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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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Form 10-K

|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                             
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|          
|           |  | For the fiscal year ended December 31,
    2002                                             
|          
|or        
|          
|o          |  | 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

Document Sciences Corporation

(Exact name of registrant as specified in its
charter)


|                                                                   |  |                                     
|------------------------------------------------------------------ |  | ------------------------------------
|Delaware                                                           |  | 33-0485994                          
|(State or other jurisdiction of incorporation
    or organization) |  | (I.R.S. Employer Identification No.)
|                                                                  
|6339 Paseo del Lago, Carlsbad,
    California                      |  | 92009                               
|(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 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 þ          No o

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.     o

Indicate by check mark whether the Registrant is
an accelerated filer (as defined in Exchange Act
Rule 12b-2).     Yes o          No þ

The aggregate market value of the common equity
held by non-affiliates computed by reference to the price at
which the common equity was last sold at June 28, 2002 was
$6,589,084. As of March 24, 2003, there were
3,874,730 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
pursuant to Schedule 14A for its 2003 Annual Meeting of
Stockholders to be held on April 29, 2003, which proxy
statement will be filed no later than 120 days after the
close of Registrants fiscal year ended December 31,
2002.



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TABLE OF CONTENTS



|                                                  |                                                                                               |  |  |  |  |  |  | 
|------------------------------------------------- | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|TABLE OF CONTENTS                                
|A WARNING ABOUT FORWARD-LOOKING STATEMENTS       
|PART I                                           
|                                                  | Item 1. Business                                                                             
|                                                  | Item 2. Properties                                                                           
|                                                  | Item 3. Legal Proceedings                                                                    
|                                                  | Item 4. Submission of Matters to a Vote of Security Holders                                  
|PART II                                          
|                                                  | Item 5. Market for Registrants Common Equity and Related Stockholder Matters                
|                                                  | Item 6. Selected Financial Data                                                              
|                                                  | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                                                  | Item 7A. Quantitative and Qualitative Disclosures About Market Risk                          
|                                                  | Item 8. Financial Statements and Supplementary Data                                          
|                                                  | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 
|PART III                                         
|                                                  | Item 10. Directors and Executive Officers of the Registrant                                  
|                                                  | Item 11. Executive Compensation                                                              
|                                                  | Item 12. Security Ownership of Certain Beneficial Owners and Management                      
|                                                  | Item 13. Certain Relationships and Related Transactions                                      
|                                                  | Item 14. Controls and Procedures                                                             
|PART IV                                          
|                                                  | Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K                     
|SIGNATURES                                       
|POWER OF ATTORNEY                                
|CERTIFICATION                                    
|INDEX TO EXHIBITS                                
|INDEX TO CONSOLIDATED FINANCIAL STATEMENTS       
|REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
|CONSOLIDATED BALANCE SHEETS                      
|CONSOLIDATED STATEMENTS OF INCOME                
|CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY  
|CONSOLIDATED STATEMENTS OF CASH FLOWS            
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS       
|SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS  
|EXHIBIT 23.1                                     
|EXHIBIT 99.1                                     



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TABLE OF CONTENTS

|                                           |  |                                                                                           |   |      |     | 
|------------------------------------------ |  | ----------------------------------------------------------------------------------------- | - | ---- | --- | 
|                                           |  |                                                                                           |   | Page
|                                           |  |                                                                                           |   |     
|A Warning About Forward-Looking Statements |  |                                                                                           | 2 |     
|PART I                                    
|Item 1                                     |  | Business                                                                                  |   |      | 2   | 
|Item 2                                     |  | Properties                                                                                |   |      | 14  | 
|Item 3                                     |  | Legal Proceedings                                                                         |   |      | 14  | 
|Item 4                                     |  | Submission of Matters to a Vote of Security
    Holders                                   |   |      | 14  | 
|PART II                                   
|Item 5                                     |  | Market for Registrants Common Equity and
    Related Stockholder Matters                 |   |      | 14  | 
|Item 6                                     |  | Selected Financial Data                                                                   |   |      | 15  | 
|Item 7                                     |  | Managements Discussion and Analysis of
    Financial Condition and Results of Operations |   |      | 15  | 
|Item 7A                                    |  | Quantitative and Qualitative Disclosures About
    Market Risk                            |   |      | 22  | 
|Item 8                                     |  | Financial Statements and Supplementary Data                                               |   |      | 23  | 
|Item 9                                     |  | Changes in and Disagreements with Accountants on
    Accounting and Financial Disclosures |   |      | 23  | 
|PART III                                  
|Item 10                                    |  | Directors and Executive Officers of the Registrant                                        |   |      | 23  | 
|Item 11                                    |  | Executive Compensation                                                                    |   |      | 24  | 
|Item 12                                    |  | Security Ownership of Certain Beneficial Owners
    and Management                        |   |      | 24  | 
|Item 13                                    |  | Certain Relationships and Related Transactions                                            |   |      | 24  | 
|Item 14                                    |  | Controls and Procedures                                                                   |   |      | 24  | 
|PART IV                                   
|Item 15                                    |  | Exhibits, Financial Statement Schedules and
    Reports on Form 8-K                       |   |      | 25  | 
|                                           |  | Signatures                                                                                |   |      | 26  | 
|                                           |  | Certification                                                                             |   |      | 27  | 
|                                           |  | Index to Exhibits                                                                         |   |      | 28  | 
|                                           |  | Financial Statements                                                                      |   |      | F-1 | 

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A WARNING ABOUT FORWARD-LOOKING
STATEMENTS

We make forward-looking statements in this Annual
Report 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 and regulatory conditions and developments;
|
| |  | the market for document automation software
    (currently includes the emerging content processing market);     
|
| |  | market acceptance of enhancements to our existing
    products and introduction of new products;                 
|
| |  | continued profitability of our professional
    services;                                                        
|
| |  | maintaining our relationships with Xerox
    Corporation; and                                                    
|
| |  | other uncertainties, all of which are difficult
    to predict and many of which are beyond our control.         

Foreseeable risks and uncertainties are described
elsewhere in this report and in detail under Item 1.
Business  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. We undertake no obligation to publicly
release the results of any revision of the forward-looking
statements.




PART I




Item 1.     Business

Document Sciences Corporation develops, markets
and supports a family of document automation software used in
high volume print and transactional web-based applications.
Document automation has become increasingly important as more
companies realize the productivity benefits of automating the
generation of personalized documents that include the precise
layout of regulated content, personal financial data and
in-context, one-to-one marketing information. Document
automation, or content processing, is becoming
recognized as a key component within the emerging Enterprise
Content Management (ECM) software market. Our established
Autograph document automation software products, as well
as our new xPression content processing product family,
each enable automated publishing solutions for many industries,
including insurance, financial services, managed healthcare,
government, telecommunications, manufacturing and commercial
print outsourcing. Our software products facilitate an important
form of communication between organizations and their customers
by employing enterprise database assets and business compliance
rules to produce high-quality, highly-personalized regulated
documents that are ready to print on demand, to email or to
distribute over the web in real-time using HTML or Adobe
Systems (Adobe) PDF® technology. Our Autograph
and xPression software products are licensed to
approximately 600 customers worldwide who collectively
produce over one billion customized documents per month. Our
highly portable Autograph and our new xPression
software platforms enable cost-effective, on demand, high volume
or real-time transactional publishing that is high quality, in
compliance and fully automated. Our software products are
compatible with a wide array of popular computing environments
from traditional mainframe computer systems, distributed
client/server PC and Unix configurations, as well as highly
scalable J2EE application server platforms.

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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 has been reduced to 19.9%. See
Managements Discussion and Analysis of Financial
Condition and Results of Operations  Liquidity and
Capital Resources.

Products

Our established Autograph and our new
xPression software product families currently address two
major functional areas within the emerging ECM arena: Regulated
Content Management and Document Publishing, as described below.
All of our software products can be complemented by our
professional services organization.

We generally license our products for an upfront
initial license fee and an annual renewal license and support
fee, usually between 15% and 20% of the initial license fee,
which is required for the initial year and subsequent years. We
also offer the right to license for perpetual use of our
products and, in these cases, maintenance agreements are charged
at between 15% and 20% of the list price of the initial license
fees. The list price for a license of CompuSet, our core
Autograph product, is currently $90,000 for a mainframe
installation and ranges down to $45,000 for a PC NT server
installation. The list price for an initial license of
xPression, our new product, is currently $200,000 for the
IBM WebSphere platform. Additional product options currently
range from $3,000 to $50,000. A typical new account sale through
our direct channel is currently about $200,000 for software
licenses and approximately $75,000 for professional services.



| |                             
| | ----------------------------
| | Regulated Content Management

Our Autograph and xPression
regulated content management products provide solutions for the
creation, revision and management of document content used in
several types of regulated document automation applications. In
the Autograph product family, they consist of the
Document Library Service (DLS) Server and Client products,
DLS eCor and DLSCOM. Unlike other general-purpose content
management products, our Autograph DLS products are
optimized for highly regulated document applications such as
contract and policy production. In xPression, an enhanced
version of the equivalent Autograph product functionality
is provided through a more open J2EE/ XML architecture that can
be integrated with general-purpose content management. As such,
the xPression content processing components can coexist
with and significantly extend the capabilities of a scalable ECM
environment.

Autograph DLS Server and Clients.DLS Server manages the document
content creation process required in complex, regulated
text-intensive documents, such as proposals, contracts, policies
and customer correspondence. Our DLS products use a client
server architecture for accessing data and files stored on a
mainframe or on an NT network server. Our DLS Client product
manages the text content created with Microsoft
Corporations (Microsoft) Word® and internally stored
in HTML. The DLS text content is tracked and managed in a
multi-authoring environment that supports access security,
content searching, revision control and approval workflow. In
addition to content creation and management, the DLS Client
product enables the definition of complex assembly and business
rules required for interactive or automated document assembly
and composition using Microsoft Word and/or our CompuSet
publishing engine. DLS supports criteria-based content selection
mechanism for generating a Microsoft Word document or a CompuSet
tagged file, based on application volume requirements. The
personalized document assembly can occur in a high volume
fashion on the server or in a just-in-time, on-demand fashion on
the local DLS Client computer.

Autograph DLS eCor and
DLSCOM.DLS eCor and DLSCOM further
augment our DLS technology capabilities by providing a rich
feature-set that is targeted at enterprise-wide correspondence
applications. DLS eCor enables the on-demand generation of
customer correspondence through corporate call centers. DLS eCor
is web based and features an integrated Java editor that can be
used to make additional manual or exception changes to
pre-assembled customer correspondence. DLS eCor supports an
email-based change

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tracking, approval and workflow process to ensure
document integrity and compliance. DLSCOM is a component product
version that enables the deployment of our DLS technology in a
Microsoft COM/ DCOM environment. With DLSCOM and/or DLS eCor,
customers can tightly integrate our DLS products into a CRM or
eCRM system of their choice. In 2002, we released certified
support for Siebel CRM product connectivity.


XPression Regulated Content Management:Our new xPression product
family provides a migration path for the established
Autograph DLS product family. XPression is
entirely developed in Java, adhering to J2EE open standards for
compatibility with application server platforms such as IBM
WebSphere. Furthermore, xPression is based around open
XML standards for open data and business logic description and
interchange. XPression supports all of the capabilities
found within the Autograph DLS product line, as well as
significantly extends core functionality in the areas of data
capture and handling (xPression Admin), document and rules
design (xPression Design), interactive real-time document
generation (xPression Response), as well as in the areas of
integration and connectivity (xPression Framework). In 2002, we
released the first version of xPression following the
successful completion of our Beta testing during the third and
fourth quarters. In 2003, we expect to release additional
extensions to our xPression product family.



| |                    
| | -------------------
| | Document Publishing

Document Composition.CompuSet software automates content
assembly and document composition using corporate data and
variable content. CompuSet consists of a rule-based language and
a robust composition engine that provides high-speed content
assembly and composition of complex personalized documents at a
high level of quality. Corporate data and variable content are
marked with CompuSet tags that, in turn, are defined in
logically separate CompuSet style specifications. The CompuSet
tags are conceptually and syntactically similar to HTML or XML
tags, the current web standards for content tagging, and the
CompuSet style specifications are conceptually similar to CSS
and XSL, the current web standards for style definition. Without
requiring any real-time user interaction, CompuSet transforms
the tagged data, the style specifications, and the variable
content into high-quality electronic documents that are
assembled and composed at rates in excess of 50 pages per
second, depending on the computing platform configuration and
the complexity of the document. The document composition
features are rich and extensive, including the automatic
generation of multi-dimensional dynamic data driven graphics,
and the support of full color text and images. The assembly and
composition process can be optimized for print, email and/or web
presentation media for multi-channel distribution.

Document Output Processing.The CompuSet Emitters transform
CompuSet generated output into a number of popular Page
Description Languages, or 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
finished documents. The Emitters also condition the PDLs for
transport over a variety of high-speed printing interfaces and
for support of various finishing devices. The PDL formats
currently supported are Xerox Metacode, International Business
Machines Corporations (IBM) AFPDS®,
Hewlett-Packard Companys PCL® and Adobes
PostScript® and Portable Document Format (PDF). Output
Processing extends the Emitters by enabling inline output stream
manipulation including stream splitting, merging, resequencing,
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. This part of the Autograph architecture is
extensible and new Emitters can be developed as necessary. In
2002, several additional Emitter extensions were released,
including support for Xeroxs popular VIPP specification,
enabling high-volume full-color production on Xerox DocuColor
and iGen product lines.

