed untilDecember 31, 2007. The Company may also consider approving the payment ofbonuses to holders of those amended options to compensate them for theresulting increase in their option exercise price. The amount of these bonuseswould be effectively repaid to the Company if and when the options areexercised and the increased exercise price is paid (but there is no assurancethat the options will be exercised).  TheCompany has not estimated the expense of any such bonus payments.

Two executive officeroption holders were subject to a December 31, 2006 deadline to accomplish anyamendment of 409A Affected Options in accordance with IRS guidelines.Accordingly, in December 2006, the Company amended the 409A Affected Optionsheld by Dr. Gerzberg and Mr. Schneider to increase the exercise price of thoseoptions to the fair market value of the Company’s common stock on the revisedmeasurement date so that these options are no longer subject to a penalty taxunder IRC Section 409A.

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**Item 2.**           Management’s Discussion and Analysis ofFinancial Condition and Results of Operations

*This report includes a number of forward-lookingstatements which reflect the Company’s current views with respect to futureevents and financial performance. These forward-looking statements aresubject to certain risks and uncertainties, including those discussed in “PartII, Item 1A. Risk Factors” below. In this report, the words “anticipates,” “believes,”“expects,” “intends,” “future” and similar expressions identify forward-lookingstatements. Readers are cautioned not to place undue reliance on these forward-lookingstatements, which speak only as of the date hereof.*

The following informationhas been adjusted to reflect the restatement of the Company’s financialresults, which is more fully described in the “Explanatory Note” immediatelypreceding Part I, Item 1 and in Note 2, “Restatement of CondensedConsolidated Financial Statements” of the Notes to Condensed ConsolidatedFinancial Statements.

**Restatements**

On July 3, 2006, the Company announced that, at therecommendation of the Audit Committee, the Board of Directors had created aspecial committee of independent directors (“Special Committee”) to conduct areview of our historical stock option practices. As a result of itsinvestigation, the Special Committee found, among other things, that some ofthe original measurement dates used by the Company for option grants were notadequately supported by contemporaneous records, and therefore the measurementdates used by us for accounting purposes required adjustment. The SpecialCommittee concluded that the evidence did not establish that the errors whichit identified resulted from fraud or intentional misconduct by our currentsenior management.

Based on the Special Committee’s findings and its ownreview of the facts, the Board of Directors concluded that there was no fraudor intentional misconduct by any current member of senior management.  The Board also concluded that it hasconfidence in the integrity of the Company’s Chief Executive Officer, Dr. LevyGerzberg, and the Company’s Chief Financial Officer, Mr. Karl Schneider.

Based on information obtained from the SpecialCommittee’s review and additional work undertaken by the Company, managementhas concluded, and the Audit Committee has agreed, that the Company shouldrestate certain previously filed financial statements, to reflect additionalstock-based compensation expense with regard to certain past stock optiongrants. The corrections made in the restatements relate to options coveringapproximately 3.6 million shares. These adjustments, after tax, amounted to anadditional stock-based compensation expense of $60,000 and $686,000 in thethree months ended September 30, 2006 and 2005 and $420,000 and $1,404,000 inthe nine months ended September 30, 2006 and 2005 respectively. There was notax impact of these additional stock-based compensation expenses due to the fullvaluation allowance on our tax assets.

In connection with the restatement, the Company isrecording additional non-cash adjustments that were previously considered to beimmaterial relating to the timing of revenue recognition, accrued expenses,amortization of premiums and discounts on investments, additional expenserelated to options granted to a consultant, and the amortization of stock-basedcompensation relating to a business combination in 2003.  The Company is also recording losses underAccounting Principles Board (“APB”) Opinion No. 18 (“APB No. 18”), “TheEquity Method of Accounting for Investments in Common Stock,” to record thelosses on investment of the prior 17% ownership of Oren Semiconductor, Inc.under the equity method of accounting which was subsequently acquired by Zoranin 2005.   These additional adjustmentsresulted in a cumulative expense of $1.3 million, including $0.2 million of taxexpense, for the periods 2000 through 2005.

Through 2005, we applied APB No. 25, “Accounting forStock Issued to Employees,” and its related interpretations, and provided therequired pro forma disclosures under (“APB No. 25”) of Financial AccountingStandards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” and SFASNo. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure.” Under APB No. 25, non-cash, stock-basedcompensation expense was recognized for any option for which the exercise pricewas below the market price of our common stock on the actual grant date.Because each of the options identified below (other than those which we havedetermined should be accounted for variably) was deemed to have an exerciseprice below the market price on the appropriate measurement date, we shouldhave recognized a charge for each of those options under APB No. 25, in anamount equal to the number of shares covered by such options, multiplied by thedifference between the exercise price and the market price on the appropriatemeasurement date. That expense should have been amortized over the vestingperiods of the options. Starting in 2006, we adopted SFAS No. 123(R),“Share-Based Payment.” As a result, for 2006, the additional stock-basedcompensation expense required to be recorded for each of the options identifiedbelow was equal to the incremental fair value of those options on theappropriate measurement date over the remaining vesting periods of thoseoptions.  We did not record such stock-basedcompensation expenses under APB No. 25 or SFAS No. 123(R) in ourpreviously issued financial statements, and that is the reason for therestatement in this report.  To correctour past accounting for stock options, we recorded additional pre-tax,non-cash, stock-based compensation expense of (a) $11.7 million for the periods1997 to 2005 under APB No. 25 and (b) $60,000 and $420,000 for the three monthsand nine months ended September 30, 2006 under SFAS No. 123(R).  The fair value of the options is beingrecorded using the accelerated amortization method under FIN 28 over therespective vesting periods of the awards.

Consistent with the accounting literature and recentguidance from the Securities and Exchange Commission (“SEC”), the Company hasorganized the grants with respect to which an accounting adjustment is requiredinto categories based on grant type and process by which the grant wasfinalized.  Based on the relevant factsand circumstances, the Company applied the relevant accounting standards todetermine the measurement date for every grant within each category. TheCompany recorded accounting adjustments as required, resulting in stock-basedcompensation expense and related tax effects. The Company organized the grants where adjustments were required asfollows:

·                                          *Company-wide option grants where optionees were addedor grant amounts were changed after the option list was complete, or whereinsufficient contemporaneous documentation of the grant date exists.* For seven Company-wide refresh and retentiongrants made between 1998 and 2003, the Company determined that some employeeswho were omitted from the option grant list were added to the list after thestated grant date, and that the number of shares covered by option grants tosome employees was not finally determined until after the stated grantdate.  Further, in 2001 and 

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2002, insufficient contemporaneous documentation of the stated grantdate existed.  As a result of theseissues, the Company restated its historical financial statements to increasestock-based compensation expense by approximately $6.3 million, recognized overthe vesting periods of the relevant options.

·                                          *Re-priced options.*In August 2002, after consideration of relevant information, theCompensation Committee rescinded its April 2002 grant, and its June 2002 grant,to executives and other key employees.  TheCompany thereafter reissued the grants in August 2002.  At the time, in consultation with ourexternal advisors, we determined that these transactions did not requirevariable accounting.  As a result of the SpecialCommittee review of our historical option practices, we have reassessed thecircumstances surrounding these transactions with our external advisors andhave determined that the grants should have been accounted for variably.  As a result, the Company restated itshistorical financial statements to increase stock-based compensation expense bya cumulative net amount of approximately $3.8 million, recognized over thevesting periods of these options.

·                                          *Acquisition-related options*.  The Company determined a grant given toretain employees hired in connection with an acquisition in October 2000 shouldhave been accounted for variably.  As aresult, the Company restated its historical financial statements to increasestock-based compensation expense by approximately $267,000, recognized over thevesting periods of these options.

·                                          *Improper measurement dates for non-refresh stockoption grants. *The Companyrevised the measurement dates for**certaingrants made to new hires and for promotional and other miscellaneousnon-refresh grants made between 1997 and 2003 as a result of approvals thatwere obtained subsequent to the stated grant dates or as a result ofadministrative delays or errors and a small number of stock option grants tonon-executives that were determined to have been established retrospectively.As a result, the Company restated its historical financial statements toincrease stock-based compensation expense by approximately $1.3 million,recognized over the vesting periods of these options.

In the aggregate, we have recorded additionalstock-based compensation expense for the periods 1997 through 2005 ofapproximately $11.7 million on stock option grants made from 1997 through 2003.

**The incremental impact fromrecognizing stock-based compensation expense resulting from the investigationof past stock option grants is as follows (dollars in thousands):**

** **

** **

|                                        | ** ** | **Expense  (Benefit)** | ** ** |
|----------------------------------------|------------|------------------------|------------|
| **Fiscal Year**                        | ** ** | ** **             | ** ** |
| 1997                                   |       | $                      | 190        |   |
| 1998                                   |       | 223                    |       |
| 1999                                   |       | 123                    |       |
| 2000                                   |       | 120                    |       |
| 2001                                   |       | 1,385                  |       |
| 2002                                   |       | 3,182                  |       |
| 2003                                   |       | 5,299                  |       |
| Cumulative effect at December 21, 2003 |       | 10,522                 |       |
| 2004                                   |       | (1,476                 | )          |
| 2005                                   |       | 2,623                  |       |
|                                   |       | $                      | 11,669     |   |

 

The cumulative effect of all of the restatements upthrough December 31, 2003 increased additional paid-in capital by $10.7 millionfrom $703.8 million to $714.5 million, increased accumulated deficit by $9.0million from $156.4 million to $165.4 million, and decreased total stockholders’equity by $0.7 million from $534.3 million to $533.6 million. All therestatements of financial statements, financial data and related disclosuresdescribed in this report are collectively referred to in this report as the “restatements.”

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In December 2006, the Company amended options topurchase approximately 218,000 shares of common stock held by Dr. Gerzberg andMr. Schneider, to increase the exercise price of those options to the fairmarket value of the Company’s common stock on the revised measurement date sothat these options are no longer subject to IRC Section 409A.

We have not amended, and we do not intend to amend,any of our other previously filed Annual Reports on Form 10-K.  We have amended our Quarterly Report for theperiod ended March 31, 2006 concurrent with the filing of our Annual Report onForm 10-K, and we do not intend to amend, any of our other previously filedQuarterly Reports on Form 10-Q for the periods affected by therestatements.  We presented restatedquarterly financial information for each of the quarters in 2006 and 2005 in “SelectedQuarterly Financial Information (Unaudited)” included in the Company’s Annual Reporton Form 10-K for 2006.

The impact of the restatements is disclosed in Note 2,“Restatement of Condensed Consolidated Financial Statements” of Notes toConsolidated Financial Statements. The restatements did not have a materialimpact on our analysis of results of operations, financial position and changesin financial position included in Management’s Discussion and Analysis ofFinancial Condition and Results of Operations of our previously filed QuarterlyReports on Form 10-Q. Accordingly, we have not updated those discussions andanalyses.

**Internal Controls**

Based on the definition of “material weakness” in thePublic Company Accounting Oversight Board’s Auditing Standard No. 2, *An Audit of Internal Control Over Financial Reporting Performed inConjunction With an Audit of Financial Statements*, the restatementof financial statements in prior filings with the SEC is a strong indicator ofthe existence of a “material weakness” in the design or operation of internalcontrol over financial reporting. However, the Company has concluded that thecontrol deficiencies that resulted in the restatement of the previously issuedconsolidated financial statements did not constitute a material weakness as ofSeptember 30, 2006 because management determined that as of September 30, 2006the Company’s internal controls were effective.

For a more complete discussion of remedial measuresand our controls and procedures, please refer to Item 4 — Controls andProcedures.

The SEC may disagree with the manner in which we haveaccounted for and reported, or not reported, the financial impact of pastoption grant measurement date errors, and there is a risk that its inquirycould lead to circumstances in which we may have to further restate our priorfinancial statements, amend prior filings with the SEC, or otherwise take otheractions not currently contemplated. In addition, the SEC may issue guidance ondisclosure requirements related to the financial impact of past option grantmeasurement date errors that may require us to amend this filing or priorfilings with the SEC to provide additional disclosures pursuant to thisguidance. Any such circumstance could also lead to future delays in filing oursubsequent SEC reports and delisting of our common stock from the NASDAQ GlobalSelect Market.

