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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



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(Mark One)



|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
|- | -----------------------------------------------------------------------------------

For the fiscal year ended December 31, 2006

OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the transition period from                     
to

Commission File Number: 0-20981



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DOCUMENT SCIENCES CORPORATION

(Exact name of registrant as specified in its charter)



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|                                                              |  |                                    
|------------------------------------------------------------- |  | -----------------------------------
|Delaware                                                      |  | 33-0485994                         
|(State or other jurisdiction ofincorporation or organization) |  | (I.R.S. EmployerIdentification No.)
|                                                              | 
|5958 Priestly Drive, Carlsbad, California                     |  | 92008                              
|(Address of principal executive offices)                      |  | (Zip code)                         

Registrants telephone number, including area code: (760) 602-1400



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

Securities registered pursuant to Section 12(g)of the Act:

Common Stock, $.001 par value per share

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the
Securities Act.    Yes ̈No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act.    Yes ̈No  x

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

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

Indicate by check mark whether the Registrant is a large accelerated
filer, an accelerated filer or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ̈Accelerated filer ̈Non-accelerated filer  x

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act).    Yes ̈No  x

The aggregate market value of the Registrants voting common equity held by non-affiliates computed by reference to the price at which the common
equity was last sold as of June 30, 2006 was $19,858,658.

As of March 20, 2007, there were 4,343,864 shares of the
Registrants common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Part III incorporates certain information by reference from Registrants definitive proxy statement for its 2007 Annual Meeting of Stockholders or a
Form 10-K/A that is filed within 120 days after the close of the Registrants fiscal year ended December 31, 2006.



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TABLE OF CONTENTS



|                                           |  |                                                                                                              |  |     
|------------------------------------------ |  | ------------------------------------------------------------------------------------------------------------ |  | ----
|                                           |  |                                                                                                              |  | Page
|                                           | 
|A Warning About Forward-Looking Statements |  | 1                                                                                                           
|                                           |  |                                                                                                             
|                                           |  | PART I                                                                                                       |  |     
|                                           |  |                                                                                                             
|Item 1                                     |  | Business                                                                                                     |  | 2   
|Item 1A                                    |  | Risk Factors                                                                                                 |  | 9   
|Item 1B                                    |  | Unresolved Staff Comments                                                                                    |  | 15  
|Item 2                                     |  | Properties                                                                                                   |  | 15  
|Item 3                                     |  | Legal Proceedings                                                                                            |  | 15  
|Item 4                                     |  | Submission of Matters to a Vote of Security Holders                                                          |  | 15  
|                                           |  |                                                                                                             
|                                           |  | PART II                                                                                                      |  |     
|                                           |  |                                                                                                             
|Item 5                                     |  | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |  | 16  
|Item 6                                     |  | Selected Financial Data                                                                                      |  | 18  
|Item 7                                     |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                        |  | 18  
|Item 7A                                    |  | Quantitative and Qualitative Disclosures About Market Risk                                                   |  | 26  
|Item 8                                     |  | Financial Statements and Supplementary Data                                                                  |  | 27  
|Item 9                                     |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                         |  | 27  
|Item 9A                                    |  | Controls and Procedures                                                                                      |  | 27  
|Item 9B                                    |  | Other Information                                                                                            |  | 28  
|                                           |  |                                                                                                             
|                                           |  | PART III                                                                                                     |  |     
|                                           |  |                                                                                                             
|Item 10                                    |  | Directors, Executive Officers and Corporate Governance                                                       |  | 29  
|Item 11                                    |  | Executive Compensation                                                                                       |  | 29  
|Item 12                                    |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters               |  | 29  
|Item 13                                    |  | Certain Relationships and Related Transactions and Director Independence                                     |  | 29  
|Item 14                                    |  | Principal Accounting Fees and Services                                                                       |  | 29  
|                                           |  |                                                                                                             
|                                           |  | PART IV                                                                                                      |  |     
|                                           |  |                                                                                                             
|Item 15                                    |  | Exhibits and Financial Statement Schedules                                                                   |  | 30  
|                                           |  | Signatures                                                                                                   |  | 31  
|                                           |  | Index to Exhibits                                                                                            |  | 32  
|                                           |  | Financial Statements                                                                                         |  | F-1 



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A WARNING ABOUT FORWARD-LOOKING STATEMENTS

We make forward-looking statements in this annual report on Form
10-K that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our financial condition, operations, plans, objectives and performance. Additionally, when we use the
words believe, expect, anticipate, estimate or similar expressions, we are making forward-looking statements. Many possible events or factors could affect our future financial results and performance.
This could cause our results or performance to differ materially from those expressed in our forward-looking statements. You should consider these risks when you review this document, along with the following possible events or factors:



| |  |  | national, international, regional and local economic, competitive, geopolitical and regulatory conditions and developments;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | the markets for dynamic content publishing software;
| | - |  | ----------------------------------------------------



| |  |  | market acceptance of enhancements to our existing products and introduction of new products;
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | continued profitability of our professional services; and
| | - |  | ---------------------------------------------------------



| |  |  | maintaining our relationships with our distribution partners.
| | - |  | -------------------------------------------------------------

Foreseeable risks and uncertainties are described elsewhere in this report and in detail under Item 1A. Risk Factors. You are cautioned not to place undue reliance on these forward-looking statements,
which reflect managements analysis only as of the date of this annual report. Except as required by law, we undertake no obligation to publicly release the results of any revision of, or otherwise update, the forward-looking statements.



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PART I



|ITEM 1. | BUSINESS
|------- | --------

Document Sciences Corporation develops
and markets Dynamic Content Publishing (DCP) software products that automate business-to-customer (B2C) and business-to-business (B2B) personalized customer communications. Dynamic content publishing has become increasingly important as more
companies benefit from providing their customers highly-personalized documents that improve communications through the precise assembly and layout of regulated content, personal financial data and in-context one-to-one marketing information.
Additional drivers for DCP adoption include the trend towards Straight Through Processing (STP), Self-Service applications, as well as ongoing technology consolidation and eBusiness adoption. Our DCP software products enable the automated generation
and distribution of personalized customer communications by processing enterprise data and content assets through customizable business rules to produce high quality and highly-personalized documents that are ready to print in high-volume or
on-demand, and/or to email, deliver via mobile, or fulfill in real-time over the web using XML, HTML or Adobe Systems (Adobe) Portable Document Format (PDF®).

Using
modern enterprise-class architecture standards, our latest generation xPression product suite enables scalable dynamic content publishing solutions across numerous industries, including insurance, financial services, managed healthcare, manufacturing, distribution, government and
commercial outsourcing. Our entire product portfolio, including our previous generation Autographproduct family, is licensed to more than 500 customers worldwide who collectively produce over an estimated one billion personalized documents per month, operating on computing
environments ranging from modern highly-scalable J2EE application server platforms such as BEA WebLogic and IBM WebSphere, distributed client/server PC/UNIX configurations, to traditional enterprise mainframe systems.

Company Formation

We were incorporated in Delaware
in October 1991 as a wholly owned subsidiary of Xerox Corporation (Xerox). Following our initial public offering of stock in September 1996, Xerox ownership was reduced to approximately 62%. As a result of our tender offer and our exercise of an
option to purchase additional shares from Xerox, in April 2001, Xeroxs ownership interest was reduced to 19.9%, and then on November 18, 2003, we purchased Xeroxs remaining shares in a private transaction. In 2004, we acquired
Objectiva Software Solutions (Objectiva), a China-based development outsourcing company that provided us with incremental cost-effective software development capabilities as well as incremental offshore Document Factory services capacity. In early
2007, we acquired the assets of CambridgeDocs, a software company with key technology assets for XML content conversion and publishing.

Available
Information

This annual report, and each of our other periodic and current reports, including any amendments thereto, are available,
free of charge, on our website at www.docscience.com, as soon as reasonably practical after such material is electronically filed with, or furnished to, the Securities and Exchange Commission. The information contained on our website is not
incorporated by reference in this report and should not be considered part of this report. In addition, the Securities and Exchange Commission website, www.sec.gov, contains reports, proxy and information statements and other information about us.

Products

Our latest generation
xPression product suite addresses a major functional area within the large and growing Enterprise Content Management (ECM) arena: Dynamic Content Publishing (DCP). During 2006, we released upgraded versions of our xPression Enterprise
Edition (EE) including our new higher-performance xPublish composition engine, and this has resulted in incremental xPression installation growth to nearly 100 customers worldwide, now representing the majority of new license revenues. During
2006, we maintained the certification



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of our xPression product suite through EMC Softwares Designed for EMC (DFE) program to enable pre-integrated deployment within EMC
Softwares Documentum install base, as well as developed new integration with IBM Filenet P8. In 2007 we plan on incremental integration with EMC Software, IBM Filenet and other ECM platforms.

In 2006 we expanded our xPression product suite and released xPression Workgroup Edition (WE) which includes expanded xPRS Server output
processing functionality as well as upgraded versions of our xPresso for InDesign product, providing best-of-breed DCP application design using Adobe Creative Suitethe worlds leading desktop publishing product. xPresso
provides a very user-friendly DCP application design environment using industry standard WYSIWYG tools such as Adobe InDesign. xPresso for InDesign is targeted at facilitating the development of high-value relationship statements and
marketing automation applications. In addition, we also introduced xPresso for Dreamweaver, a companion product that enables the dynamic generation of richly personalized email and web content, through (Adobe) Macromedia Dreamweaver. In 2007,
we plan on introducing additional xPresso design products targeted at other growth applications in the markets we serve.

We offer
the right to use our products through annual licenses and perpetual licenses. We also offer post contract support and license renewal, when applicable, and training in the use of our products.

In addition, all of our software products can be complemented by our professional services organization, including offshore services provided by our
China-based Document Factory, thereby enabling the delivery of cost-effective and fully-integrated functional solutions to our worldwide customer base.

Ongoing Autograph to xPression Migration

From its introduction in late 2002 through 2006, we have installed our latest
generation xPression product suite in nearly 100 major accounts worldwideboth new accounts including competitive installations, as well as previous generation Autograph accounts. These installations validate our ability to
migrate Autograph, as well as competitive accounts, to xPression using a scalable and reliable services delivery model. We also market packaged offerings consisting of additional software and services for further facilitating the
migration of our existing Autograph customers, as well as from select competitive products, to our xPressionEnterprise or Workgroup Editions. During 2007, we plan to continue actively marketing these packaged offerings to generate
additional migrations from competitive or Autograph installations.

Dynamic Content Publishing

Our xPression product suite provides DCP capabilities using an open J2EE architecture. As such, our xPression products are developed in
Java, adhering to J2EE open standards for compatibility with application server platforms such as BEA WebLogic, IBM WebSphere, Red Hat JBoss as well as Apache Tomcat. The xPression product suite is based on XML open standards for data and
content interchange, and on the Unicode text encoding standard for worldwide language support. Because of its very open architecture and its adherence to industry standards, our xPression product suite can be tightly integrated with other
enterprise applications to extend the capabilities of existing ECM platforms, customer relationship management (CRM) systems, Line-of-Business (LOB) applications, self-service web portals and other enterprise technology assets. These characteristics
are most attractive to customers seeking inter-operability between their enterprise applications through adherence to open standards, which is a growing technology acquisition trend.

xPRS Server and Client products. The xPression product suite is comprised of the xPRS Server and several web-integrated client
applications. The xPRS Server manages the robust document assembly and publishing process required in complex, regulated text-intensive and graphical documents such as marketing collateral, proposals, contracts, policies, statements and customer
correspondence. The xPRS Server also supports several client applications that provide user interfaces for systems management (xAdmin), operational management



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(xDashboard), personalized document design (xDesign and xPresso), interactive real-time document generation (xResponse) and collaborative document
generation, revision and approval (xRevise). Customers can configure their xPression product suite installations with any number of xPRS servers and any number of client applications as required by the application type(s) and its performance
and deployment requirements.

xAdmin and xDashboard manage all aspects of the xPression product suite configuration including access
security, customer data sources and mapping, ECM content integration, document production, multi-channel output processing and distribution. xAdmin and xDashboard are designed for use by system administrators familiar with the overall operating
environment. Conversely, xDesign and xPresso are designed for non-technical business users responsible for the creation and management of personalized document applications. This is accomplished using a hierarchy of content items that is
created and managed using open authoring and design environments such as Adobe InDesign and Dreamweaver, the industry-standard design tools for highly-graphical documents such as marketing collateral and high-value statements, including email and
web pages, as well as Microsoft Corporations (Microsoft) Word®, the industry-standard authoring and design tool for regulated documents such as proposals, contracts and correspondence. The support of open tools such as Microsoft Word and Adobe InDesign enables our customers to
redeploy the development and maintenance of applications from their generally higher-cost IT department to the line-of-businesses responsible for the application.

xDesign manages and tracks the personalized document applications and their content items using a secure multi-user environment that supports powerful user-definable attributes (e.g. language, jurisdiction,
affectivity, etc), multi-level revisioning, multi-level approval workflows and advanced content searching. xDesign enables the definition of simple or complex content assembly and business rules that control content selection and personalization
based on unique customer data. The process is similar for our companion xPresso design products, but with a greater emphasis on the incorporation of rich graphical elements. Once a personalized document application has been created,
validated, and approved, the xPRS Server manages the subsequent document assembly and publishing processes. These can execute in a high volume production mode, or as real-time, on-demand transactions. By leveraging the benefits of application
servers, xPRS Server is highly-scalable and supports multi-threaded clustered configurations, providing high-volume as well as high-concurrency performance.

xResponse is a web browser based out-of-the-box client application that enables the on-demand generation of customer correspondence and other documents created using xDesign. xResponse features an integrated Java
editor that can be used to make additional manual or exception changes to automatically pre-assembled documents. xResponse also supports web-based change tracking, approval and workflow processes to ensure continuous document integrity and
compliance. The xResponse user interface is factorable and can be integrated with a CRM or other correspondence management or call center system of choice. xRevise provides more sophisticated capabilities for managing complex contract applications
that require re-issuance control and a high-level of collaboration. xRevise enables the creation and management of multiple versions of a document from a common document template. Each version can vary significantly from the base template, and each
version can also be personalized for individual groups of recipients. xRevise is ideal for complex master-sub contract applications.

Finally, thexPression product suite also provides extensible capabilities in the increasingly important areas of enterprise application integration (EAI) using xPRS Framework APIs as well as industry standard Web Services. Because
of its open architecture and its adherence to XML standards, the xPression product suite can be tightly integrated with a wide variety of line-of-business applications such as financial administration systems, business workflow systems, as
well as popular ECM platforms. To further our capabilities in the connectivity area, we also support vertical XML dialects such as the ACORD standard which has been widely adopted in the insurance-industry. Furthermore, we enhance our technical
connectivity by developing strong partnerships with other open system providers in target markets. In 2007 we plan on introducing additional enterprise connectivity capabilities as additional end-user applications that can be widely deployed within
an enterprise.



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Composition Engine.The xPression product suite supports our new Java-based xPublish
composition engine operating at scalable speeds of well over 100 pages per second per CPUthereby providing highly-scalable processing in even the most demanding production environment. The design of the new composition engine incorporates the
majority of features available in our previous generation CompuSet composition engine, including the automatic generation of multi-dimensional dynamic data driven graphics, and the support of full color text and images. It also provides significant
extensions in the areas of multi-frame page layout, multi-language support including support for double-byte Asian languages and scalable multi-threaded performance. In 2007 we plan on continuing to enhance our new xPublish composition engine,
including the support of incremental Output Processing functionality as well as incremental features that take full advantage of our new xPresso application design products. Optionally, the xPression product suite also supports the use
of our previous generation CompuSet composition engine, thus enabling and facilitating the migration of existing Autograph applications to our xPression product suite.

The composition process is further optimized for high-volume or on-demand print, email and/or web media for multi-channel distribution. The
xPression product suite supports XML and web standard HTML generation as well as a number of popular Page Description Languages (PDLs) for subsequent printing, electronic distribution and/or archive storage for future retrieval and viewing.
These PDLs provide device-specific instructions for rendering text, forms, images and graphics into printable streams or into electronic documents. Output Processing capabilities include inline output stream manipulation for splitting, merging,
re-sequencing, sorting, bundling and bar coding. These features are necessary for postal optimization, for the support of finishing equipment without further post-processing and for multi-channel applications that require both print and electronic
(email) distribution. The PDL formats currently supported are Xerox Metacode, International Business Machines Corporations (IBM) AFPDS®, Hewlett-Packard Companys PCL® and Adobes PostScript®, including Xerox VIPP and VPS extensions for high-volume full-color production on Xerox DocuColor and iGen product lines, and well as Adobe PDF.

In late January 2007, we completed the acquisition of CambridgeDocs, a leading provider of document transformation and repurposing
technology. The acquisition of their technology represents a natural extension to Document Sciences customer communications management platform and adds several new components to the xPression product suite. The acquired technology will
allow xPression to import and repurpose content from a plethora of widely popular formats, including Word, HTML, PDF, Excel, RTF, and Adobe FrameMaker, enabling customers to leverage the tens of thousands of documents existing throughout an
enterprise without having to manually recreate the content. Document transformation and repurposing, which provides for the conversion of content in popular formats into an XML format that is readily transformable and reusable, has become
increasingly important due to the proliferation of document formats. Once transformed, the content can be made available for delivery through Document Sciences xPression product suite, as well as independently through XML-based Web Services.
The transformed content can also be easily classified and indexed within enterprise information portals, and aggregated, assembled and (re)published in multiple formats, including HTML, PDF, Postscript, IBM AFP, PCL and RTF, on virtually any
operating system.

Professional Services

In addition to our software products, we provide a comprehensive suite of professional services that can assist customers in the implementation of mission-critical dynamic content publishing applications. Professional services include
on-site software installation, consulting services, customer training programs and telephone support programs. Our consulting services are currently focused on assisting in the sale of higher margin initial software licenses by providing project
management, requirements analysis, system architecture, application design and development services. The capacity of our domestic professional services has been extended through the use of our cost effective China-based Document Factory team. Our
consulting services can also be provided in conjunction with our system integration partners.



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In addition to consulting services, we provide introductory and advanced-level education classes for our
xPression and Autograph products at our headquarters in San Diego, our offices in Milwaukee and at customer sites. We believe that the use of our professional services enables customers to deploy our dynamic content publishing products
more rapidly and more cost-effectively. In 2006 we expanded our team of Technical Directors responsible for account management and associated services revenue and significantly grew our professional services delivery. In 2007 we anticipate further
growth as we continue to scale our services delivery capacity inline with demand.

Development Outsourcing Services

In addition to our software products and professional services, we also provide cost effective development outsourcing services through our
subsidiarys, Objectiva Software Solutions Inc. (Objectiva), software engineering team primarily based in Beijing, China. These software engineering services include project management, design and architecture, prototyping, coding, testing and
productizing. Our Objectiva software engineering team has achieved CMM Level 3 certification, a recognized global standard for quality service delivery, as well as other vendor specific recognitions such as Microsoft MVP certified engineers. In
2006, we significantly grew our development outsourcing services and in early 2007, we expanded our offshore capacity with incremental facilities in Xian, China, and we anticipate continued investment and growth in our Objectiva software engineering
outsourcing services.

Marketing and Sales

Our marketing and sales organization targets markets that require dynamic content publishing for high volume, high quality document personalization. We currently license our products worldwide using a combination of direct sales and
alternative channels. In North America, we market our products primarily through a direct sales force that manages our existing base of corporate accounts, as well as targets new accounts in select market segments. Our sales account executives are
provided with pre-sales technical support through qualified solution analysts. Account executives and solution analysts are located throughout North America to provide optimal coverage. In 2006 we significantly augmented our North American direct
sales model including the addition of several co-selling System Integrator (SI) channels and in 2007 we plan on further growing our North American direct sales model as well as co-selling SI channels in order to augment coverage in additional target
markets.

Outside of North America, we distribute our software products primarily through Value Added Reseller (VAR) channels. We market
our products throughout Europe, the Middle East and Africa (EMEA) by defining EMEA specific market and product requirements, providing VAR channel management as well as providing sales and technical support. In 2006, we made further investments in
our EMEA organization headquartered in London, England. We likewise support VAR channels in Australia, South America and Asia. In 2007 we plan on further growing our EMEA operations, as well as establishing facilities in Australia to focus on Asia
Pacific operations.

We are also continuing to increase our development relationships and joint marketing and sales with other major
companies. Current relationships include formal and informal marketing and sales alliances with EMC Software, IBM Inc., Microsoft Corporation and Xerox Corporation. These relationships provide qualified sales leads for our products and significantly
extend our sales coverage and networking capabilities. In addition, we also support partner relationships with complementary technology companies as well as several insurance administration system vendors such as CSC, Fiserv, Harlosh, Solcorp and
Worldgroup. We participate in joint marketing events with our key partners whenever appropriate and feasible. Furthermore, we actively market our products and solutions at industry focused trade shows, through focused regional seminars and through a
variety of web marketing mechanisms, including webinars.



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Research and Development

We continue to enhance our product offerings, engaging key customers and prospects to identify requirements and to prioritize specific product features. We also engage industry and technology analysts, and key
partners to understand existing market trends, new target markets, and overall technology directions. In 2006 we formed a Customer Advisory Council focused at providing incremental direction for our xPression product suite. Our 2007
development roadmap addresses key requirements for tighter integration into the emerging ECM Enterprise Reference Architecture (ERA), incremental xPresso application design products targeted at new applications, and incremental xPublish
capabilities to take full advantage of the breadth of our application design environments.