Autograph Rapid Application Development
Tools.The Visual CompuSet
Professional Edition (VCPro) application development tools run
on Microsoft Windows® and simplify variable document
application design and prototyping. Visual CompuSet supports all
of the composition features of the NT, Unix and mainframe
CompuSet production engines to ensure exact design for all
supported production platforms, and includes a variety of
content Importer, Merge, Font and Emitter tools necessary for
basic application development. The content Importers accept
externally generated document content, including text and forms,

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static graphics and scanned images, and converts
them into CompuSet compatible formats. Visual CompuSet also
provides an extensible and easy-to-use Graphical User Interface
(GUI) platform that enables the description of a complex
variable data environment, including related data processing and
tagging instructions, and associates this data with CompuSet
style specifications and variable content such as sections,
paragraphs, tabular elements, images, photographs and
data-driven graphics. VCPro features WYSIWYG interaction and
drag-and-drop operability. The feature set is rich and
general-purpose and the design centerline is the generation of
complex high-value investment and other financial statements. In
2002, VCPro was extended to provide support for the new Xerox
VIPP Emitter option as well as to enable the transactional
generation of documents in web server applications.


XPression Document
Publishing:As with Autograph,
our new xPression product family is fully compatible with
our core CompuSet, Emitter and Output Processing products.
However, and rather than using the Autograph VCPro
application development tools, xPression Design is integrated
with Microsoft Word, the industry-standard authoring and design
tool for regulated documents such as contracts and
correspondence. Furthermore, xPression Design has been designed
to integrate with other XML-compatible industry-standard tools
planned to be supported in the future. In 2002, we began the
design and development of a new Java-based composition engine.
The design of the new composition engine incorporates the
majority of the features available in the established CompuSet
engine as well as significant extensions in the areas of complex
multi-frame page layout, Unicode multi-language support
including support for double-byte Asian languages and scalable
multi-threaded performance. The new composition engine will
support high-volume print applications as well as real-time
transactional eBusiness applications. During 2003, we plan on
releasing the first versions of our new xPression
composition engine.



| |                                               
| | ----------------------------------------------
| | Autograph and xPression for the
    Enterprise

Our products are usually licensed initially for a
single document automation application. Regulated content
applications such as policies and contracts are typically
implemented using our Autograph DLS products whereas
statement applications are typically implemented using our
Autograph VCPro products, in each case driving document
production through the CompuSet products. A growing number of
customers are enterprise. Our xPression product family is
targeted at customers that require universal content processing
services on an open, standardized, enterprise-wide basis.

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 document
automation applications. Professional services include on-site
software installation, customer training programs, telephone
support programs and consulting services. Our consulting
services are currently focused on assisting in the sale of high
margin initial software licenses by providing project
management, requirements analysis, application design and
development services. Our consulting services can also be
provided in conjunction with our system integration
(SI) partners. In addition to consulting services, we
provide introductory and advanced-level education classes in
Autograph and xPression products at our
headquarters in San Diego, our offices in Milwaukee and
Washington DC and at customer sites. We believe that the use of
our professional services enables customers to deploy our
document automation products more rapidly and effectively. The
professional services and support organizations employed a staff
of 40 as of December 31, 2002.

Sales and Marketing

Our sales and marketing organization targets
vertical industry markets that require document automation and
high volume, high quality document personalization. We currently
license our products 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 the United States and Canada to provide
optimal coverage. Outside of North America, we distribute our

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software products through value added resellers
(VARs) such as Fuji Xerox Co., Ltd. in Australia and Xerox
Brazil, Ltd. in Brazil. Our subsidiary, Document Sciences
Europe, markets our products in Europe, Africa and the Middle
East by providing VAR channel management and support and by
defining European market and product requirements. Our European
VARs are principally Xerox Europe affiliates who re-market our
products. Our revenues from export transactions with Xerox
affiliates were $4.7 million and $3.7 million and
$3.6 million in 2000, 2001 and 2002, respectively. The
sales and marketing organization employed a staff of 39 as of
December 31, 2002.


We intend to increase both our product offerings
and markets through joint marketing, sales and distribution and
development relationships with other major companies. Current
relationships include formal and informal marketing and sales
alliances with IBM, Xerox, American Management Systems Inc. and
Edgewater Technology Inc. These relationships provide qualified
sales leads for our products and extend our sales coverage and
networking capabilities. In addition, we also support partner
relationships with complementary technology companies such as
Siebel Systems, Inc., FileNet and Oracle, Inc. We participate in
joint marketing events with our key partners whenever
appropriate and feasible. Furthermore, we actively market our
products and solutions at major trade shows, through focused
regional seminars and through a variety of web marketing
mechanisms, including webinars.

Research and Development

We are continuing to enhance our web
functionality across all of our major product offerings. We
engage customers in a formal requirements analysis that is based
on the Quality Function Deployment (QFD) process, which is
a formal procedure for interviewing customers, identifying their
needs and prioritizing specific product features. As a result,
we have identified a number of customer requirements for the
production of regulated, electronic documents of the future. Our
major development initiatives in 2003 address several of these
key requirements as brought to our attention through our ongoing
QFD process.

In general, our product development strategy is
based on delivering document automation solutions for specific
types of documents in one or more vertical markets or
industries. A cross-functional team that includes a
representative from each discipline in the company is
responsible for delivering each focused offering. We use a
documented business planning and product delivery process to
guide our product development and delivery activities. We also
employ iterative and rapid prototyping development methodologies.

Our recent offerings continue to build on the
Autograph family of products. These well-established
products are maintained by teams that respond to customer
requests for defect corrections and feature enhancements. By
building on our existing products, we maximize our reuse of
existing software and our expertise and we enable our
Autograph customers to purchase these new offerings as
upgrades to their existing product configurations.

The xPression product offerings are being
developed as components that adhere to open standards for
large-scale systems integration such as J2EE and XML. By
developing products using open standards we can expand the
delivery of our products through large systems integrators and
other channels. By offering application migration paths wherever
possible we enable our Autograph customers to purchase
our new xPression offerings. We have a two-year,
$3.1 million agreement with Objectiva Software Solutions,
Inc. (Objectiva) to provide us development services in
connection with our development of xPression.

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

We expect to continue enhancing our existing
products and to develop future new products, particularly as
they relate to multi-channel content automation applications.
Our research and development expenditures have grown
substantially since our inception. Such expenditures, not
including amounts capitalized, were $5.3 million,
$5.9 million and $7.0 million in 2000, 2001 and 2002,
respectively. Our development organization

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employed a staff of 36 as of December 31,
2002. Through our contractual arrangements with Objectiva, we
have a dedicated staff of 14 developers and architects. We also
employ independent contractors as needed to supplement our
permanent development staff.


Competition

The market for document automation 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
automation processes to our document automation software. We
also face competition from DocuCorp International, Inc. and
InSystems Technologies, Inc., in the insurance industry;
Metavante in banking and financial services; Group 1 Software,
Inc. and Exstream Software, Inc. in commercial direct mailing
and marketing, as well as numerous other smaller competitors.
Several of our competitors have longer operating histories,
significantly greater financial, technical and marketing
resources, greater name recognition 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, 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 Oracle Corporation. In addition, Xerox or
IBM, either directly or through affiliated entities, could
become large competitors. Moreover, as the market for document
automation 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 document
automation 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 Risk Factors  Our growth 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, identified, licensed and
integrated, which would adversely affect our business, operating
results and financial condition.

7



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Customers

We derived 17% of our revenues through Xerox and
its affiliates in 2002. 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, 2002, we had 127
employees including 40 in professional services, 39 in sales and
marketing, 36 in research and development and 12 in finance and
administration. None of our employees are represented by labor
unions. We have experienced no work stoppages and believe our
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 the
Annual Report under the heading Notes to Consolidated
Financial Statements  3. Segment Information
and is incorporated herein by reference.

Recent Developments

On February 10, 2003, we announced that we
received approval from the Nasdaq Listing Qualifications
department to transfer listing of our common stock from the
Nasdaq National Market to the Nasdaq SmallCap Market. The
transfer became effective at the opening of business on
February 18, 2003.

We applied to transfer to the Nasdaq SmallCap
Market due to a change in a maintenance listing standard of the
Nasdaq National Market from one based on Net Tangible Assets to
one based on Stockholders Equity. In April 2001, we
repurchased $14 million worth of its shares via a
self-tender offer. This repurchase, which reduced our
stockholders equity on the balance sheet by
$14 million, was undertaken when the maintenance listing
standard for the Nasdaq National Market required $4 million
of Net Tangible Assets, with which we were in compliance. In
November 2002, the Nasdaq National Market replaced the Net
Tangible Assets listing standard with a minimum requirement of
$10 million of Stockholders Equity. A consequence of
our share repurchase, undertaken over a year earlier when the
Net Tangible Assets listing standard was in place, is that our
stockholders equity fell short of the Nasdaq National
Markets new Stockholders Equity listing standard.

For more information regarding the transfer of
listing of our common stock to the Nasdaq SmallCap Market,
please see our Current Report on Form 8-K filed with the
Securities and Exchange Commission on February 18, 2003.

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 all or part of your
investment.

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

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



| |   |                                                                                                       
| | - | ------------------------------------------------------------------------------------------------------
| |  | the demand for our products;                                                                          
|
| |  | the level of product and price competition we
    face;                                               
|
| |  | the length of our sales cycle;                                                                        
|
| |  | the size and timing of individual license
    transactions;                                           
|
| |  | 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 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;                                                                     
|
| |  | the activities of and acquisitions by our
    competitors;                                            
|
| |  | our timing of new hires;                                                                              
|
| |  | changes in foreign currency exchange rates;                                                           
|
| |  | our ability to develop and market new products
    and to control costs; and                          
|
| |  | general domestic and international economic
    conditions.                                           

Our initial license fee revenues mainly depend on
when orders are received and shipped. However, because of our
sales model, our customers implementation schedule and the
complexity in implementing some of our software, 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. If such expenses
precede increased revenues, our operating results would 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 are not necessarily meaningful. Accordingly, you
should not rely upon them as an indication of our future
performance. Furthermore, our operating results in some future
quarter may fall below the expectations of public market
analysts and investors. If this occurs, the price of our common
stock would likely be materially adversely affected.



| |                                                                             
| | ----------------------------------------------------------------------------
| | 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
$5.2 million, $4.1 million and $4.0 million in
2000, 2001 and 2002, respectively, representing 23%, 19% and 17%
of our total revenues, respectively.

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. Though we intend to continue and further develop our
existing relationships with Xerox, our strategy is to continue
to lessen our dependence

9



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on Xerox as a percent of our total revenue.
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 move to become more independent
will not adversely affect our business, results of operations
and financial condition. Our failure to maintain these
relationships, particularly with Xerox and its affiliates, or to
establish new relationships in the future, could have a material
adverse effect on our business, operating results and financial
condition.


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 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 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 precautions, 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, software piracy can be expected 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 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.



| |                                                                                  
| | ---------------------------------------------------------------------------------
| | Our growth is dependent upon successfully
    focusing our distribution channels.

We intend to optimize our worldwide sales and
distribution channels by focusing on key target industry market
segments where our current and planned products enjoy a
significant competitive advantage and a current, high market
demand. We also plan on leveraging our existing relationships
with Xerox, IBM Corporation and their channels and affiliates 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. In
addition, we intend to form additional partnerships with system
integrators and consultants in order to broaden our capacity to
deliver complete document automation solutions that incorporate
significant services content, while also maintaining our core
domain expertise. We cannot assure you that we will be able to
successfully optimize and focus our worldwide channels, leverage
our existing relationships or form new alliances. If we fail to
do so, it will have a material adverse effect on our business,
operating results and financial condition.



| |                                                                                        
| | ---------------------------------------------------------------------------------------
| | 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 document automation applications. This strategy
is dependent on retaining and hiring professionals to perform
these consulting

10



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services. Should we be unable to maintain the
necessary services workforce, our business and financial
condition could be materially adversely affected.




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

The market for our document automation products
is intensely competitive. We face competition from a broad range
of competitors, some 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
MIS departments of large organizations and direct competition
from numerous software vendors, including DocuCorp
International, Inc., Metavante Corporation, Group 1
Software, Inc., Exstream Software, Inc. and InSystems
Technologies, Inc. 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 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, new
solutions introduced by existing competitors or by new companies
entering the market.



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

Our future business, operating results and
financial condition will 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
Autograph family 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 new products and product enhancements
will adequately meet the requirements of the marketplace or
achieve market acceptance. Delays in our commercial shipments of
new products or enhancements may result in client
dissatisfaction and a delay or loss of product revenues.