As a result of the investigation of its historicaloption practices, we analyzed Zoran’s internal control over financial reportingfor periods before January 1, 2003, and determined that the Company did nothave sufficient safeguards in place to monitor its control practices regardingstock option pricing and related financial reporting and to foster an effectiveflow of information between those responsible for stock option pricing andthose responsible for financial reporting. Inadequate training, communicationand coordination in and among the Company’s human resources, stockadministration, legal and finance functions prevented the Company from assuringthat stock options were priced and accounted for correctly, primarily for theyears 1997 through 2002.

From 2003 through 2005, in compliance with theSarbanes-Oxley Act of 2002 and evolving accounting guidance, the Companyimplemented improved procedures, processes and systems to provide additionalsafeguards and greater internal control over its stock option granting andadministration. These improvements included:

·                  Documenting andassessing the design and operation of internal controls;

·                  Segregatingresponsibilities, adding reviews and reconciliations, and redefining roles andresponsibilities;

·                  Implementing anew equity accounting system and a new stock administration function; and

·                  Implementing,prior to the adoption of SFAS No. 123(R), the practice of using the receipt ofthe final Board or Compensation Committee approval as the grant and measurementdate for stock option grants.

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As a result of the recommendations of the SpecialCommittee of our Board of Directors and deliberations of the CompensationCommittee of our Board of Directors, we have adopted the following policiesgoverning all stock option grants: 

·                  All optiongrants must be approved by the Compensation Committee or the Board ofDirectors; the authority to approve option grants may not be delegated. 

·                  Option grants(including officer, vice president, rank and file, promotional and new hiregrants) are generally considered at regularly scheduled quarterly meetings ofthe Compensation Committee or the Board of Directors, and action may not betaken by unanimous written consent.  

·                  Grants aregenerally effective as of the later of (i) the second trading day following theCompany’s public announcement of its financial results for the precedingquarter or (ii) the date of the Board or committee meeting.   

·                  Grantsshould be recorded promptly in the Company’s option accounting database, andgrantees should receive prompt written notification of their grants.

·                  Theannual focal review process will identify a specific date to complete theprocess of generating recommended grant amounts, after which therecommendations will be submitted to the Compensation Committee or the Board ofDirectors for approval. 

·                  Boardor committee minutes are to be drafted and circulated to directors for commentas soon as reasonably possible.

The Special Committeeinvestigation and the Company’s related activities discovered no stock optiongrant after December 31, 2003 that required accounting adjustments.

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**Related Proceedings**

*U.S.Attorney and SEC Requests.* On July 3, 2006, Zoran disclosed in a pressrelease that it received a grand jury subpoena from the office of the U.S.attorney for the Northern District of California requesting documents from 1995through the present referring to, relating to or involving stock options, andalso received an informal inquiry from the SEC requesting documents related toZoran’s stock option grants.  Zoranintends to cooperate fully in all government inquiries or investigations.  There is no assurance that we will not besubject to inquiries related to our stock option grant practices by otherfederal, state or foreign regulatory agencies. All such inquiries are likely torequire us to continue to expend significant management time and incursignificant legal and other expenses, and could result in civil and criminalactions seeking injunctions, fines or other sanctions that could adverselyaffect our business and financial results.

*ShareholderClass Actions and Derivative Litigation Relating to Historical Stock OptionPractices:*****Asdiscussed under Part II—Item 1—Legal Proceedings above, certain persons and entitiesidentifying themselves as shareholders of Zoran have filed class actioncomplaints against the Company and derivative actions purporting to assertclaims on behalf of and in the name of the Company against various of theCompany’s current and former directors and officers relating to Zoran’shistorical accounting for and disclosures related to stock options. There maybe additional lawsuits of this nature filed in the future.  We cannot predict the outcome of any suchlitigation, or the amount of time and expenses that will be required to resolvethem.  If these lawsuits become timeconsuming and expensive, or if there are unfavorable outcomes in any of thesecases, there could be a material adverse effect on our business, financialcondition and results of operations.

*Cost ofRelated Proceedings and Restated Financial Statements*. Wehave incurred substantial expenses for legal, accounting, tax and otherprofessional services in connection with the Special Committee investigation,our own related review work, the preparation of the restated financialstatements, the SEC and Department of Justice matters and inquiries from othergovernment agencies, and the related litigation. We have recorded expenses of$5.8 million in aggregate through 2006 and we expect to incur additionalcosts in the future.

*Restatement and Impact on FinancialStatements*

The following informationhas been adjusted to reflect the restatement of the Company’s financialresults, which is more fully described in the “Explanatory Note” immediatelypreceding Part I, Item 1 and in Note 2, “Restatement of ConsolidatedFinancial Statements” in Notes to Consolidated Financial Statements of our AnnualReport on Form 10-K.

In connection with therestatement, the Company is recording additional non-cash adjustments that werepreviously considered to be immaterial relating to the limiting of revenuerecognition, accrued expenses, amortization of premiums and discounts oninvestments, additional expense related to options granted to a consultant, andthe calculation of amortization of stock-based compensation relating to abusiness combination in 2003.

For additionalinformation, refer to “Note 2—Restatement of Consolidated FinancialStatements,” in Notes to Consolidated Financial Statements.

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The income statement impact of the restatements are asfollows (in thousands):
| ** **                                                                                                                | ** ** | **Cumulative  effect at  December  31, 2005** | ** ** | **Year  Ended  December  31, 2005** | ** ** | **Year  Ended  December  31, 2004** | ** ** | **Cumulative  effect at  December  31, 2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                                | ** ** | ** **                                              | ** ** | ** **                               | ** ** | ** **                               | ** ** | ** **                                              | ** ** |
| Net loss, as  previously reported                                                                                         |       |                                                    |       | $                                        | (26,971    | )                                        | $          | (47,354                                                 | )          |   |   |
| Additional  compensation (expense) benefit resulting from improper measurement dates for  stock option grants, net of tax |       | $                                                       | (11,669    | )                                        | (2,623     | )                                        | 1,476      |                                                    | $          | (10,522 | ) |
| Other adjustments,  net of tax                                                                                            |       | (1,374                                                  | )          | (678                                     | )          | (2,230                                   | )          | 1,534                                                   |       |
| Total increase to  net loss                                                                                               |       | (13,043                                                 | )          | (3,301                                   | )          | (754                                     | )          | (8,988                                                  | )          |
| Net loss, as restated                                                                                                     |       |                                                    |       | (30,272                                  | )          | (48,108                                  | )          |                                                    |       |
|                                                                                                                           |            |                                                         |            |                                          |            |                                          |            |                                                         |            |  |  |  |  |

 

 
| ** **                                                                                          | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** | **1998** | ** ** | **1997** | ** ** |
| ** **                                                                                          | ** ** | ** **                                 | ** ** |
| Stock based  compensation expense, as previously reported                                           |       | $                                          | (6,281     | ) | $ | (292 | ) | $ | (544 | ) | $ | (99 | ) | $ | — |   | $ | — |   | $ | — |   |
| Additional  compensation expense resulting from improper measurement dates for stock  option grants |       | (5,299                                     | )          | (3,182 | ) | (1,385 | ) | (120 | ) | (123 | ) | (223 | ) | (190 | ) |
| Stock based  compensation expense, as restated                                                      |       | $                                          | (11,580    | ) | $ | (3,474 | ) | $ | (1,929 | ) | $ | (219 | ) | $ | (123 | ) | $ | (223 | ) | $ | (190 | ) |

 

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**Overview**

Our products consist of integrated circuits andrelated products used in digital versatile disc players, or DVDs, movie andhome theater systems, digital cameras and video editing systems.  We also provide integrated circuits, softwareand platforms for digital television applications that enable the delivery anddisplay of digital video content through a set-top box or television as well asdigital imaging products consisting of semiconductor hardware and software thatenable users to print, scan, process and transmit documents to computerperipherals that perform printing functions. Subsequent to our acquisition of Emblaze Semiconductor Ltd. onJuly 8, 2004, we also provide highperformance, low-power application processors, technology and products for themultimedia mobile telephone market. Through the acquisition of Oren Semiconductor, Inc. onJune 10, 2005, we obtained Oren’s demodulator ICtechnology for the global high definition television market.

We derive most of our revenues from the sale of ourintegrated circuit products. Historically, average selling prices in the semiconductor industry ingeneral, and for our products in particular, have decreased over the life of aparticular product.  Average sellingprices for our hardware products have fluctuated substantially from period toperiod, primarily as a result of changes in our customer mix of originalequipment manufacturer, or OEM, sales versus sales to resellers and thetransition from low-volume to high-volume production.  In the past, we have periodically reduced theprices of some of our products in order to better penetrate the consumermarket.  We believe that, as our productlines continue to mature and competitive markets evolve, we are likely toexperience further declines in the average selling prices of our products,although we cannot predict the timing and amount of such future changes withany certainty.

Our cost of hardware product revenues consistsprimarily of fabrication costs, assembly and test costs, and the cost ofmaterials and overhead from operations. If we are unable to reduce our cost of hardware product revenues tooffset anticipated decreases in average selling prices, our product grossmargins will decrease.  We expect bothproduct and customer mix to continue to fluctuate in future periods, causingfluctuations in margins.

We also derive revenue from licensing our software andother intellectual property.  Licensingrevenue includes one-time license fees and royalties based on the number ofunits distributed by the licensee. Quarterly licensing revenue can be significantly affected by the timingof a small number of licensing transactions, each accounting for substantialrevenues.  Accordingly, licensingrevenues have fluctuated, and will continue to fluctuate, on a quarterlybasis.  In addition, we have historicallygenerated a portion of our total revenues from development contracts, primarilywith key customers, although development revenue has declined substantially asa percentage of total revenues over the past several years.  These development contracts have provided uswith partial funding for the development of some of our products.  These development contracts provide forlicense and milestone payments which are recorded as development revenue.  We classify all development costs, includingcosts related to these development contracts, as research and developmentexpenses.  We retain ownership of theintellectual property developed by us under these development contracts.  While we intend to continue to enter intodevelopment contracts with certain strategic partners, we expect developmentrevenue to continue to decline as a percentage of total revenues.

We recognize software license revenues in accordancewith the provisions of Statement of Position (SOP) No. 97-2, “Software Revenue Recognition, asamended by SOP No. 98-9, Modificationof SOP No. 97-2, SoftwareRevenue Recognition, With Respect to Certain Transactions”. Our softwarelicense agreements typically include obligations to provide maintenance andother support over a fixed term and allow for renewal of maintenance serviceson an annual basis. We determine the fair value of our maintenance obligationswith reference to substantive renewal rates within the agreement or objectiveevidence of fair value as required under SOP No. 97-2. Maintenance and supportrevenue is recognized ratably over the term of the arrangement.  We also receive royalty revenues based on perunit shipments of products embedding our software which we recognize uponreceipt of a royalty report from the customer, typically one quarter inarrears.

Our research and development expenses consist ofsalaries and related costs of employees engaged in ongoing research, design anddevelopment activities and costs of engineering materials and supplies.  We are a party to research and developmentagreements with the Chief Scientist in Israel’s Ministry of Industry and Tradeand the Israel-United States Binational Industrial Research and DevelopmentFoundation, which fund up to 50% of incurred project costs for approvedproducts up to specified contract maximums. These agreements require us to use our best efforts to achieve specifiedresults and require us to pay royalties at rates of 3% to 5% of resultingproduct sales, and up to 30% of resulting license revenues, up to a maximum of100% to 150% of total funding received.  Reportedresearch and development expenses are net of these grants, which fluctuate fromperiod to period.  We believe thatsignificant investments in research and development are required for us toremain competitive, and we expect to continue to devote significant resourcesto product development, although such expenses as a percentage of totalrevenues may fluctuate.