In general, our product development strategy is
based on delivering dynamic content publishing solutions for specific types of document applications in one or more vertical markets or industries, or in identifying more horizontal applications that can be sold across many market segments. A
product manager is responsible for managing the team responsible for delivering each focused offering based on requirements gathered by focused business directors. We use a structured business planning and product delivery process to guide our
product development and delivery activities throughout the year. We also employ rapid prototyping to validate new product concepts, and agile development methodologies to be responsive in a rapidly-evolving technology environment.

The acquisition of Objectiva in 2004 has significantly increased our software development and innovation capacity, including our ability to respond more
rapidly to unanticipated requirements driven by new technologies, new partnerships, or new business opportunities. The majority of our development is focused on our xPression product suite, including the development of our Dynamic Content
Publishing Infrastructure (DCPI) which includes our new xPublish composition engine, as well as our existing and new xPresso application design products.

We continue to maintain and enhance our Autographproduct line for operation on traditional platforms such as mainframe environments. These well-established products, including DLS and VC Pro, are maintained by
teams that respond to customer requests for defect corrections and feature enhancements. These products are proven and feature rich, and we do not anticipate the need to significantly enhance them during 2007.

We expect to continue enhancing our existing product portfolio and to develop new products, particularly as they relate to multi-channel applications,
including electronic distribution and web portals. Our development expenditures continue to be a major focus of our resources. Such expenditures, not including amounts capitalized, were $5.9 million, $5.4 million and $5.8 million in 2006, 2005 and
2004, respectively.

We can make no assurance that we will be successful in developing, introducing and marketing new products on a timely
and cost-effective basis, if at all, or that such new products will achieve market acceptance. See Item 1A. Risk FactorsOur growth depends on market acceptance of our existing products, enhancements to existing products and our
introduction of new products.

Competition

The market for dynamic content publishing products is intensely competitive, subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. Our
software products are targeted at document intensive organizations that require the ability to produce large quantities of personalized documents in paper or electronic form. We face direct and indirect competition from a broad range of competitors
who offer a variety of products and solutions to our current and potential customers. Our principal competition currently comes from systems developed in-house by the internal MIS departments of large organizations where there is a reluctance to
commit the time and effort necessary to convert their existing document publishing processes to our dynamic content publishing software. We also face competition from system integrators (SI) who can custom build dynamic content publishing solutions
using XML or other technology.



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We also face competition from DocuCorp International, Inc. in the insurance industry; Metavante in
banking and financial services; Pitney Bowes Group 1 Software, Inc.; Exstream Software, Inc. and numerous other smaller competitors. Several of our competitors have longer operating histories, significantly greater financial, technical and marketing
resources, greater name recognition in global or regional markets and a larger installed base of customers than we do. We believe that the principal competitive factors affecting our market include product performance and functionality, ease of use,
scalability, operating across multiple computer and operating system platforms, product and company reputation, key partnerships, client service and support and price.

It is also possible that we will face competition from new competitors. These include large independent software companies offering personal computer-based application software solutions, such as Microsoft and Adobe,
and from large corporations providing database and content management software solutions, such as IBM, Oracle Corporation and EMC Software. In addition, Xerox, HP, Ricoh or other print-technology vendors, either directly or through affiliated
entities, could become large competitors. Moreover, as the market for dynamic content publishing software develops, a number of these or other companies with significantly greater resources than ours could attempt to enter or increase their presence
in the dynamic content publishing market by either acquiring or forming strategic alliances with our competitors or by increasing their focus on the industry. In addition, current and potential competitors have established or may establish
cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of our current and prospective customers. It is possible that new competitors or alliances among competitors may emerge
and rapidly acquire significant market share. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, operating results and financial
condition.

Patents, Licenses and Proprietary Rights

Our success is dependent, in part, on our ability to protect our proprietary technology. We rely primarily on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual
provisions to protect our proprietary rights. We seek to protect our software, documentation and other written materials under trade secret and copyright laws. However, these afford only limited protection. We presently have no patents or patent
applications pending. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. See Item 1A. Risk FactorsOur
business is dependent upon successfully protecting our proprietary rights.

In addition, we also rely on certain software that we
license from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. There can be no assurances that such firms will remain in business, that they will continue to
support their products or that their products will otherwise continue to be available to us on commercially reasonable terms. The loss or inability to maintain any of these software licenses could result in delays or reductions in product shipments
until equivalent software can be developed, licensed and integrated, which would adversely affect our business, operating results and financial condition.

Customers

We derived 10%, 13% and 18% of our revenues through Xerox and its affiliates in 2006, 2005 and 2004,
respectively. As a result, discontinuation of agreements and other business transactions that may adversely impact our relationship with Xerox could have a material adverse effect on our business, operating results and financial condition.

Employees

As of December 31,
2006, we had 392 employees comprised of 182 in professional services and customer support, 57 in sales and marketing, 116 in research and development and 37 in finance and administration. None of our employees are represented by labor unions. We
have experienced no work stoppages and believe our



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relationship with our employees is good. Competition for qualified personnel in the industry in which we compete is intense. We believe that our future
success will depend in part on our continued ability to attract, hire and retain qualified personnel.

Financial Information about Segments and
Geographic Areas

The information regarding revenues and operating profit by reportable segments and revenues from unaffiliated
customers by geographic region is set forth at the end of this annual report on Form 10-K under Note 3. Geographic Information of the Notes to Consolidated Financial Statements included in Item 8 of this annual report on Form 10-K
and is incorporated herein by reference.



|ITEM 1A. | RISK FACTORS
|-------- | ------------

The following is a discussion of
certain factors that currently impact or may impact our business, operating results and/or financial condition. Anyone making an investment decision with respect to our common stock or other securities is cautioned to carefully consider these
factors. If any of the following risks actually occur, our business, results of future operations and financial condition could be materially adversely affected. In such case, the trading price of our common stock could decline and you may lose part
or all of your investment.

Our quarterly results fluctuate significantly and we may not be able to grow our business.

Our total revenues and operating results are difficult to forecast and can vary, sometimes substantially, from quarter to quarter, and we expect them to
vary significantly in the future. Our future quarterly operating results are affected by many factors, including the following:



| |  |  | the demand for our products and services;
| | - |  | -----------------------------------------



| |  |  | the level of product and price competition;
| | - |  | -------------------------------------------



| |  |  | the length of our sales cycle;
| | - |  | ------------------------------



| |  |  | the size, elements and timing of individual software arrangements;
| | - |  | ------------------------------------------------------------------



| |  |  | the renewal rates for our annual software licenses;
| | - |  | ---------------------------------------------------



| |  |  | the delay or deferral of customer implementations;
| | - |  | --------------------------------------------------



| |  |  | the budget cycles of our customers;
| | - |  | -----------------------------------



| |  |  | our success in expanding our direct sales force or indirect distribution channels;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | the acceptance and timing of our new product introductions and enhancements, as well as those of our competitors;
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | our mix of products and services;
| | - |  | ---------------------------------



| |  |  | our level of international sales;
| | - |  | ---------------------------------



| |  |  | our ability to successfully implement our operational, growth and other strategies;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | the timing and amount of software capitalization and amortization;
| | - |  | ------------------------------------------------------------------



| |  |  | the activities of and acquisitions by our competitors;
| | - |  | ------------------------------------------------------



| |  |  | our timing of new hires;
| | - |  | ------------------------



| |  |  | changes in foreign currency exchange rates; and
| | - |  | -----------------------------------------------



| |  |  | our ability to develop and market new products and to control costs.
| | - |  | --------------------------------------------------------------------



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Our license fee revenues depend on when orders are received from and shipped to customers. However,
because of our revenue recognition policies, our customers implementation schedule and the complexity of the implementation process, revenue from some software shipments may not be recognized in the same quarter as the shipment occurs. Our
operating expenses are primarily based on anticipated revenue levels. Since a high percentage of those expenses are relatively fixed, a delay in the recognition of revenue from license transactions could cause significant variations in operating
results from quarter to quarter, and we may sustain losses as a result. To the extent such expenses precede, and/or are not subsequently followed by, increased revenues, our operating results could be materially adversely affected.

As a result of these factors, results from operations for any quarter are subject to significant variation, and we believe that period-to-period
comparisons of our results of operations may not necessarily be meaningful. Accordingly, you should not rely upon them as an indication of our future performance. Furthermore, our operating results in future quarters may fall below the expectations
of market analysts and investors. If this occurs, the price of our common stock could be materially adversely affected.

Our growth depends on market
acceptance of our existing products, enhancements to existing products and introduction of new products.

Our future business, operating
results and financial condition depend upon market acceptance of our existing products, as well as our ability to respond to emerging industry standards and practices and to develop new products that address the future needs of our target markets.
Our Autographfamily of products has been applied mainly to document automation applications producing paper-based documents. We have started to extend our core technology to the Internet, intranets and commercial on-line services. However,
we cannot assure you that we will be successful in developing, introducing and marketing new products or product enhancements, including new products or the extension of existing products for the Internet, intranets and commercial on-line services,
on a timely and cost effective basis, if at all. In addition, we cannot assure you that our newer products, such asxPressoand xPression, or enhancements to existing products will adequately meet the requirements of the marketplace or
achieve market acceptance. Moreover, delays in our commercial shipments of new products or enhancements may result in client dissatisfaction and a delay or loss of product revenues. In addition, in order to provide our customers with integrated
product solutions, our future success will also depend in part upon our ability to maintain and enhance relationships with our technology partners.

If for technological or other reasons we are unable to develop and introduce new products or enhancements of existing products in a timely manner in response to changing market conditions or client requirements, then our business, operating
results and financial condition could be materially adversely affected. In addition, we cannot assure you that our existing products, new products or new versions of our existing products will achieve market acceptance.

Longer than expected sales cycles and implementation periods have and may continue to affect our revenues and operating results.

The licensing of our software products is often an enterprise-wide decision by prospective customers and generally involves a sales cycle of three months
to more than one year in order to educate these prospective customers regarding the use and benefits of our products, often requiring us to expend considerable financial and personnel resources without any assurance that revenue will be realized. In
addition, the implementation of our products by customers involves a significant commitment of their resources over an extended period of time and is commonly associated with substantial customer business process reengineering efforts. Sales of our
enterprise-wide xPression product line often involve many participants in the corporate decision-making process. Additionally, we have experienced and may, from time to time, continue to experience defects in our software which cause
implementation problems and affect our revenues and our sales cycle. For these and other reasons, our sales cycles and customer implementation periods are subject to a number of significant delays over which we may have little or no control. Any
delay in the sale or customer implementation of a limited number of license transactions could have a material adverse effect on our business and results of operations and cause our operating results to vary significantly from quarter to quarter.



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We currently derive a significant portion of our revenues through Xerox.

We currently have a variety of contractual and informal relationships with Xerox and affiliates of Xerox, including a cooperative marketing agreement, a
transfer and license agreement and various distribution agreements. We rely on these relationships and agreements for a significant portion of our total revenues. Revenues derived from relationships with Xerox and affiliates of Xerox accounted for
approximately $3.4 million, $3.8 million and $4.1 million in 2006, 2005 and 2004, respectively, representing approximately 10%, 13% and 18% of our total revenues, respectively.

In November 2003, we paid $2.7 million to Xerox to repurchase the remaining 740,024 shares of Document Sciences common stock owned by Xerox. Since
Xerox no longer has an equity interest in us, there may be less incentive in continuing to do business with us at the same level. Though we intend to continue our existing relationships with Xerox, our strategy has been, and continues to be, to
lessen our dependence on Xerox. However, there can be no assurance that we will be able to do so and, because of our current level of dependence on Xerox, there can be no assurance that our plans to become more independent will not adversely affect
our business, results of operations and financial condition. Our failure to maintain these relationships with Xerox or to establish new relationships in the future could have a material adverse effect on our business, operating results and financial
condition.

There can be no assurance that existing and potential customers will continue to do business with us because of these
relationships or our historical ties with Xerox and its affiliates. Xerox has strategic alliances and other business relationships with other companies who supply software and services used in high volume electronic publishing applications and who
now are, or in the future may become, our competitors. There can be no assurance that Xerox or one of its affiliated companies will not engage in a business that directly competes with us. In addition, Xerox has ongoing internal development
activities that could in the future lead to products that compete with us. Xerox could in the future expand these relationships or enter into additional ones, and as a result our business could be materially adversely affected.

Our growth depends on our ability to compete successfully against current and future competitors.

The market for dynamic content publishing products is intensely competitive. We face competition from a broad range of competitors, many of whom have
greater financial, technical and marketing resources than we do. Our principal competition currently comes from systems developed in-house by the internal IS departments of large organizations and direct competition from numerous software vendors,
including Docucorp International, Inc., InSystems Technologies, Inc., Group 1 Software, Inc., Exstream Software, Inc. and Metavante Corporation. We believe that the principal competitive factors affecting our market include product performance and
functionality, ease of use, scalability, operating across multiple computer and operating system platforms, product and company reputation, client service and support and price. Although we believe that we currently compete favorably with respect to
such factors, we can not assure you that we will be able to maintain our competitive position against current and future competitors, especially those with greater financial, technical and marketing resources than us, or that we will be successful
in the face of increasing competition from new products or new solutions introduced by existing competitors or by new competitors entering the market.

Our operating results are substantially dependent on sales of a small number of products in highly concentrated industries.

We derived a substantial percentage of our license revenue from two product lines in 2006 and 2005. As a result, factors that may adversely impact the pricing of or demand for these products, such as competition from other products,
negative publicity or obsolescence of the hardware or software environments in which our products run, could have a material adverse effect on our business, operating results and financial condition. Our financial performance will depend
significantly on the successful development, introduction and customer acceptance of new and enhanced versions of our xPression software and xPresso software, as well as continued customer acceptance of CompuSet, DLS and related
products.



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Revenues from end users in the insurance industry accounted for 46% of total revenues in 2006. Our future
success will depend on our ability to continue to successfully market our products in the insurance industry, as well as the finance and print services industries, and introduce their use in new industries. Our failure to do so could have a material
adverse effect on our business, operating results and financial condition.

Inaccurate sales forecasts and/or revenue projections could cause improper
planning and budgeting of our resources.

Our revenues, and particularly our new software license revenues, are difficult to forecast,
and as a result our quarterly operating results can fluctuate substantially. We use a pipeline system, a common industry practice, to forecast sales and trends in our business. In particular, our sales personnel monitor the status of all
proposals and estimate when a customer will make a purchase decision and the dollar amount of the sale. These estimates are aggregated periodically to generate a sales pipeline. Our pipeline estimates can prove to be unreliable both in a particular
quarter and over a longer period of time, in part because the conversion rate of the pipeline into contracts can be very difficult to estimate. A variation in the conversion rate, or in the pipeline itself, could cause us to plan or
budget incorrectly and adversely affect our business or results of operations. While this sales estimation process provides us with some guidance in business planning, it is based on estimates only and is therefore subject to numerous risks and
uncertainties. Because a substantial portion of our new software license revenue contracts are completed in the latter part of a quarter, and our cost structure is largely fixed in the short term, revenue shortfalls tend to have a disproportionately
negative impact on our profitability. A delay in even a small number of large new software license transactions could cause our quarterly new software licenses revenues to fall significantly short of our predictions.

Our growth is dependent upon successfully focusing our distribution channels.

To grow our business, we must improve the performance of our worldwide sales and distribution channels by focusing on key target industry market segments where our current and planned products can enjoy a significant
competitive advantage and high market demand. We also must leverage our existing relationships with Xerox and other partners by launching targeted joint marketing and value added reseller programs and by introducing new product offerings that are
optimized for selected target markets and marketing channels. Additionally, we must form additional partnerships with system integrators and consultants in order to broaden our capacity to deliver complete dynamic content publishing solutions that
incorporate significant services content, while also maintaining our core domain expertise. We cannot assure you that we will be able to successfully streamline and focus our worldwide channels, leverage our existing relationships or form new
alliances. If we fail to do so, it could have a material adverse effect on our business, operating results and financial condition.

Our products may
suffer from defects or errors.

Software products, as complex as those we offer, may contain undetected defects or errors when first
introduced or as new versions are released. As a result, depending on the severity of the defect or error, we could in the future forego or delay recognition of revenues as a result of these errors or defects. In addition, our products are typically
intended for use in applications that may be critical to a customers business. As a result, we expect that our customers and potential customers have a greater aversion and sensitivity to product defects than the general market for software
products. We experienced defects in connection with the introduction of our xPression product line in 2004, and believe that we have addressed this problem, but we cannot assure you that, despite our testing, as well as testing by current and
potential customers, additional errors will not be found in our existing products or new products or releases. Defects discovered after the commencement of commercial shipments, can result in loss of revenue, delay in market acceptance, diversion of
our development resources, damage to our reputation and/or increased service and warranty costs.



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Maintaining our professional services expertise is necessary for our future growth.

We are continuing our focus on the consulting services component of our professional services to assist customers in the planning and implementation of
enterprise-wide, mission-critical dynamic content publishing applications. This strategy is dependent on hiring and retaining qualified professional staff to perform these consulting services. Our business, operating results and financial condition
could be materially adversely affected if we are unsuccessful in developing and retaining our professional services workforce.

We are exposed to risks
associated with international operations.

Our revenues from export sales accounted for 14%, 17% and 25% of our total revenues in 2006,
2005 and 2004, respectively.

We license our products in Europe through value-added resellers (VARs) and to a much lesser extent, direct
sales. Revenues generated by these activities were $3.1 million, $3.2 million and $3.5 million in 2006, 2005 and 2004, respectively.

In
Australia, Canada and Latin America, our products are distributed and/or supported by Xerox affiliates and also by direct sales in Canada. In China, our products are distributed and/or supported by our subsidiary, Objectiva. Revenues generated in
these regions were $1.5 million, $1.8 million and $2.3 million in 2006, 2005 and 2004, respectively.

In order to successfully expand
export sales, we must increase our international presence in select countries, hire additional personnel and develop relationships with additional international resellers. If we are unable to do so in a timely manner, our growth in international
export sales could be limited, and our business, operating results and financial condition could be materially adversely affected. In addition, we cannot assure you that we will be able to maintain or increase international market demand for our
products.

Our international business activities could also be adversely impacted by losing the services of key VARs, difficulties in
managing our international operations, our limited experience in localizing products for foreign countries resulting in a lack of acceptance of these localized products, longer payment cycles for accounts receivable, currency fluctuations,
unexpected adverse changes in regulatory requirements and tariffs, imposition of additional trade barriers and restrictions, potentially adverse tax consequences including restrictions on the repatriation of earnings, and the burdens of complying
with a wide variety of foreign laws.

Our Objectiva software engineering and professional services team of 222 employees is located in a
21,800 square foot facility in Beijing, China. We are subject to a variety of risks associated with conducting operations in China, including those related to general economic conditions, regulatory changes, political unrest and potential reduced
protection for our intellectual property rights. In addition to facing the difficulty of managing a large offshore organization, we must comply with a variety of laws and regulations, including trade restrictions, local labor ordinances, changes in
tariff rates and import and export licensing requirements. Our success depends, in part, on our ability to anticipate these risks and manage these difficulties.

A portion of our business is conducted in currencies other than the U.S. Dollar, primarily the Euro and the Chinese Yuan. Although exchange rate fluctuations have not had a significant impact on us, fluctuations
in the value of the currencies in which we conduct our business relative to the U.S. Dollar could cause currency transaction gains and losses in future periods. We do not currently engage in currency hedging transactions, and we cannot assure
you that fluctuations in currency exchange rates in the future will not have a material adverse impact on our international revenues and our business, operating results and financial condition.

Our business is dependent on the market for dynamic content publishing software.

The market for dynamic content publishing software is intensely competitive, highly fragmented and subject to rapid change. We cannot assure you that the market for dynamic content publishing software will continue to
grow or that, if it does grow, organizations will adopt our products. Although we have spent, and intend to



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continue to spend, significant resources developing open-architecture software products and educating potential customers about the benefits of our products,
we cannot assure you that such expenditures will enable our products to achieve further market acceptance. Additionally, if the dynamic content publishing software market develops more slowly than we currently anticipate, our business, operating
results and financial condition could be materially adversely affected.

Furthermore, the market for dynamic content publishing of
electronic documents designed for use with the Internet, intranets and commercial on-line services has only recently begun to develop, and the success of our products designed for this market will depend in part on their compatibility with these
elements. Since the increased commercial use of the Internet, intranets and commercial on-line services is difficult to predict and could require substantial modification and customization of certain of our products and services, as well as the
introduction of new products and services, we cannot assure you that we will be able to effectively or successfully compete in this market.

Our ability
to manage future change could affect our business.

Our ability to compete effectively and to manage future change will require us to
continue to improve our financial and management controls, reporting systems and procedures on a timely basis and to expand, train and manage our work force. We cannot assure you that we will be able to do so successfully. Our failure to do so could
have a material adverse effect on our business, operating results and financial condition.

Our executive officers and certain key personnel are
critical to our business, and these officers and key personnel may not remain with us in the future.

Our future performance depends in
significant part upon the continued service of our key technical, sales and senior management personnel. The loss of the services of one or more of our executive officers could have a material adverse effect on our business, operating results and
financial condition. Our future success also depends on our continuing ability to attract and retain highly qualified product development, sales and management personnel. Competition for such personnel is intense, and there can be no assurance that
we will be able to retain our key employees or that we will be able to attract or retain other highly qualified product development, sales and managerial personnel in the future.