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 will 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. 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.



| |                                                                                      
| | -------------------------------------------------------------------------------------
| | A longer than expected sales cycle may
    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 to twelve months in
order to educate our prospective customers regarding the use and
benefits of our products. 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. For these and other reasons, our sales
and customer implementation cycles are subject to a number of
significant delays over which we 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.

11



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##### Table of Contents





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

We derived 70% and 23% of our initial license
revenues from our CompuSet and DLS product lines in 2002,
respectively. 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
continue to depend significantly on the successful development,
introduction and customer acceptance of new and enhanced
versions of our CompuSet and DLS software and related products.

Licenses to end users in the insurance, finance
and print service industries in the United States accounted for
90%, 97% and 97% of initial license revenues in 2000, 2001 and
2002, respectively. Our future success will depend on our
ability to continue to successfully market our products in these
and other industries. We cannot assure you that we will continue
to be successful in developing and marketing CompuSet and DLS
products and related services. Our failure to do so would have a
material adverse effect on our business, operating results and
financial condition.



| |                                                                         
| | ------------------------------------------------------------------------
| | We may be exposed to risks associated with
    international operations.

Our revenues from export sales, including sales
through our foreign subsidiary, accounted for 28%, 21% and 23%
of our total revenues in 2000, 2001 and 2002, respectively.

Our wholly owned subsidiary, Document Sciences
Europe, markets and supports our products in Europe, for which
they receive an agent fee. We license our products in Europe
through VARs and to a much lesser extent, direct sales.
Our VARs are principally Xerox affiliates who re-market our
products. Revenues generated by the activities of this
subsidiary were $3.9 million, $2.7 million and
$3.2 million in 2000, 2001 and 2002, respectively.

In Australia, Canada and Brazil, we distribute
our products through Fuji Xerox Co., Xerox Canada, Ltd. and
Xerox do Brazil, Ltd., respectively. Revenues generated by these
Xerox affiliates were $2.4 million, $2.1 million and
$1.7 million in 2000, 2001 and 2002, respectively.

In order to successfully expand export sales, we
must establish additional foreign operations, 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.

Additional risks inherent in our international
business activities include:



| |   |                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------
| |  | currency fluctuations;                                                                              
|
| |  | unexpected changes in regulatory requirements;                                                      
|
| |  | tariffs and other trade barriers;                                                                   
|
| |  | our limited experience in localizing products for
    foreign countries;                            
|
| |  | lack of acceptance of our localized products in
    foreign countries;                              
|
| |  | longer accounts receivable payment cycles;                                                          
|
| |  | difficulties in managing our international
    operations;                                          
|
| |  | potentially adverse tax consequences including
    restrictions on the repatriation of earnings; and
|
| |  | the burdens of complying with a wide variety of
    foreign laws.                                   

A portion of our business is conducted in
currencies other than the U.S. Dollar, primarily the Euro.
Although exchange rate fluctuations have not had a significant
impact on us, fluctuations in the value of the

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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
    document automation software.

The market for document automation software is
intensely competitive, highly fragmented and subject to rapid
change. We cannot assure you that the market for document
automation software will grow or that, if it does grow,
organizations will adopt our products. We have spent, and intend
to continue to spend, significant resources educating potential
customers about the benefits of our products. However, we cannot
assure you that such expenditures will enable our products to
achieve further market acceptance, and if the document
automation software market fails to develop or develops more
slowly than we currently anticipate, our business, operating
results and financial condition would be materially adversely
affected.

In addition, the commercial market for document
automation 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 such services. It is difficult to predict
whether the demand for related products and services would
increase or decrease in the future. Since the increased
commercial use of the Internet, intranets and commercial on-line
services 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 our growth will
    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. Only our President and Chief
Executive Officer and Chief Scientist have signed employment
agreements with us. 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, assimilate or
retain other highly qualified product development, sales and
managerial personnel in the future.



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

13



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| |                                                    
| | ---------------------------------------------------
| | 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, we could in the
future lose or delay recognition of revenues as a result of
software 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 sensitivity to
product defects than the general market for software products.
Although our business has not been adversely affected by any
such errors to date, we cannot assure you that, despite our
testing and testing by current and potential customers, errors
will not be found in our products or releases. If these errors
are discovered after the commencement of commercial shipments,
it could result in any of the following:



| |   |                                               
| | - | ----------------------------------------------
| |  | loss of revenue or delay in market acceptance;
|
| |  | diversion of our development resources;       
|
| |  | damage to our reputation; or                  
|
| |  | increased service and warranty costs.         

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




Item
2.     Properties

We lease approximately 21,300 square feet
for our principal administrative, sales, marketing, training and
research and development facility in Carlsbad, California. This
lease expires on February 28, 2005. Our subsidiary in
France occupies approximately 2,200 square feet of office
space with a renewable lease expiring on April 15, 2004. In
addition, our regional office in Milwaukee, Wisconsin occupies
approximately 7,500 square feet of office space pursuant to
a lease expiring on June 30, 2003. Sales representatives
and field technical support personnel operate from their homes.
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 21, 2003, 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 2002.




PART II






|        |                                                                          
|------- | -------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Equity
    and Related Stockholder Matters

Our common stock is presently traded on The
Nasdaq SmallCap under the symbol DOCX. Until
February 18, 2003, our common stock was traded on The
Nasdaq National Market System. The following table sets forth
the range of high and low sales prices of our common stock for
the periods indicated, as

14



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##### Table of Contents



reported on The Nasdaq National 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 2001                            |  |             |      |     |  |   |      | 
|First quarter ended March 31, 2001     |  | $           | 1.88 |     |  | $ | 0.75 | 
|Second quarter ended June 30, 2001     |  | $           | 2.11 |     |  | $ | 1.30 | 
|Third quarter ended September 30, 2001 |  | $           | 4.49 |     |  | $ | 1.43 | 
|Fourth quarter ended December 31, 2001 |  | $           | 3.40 |     |  | $ | 2.30 | 
|Fiscal 2002                            |  |             |      |     |  |   |      | 
|First quarter ended March 31, 2002     |  | $           | 3.00 |     |  | $ | 2.30 | 
|Second quarter ended June 30, 2002     |  | $           | 2.60 |     |  | $ | 2.10 | 
|Third quarter ended September 30, 2002 |  | $           | 2.55 |     |  | $ | 2.10 | 
|Fourth quarter ended December 31, 2002 |  | $           | 3.50 |     |  | $ | 1.95 | 

We had 3,874,730 shares outstanding and 106
record holders of our common stock as of March 24, 2003. We
did not make any sales of unregistered stock in 2000, 2001 or
2002. We have not paid dividends on our common stock and do not
anticipate paying dividends in the foreseeable future.




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 and
Managements Discussion and Analysis of Financial
Condition and Results of Operations in Item 7. The
drop in working capital from 2000 to 2001 was due to our tender
offer completed in April 2001 where we purchased
6,000,000 shares of our outstanding common stock for
$2.00 per share.

|                                                |  |                                       |         |      |  |      |        |      |  |      |        |   |  |   |        |  |  |   |        | 
|----------------------------------------------- |  | ------------------------------------- | ------- | ---- |  | ---- | ------ | ---- |  | ---- | ------ | - |  | - | ------ |  |  | - | ------ | 
|                                                |  |                                      
|                                                |  | Years Ended December 31,             
|                                                |  |                                      
|                                                |  | 1998                                  |         | 1999 |  | 2000 |        | 2001 |  | 2002
|                                                |  |                                       |         |      |  |      |        |      |  |     
|                                                |  |                                      
|                                                |  | (In thousands, except per share data)
|Statement of Operations                         |  |                                       |         |      |  |      |        |      |  |      |        |   |  |   |        |  |  |   |        | 
|Net revenues                                    |  | $                                     | 20,107  |      |  | $    | 24,305 |      |  | $    | 22,579 |   |  | $ | 22,120 |  |  | $ | 23,086 | 
|Income (loss) from operations                   |  |                                       | (10,361 | )    |  |      | 1,366  |      |  |      | (416   | ) |  |   | 359    |  |  |   | 1,173  | 
|Net income (loss)                               |  |                                       | (9,154  | )    |  |      | 2,111  |      |  |      | 531    |   |  |   | 638    |  |  |   | 1,560  | 
|Net income (loss) per share                     |  |                                       | (0.86   | )    |  |      | 0.20   |      |  |      | 0.05   |   |  |   | 0.11   |  |  |   | 0.36   | 
|Shares used in per share calculations           |  |                                       | 10,690  |      |  |      | 10,817 |      |  |      | 11,153 |   |  |   | 5,831  |  |  |   | 4,286  | 
|Balance Sheet                                   |  |                                       |         |      |  |      |        |      |  |      |        |   |  |   |        |  |  |   |        | 
|Working capital                                 |  | $                                     | 14,883  |      |  | $    | 16,611 |      |  | $    | 17,151 |   |  | $ | 5,036  |  |  | $ | 6,004  | 
|Total assets                                    |  |                                       | 30,989  |      |  |      | 30,423 |      |  |      | 31,496 |   |  |   | 19,706 |  |  |   | 21,185 | 
|Capital lease obligations, less current portion |  |                                       | 13      |      |  |      | 1      |      |  |      |       |   |  |   |       |  |  |   |       | 
|Stockholders equity                            |  |                                       | 18,410  |      |  |      | 20,280 |      |  |      | 21,134 |   |  |   | 7,700  |  |  |   | 9,181  | 






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|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 in the section entitled,
Business  Risk Factors, and elsewhere in
this Annual Report. Our discussion and analysis of the financial
condition and results of operations of Document Sciences and its
subsidiary should be read in conjunction with the consolidated
financial statements and related notes.

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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, computer
software 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.

Revenue Recognition.We recognize revenue in accordance
with Statement of Position (SOP) 97-2, Software Revenue
Recognition, and Staff Accounting Bulletin
(SAB) No. 101, Revenue Recognition in Financial
Statements. Initial license fees are recognized when a
contract exists, the fee is fixed and determinable, software
delivery has occurred and collection of the receivable is deemed
probable. We use the residual method to recognize revenue for
all of our license models. Our contracts specifically state the
amount of initial and annual license fees due for each type of
software licensed. If an undelivered element of the arrangement
exists under the license arrangement, revenue is deferred based
on vendor-specific objective evidence of the fair value of the
undelivered element. If vendor-specific objective evidence of
fair value does not exist for all undelivered elements, all
revenue is deferred until sufficient evidence exists or all
elements have been delivered. We recognize revenue on
transactions with payment terms greater than 30 days but
less than twelve months from the contract date, if we have a
history of successfully collecting from the specific customer
without providing concessions. Amounts billed or payments
received in advance of revenue recognition are recorded as
deferred revenue.

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.

Annual renewal license and support fees
(ALF) are recognized ratably over the contract period.
Included in our ALF are unspecified maintenance releases. Our
contracts do not provide for specific upgrades. Our standard
contracts do not provide for rights of return or conditions of
acceptance; however, in the rare case that acceptance criteria
are provided, revenue is deferred and not recognized until all
conditions are satisfied and written customer acceptance is
obtained. We believe this approach to revenue recognition, when
acceptance criteria exist, would not result in materially
different amounts being reported under different conditions or
using different assumptions.

Revenues generated from consulting services are
recognized as the related services are performed and
collectibility is deemed probable. However, when such 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
(i) the phases of our consulting projects are generally not
of great duration (2-6 weeks on average) and (ii) we
have a variety of projects progressing at the same time, 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 consider our anticipated revenue levels when
making decisions about our operating expenses. 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. Since revenue
may not be recognized in the same quarter as when shipment
occurs and if such fixed expenses are incurred before we
recognize revenues for these shipments, our operating results
would be materially adversely affected.

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.

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 was made. At the end of each reporting period, we
perform a rigorous 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, 2002, we had net deferred tax assets of
$2.0 million. Due to the uncertainty of realizing a portion
of these net deferred tax assets, we have maintained a valuation
allowance of $1.6 million for 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. 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. No valuation allowance has
been recorded to offset the remaining $305,000 of net deferred
tax assets as we have determined that it is more likely than not
that these assets will be realized during the year ending
December 31, 2003. 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 record a valuation allowance
against all or a portion of these net deferred tax assets. An
example of a future event that may occur which would make the
realization of such assets not likely is a lack of taxable
income resulting from poor operating results.