 

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Our selling,general and administrative expenses consist primarily of employee-relatedexpenses, sales commissions, product promotion and other professionalservices.  We expect that selling,general and administrative expenses will continue to increase to support ouranticipated growth.

We conduct amaterial amount of our research and development and certain sales and marketingand administrative operations in our foreign subsidiary offices.  As a result, some of our expenses areincurred in foreign currency.  To date,substantially all of our hardware product revenues and our software and otherrevenues have been denominated in U.S. dollars and most costs of hardwareproduct revenues have been incurred in U.S. dollars.  We expect that most of our revenues and costsof revenue will continue to be denominated and incurred in U.S. dollars for theforeseeable future.  We have notexperienced material losses or gains as a result of currency exchange ratefluctuations and have not engaged in hedging transactions to reduce ourexposure to such fluctuations.  We may inthe future elect to take action to reduce our foreign exchange risk.

Our effectiveincome tax rate has benefited from the availability of previously unbenefittednet operating losses which we have utilized to reduce taxable income for U.S.federal income tax purposes and by our Israel based subsidiary’s status as an “ApprovedEnterprise” under Israeli law, which provides a ten-year tax holiday for incomeattributable to a portion of our operations in Israel.  Our U.S. federal net operating losses expireat various times between 2017 and 2024 and the benefits from our subsidiary’sApproved Enterprise status expire at various times beginning in 2008.

**RecentAcquisition**

On June 10,2005, we completed our acquisition of Oren Semiconductor, Inc. (“Oren”), aprivately-held provider of demodulator ICs for the global high definitiontelevision market.  Prior to thisacquisition, we had made investments in Oren that represented a 17% ownershipinterest with a net book value of $3.4 million at the time of acquisition.Under the terms of the acquisition agreement, we acquired the remaining 83% ofOren’s outstanding stock by means of a merger of Oren with a wholly-ownedsubsidiary of Zoran, in consideration for which we paid an aggregate of$28.4 million in cash and issued 1,188,061 shares of Zoran common stockvalued at $12.9 million, for total consideration of $41.3 million, to theother stockholders of Oren and to employees holding Oren options.  The acquisition was accounted for under thepurchase method of accounting.

Following thecompletion of the acquisition, the results of operations of Oren have beenincluded in our consolidated financial statements.  In addition, we recorded lossesunder Accounting Principles Board Opinion No. 18 (“APB No. 18”), “The EquityMethod of Accounting for Investments in Common Stock,” to recordthe losses on investment of the prior 17% ownership of OrenSemiconductor, Inc. under the equity method of accounting.  Accordingly, our results of operations forthe three and nine months ended September 30, 2006 include Oren’s operationsfor the full year; our results of operations for the three and six months endedJune 30, 2005 include Oren’s operations between June 10, 2005 and December 31,2005 and $218,000 representing our portion of the losses incurred by Orenbetween January 1, 2005 and June 10, 2005; and our results of operations forthe year ended December 31, 2004 do not include Oren’s operations.

**Segments**

Our products are based onhighly integrated application-specific integrated circuits, or ASICs, andsystem-on-a-chip, or SOC, solutions.  Wealso license certain software and other intellectual property.  During the first quarter of 2006, wereorganized our operating structure to bring together our consumer electronicproduct lines under a single operating group, in recognition of theaccelerating convergence of consumer products and our strategy of sharingtechnology among our various product lines. The new Consumer operating segment combines the former Digital VersatileDisc (DVD), Digital Television (DTV) and Mobile product groups whose operationswere previously reported separately.  Wewill continue to report the operations of our Imaging group as a separateoperating segment.

**Results of Operations**

*Revenues*

Totalrevenues increased 10.1% to $129.4 million for the three months ended September30, 2006 compared to $117.5 million for the three months ended September 30,2005.  This increase was a result of a $13.9million increase in Consumer segment revenues primarily due to increases inhardware product revenues across all product lines. This increase was partiallyoffset by a $2.0 million decrease in Imaging segment revenues for the threemonth period ended September 30, 2006, compared to the same period in 2005,primarily due to decrease in unit shipments . For the nine months endedSeptember 30, 2006, total revenues increased 39.5% to $399.6 million comparedto $286.4 million recorded during the same period of 2005. This increase wasprimarily due to increase in Consumer

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segmentrevenues by $122.2 million. Within the Consumer segment, license revenuesrelated to the litigation settlement accounted for $35.8 million of theincrease and the remaining increase of $86.4 million was primarily as a resultof increase in hardware product revenues by $87.4 million across all productlines. This increase was partially offset by a $9.0 million decrease in Imagingsegment revenues for the nine months ended September 30, 2006, compared to thesame period in 2005 primarily due to a $8.5 million decrease in hardwareproduct revenues due to decrease in unit shipments.

Hardwareproduct revenues for the three months ended September 30, 2006 were $115.6million compared to $104.2 million for the comparable period of the prior year.The increase in hardware product revenues was driven by growth in Consumersegment product revenues. Within the Consumer segment, hardware productrevenues increased $6.2 million in the DTV product line, $4.2 million in theMobile product line and $3.3 million in the DVD product line, in each casedriven by increased unit shipments. Hardware product revenues for the ninemonths ended September 30, 2006 were $323.0 million compared to $244.1 millionfor the same period of the prior year. The increase was also due to an increasein Consumer segment product revenues. Within the Consumer segment, hardwareproduct revenues increased $43.4 million in the Mobile product line, $30.9million in the DTV product line and $13.1 million in the DVD product line, ineach case driven by increased unit shipments.

Softwareand other revenues for the three months ended September 30, 2006 were $13.8million compared to $13.3 million for the comparable period of the prior year.The increase in software and other revenues for the three months endedSeptember 30, 2006 reflected a $0.3 million increase in Imaging segmentrevenues and a $0.2 million increase in Consumer segment revenues. Software andother revenues were $40.8 million and $42.3 million for the nine month periodsended September 30, 2006 and 2005, respectively.  The decrease in software and other revenuesfor the nine months ended September 30, 2006 reflected a $1.0 million decreasein Consumer segment revenues and a $0.5 million decrease in Imaging segmentrevenues. These changes were primarily due to the timing of new agreements.

*Cost of Hardware Product Revenues*

Cost of hardware product revenues for the three monthsended September 30, 2006 were $66.8 million compared to $53.9 million for thecomparable period of the prior year and $180.8 million and $136.2 million forthe nine month periods ended September 30, 2006 and 2005, respectively. Theincrease in costs was primarily a result of the corresponding increase inhardware product revenues.  As apercentage of hardware product revenues, hardware product costs were 57.8% and56.0%, respectively,  for the three andnine month periods ended September 30, 2006, compared to 51.7% and 55.8%,respectively, for the three and nine month periods ended September 30, 2005 .Hardware product costs for the three and nine month periods ended September 30,2005 included adjustments resulting in a decrease in inventory allowance.Excluding the benefit of the net reduction in the inventory allowance, hardwareproduct costs as a percentage of hardware product revenues would have been 57.3% and 58.9 %, respectively, for the three and nine month periods endedSeptember 30, 2005. The decrease in hardware product costs as a percentage ofhardware product revenues for the nine month periods ended September 30, 2006(excluding the effect of the reduction in the inventory allowance) reflected achange in product mix as revenues from the lower margin DVD segment representeda smaller proportion of total hardware product revenue with a relative increasein revenue from the higher margin Mobile and DTV segments.

*Research and Development*

Researchand development expenses for the three months ended September 30, 2006 were$25.3 million compared to $23.7 million for the comparable period of the prioryear and $74.7 million and $65.3 million for the nine month periods endedSeptember 30, 2006 and 2005, respectively. The increase for the three monthsended September 30, 2006 was primarily due to stock-based compensation expensesof $1.2 million recorded in the current quarter as a result of the adoption ofSFAS No. 123(R), compared with stock-based compensation expense of $0.2 millionand $0.4 million in the three and six month periods ended June 30, 2005 priorto the adoption of SFAS No. 123(R) .  Theincrease for the nine months ended September 30, 2006 was primarily due tostock-based compensation expenses of $4.3 million recorded in the currentperiod, the inclusion of the operations of Oren which was acquired in June 2005for the full 2006 periods as well as continued investments in research anddevelopment across all of our segments.

*Selling, General and Administrative*

Selling,general and administrative expenses for the three months ended September 30,2006 were $25.9 million compared to $22.3 million for the comparable period ofthe prior year and $80.9 million and $69.9 million for the nine month periodsended September 30, 2006 and 2005, respectively. The increase for the threemonths ended September 30, 2006 was primarily due to stock-based compensationexpenses of $2.4 million recorded in the current quarter as a result of theadoption of SFAS No. 123(R), compared with stock-based compensation expense of$0.4 million and $0.6 million in the three and six month periods ended June 30,2005 prior to the adoption of SFAS No. 123(R) and increased legal costs. The increase for the nine months endedSeptember 30, 2006 was primarily due to

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stock-basedcompensation expenses of $9.0 million recorded in the current period, increasein the allowance for doubtful accounts by $3.2 million and the inclusion of theoperations of Oren which was acquired in June 2005 for the full 2006 periods.

*Amortizationof Intangible Assets*

During the three and ninemonth periods ended September 30, 2006, we incurred charges of $12.4 millionand $37.9 million, respectively, related to the amortization of intangibleassets compared to $12.8 million and $37.5 million for the three and ninemonths ended September 30, 2005, respectively. At September 30, 2006, we had approximately $81.3 million in netintangible assets acquired through the Oak, Emblaze and Oren acquisitions whichwe will continue to amortize on a straight line basis through 2010.

*Amortization of stock compensationresulting from business combinations*

As a result of theadoption of SFAS No. 123(R) during the first quarter of 2006, we now record acharge for all stock-based compensation expenses as described in Note 2 toCondensed Consolidated Financial Statements. As a result, we no longer record a separate charge for Amortization ofstock compensation resulting from business combinations.  For the three and nine months periods endedSeptember 30, 2005, we recorded charges of $344,000 and $1.3 million,  respectively, related to the Amortization of stock compensation resulting frombusiness combinations primarily as a result of stock options granted inconnection with the Oak acquisition.

*Interest and Other Income*

Interestand other income were $2.8 million and $8.1 million, respectively, for thethree and nine month periods ended September 30, 2006, compared to $ 679,000and $1.1 million for the same periods of 2005. These increases were a result of an increase in interest income as aresult of our higher average cash and short term investment balances and netrealized gains in investments of $1.0 million recorded during the first quarterof 2006.

*Provision for Income Taxes*

Werecorded a tax benefit of $70,000 and a tax provision of $5.9 million for thethree and nine month periods ended September 30, 2006. We recorded a taxprovision of $1.2 million for the three and nine month periods ended September30, 2005. The provision for income taxes reflects the estimated annualizedeffective tax rate applied to earnings excluding charges for amortization ofintangible assets for the interim periods and a one time charge of $4.3 millionfor tax expense related to the Media-Tek settlement. The effective tax ratediffers from the U.S. statutory rate due to utilization of previouslyunbenefitted net operating losses and State of Israel tax benefits on foreignearnings.  At September 30, 2006, wecontinue to carry a full valuation allowance against our net deferred taxassets as management has determined that it is more likely than not that ourdeferred tax assets may not be realized.

**Liquidity and Capital Resources**

At September 30, 2006, wehad $86.6 million of cash and cash equivalents, $193.7 million of short-terminvestments and $305.7 million of working capital.

Our operating activitiesgenerated cash of $82.8 million during the first nine months of 2006, primarilydue to net income of $27.3 million adjusted for non-cash items such asamortization of $37.9 million, depreciation of $7.1 million and stock-basedcompensation expense of $13.7 million. Cash provided by operations also increased due to a decrease of $7.2million in accounts receivable due to the timing of collections and a netincrease in accounts payable, accrued expenses and other liabilities, goodwilland other long term liabilities totaling $1.0 million.  These increases were partially offset by a$12.6 million increase in inventories to meet the increasing demand for ourproducts.