Our business is dependent upon successfully protecting our proprietary rights.

We rely on a
combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. Despite these protective measures, it may be possible for unauthorized third parties to copy
portions of our products or use information we consider proprietary. Policing unauthorized use of our products is difficult and, while we are unable to determine the extent to which piracy of our software products exists, we expect software piracy
to be a persistent problem. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. We cannot assure you that our means of protecting our proprietary rights
will be adequate or that our competitors will not independently develop similar technology.

We are not aware of any infringement of our
products upon the proprietary rights of third parties. However, we cannot assure you that third parties will not claim infringement by us with respect to current or future products. We expect that software product developers will increasingly be
subject to infringement claims as the number of products and competitors in our industry segment grows, companies hire employees from competitors, and the functionality of products in different industry segments overlaps. Any such claims, with or
without merit, could be time consuming, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms
acceptable to us or at all, which could have a material adverse effect upon our business, operating results and financial condition.



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Our failure to adequately limit our exposure to product liability claims may adversely affect us.

Our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims. However, it
is possible that the limitation of liability provisions contained in our license agreements may not be effective under the laws of certain jurisdictions. Although we have not experienced any product liability claims to date, sale and support of our
products may entail the risk of such claims in the future. A successful product liability claim brought against us or a claim arising as a result of our professional services could have a material adverse effect upon our business, operating results
and financial condition.

Integration of potential business or technology acquisitions may be difficult.

If we acquire complementary businesses, products or technologies instead of developing them ourselves, we may be unable to successfully integrate an
acquired business, product or technology in a cost-effective and non-disruptive manner. Integrating any business, product or technology that we acquire could be expensive and time-consuming, disrupt our ongoing business and distract company
management. In addition, in order to finance any acquisition, we might need to raise additional funds through public or private equity or debt financings. In that event, we could be forced to obtain financing on less than favorable terms which, in
the case of equity financing, may result in dilution to our stockholders. If we are unable to integrate any acquired entities, products or technologies effectively, our business, operating results and financial condition could be materially
adversely affected. In addition, under certain circumstances, amortization of assets or charges resulting from the costs of acquisitions could have a negative impact on our reported operating results and financial condition.

Enacted and proposed changes in securities laws and regulations are likely to increase our costs.

The Sarbanes-Oxley Act of 2002 and the rules subsequently implemented by the SEC and the NASD have imposed various new requirements on public companies,
including requiring changes in corporate governance practices. Our management and other personnel will need to continue to devote a substantial amount of time to comply with these requirements. Moreover, these rules and regulations have increased
our annual legal and financial compliance costs, have made some activities more time-consuming and costly, and could expose us to additional liability. In addition, these rules and regulations may make retention and recruitment of qualified persons
to serve on our board of directors or executive management team more difficult.

If any of these events occur, it could have a material
adverse effect upon our business, operating results and financial condition.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2. PROPERTIES

We lease approximately 20,300 square feet of office space for our principal
administrative, sales, marketing, training and research and development facility in Carlsbad, California. This lease expires on June 15, 2011. Our regional office in Milwaukee, Wisconsin occupies approximately 3,400 square feet of office space
pursuant to a lease expiring on October 31, 2008. Our regional office in London, England, occupies approximately 215 square feet of office space pursuant to a month-to-month lease. In addition, our subsidiary in China occupies approximately
21,800 square feet of office space in two facilities expiring May 20, 2009. Sales representatives and field technical support personnel operate from their homes. We believe that the current properties that we lease are adequate for our current
needs.

ITEM 3. LEGAL PROCEEDINGS

In the ordinary course of business, we may become involved in legal proceedings
from time to time. As of March 20, 2007, we were not a party, nor was our property subject, to any material pending legal proceedings.

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

No matters were submitted to a vote of
security holders during the fourth quarter of fiscal year 2006.



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PART II

ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is presently traded on The Nasdaq Capital Market under the symbol DOCX. The following table sets forth the range of high and low sales prices of our common stock for the periods indicated,
as reported on The Nasdaq Capital Market System. Such quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions.



|                                       |  |             |      |     |   |     
|-------------------------------------- |  | ----------- | ---- | --- | - | ----
|                                       |  | Price Range
|                                       |  | High        |      | Low
|Fiscal 2005                            |  |             |      |     |   |     
|First quarter ended March 31, 2005     |  | $           | 6.75 |     | $ | 4.66
|Second quarter ended June 30, 2005     |  | $           | 7.83 |     | $ | 5.24
|Third quarter ended September 30, 2005 |  | $           | 8.20 |     | $ | 6.25
|Fourth quarter ended December 31, 2005 |  | $           | 8.12 |     | $ | 6.40
|                                       |  |            
|Fiscal 2006                            |  |             |      |     |   |     
|First quarter ended March 31, 2006     |  | $           | 8.00 |     | $ | 6.12
|Second quarter ended June 30, 2006     |  | $           | 7.40 |     | $ | 5.54
|Third quarter ended September 30, 2006 |  | $           | 6.43 |     | $ | 5.55
|Fourth quarter ended December 31, 2006 |  | $           | 6.90 |     | $ | 5.72

We had 4,343,864 shares outstanding and 106 record holders of our common stock as of
March 20, 2007. Historically, we have not paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future.



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DOCUMENT SCIENCES STOCK PRICE PERFORMANCE GRAPH

The following graph compares the 5-year cumulative total return on Document Sciences stock with that of the NASDAQ National Market Composite and the
NASDAQ Computer Index. Each of the returns assumes an investment of $100 on December 31, 2001 and the reinvestment of all dividends. The comparisons in the graph are required by the Securities and Exchange Commission and are not intended to
forecast or be indicative of possible future performance of our common stock.

LOGO



|                                 |  |                         |  |       |  |       |  |       |  |       |  |      
|-------------------------------- |  | ----------------------- |  | ----- |  | ----- |  | ----- |  | ----- |  | -----
|                                 |  | Cumulative Total Return
|                                 |  | 12/01                   |  | 12/02 |  | 12/03 |  | 12/04 |  | 12/05 |  | 12/06
|Document Sciences Corporation    |  | 100                     |  | 111   |  | 161   |  | 180   |  | 296   |  | 248  
|NASDAQ National Market Composite |  | 100                     |  | 68    |  | 102   |  | 111   |  | 113   |  | 124  
|NASDAQ Computer Index            |  | 100                     |  | 64    |  | 95    |  | 98    |  | 101   |  | 107  

The following table provides information about purchases by the Company during the fiscal quarter
ended December 31, 2006 of equity securities that are registered by the Company pursuant to Section 12 of the Securities Exchange Act of 1934, as amended.



|                                |  |                  |  |                             |      |                                                                   |        |                                                                 |   |        
|------------------------------- |  | ---------------- |  | --------------------------- | ---- | ----------------------------------------------------------------- | ------ | --------------------------------------------------------------- | - | -------
|Period                          |  | Shares Purchased |  | Average Price Paidper Share |      | Total Number of Shares Purchasedas Part of PubliclyAnnounced Plan |        | Approximate DollarValue of Shares that May Yet be Purchased (1)
|October 1-31, 2006              |  | 2,027            |  | $                           | 6.11 |                                                                   | 4,789  |                                                                 | $ | 970,500
|November 1-30, 2006             |  | 13,674           |  | $                           | 6.25 |                                                                   | 18,463 |                                                                 | $ | 885,100
|December 1-31, 2006             |  | 7,463            |  | $                           | 6.66 |                                                                   | 25,926 |                                                                 | $ | 835,300
|                                |  |                  |  |                             |      |                                                                   |        |                                                                 |   |        
|Total (as of December 31, 2006) |  | 23,164           |  | $                           | 6.37 |                                                                   | 25,926 |                                                                 | $ | 835,300
|                                |  |                  |  |                             |      |                                                                   |        |                                                                 |   |        

---

|(1) | On August 1, 2006, the Company announced that the Board of Directors had authorized it to repurchase up to $1,000,000 of its common stock in open market or in private
transactions, subject to the Companys assessment of market conditions and buying opportunities from time to time, and may, either in whole or in part, repurchase such stock through a trading plan pursuant to Rule 10b5-1 under the Securities
Exchange Act of 1934. The Company expects to complete the repurchase program within one year, unless market conditions change significantly or the program is either terminated sooner or extended by the Board of Directors.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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ITEM 6. SELECTED FINANCIAL DATA

The following table presents selected financial data of Document Sciences
Corporation. This historical data should be read in conjunction with the Consolidated Financial Statements and the related notes thereto in Item 8 of this annual report on Form 10-K and Managements Discussion and Analysis of
Financial Condition and Results of Operations in Item 7 of this annual report on Form 10-K.



|                                    |  |                                       |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |       
|----------------------------------- |  | ------------------------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | - |  | ---- | ------ | - |  | - | ------
|                                    |  | Years ended December 31,             
|                                    |  | 2006                                  |        |   | 2005 |   |        | 2004 |  |   | 2003   |   |  | 2002
|                                    |  | (in thousands, except per share data)
|Statement of Operations             |  |                                       |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |       
|Net revenues                        |  | $                                     | 33,411 |   |      | $ | 29,574 |      |  | $ | 23,038 |   |  | $    | 22,243 |   |  | $ | 23,058
|Income (loss) from operations       |  |                                       | (1,391 | ) |      |   | (147   | )    |  |   | 606    |   |  |      | (104   | ) |  |   | 1,185 
|Net income (loss)                   |  |                                       | (1,479 | ) |      |   | 19     |      |  |   | 598    |   |  |      | (131   | ) |  |   | 1,572 
|Net income (loss) per sharediluted |  |                                       | (0.35  | ) |      |   | 0.00   |      |  |   | 0.13   |   |  |      | (0.03  | ) |  |   | 0.37  
|Shares used in diluted calculations |  |                                       | 4,264  |   |      |   | 5,334  |      |  |   | 4,729  |   |  |      | 3,768  |   |  |   | 4,286 
|                                    |  |                                       |        |   |     
|Balance Sheet                       |  |                                       |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |       
|Working capital                     |  | $                                     | 236    |   |      | $ | (84    | )    |  | $ | (1,886 | ) |  | $    | (1,929 | ) |  | $ | 1,750 
|Total assets                        |  |                                       | 26,114 |   |      |   | 24,086 |      |  |   | 23,995 |   |  |      | 17,918 |   |  |   | 21,654
|Stockholders equity                |  |                                       | 6,196  |   |      |   | 6,871  |      |  |   | 6,377  |   |  |      | 2,114  |   |  |   | 4,928 

The decrease in the balance sheet items from 2002 to 2003 was primarily due to our November 2003
purchase of 740,024 shares of our outstanding common stock for $2.7 million and a decrease in accounts receivable of $1.9 million. The increase in total assets and stockholders equity from 2003 to 2004 was primarily due to the issuance of
629,793 shares of our common stock in conjunction with our July 2004 purchase of Objectiva.

ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Except
for the historical information, the following discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ substantially from those described below, including those risks described under
Item 1A. Risk Factors, and elsewhere in this annual report on Form 10-K. Our discussion and analysis of the financial condition and results of operation of Document Sciences and its subsidiaries should be read in conjunction with the
Consolidated Financial Statements and related notes included in Item 8 in this annual report on Form 10-K.

Critical Accounting Policies

Our discussion and analysis of the financial condition and results of operations are based on our consolidated financial statements,
which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to revenue recognition, software development costs, allowance for
doubtful accounts and valuation allowance for net deferred tax assets. We base our estimates on historical and anticipated results and trends and on assumptions that we believe are reasonable under the circumstances, including assumptions as to
future events. These estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty.
Actual results may differ from our estimates. We believe that the following critical accounting policies and assumptions may involve a higher degree of judgment and complexity than others.



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Revenue Recognition.We derive our revenues principally from the licensing of software, post
contract support fees (PCS) and professional services. We recognize revenue in accordance with Statement of Position (SOP) 97-2, Software Revenue Recognition. Although some software is licensed on a perpetual basis, the majority of our
licenses are currently time-based licenses that are required to be renewed annually. Revenues are recognized when a contract exists, the fee is fixed and determinable, software delivery has occurred and collection of the receivable is deemed
probable. Amounts billed or payments received in advance of revenue recognition are recorded as deferred revenue.

If an arrangement
includes multiple elements, we allocate the contract amount to the various elements based on vendor-specific objective evidence (VSOE) of fair value, regardless of any separate prices stated within the contracts for each element. We base our VSOE on
the price charged when the same element is sold separately. If an undelivered element of the arrangement exists, revenue is deferred based on VSOE of the fair value of the undelivered element. If VSOE of fair value does not exist for all undelivered
elements, all revenue is deferred until sufficient evidence exists or all elements have been delivered. We use the residual method to recognize revenue when an arrangement includes one or more elements to be delivered at a future date and VSOE of
the fair value of all undelivered elements exists.

We recognize fees for annual licensing arrangements ratably over the contract term of
twelve months because we are unable to establish VSOE for the license and support elements under this type of bundled arrangement.

For
perpetual license arrangements, VSOE of fair value for ongoing maintenance and support obligations (PCS) is determined based upon the historical, stand-alone renewal rates or pricing. We recognize revenue relating to the perpetual software license
arrangements at inception of the arrangement using the residual method as discussed above.

Our contracts do not provide for specific
upgrades. In addition, our standard contracts do not provide for rights of return or conditions of acceptance; however, in cases where acceptance criteria are provided, revenue is deferred and not recognized until all conditions are satisfied and
written customer acceptance is obtained.

Professional services revenue includes consulting services and training related to our software
products. Revenues generated from consulting services and training are recognized as the related services are performed and collectibility is deemed probable, based on VSOE of fair value of the services. VSOE of fair value for professional services
is determined based upon the price charged when these services are sold separately. For professional services that are bundled with annual software licenses and are not deemed to be essential to the functionality of the delivered software product,
we recognize the entire arrangement fee ratably over the longer of the period over which the professional services are expected to be rendered, or the PCS period, beginning with delivery of the software and commencement of the professional services.
In the vast majority of cases, the arrangement fee is recognized ratably over the twelve month PCS period. In certain limited situations where we determine that professional services period is the longer period, upon the end of the PCS term, we
recognize license and PCS revenues at that stage (on the residual basis), recognizing the remaining deferred revenue for the unfinished services over the remaining period of such services.

If consulting services are deemed to be essential to the functionality of the delivered software product, revenue from the entire arrangement is
recognized on a percentage of completion method or not until the contract is completed in accordance with SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts, and Accounting Research Bulletin (ARB)
No. 45, Long-Term Construction-Type Contracts. We measure progress under the percentage of completion method, depending on how the contract language is written, either by using the percentage of total project hours completed or by the
completion of phases in the consulting project. Because the phases of our consulting projects are generally not of great duration (2-6 weeks on average), we believe that there are very limited circumstances where materially different amounts would
be reported under different conditions or using different assumptions.



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We work in conjunction with our established VARs, with whom we have formal contracts defining the rights
and obligations of the parties, to license software to end-users. We license software to our VARs, less a discount, from a fixed price list. We require a binding purchase order as evidence of an unconditional order by an end user from our VARs, with
no rights of return or acceptance. License revenue from our VARs is recognized when software is licensed to an end user.

Software
Development Costs. In accordance with Statement of Financial Accounting Standards (SFAS) No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, costs incurred in the research and development
of new software products and significant enhancements to existing software products are expensed as incurred until technological feasibility of the product has been established. After technological feasibility has been established, direct production
costs, including programming and testing, are capitalized until general release of the product.

Capitalized costs of software to be sold,
licensed or otherwise marketed are amortized using the greater of the amount computed using the ratio of current period product revenues to estimated total product revenues or the straight-line method over the remaining estimated economic lives of
the products. It is possible that estimated total product revenues, the estimated economic life of the product, or both, will be reduced in the future. As a result, the carrying amount of capitalized software costs may be reduced in the future,
which could cause our operating results in future periods to be adversely affected.

Impairment of Goodwill.The value of our
goodwill could be impacted by future adverse changes such as declines in our operating results or failure to meet the performance projections included in our forecasts of future operating results. We evaluate these assets on an annual basis or more
frequently if indicators of impairment exist. In the process of our annual impairment review, we primarily use a discounted cash flow method to determine the fair value of our assets. Significant management judgment is required in the forecasts of
future operating results that are used in the discounted cash flow method of valuation. The estimates we have used are consistent with the plans and estimates that we use to manage our business. It is possible, however, that the plans and estimates
used may be incorrect. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur impairment charges.

Allowance for Doubtful Accounts. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers
to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required, which would result in an additional general and
administrative expense in the period such determination is made. At the end of each reporting period, we perform a detailed review of outstanding balances by customer and invoice. We utilize statistical and account specific analysis to determine the
adequacy of our reserve, as well as comparing balances to historical losses. If our assumptions or analysis are incorrect, our operating results for future periods may be adversely affected.

Deferred Income Taxes. Deferred income taxes reflect the net effect of temporary differences between the carrying amounts of assets and
liabilities for financial reporting purposes and the amounts used for income tax purposes. At December 31, 2006, we had net deferred tax assets of $5.1 million. Due to the uncertainty of realizing these net deferred tax assets, we have recorded
a valuation allowance of $5.1 million. Such uncertainty primarily relates to the potential for future taxable income as well as loss carryforwards and tax credits expiring in 2018 and 2012, respectively. In addition, pursuant to Sections 382 and 383
of the Internal Revenue Code, annual use of our net operating loss carryforwards may be limited in the event of a cumulative change in ownership of more than 50% within a three-year period. We will continue to assess the likelihood of realization of
such assets; however, if future events occur which do not make the realization of such assets more likely than not, we will continue to record a valuation allowance against all or a portion of the remaining net deferred tax assets. Examples of
future events that might occur which would make the realization of such assets not likely is a lack of taxable income resulting from poor operating results during 2007.



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Results of Operations for the Years Ended December 31, 2006, 2005 and 2004

The following table shows the percentage of revenues, cost of revenues, operating expenses and other items to total revenues in our consolidated
statements of operations for the periods indicated:



|                                     |  |                          |    |  |      |   |  |      |  
|------------------------------------ |  | ------------------------ | -- |  | ---- | - |  | ---- | -
|                                     |  | Years Ended December 31, |   
|                                     |  | 2006                     |    |  | 2005 |   |  | 2004 |  
|Revenues:                            |  |                          |    |  |      |   |  |      |  
|License fees                         |  | 67                       | %  |  | 67   | % |  | 80   | %
|Services and other                   |  | 33                       |    |  | 33   |   |  | 20   |  
|                                     |  |                          |    |  |      |   |  |      |  
|Total revenues                       |  | 100                      |    |  | 100  |   |  | 100  |  
|Cost of revenues:                    |  |                          |    |  |      |   |  |      |  
|License fees                         |  | 13                       |    |  | 15   |   |  | 15   |  
|Services and other                   |  | 30                       |    |  | 27   |   |  | 15   |  
|                                     |  |                          |    |  |      |   |  |      |  
|Total cost of revenues               |  | 43                       |    |  | 42   |   |  | 30   |  
|                                     |  |                          |    |  |      |   |  |      |  
|Gross profit                         |  | 57                       |    |  | 58   |   |  | 70   |  
|                                     |  |                          |   
|Operating expenses:                  |  |                          |    |  |      |   |  |      |  
|Research and development             |  | 18                       |    |  | 18   |   |  | 17   |  
|Selling and marketing                |  | 31                       |    |  | 28   |   |  | 36   |  
|General and administrative           |  | 12                       |    |  | 13   |   |  | 14   |  
|                                     |  |                          |    |  |      |   |  |      |  
|Total operating expenses             |  | 61                       |    |  | 59   |   |  | 67   |  
|                                     |  |                          |    |  |      |   |  |      |  
|Income (loss) from operations        |  | (4                       | )  |  | (1   | ) |  | 3    |  
|Interest and other income, net       |  | 1                        |    |  | 1    |   |  | 0    |  
|                                     |  |                          |    |  |      |   |  |      |  
|Income (loss) before income taxes    |  | (3                       | )  |  | 0    |   |  | 3    |  
|Provision (benefit) for income taxes |  | 1                        |    |  | 0    |   |  | 0    |  
|                                     |  |                          |    |  |      |   |  |      |  
|Net income (loss)                    |  | (4                       | )% |  | 0    | % |  | 3    | %
|                                     |  |                          |    |  |      |   |  |      |  

Revenues

Our revenues are divided into two categories based upon the sources from which they are derived: (i) perpetual licenses and related support fees and term-based licenses and related annual renewal license and
support fees, and (ii) services and other revenues. License fees consist primarily of perpetual fees, fees for the first year of use of our products and annual renewal license and PCS fees. Services and other revenues consist of fees for
consulting, software outsourcing, application development and training services performed by us as well as miscellaneous other operational revenues. We sell our products principally through our direct sales force domestically and through
distributors and VARs internationally. The following table summarizes revenues (in thousands) and the percentage change over the previous year for the periods indicated:



|                   |  |                          |        |  |    |   |      |   |        |  |     |      |  |   |        |  |    |  
|------------------ |  | ------------------------ | ------ |  | -- | - | ---- | - | ------ |  | --- | ---- |  | - | ------ |  | -- | -
|                   |  | Years Ended December 31, |       
|                   |  | 2006                     |        |  |    |   | 2005 |   |        |  |     | 2004 |  |   |       
|License fees       |  | $                        | 22,368 |  | 12 | % |      | $ | 19,926 |  | 8   | %    |  | $ | 18,534 |  | 2  | %
|Services and other |  |                          | 11,043 |  | 14 |   |      |   | 9,648  |  | 114 |      |  |   | 4,504  |  | 12 |  
|                   |  |                          |        |  |    |   |      |   |        |  |     |      |  |   |        |  |    |  
|Total revenues     |  | $                        | 33,411 |  | 13 | % |      | $ | 29,574 |  | 28  | %    |  | $ | 23,038 |  | 4  | %
|                   |  |                          |        |  |    |   |      |   |        |  |     |      |  |   |        |  |    |  

Cost of Revenues

Cost of license fees. Cost of license fees includes amortization of previously capitalized software development costs, costs of licensing third party software, employee related costs for distribution personnel
and technical support staff and product packaging. Costs of services and other consist principally of the employee



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related costs of our consulting and training staff. The following table summarizes cost of revenues (in thousands) and the percentage change over the
previous year for the periods indicated:



|                       |  |                          |        |  |    |    |      |   |        |  |     |      |  |   |       |  |    |  
|---------------------- |  | ------------------------ | ------ |  | -- | -- | ---- | - | ------ |  | --- | ---- |  | - | ----- |  | -- | -
|                       |  | Years Ended December 31, |       
|                       |  | 2006                     |        |  |    |    | 2005 |   |        |  |     | 2004 |  |   |      
|License fees           |  | $                        | 4,205  |  | (5 | )% |      | $ | 4,425  |  | 28  | %    |  | $ | 3,466 |  | 25 | %
|Services and other     |  |                          | 10,211 |  | 27 |    |      |   | 8,030  |  | 130 |      |  |   | 3,487 |  | 24 |  
|                       |  |                          |        |  |    |    |      |   |        |  |     |      |  |   |       |  |    |  
|Total cost of revenues |  | $                        | 14,416 |  | 16 | %  |      | $ | 12,455 |  | 79  | %    |  | $ | 6,953 |  | 24 | %
|                       |  |                          |        |  |    |    |      |   |        |  |     |      |  |   |       |  |    |  

Operating Expenses

Research and development.Research and development expenses consist primarily of the employee related costs of personnel associated with developing new products, enhancing existing products, testing software
products and developing product documentation.