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Results of Operations for the Years Ended
December 31, 2000, 2001 and 2002

The following table sets forth, for the periods
indicated, certain financial data as a percentage of total
revenues:

|                              |                                         |                          |    |      |     |      |    |    |     |  |    |    |     | 
|----------------------------- | --------------------------------------- | ------------------------ | -- | ---- | --- | ---- | -- | -- | --- |  | -- | -- | --- | 
|                              |                                         |                         
|                              |                                         | Years Ended             
|                              |                                         | December 31,            
|                              |                                         |                         
|                              |                                         | 2000                     |    | 2001 |     | 2002
|                              |                                         |                          |    |      |     |     
|Revenues:                     |                                         |                          |    |      |     |      |    |    |     |  |    |   
|                              | Initial license fees                    |                          |    | 46   | %   |      |    | 37 | %   |  |    | 42 | %  
|                              | Annual renewal license and support fees |                          |    | 38   |     |      |    | 39 |     |  |    | 41 |    
|                              | Services and other                      |                          |    | 16   |     |      |    | 24 |     |  |    | 17 |    
|                              |                                         |                          |    |      |     |      |    |    |     |  |    |   
|                              |                                         | Total revenues           |    |      | 100 |      |    |    | 100 |  |    |    | 100 | 
|Cost of revenues:             |                                         |                          |    |      |     |      |    |    |     |  |    |   
|                              | Initial license fees                    |                          |    | 7    |     |      |    | 7  |     |  |    | 7  |    
|                              | Annual renewal license and support fees |                          |    | 6    |     |      |    | 7  |     |  |    | 7  |    
|                              | Services and other                      |                          |    | 11   |     |      |    | 13 |     |  |    | 11 |    
|                              |                                         |                          |    |      |     |      |    |    |     |  |    |   
|                              |                                         | Total cost of revenues   |    |      | 24  |      |    |    | 27  |  |    |    | 25  | 
|                              |                                         |                          |    |      |     |      |    |    |     |  |    |   
|Gross profit                  |                                         |                          | 76 |      |     |      | 73 |    |     |  | 75 |   
|Operating expenses:           |                                         |                          |    |      |     |      |    |    |     |  |    |   
|                              | Research and development                |                          |    | 19   |     |      |    | 24 |     |  |    | 24 |    
|                              | Selling and marketing                   |                          |    | 37   |     |      |    | 32 |     |  |    | 33 |    
|                              | General and administrative              |                          |    | 22   |     |      |    | 15 |     |  |    | 13 |    
|                              |                                         |                          |    |      |     |      |    |    |     |  |    |   
|                              |                                         | Total operating expenses |    |      | 78  |      |    |    | 71  |  |    |    | 70  | 
|                              |                                         |                          |    |      |     |      |    |    |     |  |    |   
|Income (loss) from operations |                                         |                          | (2 | )    |     |      | 2  |    |     |  | 5  |   
|                              | Interest and other income, net          |                          |    | 4    |     |      |    | 1  |     |  |    | 1  |    
|                              |                                         |                          |    |      |     |      |    |    |     |  |    |   
|Income before income taxes    |                                         |                          | 2  |      |     |      | 3  |    |     |  | 6  |   
|                              | Provision (benefit) for income taxes    |                          |    | 0    |     |      |    | 0  |     |  |    | (1 | )  
|                              |                                         |                          |    |      |     |      |    |    |     |  |    |   
|Net income                    |                                         |                          | 2  | %    |     |      | 3  | %  |     |  | 7  | % 
|                              |                                         |                          |    |      |     |      |    |    |     |  |    |   



| |         
| | --------
| | Revenues

Total revenues were $22.6 million,
$22.1 million and $23.1 million in 2000, 2001 and
2002, respectively, representing a decrease of 2% from 2000 to
2001 and an increase of 5% from 2001 to 2002. Our revenues are
divided into three categories based upon the sources from which
they are derived: initial license fees, annual renewal license
and support fees, and services and other revenues. Initial
license fees consist primarily of upfront license fees for the
first year of use of our products. Annual renewal license and
support fees consist of license fees for the initial and
continued use and support of our licensed products. Services and
other revenues consist of fees for consulting, 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 internationally through
distributors and VARs. Revenues from export sales and sales
through our foreign subsidiary were $6.3 million,
$4.7 million and $5.3 million in 2000, 2001 and 2002,
respectively, representing a decrease of 25% from 2000 to 2001
and an increase of 13% from 2001 to 2002. Revenue from export
sales were 28%, 21% and 23% of total revenues in 2000, 2001 and
2002, respectively. The increase from 2001 to 2002 was the
result of higher revenues in Europe and Canada, offset by lower
revenues in Brazil. The decrease from 2000 to 2001 was the
result of lower initial license fees in all regions.

We have entered into distributorship agreements
with various Xerox foreign affiliates to remarket our products
internationally. Our revenues from these agreements were
$4.7 million, $3.7 million and $3.6 million

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in 2000, 2001 and 2002, respectively. The
decrease from 2001 to 2002 was the result of lower revenues in
Brazil. The decrease from 2000 to 2001 was the result of lower
initial license fees in all regions.


Initial license fees.Initial license fees were
$10.3 million, $8.2 million and $9.6 million in
2000, 2001 and 2002, respectively, representing a decrease of
20% from 2000 to 2001 and an increase of 17% from 2001 to 2002.
The increase in 2002 was due to higher sales in the United
States, Canada and Europe, as well as the release of our new
product, xPression. Additionally, 2002 initial license
fees have benefited from several contracts where customers
extended their relationship with us following the expiration of
their three-year contracts. Such contract extensions totaled
$2.4 million. Because we have de-emphasized three-year term
agreements, it is expected that the revenue from such extensions
will decline significantly in 2003. The decrease in 2001 was
largely the result of fewer sales and fewer new customers from
our foreign resellers.

The components of initial license fees consist of
the following:

|                           |                           |                          |            |           |  |      |           |           |  |   |           |           | 
|-------------------------- | ------------------------- | ------------------------ | ---------- | --------- |  | ---- | --------- | --------- |  | - | --------- | --------- | 
|                           |                           |                         
|                           |                           | Years Ended December 31,
|                           |                           |                         
|                           |                           | 2000                     |            | 2001      |  | 2002
|                           |                           |                          |            |           |  |     
|Products:                  |                           |                          |            |           |  |      |           |           |  |   |           |          
|                           | CompuSet                  |                          | $          | 7,390,939 |  |      | $         | 5,400,603 |  |   | $         | 6,665,976 | 
|                           | Document Library Services |                          |            | 2,427,608 |  |      |           | 2,718,395 |  |   |           | 2,216,294 | 
|                           | Document Viewing Services |                          |            | 439,086   |  |      |           | 81,161    |  |   |           | 93,469    | 
|                           | xPression                 |                          |            |          |  |      |           |          |  |   |           | 616,270   | 
|                           |                           |                          |            |           |  |      |           |           |  |   |           |          
|Total initial license fees |                           | $                        | 10,257,633 |           |  | $    | 8,200,159 |           |  | $ | 9,592,009 |          
|                           |                           |                          |            |           |  |      |           |           |  |   |           |          

Annual renewal license and support fees.Annual renewal license fees were
$8.6 million, $8.7 million and $9.6 million in
2000, 2001 and 2002, respectively, representing increases of 1%
from 2000 to 2001 and 10% from 2001 to 2002. The increase in
2002 was due to increases in our base of licensed software and
in our list prices. The increase in 2001 was due to an increase
in our installed base of users offset by the impact of
discontinuing support for certain products and platforms.

Services and other.Revenues from services and other were
$3.7 million, $5.2 million and $3.9 million in
2000, 2001 and 2002, respectively, representing an increase of
41% from 2000 to 2001 and a decrease of 25% from 2001 to 2002.
The decrease in 2002 was largely due to customer delays in
initiating contracted projects, as well as the mix of software
being licensed that requires fewer services. The increase in
2001 was due to the delivery of consulting services needed to
implement new product sales made during the fourth quarter of
2000 as well as significant follow-on services to existing
customers.



| |                                            
| | -------------------------------------------
| | Cost of Revenues and Operating
    Expenses

Cost of initial license fees.Costs of initial license fees were
$1.6 million, $1.5 million and $1.6 million in
2000, 2001 and 2002, respectively, representing 16%, 18% and 17%
of initial license fees in 2000, 2001 and 2002, respectively.
Cost of initial license fees includes amortization of previously
capitalized software development costs, costs of third party
software, employment costs for distribution personnel and
product packaging. The increase in 2002 compared to 2001 was
primarily the result of higher sales and an increase in the
amortization of software. The decrease in 2001 compared to 2000
was due to lower sales and a decrease in the amortization of
software.

Cost of annual renewal license and support
fees.Costs of annual license fees
were $1.3 million, $1.5 million and $1.5 million
in 2000, 2001 and 2002, respectively, representing 15%, 17% and
16% of annual license fees in 2000, 2001 and 2002, respectively.
Costs of annual renewal license fees consist principally of the
employment-related costs for our technical support staff. Due to
increased efficiencies, we were able to keep a steady headcount
in 2002 compared to 2001. The increase in 2001 compared to 2000
was due to additional technical support personnel to support our
increasing customer base.

Cost of services and other.Costs of services and other were
$2.5 million, $3.0 million and $2.6 million in
2000, 2001 and 2002, respectively, representing 68%, 58% and 67%
of services and other revenue in 2000, 2001

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and 2002, respectively. Costs of services and
other consist principally of the employment-related costs of our
consulting and training staff. The decrease in 2002 compared to
2001 was primarily due to attrition and redeployment of
personnel to other departments. The increase in 2001 compared to
2000 was primarily due to additional personnel costs and the
greater use of outside consultants to complete our increased
consulting work in 2001.


Research and development.Research and development expenses were
$4.2 million, $5.2 million and $5.5 million in
2000, 2001 and 2002, respectively, representing increases of 24%
from 2000 to 2001 and 6% from 2001 to 2002. Research and
development expenses consist primarily of the employment-related
costs of personnel associated with developing new products,
enhancing existing products, testing software products and
developing product documentation. We anticipate that we will
continue to direct significant resources to the development and
enhancement of our products. In connection with a development
services and referral agreement effective January 16, 2002,
we have a two-year, $3.1 million agreement with Objectiva
to provide us development services in connection with our new
product, xPression. In 2002, Objectiva performed
approximately 50% of the services of this agreement and we paid
them $1.6 million.

We capitalized software development costs of
$1.2 million, $717,000 and $1.6 million in 2000, 2001
and 2002, respectively. The increase between 2002 and 2001 was
mainly due to development costs of our new product,
xPression. The decrease between 2001 and 2000 was due to
timing of technological feasibility. Capitalized software
development costs mainly include payroll related costs and
consulting fees paid to Objectiva in relation to the development
of xPression. The amount of software development costs to
be capitalized in the future may change if the time between the
establishment of technological feasibility of a product and its
general release changes.

Selling and marketing.Selling and marketing expenses were
$8.4 million, $7.2 million and $7.8 million in
2000, 2001 and 2002, respectively, representing a decrease of
14% from 2000 to 2001 and an increase of 8% from 2001 to 2002.
Selling and marketing expenses consist primarily of salaries,
commissions, marketing programs and related costs for pre- and
post-sales activity. The increase in 2002 was primarily due to
increased personnel costs, as well as higher trade show and
travel costs. The decrease in 2001 was primarily due to fewer
personnel and decreased commissions due to decreased initial
license fees.

General and administrative.General and administrative expenses
were $5.0 million, $3.4 million and $3.0 million
in 2000, 2001 and 2002, respectively, representing decreases of
32% from 2000 to 2001 and 12% from 2001 to 2002. General and
administrative expenses consist of employment-related costs for
finance, administration and human resources, allowance for
doubtful accounts and general corporate management expenses,
including legal and audit fees. These decreases were primarily
due to decreased personnel and outside consultant costs.

Other income (expense).Other income (expense) is
composed of interest income from cash and cash equivalents and
short-term investments offset by interest expense related to
notes to Xerox and losses on disposal of fixed assets. Other
income was $961,000, $281,000 and $93,900 in 2000, 2001 and
2002, respectively. The decrease in 2002 was the result of less
interest income due lower cash balances following the
$2.5 million debt payment in February and lower interest
rates. The decrease in 2001 was the result of less interest
income following a large decrease in our cash balances as a
result of our tender offer which was completed in April 2001.

Provision (benefit) for income taxes.As a result of releasing a portion of
our previously recorded valuation allowance on net deferred tax
assets, we have recorded a $290,000 benefit for income taxes in
the year ended December 31, 2002. We will continue to assess the
likelihood of realization of our tax credits and other 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. The provision for income taxes for 2000
and 2001 was for taxes under the alternative minimum tax.

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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,
the level of product and price competition, the length of our
sales cycle, the size and timing of individual license
transactions, 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, 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.

Our software products generally are shipped as
orders are received. As a result, initial license fees in any
quarter are substantially dependent on orders booked and shipped
in that quarter. The timing of receipt of initial license fees
is difficult to predict because of the length of our sales
cycle, typically three to twelve months from the 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

At December 31, 2002, we had
$8.6 million in cash, cash equivalents and short-term
investments. This is a decrease of $0.3 million from
December 31, 2001. In February 2002, we paid
$2.5 million to Xerox to retire debt pursuant to our 2001
tender offer.

Net cash provided by operating activities
increased 33% to $4.0 million for the year ended
December 31, 2002 from $3.0 million for the year ended
December 31, 2001. This increase is due largely to a
favorable change in operating assets and liabilities.

Net cash used in investing activities was
$2.5 million for the year ended December 31, 2002. Net
cash provided by investing activities was $7.3 million for
the year ended December 31, 2001. Cash used in investing
activities for the year ended December 31, 2002 related
primarily to the capitalization of computer software costs and
net purchases of short-term investments. Cash provided by
investing activities for the year ended December 31, 2001
related primarily to proceeds received from our 2001 sale of
short-term investments in preparation for payments made in April
2001 in connection with our tender offer in which we purchased
6,000,000 shares of our common stock for $12 million.