Cash used in investingactivities was $127.2 million during the nine months ended September 30, 2006,principally reflecting the net purchase of investments of $121.8 million. Inaddition we spent $5.4 million for purchases of property and equipment.

Cashprovided by financing activities during the nine months ended September 30,2006 was $52.1 million consisting of proceeds received from issuances ofcommon stock through exercises of employee stock options and proceeds from thesale of stock under our employee stock purchase plan.

Net cash provided byoperating activities during the first nine months of 2005 was $33.7million.  While we recorded a net loss of$26.5 million, this loss included non-cash charges for depreciation of propertyand equipment of $7.7 million, amortization of $37.6

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million and stock-basedcompensation of $2.8 million.  Changes incurrent assets and liabilities resulted in additional cash totaling $9.4million which included a $22.9 million decrease in inventory and a $6.1 millionincrease in accounts payable, accrued expenses and other liabilities, offset bya $20.5 million increase in accounts receivable. The changes in inventory andaccounts receivable were primarily the result of an increase in shipmentsduring the quarter ended September 30, 2005 due to normal seasonal factors.

Cash used in investingactivities was $11.9 million during the nine months ended September 30, 2005,reflecting $27.6 million used in the acquisition of Oren and purchases ofproperty and equipment totaling $6.4 million, partially offset by the net salesand maturities of investments of $22.1 million.

Cash provided byfinancing activities was $5.6 million during the nine months ended September30, 2005 attributable to the issuance of common stock during the period.

AtSeptember 30, 2006, we did not have any relationships with unconsolidatedentities or financial partnerships, such as entities often referred to asstructured finance or special purpose entities, established for the purpose offacilitating off-balance sheet arrangements or other contractually narrow orlimited purposes.  Accordingly, we arenot exposed to the type of financing, liquidity, market or credit risk thatcould arise if we had engaged in such relationships.

We believe that ourcurrent balances of cash, cash equivalents and short-term investments, andanticipated cash flow from operations, will satisfy our anticipated workingcapital and capital expenditure requirements at least through the next 12months.  Nonetheless, our future capitalrequirements may vary materially from those now planned and will depend on manyfactors including, but not limited to:

·                  the levels atwhich we maintain inventories and accounts receivable;

·                  the marketacceptance of our products;

·                  the levels ofpromotion and advertising required to launch our new products or to entermarkets and attain a competitive position in the marketplace;

·                  our business,product, capital expenditure and research and development plans and technologyroadmap;

·                  volume pricingconcessions;

·                  capitalimprovements to new and existing facilities;

·                  technological advances;

·                  the response ofcompetitors to our products; and

·                  ourrelationships with our suppliers and customers.

In addition, we mayrequire an increase in the level of working capital to accommodate plannedgrowth, hiring and infrastructure needs. Additional capital may also be required for additional acquisitions ofbusinesses, products or technologies.

Tothe extent that our existing resources and cash generated from operations areinsufficient to fund our future activities, we may need to raise additionalfunds through public or private financings or borrowings.  If additional funds are raised through theissuance of debt securities, these securities could have rights, preferencesand privileges senior to holders of common stock, and the terms of this debtcould impose restrictions on our operations. The sale of additional equity or convertible debt securities couldresult in additional dilution to our stockholders.  We cannot be certain that additionalfinancing will be available in amounts or on terms acceptable to us, if atall.  If we are unable to obtain thisadditional financing, we may be required to reduce the scope of our plannedproduct development and sales and marketing efforts, which could harm our business,financial condition and operating results.

**Item3.  Quantitative and QualitativeDisclosures About Market Risk**

We are exposed to financial market risks includingchanges in interest rates and foreign currency exchange rates.

Thefair value of our investment portfolio or related income would not besignificantly impacted by either a 10% increase or decrease in interest ratesdue mainly to the short-term nature of the major portion of our investmentportfolio.

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Amajority of our revenue and capital spending is transacted in U.S. dollars, althougha portion of the cost of our operations, relating mainly to our personnel andfacilities in Israel, is incurred in New Israeli Shekels.  As a result, we bear the risk that the rateof inflation in Israel or the decline in the value of U.S. dollars compared tothe New Israeli Shekel will increase our costs as expressed in U.S. dollars..  We have not engaged in hedgingtransactions to reduce our exposure to fluctuations that may arise from changesin foreign exchange rates.  Based on ouroverall currency rate exposure at September 30, 2006, a near-term 10%appreciation or depreciation of the New Israeli Shekel would have an immaterialaffect on our financial condition.

**Item 4.Controls and Procedures**

DisclosureControls and Procedures

Under thesupervision and with the participation of the Company’s management, includingthe Company’s Chief Executive Officer and Chief Financial Officer, the Companyconducted an evaluation of its disclosure controls and procedures as defined inRules 13a-15(e) and 15d-15(c) under the Securities Exchange Act of 1934, asamended (“Exchange Act”). Based on this evaluation, our Chief Executive Officerand Chief Financial Officer concluded that the Company’s disclosure controlsand procedures were effective as of September 30, 2006.  The Company’s disclosure controls andprocedures are designed to ensure that information required to be disclosed byus in the reports we file under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms that such information is accumulated and communicated to management,including the Chief Executive Officer and Chief Financial Officer, to allowtimely discussions regarding required disclosures.

Management’sConsideration of the Restatement

As disclosed inNote 2, “Restatement of Consolidated Financial Statements,” to our consolidatedfinancial statements included in Item 8 of our Annual Report on Form 10-K, werestated previously issued financial statements to record incremental non-cashstock based compensation charges under APB No. 25 in the amount of $11.7million between 1997 and 2005 and an additional $0.4 million in 2006 under SFASNo. 123(R). These accounting errors arose from the use of incorrect stockoption grant measurement dates for grants made during the period 1997 to 2003.

 

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In coming to the conclusionthat our disclosure controls and procedures were effective as of September 30,2006, management considered control deficiencies related to the stock optiongranting process that resulted in the need to restate our previously issuedfinancial statements.

During fiscal year2004 in compliance with the Sarbanes-Oxley Act of 2002, the Company implementedimproved procedures, processes and systems to provide additional safeguards andgreater internal control over its stock option granting and administration.These improvements included:

·                  Segregatingresponsibilities, adding reviews and reconciliations, and redefining roles andresponsibilities in the human resources function;

·                  Upgradingsystems and system controls that support the grant process and improving theaccuracy and timeliness of accounting for grants, including robustdocumentation of grant approvals and usage of a hosted stock administrationsystem; and

·                  Obtaining andtraining more qualified competent individuals in the human resources and stockadministration function.

The Companybelieves that these changes remediated the historical control deficiency. Consequently,the stock option grand process did not constitute a control deficiency as of December 31,2006.

Changes toInternal Control over Financial Reporting

There were nochanges in the Company’s internal control over financial reporting during thequarter ended September 30, 2006 that have materially affected, or are reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

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**Backgroundof Restatement**

**PART II. OTHER INFORMATION**

**Item 1.Legal Proceedings**

*U.S.Attorney and SEC Investigations:* On July 3, 2006, Zoran disclosed in a pressrelease that it received a grand jury subpoena from the office of the U.S.attorney for the Northern District of California requesting documents from 1995through the present referring to, relating to or involving stock options, andalso received an informal inquiry from the SEC requesting documents related toZoran’s stock option grants.  Zoran intendsto cooperate fully in all government investigations.  These inquiries likely will require theCompany to expend significant management time and incur significant legal andother expenses, and could result in civil and criminal actions seeking, among otherthings, injunctions against the Company and its officers and directors and thepayment of significant fines and penalties by the Company and its officers anddirectors, which may adversely affect its results of operations and cashflow.  The Company cannot predict howlong it will take to or how much more time and resources it will have to expendto resolve these government inquiries, nor can it predict the outcome of theseinquiries. Also, there can be no assurance that other inquiries, investigationsor actions will not be started by other United States federal or stateregulatory agencies or by foreign governmental agencies.

*Late SEC Filings and NasdaqDelisting Proceedings* Due to the Special Committeeinvestigation and the resulting restatements, the Company did not file on timeits Quarterly Reports on Form 10-Q for the quarters ended June 30, 2006 andSeptember 30, 2006. As a result, the Company received Nasdaq StaffDetermination letters, dated August 14, 2006, November 15, 2006, and March 20,2007 stating that it was not in compliance with the filing requirements ofMarketplace Rule 4310(c)(14) and, therefore, that the Company’s stock wassubject to delisting from the Nasdaq Global Select Market.  A hearing before a Nasdaq ListingQualifications Panel was held on September 27, 2006 and a decision to grant theCompany’s request for continued listing on Nasdaq subject to certain conditionsoccurred on December 28, 2006.  TheCompany has appealed this decision, and the Nasdaq Listing Council has determinedto stay the December 28, 2006 Panel decision, and any future Paneldeterminations to suspend Zoran’s securities from trading, pending furtheraction from the Listing Council.  OnMarch 2, 2007, the Company provided the Listing Council with an additionalsubmission for its consideration regarding continued listing.  The Listing Council will review the matter onthe basis of the written record.

*ShareholderClass Actions and Derivative Litigation Relating to Historical Stock OptionPractices:*****Asdiscussed further below, certainpersons and entities identifying themselves as shareholders of Zoran have filedclass action complaints against the Company and derivative actions purportingto assert claims on behalf of and in the name of the Company against various ofthe Company’s current and former directors and officers relating to itshistorical accounting for stock options.

*Zucker v. Zoran Corporation, et al..*  On August 10, 2006, a securities class actioncomplaint was filed against Zoran and certain of its officers and directors inthe United States District Court, Northern District of California, allegingviolations of federal securities laws. The Court selected Middlesex Pension Fund as lead plaintiff and approvedlead plaintiff’s selection of counsel for the class.  Plaintiff filed an amended complaint onFebruary 1, 2007 and a second amended complaint on February 20, 2007.  On March 8, 2007, Defendants filed a motionto dismiss.  On March 20, 2007, leadplaintiff filed a notice voluntarily dismissing the action with prejudice as tothe lead plaintiff.

*NCEA-IBEW Pension Fund (The Decatur Plan) v. Galil,et al.*  On June 12,2006, a purported shareholder derivative action was filed by the Decatur Planagainst Zoran as a nominal defendant and certain of its  officers and directors in the United StatesDistrict Court, Northern District of California, alleging, inter alia,violations of federal and state securities laws and breaches of fiduciary duty.  On December 4, 2006, Decatur Plan filed anotice of voluntary dismissal.

*Pfeiffer v. Zoran Corporation et al.*  On September 7, 2006, a purported shareholderderivative action was filed by Milton Pfeiffer against Zoran as a nominaldefendant and certain of its officers and directors in the United StatesDistrict Court, Northern District of California, alleging, inter alia,violations of federal securities laws and breaches of fiduciary duties.

*Gerald del Rosario v. Aharon et al.** *OnSeptember 26, 2006, a purported shareholder derivative action was filed byGerald del Rosario against Zoran as a nominal defendant and certain of itscurrent and former officers and directors in the United States District Court,Northern District of California, alleging, inter alia, violations of federalsecurities laws and breaches of fiduciary duty. On December 8, 2006, the Court issued an order consolidating the *Del Rosario* action with the *Pfeiffer*action.  

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The Court selected del Rosario as lead plaintiff and approved leadplaintiff’s selection of counsel for the consolidated derivative action.  Plaintiffs filed a consolidated amendedcomplaint on March 14, 2007.

*Barone v. Gerzberg et al.; Durco v. Gerzberg et al.* On October 23, 2006,two purported shareholder derivative actions were filed by Moshe Barone andJohn Durco against Zoran as a nominal defendant and certain of its current andformer officers and directors in the California Superior Court of Santa ClaraCounty, alleging, inter alia, violations of state securities laws and breachesof fiduciary duty.  On January 24, 2007 theCourt consolidated the *Barone*and *Durco*actions, appointed Messrs. Barone and Durco as co-leadplaintiffs and approved their selection of counsel for the consolidatedderivative action.  Co-Lead Plaintiffsfiled a consolidated amended complaint on March 26, 2007.