Selling and marketing.Selling and marketing expenses consist primarily of salaries,
commissions, marketing programs and related costs for pre- and post-sales activity.

General and administrative.General and
administrative expenses consist of employee related costs for finance, administration, information technology and human resources, allowance for doubtful accounts and general corporate management expenses, including public company expenses, director
expenses, legal fees, and accounting fees.

The following table summarizes operating expenses (in thousands) and the percentage change over
the previous year for the periods indicated:



|                           |  |                          |        |  |    |   |      |   |        |  |    |      |  |   |        |  |     |   
|-------------------------- |  | ------------------------ | ------ |  | -- | - | ---- | - | ------ |  | -- | ---- |  | - | ------ |  | --- | --
|                           |  | Years Ended December 31, |       
|                           |  | 2006                     |        |  |    |   | 2005 |   |        |  |    | 2004 |  |   |       
|Research and development   |  | $                        | 5,913  |  | 9  | % |      | $ | 5,420  |  | 39 | %    |  | $ | 3,888  |  | (16 | )%
|Selling and marketing      |  |                          | 10,300 |  | 25 |   |      |   | 8,222  |  | (1 | )    |  |   | 8,285  |  | (5  | ) 
|General and administrative |  |                          | 4,172  |  | 15 |   |      |   | 3,624  |  | 10 |      |  |   | 3,307  |  | (2  | ) 
|                           |  |                          |        |  |    |   |      |   |        |  |    |      |  |   |        |  |     |   
|Total operating expenses   |  | $                        | 20,385 |  | 18 | % |      | $ | 17,266 |  | 12 | %    |  | $ | 15,480 |  | (8  | )%
|                           |  |                          |        |  |    |   |      |   |        |  |    |      |  |   |        |  |     |   

The following table adds back capitalized software development costs (in thousands) and shows the
percentage change over the same period of the prior year:



|                                       |  |                          |       |  |   |   |      |   |       |  |      |      |  |   |       |  |     |   
|-------------------------------------- |  | ------------------------ | ----- |  | - | - | ---- | - | ----- |  | ---- | ---- |  | - | ----- |  | --- | --
|                                       |  | Years Ended December 31, |      
|                                       |  | 2006                     |       |  |   |   | 2005 |   |       |  |      | 2004 |  |   |      
|Research and development (net)         |  | $                        | 5,913 |  | 9 | % |      | $ | 5,420 |  | 39   | %    |  | $ | 3,888 |  | (16 | )%
|Capitalized software development costs |  |                          |      |  | 0 |   |      |   |      |  | (100 | )    |  |   | 1,881 |  | 14  |   
|                                       |  |                          |       |  |   |   |      |   |       |  |      |      |  |   |       |  |     |   
|Research and development (gross)       |  | $                        | 5,913 |  | 9 | % |      | $ | 5,420 |  | (6   | )%   |  | $ | 5,769 |  | (9  | )%
|                                       |  |                          |       |  |   |   |      |   |       |  |      |      |  |   |       |  |     |   

Other Items

Interest and other income, net.Interest and other income, net is composed primarily of interest income from cash and cash equivalents and proceeds from short-term investment disposals, offset by interest
expense related to capital leases.

Provision (benefit) for income taxes. Provision for income taxes reflects the net effect of temporary
differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.



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Year ended December 31, 2006 compared to the year ended December 31, 2005

The 12% increase in license fee revenue in 2006 over 2005 was primarily due to higher initial sales of our xPressionEnterprise Suite and increased
PCS revenues from our increasing base of licensed software users.

Services and other revenues increased 14% over 2005 amounts. A majority
of growth was from the delivery of implementation and follow on services to customers who have licensed our xPression software. Additionally, our results benefited from consulting services delivered by our Objectiva subsidiary.

The 5% decrease in license fees cost of revenue in 2006 was primarily due to a $600,000 decrease in amortization of software development
costs from 2005, due to older products being fully amortized in 2005, somewhat offset by increased royalty costs, and increases in personnel costs of approximately $225,000 over 2005, to support our increasing customer base and product set.

Services and other cost of revenues in 2006 increased by 27% over 2005 due to an increase of approximately $2.0 million in personnel
related costs and management, added primarily late in the fourth quarter of 2005. This staffing was required to sustain existing projects and to staff anticipated new projects. Increased facility costs both in the United States and at our facility
in China also contributed to the increase.

The increase in research and development costs in 2006 was primarily due to an increase in
payroll related costs of our software engineers and consulting fees related to the enhancement of xPression. We did not capitalize any software development costs in 2006 because the establishment of technological feasibility coincided with
the general releases of our products.

The 25% increase in 2006 selling and marketing expenses over 2005 was primarily due to an increase
in salary related expenses and commissions of approximately $1.7 million caused by the increase in staffing in this area from 39 employees at the end of 2005 to 57 employees at the end of 2006. The remainder of the increase was primarily composed of
increases in travel and entertainment, trade show and advertising expenses, somewhat offset by a decrease in allocated facilities expenses.

The 15% increase in 2006 general and administrative expenses was primarily due to increases in personnel costs and expenses associated with being a public company. When 2005 expenses are adjusted for a VAT refund credit of $391,000, 2006
general and administrative expenses increased over comparable amounts by 4%.

Interest and other income, net totaled $237,000 and $205,000
in 2006 and 2005, respectively. The increase in 2006 was the result of higher interest income due to higher 2006 monthly cash balances.

The provision for income taxes in 2006 and 2005, was $325,000 and $39,000 respectively. $50,000 of the 2006 amount and the entire 2005 amount were due to foreign taxes. In 2006, we recorded an additional $275,000 of tax expense due to an
increase in the valuation allowance against net deferred tax assets recorded in prior years. We will continue to assess the likelihood of realization of our net deferred tax assets. If future events occur that do not make the realization of such
assets more likely than not, a valuation allowance will be established against all or a portion of the net deferred tax assets.

Year
ended December 31, 2005 compared to the year ended December 31, 2004

The 8% increase in license fee revenue in 2005 over 2004
was primarily due to higher initial sales of our xPressionEnterprise Suite and increased PCS revenues from our increasing base of licensed software users, somewhat offset by reduced sales in our older Autograph suite.

Services and other revenues increased 114% over 2004 amounts. A majority of growth was from the delivery of implementation services to customers who have
licensed our xPression software. Additionally, our results benefited from consulting services delivered by our Objectiva subsidiary.



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The 28% increase in license fees cost of revenue in 2005 was primarily due to a $420,000 increase in
amortization of software development costs over 2004, due to the release of xPression 2.0 in the fourth quarter of 2004, and increases in 2005 personnel costs of $263,000 over 2004, as additional staff was required to support our customer
base and product set.

Services and other cost of revenues in 2005 increased by 130% over 2004 due to an increase in personnel related
costs and management required to sustain existing projects and to staff anticipated new projects. Increased recruiting costs, computer and computer-related costs, facility costs related to our new headquarters facility, and outside consulting costs
incurred to meet project deadlines while we staffed up our professional services group also contributed to the percentage growth in services costs in excess of the percentage growth in services revenues.

The decrease in gross research and development costs in 2005 was primarily due to a decrease in outside consultant costs of approximately $1,026,000
offset by an increase in employee-related costs of $697,000, largely driven by the impact of our acquisition of Objectiva. Capitalized software development costs mainly include payroll related costs of our software engineers and consulting fees
related to the development of xPression. We did not capitalize any software development costs in 2005 because the establishment of technological feasibility coincided with the general releases of our products.

The slight decrease in 2005 selling and marketing expenses from 2004 was primarily due to decreases in employee related costs and outside consultant
costs partially offset by an increase in sales commissions.

The 10% increase in 2005 general and administrative expenses was primarily due
to increases in personnel costs of $435,000, telephone and office costs of $131,000 and outside consultant costs of $78,000, partially offset by a French VAT refund of $391,000.

Interest and other income, net totaled $204,900 and $17,400 in 2005 and 2004, respectively. The increase in 2005 was largely the result of a gain on the
sale of stock, as well as higher interest income due to higher cash balances.

The $39,000 and $24,700 provisions for income taxes in 2005
and 2004, respectively, were due to foreign taxes. We will continue to assess the likelihood of realization of our net deferred tax assets. If future events occur that do not make the realization of such assets more likely than not, a valuation
allowance will be established against all or a portion of the net deferred tax assets.

Trends and Factors That May Affect Future Operating Results

Our total revenues and operating results can vary, sometimes substantially, from quarter to quarter and are expected to vary
significantly in the future. Our revenues and operating results are difficult to forecast. Future results will depend upon many factors, including the demand for our products and services, the level of product and price competition, the length of
our sales cycle, the size, elements and timing of individual software arrangements, the delay or deferral of customer implementations, the budget cycles of our customers, our success in expanding our direct sales force and indirect distribution
channels, the timing of new product introductions and product enhancements by us and our competitors, the mix of products and services sold, levels of international sales, activities of and acquisitions by competitors, the timing of new hires,
changes in foreign currency exchange rates, our ability to develop and market new products, the renewal rates for our annual software licenses, controlling costs and general domestic and international economic conditions. In addition, our sales
generally reflect a relatively high amount of revenue per order, and, therefore, the loss or delay of individual orders could have a significant impact on our revenues and quarterly operating results. In addition, a significant amount of our
revenues occur predominantly in the third month of each fiscal quarter and tend to be concentrated in the latter half of that third month.



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Our license fee revenues depend on when orders are received from and shipped to customers; however,
because of our revenue recognition policies, our customers implementation schedules and the complexity of the implementation process, revenue from some software shipments may not be recognized in the same quarter as the shipment occurs. The
timing of receipt of these license fees is also difficult to predict because of the length of our sales cycle. For Autograph products, our sales cycle is typically three to nine months from initial contact. For xPression products, our
sales cycle is typically nine months to over one year from initial contact. Because our operating expenses are based on anticipated revenue trends and because a high percentage of our expenses are relatively fixed, a delay in the recognition of
revenue from a limited number of initial license transactions could cause significant variations in operating results from quarter to quarter and could result in losses. To the extent such expenses precede, or are not subsequently followed by,
increased revenues, our operating results could be materially adversely affected.

Due to the foregoing factors, revenues and operating
results for any quarter are subject to significant variation, and we believe that period-to-period comparisons are not necessarily meaningful and should not be relied upon as indications of future performance.

Liquidity and Capital Resources

Our sources of cash
are derived primarily from operations and sales and maturities of short-term investments. We currently do not have any debt from borrowed money. Our short-term investments are invested in U.S. government agency obligations and high quality
commercial paper.

We believe that our existing cash balances and anticipated cash flows from operations will be sufficient to meet our
anticipated cash needs for working capital and capital expenditures at least through the next twelve months. In this regard, a portion of our cash could be used to acquire or invest in complementary businesses or products or to obtain the right to
use complementary technologies. We have no material current understandings, commitments or agreements with respect to any acquisition in whole of other businesses, products or technologies.

At December 31, 2006, we had approximately $7.1 million in cash, cash equivalents and short-term investments, a decrease of approximately $778,000
from the December 31, 2005 balance. Our loss for the year was somewhat offset by non-cash depreciation and amortization expense of approximately $1.2 million, much of which relates to amortization of previously capitalized software development
costs, $577,000 of non-cash stock-based compensation expense and an increase in deferred revenue of $1.9 million. Also contributing to cash growth was $244,000 in proceeds from the issuance of common stock in conjunction with the exercise of
our stock options and purchases through our employee stock purchase plan. Offsetting these items were an increase in accounts receivable of $3.6 million, purchases of fixed assets of $224,000 and a net increase in the remaining operating
liabilities over operating assets of $579,000.

Off-Balance Sheet Arrangements

As of December 31, 2005 and 2006, we did not have any other relationships with unconsolidated entities or financial partners, such as entities often
referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not materially exposed
to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.



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Tabular Disclosure of Contractual Obligations

The following information as of December 31, 2006 is shown with respect to known contractual obligations for the periods specified below.



|                            |  |        |           |                       |   |           |  |           |           |  |   |        
|--------------------------- |  | ------ | --------- | --------------------- | - | --------- |  | --------- | --------- |  | - | -------
|                            |  |        |           | Payment Due by Period
|                            |  | Totals |           | Less than1 year       |   | 1-3 Years |  | 3-5 Years
|Capital Lease Obligations   |  | $      | 27,521    |                       | $ | 20,822    |  | $         | 6,699     |  | $ |       
|Operating Lease Obligations |  |        | 3,092,171 |                       |   | 881,001   |  |           | 1,457,380 |  |   | 753,790
|                            |  |        |           |                       |   |           |  |           |           |  |   |        
|Totals                      |  | $      | 3,119,692 |                       | $ | 901,823   |  | $         | 1,464,079 |  | $ | 753,790
|                            |  |        |           |                       |   |           |  |           |           |  |   |        

Recently Issued Accounting Standards

In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income
Taxesan interpretation of FASB Statement No. 109, which clarifies the accounting for income taxes, by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements.
FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We will adopt
FIN 48 as of January 1, 2007, as required. The cumulative effect of adopting FIN 48 will be recorded in retained earnings and other accounts as applicable. We are evaluating the potential impact of this interpretation on our future results of
operations and financial condition.

On September 13, 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin
(SAB) No. 108, Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements, which provides interpretive guidance on how the effects of the carryover or reversal of prior year
misstatements should be considered in quantifying a current year misstatement. The guidance is applicable for our fiscal 2006. The adoption of SAB 108 did not have a material impact on our consolidated financial statements.

In September 2006, the FASB issued SFAS 157, Fair Value Measurements. This statement provides a single definition of fair value, a framework for
measuring fair value, and expanded disclosures concerning fair value. Previously, different definitions of fair value were contained in various accounting pronouncements creating inconsistencies in measurement and disclosures. SFAS 157 applies under
those previously issued pronouncements that prescribe fair value as the relevant measure of value, except SFAS 123(R) and related interpretations and pronouncements that require or permit measurement similar to fair value but are not intended to
measure fair value. This pronouncement is effective for fiscal years beginning after November 15, 2007. We do not expect the adoption of SFAS 157 to have a material impact on our financial position, results of operations, or cash flows.



|ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|-------- | ----------------------------------------------------------

Foreign Currency Exchange Risk

Our earnings and cash flows are subject to fluctuations due to changes in foreign currency
exchange rates. To a certain extent, foreign currency exchange rate movements also affect our competitive position, as exchange rate changes may affect business practices and/or pricing strategies on non-U.S. based competitors. Our primary foreign
currency risk exposures are related to U.S. Dollar to Euro and U.S. Dollar to Chinese Yuan conversions. Our subsidiary in China conducts business primarily in the Chinese Yuan. Considering the anticipated cash flows from firm sales
commitments and anticipated sales for the next quarter, a hypothetical 10% weakening of the U.S. Dollar relative to the Euro would not materially adversely affect expected first quarter 2007 earnings or cash flows. This analysis is dependent on
actual export sales during the next quarter occurring within 90% of budgeted



26



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##### Table of Contents

forecasts. The effect of the hypothetical change in exchange rates ignores the effect this movement may have on other variables including competitive risk.
If it were possible to quantify this competitive impact, the results could well be different than the sensitivity effects described above. Each month, we review our position for expected currency exchange rate movements.

Interest Rate Risk

We are exposed to changes in
interest rates primarily from our short-term available-for-sale investments. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. A hypothetical 100 basis point adverse move in
interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive financial instruments at December 31, 2006. Declines in interest rates over time will, however, reduce our interest
income.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The financial statements and supplementary data
required by this item are set forth at the end of this annual report on Form 10-K beginning on page F-1 and are incorporated into this item by reference.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.

None.

ITEM 9A. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

We have established and currently maintain disclosure controls and other procedures designed to ensure that information required to be disclosed in our
reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified by the Securities and Exchange Commissions rules and forms, and that such information is accumulated and
communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. In designing and evaluating our disclosure controls and procedures,
management recognizes that any control or procedure, no matter how well designed and functioning, can provide only reasonable, but not absolute assurance of achieving the desired control objectives. In reaching a reasonable level of assurance,
management applied its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Additionally, the design of any system of controls is partially based upon certain assumptions of the likelihood of future events, and
there can be no assurance that any design will achieve its stated goals under all potential future conditions. Over time, controls may become inadequate because of changing conditions, or the degree of compliance with policies and procedures may
deteriorate. Consequently, because of the inherent limitations of a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

As of the end of the period covered by this Annual Report on Form 10-K, we conducted an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief
Financial Officer, of the effectiveness and the design and operation of our disclosure controls and procedures. Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that, as of December 31, 2006, our
disclosure controls and procedures were not effective, due to the identification of the material weaknesses in internal control over financial reporting described below.

Notwithstanding the material weaknesses described below, management believes the consolidated financial statements included in this report fairly present, in all material respects, our financial condition, results of
operations and cash flows for the periods presented.



27



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Material Weaknesses in Internal Control Over Financial Reporting

A material weakness is a control deficiency, or combination of control deficiencies, that results in a more than remote likelihood that a material
misstatement of the annual or interim financial statements will not be prevented or detected. In connection with the preparation of our 2006 consolidated financial statements, we have identified the following control deficiencies, which represent
material weaknesses in the Companys internal control over financial reporting as of December 31, 2006:

Inability to
Appropriately Analyze Certain Accounts. We did not maintain effective controls with respect to the analysis of our revenue recognition and various accrual accounts. Specifically, we did not perform a complete and timely review of two of our
customer agreements, which resulted in audit adjustments related to the improper recognition of revenue during the three-month period ended December 31, 2006. In addition, we did not perform a complete analysis of various accrual accounts,
including accrued commissions expenses, resulting in audit adjustments in the 2006 consolidated financial statements. Additionally, these control deficiencies could result in a misstatement in the aforementioned accounts that would result in a
material misstatement to the annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management has concluded that this control deficiency constitutes a material weakness.

Ineffective Segregation of Duties Within Key Information Systems Applications. We did not maintain effective segregation of duties within the
administration of certain of our key information systems applications. We did not adequately segregate duties between those employees with everyday duties to initiate, process and record transactions from those who administer the application.
Accordingly, management has concluded that this control deficiency constitutes a material weakness.

Managements Remediation Initiatives

During the first quarter of 2007, we began remediation of these material weaknesses as follows:



| |  |  | We implemented compensating controls to ensure that revenue is not recognized if the customer agreement has not been signed by both parties. We also implemented
controls to ensure that revenue is not recognized until any right of return from the customer expires.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We implemented an enhanced quarterly and annual financial statement close, review and reporting process to include additional levels of analysis and review to
ensure that appropriate accrued expenses are recorded in the proper period.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We are revising the administration of the aforementioned information system applications to segregate duties of employees in such a manner so as to separate
administrative functions from transaction processing functions.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Notwithstanding the remediation initiatives described
above, the control deficiencies will not be considered remediated until new controls are implemented, in operation for a sufficient period of time, are tested and our management concludes that the new controls are operating effectively

Changes in Internal Control over Financial Reporting

Other than the changes described above, we have made no significant change in our internal control over financial reporting during the most recent fiscal quarter covered by this report on Form 10-K that has materially affected, or is
reasonably likely to materially affect, our internal control over financial reporting.



|ITEM 9B. | OTHER INFORMATION
|-------- | -----------------

Not applicable.