Net cash used in financing activities decreased
80% to $2.4 million for the year ended December 31,
2002 from $11.9 million for the year ended December 31,
2001. Cash used in financing activities for the year ended
December 31, 2002 related primarily to the payment of notes
to Xerox pursuant to our 2001 tender offer. Cash used in
financing activities for the year ended December 31, 2001
reflected the cash portion of our 2001 tender offer.

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. However,
if there were a decrease in customer demand for our products,
our availability of funds would be reduced. A portion of our
remaining cash could be used to acquire or invest in
complementary

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businesses or products or obtain the right to use
complementary technologies. We are currently evaluating, in our
ordinary course of business, potential investments such as
businesses, products or technologies. We have no material
current understandings, commitments or agreements with respect
to any acquisition in whole of other businesses, products or
technologies.


As of December 31, 2001 and 2002, 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.

Recently Issued Accounting Standards

In December 2002, the Financial Accounting
Standards Board (FASB) issued SFAS No. 148,
Accounting for Stock-Based Compensation 
Transition and Disclosure  an Amendment of FASB
Statement No. 123. This statement amends SFAS
No. 123 Accounting for Stock-Based
Compensation to provide alternative methods of
voluntarily transitioning to the fair value based method of
accounting for stock-based employee compensation. SFAS
No. 148 also amends the disclosure requirements of SFAS
No. 123 to require disclosure of the method used to account
for stock-based employee compensation and the effect of the
method on reported results in both annual and interim financial
statements. The disclosure provisions will be effective for us
beginning with our year ended December 31, 2003. We have
not yet completed the final evaluation of the options presented
by SFAS No. 148. However, within this fiscal year, we
expect to reach a determination of whether and, if so, when to
change our existing accounting for stock-based compensation to
the fair value method in accordance with the transition
alternatives of SFAS No. 148.

In June 2002, the FASB issued SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal.
SFAS No. 146 addresses financial accounting and reporting
for costs associated with exit or disposal activities and
nullifies EITF Issue No. 94-3, Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a
Restructuring). The principal difference between SFAS
No. 146 and Issue 94-3 relates to SFAS No. 146s
requirements for recognition of a liability for a cost
associated with an exit or disposal activity. SFAS No. 146
requires that a liability for a cost associated with an exit or
disposal activity be recognized when the liability is incurred.
Under Issue 94-3, a liability for an exit cost as generally
defined in Issue 94-3 was recognized at the date of an
entitys commitment to an exit plan. The provisions of SFAS
No. 146 are effective for exit or disposal activities that
are initiated after December 31, 2002, with early
application encouraged. We will adopt SFAS No. 146
effective January 1, 2003. We do not expect that the
adoption of SFAS No. 146 will have a material impact on our
financial statements.




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. The primary foreign currency
risk exposure is related to U.S. Dollar to Euro
conversions. 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
all other currencies would not materially adversely affect
expected first quarter 2003 earnings or cash flows. This
analysis is dependent on actual export sales during the next
quarter occurring within 90% of budgeted forecasts. The effect
of the hypothetical change in exchange rates ignores the affect
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. In addition, it is unlikely that all currencies
would uniformly strengthen or weaken relative to the
U.S. Dollar. In reality, some currencies may weaken while
others may strengthen. Each month, we review our position for
expected currency exchange rate movements.

22



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##### Table of Contents



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, 2002. 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 is
incorporated into this item by reference.




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

None.




PART III




Item 10.     Directors
and Executive Officers of the Registrant

The information required by this item concerning
our directors and certain information regarding our executive
officers is incorporated by reference to the information set
forth in the sections entitled Election of
Directors  Nominees, Compensation of
Executive Officers and Section 16(a) Beneficial
Ownership Reporting Compliance in our Proxy Statement for
the 2003 Annual Meeting of Stockholders.

Executive Officers of Document
Sciences

The executive officers of Document Sciences and
their ages, as of March 24, 2003, are as follows:

|                  |  |     |    |          |  |                                                                   
|----------------- |  | --- | -- | -------- |  | ------------------------------------------------------------------
|Name              |  | Age |    | Position
|                  |  |     |    |         
|John L. McGannon  |  |     | 42 |          |  | President, Chief Executive Officer and Chief
    Financial Officer
|Daniel J. Fregeau |  |     | 46 |          |  | Executive Vice President                                          
|J. Douglas Pike   |  |     | 47 |          |  | Vice President, Worldwide Sales                                   
|Lisa L. Sutrick   |  |     | 39 |          |  | Vice President, Product Planning and Development                  

John L.
McGannonhas served as President and
Chief Executive Officer since January 2001 and Chief Financial
Officer since December 1999. He has also served as Vice
President, Chief Administrative Officer and Controller since
joining Document Sciences in September 1998. From June 1997
through August 1998, Mr. McGannon served as the Manager of
Financial Analysis and Planning for Simulation Sciences, Inc., a
California-based software developer for the oil and chemical
engineering industries. Mr. McGannon worked for Chevron
Corporation from 1988 to 1997 in a variety of financial
management positions. Mr. McGannon holds a BA degree
from Stanford University and an MBA from Carnegie Mellon
University.

Daniel J.
Fregeauhas served as Executive Vice
President since January 2001. From 1998 to 2001, he served as
Vice President of Worldwide Sales and Business Development, from
1997 to 1998, he served as Vice President, Business Development,
from 1994 to 1997, he served as Vice President, Marketing and
from 1992 to 1994, he served as Vice President, Sales. Prior to
joining Document Sciences, Mr. Fregeau was Marketing
Manager for the Networking Division of Sears Business Centers,
San Diego, from 1990 to 1992. Mr. Fregeau was a founder and
principal of MicroAge in San Diego from 1988 to 1990. From 1982
to 1988, Mr. Fregeau held several positions with Xerox
Corporations Electronic Publishing Business Unit including
Manager of Systems Engineering and Integration, Technical
Program Manager and Project Manager. While at Xerox,

23



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##### Table of Contents



Mr. Fregeau designed and directed the
development of several publishing products and was a key
contributor to the launch of the XICS (now CompuSet) product in
the U.S. and Canada.


J. Douglas Pikehas served as Vice President, Worldwide Sales since January
2001. He had previously served as Director of U.S. Sales
and Area Sales Manager since joining Document Sciences in
January 1995. From 1990 to 1994, Mr. Pike was employed by
Xerox Corporation to provide digital printing solutions to major
accounts in the insurance and finance industries. Mr. Pike
also worked for Unisys Corporation for seven years providing
custom software application and database solutions as an account
executive. Mr. Pike holds a B.S. degree in Industrial
Technology from the State University of New York.

Lisa L. Sutrickhas served as Vice President, Product Planning and Development
since January 2002. She had previously served in the capacities
of Director of Product Planning and Development, Director of
Product Marketing, Product Marketing Manager for Document
Library Services and Program Manager in Development since
joining Document Sciences in May 1997. From 1987 to 1997,
Ms. Sutrick worked for Data Retrieval Corporation, a
Wisconsin software company purchased by Document Sciences in May
1997, in a variety of customer focused software development
positions. Ms. Sutrick holds a B.S. degree in Applied
Mathematics from the University of Wisconsin, Stout.

Executive officers are appointed by the Board of
Directors and serve at the discretion of the Board. There are no
family relationships among any directors or executive officers
of Document Sciences.






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

The information required by this item regarding
executive compensation is incorporated by reference to the
information set forth in the sections entitled Executive
Officer Compensation and Compensation of
Directors in our Proxy Statement for the 2003 Annual
Meeting of Stockholders.






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management

The information required by this item regarding
security ownership of certain beneficial owners and management
is incorporated by reference to the information set forth in the
section entitled Security Ownership of Management and
Certain Beneficial Owners in our Proxy Statement for the
2003 Annual Meeting of Stockholders.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

The information required by this item regarding
certain relationships and related transactions is incorporated
by reference to the information set forth in the section
entitled Certain Transactions in our Proxy Statement
for the 2003 Annual Meeting of Stockholders.






|         |                        
|-------- | -----------------------
|Item 14. | Controls and Procedures

(a) Under the supervision and with the
participation of our management, including our principal
executive officer/ principal financial officer, we conducted an
evaluation of the effectiveness of design and operation of our
disclosure controls and procedures, as such term is defined
under Rule 13a-14(c) promulgated under the Securities
Exchange Act of 1934, as amended, within 90 days prior to
the filing date of this Annual Report. Based on his evaluation,
our principal executive officer/ principal financial officer
concluded that our disclosure controls and procedures are
effective as of the evaluation date.

(b) There have been no significant changes
(including corrective actions with regard to significant
deficiencies or material weaknesses) in our internal controls or
in other factors that could significantly affect these controls
subsequent to the date of the evaluation referenced in
paragraph (a) above.

24



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##### Table of Contents






PART IV






|         |                                                                    
|-------- | -------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules and
    Reports on Form 8-K

(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 Auditors 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, 2000, 2001 and 2002 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(c)
    below.                                                                                                                         

(b) Reports on Form 8-K.No
reports on Form 8-K were filed by us during the fiscal
quarter ended December 31, 2002.

(c) 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.

(d) Financial Statement Schedules.See Item 15(a) above.

25



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SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, the Registrant
has duly caused this Form 10-K to be signed on its behalf
by the undersigned, thereunto duly authorized.



| |                              
| | -----------------------------
| | DOCUMENT SCIENCES CORPORATION



| |     |                     
| | --- | --------------------
| | By: | /s/ JOHN L. MCGANNON

| |                                          
| | -----------------------------------------
| |                                          
| | John L. McGannon                         
| | President and Chief Executive
    Officer

Dated: March 24, 2003




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 Form 10-K, 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 Form 10-K has been signed below
by the following persons on behalf of the Registrant on
March 24, 2003 in the capacities indicated:

|                                       |  |                                                                                                                                          |  |      
|-------------------------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------- |  | -----
|                                       |  | Signatures                                                                                                                               |  | Title
|                                       |  |                                                                                                                                          |  |      
|                                      
|/s/ JOHN L. MCGANNONJohn L. McGannon   |  | President, Chief Executive Officer,
    Chief Financial Officer and Director
    (principal executive, financial and accounting officer)
|                                      
|/s/ THOMAS L. RINGERThomas L. Ringer   |  | Chairman of the Board of Directors                                                                                                      
|                                      
|/s/ BARTON L. FABERBarton L. Faber     |  | Director                                                                                                                                
|                                      
|/s/ COLIN J. OBRIENColin J. OBrien   |  | Director                                                                                                                                
|                                      
|/s/ JAMES J. COSTELLOJames J. Costello |  | Director                                                                                                                                

26



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CERTIFICATION

PURSUANT TO SECTION 302 OF THE
SARBANES-OXLEY ACT OF 2002

I, John L. McGannon, certify that:

1. I have reviewed this Annual Report on
Form 10-K of Document Sciences Corporation;

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

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

4. I am responsible for establishing and
maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant
and have:



| |                                                                                                                                                                                                                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (a) Designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to me by others within those entities, particularly during
    the period in which this Annual Report is being prepared;
|
| | (b) Evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this Annual
    Report (the Evaluation Date); and                                                                                                      
|
| | (c) Presented in this Annual Report my
    conclusions about the effectiveness of the disclosure controls
    and procedures based on my evaluation as of the Evaluation Date;                                                                                                                                  

5. I have disclosed, based on my most recent
evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons
performing the equivalent function):



| |                                                                                                                                                                                                                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (a) All significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | (b) Any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    

6. I have indicated in this Annual Report
whether or not there were significant changes in internal
controls or in other factors that could significantly affect
internal controls subsequent to the date of my most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.



| |                                           
| | ------------------------------------------
| | /s/ JOHN L. MCGANNON                      
| |                                           
| | John L. McGannon                          
| | President, Chief Executive Officer
    and
| | Chief Financial Officer                   

Date: March 24, 2003

27



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DOCUMENT SCIENCES CORPORATION