On February 20, 2007, theCompany filed a complaint against ArcSoft Inc. in the California Superior Courtfor the County of Alameda, seeking payment of $4 million in principal, togetherwith accrued interest then in the amount of approximately $525,000, under four separateconvertible promissory notes. On February 28, 2007, the Company filed anapplication with the Court seeking to attach assets of ArcSoft as security forthe payment of its obligations under the notes. The notes represent amountsloaned by the Company to ArcSoft in 2004 in connection with a transactioninvolving the transfer to ArcSoft of rights related to the software productthen under development and related agreements regarding the continueddevelopment and commercialization of the product. On March 28, 2007, ArcSoftfiled an answer denying liability under the notes and asserting variousaffirmative defenses. ArcSoft also filed a cross complaint alleging fraud inthe inducement of the business arrangement, fraudulent and negligentmisrepresentation, breach of contract and of the implied covenant of good faithand fair dealing, and unjust enrichment and seeking monetary damages of morethan $6.9 million. The hearing on our application for an attachment iscurrently schedules for May 14, 2007.

*Indemnification Obligations***.** Subject to certain limitations, theCompany is obligated to indemnify its current and former directors, officersand employees in connection with the investigation of the Company’s historicalstock option practices and related government inquiries and litigation. Theseobligations arise under the terms of the Company’s certificate ofincorporation, its bylaws, applicable contracts, and Delaware and Californialaw. The obligation to indemnify generally means that the Company is requiredto pay or reimburse the individuals’ reasonable legal expenses and possiblydamages and other liabilities incurred in connection with these matters. TheCompany is currently paying or reimbursing legal expenses being incurred inconnection with these matters by a number of its current and former directors,officers and employees.

*Other Legal Matters.*The Company is named from time to time as a party to lawsuits in the normalcourse of its business. Litigation, in general, and intellectual property and securitieslitigation in particular, can be expensive and disruptive to normal businessoperations. Moreover, the results of legal proceedings are difficult topredict.

**Item 1A.   RiskFactors**

Our future business, operating results and financialcondition are subject to various risks and uncertainties, including thosedescribed below.

**The discovery that the appropriate measurementdates for financial accounting purposes of certain stock option grants differedfrom the recorded grant dates of those awards has had, and may continue tohave, a material adverse effect on our financial results.**

Wecannot predict the outcome of the pending government inquiries or stockholderlawsuits, and we may face additional government actions, stockholder lawsuitsand other legal proceedings related to our historical stock option practicesand the remedial actions we have taken. All of these events have required us, andwill continue to require us, to expend significant management time and incursignificant accounting, legal, and other expenses. This could divert attentionand resources from the operation of our business and adversely affects ourfinancial condition and results of operations.

**The independent investigation of our historicalstock option practices and resulting restatements has been time consuming andexpensive, and has had a material adverse effect on our financial performance.**

Theindependent investigation of our historical stock option practices andresulting restatement activities have required us to expend significantmanagement time and incur significant accounting, legal and other expensestotaling $5.8 million in 2006 and we expect to incur additional costs in thefuture periods.  The resultingrestatements have had a material adverse effect on our results of operations.We have recorded additional stock-based compensation expense of $11.7 million forstock option grants, recognized over the periods from 1997 to 2005. There wasno tax impact of these additional stock-based compensation expenses due to thefull valuation allowance on our tax assets. In addition, we have recorded other adjustments previously considered tobe immaterial totaling $1.3 million (net of tax of $0.2 million.)  As a result, our restated consolidatedfinancial statements reflect an overall decrease in net income of $13.0 millionfor the period of 1997 to 2005.  Theeffect of the restatement adjustments on our consolidated balance sheet atDecember 31, 2005 resulted in a $2.4 million decrease in stockholders’ equity.

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**Ongoing government inquiriesrelating to our historical stock option practices are time consuming andexpensive and could result in injunctions, fines and penalties that may have amaterial adverse effect on our financial condition and results of operations.**

The inquiries by the United States Attorney’sOffice for the Northern District of California (“USAO”) and the United StatesSecurities and Exchange Commission (“SEC”) into our historical stock optionpractices are ongoing. We have cooperated with the USAO and the SEC and intendto continue to do so. The period of time necessary to resolve these inquiriesis uncertain, and we cannot predict the outcome of these inquiries or whetherwe will face additional government inquiries, investigations or other actionsrelated to our historical stock option practices. These inquiries will likelyrequire us to continue to expend significant management time and incursignificant legal and other expenses, and could result in civil and criminalactions seeking, among other things, injunctions against the Company and thepayment of significant fines and penalties by the Company, which may have a materialadverse effect on our financial condition, results of operations and cash flow.

**Wehave not been in compliance with SEC reporting requirements and Nasdaq listingrequirements and may continue to face compliance issues with both. If we areunable to remain in compliance with SEC reporting requirements and Nasdaqlisting requirements, there may be a material adverse effect on us and ourstockholders.**

Due to the independent investigation andresulting restatements, in recent periods we were unable to file our periodicreports with the SEC on time and faced the possibility of delisting of ourstock from the Nasdaq Global Select Market. As a result of our delay in filingperiodic reports on a timely basis, we will not be eligible to use aregistration statement on Form S-3 to register offers and sales of our securitiesuntil all periodic reports have been timely filed for at least 12 months then Ifthe Nasdaq Listing and Hearing Review Council concludes that we are not incompliance with applicable listing requirements, then we may be unable tomaintain an effective listing of our stock on a national securities exchange.If this happens, the price of our stock and the ability of our stockholders totrade in our stock could be adversely affected. In addition, we would besubject to a number of restrictions regarding the registration of our stockunder federal securities laws, and we would not be able to issue stock optionsor other equity awards to our employees or non-employees or allow them toexercise their outstanding options, which could adversely affect our businessand results of operations.

**Wehave been named as a party to stockholder derivative and class action lawsuitsrelating to our historical stock option practices, and we may be named inadditional lawsuits in the future. This litigation could become time consumingand expensive and could result in the payment of significant judgments andsettlements, which could have a material adverse effect on our financialcondition and results of operations.**

In connection with ourhistorical stock option practices and resulting restatements, a number ofderivative actions were filed against certain of our current and formerdirectors, officers and certain other individuals purporting to assert claimson Zoran’s behalf. In addition, a securities class action complaint was filedagainst us and certain of our current and former officers and our currentdirectors, seeking damages related to our historical stock option practices.There may be additional lawsuits of this nature filed in the future. We cannotpredict the outcome of these lawsuits, nor can we predict the amount of timeand expense that will be required to resolve these lawsuits. If these lawsuitsbecome time consuming and expensive, or if there are unfavorable outcomes inany of these cases, there could be a material adverse effect on our business,financial condition and results of operations.

Our insurance coverage will not cover our totalliabilities and expenses in these lawsuits, in part because we have asignificant deductible on certain aspects of the coverage. In addition,  we are obligated to indemnify our current andformer directors, officers and employees in connection with the investigationof our historical stock option practices and the related government inquiriesand litigation. We currently hold insurance policies for the benefit of ourdirectors and officers, although our insurance coverage may not be sufficientin some or all of these matters. Furthermore, the insurers may seek to deny orlimit coverage in some or all of these matters, in which case we may have toself-fund all or a substantial portion of our indemnification obligations.

**Weare subject to the risks of additional lawsuits from former officers andemployees in connection with our historical stock option practices, theresulting restatements, and the remedial measures we have taken.**

In addition to the possibilities that there maybe additional governmental actions and shareholder lawsuits against us, we maybe sued or taken to arbitration by former officers and employees in connectionwith their stock options and other matters. These lawsuits may be timeconsuming and expensive, and cause further distraction from the operation ofour business. The adverse resolution of any specific lawsuit could have amaterial adverse effect on our business, financial condition and results ofoperations.

**Failureto maintain effective internal controls may cause us to delay filing ourperiodic reports with the SEC, affect our Nasdaq listing, and adversely affectour stock price.**

We are required to include a report ofmanagement on internal control over financial reporting in our Annual Report onForm 10-K that contains an assessment by management of the effectiveness of ourinternal control over financial reporting. In addition, our 

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independent registered public accounting firmmust attest to and report on management’s assessment of the effectiveness ofthe internal control over financial reporting. The restatement of financial statements in prior filings with the SEC isa strong indicator of the existence of a “material weakness” in the design oroperation of internal control over financial reporting. However, we haveconcluded that the control deficiencies that resulted in the restatement of thepreviously issued consolidated financial statements did not constitute amaterial weakness as of December 31, 2006 because management determined that asof December 31, 2006 there were effective controls designed and in place toprevent or detect a material misstatement and therefore the likelihood ofstock-based compensation, deferred compensation and deferred tax assets beingmaterially misstated is not more than remote.

The SEC may disagree with the manner in which wehave accounted for and reported, or not reported, the financial impact of pastoption grant measurement date errors, and there is a risk that its inquirycould lead to circumstances in which we may have to further restate our priorfinancial statements, amend prior filings with the SEC, or otherwise take otheractions not currently contemplated. In addition, the SEC may issue guidance ordisclosure requirements related to the financial impact of past option grantmeasurement date errors that may require us to amend this filing or prior filingswith the SEC to provide additional disclosures pursuant to this guidance. Anysuch circumstance could also lead to future delays in filing our subsequent SECreports and delisting of our common stock from the NASDAQ Global Select Market.

**Itmay be difficult or costly to obtain director and officer liability insurancecoverage as a result of our stock options problems.**

We expect that the issues arising from ourhistorical stock option grant practices and the related accounting will make itmore difficult to obtain director and officer insurance coverage in thefuture.  If we are able to obtain this coverage, it could be significantlymore costly than in the past, which would have an adverse effect on ourfinancial results and cash flow. As a result of this and related factors, ourdirectors and officers could face increased risks of personal liability inconnection with the performance of their duties. As a result, we may havedifficultly attracting and retaining qualified directors and officers, whichcould adversely affect our business.

**Ourannual revenues and operating results fluctuate due to a variety of factors,which may result in volatility or a decline in the prices of our common stock.**

Our historical operating results have variedsignificantly from period to period due to a number of factors, including:

·                  fluctuation indemand for our products;

·                  the timing ofnew product introductions or enhancements by us and our competitors;

·                  the level ofmarket acceptance of new and enhanced versions of our products and ourcustomers’ products;

·                  the timing orcancellation of large customer orders;

·                  the length andvariability of the sales cycle for our products;

·                  pricing policychanges by us and by our competitors and suppliers;

·                  the cyclicalnature of the semiconductor industry;

·                  the availabilityof development funding and the timing of development revenue;

·                  changes in themix of products sold;

·                  seasonality indemand for our products;

·                  increasedcompetition in product lines, and competitive pricing pressures; and

·                  the evolving andunpredictable nature of the markets for products incorporating our integratedcircuits and embedded software.

We expect that ouroperating results will continue to fluctuate in the future as a result of thesefactors and a variety of other factors, including:

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·                  the cost andavailability of adequate foundry capacity;

·                  fluctuations inmanufacturing yields;

·                  changes in orthe emergence of new industry standards;

·                  failure toanticipate changing customer product requirements;

·                  the loss or gainof important customers;

·                  productobsolescence; and

·                  the amount ofresearch and development expenses associated with new product introductions.

Our operating results could also be harmed by:

·                  economicconditions generally or in various geographic areas where we or our customersdo business;

·                  terrorism andinternational conflicts or other crises;

·                  other conditionsaffecting the timing of customer orders;

·                  changes ingovernmental regulations that could affect our products;

·                  a downturn in themarkets for our customers’ products, particularly the consumer electronicsmarket;

·                  disruptionin commercial activities associated with heightened security concerns affectinginternational travel and commerce;

·                  reduceddemand for consumer electronic products due to a potential economic slowdown;

·                  tightenedimmigration controls that may adversely affect the residence status of keynon-U.S. managers and technical employees in our U.S. facilities or our abilityto hire new non-U.S. employees in such facilities; or

·                  potentialexpansion of armed conflict in the Middle East which could adversely affect ouroperations in Israel.