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##### Table of Contents

PART III



|ITEM 10. | DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
|-------- | ------------------------------------------------------

The information required by this item is incorporated by reference to the information set forth in our definitive proxy statement relating to the 2007 Annual Meeting of Stockholders or a Form 10-K/A that is filed within 120 days after the
close of the our fiscal year ended December 31, 2006.



|ITEM 11. | EXECUTIVE COMPENSATION
|-------- | ----------------------

The information required by
this item is incorporated by reference to the information set forth in our definitive proxy statement relating to the 2007 Annual Meeting of Stockholders or a Form 10-K/A that is filed within 120 days after the close of the our fiscal year ended
December 31, 2006.



|ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
|-------- | -----------------------------------------------------------------------------------------------

The information required by this item is incorporated by reference to the information set forth in our definitive proxy statement relating to the 2007
Annual Meeting of Stockholders or a Form 10-K/A that is filed within 120 days after the close of the our fiscal year ended December 31, 2006.

Securities Available for Issuance under the Companys Equity Compensation Plans

The following table provides
information with respect to our equity compensation plans as of December 31, 2006, which plans were as follows: the 1995 Stock Incentive Plan, the 2004 Stock Incentive Plan and the 1997 Employee Stock Purchase Plan, as amended.



|                                                           |  |                                                                                             |     |  |                                                                              |      |                                                                                                                                            |         |    
|---------------------------------------------------------- |  | ------------------------------------------------------------------------------------------- | --- |  | ---------------------------------------------------------------------------- | ---- | ------------------------------------------------------------------------------------------------------------------------------------------ | ------- | ---
|Plan Category                                              |  | (a) Number of Securitiesto be Issued uponExercise of OutstandingOptions, Warrants
andRights |     |  | (b) Weighted-averageExercise Price ofOutstanding Options,Warrants and Rights |      | (c) Number of SecuritiesRemaining Available forFuture Issuance underEquity Compensation Plans(Excluding
SecuritiesReflected in Column (a)) |        
|Equity compensation plans approved by security holders     |  | 2,277,613                                                                                   | (1) |  | $                                                                            | 2.97 |                                                                                                                                            | 196,513 | (2)
|Equity compensation plans not approved by security holders |  | 50,000                                                                                      | (1) |  |                                                                              | 3.10 |                                                                                                                                            |        |    
|                                                           |  |                                                                                             |     |  |                                                                              |      |                                                                                                                                            |         |    
|Totals                                                     |  | 2,327,613                                                                                   |     |  | $                                                                            | 2.97 |                                                                                                                                            | 196,513 |    
|                                                           |  |                                                                                             |     |  |                                                                              |      |                                                                                                                                            |         |    

---

|(1) | Includes restricted stock grants at no cost to grantee.
|--- | -------------------------------------------------------

|(2) | Includes 74,657 shares of our common stock that may be issued under the 1997 Employee Stock Purchase Plan.
|--- | ----------------------------------------------------------------------------------------------------------



|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
|-------- | ----------------------------------------------

The
information required by this item is incorporated by reference to the information set forth in our definitive proxy statement relating to the 2007 Annual Meeting of Stockholders or a Form 10-K/A that is filed within 120 days after the close of the
our fiscal year ended December 31, 2006.



|ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND SERVICES
|-------- | --------------------------------------

The
information required by this item is incorporated by reference to the information set forth in our definitive proxy statement relating to the 2007 Annual Meeting of Stockholders or a Form 10-K/A that is filed within 120 days after the close of the
our fiscal year ended December 31, 2006.



29



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##### Table of Contents

PART IV



|ITEM 15. | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
|-------- | ------------------------------------------

(a) The
following documents are filed as part of this Form 10-K:

1. Financial Statements. The financial statements, related
notes thereto and the Report of Independent Registered Public Accounting Firm required hereunder are set forth at the end of this Annual Report beginning on page F-1.

2. Financial Statement Schedule. The following financial statement schedule for the fiscal years ended December 31, 2006, 2005
and 2004 is filed as part of this Form 10-K beginning on page S-1 and should be read in conjunction with our consolidated financial statements and related notes thereto.

Schedule II Valuation and Qualifying Accounts

Schedules other than those listed above have been omitted since they are either not required, not applicable or the information is
otherwise included.

3. Exhibits. See Item 15(b) below.

(b) Exhibits. The exhibits listed on the accompanying index to exhibits immediately following the financial statement schedules are filed as part
of, or incorporated by reference into, this Form 10-K.

(c) Financial Statement Schedules required by Regulation S-X excluded from the
annual report to shareholders by Rule 14a-3(b). Not applicable.



30



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##### Table of Contents

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



DOCUMENT SCIENCES CORPORATIONBy:

/s/    JOHN L.
MCGANNONJohn L. McGannon President and Chief Executive Officer


Dated: March 20, 2007

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints John L. McGannon his attorney-in-fact, with full power of substitution, for him in any and all capacities, to sign any and all amendments to this report, and to file the same, with exhibits thereto and other documents
in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that said attorney-in-fact or his substitute, may do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the
Registrant on March 20, 2007 in the capacities indicated:



|                                           |  |                                                                                   
|------------------------------------------ |  | ----------------------------------------------------------------------------------
|Signatures                                 |  | Title                                                                             
|                                           | 
|/s/    JOHN L.
MCGANNON John L. McGannon   |  | President, Chief Executive Officer and Director (principal executive officer)     
|                                           | 
|/s/    TODD W.
SCHMIDT Todd W. Schmidt     |  | Chief Financial Officer and Secretary (principal financial and accounting officer)
|                                           | 
|/s/    THOMAS L.
RINGER Thomas L. Ringer   |  | Chairman of the Board of Directors                                                
|                                           | 
|/s/    RONALD S.
BEARD Ronald S. Beard     |  | Director                                                                          
|                                           | 
|/s/    MARGARET A.
BREYA Margaret A. Breya |  | Director                                                                          
|                                           | 
|/s/    BARTON L.
FABER Barton L. Faber     |  | Director                                                                          
|                                           | 
|/s/    COLIN J.
OBRIEN Colin J. OBrien   |  | Director                                                                          



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##### Table of Contents

DOCUMENT SCIENCES CORPORATION

ANNUAL REPORT ON FORM 10-K

FOR YEAR ENDED DECEMBER 31, 2006

INDEX TO EXHIBITS



|               |  |                                                                                                                                                                                                                                                                                                           
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Exhibit Description                                                                                                                                                                                                                                                                                       
|3.1(1)         |  | Amended and Restated Certificate of Incorporation.                                                                                                                                                                                                                                                        
|               | 
|3.2(1)         |  | Amended and Restated Bylaws.                                                                                                                                                                                                                                                                              
|               | 
|4.1(2)         |  | Specimen Stock Certificate.                                                                                                                                                                                                                                                                               
|               | 
|4.2(3)         |  | Rights Agreement between the Registrant and U.S. Stock Transfer Corporation, as Rights Agent, dated May 11, 2001, which includes as Exhibit A thereto the form of Rights Certificate to be
Distributed to Holders of Rights after the Distribution Date (as that term is defined in the Rights Agreement).
|               | 
|10.1(2, #)     |  | Form of Indemnity Agreement Between the Registrant and each of its Officers and Directors.                                                                                                                                                                                                                
|               | 
|10.2(3)        |  | Form of Software License and Software Support Agreement.                                                                                                                                                                                                                                                  
|               | 
|10.3(3)        |  | Form of Professional Services Agreement.                                                                                                                                                                                                                                                                  
|               | 
|10.4(3)        |  | Form of Value Added Reseller Agreement.                                                                                                                                                                                                                                                                   
|               | 
|10.5(4, #)     |  | 1997 Employee Stock Purchase Plan, as Amended.                                                                                                                                                                                                                                                            
|               | 
|10.6(4)        |  | Lease for Principal Facilities, as Amended, and Assignment of Lease.                                                                                                                                                                                                                                      
|               | 
|10.7(5)        |  | Stock Repurchase Agreement Between Xerox and the Registrant.                                                                                                                                                                                                                                              
|               | 
|10.8(6)        |  | Development Services and Referral Agreement Between Objectiva Software Solutions, Inc. and the Registrant dated January 16, 2004.                                                                                                                                                                         
|               | 
|10.9(7)        |  | 2004 Stock Incentive Plan.                                                                                                                                                                                                                                                                                
|               | 
|10.10(8)       |  | Stock Purchase Agreement Between Objectiva Software Solutions, Inc. and the Registrant.                                                                                                                                                                                                                   
|               | 
|10.11(9)       |  | Lease for New Principal Facilities.                                                                                                                                                                                                                                                                       
|               | 
|10.12(10, #)   |  | Form of Stock Option Agreement Used in Connection with the Registrants 2004 Stock Incentive Plan.                                                                                                                                                                                                        
|               | 
|10.13(11, #)   |  | John L. McGannon Employment Agreement.                                                                                                                                                                                                                                                                    
|               | 
|10.14(11, #)   |  | Daniel Fregeau Employment Agreement.                                                                                                                                                                                                                                                                      
|               | 
|10.15(11, #)   |  | Nasser Barghouti Employment Agreement.                                                                                                                                                                                                                                                                    
|               | 
|10.16(11, #)   |  | J. Douglas Winter Employment Agreement.                                                                                                                                                                                                                                                                   
|               | 
|10.17(11, #)   |  | Tao Ye Employment Agreement.                                                                                                                                                                                                                                                                              
|               | 
|10.18(12, #)   |  | Edward Calnan Employment Agreement. Edward Calnan Stock Option and Restricted Stock Plan and Agreement.                                                                                                                                                                                                   
|               | 
|14.1(7)        |  | Code of Conduct.                                                                                                                                                                                                                                                                                          
|               | 
|21.1(*)        |  | Significant Subsidiaries of the Registrant.                                                                                                                                                                                                                                                               
|               | 
|23.1(*)        |  | Consent of Independent Registered Public Accounting Firm.                                                                                                                                                                                                                                                 
|               | 
|31.1(*)        |  | Certification of CEO Pursuant to Rules 13a-14 and 15d-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                           



32



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##### Table of Contents

|               |  |                                                                                                                                
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Exhibit Description                                                                                                            
|31.2(*)        |  | Certification of CFO Pursuant to Rules 13a-14 and 15d-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|               | 
|32.1(*)        |  | Certification of CEO Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 
|               | 
|32.2(*)        |  | Certification of CFO Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 

---

|(1) | Previously filed as an exhibit to the Registrants Current Report on Form 8-K filed with the Securities and Exchange Commission on May 20, 2004.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Previously filed as exhibits to Registration Statement on Form S-1 Registration Number 333-06344 filed with the Securities and Exchange Commission on June 20, 1996.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Previously filed as exhibits to the Registrants Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
|--- | ------------------------------------------------------------------------------------------------------------------------

|(4) | Previously filed as exhibits to the Registrants Annual Report on Form 10-K for the fiscal year ended December 31, 1998.
|--- | ------------------------------------------------------------------------------------------------------------------------

|(5) | Previously filed as an exhibit to the Registrants Current Report on Form 8-K filed with the Securities and Exchange Commission on November 20, 2003.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Previously filed as exhibits to the Registrants Annual Report on Form 10-K for the fiscal year ended December 31, 2003.
|--- | ------------------------------------------------------------------------------------------------------------------------

|(7) | Previously filed as Appendix A to the Registrants Proxy Statement on Schedule 14A filed with the Securities and Exchange Commission on March 29, 2004.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) | Previously filed as an exhibit to the Registrants Current Report on Form 8-K filed with the Securities and Exchange Commission on August 4, 2004.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------

|(9) | Previously filed as an exhibit to the Registrants Current Report on Form 8-K with the Securities and Exchange Commission on March 2, 2005.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------

|(10) | Previously filed as an exhibit to the Registrants Annual Report on Form 10-K for the fiscal year ended December 31, 2004.
|---- | --------------------------------------------------------------------------------------------------------------------------

|(11) | Previously filed as exhibits to the Registrants Current Report on Form 8-K filed with the Securities and Exchange Commission on November 14, 2005.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------

|(12) | Previously filed as an exhibit to the Registrants Current Report on Form 8-K filed with the Securities and Exchange Commission on September 20, 2006.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------

|(#) | Indicates management compensatory plan, contract or arrangement.
|--- | ----------------------------------------------------------------

|(*) | Filed herewith.
|--- | ---------------



33



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##### Table of Contents

DOCUMENT
SCIENCES CORPORATION

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                        |  |    
|------------------------------------------------------- |  | ---
|Report of Independent Registered Public Accounting Firm |  | F-2
|Consolidated Balance Sheets                             |  | F-3
|Consolidated Statements of Operations                   |  | F-4
|Consolidated Statements of Stockholders Equity         |  | F-5
|Consolidated Statements of Cash Flows                   |  | F-6
|Notes to Consolidated Financial Statements              |  | F-7



F-1



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##### Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

Document Sciences Corporation

We have audited the
accompanying consolidated balance sheets of Document Sciences Corporation as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders equity and cash flows for each of the three years in the
period ended December 31, 2006. Our audits also included the financial statement schedule listed in Item 15(a). These financial statements and schedule are the responsibility of the Companys management. Our responsibility is to
express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the
standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were
not engaged to perform an audit of the Companys internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Document Sciences Corporation at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended
December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.

As discussed in Note 1 to the consolidated financial statements, effective
January 1, 2006, Document Sciences Corporation changed its method of accounting for share-based payments in accordance with Statement of Financial Accounting Standards No. 123 (Revised 2004).

/s/    ERNST & YOUNG LLP

San Diego, California

March 16, 2007



F-2



---

##### Table of Contents

DOCUMENT SCIENCES CORPORATION

CONSOLIDATED BALANCE SHEETS



|                                                                                                                                               |  |              |            |   |      |   |            |  
|---------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ---------- | - | ---- | - | ---------- | -
|                                                                                                                                               |  | December 31, |           
|                                                                                                                                               |  | 2006         |            |   | 2005 |  
|Assets                                                                                                                                         |  |              |            |   |      |   |            |  
|Current assets:                                                                                                                                |  |              |            |   |      |   |            |  
|Cash and cash equivalents                                                                                                                      |  | $            | 5,657,380  |   |      | $ | 6,692,642  |  
|Short-term investments                                                                                                                         |  |              | 1,437,214  |   |      |   | 1,179,851  |  
|Accounts receivable, less allowance for doubtful accounts of $335,796 and $339,669 in 2006 and 2005, respectively                              |  |              | 11,165,100 |   |      |   | 7,564,929  |  
|Other current assets                                                                                                                           |  |              | 1,888,203  |   |      |   | 1,666,382  |  
|                                                                                                                                               |  |              |            |   |      |   |            |  
|Total current assets                                                                                                                           |  |              | 20,147,897 |   |      |   | 17,103,804 |  
|Property and equipment, net                                                                                                                    |  |              | 725,029    |   |      |   | 788,567    |  
|Software development costs, net of accumulated amortization of $2,110,053 and $1,157,941 in 2006 and 2005, respectively                        |  |              | 746,282    |   |      |   | 1,698,394  |  
|Goodwill                                                                                                                                       |  |              | 4,495,192  |   |      |   | 4,495,192  |  
|                                                                                                                                               |  |              |            |   |      |   |            |  
|                                                                                                                                               |  | $            | 26,114,400 |   |      | $ | 24,085,957 |  
|                                                                                                                                               |  |              |            |   |      |   |            |  
|Liabilities and stockholders equity                                                                                                           |  |              |            |   |      |   |            |  
|Current liabilities:                                                                                                                           |  |              |            |   |      |   |            |  
|Accounts payable                                                                                                                               |  | $            | 342,103    |   |      | $ | 160,160    |  
|Accrued compensation                                                                                                                           |  |              | 2,169,320  |   |      |   | 1,719,869  |  
|Other accrued liabilities                                                                                                                      |  |              | 615,195    |   |      |   | 445,659    |  
|Deferred revenue                                                                                                                               |  |              | 16,785,570 |   |      |   | 14,861,856 |  
|                                                                                                                                               |  |              |            |   |      |   |            |  
|Total current liabilities                                                                                                                      |  |              | 19,912,188 |   |      |   | 17,187,544 |  
|                                                                                                                                               |  |             
|Obligations under capital leases, net of current portion                                                                                       |  |              | 6,699      |   |      |   | 27,521     |  
|                                                                                                                                               |  |             
|Commitments                                                                                                                                    |  |              |            |   |      |   |            |  
|                                                                                                                                               |  |             
|Stockholders equity:                                                                                                                          |  |              |            |   |      |   |            |  
|Preferred stock, $.001 par value; Authorized shares2,000,000; No shares issued and outstanding                                                |  |              |           |   |      |   |           |  
|Common stock, $.001 par value; Authorized shares30,000,000; Issued shares4,424,335 and 4,315,334 at December 31, 2006 and
2005, respectively |  |              | 4,424      |   |      |   | 4,315      |  
|Treasury stock100,583 and 102,566 shares at December 31, 2006 and 2005, respectively                                                          |  |              | (362,889   | ) |      |   | (344,858   | )
|Additional paid-in capital                                                                                                                     |  |              | 14,079,885 |   |      |   | 13,258,962 |  
|Accumulated other comprehensive income                                                                                                         |  |              | 302        |   |      |   | 18         |  
|Retained deficit                                                                                                                               |  |              | (7,526,209 | ) |      |   | (6,047,545 | )
|                                                                                                                                               |  |              |            |   |      |   |            |  
|Total stockholders equity                                                                                                                     |  |              | 6,195,513  |   |      |   | 6,870,892  |  
|                                                                                                                                               |  |              |            |   |      |   |            |  
|                                                                                                                                               |  | $            | 26,114,400 |   |      | $ | 24,085,957 |  
|                                                                                                                                               |  |              |            |   |      |   |            |  

See accompanying notes.



F-3



---

##### Table of Contents

DOCUMENT SCIENCES CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS



|                                                    |  |                          |            |   |      |   |            |      |  |   |           
|--------------------------------------------------- |  | ------------------------ | ---------- | - | ---- | - | ---------- | ---- |  | - | ----------
|                                                    |  | Years Ended December 31,
|                                                    |  | 2006                     |            |   | 2005 |   |            | 2004
|Revenues:                                           |  |                          |            |   |      |   |            |      |  |   |           
|License fees                                        |  | $                        | 22,367,923 |   |      | $ | 19,926,392 |      |  | $ | 18,534,418
|Services and other                                  |  |                          | 11,042,630 |   |      |   | 9,647,452  |      |  |   | 4,503,807 
|                                                    |  |                          |            |   |      |   |            |      |  |   |           
|Total revenues                                      |  |                          | 33,410,553 |   |      |   | 29,573,844 |      |  |   | 23,038,225
|Cost of revenues:                                   |  |                          |            |   |      |   |            |      |  |   |           
|License fees                                        |  |                          | 4,204,971  |   |      |   | 4,425,290  |      |  |   | 3,465,775 
|Services and other                                  |  |                          | 10,211,437 |   |      |   | 8,029,637  |      |  |   | 3,487,192 
|                                                    |  |                          |            |   |      |   |            |      |  |   |           
|Total cost of revenues                              |  |                          | 14,416,408 |   |      |   | 12,454,927 |      |  |   | 6,952,967 
|                                                    |  |                          |            |   |      |   |            |      |  |   |           
|Gross profit                                        |  |                          | 18,994,145 |   |      |   | 17,118,917 |      |  |   | 16,085,258
|Operating expenses:                                 |  |                          |            |   |      |   |            |      |  |   |           
|Research and development                            |  |                          | 5,912,828  |   |      |   | 5,419,808  |      |  |   | 3,887,951 
|Selling and marketing                               |  |                          | 10,300,470 |   |      |   | 8,221,788  |      |  |   | 8,284,689 
|General and administrative                          |  |                          | 4,171,594  |   |      |   | 3,624,037  |      |  |   | 3,307,035 
|                                                    |  |                          |            |   |      |   |            |      |  |   |           
|Total operating expenses                            |  |                          | 20,384,892 |   |      |   | 17,265,633 |      |  |   | 15,479,675
|                                                    |  |                          |            |   |      |   |            |      |  |   |           
|Income (loss) from operations                       |  |                          | (1,390,747 | ) |      |   | (146,716   | )    |  |   | 605,583   
|Interest and other income, net                      |  |                          | 237,272    |   |      |   | 204,930    |      |  |   | 17,445    
|                                                    |  |                          |            |   |      |   |            |      |  |   |           
|Income (loss) before provision for income taxes     |  |                          | (1,153,475 | ) |      |   | 58,214     |      |  |   | 623,028   
|Provision for income taxes                          |  |                          | 325,189    |   |      |   | 38,959     |      |  |   | 24,748    
|                                                    |  |                          |            |   |      |   |            |      |  |   |           
|Net income (loss)                                   |  | $                        | (1,478,664 | ) |      | $ | 19,255     |      |  | $ | 598,280   
|                                                    |  |                          |            |   |      |   |            |      |  |   |           
|Net income (loss) per sharebasic                   |  | $                        | (0.35      | ) |      | $ | 0.00       |      |  | $ | 0.17      
|                                                    |  |                          |            |   |      |   |            |      |  |   |           
|Weighted average shares used in basic calculation   |  |                          | 4,264,482  |   |      |   | 4,147,622  |      |  |   | 3,624,362 
|                                                    |  |                          |            |   |      |   |            |      |  |   |           
|Net income (loss) per sharediluted                 |  | $                        | (0.35      | ) |      | $ | 0.00       |      |  | $ | 0.13      
|                                                    |  |                          |            |   |      |   |            |      |  |   |           
|Weighted average shares used in diluted calculation |  |                          | 4,264,482  |   |      |   | 5,333,868  |      |  |   | 4,729,373 
|                                                    |  |                          |            |   |      |   |            |      |  |   |           

See accompanying notes.