ANNUAL REPORT ON FORM 10-K

For Year Ended December 31,
2002







INDEX TO EXHIBITS


|        |             |                     |  |                                                                                                                                                                                                                                                                                                                               
|------- | ----------- | ------------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |             |                    
|Number  |             | Exhibit Description
|        |             |                    
|        | 3.1(1)      |                     |  | Restated Certificate of Incorporation of the
    Registrant filed May 1, 1992.                                                                                                                                                                                                                                                
|        | 3.2(1)      |                     |  | Form of Amended and Restated Certificate of
    Incorporation of the Registrant.                                                                                                                                                                                                                                              
|        | 3.3(1)      |                     |  | Amended and Restated Bylaws of the Registrant.                                                                                                                                                                                                                                                                                
|        | 3.4(1)      |                     |  | Form of Certificate of Amendment of Certificate
    of Incorporation of the Registrant.                                                                                                                                                                                                                                       
|        | 4.1(1)      |                     |  | Specimen Stock Certificate.                                                                                                                                                                                                                                                                                                   
|        | 4.2(6)      |                     |  | 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(1, 2)  |                     |  | Form of Indemnity Agreement Between the
    Registrant and each of its Officers and Directors.                                                                                                                                                                                                                                
|        | 10.2(1, 2)  |                     |  | 1993 Stock Option Plan and Form of Agreement.                                                                                                                                                                                                                                                                                 
|        | 10.3(4)     |                     |  | 1995 Stock Incentive Plan and Form of Agreement,
    as amended.                                                                                                                                                                                                                                                              
|        | 10.4(1, 2)  |                     |  | Stockholder Rights Agreement Dated September 1996
    Between the Registrant and Xerox Corporation.                                                                                                                                                                                                                           
|        | 10.5(1)     |                     |  | Tax Sharing Agreement Dated August 1996 Between
    the Registrant and Xerox Corporation.                                                                                                                                                                                                                                     
|        | 10.6(1)     |                     |  | Transfer and License Agreement Dated July 1,
    1992, as Amended in September 1994, Between the Registrant and
    Xerox Corporation.                                                                                                                                                                                        
|        | 10.7(1)     |                     |  | Strategic Marketing Alliance Agreement Dated
    September 1, 1993, Between the Registrant and Xerox
    Corporation.                                                                                                                                                                                                         
|        | 10.8(4)     |                     |  | 1997 Employee Stock Purchase Plan, as amended.                                                                                                                                                                                                                                                                                
|        | 10.9(3)     |                     |  | Xerox Cooperative Marketing Agreement.                                                                                                                                                                                                                                                                                        
|        | 10.10(3)    |                     |  | Xerox Canada Cooperative Marketing and Customer
    Support Agreement.                                                                                                                                                                                                                                                        
|        | 10.11(4)    |                     |  | International Business Machines Marketing
    Agreement.                                                                                                                                                                                                                                                                      
|        | 10.12(4)    |                     |  | Lease for Companys new Principal
    Facilities, as Amended, and Assignment of Lease.                                                                                                                                                                                                                                        
|        | 10.13(2, 5) |                     |  | John L. McGannon Employment Agreement.                                                                                                                                                                                                                                                                                        
|        | 10.14(6)    |                     |  | Form of Software License and Software Support
    Agreement.                                                                                                                                                                                                                                                                  
|        | 10.15(6)    |                     |  | Form of Professional Services Agreement.                                                                                                                                                                                                                                                                                      
|        | 10.16(6)    |                     |  | Form of Value Added Reseller Agreement.                                                                                                                                                                                                                                                                                       
|        | 10.17(6)    |                     |  | Development Services and Referral Agreement
    Between Objectiva Software Solutions, Inc. and the Registrant.                                                                                                                                                                                                                
|        | 21.1(1)     |                     |  | List of Subsidiaries.                                                                                                                                                                                                                                                                                                         
|        | 23.1(7)     |                     |  | Consent of Ernst & Young LLP,
    Independent Auditors.                                                                                                                                                                                                                                                                       
|        | 24.1(7)     |                     |  | Power of Attorney (See page 23)                                                                                                                                                                                                                                                                                               
|        | 99.1(7)     |                     |  | Certification Pursuant to 18 U.S.C.
    Section 1350, as Adopted, Pursuant to Section 906 of
    the Sarbanes-Oxley Act                                                                                                                                                                                                       



---



|    |                                                                                                                                 
|--- | --------------------------------------------------------------------------------------------------------------------------------
|(1) | Previously filed as exhibits to Registration
    Statement on Form S-1 Registration Number 333-06344.                           
|   
|(2) | Indicates management compensatory plan, contract
    or arrangement.                                                            
|   
|(3) | Previously filed as exhibits to the
    Registrants Annual Report on Form 10-K for the fiscal
    year ended December 31, 1997.

28



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##### Table of Contents





|    |                                                                                                                                 
|--- | --------------------------------------------------------------------------------------------------------------------------------
|(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 exhibits to the
    Registrants Annual Report on Form 10-K for the fiscal
    year ended December 31, 2000.
|   
|(6) | Previously filed as exhibits to the
    Registrants Annual Report on Form 10-K for the fiscal
    year ended December 31, 2001.
|   
|(7) | Filed herewith.                                                                                                                 

29



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##### Table of Contents



DOCUMENT SCIENCES CORPORATION






INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS


|                                                      |  |      |     | 
|----------------------------------------------------- |  | ---- | --- | 
|                                                      |  | Page
|                                                      |  |     
|Report of Ernst & Young LLP, Independent
    Auditors |  |      | F-2 | 
|Consolidated Balance Sheets                           |  |      | F-3 | 
|Consolidated Statements of Income                     |  |      | 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



---



##### Table of Contents






REPORT OF ERNST & YOUNG LLP,
INDEPENDENT AUDITORS

The Board of Directors and Stockholders

Document Sciences Corporation


We have audited the accompanying consolidated
balance sheets of Document Sciences Corporation (the
Company) as of December 31, 2001 and 2002, and
the related consolidated statements of income,
stockholders equity and cash flows for each of the three
years in the period ended December 31, 2002. Our audits
also included the financial statement schedule listed in the
Index at 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
auditing standards generally accepted in the 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. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant
estimates made by management, as well as 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, 2001 and 2002, and the consolidated results
of its operations and its cash flows for each of the three years
in the period ended December 31, 2002, in conformity with
accounting principles generally accepted in the United States.
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, Document Sciences Corporation changed its
method of accounting for purchased goodwill and other intangible
assets in accordance with Statement of Financial Accounting
Standards No. 142 during the first quarter of fiscal 2002.



| |                  
| | -----------------
| | ERNST & YOUNG LLP

San Diego, California

January 24, 2003


F-2



---



##### Table of Contents



DOCUMENT SCIENCES CORPORATION






CONSOLIDATED BALANCE SHEETS


|                                                                                                                              |                                                                                                                                |                            |            |            |            |   |            |            |            | 
|----------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------ | -------------------------- | ---------- | ---------- | ---------- | - | ---------- | ---------- | ---------- | 
|                                                                                                                              |                                                                                                                                |                           
|                                                                                                                              |                                                                                                                                | December 31,              
|                                                                                                                              |                                                                                                                                |                           
|                                                                                                                              |                                                                                                                                | 2001                       |            | 2002      
|                                                                                                                              |                                                                                                                                |                            |            |           
|ASSETS                                                                                                                       
|Current assets:                                                                                                               |                                                                                                                                |                            |            |            |            |   |            |           
|                                                                                                                              | Cash and cash equivalents                                                                                                      |                            | $          | 3,187,229  |            |   | $          | 2,284,367  |           
|                                                                                                                              | Short-term investments                                                                                                         |                            |            | 5,736,200  |            |   |            | 6,294,838  |           
|                                                                                                                              | Accounts receivable, less allowance for doubtful
    accounts of $427,683 and $333,566 in 2001 and 2002, respectively          |                            |            | 5,028,059  |            |   |            | 7,223,750  |           
|                                                                                                                              | Due from affiliates                                                                                                            |                            |            | 1,739,739  |            |   |            | 1,242,196  |           
|                                                                                                                              | Unbilled revenue                                                                                                               |                            |            | 400,164    |            |   |            | 161,159    |           
|                                                                                                                              | Other current assets                                                                                                           |                            |            | 519,163    |            |   |            | 756,268    |           
|                                                                                                                              |                                                                                                                                |                            |            |            |            |   |            |           
|                                                                                                                              |                                                                                                                                | Total current assets       |            |            | 16,610,554 |   |            |            | 17,962,578 | 
|Property and equipment, net                                                                                                   |                                                                                                                                |                            | 1,178,600  |            |            |   | 781,874    |           
|Software development costs, net of accumulated
    amortization of $1,288,326 and $276,712 in 2001 and 2002,
    respectively |                                                                                                                                |                            | 1,143,618  |            |            |   | 1,518,102  |           
|Goodwill, net of accumulated amortization of
    $327,246 in 2001 and 2002                                                    |                                                                                                                                |                            | 724,615    |            |            |   | 724,615    |           
|Other assets                                                                                                                  |                                                                                                                                |                            | 48,785     |            |            |   | 197,497    |           
|                                                                                                                              |                                                                                                                                |                            |            |            |            |   |            |           
|                                                                                                                              |                                                                                                                                | $                          | 19,706,172 |            |            | $ | 21,184,666 |           
|                                                                                                                              |                                                                                                                                |                            |            |            |            |   |            |           
|LIABILITIES AND STOCKHOLDERS
    EQUITY                                                                                     
|Current liabilities:                                                                                                          |                                                                                                                                |                            |            |            |            |   |            |           
|                                                                                                                              | Accounts payable                                                                                                               |                            | $          | 191,919    |            |   | $          | 192,945    |           
|                                                                                                                              | Accrued compensation                                                                                                           |                            |            | 881,791    |            |   |            | 1,580,521  |           
|                                                                                                                              | Other accrued liabilities                                                                                                      |                            |            | 520,599    |            |   |            | 495,679    |           
|                                                                                                                              | Deferred revenue                                                                                                               |                            |            | 7,851,670  |            |   |            | 9,689,774  |           
|                                                                                                                              | Short-term notes                                                                                                               |                            |            | 2,128,219  |            |   |            |           |           
|                                                                                                                              |                                                                                                                                |                            |            |            |            |   |            |           
|                                                                                                                              |                                                                                                                                | Total current liabilities  |            |            | 11,574,198 |   |            |            | 11,958,919 | 
|Long-term notes                                                                                                               |                                                                                                                                |                            | 297,099    |            |            |   |           |           
|Deferred revenue  long-term                                                                                                  |                                                                                                                                |                            | 134,430    |            |            |   | 44,810     |           
|                                                                                                                             
|Commitments                                                                                                                   |                                                                                                                                |                            |            |            |            |   |            |           
|Stockholders equity:                                                                                                         |                                                                                                                                |                            |            |            |            |   |            |           
|                                                                                                                              | Common stock, $.001 par value; Authorized
    shares  30,000,000; Issued shares 
    3,824,896 in 2001 and 3,858,479 in 2002 |                            |            | 3,825      |            |   |            | 3,858      |           
|                                                                                                                              | Additional paid-in capital                                                                                                     |                            |            | 10,781,055 |            |   |            | 10,786,007 |           
|                                                                                                                              | Accumulated comprehensive income                                                                                               |                            |            | 95,514     |            |   |            | 10,981     |           
|                                                                                                                              | Retained deficit                                                                                                               |                            |            | (3,179,949 | )          |   |            | (1,619,909 | )         
|                                                                                                                              |                                                                                                                                |                            |            |            |            |   |            |           
|                                                                                                                              |                                                                                                                                | Total stockholders equity |            |            | 7,700,445  |   |            |            | 9,180,937  | 
|                                                                                                                              |                                                                                                                                |                            |            |            |            |   |            |           
|                                                                                                                              |                                                                                                                                | $                          | 19,706,172 |            |            | $ | 21,184,666 |           
|                                                                                                                              |                                                                                                                                |                            |            |            |            |   |            |           

See accompanying notes.