These factors aredifficult or impossible to forecast.  Weplace orders with independent foundries several months in advance of thescheduled delivery date, often in advance of receiving non-cancelable ordersfrom our customers.  This limits ourability to react to fluctuations in demand for their products.  If anticipated shipments in any quarter arecanceled or do not occur as quickly as expected, or if we fail to foresee atechnology change that could render a product obsolete, expense and inventorylevels could be disproportionately high. If anticipated license revenues in any quarter are canceled or do notoccur, gross margins may be reduced.

A significantportion of our expenses are relatively fixed, and the timing of increases inexpenses is based in large part on our forecast of future revenues.  As a result, if revenues do not meet ourexpectations, we may be unable to quickly adjust expenses to levels appropriateto actual revenues, which could harm our operating results.

**Ourcustomers experience fluctuating product cycles and seasonality, which causestheir sales to fluctuate.**

Because themarkets that our customers serve are characterized by numerous new productintroductions and rapid product enhancements, our operating results may varysignificantly from quarter to quarter. During the final production of a mature product, our customers typicallyexhaust their existing inventories of our products.  Consequently, orders for our products maydecline in those circumstances, even if the products are incorporated into bothmature products and replacement products. A delay in a customer’s transition to commercial production of a replacementproduct would delay our ability to recover the lost sales from thediscontinuation of the related mature product. Our customers also experience significant seasonality in the sales oftheir consumer products, which affects their orders of our products.  Typically, the second half of the calendaryear represents a disproportionate percentage of sales for our customers due tothe holiday shopping period for consumer electronics products, and therefore, adisproportionate percentage of our sales. We expect these seasonal sales fluctuations to continue for theforeseeable future.

Our ability to match production mix with the product mix needed to fillcurrent orders and orders to be delivered in the given quarter may affect ourability to meet that quarter’s revenue forecast.  In addition, when responding to customers’requests for shorter shipment 

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lead times, we manufacture products based on forecasts of customers’demands.  These forecasts are based onmultiple assumptions.  If we inaccuratelyforecast customer demand, we may hold inadequate, excess or obsolete inventorythat would reduce our profit margins and adversely affect our results ofoperations and financial condition.

**Ourproducts are characterized by average selling prices that decline overrelatively short time periods; if we are unable to reduce our costs orintroduce new products with higher average selling prices, our financialresults will suffer.**

Average sellingprices for our products decline over relatively short time periods, while manyof our manufacturing costs are fixed. When our average selling prices decline,our revenues decline unless we are able to sell more units, and our grossmargins decline unless we are able to reduce our manufacturing costs by acommensurate amount.  Our operatingresults suffer when gross margins decline. We have experienced these problems, and we expect to continue toexperience them in the future, although we cannot predict when they may occuror how severe they will be.

**Productsupply and demand in the semiconductor industry is subject to cyclicalvariations.**

The semiconductorindustry is subject to cyclical variations in product supply and demand.  Downturns in the industry often occur inconnection with, or anticipation of, maturing product cycles for bothsemiconductor companies and their customers and declines in general economicconditions.  These downturns have beencharacterized by abrupt fluctuations in product demand, productionover-capacity and accelerated decline of average selling prices.  In some cases, these downturns have lastedmore than one year. We cannot predict whether we will achieve timely,cost-effective access to that capacity when needed, or when there will be acapacity shortage again in the future.  Adownturn in the semiconductor industry could harm our sales and revenues ifdemand drops, or our gross margins if average selling prices decline.

**Oursuccess for the foreseeable future will depend on demand for integratedcircuits for a limited number of applications.**

In recent years, we have derived a substantialmajority of our product revenues from the sale of integrated circuits for DVDand digital camera applications.  Weexpect that sales of our products for these applications will continue toaccount for a significant portion of our revenues for the foreseeable future.Our future financial performance will also depend on our ability tosuccessfully develop and market new products in the digital television, HDTVand digital imaging markets.  If themarkets for these products and applications decline or fail to develop asexpected, or we are not successful in our efforts to market and sell ourproducts to manufacturers who incorporate integrated circuits into theseproducts, our financial results will be harmed.

**Ourfinancial performance is highly dependent on the timely and successfulintroduction of new and enhanced products.**

Our financial performance depends in large part on ourability to successfully develop and market next-generation and new products ina rapidly changing technological environment. If we fail to successfully identify new product opportunities and timelydevelop and introduce new products that achieve market acceptance, we may loseour market share and our future revenues and earnings may suffer.

In the consumerelectronic market, our performance has been dependent on our successfuldevelopment and timely introduction of integrated circuits for DVD players, DVDrecorders, digital cameras, broadband digital television and HDTV.  These markets are characterized by theincorporation of a steadily increasing level of integration and numbers offeatures on a chip at the same or lower system cost, enabling originalequipment manufacturers, or OEMs, to continually improve the features or reducethe prices of the systems they sell.  Ifwe are unable to continually develop and introduce integrated circuits withincreasing levels of integration and new features at competitive prices, ouroperating results will suffer.

In the Imaging market,our performance has been dependent on our successful development and timelyintroduction of integrated circuits for printers and multi-functionperipherals.  These markets arecharacterized by the incorporation of a steadily increasing level ofintegration and higher speeds on a chip at the same or lower system cost,enabling original equipment manufacturers, or OEMs, to continually improve theperformance and features or reduce the prices of the systems they sell.  If we are unable to develop and introduceintegrated circuits with increasing levels of integration, performance and newfeatures at competitive prices, our operating results will suffer. Theperformance of our software licensing business is dependent on our ability todevelop and introduce new releases of our software, which incorporate new orenhanced printing standards, as well as performance enhancements required byour OEM customers. If we are unable to develop and release versions of oursoftware supporting required standards and offering enhanced performance, our operatingresults will suffer.

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**Weface competition or potential competition from companies with greater resourcesthan ours, and if we are unable to compete effectively with these companies,our market share may decline and our business could be harmed.**

Themarkets in which we compete are intensely competitive and are characterized byrapid technological change, declining average unit selling prices and rapidproduct obsolescence.  We expectcompetition to increase in the future from existing competitors and from othercompanies that may enter our existing or future markets with solutions whichmay be less costly or provide higher performance or more desirable featuresthan our products.  Competition typicallyoccurs at the design stage, when customers evaluate alternative designapproaches requiring integrated circuits. Because of short product life cycles,there are frequent design win competitions for next-generation systems.

Our existing and potential competitors include many largedomestic and international companies that have substantially greater financial,manufacturing, technological, market, distribution and other resources.  These competitors may also have broaderproduct lines and longer standing relationships with customers and suppliersthan we have.

Some of our principalcompetitors maintain their own semiconductor foundries and may thereforebenefit from capacity, cost and technical advantages. Our principal competitorsin the integrated audio and video devices for DVD applications include Cheertek,ESS, LSI Logic, Magnum Semiconductor, Matsushita, MediaTek, Renesas Technology,Samsung and Sunplus. In the markets for JPEG-based products for use in digitalcameras, our principal competitors are in-house solutions developed and used bymajor Japanese OEMs, as well as products sold by Sunplus and TexasInstruments.  In the market forJPEG-based products for desktop video editing applications, our principalcompetitor is Sunplus.  Cirrus Logic(Crystal Semiconductor), Fujitsu, Freescale Semiconductor, STMicroelectronicsand Yamaha are currently shipping Dolby Digital-based audio compressionproducts.  Our principal competitors fordigital semiconductor devices in the digital television market include AdvancedMicro Devices, Broadcom, Renesas Technology, M-Star, Mediatek and STMicroelectronics.  Others who alsoparticipate in this market are ALi Corporation, Cheertek, Fujitsu, GenesisMicrochip, NEC, Pixelworks and Trident Microsystems. Competitors in the Printerand Multifunction peripheral space include Sigmatel Inc., MarvellSemiconductor, TAK Imaging, Peerless Systems, Global Graphics and in-housecaptive suppliers.

Webelieve that growth of the DVD player market will be modest in the foreseeablefuture, and that continued strong competition will lead to further pricereductions, and reduced profit margins. We also face significantcompetition in the digital Imaging and digital camera markets.  The futuregrowth of both markets is highly dependent on OEMs continuing to outsourcean increasing portion of their product development work. Many of our existing competitors,as well as OEM customers that are expected to compete with us in the future,have substantially greater financial, manufacturing, technical, marketing,distribution and other resources, broader product lines and longer standingrelationships with customers than we have.  In addition, much of ourfuture success is dependent on the success of our OEM customers.  If we orour OEM customers are unable to compete successfully against current and futurecompetitors, we could experience price reductions, order cancellations andreduced gross margins, any one of which could harm our business.

**Wemust keep pace with rapid technological changes and evolving industry standardsto remain competitive.**

Our future successwill depend on our ability to anticipate and adapt to changes in technology andindustry standards and our customers’ changing demands.  The consumer electronics market, inparticular, is characterized by rapidly changing technology, evolving industrystandards, frequent new product introductions, short product life cycles andincreasing demand for higher levels of integration.  Our ability to adapt to these changes and toanticipate future standards, and the rate of adoption and acceptance of thosestandards, will be a significant factor in maintaining or improving ourcompetitive position and prospects for growth. If new industry standards emerge, our products or the products of ourcustomers could become unmarketable or obsolete, and we could lose market shareor be required to incur substantial unanticipated costs to comply with thesenew standards**.**

Our success willalso depend on the successful development of new markets and the applicationand acceptance of new technologies and products in those new markets.  For example, our success will depend on theability of our customers to develop new products and enhance existing productsin the recordable DVD player market and products for the broadband digitaltelevision and HDTV markets and to introduce and promote those productssuccessfully.  These markets may notcontinue to develop to the extent or in the time periods that we currentlyanticipate due to factors outside our control, such as delays in implementationof FCC 02-320 requiring all new televisions to include a digital receiver byFebruary 2009. If new markets do not develop as we anticipate, or if ourproducts do not gain widespread acceptance in these markets, our business,financial condition and results of operations could be harmed.  The emergence of new markets for our productsis also dependent in part upon third parties developing and marketing contentin a format compatible with commercial and consumer products that incorporateour products.  If this content is notavailable, manufacturers may not be able to sell products incorporating ourproducts, and our sales would suffer.

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**We relyon independent foundries and contractors for the manufacture, assembly andtesting of our integrated circuits and other hardware products, and the failureof any of these third parties to deliver products or otherwise perform asrequested could damage our relationships with our customers and harm our salesand financial results.**

We do not operate any manufacturing facilities, and werely on independent foundries to manufacture substantially all of ourproducts.  These independent foundriesfabricate products for other companies and may also produce products of theirown design.  From time to time, there aremanufacturing capacity shortages in the semiconductor industry.  We do not have long-term supply contractswith any of our suppliers, including our principal supplier, TaiwanSemiconductor Manufacturing Company, or TSMC. Therefore, TSMC and our other suppliers are not obligated to manufactureproducts for us for any specific period, in any specific quantity or at anyspecified price, except as may be provided in a particular purchase order.

Our reliance on independent foundries involves anumber of risks, including:

·                  the inability toobtain adequate manufacturing capacity;

·                  theunavailability of or interruption in access to certain process technologiesnecessary for manufacture of our products;

·                  lack of controlover delivery schedules;

·                  lack of controlover quality assurance;

·                  lack of controlover manufacturing yields and cost; and

·                  potentialmisappropriation of our intellectual property.

In addition, TSMCand some of our other foundries are located in areas of the world that aresubject to natural disasters such as earthquakes.  While the 1999 earthquake in Taiwan did nothave a material impact on our independent foundries, a similar event centerednear TSMC’s facility could severely reduce TSMC’s ability to manufacture ourintegrated circuits.  The loss of any ofour manufacturers as a supplier, our inability to expand the supply of theirproducts in response to increased demand, or our inability to obtain timely andadequate deliveries from our current or future suppliers due to a naturaldisaster or any other reason could delay or reduce shipments of ourproducts.  Any of these circumstancescould damage our relationships with current and prospective customers and harmour sales and financial results.