F-4



---

##### Table of Contents

DOCUMENT SCIENCES CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY



|                                                          |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   |            |  
|--------------------------------------------------------- |  | ------------ | - |  | -------------- | ----- | - | ------ | ------- | - | ------ | - | -------- | -------------------------- |  | - | --------------------------------------------- | - |  | ---------------- | ------- | - | -------------------------- | - | ---------- | - |  | - | ---------- | -
|                                                          |  |              |   |  |                |       |   |        |         |   |        |   |          | Additional Paid-in Capital |  |   | Accumulated Other Comprehensive Income (Loss) |   |  | Retained Deficit |         |   | Total Stockholders Equity |  
|                                                          |  | Common Stock |   |  | Treasury Stock |       |   |        |         |  
|                                                          |  | Shares       |   |  | Amount         |       |   | Shares |         |   | Amount |   |          |                            |  |  
|Balance at December 31, 2003                              |  | 3,330,806    |   |  | $              | 3,331 |   |        | 153,500 |   |        | $ | (556,352 | )                          |  | $ | 9,283,770                                     |   |  | $                | (88,611 | ) |                            | $ | (6,528,493 | ) |  | $ | 2,113,645  |  
|Issuance of common stock upon exercise of options         |  | 318,972      |   |  |                | 319   |   |        |        |   |        |   |         |                            |  |   | 663,578                                       |   |  |                  |        |   |                            |   |           |   |  |   | 663,897    |  
|Issuance of common stock upon purchase of Objectiva       |  | 629,793      |   |  |                | 630   |   |        |        |   |        |   |         |                            |  |   | 3,216,353                                     |   |  |                  |        |   |                            |   |           |   |  |   | 3,216,983  |  
|Purchase of treasury stock                                |  |             |   |  |                |      |   |        | 71,195  |   |        |   | (339,835 | )                          |  |   |                                              |   |  |                  |        |   |                            |   |           |   |  |   | (339,835   | )
|Sale of treasury stock                                    |  |             |   |  |                |      |   |        | (28,999 | ) |        |   | 104,035  |                            |  |   |                                              |   |  |                  |        |   |                            |   |           |   |  |   | 104,035    |  
|Retirement of treasury stock                              |  | (74,695      | ) |  |                | (75   | ) |        | (74,695 | ) |        |   | 351,222  |                            |  |   | (220,458                                      | ) |  |                  |        |   |                            |   | (130,689   | ) |  |   |           |  
|Comprehensive income:                                     |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   |            |  
|Net change in unrealized loss on short-term investments   |  |             |   |  |                |      |   |        |        |   |        |   |         |                            |  |   |                                              |   |  |                  | (20,633 | ) |                            |   |           |   |  |   | (20,633    | )
|Foreign currency translation adjustment                   |  |             |   |  |                |      |   |        |        |   |        |   |         |                            |  |   |                                              |   |  |                  | 40,968  |   |                            |   |           |   |  |   | 40,968     |  
|Net income                                                |  |             |   |  |                |      |   |        |        |   |        |   |         |                            |  |   |                                              |   |  |                  |        |   |                            |   | 598,280    |   |  |   | 598,280    |  
|                                                          |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   |            |  
|Comprehensive income                                      |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   | 618,615    |  
|                                                          |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   |            |  
|Balance at December 31, 2004                              |  | 4,204,876    |   |  |                | 4,205 |   |        | 121,001 |   |        |   | (440,930 | )                          |  |   | 12,943,243                                    |   |  |                  | (68,276 | ) |                            |   | (6,060,902 | ) |  |   | 6,377,340  |  
|Issuance of common stock upon exercise of options         |  | 111,999      |   |  |                | 112   |   |        |        |   |        |   |         |                            |  |   | 320,452                                       |   |  |                  |        |   |                            |   |           |   |  |   | 320,564    |  
|Purchase of treasury stock                                |  |             |   |  |                |      |   |        | 1,541   |   |        |   | (10,633  | )                          |  |   |                                              |   |  |                  |        |   |                            |   |           |   |  |   | (10,633    | )
|Sale of treasury stock                                    |  |             |   |  |                |      |   |        | (18,435 | ) |        |   | 96,072   |                            |  |   |                                              |   |  |                  |        |   |                            |   |           |   |  |   | 96,072     |  
|Retirement of treasury stock                              |  | (1,541       | ) |  |                | (2    | ) |        | (1,541  | ) |        |   | 10,633   |                            |  |   | (4,733                                        | ) |  |                  |        |   |                            |   | (5,898     | ) |  |   |           |  
|                                                          |  |              |   |  |                |       |   |       
|Comprehensive income:                                     |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   |            |  
|Net change in unrealized loss on short-term investments   |  |             |   |  |                |      |   |        |        |   |        |   |         |                            |  |   |                                              |   |  |                  | 1,997   |   |                            |   |           |   |  |   | 1,997      |  
|Foreign currency translation adjustment                   |  |             |   |  |                |      |   |        |        |   |        |   |         |                            |  |   |                                              |   |  |                  | 66,297  |   |                            |   |           |   |  |   | 66,297     |  
|Net income                                                |  |             |   |  |                |      |   |        |        |   |        |   |         |                            |  |   |                                              |   |  |                  |        |   |                            |   | 19,255     |   |  |   | 19,255     |  
|                                                          |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   |            |  
|Comprehensive income                                      |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   | 87,549     |  
|                                                          |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   |            |  
|Balance at December 31, 2005                              |  | 4,315,334    |   |  |                | 4,315 |   |        | 102,566 |   |        |   | (344,858 | )                          |  |   | 13,258,962                                    |   |  |                  | 18      |   |                            |   | (6,047,545 | ) |  |   | 6,870,892  |  
|Issuance of common stock upon exercise of options         |  | 83,188       |   |  |                | 83    |   |        |        |   |        |   |         |                            |  |   | 243,828                                       |   |  |                  |        |   |                            |   |           |   |  |   | 243,911    |  
|Issuance of common stock upon release of restricted stock |  | 25,813       |   |  |                | 26    |   |        |        |   |        |   |         |                            |  |   | (26                                           | ) |  |                  |        |   |                            |   |           |   |  |   |           |  
|Purchase of treasury stock                                |  |             |   |  |                |      |   |        | 25,926  |   |        |   | (164,676 | )                          |  |   |                                              |   |  |                  |        |   |                            |   |           |   |  |   | (164,676   | )
|Sale of treasury stock                                    |  |             |   |  |                |      |   |        | (27,909 | ) |        |   | 146,645  |                            |  |   |                                              |   |  |                  |        |   |                            |   |           |   |  |   | 146,645    |  
|Stock-based compensation expense                          |  |             |   |  |                |      |   |        |        |   |        |   |         |                            |  |   | 577,121                                       |   |  |                  |        |   |                            |   |           |   |  |   | 577,121    |  
|Comprehensive loss:                                       |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   |            |  
|Net change in unrealized gain on short-term investments   |  |             |   |  |                |      |   |        |        |   |        |   |         |                            |  |   |                                              |   |  |                  | 284     |   |                            |   |           |   |  |   | 284        |  
|Net loss                                                  |  |             |   |  |                |      |   |        |        |   |        |   |         |                            |  |   |                                              |   |  |                  |        |   |                            |   | (1,478,664 | ) |  |   | (1,478,664 | )
|                                                          |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   |            |  
|Comprehensive loss                                        |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   | (1,478,380 | )
|                                                          |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   |            |  
|Balance at December 31, 2006                              |  | 4,424,335    |   |  | $              | 4,424 |   |        | 100,583 |   |        | $ | (362,889 | )                          |  | $ | 14,079,885                                    |   |  | $                | 302     |   |                            | $ | (7,526,209 | ) |  | $ | 6,195,513  |  
|                                                          |  |              |   |  |                |       |   |        |         |   |        |   |          |                            |  |   |                                               |   |  |                  |         |   |                            |   |            |   |  |   |            |  

See accompanying notes.



F-5



---

##### Table of Contents

DOCUMENT SCIENCES CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS



|                                                                                                   |  |                          |            |   |      |   |            |      |  |   |            |  
|-------------------------------------------------------------------------------------------------- |  | ------------------------ | ---------- | - | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                                                                                   |  | Years ended December 31, |           
|                                                                                                   |  | 2006                     |            |   | 2005 |   |            | 2004 | 
|Operating activities                                                                               |  |                          |            |   |      |   |            |      |  |   |            |  
|Net income (loss)                                                                                  |  | $                        | (1,478,664 | ) |      | $ | 19,255     |      |  | $ | 598,280    |  
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |  |                          |            |   |      |   |            |      |  |   |            |  
|Depreciation and amortization                                                                      |  |                          | 254,784    |   |      |   | 276,989    |      |  |   | 396,248    |  
|Loss on disposal of fixed assets                                                                   |  |                          | 32,554     |   |      |   | 3,475      |      |  |   | 50,685     |  
|Amortization of software development costs                                                         |  |                          | 952,112    |   |      |   | 1,548,800  |      |  |   | 1,128,534  |  
|Provision for doubtful accounts                                                                    |  |                          | (3,873     | ) |      |   | (166,832   | )    |  |   | (191,239   | )
|Stock-based compensation expense                                                                   |  |                          | 577,121    |   |      |   |           |      |  |   |           |  
|Changes in operating assets and liabilities, net of effects of acquired business:                  |  |                          |            |   |      |   |            |      |  |   |            |  
|Accounts receivable                                                                                |  |                          | (3,596,298 | ) |      |   | 203,388    |      |  |   | (372,141   | )
|Other assets                                                                                       |  |                          | (221,821   | ) |      |   | (250,795   | )    |  |   | (406,460   | )
|Accounts payable                                                                                   |  |                          | 181,943    |   |      |   | 22,274     |      |  |   | (67,550    | )
|Accrued compensation                                                                               |  |                          | 449,451    |   |      |   | 263,608    |      |  |   | 367,473    |  
|Other accrued liabilities                                                                          |  |                          | 169,536    |   |      |   | (203,866   | )    |  |   | (530,823   | )
|Deferred revenue                                                                                   |  |                          | 1,923,714  |   |      |   | (463,529   | )    |  |   | 2,041,777  |  
|                                                                                                   |  |                          |            |   |      |   |            |      |  |   |            |  
|Net cash provided by (used in) operating activities                                                |  |                          | (759,441   | ) |      |   | 1,252,767  |      |  |   | 3,014,784  |  
|Investing activities                                                                               |  |                          |            |   |      |   |            |      |  |   |            |  
|Purchases of short-term investments                                                                |  |                          | (3,847,079 | ) |      |   | (4,731,034 | )    |  |   | (931,621   | )
|Maturities of short-term investments                                                               |  |                          | 3,590,000  |   |      |   | 5,150,000  |      |  |   | 3,335,000  |  
|Purchases of property and equipment, net                                                           |  |                          | (223,800   | ) |      |   | (557,713   | )    |  |   | (268,124   | )
|Net cash paid to purchase of Objectiva Software Solutions                                          |  |                          |           |   |      |   |           |      |  |   | (403,594   | )
|Additions to software development costs                                                            |  |                          |           |   |      |   |           |      |  |   | (1,881,094 | )
|                                                                                                   |  |                          |            |   |      |   |            |      |  |   |            |  
|Net cash used in investing activities                                                              |  |                          | (480,879   | ) |      |   | (138,747   | )    |  |   | (149,433   | )
|Financing activities                                                                               |  |                          |            |   |      |   |            |      |  |   |            |  
|Principal payments under capital lease obligations                                                 |  |                          | (20,822    | ) |      |   | (20,821    | )    |  |   | (21,063    | )
|Purchase of treasury stock                                                                         |  |                          | (164,676   | ) |      |   |           |      |  |   | (339,835   | )
|Sale of treasury stock                                                                             |  |                          | 146,645    |   |      |   | 96,072     |      |  |   | 104,035    |  
|Proceeds from issuance of common stock                                                             |  |                          | 243,911    |   |      |   | 309,931    |      |  |   | 663,897    |  
|                                                                                                   |  |                          |            |   |      |   |            |      |  |   |            |  
|Net cash provided by financing activities                                                          |  |                          | 205,058    |   |      |   | 385,182    |      |  |   | 407,034    |  
|                                                                                                   |  |                          |            |   |      |   |            |      |  |   |            |  
|Increase (decrease) in cash and cash equivalents                                                   |  |                          | (1,035,262 | ) |      |   | 1,499,202  |      |  |   | 3,272,385  |  
|Effect of foreign currency on cash                                                                 |  |                          |           |   |      |   |           |      |  |   | 4,460      |  
|Cash and cash equivalents at beginning of year                                                     |  |                          | 6,692,642  |   |      |   | 5,193,440  |      |  |   | 1,916,595  |  
|                                                                                                   |  |                          |            |   |      |   |            |      |  |   |            |  
|Cash and cash equivalents at end of year                                                           |  | $                        | 5,657,380  |   |      | $ | 6,692,642  |      |  | $ | 5,193,440  |  
|                                                                                                   |  |                          |            |   |      |   |            |      |  |   |            |  
|                                                                                                   |  |                          |           
|Supplemental disclosure of cash flow information:                                                  |  |                          |            |   |      |   |            |      |  |   |            |  
|Interest paid                                                                                      |  | $                        | 2,895      |   |      | $ | 2,895      |      |  | $ | 2,803      |  
|                                                                                                   |  |                          |            |   |      |   |            |      |  |   |            |  
|Income taxes paid                                                                                  |  | $                        | 50,189     |   |      | $ | 38,959     |      |  | $ | 24,748     |  
|                                                                                                   |  |                          |            |   |      |   |            |      |  |   |            |  

See accompanying notes.



F-6



---

##### Table of Contents

DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Organization and Summary of Significant Accounting Policies

Organization

Document Sciences Corporation was incorporated on October 18, 1991 in Delaware as a subsidiary of Xerox
Corporation (Xerox). We develop, market and support a family of dynamic content publishing software products and services used in high volume print and transactional web-based applications. Our products enable automated publishing solutions for many
industries, including insurance, financial services, managed healthcare and commercial outsourcing.

We currently derive all of our license
revenues from licenses of our xPression and Autographproducts. Our service revenues come from fees for services related to these products, as well as fees for outsourced development through our subsidiary, Objectiva Software
Solutions, Inc. (Objectiva).

Basis of Presentation

The accompanying consolidated financial statements include the accounts of all our operations. Significant intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates in the Preparation of Financial Statements

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

Foreign Operations

The functional currency of Objectivas subsidiary, Objectiva Software Solutions (Beijing), is the
Chinese Yuan. The balance sheet accounts of our subsidiaries are translated into U.S. Dollars at exchange rates prevailing at the balance sheet dates. Revenues and expenses are translated into U.S. Dollars at the average rates of exchange during the
period. Foreign currency translation gains and losses are recorded as a separate component of stockholders equity. Foreign currency transaction gains and losses are included in selling and marketing expenses in the consolidated statements of
operations and were not significant during the years ended December 31, 2006, 2005 and 2004.

Cash, Cash Equivalents and Short-term Investments

Cash and cash equivalents consist of cash and highly liquid investments that include debt securities with remaining maturities when
acquired of three months or less and are stated at fair market value. We evaluate the financial strength of institutions at which significant investments are made and believe the related credit risk is limited to an acceptable level.

In accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity
Securities, we have classified our investments as available-for-sale. Available-for-sale securities are carried at fair value. Unrealized gains and losses, net of tax, are reported in stockholders equity. Realized gains and losses and
declines in value judged to be other-than-temporary, if any, on available-for-sale securities will be included in investment income. The cost of securities sold is based on the specific identification method.



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DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Concentration of Credit Risk

We sell our products primarily to large, multinational customers in the United States, Europe, Canada, Australia and South America. We derived 14%, 17% and 25% of our total revenues from customers outside the United
States for the years ended December 31, 2006, 2005 and 2004, respectively. A significant concentration of our customers is in the insurance, finance and commercial print service industries. Xerox was the only customer that accounted for more
than 10% of our revenue in any one year. It accounted for 10%, 13% and 18% for the years ended December 31, 2006, 2005 and 2004, respectively.

Credit is extended based on an evaluation of the customers financial condition and a cash deposit is generally not required. We estimate our potential losses on trade receivables on an ongoing basis.

Allowance for Doubtful Accounts

We maintain an
allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make
payments, additional allowances may be required, which would result in an additional general and administrative expense in the period such determination is made.

Net Deferred Tax Assets

We follow the liability method of accounting for income taxes, as set forth in SFAS 109,
Accounting for Income Taxes. Deferred income taxes reflect the net effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. At
December 31, 2006, we had net deferred tax assets of $5.1 million. Due to the uncertainty of realizing these net deferred tax assets, we have a valuation allowance of $5.1 million on our deferred tax assets. Such uncertainty primarily relates
to the potential for future taxable income as well as loss carryforwards and tax credits expiring in 2018 and 2012, respectively.

Property and
Equipment, Depreciation and Amortization

Property and equipment are carried at cost, less accumulated depreciation and amortization.
Depreciation is provided on a straight-line method over the estimated useful lives of the assets (generally three to seven years). Amortization of leasehold improvements is provided over the lesser of the remaining lease term or the estimated useful
life of the improvements.

Impairment of Long-Lived Assets

We review the recoverability of the carrying value of long-lived assets, primarily property, plant and equipment, intangible assets and software development costs, for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be fully recoverable. Should indicators of impairment exist, the carrying values of the assets are evaluated in relation to the operating performance and future undiscounted cash
flows of the underlying asset. The net book value of an asset is adjusted to fair value if its expected future undiscounted cash flow is less than its book value. We have identified no such impairment losses as of December 31, 2006 and 2005.

Software Development Costs

In
accordance with SFAS 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, costs incurred in the research and development of new software products and significant enhancements to existing software
products are expensed as incurred until technological feasibility of the product has been established. After technological feasibility has been established, direct production costs, including programming and testing, are capitalized until general
release of the product.



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DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Capitalized costs of software to be sold, licensed or otherwise marketed are amortized using the
greater of the amount computed using the ratio of current period product revenues to estimated total product revenues or the straight-line method over the remaining estimated economic lives of the products. It is possible that estimated total
product revenues, the estimated economic life of the product, or both, will be reduced in the future. As a result, the carrying amount of capitalized software costs may be reduced in the future, which could cause our operating results in future
periods to be adversely affected. We expect to expense the remaining software development cost balance in 2007.

Goodwill

Upon acquisition of a business, we allocate the purchase price to tangible assets and liabilities acquired and identifiable intangible assets. Any
residual purchase price is recorded as goodwill. The allocation of the purchase price requires management to make significant estimates in determining the fair values of assets acquired and liabilities assumed, especially with respect to intangible
assets. These estimates are based on historical experience and information obtained from the management from the acquired company. Estimates used in determining the fair value of assets acquired and liabilities assumed are inherently uncertain and
unpredictable.

We have recorded goodwill in connection with our acquisitions of Objectiva and Data Retrieval. Under SFAS 142, Goodwill
and Other Intangible Assets, goodwill and other intangible assets with indefinite useful lives are not amortized, but are reviewed annually for impairment or more frequently if impairment indicators arise. We annually assess the underlying value
of our goodwill by analyzing the related future net cash flows and determine whether an adjustment to the carrying value is required. For 2006 and 2005, no adjustment was required. Separable intangible assets that have finite lives are amortized
over their useful lives. We assess the impairment of identifiable intangible assets whenever events or changes in circumstances indicate that its carrying amount may not be recoverable.

Guarantees

In the ordinary course of business, we include standard indemnification provisions in our
customer and distributor agreements. Pursuant to these agreements, we typically indemnify, hold harmless and reimburse the indemnified party for those losses suffered or incurred by the indemnified party arising from any trade secret, trademark,
copyright, patent or other intellectual property infringement claim by any third party with respect to our software and services. The term of these indemnification agreements is generally perpetual. The maximum potential amount of future payments
that we could be required to make under these indemnification agreements is unlimited; however, we have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. We believe the estimated fair value of our
obligation under these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements as of December 31, 2006 and 2005.

We currently provide software product warranties to our customers. The product warranties generally provide that the licensed software will operate substantially in accordance with the applicable user documentation
for a period typically 90 days from delivery. At December 31, 2006 and 2005, we did not have material product warranty liabilities.

We have agreements in place with our directors and officers whereby we indemnify them for certain events or occurrences while the officer or director is, or was, serving at our request in such capacity. The maximum potential amount of
future payments we could be required to make under these indemnification agreements is unlimited; however, we have a director and officer insurance policy that may enable us to recover a portion of any future amounts paid.