F-3



---



##### Table of Contents



DOCUMENT SCIENCES CORPORATION






CONSOLIDATED STATEMENTS OF INCOME


|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |           |            | 
|------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------ | ---------- | ---------- | ---------- | ---- | ---------- | --------- | ---------- | - | ---------- | --------- | ---------- | 
|                                                        |                                                                                                                                                        |                         
|                                                        |                                                                                                                                                        | Years Ended December 31,
|                                                        |                                                                                                                                                        |                         
|                                                        |                                                                                                                                                        | 2000                     |            | 2001       |            | 2002
|                                                        |                                                                                                                                                        |                          |            |            |            |     
|Revenues:                                               |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|                                                        | Initial license fees (including $2,671,800,
    $1,717,700 and $1,276,300 from affiliates in 2000, 2001 and
    2002, respectively)                    |                          | $          | 10,257,633 |            |      | $          | 8,200,159 |            |   | $          | 9,592,009 |           
|                                                        | Annual renewal license and support fees
    (including $2,235,700, $2,182,500 and $2,627,400 from affiliates
    in 2000, 2001 and 2002, respectively) |                          |            | 8,620,958  |            |      |            | 8,707,247 |            |   |            | 9,576,671 |           
|                                                        | Services and other (including $279,900, $224,500
    and $102,400 from affiliates in 2000, 2001 and 2002,
    respectively)                            |                          |            | 3,700,336  |            |      |            | 5,212,231 |            |   |            | 3,917,099 |           
|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|                                                        |                                                                                                                                                        | Total revenues           |            |            | 22,578,927 |      |            |           | 22,119,637 |   |            |           | 23,085,779 | 
|Cost of revenues:                                       |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|                                                        | Initial license fees                                                                                                                                   |                          |            | 1,643,617  |            |      |            | 1,495,073 |            |   |            | 1,599,958 |           
|                                                        | Annual renewal license and support fees                                                                                                                |                          |            | 1,311,196  |            |      |            | 1,498,664 |            |   |            | 1,513,812 |           
|                                                        | Services and other                                                                                                                                     |                          |            | 2,501,372  |            |      |            | 2,992,555 |            |   |            | 2,606,356 |           
|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|                                                        |                                                                                                                                                        | Total cost of revenues   |            |            | 5,456,185  |      |            |           | 5,986,292  |   |            |           | 5,720,126  | 
|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|Gross profit                                            |                                                                                                                                                        |                          | 17,122,742 |            |            |      | 16,133,345 |           |            |   | 17,365,653 |          
|Operating expenses:                                     |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|                                                        | Research and development                                                                                                                               |                          |            | 4,154,364  |            |      |            | 5,203,525 |            |   |            | 5,456,164 |           
|                                                        | Selling and marketing                                                                                                                                  |                          |            | 8,358,577  |            |      |            | 7,151,651 |            |   |            | 7,755,772 |           
|                                                        | General and administrative                                                                                                                             |                          |            | 5,025,417  |            |      |            | 3,418,823 |            |   |            | 2,981,169 |           
|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|Total operating expenses                                |                                                                                                                                                        |                          | 17,538,358 |            |            |      | 15,773,999 |           |            |   | 16,193,105 |          
|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|Income (loss) from operations                           |                                                                                                                                                        |                          | (415,616   | )          |            |      | 359,346    |           |            |   | 1,172,548  |          
|Interest and other income, net                          |                                                                                                                                                        |                          | 960,581    |            |            |      | 280,921    |           |            |   | 93,903     |          
|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|Income before provision for income taxes                |                                                                                                                                                        |                          | 544,965    |            |            |      | 640,267    |           |            |   | 1,266,451  |          
|Provision (benefit) for income taxes                    |                                                                                                                                                        |                          | 14,026     |            |            |      | 1,807      |           |            |   | (293,589   | )        
|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|Net income                                              |                                                                                                                                                        | $                        | 530,939    |            |            | $    | 638,460    |           |            | $ | 1,560,040  |          
|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|Net income per share  basic                            |                                                                                                                                                        | $                        | 0.05       |            |            | $    | 0.12       |           |            | $ | 0.41       |          
|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|Weighted average shares used in basic calculation       |                                                                                                                                                        |                          | 10,771,588 |            |            |      | 5,547,872  |           |            |   | 3,843,850  |          
|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|Net income per share  diluted                          |                                                                                                                                                        | $                        | 0.05       |            |            | $    | 0.11       |           |            | $ | 0.36       |          
|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          
|Weighted average shares used in diluted
    calculation |                                                                                                                                                        |                          | 11,153,893 |            |            |      | 5,830,728  |           |            |   | 4,286,485  |          
|                                                        |                                                                                                                                                        |                          |            |            |            |      |            |           |            |   |            |          

See accompanying notes.

F-4



---



##### Table of Contents



DOCUMENT SCIENCES CORPORATION






CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY


|                                                                                       |                                                             |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             |           |  
|-------------------------------------------------------------------------------------- | ----------------------------------------------------------- | ------------ | ---------- | -------------- |  | ---------- | ------ | -------- |  | ------------- | ---------- | ------------ |  | ------------- | ----------- | --------- |  | ------ | ----------- | - |  | - | ------- | - |  | - | -------- | ------- | - | - | ---------- | --------- |  | - | ----------- | --------- | -
|                                                                                       |                                                             |              |            |                |  |            |        |          |  | Accumulated   |            |              |  |              
|                                                                                       |                                                             | Common Stock |            | Treasury Stock |  | Additional |        |          |  | Comprehensive |            |              |  | Total        
|                                                                                       |                                                             |              |            |                |  | Paid-in    |        | Deferred |  | Income        |            | Retained     |  | Stockholders
|                                                                                       |                                                             | Shares       |            | Amount         |  | Shares     |        | Amount   |  | Capital       |            | Compensation |  | (Loss)        |             | (Deficit) |  | Equity
|                                                                                       |                                                             |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |       
|Balance at December 31, 1999                                                           |                                                             |              | 10,919,051 |                |  | $          | 10,919 |          |  |               | 174,882    |              |  | $             | (609,983    | )         |  | $      | 25,425,809  |   |  | $ | (10,794 | ) |  | $ | (186,500 | )       |   | $ | (4,349,348 | )         |  | $ | 20,280,103  |          
|Issuance of common stock upon exercise of options                                      |                                                             |              | 4,050      |                |  |            | 4      |          |  |               |           |              |  |               |            |           |  |        | 10,497      |   |  |   |        |   |  |   |         |         |   |   |           |           |  |   | 10,501      |          
|Sale of treasury stock                                                                 |                                                             |              |           |                |  |            |       |          |  |               | (86,920    | )            |  |               | 106,710     |           |  |        |            |   |  |   |        |   |  |   |         |         |   |   |           |           |  |   | 106,710     |          
|Amortization of deferred compensation                                                  |                                                             |              |           |                |  |            |       |          |  |               |           |              |  |               |            |           |  |        |            |   |  |   | 10,794  |   |  |   |         |         |   |   |           |           |  |   | 10,794      |          
|Comprehensive income (loss):                                                           |                                                             |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             |          
|                                                                                       | Net change in unrealized loss on short-term
    investments |              |            |               |  |            |        |         |  |               |            |             |  |               |             |          |  |        |             |  |  |   |         |  |  |   |          | 212,916 |   |   |            |          |  |   |             | 212,916   |  
|                                                                                       | Foreign currency translation adjustment                     |              |            |               |  |            |        |         |  |               |            |             |  |               |             |          |  |        |             |  |  |   |         |  |  |   |          | (17,954 | ) |   |            |          |  |   |             | (17,954   | )
|                                                                                       | Net loss                                                    |              |            |               |  |            |        |         |  |               |            |             |  |               |             |          |  |        |             |  |  |   |         |  |  |   |          |        |   |   |            | 530,939   |  |   |             | 530,939   |  
|                                                                                       |                                                             |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             |          
|                                                                                       | Comprehensive income                                        |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             | 725,901   |  
|                                                                                       |                                                             |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             |          
|Balance at December 31, 2000                                                           |                                                             |              | 10,923,101 |                |  |            | 10,923 |          |  |               | 87,962     |              |  |               | (503,273    | )         |  |        | 25,436,306  |   |  |   |        |   |  |   | 8,462    |         |   |   | (3,818,409 | )         |  |   | 21,134,009  |          
|Issuance of common stock upon exercise of options                                      |                                                             |              | 44,406     |                |  |            | 44     |          |  |               |           |              |  |               |            |           |  |        | 11,939      |   |  |   |        |   |  |   |         |         |   |   |           |           |  |   | 11,983      |          
|Warrants issued to non-employee                                                        |                                                             |              |           |                |  |            |       |          |  |               |           |              |  |               |            |           |  |        | 30,600      |   |  |   |        |   |  |   |         |         |   |   |           |           |  |   | 30,600      |          
|Purchase of treasury stock                                                             |                                                             |              |           |                |  |            |       |          |  |               | 7,144,854  |              |  |               | (14,294,972 | )         |  |        |            |   |  |   |        |   |  |   |         |         |   |   |           |           |  |   | (14,294,972 | )        
|Sale of treasury stock                                                                 |                                                             |              |           |                |  |            |       |          |  |               | (90,204    | )            |  |               | 93,313      |           |  |        |            |   |  |   |        |   |  |   |         |         |   |   |           |           |  |   | 93,313      |          
|Retirement of treasury stock                                                           |                                                             |              | (7,142,611 | )              |  |            | (7,142 | )        |  |               | (7,142,612 | )            |  |               | 14,704,932  |           |  |        | (14,697,790 | ) |  |   |        |   |  |   |         |         |   |   |           |           |  |   |            |          
|Comprehensive income (loss):                                                           |                                                             |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             |          
|                                                                                       | Net change in unrealized gain on short-term
    investments |              |            |               |  |            |        |         |  |               |            |             |  |               |             |          |  |        |             |  |  |   |         |  |  |   |          | 82,686  |   |   |            |          |  |   |             | 82,686    |  
|                                                                                       | Foreign currency translation adjustment                     |              |            |               |  |            |        |         |  |               |            |             |  |               |             |          |  |        |             |  |  |   |         |  |  |   |          | 4,366   |   |   |            |          |  |   |             | 4,366     |  
|                                                                                       | Net income                                                  |              |            |               |  |            |        |         |  |               |            |             |  |               |             |          |  |        |             |  |  |   |         |  |  |   |          |        |   |   |            | 638,460   |  |   |             | 638,460   |  
|                                                                                       |                                                             |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             |          
|                                                                                       | Comprehensive income                                        |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             | 725,512   |  
|                                                                                       |                                                             |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             |          
|Balance at December 31, 2001                                                           |                                                             |              | 3,824,896  |                |  |            | 3,825  |          |  |               |           |              |  |               |            |           |  |        | 10,781,055  |   |  |   |        |   |  |   | 95,514   |         |   |   | (3,179,949 | )         |  |   | 7,700,445   |          
|Issuance of common stock upon exercise of options                                      |                                                             |              | 45,030     |                |  |            | 45     |          |  |               |           |              |  |               |            |           |  |        | 28,933      |   |  |   |        |   |  |   |         |         |   |   |           |           |  |   | 28,978      |          
|Stock compensation associated with the repurchase
    of common stock from an employee |                                                             |              |           |                |  |            |       |          |  |               |           |              |  |               |            |           |  |        | 30,474      |   |  |   |        |   |  |   |         |         |   |   |           |           |  |   | 30,474      |          
|Purchase of treasury stock                                                             |                                                             |              |           |                |  |            |       |          |  |               | 71,238     |              |  |               | (168,672    | )         |  |        |            |   |  |   |        |   |  |   |         |         |   |   |           |           |  |   | (168,672    | )        
|Sale of treasury stock                                                                 |                                                             |              |           |                |  |            |       |          |  |               | (59,791    | )            |  |               | 114,205     |           |  |        |            |   |  |   |        |   |  |   |         |         |   |   |           |           |  |   | 114,205     |          
|Retirement of treasury stock                                                           |                                                             |              | (11,447    | )              |  |            | (12    | )        |  |               | (11,447    | )            |  |               | 54,467      |           |  |        | (54,455     | ) |  |   |        |   |  |   |         |         |   |   |           |           |  |   |            |          
|Comprehensive income (loss):                                                           |                                                             |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             |          
|                                                                                       | Net change in unrealized gain on short-term
    investments |              |            |               |  |            |        |         |  |               |            |             |  |               |             |          |  |        |             |  |  |   |         |  |  |   |          | 4,921   |   |   |            |          |  |   |             | 4,921     |  
|                                                                                       | Foreign currency translation adjustment                     |              |            |               |  |            |        |         |  |               |            |             |  |               |             |          |  |        |             |  |  |   |         |  |  |   |          | (89,454 | ) |   |            |          |  |   |             | (89,454   | )
|                                                                                       | Net income                                                  |              |            |               |  |            |        |         |  |               |            |             |  |               |             |          |  |        |             |  |  |   |         |  |  |   |          |        |   |   |            | 1,560,040 |  |   |             | 1,560,040 |  
|                                                                                       |                                                             |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             |          
|                                                                                       | Comprehensive income                                        |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             | 1,475,507 |  
|                                                                                       |                                                             |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             |          
|Balance at December 31, 2002                                                           |                                                             |              | 3,858,479  |                |  | $          | 3,858  |          |  |               |           |              |  | $             |            |           |  | $      | 10,786,007  |   |  | $ |        |   |  | $ | 10,981   |         |   | $ | (1,616,909 | )         |  | $ | 9,180,937   |          
|                                                                                       |                                                             |              |            |                |  |            |        |          |  |               |            |              |  |               |             |           |  |        |             |   |  |   |         |   |  |   |          |         |   |   |            |           |  |   |             |          

See accompanying notes.