We also rely on alimited number of independent contractors for the assembly and testing of ourproducts.  Our reliance on independentassembly and testing houses limits our control over delivery schedules, qualityassurance and product cost.  Disruptionsin the services provided by our assembly or testing houses or other circumstancesthat would require them to seek alternative sources of assembly or testingcould lead to supply constraints or delays in the delivery of ourproducts.  These constraints or delayscould damage our relationships with current and prospective customers and harmour financial results.

**Becausefoundry capacity is limited from time to time, we may be required to enter intocostly long-term supply arrangements to secure foundry capacity.**

If we are not ableto obtain additional foundry capacity as required, our relationships with ourcustomers would be harmed and our sales would likely be reduced.  In order to secure additional foundrycapacity, we have considered, and may in the future need to consider, variousarrangements with suppliers, which could include, among others:

·                  option paymentsor other prepayments to a foundry;

·                  nonrefundabledeposits with or loans to foundries in exchange for capacity commitments;

·                  contracts thatcommit us to purchase specified quantities of silicon wafers over extendedperiods;

·                  issuance of ourequity securities to a foundry;

·                  investment in afoundry;

·                  joint ventures;or

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·                  otherpartnership relationships with foundries.

We may not be ableto make any such arrangement in a timely fashion or at all, and sucharrangements, if any, may not be on terms favorable to us.  Moreover, if we are able to secure foundrycapacity, we may be obligated to utilize all of that capacity or incurpenalties.  Such penalties may beexpensive and could harm our financial results.

**Ifour independent foundries do not achieve satisfactory yields, our relationshipswith our customers may be harmed.**

The fabrication ofsilicon wafers is a complex process. Minute levels of contaminants in the manufacturing environment, defectsin photo masks used to print circuits on a wafer, difficulties in thefabrication process or other factors can cause a substantial portion of theintegrated circuits on a wafer to be non-functional.  Many of these problems are difficult to detectat an early stage of the manufacturing process and may be time consuming andexpensive to correct.  As a result,foundries often experience problems achieving acceptable yields, which arerepresented by the number of good integrated circuits as a proportion of thenumber of total integrated circuits on any particular wafer.  Poor yields from our independent foundrieswould reduce our ability to deliver our products to customers, harm ourrelationships with our customers and harm our business.

**Weare dependent upon our international sales and operations; economic, politicalor military events in a country where we make significant sales or havesignificant operations could interfere with our success or operations there andharm our business.**

During2006, only 7% of our total revenues were derived from North America sales.  We anticipate that international sales willcontinue to account for a substantial majority of our total revenues for theforeseeable future.  In addition,substantially all of our semiconductor products are manufactured, assembled andtested outside of the United States by independent foundries andsubcontractors.

We are subject to avariety of risks inherent in doing business internationally, including:

·                  unexpectedchanges in regulatory requirements;

·                  fluctuations inexchange rates;

·                  political andeconomic instability;

·                  imposition oftariffs and other barriers and restrictions;

·                  the burdens ofcomplying with a variety of foreign laws; and

·                  health risks ina particular region.

A material amount of ourresearch and development personnel and facilities and a portion of our salesand marketing personnel are located in Israel. Political, economic and military conditions in Israel directly affectour operations.  Some of our employees inIsrael are obligated to perform up to 39 days of military reserve dutyannually.  The absence of these employeesfor significant periods during the work week may cause us to operateinefficiently during these periods.

Our operations in Chinaare subject to the economic and political uncertainties affecting thatcountry.  For example, the Chineseeconomy has experienced significant growth in the past decade, but such growthhas been uneven across geographic and economic sectors.  This growth may decrease and any slowdown mayhave a negative effect on our business. We also maintain offices in Taipei, Taiwan, Hong Kong and Seoul, Korea,and our operations are subject to the economic and political uncertaintiesaffecting these countries as well.

The significantconcentration of our manufacturing activities with third party foundries inTaiwan exposes us to the risk of political instability in Taiwan, including thepotential for conflict between Taiwan and China.  We have several significant OEM customers inJapan, Korea and other parts of Asia. Adverse economic circumstances in Japan and elsewhere in Asia couldaffect these customers’ willingness or ability to do business with us in thefuture or their success in developing and launching devices containing ourproducts.

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**Theprices of our products may become less competitive due to foreign exchangefluctuations.**

Foreign currencyfluctuations may affect the prices of our products.  Prices for our products are currentlydenominated in U.S. dollars for sales to our customers throughout theworld.  If there is a significantdevaluation of the currency in a specific country, the prices of our productswill increase relative to that country’s currency, our products may be lesscompetitive in that country and our revenues may be adversely affected.  Also, we cannot be sure that ourinternational customers will continue to be willing to place orders denominatedin U.S. dollars.  If they do not, ourrevenue and operating results will be subject to foreign exchange fluctuations.

**Becausewe have significant operations in Israel, our business and future operatingresults could be harmed by future terrorist activity or military conflict.**

We conduct a significant portion of our research anddevelopment and engineering activities at our design center in Haifa, Israel, a109,700 square foot facility where we employ approximately 390 people.  We also conduct a portion of our sales andmarketing operations at our Haifa facility. We have an additional 16,100 squarefoot facility in Kfar Netter, Israel, where we conduct research and developmentactivities.

Haifa was a principal target in the recent armedconflict in Northern Israel, and, accordingly, our facility and personnel inHaifa were at significant risk during that conflict.  Although we suffered no damage to ourfacilities or injury to our personnel during the recent conflicts, significantdamage to our facilities in Israel, injury of our employees working there, ordamage to the Israeli business or transportation infrastructure as a result offuture military conflict or terrorist activity could materially affect ouroperations in Israel and harm our business. In addition, some of our employees in Israel serve in the militaryreserve. Any prolonged absence of a substantial number of these employees couldmaterially harm our business.

In addition to their impact on our operations inIsrael, military conflict in the Middle East or future terrorist activitiesthere or elsewhere in the world could harm our business as a result of adisruption in commercial activity affecting international commerce or a generaleconomic slowdown and reduced demand for consumer electronic products.

**The Israeli rate of inflation maynegatively impact our costs if it exceeds the rate of devaluation of the NewIsraeli Shekel against the United States dollar.**

A portion of the cost of our operations, relatingmainly to our personnel and facilities in Israel, is incurred in New Israeli Shekels.  As a result, we bear the risk that the rateof inflation in Israel or the decline in the value of United States dollarcompared to the New Israeli Shekel will increase our costs as expressed inUnited States dollars.  To date, we havenot engaged in hedging transactions.  Inthe future, we may enter into currency hedging transactions to decrease therisk of financial exposure from fluctuations in the exchange rate of the UnitedStates dollar against the New Israeli Shekel. These measures may not adequately protect us from the impact ofinflation in Israel.

**We derive most of our revenue fromsales to a small number of large customers, and if we are not able to retainthese customers, or they reschedule, reduce or cancel orders, our revenueswould be reduced and our financial results would suffer.**

Our largest customers have accounted for a substantialpercentage of our revenues.  In 2005, nosingle customer accounted for more than 10% of our total revenues, althoughsales to our four largest customers accounted for 29% of our total revenues.  In 2004, one customer accounted for 11% of ourtotal revenues while sales to our four largest customers accounted for 35% ofour total revenues.  Sales to these largecustomers have varied significantly from year to year and will continue tofluctuate in the future.  These salesalso may fluctuate significantly from quarter to quarter.  We may not be able to retain our keycustomers, or these customers may cancel purchase orders or reschedule ordecrease their level of purchases from us. Any substantial decrease or delay in sales to one or more of our keycustomers could harm our sales and financial results.  In addition, any difficulty in collectingamounts due from one or more key customers could harm our financial results.

**Our products generally have longsales cycles and implementation periods, which increases our costs in obtainingorders and reduces the predictability of our operating results.**

Our products are technologically complex.  Prospective customers generally must make asignificant commitment of resources to test and evaluate our products and tointegrate them into larger systems.  As aresult, our sales processes are often subject to delays associated with lengthyapproval processes that typically accompany the design and testing of newproducts.  The sales cycles of ourproducts often last for many months**. **Longer sales cycles require us toinvest significant resources in attempting to make sales and delay thegeneration of revenue**.**

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Long sales cycles alsosubject us to other risks, including customers’ budgetary constraints, internalacceptance reviews and cancellations.  Inaddition, orders expected in one quarter could shift to another because of thetiming of customers’ purchase decisions. The time required for our customers to incorporate our products intotheir own can vary significantly with the needs of our customers and generallyexceeds several months, which further complicates our planning processes andreduces the predictability of our operating results.

**Weare not protected by long-term contracts with our customers.**

We generally do not enterinto long-term purchase contracts with our customers, and we cannot be certainas to future order levels from our customers. Customers generally purchase our products subject to cancelable short-termpurchase orders.  We cannot predict whetherour current customers will continue to place orders, whether existing orderswill be canceled, or whether customers who have ordered products will payinvoices for delivered products.  When wedo enter into a long-term contract, the contract is generally terminable at theconvenience of the customer.  Earlytermination by one of our major customers would harm our financial results.

**Ourproducts could contain defects, which could reduce sales of those products orresult in claims against us.**

We develop complex andevolving products.  Despite testing by usand our customers, errors may be found in existing or new products.  This could result in, among other things, adelay in recognition or loss of revenues, loss of market share or failure toachieve market acceptance.  These defectsmay cause us to incur significant warranty, support and repair costs, divertthe attention of our engineering personnel from our product development effortsand harm our relationships with customers. The occurrence of these problems could result in the delay or loss ofmarket acceptance of our products and would likely harm our business.  Defects, integration issues or otherperformance problems in our products could result in financial or other damagesto customers or could damage market acceptance of such products.  Our customers could also seek damages from usfor their losses.  A product liabilityclaim brought against us, even if unsuccessful, would likely be time consumingand costly to defend.

**Regulationof our customers’ products may slow the process of introducing new products andcould impair our ability to compete.**

The FederalCommunications Commission, or FCC, has broad jurisdiction over our targetmarkets in the digital television business. Various international entities or organizations may also regulateaspects of our business or the business of our customers.  Although our products are not directlysubject to regulation by any agency, the transmission pipes, as well as much ofthe equipment into which our products are incorporated, are subject to directgovernment regulation.  For example,before they can be sold in the United States, advanced televisions and emerginginteractive displays must be tested and certified by Underwriters Laboratoriesand meet FCC regulations.  Accordingly,the effects of regulation on our customers or the industries in which ourcustomers operate may in turn harm our business.  FCC regulatory policies affecting the abilityof cable operators or telephone companies to offer certain services and otherterms on which these companies conduct their business may impede sales of ourproducts.  In addition, our digitaltelevision business may also be adversely affected by the imposition oftariffs, duties and other import restrictions on our suppliers or by theimposition of export restrictions on products that we sellinternationally.  Changes in current lawsor regulations or the imposition of new laws or regulations in the UnitedStates or elsewhere could harm our business. For example, any delays by the FCC in imposing its pending requirementthat all new televisions have a digital receiver could have an adverse effecton our HDTV business.

**Ourability to compete could be jeopardized if we are unable to protect ourintellectual property rights.**

Our success and abilityto compete depend in large part upon protection of our proprietarytechnology.  We rely on a combination ofpatent, trade secret, copyright and trademark laws, non-disclosure and othercontractual agreements and technical measures to protect our proprietaryrights.  These agreements and measuresmay not be sufficient to protect our technology from third-party infringement,or to protect us from the claims of others. Monitoring unauthorized use of our products is difficult, and we cannotbe certain that the steps we have taken will prevent unauthorized use of ourtechnology, particularly in foreign countries where the laws may not protectour proprietary rights as fully as in the United States.  The laws of certain foreign countries inwhich our products are or may be developed, manufactured or sold, includingvarious countries in Asia, may not protect our products or intellectualproperty rights to the same extent as do the laws of the United States and thusmake the possibility of piracy of our technology and products more likely inthese countries.  If competitors are ableto use our technology, our ability to compete effectively could be harmed.