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DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Revenue Recognition

We derive our revenues principally from the licensing of software, post contract support fees (PCS) and professional services. We recognize revenue in accordance with Statement of Position (SOP) 97-2, Software
Revenue Recognition. Although some software is licensed on a perpetual basis, the majority of our licenses are currently time-based licenses that are required to be renewed annually. Revenues are recognized when a contract exists, the fee is
fixed and determinable, software delivery has occurred and collection of the receivable is deemed probable. Amounts billed or payments received in advance of revenue recognition are recorded as deferred revenue.

If an arrangement includes multiple elements, we allocate the contract amount to the various elements based on vendor-specific objective evidence (VSOE)
of fair value, regardless of any separate prices stated within the contracts for each element. We base our VSOE on the price charged when the same element is sold separately. If an undelivered element of the arrangement exists, revenue is deferred
based on VSOE of the fair value of the undelivered element. If VSOE of fair value does not exist for all undelivered elements, all revenue is deferred until sufficient evidence exists or all elements have been delivered. We use the residual method
to recognize revenue when an arrangement includes one or more elements to be delivered at a future date and VSOE of the fair value of all undelivered elements exists.

We recognize fees for annual licensing arrangements ratably over the contract term of twelve months because we are unable to establish VSOE for the license and support elements under this type of bundled arrangement.

For perpetual license arrangements, VSOE of fair value for ongoing maintenance and support obligations (PCS) is determined based upon the
historical, stand-alone renewal rates or pricing. We recognize revenue relating to the perpetual software license arrangements at inception of the arrangement using the residual method as discussed above.

Our contracts do not provide for specific upgrades. In addition, our standard contracts do not provide for rights of return or conditions of acceptance;
however, in cases where acceptance criteria are provided, revenue is deferred and not recognized until all conditions are satisfied and written customer acceptance is obtained.

Professional services revenue includes consulting services and training related to our software products. Revenues generated from consulting services and
training are recognized as the related services are performed and collectibility is deemed probable, based on VSOE of fair value of the services. VSOE of fair value for professional services is determined based upon the price charged when these
services are sold separately. For professional services that are bundled with annual software licenses and are not deemed to be essential to the functionality of the delivered software product, we recognize the entire arrangement fee ratably over
the longer of the period over which the professional services are expected to be rendered, or the PCS period, beginning with delivery of the software and commencement of the professional services. In the vast majority of cases, the arrangement fee
is recognized ratably over the twelve month PCS period. In certain limited situations where we determine that professional services period is the longer period, upon the end of the PCS term, we recognize license and PCS revenues at that stage (on
the residual basis), recognizing the remaining deferred revenue for the unfinished services over the remaining period of such services.

If
consulting services are deemed to be essential to the functionality of the delivered software product, revenue from the entire arrangement is recognized on a percentage of completion method or not until the contract is completed in accordance with
SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts, and Accounting Research Bulletin (ARB) No. 45, Long-Term Construction-Type



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DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Contracts. We measure progress under the percentage of completion method, depending on how the contract language is written, either by using the
percentage of total project hours completed or by the completion of phases in the consulting project. Because the phases of our consulting projects are generally not of great duration (2-6 weeks on average), we believe that there are very limited
circumstances where materially different amounts would be reported under different conditions or using different assumptions.

We work in
conjunction with our established VARs, with whom we have formal contracts defining the rights and obligations of the parties, to license software to end-users. We license software to our VARs, less a discount, from a fixed price list. We require a
binding purchase order as evidence of an unconditional order by an end user from our VARs, with no rights of return or acceptance. License revenue from our VARs is recognized when software is licensed to an end user.

Computation of Net Income (Loss) Per Share

We
present our net income (loss) per share information in accordance with SFAS 128, Earnings per Share (EPS). Basic EPS is computed by dividing income or loss available to common stockholders (the numerator) by the weighted-average number of
common shares outstanding (the denominator) during the period. Shares issued during the period and shares reacquired during the period are weighted for the portion of the period that they were outstanding. Basic EPS excludes any dilutive effects of
options, warrants and convertible securities.

The computation of diluted EPS is similar to the computation of basic EPS, except that the
denominator is increased to include the number of additional common shares that would have been outstanding if the common shares underlying outstanding options and warrants had been issued. The dilutive effect of outstanding options and warrants has
been reflected in EPS by application of the treasury stock method. The treasury stock method recognizes the use of proceeds that could be obtained upon exercise of options and warrants in computing diluted EPS. It assumes that any proceeds would be
used to purchase common stock at the average market price during the period. Options and warrants will have a dilutive effect under the treasury stock method only when the average market price of the common stock during the period exceeds the
exercise price of the options or warrants. Common stock options to purchase 49,482, 28,121 and 185,439 shares were excluded from the calculation of weighted-average shares used in determining diluted EPS for 2006, 2005 and 2004, respectively, as
their effect would have been antidilutive.

The following table reconciles the shares used in computing basic and diluted EPS for the
periods indicated:



|                                                                         |  |                          |  |           |  |          
|------------------------------------------------------------------------ |  | ------------------------ |  | --------- |  | ---------
|                                                                         |  | Years Ended December 31,
|                                                                         |  | 2006                     |  | 2005      |  | 2004     
|Weighted average common shares outstanding used in basic EPS calculation |  | 4,264,482                |  | 4,147,622 |  | 3,624,362
|Effect of dilutive stock options                                         |  |                         |  | 1,186,246 |  | 1,105,011
|                                                                         |  |                          |  |           |  |          
|Shares used in diluted EPS calculation                                   |  | 4,264,482                |  | 5,333,868 |  | 4,729,373
|                                                                         |  |                          |  |           |  |          

Stock-Based Compensation

Effective January 1, 2006, we adopted SFAS 123(R) Share-Based Payment, which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and
directors, including employee stock options and employee stock purchases, based on estimated fair values. In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 107 relating to SFAS 123(R). We
have applied the provisions of SAB 107 in our adoption of SFAS 123(R).



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DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



In November 2005, the FASB issued FASB Staff Position (FSP) SFAS 123R-3, Transition Election
Related to Accounting for the Tax Effects of Share-Based Payment Awards. FSP SFAS 123R-3 provides an elective alternative transition method, to SFAS 123R, in accounting for the tax effects of share-based payment awards to employees. The elective
method utilizes a computational component that establishes a beginning balance of the Additional Paid-In Capital (APIC) pool related to employee compensation and a simplified method to determine the subsequent impact on the APIC pool of employee
awards that are fully vested and outstanding upon the adoption of SFAS 123R. The impact on the APIC pool of awards partially vested upon, or granted after, the adoption of SFAS 123R should be determined in accordance with the guidance in SFAS 123R.
We have adopted the transition election of FSP SFAS 123R-3. The adoption of FAS 123R-3 for the year ended December 31, 2006 did not have a material impact on our consolidated financial statements.

SFAS 123(R) requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of
the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our consolidated income statement. SFAS 123(R) supersedes our previous accounting under the provisions of SFAS 123,
Accounting for Stock-Based Compensation. As permitted by SFAS 123, we measured compensation cost for options granted prior to January 1, 2006, in accordance with Accounting Principles Board Opinion (APB) No. 25, Accounting for
Stock Issued to Employees, and related interpretations. Accordingly, no accounting recognition was given to stock options granted at fair market value until they are exercised. Upon exercise, net proceeds, including tax benefits realized, were
credited to equity.

We adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the
accounting standard as of January 1, 2006, the first day of our fiscal year 2006. In accordance with the modified prospective transition method, our consolidated financial statements for prior periods have not been restated to reflect, and do
not include, the impact of SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R) for the year ended December 31, 2006 consisted of stock-based compensation expense related to employee stock options and employee stock
purchases of approximately $202,000, or $0.05 per share (basic). There was no stock-based compensation expense related to employee stock options and employee stock purchases recognized during the year ended December 31, 2005.

The following table summarizes stock-based compensation expense related to employee stock options and stock purchases under SFAS 123(R) for the year
ended December 31, 2006 which was allocated as follows:



|                                    |  |      |        
|----------------------------------- |  | ---- | -------
|                                    |  | 2006
|Cost of sales                       |  | $    | 117,000
|Research and development            |  |      | 28,000 
|Selling, general and administrative |  |      | 57,000 
|                                    |  |      |        
|Total                               |  | $    | 202,000
|                                    |  |      |        

We use the Black-Scholes option pricing model and the following weighted average assumptions:



|                                    |  |           |   |  |      |   |  |      |  
|----------------------------------- |  | --------- | - |  | ---- | - |  | ---- | -
|                                    |  | 2006      |   |  | 2005 |   |  | 2004 |  
|Expected life of options (in years) |  | 5.5  5.7 |   |  | 5.7  |   |  | 5.7  |  
|Expected volatility                 |  | 55  85   | % |  | 52   | % |  | 51   | %
|Risk-free interest rates            |  | 4.4  4.6 | % |  | 4.5  | % |  | 4    | %
|Dividend yields                     |  | 0         | % |  | 0    | % |  | 0    | %



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DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



In determining fair value, we used the following criteria:

Expected Life.The expected term of options granted represents the period of time that the option is expected to be outstanding. We estimate the
expected term of the option grants based on historical exercise patterns that are believed to be representative of future behavior as well as other various factors.

Expected Volatility.We estimate our volatility using our historical share price performance over the expected term of the options, which management believes is materially indicative of expectations about
expected future volatility.

Risk-Free Interest Rate.We use risk-free interest rates in the Black-Scholes option valuation model
that are based on U.S. Treasury zero-coupon issues with a remaining term equal to the expected life of the options.

Dividend Rate.We do not issue dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Therefore, we use an expected dividend yield of zero in the Black-Scholes option valuation model.

Forfeitures. SFAS 123R requires companies to estimate forfeitures at the time of grant and revise those estimates in subsequent reporting periods
if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. For purposes of calculating pro forma
information under SFAS 123 for periods prior to the date of adoption of SFAS 123R, we accounted for forfeitures as they occurred.

For
purposes of adjusted pro forma disclosures, the estimated fair value of the options is amortized to expense over the options vesting period. The effect of applying SFAS 123 for purposes of providing pro forma disclosures is not likely to be
representative of the effects on our operating results for future years because changes in the subjective input assumptions can materially affect future value estimates. Our pro forma information is as follows for the years ended December 31,
2005 and 2004:



|                                                                     |  |                          |          |   |      |   |          |  
|-------------------------------------------------------------------- |  | ------------------------ | -------- | - | ---- | - | -------- | -
|                                                                     |  | Years ended December 31, |         
|                                                                     |  | 2005                     |          |   | 2004 |  
|Net income (loss), as reported                                       |  | $                        | 19,255   |   |      | $ | 598,280  |  
|Less stock-based compensation expense                                |  |                          | (995,603 | ) |      |   | (688,841 | )
|                                                                     |  |                          |          |   |      |   |          |  
|Net income (loss), as reported less stock-based compensation expense |  | $                        | (976,348 | ) |      | $ | (90,561  | )
|                                                                     |  |                          |          |   |      |   |          |  
|Pro forma basic and diluted net income (loss) per share              |  | $                        | (0.24    | ) |      | $ | (0.03    | )

As of December 31, 2006, there was approximately $149,000 of total compensation cost related
to nonvested share-based compensation arrangements for stock options granted under the plans. That cost is expected to be recognized over a weighted average period of 2.17 years. During the year ended December 31, 2006, we recognized
approximately $145,000 in compensation expense related to nonvested shares.

As of December 31, 2006, there was approximately $776,000
of total compensation cost related to nonvested share-based compensation arrangements for restricted stock granted under the plans. That cost is expected to be recognized over a weighted average period of 1.83 years. During the year ended
December 31, 2006, we recognized approximately $375,000 in compensation expense related to nonvested restricted shares.

Comprehensive Income
(Loss)

In 1998, we adopted SFAS 130, Reporting Comprehensive Income. SFAS 130 requires that all components of comprehensive
income (loss), including net income (loss), be reported in the financial statements in the period they are recognized. Comprehensive income (loss) is defined as the change in equity during a period from



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DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



transactions and other events and circumstances from non-owner sources. Net income (loss) and other comprehensive income (loss), including foreign currency
translation adjustments and unrealized gains and losses on investments, shall be reported, net of their related tax effect, to arrive at comprehensive income (loss). We have disclosed comprehensive income (loss) in our financial statements
accordingly.

Segment Information

Operating segments, as defined in SFAS 131, Disclosures about Segments of an Enterprise and Related Information, are components of an enterprise for which separate financial information is available and is evaluated regularly by a
company in deciding how to allocate resources and in assessing performance. This financial information is required to be reported on the basis that is used internally for evaluating the segment performance. The chief operating decision maker has
determined that we operate in one business segment, which is software development. Geographic information, however, has been disclosed in accordance with the provisions of SFAS 131.

Recently Issued Accounting Pronouncements

In July 2006, the Financial Accounting Standards
Board (FASB) issued FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109, which clarifies the accounting for income taxes, by prescribing a minimum recognition
threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and
transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We will adopt FIN 48 as of January 1, 2007, as required. The cumulative effect of adopting FIN 48 will be recorded in retained earnings and other accounts
as applicable. We are evaluating the potential impact of this interpretation on our future results of operations and financial condition.

On September 13, 2006, the SEC issued SAB 108, Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements, which provides interpretive guidance on how the effects of
the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The guidance is applicable for our fiscal 2006. The adoption of SAB 108 did not have a material impact on our consolidated
financial statements.

In September 2006, the FASB issued SFAS 157, Fair Value Measurements. This statement provides a single
definition of fair value, a framework for measuring fair value, and expanded disclosures concerning fair value. Previously, different definitions of fair value were contained in various accounting pronouncements creating inconsistencies in
measurement and disclosures. SFAS 157 applies under those previously issued pronouncements that prescribe fair value as the relevant measure of value, except SFAS 123(R) and related interpretations and pronouncements that require or permit
measurement similar to fair value but are not intended to measure fair value. This pronouncement is effective for fiscal years beginning after November 15, 2007. We do not expect the adoption of SFAS 157 to have a material impact on our
financial position, results of operations, or cash flows.



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DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



2. Financial Statement Information

Short-term Investments

We have classified all of our short-term investment securities as
available-for-sale. The following table summarizes available-for-sale securities at December 31, 2006 and 2005:



|                                   |  |                |           |                        |   |                         |  |   |                      |   |  |   |          
|---------------------------------- |  | -------------- | --------- | ---------------------- | - | ----------------------- |  | - | -------------------- | - |  | - | ---------
|December 31, 2006                  |  | Amortized Cost |           | Gross Unrealized Gains |   | Gross Unrealized Losses |  |   | Estimated Fair Value
|Commercial paper                   |  | $              | 892,004   |                        | $ | 33                      |  | $ | (3                   | ) |  | $ | 892,034  
|Corporate debentures/bonds         |  |                | 545,182   |                        |   | 84                      |  |   | (86                  | ) |  |   | 545,180  
|                                   |  |                |           |                        |   |                         |  |   |                      |   |  |   |          
|                                   |  | $              | 1,437,186 |                        | $ | 117                     |  | $ | (89                  | ) |  | $ | 1,437,214
|                                   |  |                |           |                        |   |                         |  |   |                      |   |  |   |          
|                                   |  |                |           |                       
|December 31, 2005                  |  |                |           |                        |   |                         |  |   |                     
|Commercial paper                   |  | $              | 693,189   |                        | $ |                        |  | $ | (113                 | ) |  | $ | 693,076  
|U.S. government agency obligations |  |                | 362,008   |                        |   |                        |  |   | (224                 | ) |  |   | 361,784  
|Certificates of deposit            |  |                | 124,996   |                        |   |                        |  |   | (5                   | ) |  |   | 124,991  
|                                   |  |                |           |                        |   |                         |  |   |                      |   |  |   |          
|                                   |  | $              | 1,180,193 |                        | $ |                        |  | $ | (342                 | ) |  | $ | 1,179,851
|                                   |  |                |           |                        |   |                         |  |   |                      |   |  |   |          

The amortized cost and estimated fair value of available-for-sale securities at December 31,
2006 have contractual maturities of one year or less.

The following table shows the gross unrealized losses and fair value of our
investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31,
2006:



|                           |  |                     |           |                  |   |     |  
|-------------------------- |  | ------------------- | --------- | ---------------- | - | --- | -
|                           |  | Less than 12 Months |          
|                           |  | Fair Value          |           | UnrealizedLosses |  
|Commercial paper           |  | $                   | 892,034   |                  | $ | (3  | )
|Corporate debentures/bonds |  |                     | 545,180   |                  |   | (86 | )
|                           |  |                     |           |                  |   |     |  
|                           |  | $                   | 1,437,214 |                  | $ | (89 | )
|                           |  |                     |           |                  |   |     |  

The unrealized losses on our investments are due to increased interest rates and not credit
quality. Because we have the ability and intent to hold these investments until a recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2006.

Property and Equipment

Property and equipment are
stated at cost and consist of the following at December 31:



|                                               |  |      |           |   |      |   |           |  
|---------------------------------------------- |  | ---- | --------- | - | ---- | - | --------- | -
|                                               |  | 2006 |           |   | 2005 |  
|Computer equipment                             |  | $    | 628,974   |   |      | $ | 947,947   |  
|Office equipment                               |  |      | 200,895   |   |      |   | 119,714   |  
|Office furniture and fixtures                  |  |      | 324,996   |   |      |   | 202,551   |  
|Leasehold improvements                         |  |      | 43,967    |   |      |   | 43,967    |  
|                                               |  |      |           |   |      |   |           |  
|                                               |  |      | 1,198,832 |   |      |   | 1,314,179 |  
|Less accumulated depreciation and amortization |  |      | (473,803  | ) |      |   | (525,612  | )
|                                               |  |      |           |   |      |   |           |  
|                                               |  | $    | 725,029   |   |      | $ | 788,567   |  
|                                               |  |      |           |   |      |   |           |  



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DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The cost of equipment acquired under capital leases totaled $109,313 and $109,313 at
December 31, 2006 and 2005, respectively, with accumulated depreciation of $80,782 and $60,157 at December 31, 2006 and 2005, respectively. We disposed of our fully depreciated computer equipment in 2006. Depreciation and amortization
expense for the years ended December 31, 2006, 2005 and 2004 were $254,784, $276,989 and $396,248, respectively.

Deferred Revenue

The components of deferred revenue consist of the following at December 31:



|                   |  |      |            |      |   |           
|------------------ |  | ---- | ---------- | ---- | - | ----------
|                   |  | 2006 |            | 2005
|License fees       |  | $    | 16,190,364 |      | $ | 14,204,223
|Services and other |  |      | 595,206    |      |   | 657,633   
|                   |  |      |            |      |   |           
|                   |  | $    | 16,785,570 |      | $ | 14,861,856
|                   |  |      |            |      |   |           

3. Geographic Information

The tables below summarize our operating results by our major geographic locations in the United States and Europe:



|                             |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  
|---------------------------- |  | ------------- | ---------- | - | ------ | - | ------------ |  | - | ------- | - |  | - | ---------- | -
|                             |  | United States |            |   | Europe |   | Eliminations |  |   | Totals  |  
|Year ended December 31, 2006 |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  
|Revenues                     |  | $             | 30,291,553 |   |        | $ | 3,119,000    |  | $ |        |   |  | $ | 33,410,553 |  
|                             |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  
|Operating income (loss)      |  | $             | (2,339,496 | ) |        | $ | 948,749      |  | $ |        |   |  | $ | (1,390,747 | )
|                             |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  
|Identifiable assets          |  | $             | 26,114,400 |   |        | $ |             |  | $ |        |   |  | $ | 26,114,400 |  
|                             |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  
|                             |  |               |            |  
|                             |  | United States |            |   | Europe |   | Eliminations |  |   | Totals  |  
|Year ended December 31, 2005 |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  
|Revenues                     |  | $             | 26,419,167 |   |        | $ | 3,154,677    |  | $ |        |   |  | $ | 29,573,844 |  
|                             |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  
|Operating income (loss)      |  | $             | (180,964   | ) |        | $ | 34,248       |  | $ |        |   |  | $ | (146,716   | )
|                             |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  
|Identifiable assets          |  | $             | 24,085,957 |   |        | $ |             |  | $ |        |   |  | $ | 24,085,957 |  
|                             |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  
|                             |  |               |            |  
|                             |  | United States |            |   | Europe |   | Eliminations |  |   | Totals  |  
|Year ended December 31, 2004 |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  
|Revenues                     |  | $             | 19,576,019 |   |        | $ | 3,462,206    |  | $ |        |   |  | $ | 23,038,225 |  
|                             |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  
|Operating income             |  | $             | 468,383    |   |        | $ | 137,200      |  | $ |        |   |  | $ | 605,583    |  
|                             |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  
|Identifiable assets          |  | $             | 23,809,006 |   |        | $ | 202,399      |  | $ | (16,666 | ) |  | $ | 23,994,739 |  
|                             |  |               |            |   |        |   |              |  |   |         |   |  |   |            |  

Sales attributable to the United States were made to customers located in North America, South
America, Australia and Asia. Sales attributable to Europe are based on those sales generated by our European operations. These sales were made to customers located in Europe, Africa and the Middle East.