The protection offered bypatents is subject to numerous uncertainties. For example, our competitors may be able to effectively design aroundour patents, or the patents may be challenged, invalidated orcircumvented.  Those competitors may alsoindependently develop technologies that are substantially equivalent orsuperior to our technology.  Moreover,while we hold, or have applied for, patents 

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relating to the design ofour products, some of our products are based in part on standards, for which wedo not hold patents or other intellectual property rights.

We have generally limitedaccess to and distribution of the source and object code of our software andother proprietary information.  With respect to our page descriptionlanguage software, SOC platform firmware and drivers for the digital officemarket and in limited circumstances with respect to firmware on SCS products,firmware and platforms for our DTV, DVDR products, we grant licenses that giveour customers access to and restricted use of the source code of our****software.  This access increases thelikelihood of misappropriation or misuse of our technology.

**Claimsand litigation regarding intellectual property rights could seriously harm ourbusiness and require us to incur significant costs.**

In recent years, therehas been significant litigation in the United States involving patents andother intellectual property rights.  Inthe past, Zoran has been subject to claims and litigation regarding allegedinfringement of other parties’ intellectual property rights, and both Oak andZoran have been parties to a number of patent-related lawsuits, both asplaintiff and defendant.  We could becomesubject to additional litigation in the future, either to protect ourintellectual property or as a result of allegations that we infringe others’intellectual property rights.  Claimsthat our products infringe proprietary rights would force us to defendourselves and possibly our customers or manufacturers against the allegedinfringement.  Future litigation againstus, if successful, could subject us to significant liability for damages orinvalidation of our proprietary rights. These lawsuits, regardless of their success, are time-consuming andexpensive to resolve and require significant management time and attention.  Future intellectual property litigation couldforce us to do one or more of the following:

·                  stop sellingproducts that incorporate the challenged intellectual property;

·                  obtain from theowner of the infringed intellectual property right a license to sell or use therelevant technology, which license may not be available on reasonable terms orat all;

·                  pay damages; or

·                  redesign thoseproducts that use such technology.

Although patent disputesin the semiconductor industry have often been settled through cross-licensingarrangements, we may not be able in any or every instance to settle an allegedpatent infringement claim through a cross-licensing arrangement.  We have a more limited patent portfolio thanmany of our competitors.  If a successfulclaim is made against us or any of our customers and a license is not made availableto us on commercially reasonable terms or we are required to pay substantialdamages or awards, our business, financial condition and results of operationswould be materially adversely affected.

**Ifnecessary licenses of third-party technology are not available to us or arevery expensive, our products could become obsolete.**

From time to time, we maybe required to license technology from third parties to develop new products orproduct enhancements.  Third partylicenses may not be available on commercially reasonable terms, if at all.  If we are unable to obtain any third-partylicense required to develop new products and product enhancements, we may haveto obtain substitute technology of lower quality or performance standards or atgreater cost, either of which could seriously harm the competitiveness of ourproducts.

We rely on licenses to use various technologies thatare material to our products.  We do not own the patents that underliethis license.  Our rights to use these technologies and employ theinventions claimed in the licensed patents are subject to our abiding by theterms of the licenses.  Under the license agreements we must fulfillconfidentiality obligations and pay royalties.  If we fail to abide by theterms of the license, we would be unable to sell and market the products underlicense.  In addition, we do not control the prosecution of the patentssubject to this license or the strategy for determining when such patentsshould be enforced.  As a result, we are dependent upon our licensor todetermine the appropriate strategy for prosecuting and enforcing those patents.

**If weare not able to apply our net operating losses against taxable income in futureperiods, our financial results will be harmed.**

Our future net income andcash flow will be affected by our ability to apply our net operating losses, orNOLs, against taxable income in future periods. Our NOLs totaled approximately$185 million for federal and $36 million for state tax reporting purposes as ofDecember 31, 2006. The Internal Revenue Code contains a number of provisionsthat limit the use of NOLs under certain 

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circumstances.  During 2006 we reduced the NOL deferred taxasset for amounts which we believe will expire before they become available forutilization. Changes in tax laws in the United States may further limit ourability to utilize these NOLs.  Any further limitation on our ability toutilize these respective NOLs could harm our financial condition.

**Changes in, orinterpretations of, tax rules and regulations may adversely affect oureffective tax rates.**

Unanticipated changes in our tax rates couldaffect our future results of operations. Our future effective tax rates couldbe unfavorably affected by changes in tax laws or the interpretation of taxlaws, by unanticipated decreases in the amount of revenue or earnings incountries with low statutory tax rates, or by changes in the valuation of ourdeferred tax assets and liabilities. While we believe our tax reservesadequately provide for any tax contingencies, the ultimate outcomes of anyfuture tax audits are uncertain, and we can give no assurance as to whether anadverse result from one or more of them will have a material effect on ouroperating results and financial position.

**Anyadditional acquisitions we make could disrupt our business and severely harmour financial condition.**

We have made investmentsin, and acquisitions of other complementary companies, products andtechnologies, and we may acquire additional businesses, products ortechnologies in the future.  In the eventof any future acquisitions, we could:

·                  issue stock thatwould dilute its current stockholders’ percentage ownership;

·                  incur debt;

·                  use asignificant amount of our cash;

·                  assumeliabilities;

·                  incur expensesrelated to the future impairment of goodwill and the amortization of otherintangible assets; or

·                  incur otherlarge write-offs immediately or in the future.

Our operation of anyother acquired business will also involve numerous risks, including:

·                  problemscombining the purchased operations, technologies or products;

·                  unanticipatedcosts;

·                  diversion ofmanagement’s attention from our core business;

·                  adverse effectson existing business relationships with customers;

·                  risks associatedwith entering markets in which we have no or limited prior experience; and

·                  potential lossof key employees, particularly those of the purchased organizations.

We may not be able tosuccessfully complete the integration of the business, products or technologiesor personnel that we might acquire in the future, and any failure to do socould disrupt our business and seriously harm our financial condition.

**If ourgoodwill or amortizable intangible assets become impaired we may be required torecord a significant charge to earnings.**

Under generally accepted accounting principles,we review our amortizable intangible assets for impairment when events orchanges in circumstances indicate the carrying value may not be recoverable.Goodwill is required to be tested for impairment at least annually. Factorsthat may be considered a change in circumstances indicating that the carryingvalue of our goodwill or amortizable intangible assets may not be recoverableinclude a decline in stock price and market capitalization, future cash flows,and slower growth rates in our industry. We may be required to record asignificant charge to earnings in our financial statements during the period inwhich any impairment of our goodwill or amortizable intangible assets isdetermined resulting in an impact on our results of operations.

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**We mayneed additional funds to execute our business plan, and if we are unable toobtain such funds, we will not be able to expand our business as planned.**

We may requiresubstantial additional capital to finance our future growth, secure additionalfoundry capacity and fund our ongoing research and development activitiesduring 2007 and beyond.  Our capitalrequirements will depend on many factors, including:

·                  thelevels at which we maintain inventory and accounts receivable;

·                  themarket acceptance of our products;

·                  thelevels of promotion and advertising required to launch our new products or toenter markets and attain a competitive position in the marketplace;

·                  our business,product, capital expenditure and research and development plans and technologyroadmap;

·                  volume pricingconcessions;

·                  capitalimprovements to new and existing facilities;

·                  technologicaladvances;

·                  the response ofcompetitors to our products; and

·                  ourrelationships with our suppliers and customers.

In addition, we mayrequire an increase in the level of working capital to accommodate plannedgrowth, hiring and infrastructure needs. Additional capital may also be required for additional acquisitions ofbusinesses, products or technologies.

**Ifwe fail to manage our future growth, if any, our business would be harmed.**

We anticipate that ourfuture growth, if any, will require us to recruit and hire a substantial numberof new engineering, managerial, sales and marketing personnel.  Our ability to manage growth successfullywill also require us to expand and improve administrative, operational,management and financial systems and controls. Many of our key operations, including a material portion of our researchand development operations and a significant portion of our sales andadministrative operations are located in Israel.  A majority of our sales and marketing andcertain of our research and development and administrative personnel, includingour President and Chief Executive Officer and other officers, are based in theUnited States.  The geographic separationof these operations places additional strain on our resources and our abilityto manage growth effectively.  If we areunable to manage growth effectively, our business will be harmed.

**We rely on the services of ourexecutive officers and other key personnel, whose knowledge of our business andindustry would be extremely difficult to replace.**

Our success depends to a significant degree upon thecontinuing contributions of our senior management.  Management and other employees mayvoluntarily terminate their employment with us at any time upon shortnotice.  The loss of key personnel coulddelay product development cycles or otherwise harm our business.  We believe that our future success will also dependin large part on our ability to attract, integrate and retain highly-skilledengineering, managerial, sales and marketing personnel, located in the UnitedStates, Israel and China.  Competitionfor such personnel is intense, and we may not be successful in attracting,integrating and retaining such personnel. Failure to attract, integrate and retain key personnel could harm ourability to carry out our business strategy and compete with other companies.

**Provisionsin our charter documents and Delaware law could prevent or delay a change incontrol of Zoran.**

Our certificate of incorporation and bylaws and Delaware law containprovisions that could make it more difficult for a third party to acquire us,even if doing so would be beneficial to our stockholders.  These include provisions:

·                  prohibiting amerger with a party that has acquired control of 15% or more of our outstandingcommon stock, such as a party that has completed a successful tender offer,until three years after that party acquired control of 15% of our outstandingcommon stock;

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·                  authorizing theissuance of up to 3,000,000 shares of “blank check” preferred stock;

·                  eliminatingstockholders’ rights to call a special meeting of stockholders; and

·                  requiringadvance notice of any stockholder nominations of candidates for election to ourboard of directors.

**Ourstock price has fluctuated and may continue to fluctuate widely.**

The market price of ourcommon stock has fluctuated significantly since our initial public offering in1995.  Between January 1, 2005 andSeptember 30, 2006, the closing sale price of our common stock, as reported onthe Nasdaq Global Select Market, ranged from a low of $8.97 to a high of$29.13.  The market price of our commonstock is subject to significant fluctuations in the future in response to avariety of factors, including:

·                  results ofregulatory investigations;

·                  announcementsconcerning our business or that of our competitors or customers;

·                  annual andquarterly variations in our operating results;

·                  changes inanalysts’ earnings estimates;

·                  announcements oftechnological innovations;

·                  the introductionof new products or changes in product pricing policies by Zoran or itscompetitors;

·                  loss of keypersonnel;

·                  proprietaryrights or other litigation;

·                  generalconditions in the semiconductor industry; and

·                  developments inthe financial markets.

In addition, the stockmarket has, from time to time, experienced extreme price and volumefluctuations that have particularly affected the market prices for semiconductorcompanies or technology companies generally and which have been unrelated tothe operating performance of the affected companies.  Broad market fluctuations of this type mayreduce the future market price of our common stock.

**Item 6.  Exhibits**
| 31.1 | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) or 15d-14(a). |
|------|------------------------------------------------------------------------------------|
| 31.2 | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) or 15d-14(a). |
| 32.1 | Certification of Chief Executive Officer, pursuant  to 18 U.S.C. Section 1350.     |
| 32.2 | Certification of Chief Financial Officer, pursuant  to 18 U.S.C. Section 1350.     |

** **

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                             | **ZORAN CORPORATION**                                           |
|-----------------------------|-----------------------------------------------------------------|
| ** **                  |                                                            |
| ** **                  |                                                            |
| ** **                  |                                                            |
| ** **                  |                                                            |
| ** **                  |                                                            |
| Dated:  April 19, 2007 | /s/ Karl Schneider                                              |   |
|                        | Karl Schneider                                                  |
|                        | Senior Vice President, Finance                                  |
|                        | and Chief Financial Officer                                     |
|                        | (principal financial officer and principal accounting  officer) |

 

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