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##### Table of Contents

DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



4. Commitments and Guarantees

We currently lease our headquarters in Carlsbad, California that will expire June 15, 2011. Under the terms of the lease, effective approximately May 1, 2005, monthly rental payments will be increased
annually by 3%. The lease provides us with an option to extend the lease term for an additional five years at the base rent in effect for the last year of the initial lease term plus 3%. Rent expense is recorded on a straight-line basis over the
term of the lease. The difference between rent expense and amounts paid under the lease agreements is recorded as deferred rent in the accompanying consolidated balance sheets. Our offices in Milwaukee, Wisconsin; London, England and Beijing, China
are under operating leases expiring on October 31, 2008 and May 20, 2009, respectively. Annual future minimum lease payments as of December 31, 2006 are as follows:



|                          |  |   |          
|------------------------- |  | - | ---------
|Years ending December 31, |  |  
|2007                      |  | $ | 881,001  
|2008                      |  |   | 838,930  
|2009                      |  |   | 618,450  
|2010                      |  |   | 513,484  
|2011                      |  |   | 240,306  
|                          |  |   |          
|                          |  | $ | 3,092,171
|                          |  |   |          

We also lease some telephone equipment. Annual future minimum lease payments as of
December 31, 2006 are $27,521 payable in the next two years.

Rent expense for the years ended December 31, 2006, 2005 and 2004
was $998,621, $845,480 and $480,656, respectively.

5. Stockholders Equity

Stock

As of December 31, 2006, authorized capital stock consisted of 30,000,000 shares of
common stock and 2,000,000 shares of preferred stock.

Preferred Stock Purchase Right

On April 24, 2001, the Board of Directors authorized and declared a dividend of one preferred stock purchase right for each share of common stock of
Document Sciences. The dividend was payable on May 18, 2001 to the holders of record of common stock as of the close of business on such date. The preferred stock purchase rights are not exercisable until any person, other than Xerox, becomes
or attempts to become a 20% or more shareholder.

Stock Incentive Plans

Our stock incentive plans provide for the issuance of restricted stock, incentive stock options and non-statutory options to purchase common shares and
other awards to eligible employees, officers, directors and consultants. Our 2004 Stock Incentive Plan (the 2004 Plan) was approved at our Annual Meeting of Stockholders on April 29, 2004. The 2004 Plan provides for the issuance of
up to 900,000 shares. The Compensation Committee, subject to the provisions of the 2004 Plan, determines the terms of the restricted stock and stock option agreements, including vesting requirements. In general, stock grants vest over a four year
period. The maximum term of the options granted under the 2004 Plan is ten years. The exercise price of stock options under the 2004 Plan must equal at least the fair market value on the date of grant.



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##### Table of Contents

DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Our previous plans, the 1993 and 1995 Stock Option Plans, have been replaced by the 2004 Plan and no
additional awards may be granted thereunder. These plans had provided for the issuance of up to 2,279,250 shares and had been amended to provide for the issuance of an additional 2,100,000 shares. There are no shares subject to outstanding options
from the 1993 Plan as of December 31, 2004. The 1995 Plan has options exercisable through January 26, 2014.

The following table
summarizes stock option activity under all our equity incentive plans:



|                                 |  |                  |   |  |                               |     
|-------------------------------- |  | ---------------- | - |  | ----------------------------- | ----
|                                 |  | Number of Shares |   |  | WeightedAverageExercise Price
|Outstanding at December 31, 2003 |  | 2,177,049        |   |  | $                             | 2.27
|Granted                          |  | 359,375          |   |  |                               | 5.38
|Exercised                        |  | (318,972         | ) |  |                               | 2.08
|Forfeited or expired             |  | (140,532         | ) |  |                               | 4.16
|                                 |  |                  |   |  |                               |     
|Outstanding at December 31, 2004 |  | 2,076,920        |   |  | $                             | 2.76
|Granted                          |  | 423,500          |   |  |                               | 5.74
|Exercised                        |  | (111,999         | ) |  |                               | 2.34
|Forfeited or expired             |  | (93,699          | ) |  |                               | 3.40
|                                 |  |                  |   |  |                               |     
|Outstanding at December 31, 2005 |  | 2,294,722        |   |  | $                             | 3.31
|Granted                          |  | 64,000           |   |  |                               | 6.49
|Exercised                        |  | (83,188          | ) |  |                               | 2.93
|Forfeited or expired             |  | (149,008         | ) |  |                               | 6.29
|                                 |  |                  |   |  |                               |     
|Outstanding at December 31, 2006 |  | 2,126,526        |   |  | $                             | 3.18
|                                 |  |                  |   |  |                               |     

As of December 31, 2006, the aggregate intrinsic value of outstanding stock options was $7.5
million.

As of December 31, 2006, 121,856 shares were available for future issuance. Following is a breakdown of the stock options
outstanding and exercisable as of December 31, 2006:



|                         |  |                   |  |                                        |  |                                                      |      |                    |           |                                                       |   |     
|------------------------ |  | ----------------- |  | -------------------------------------- |  | ---------------------------------------------------- | ---- | ------------------ | --------- | ----------------------------------------------------- | - | ----
|Range of Exercise Prices |  | SharesOutstanding |  | Weighted AverageRemaining Life inyears |  | Weighted Average Exercise Price of SharesOutstanding |      | Shares Exercisable |           | Weighted Average Exercise Price of Shares Exercisable
|$0.91  $1.99            |  | 863,838           |  | 3.29                                   |  | $                                                    | 1.63 |                    | 863,838   |                                                       | $ | 1.63
|$2.00  $4.99            |  | 661,813           |  | 4.67                                   |  |                                                      | 2.95 |                    | 661,813   |                                                       |   | 2.95
|$5.13  $7.65            |  | 600,875           |  | 8.12                                   |  |                                                      | 5.67 |                    | 510,060   |                                                       |   | 5.56
|                         |  |                   |  |                                        |  |                                                      |      |                    |           |                                                       |   |     
|Total or Average         |  | 2,126,526         |  | 5.09                                   |  | $                                                    | 3.18 |                    | 2,035,711 |                                                       | $ | 3.04
|                         |  |                   |  |                                        |  |                                                      |      |                    |           |                                                       |   |     

Our 1997 Employee Stock Purchase Plan provides for the issuance of shares of our common stock, up
to a total of 500,000 shares, to eligible employees. The price of the common shares purchased under the Plan is equal to 85% of the fair market value of the common shares on the first or last day of the offering period, whichever is lower. Employees
who choose to participate in the plan can withhold between one and ten percent of their wages. However, an employee can not purchase more than 5,000 shares in any one offering period. As of December 31, 2006, 74,657 shares were available for
issuance.



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##### Table of Contents

DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Nonvested Shares

Stock Options. A summary of the status of our nonvested stock options issued under our 2004 Stock Incentive Plan for the year ended December 31, 2006 was as follows:



|                                                  |  |         |   |  |                                        |     
|------------------------------------------------- |  | ------- | - |  | -------------------------------------- | ----
|                                                  |  | Shares  |   |  | Weighted Average Grant-Date Fair Value
|Nonvested shares outstanding at December 31, 2005 |  | 98,350  |   |  | $                                      | 6.35
|Granted                                           |  | 64,000  |   |  | $                                      | 6.49
|Vested                                            |  | (33,935 | ) |  | $                                      | 6.28
|Forfeited                                         |  | (37,600 | ) |  | $                                      | 6.89
|                                                  |  |         |   |  |                                        |     
|Nonvested shares outstanding at December 31, 2006 |  | 90,815  |   |  | $                                      | 6.25
|                                                  |  |         |   |  |                                        |     

Restricted Stock. A summary of the status of our nonvested restricted stock issued under
our 2004 Stock Incentive Plan for the year ended December 31, 2006 was as follows:



|                                                  |  |         |   |  |                                        |     
|------------------------------------------------- |  | ------- | - |  | -------------------------------------- | ----
|                                                  |  | Shares  |   |  | Weighted Average Grant-Date Fair Value
|Nonvested shares outstanding at December 31, 2005 |  | 87,300  |   |  | $                                      | 7.36
|Granted                                           |  | 116,100 |   |  | $                                      | 6.50
|Vested                                            |  | (25,813 | ) |  | $                                      | 7.35
|Forfeited                                         |  | (26,500 | ) |  | $                                      | 7.07
|                                                  |  |         |   |  |                                        |     
|Nonvested shares outstanding at December 31, 2006 |  | 151,087 |   |  | $                                      | 6.74
|                                                  |  |         |   |  |                                        |     

Grants outside the 2004 Stock Incentive Plan

On April 12, 2006 and September 20, 2006 the Company filed Form 8-K Current Reports, for agreements pursuant to which stock options and
restricted shares were granted to the Companys Chief Marketing Officer and the Senior Vice President Sales respectively. The Chief Marketing Officer was granted options to purchase 25,000 shares at an exercise price per share of $7.07, the
fair market value on the date of the grant. The Senior Vice President Sales was granted options to purchase 25,000 shares at an exercise price per share of $6.20, the fair market value on the date of the grant. Under each plan, 30% of the stock
options granted are exercisable one year from the date of employment, and the remaining 70% vested ratably on a monthly basis on and as of the last day of each calendar month over the 24 calendar months following the date of the first year
employment anniversary. The options expire in ten years. Each employee also received at no cost, a restricted stock grant of 25,000 shares. 30% of the restricted stock vest one year from the date of employment, the next 30% vest two years from the
date of employment, and the final 40% vest three years from the date of employment. The stock option and restricted share grants for the Chief Marketing Officer were subsequently canceled due to his termination of employment with the Company.

6. Income Taxes

For financial
reporting purposes, income (loss) before income taxes includes the following components:



|              |  |                          |            |   |      |   |        |  |   |        
|------------- |  | ------------------------ | ---------- | - | ---- | - | ------ |  | - | -------
|              |  | Years ended December 31,
|              |  | 2006                     |            |   | 2005 |   | 2004  
|United States |  | $                        | (1,931,447 | ) |      | $ | 6,998  |  | $ | 244,651
|Foreign       |  |                          | 777,972    |   |      |   | 51,216 |  |   | 378,377
|              |  |                          |            |   |      |   |        |  |   |        
|              |  | $                        | (1,153,475 | ) |      | $ | 58,214 |  | $ | 623,028
|              |  |                          |            |   |      |   |        |  |   |        



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##### Table of Contents

DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The provision for income taxes is as follows:



|                   |  |                          |         |      |   |        |  |   |       
|------------------ |  | ------------------------ | ------- | ---- | - | ------ |  | - | ------
|                   |  | Years ended December 31,
|                   |  | 2006                     |         | 2005 |   | 2004  
|Current:           |  |                          |         |      |   |        |  |   |       
|Federal            |  | $                        |        |      | $ |       |  | $ |      
|Foreign            |  |                          | 50,189  |      |   | 38,959 |  |   | 24,748
|                   |  |                          |         |      |   |        |  |   |       
|                   |  |                          | 50,189  |      |   | 38,959 |  |   | 24,748
|Deferred (credit): |  |                          |         |      |   |        |  |   |       
|Federal            |  |                          | 275,000 |      |   |       |  |   |      
|                   |  |                          |         |      |   |        |  |   |       
|                   |  | $                        | 325,189 |      | $ | 38,959 |  | $ | 24,748
|                   |  |                          |         |      |   |        |  |   |       

Deferred income taxes reflect the net effect of temporary differences between the carrying amounts
of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the deferred tax assets and liabilities are as follows:



|                                                     |  |              |           |   |      |   |           |      |  |   |            |  
|---------------------------------------------------- |  | ------------ | --------- | - | ---- | - | --------- | ---- |  | - | ---------- | -
|                                                     |  | December 31, |          
|                                                     |  | 2006         |           |   | 2005 |   |           | 2004 | 
|Deferred tax assets:                                 |  |              |           |   |      |   |           |      |  |   |            |  
|Operating loss carryforwards                         |  | $            | 3,669,800 |   |      | $ | 3,572,100 |      |  | $ | 2,981,000  |  
|Tax credits                                          |  |              | 991,900   |   |      |   | 918,500   |      |  |   | 879,500    |  
|Accrued liabilities                                  |  |              | 726,700   |   |      |   | 468,600   |      |  |   | 442,300    |  
|Excess book depreciation                             |  |              |          |   |      |   | 10,000    |      |  |   | 4,700      |  
|Deferred revenue                                     |  |              |          |   |      |   |          |      |  |   | 1,287,700  |  
|                                                     |  |              |           |   |      |   |           |      |  |   |            |  
|Total deferred tax assets                            |  |              | 5,388,400 |   |      |   | 4,969,200 |      |  |   | 5,595,200  |  
|                                                     |  |              |          
|Deferred tax liabilities:                            |  |              |           |   |      |   |           |      |  |   |            |  
|Computer software development costs expensed for tax |  |              | (297,300  | ) |      |   | (676,500  | )    |  |   | (1,281,200 | )
|Document Sciences Europe earnings & profits          |  |              |          |   |      |   |          |      |  |   | (152,500   | )
|Excess tax depreciation                              |  |              | (10,600   | ) |      |   |          |      |  |   |           |  
|                                                     |  |              |           |   |      |   |           |      |  |   |            |  
|Total deferred tax liabilities                       |  |              | (307,900  | ) |      |   | (676,500  | )    |  |   | (1,433,700 | )
|                                                     |  |              |           |   |      |   |           |      |  |   |            |  
|Net deferred tax assets                              |  |              | 5,080,500 |   |      |   | 4,292,700 |      |  |   | 4,161,500  |  
|Valuation allowance                                  |  |              | 5,080,500 |   |      |   | 4,017,700 |      |  |   | 3,886,500  |  
|                                                     |  |              |           |   |      |   |           |      |  |   |            |  
|Net deferred tax asset                               |  | $            |          |   |      | $ | 275,000   |      |  | $ | 275,000    |  
|                                                     |  |              |           |   |      |   |           |      |  |   |            |  

At December 31, 2006, we had net deferred tax assets of $5.1 million. Due to the uncertainty
of realizing these net deferred tax assets, we recorded a valuation allowance of $5.1 million on our net deferred tax assets. Such uncertainty primarily relates to the potential for future taxable income as well as loss carryforwards and tax credits
expiring in 2018 and 2012, respectively. We will continue to assess the likelihood of realization of such assets; however, if future events occur which do not make the realization of such assets more likely than not, we will continue to maintain a
valuation allowance against all or a portion of these net deferred tax assets. Examples of future events that may occur which would make the realization of such assets not likely are a lack of taxable income resulting from poor operating results.

At December 31, 2006, we have federal and state net operating loss carryforwards of approximately $10.8 million and $2.3 million,
respectively, that will begin expiring in 2018 unless previously utilized. At December 31, 2006, we have federal and state research and development tax credit carryforwards of approximately $665,000 and $278,000, respectively, that will begin
expiring in 2012 unless previously utilized.



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##### Table of Contents

DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Pursuant to Sections 382 and 383 of the Internal Revenue Code, annual use of our net operating loss
carryforwards may be limited in the event of a cumulative change in ownership of more than 50% within a three-year period.

We do not
provide for income taxes which would be payable if undistributed earnings of our Chinese subsidiary were remitted because we consider these earnings to be permanently reinvested. As of December 31, 2006, the undistributed earnings of this
foreign subsidiary are approximately $2.0 million.

The differences between our income tax provision and the amounts computed by applying
the statutory Federal income tax rate of 35% in 2006, 2005 and 2004 to income before income taxes are as follows:



|                                           |  |              |           |   |      |   |          |      |  |   |          |  
|------------------------------------------ |  | ------------ | --------- | - | ---- | - | -------- | ---- |  | - | -------- | -
|                                           |  | December 31, |          
|                                           |  | 2006         |           |   | 2005 |   |          | 2004 | 
|Provision at statutory rate                |  | $            | (403,716  | ) |      | $ | 20,375   |      |  | $ | 218,060  |  
|Benefit for graduated rates                |  |              | 11,535    |   |      |   | (582     | )    |  |   | (6,230   | )
|Increase (decrease) in valuation allowance |  |              | 1,062,800 |   |      |   | 131,200  |      |  |   | 378,200  |  
|Foreign rate differential                  |  |              | (272,290  | ) |      |   | (299,485 | )    |  |   | (87,500  | )
|Stock-based compensation                   |  |              | 128,172   |   |      |   |         |      |  |   |         |  
|Permanent differences and other            |  |              | (201,312  | ) |      |   | (112,034 | )    |  |   | (565,282 | )
|                                           |  |              |           |   |      |   |          |      |  |   |          |  
|Provision (benefit) for income taxes       |  | $            | 325,189   |   |      | $ | 38,959   |      |  | $ | 24,748   |  
|                                           |  |              |           |   |      |   |          |      |  |   |          |  

7. Employee Retirement Plan

401(k) Plan

We have an employee savings and retirement plan (401(k) Plan) that is intended to
be tax-qualified covering substantially all employees. Under the terms of the 401(k) Plan, employees may elect to contribute up to 15% of their compensation, or the statutory prescribed limit, if less, to the 401(k) Plan as a savings contribution.
We may, in our discretion, match employee contributions, at such rate as we determine, up to a maximum of $3,000 or 10% of the employees compensation. The 401(k) Plan has a profit sharing element whereby we can contribute annually an amount
determined by the Board of Directors. An employees interest in matching contributions and profit sharing contributions generally vest over four years from the date of employment. For the years ended December 31, 2006, 2005 and 2004, we
made discretionary contributions of $381,000, $341,000 and $314,000, respectively.

8. Quarterly Data

Supplementary interim financial information is presented as follows (unaudited):



|                                    |  |                |           |   |         |   |              |  |             |           |  |   |            |  
|----------------------------------- |  | -------------- | --------- | - | ------- | - | ------------ |  | ----------- | --------- |  | - | ---------- | -
|                                    |  | Quarters ended |          
|2006                                |  | March 31       |           |   | June 30 |   | September 30 |  | December 31 |          
|Revenues                            |  | $              | 7,784,923 |   |         | $ | 8,459,294    |  | $           | 8,398,370 |  | $ | 8,767,966  |  
|Cost of revenues                    |  |                | 3,757,801 |   |         |   | 3,452,461    |  |             | 3,438,053 |  |   | 3,768,093  |  
|Gross profit                        |  |                | 4,027,122 |   |         |   | 5,006,833    |  |             | 4,960,317 |  |   | 4,999,873  |  
|Net income (loss)                   |  |                | (458,798  | ) |         |   | 144,209      |  |             | 115,171   |  |   | (1,279,246 | )
|Basic income (loss) per share (1)   |  |                | (0.11     | ) |         |   | 0.03         |  |             | 0.03      |  |   | (0.30      | )
|Diluted income (loss) per share (1) |  |                | (0.11     | ) |         |   | 0.03         |  |             | 0.02      |  |   | (0.30      | )



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##### Table of Contents

DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



|                                    |  |                |           |   |         |   |              |  |   |             |   |  |   |          
|----------------------------------- |  | -------------- | --------- | - | ------- | - | ------------ |  | - | ----------- | - |  | - | ---------
|                                    |  | Quarters ended
|2005                                |  | March 31       |           |   | June 30 |   | September 30 |  |   | December 31
|Revenues                            |  | $              | 6,278,559 |   |         | $ | 7,862,448    |  | $ | 7,415,439   |   |  | $ | 8,017,398
|Cost of revenues                    |  |                | 2,685,490 |   |         |   | 3,039,609    |  |   | 3,160,448   |   |  |   | 3,569,380
|Gross profit                        |  |                | 3,593,069 |   |         |   | 4,822,839    |  |   | 4,254,991   |   |  |   | 4,448,018
|Net income (loss)                   |  |                | (597,792  | ) |         |   | 340,191      |  |   | (68,630     | ) |  |   | 345,486  
|Basic income (loss) per share (1)   |  |                | (0.15     | ) |         |   | 0.08         |  |   | (0.02       | ) |  |   | 0.08     
|Diluted income (loss) per share (1) |  |                | (0.15     | ) |         |   | 0.06         |  |   | (0.02       | ) |  |   | 0.06     

---

|(1) | Income (loss) per share is computed independently for each of the quarters presented. Therefore, the sum of the quarterly per-share calculations will not necessarily equal the
annual per-share calculation.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

9. Subsequent EventAcquisition of Assets

On January 29, 2007, we acquired substantially all of the assets of CambridgeDocs, a leading provider of software utilized in document transformation
and repurposing. The aggregate consideration paid for the assets acquired included a payment of $329,000 in cash and the issuance of restricted stock grants of 52,000 shares.



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##### Table of Contents

SCHEDULE II

DOCUMENT SCIENCES CORPORATION

VALUATION AND QUALIFYING ACCOUNTS



|                                |  |                              |         |                               |   |            |  |                        |         |  |   |        
|------------------------------- |  | ---------------------------- | ------- | ----------------------------- | - | ---------- |  | ---------------------- | ------- |  | - | -------
|                                |  | Balance at Beginning of Year |         | Charged to Costs and Expenses |   | Deductions |  | Balance at End of Year
|Year Ended December 31, 2004    |  |                              |         |                               |   |            |  |                        |         |  |   |        
|Allowance for doubtful accounts |  | $                            | 697,473 |                               | $ |           |  | $                      | 190,972 |  | $ | 506,501
|Year Ended December 31, 2005    |  |                              |         |                               |   |            |  |                        |         |  |   |        
|Allowance for doubtful accounts |  |                              | 506,501 |                               |   |           |  |                        | 166,832 |  |   | 339,669
|Year Ended December 31, 2006    |  |                              |         |                               |   |            |  |                        |         |  |   |        
|Allowance for doubtful accounts |  |                              | 339,669 |                               |   |           |  |                        | 3,873   |  |   | 335,796



S-1