F-5



---



##### Table of Contents



DOCUMENT SCIENCES CORPORATION






CONSOLIDATED STATEMENTS OF CASH
FLOWS


|                                                                                                |                                                                                       |                          |            |           |           |      |             |          |           |   |            |           |            |  
|----------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------- | ------------------------ | ---------- | --------- | --------- | ---- | ----------- | -------- | --------- | - | ---------- | --------- | ---------- | -
|                                                                                                |                                                                                       |                         
|                                                                                                |                                                                                       | Years Ended December 31,
|                                                                                                |                                                                                       |                         
|                                                                                                |                                                                                       | 2000                     |            | 2001      |           | 2002
|                                                                                                |                                                                                       |                          |            |           |           |     
|Operating activities                                                                            |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          
|Net income                                                                                      |                                                                                       | $                        | 530,939    |           |           | $    | 638,460     |          |           | $ | 1,560,040  |          
|Adjustments to reconcile net income to net cash
    provided by (used in) operating activities: |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          
|                                                                                                | Depreciation and amortization                                                         |                          |            | 652,837   |           |      |             | 700,666  |           |   |            | 507,190   |           
|                                                                                                | Amortization of goodwill                                                              |                          |            | 70,124    |           |      |             | 70,124   |           |   |            |          |           
|                                                                                                | Stock based compensation                                                              |                          |            |          |           |      |             |         |           |   |            | 30,474    |           
|                                                                                                | Loss on disposal of fixed assets                                                      |                          |            | 36,534    |           |      |             | 176,378  |           |   |            | 99,312    |           
|                                                                                                | Amortization of software development costs                                            |                          |            | 1,158,170 |           |      |             | 937,774  |           |   |            | 1,206,038 |           
|                                                                                                | Amortization of deferred compensation                                                 |                          |            | 10,794    |           |      |             |         |           |   |            |          |           
|                                                                                                | Provision for doubtful accounts                                                       |                          |            | 245,170   |           |      |             | (584,312 | )         |   |            | (94,766   | )         
|                                                                                                | Changes in operating assets and liabilities, net
    of effects of acquired business: |                          |            |           |           |      |             |          |           |   |            |           |           
|                                                                                                |                                                                                       | Accounts receivable      |            |           | (264,438  | )    |             |          | 1,640,037 |   |            |           | (2,098,212 | )
|                                                                                                |                                                                                       | Due from affiliates      |            |           | 280,251   |      |             |          | (139,683  | ) |            |           | 548,105    |  
|                                                                                                |                                                                                       | Unbilled revenue         |            |           | 38,635    |      |             |          | (130,736  | ) |            |           | 239,005    |  
|                                                                                                |                                                                                       | Other assets             |            |           | 17,411    |      |             |          | 328,341   |   |            |           | (380,853   | )
|                                                                                                |                                                                                       | Accounts payable         |            |           | (272,146  | )    |             |          | (140,974  | ) |            |           | (2,343     | )
|                                                                                                |                                                                                       | Accrued compensation     |            |           | (923,771  | )    |             |          | (71,255   | ) |            |           | 698,342    |  
|                                                                                                |                                                                                       | Accrued liabilities      |            |           | (163,976  | )    |             |          | 134,622   |   |            |           | (6,369     | )
|                                                                                                |                                                                                       | Deferred revenue         |            |           | 1,589,169 |      |             |          | (556,618  | ) |            |           | 1,742,837  |  
|                                                                                                |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          
|Net cash provided by operating activities                                                       |                                                                                       |                          | 3,005,703  |           |           |      | 3,002,824   |          |           |   | 4,048,800  |          
|Investing activities                                                                            |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          
|Purchases of short-term investments                                                             |                                                                                       |                          | (7,280,780 | )         |           |      | (4,705,851  | )        |           |   | (3,520,070 | )        
|Sales of short-term investments                                                                 |                                                                                       |                          | 340,284    |           |           |      | 11,014,139  |          |           |   |           |          
|Maturities of short-term investments                                                            |                                                                                       |                          | 6,900,000  |           |           |      | 1,850,000   |          |           |   | 2,808,000  |          
|Purchases of property and equipment, net                                                        |                                                                                       |                          | (905,449   | )         |           |      | (132,963    | )        |           |   | (214,601   | )        
|Proceeds from disposal of assets                                                                |                                                                                       |                          | 73,044     |           |           |      | 7,747       |          |           |   | 7,145      |          
|Additions to software development costs                                                         |                                                                                       |                          | (1,190,758 | )         |           |      | (716,756    | )        |           |   | (1,580,522 | )        
|                                                                                                |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          
|Net cash provided by (used in) investing
    activities                                         |                                                                                       |                          | (2,063,659 | )         |           |      | 7,316,316   |          |           |   | (2,500,048 | )        
|Financing activities                                                                            |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          
|Reduction of debt                                                                               |                                                                                       |                          |           |           |           |      |            |          |           |   | (2,451,170 | )        
|Principal payments under capital lease obligations                                              |                                                                                       |                          | (12,620    | )         |           |      |            |          |           |   |           |          
|Purchase of treasury stock                                                                      |                                                                                       |                          |           |           |           |      | (12,015,772 | )        |           |   | (168,672   | )        
|Sale of treasury stock                                                                          |                                                                                       |                          | 106,710    |           |           |      | 93,313      |          |           |   | 114,205    |          
|Proceeds from issuance of common stock                                                          |                                                                                       |                          | 10,501     |           |           |      | 42,583      |          |           |   | 28,978     |          
|                                                                                                |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          
|Net cash provided by (used in) financing
    activities                                         |                                                                                       |                          | 104,591    |           |           |      | (11,879,876 | )        |           |   | (2,476,659 | )        
|                                                                                                |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          
|Increase (decrease) in cash and cash equivalents                                                |                                                                                       |                          | 1,046,635  |           |           |      | (1,560,736  | )        |           |   | (927,907   | )        
|Effect of foreign currency on cash                                                              |                                                                                       |                          | (24,472    | )         |           |      | (20,555     | )        |           |   | 25,045     |          
|Cash and cash equivalents at beginning of year                                                  |                                                                                       |                          | 3,746,357  |           |           |      | 4,768,520   |          |           |   | 3,187,229  |          
|                                                                                                |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          
|Cash and cash equivalents at end of year                                                        |                                                                                       | $                        | 4,768,520  |           |           | $    | 3,187,229   |          |           | $ | 2,284,367  |          
|                                                                                                |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          
|Supplemental disclosure of cash flow
    information:                                           |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          
|Interest paid                                                                                   |                                                                                       | $                        | 1,040      |           |           | $    |            |          |           | $ | 171,970    |          
|                                                                                                |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          
|Notes issued for purchase of treasury stock                                                     |                                                                                       | $                        |           |           |           | $    | 2,279,200   |          |           | $ |           |          
|                                                                                                |                                                                                       |                          |            |           |           |      |             |          |           |   |            |          

See accompanying notes.

F-6



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##### 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
document automation software products and services used in high
volume electronic publishing applications. Autograph, our
document automation software architecture, enables personalized
publishing solutions for many industries including insurance,
managed healthcare, financial services, commercial print
services, government, telecommunications and manufacturing.

We currently derive substantially all of our
license revenues from licenses of CompuSet and DLS,
Autographs flagship products, and related products
and from fees for services related to the CompuSet and DLS
software. Our financial performance will continue to depend, in
significant part, on the successful development, introduction
and customer acceptance of new and enhanced versions of the
CompuSet and DLS software and related products. There can be no
assurance that we will continue to be successful in developing
and marketing CompuSet and DLS products and related services.

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. There can
be no assurance that Xerox or its affiliates will continue these
relationships. Our failure to maintain these relationships with
Xerox and its affiliates could have a material adverse effect on
our financial statements.



| |                      
| | ---------------------
| | Basis of Presentation

In 1994, we established a wholly owned
subsidiary, Document Sciences Europe, in France, in order to
market and support our products to the European community. 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
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 our French subsidiary
in 2001 was the French Franc. Beginning January 1, 2002,
the functional currency became the Euro. The balance sheet
accounts of our subsidiary 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 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, 2000, 2001 and 2002.



| |                                                      
| | -----------------------------------------------------
| | 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

F-7



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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 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.



| |                             
| | ----------------------------
| | Concentration of Credit Risk

We sell our products primarily to large,
multinational customers in the United States, Europe, Canada,
Australia and Brazil. We derived 28%, 21% and 23% of our total
revenues from customers outside the United States for the years
ended December 31, 2000, 2001 and 2002, respectively. A
significant concentration of our customers is in the insurance,
finance and commercial print service industries. Xerox, acting
as a reseller, was the only customer that accounted for more
than 10% of our revenue in any one year. They accounted for 23%,
19% and 17% for the years ended December 31, 2000, 2001 and
2002, 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 and provide for
anticipated losses in the period in which the revenues are
recognized.



| |                                    
| | -----------------------------------
| | 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 was
made. At the end of each reporting period, we perform a rigorous
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.



| |                        
| | -----------------------
| | Net Deferred Tax Assets

We follow the liability method of accounting for
income taxes, as set forth in SFAS No. 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, 2002, we had
net deferred tax assets of $1.9 million.



| |                                    
| | -----------------------------------
| | 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
business. The net book value of an asset is adjusted to fair

F-8



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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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, 2002 and 2001.



| |                              
| | -----------------------------
| | 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. Prior to 2002,
amortization of goodwill was provided over an estimated life of
15 years. Beginning in 2002, we adopted SFAS No. 142,
Goodwill and Other Intangible Assets, which states that
we annually review goodwill for impairment.



| |                           
| | --------------------------
| | Software Development Costs

In accordance with 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 the 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.



| |         
| | --------
| | Goodwill

Our goodwill was recorded on May 7, 1997,
and had been amortized on a straight-line basis over
15 years. On January 1, 2002, we adopted SFAS
No. 142, Goodwill and Other Intangible Assets and
ceased amortizing our goodwill. Pursuant to this adoption, we
reassessed the underlying value of our goodwill by analyzing the
related future net cash flows and determined that no adjustment
to the carrying value was required. We amortized $70,124 of
goodwill for each of the years ended December 31, 2000 and
2001.



| |                    
| | -------------------
| | Revenue Recognition

We recognize revenue in accordance with SOP 97-2,
Software Revenue Recognition, and SAB No. 101,
Revenue Recognition in Financial Statements. Initial
license fees are recognized when a contract exists, the fee is
fixed and determinable, software delivery has occurred and
collection of the receivable is deemed probable. We use the
residual method to recognize revenue for all of our license
models. Our contracts specifically state the amount of initial
and annual license fees due for each type of software licensed.
If an undelivered element of the arrangement exists under the
license arrangement, revenue is deferred based on
vendor-specific objective evidence of the fair value of the
undelivered element. If vendor-specific objective evidence of
fair value does not exist for all undelivered elements, all
revenue is deferred until sufficient evidence exists or all
elements have been delivered. We recognize revenue on
transactions with payment terms greater than 30 days but
less than twelve months from the contract date, if we have a
history of successfully collecting from the specific customer
without providing concessions. Amounts billed or payments
received in advance of revenue recognition are recorded as
deferred revenue.

We work in conjunction with our established value
added resellers (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

F-9



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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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.

Annual renewal license and support fees
(ALF) are recognized ratably over the contract period.
Included in our ALF are unspecified maintenance releases. Our
contracts do not provide for specific upgrades. Our standard
contracts do not provide for rights of return or conditions of
acceptance; however, in the rare case that acceptance criteria
are provided, revenue is deferred and not recognized until all
conditions are satisfied and written customer acceptance is
obtained.

Revenues generated from consulting services are
recognized as the related services are performed and
collectibility is deemed probable. However, when such 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 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 (i) the phases of our
consulting projects are generally not of great duration
(2-6 weeks on average) and (ii) we have a variety of
projects progressing at the same time, we believe that there are
very limited circumstances where materially different amounts
would be reported under different conditions or using different
assumptions.

We consider our anticipated revenue levels when
making decisions about our operating expenses. 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. Since revenue
may not be recognized in the same quarter as when shipment
occurs and if such fixed expenses are incurred before we
recognize revenues for these shipments, our operating results
would be materially adversely affected.



| |                                        
| | ---------------------------------------
| | Computation of Net Income Per
    Share

We present our earnings per share information in
accordance with SFAS No. 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
227,722, 282,274 and 306,977 shares were excluded from the
calculation of weighted-average shares used in determining
Diluted EPS for 2000, 2001 and 2002, respectively, as their
effect would have been antidilutive.

F-10



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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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

|                                                                             |  |                          |            |      |  |      |           |  |  |  |           | 
|---------------------------------------------------------------------------- |  | ------------------------ | ---------- | ---- |  | ---- | --------- |  |  |  | --------- | 
|                                                                             |  |                         
|                                                                             |  | Years Ended December 31,
|                                                                             |  |                         
|                                                                             |  | 2000                     |            | 2001 |  | 2002
|                                                                             |  |                          |            |      |  |     
|Weighted average common shares outstanding used
    in basic EPS calculation |  |                          | 10,771,588 |      |  |      | 5,547,872 |  |  |  | 3,843,850 | 
|Effect of dilutive stock options                                             |  |                          | 382,305    |      |  |      | 282,856   |  |  |  | 442,635   | 
|                                                                             |  |                          |            |      |  |      |           |  |  |  |           | 
|Shares used in diluted EPS calculation                                       |  |                          | 11,153,893 |      |  |      | 5,830,728 |  |  |  | 4,286,485 | 
|                                                                             |  |                          |            |      |  |      |           |  |  |  |           | 



| |                         
| | ------------------------
| | Stock-Based Compensation

As permitted by SFAS No. 123, Accounting
for Stock-based Compensation, we have elected to follow APB
Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations in accounting for its
employee stock options. Under APB Opinion No. 25, among
other things, when the exercise price of our employee stock
options is not less than the market price of the underlying
stock on the date of grant, no compensation expense is
recognized.

As required under SFAS No. 123,
Accounting for Stock-Based Compensation, and SFAS
No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure, the pro
forma effects of stock-based compensation on net income and net
earnings per common share have been estimated at the date of
grant using the Black-Scholes option pricing model based on the
following weighted-average assumptions: risk-free interest rates
of 4%, dividend yields of 0%, expected volatility of .59 and a
weighted-average expected life of the option of seven years.

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 No. 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:

|                                                           |  |                          |          |      |  |      |         |  |  |   |           | 
|---------------------------------------------------------- |  | ------------------------ | -------- | ---- |  | ---- | ------- |  |  | - | --------- | 
|                                                           |  |                         
|                                                           |  | Years Ended December 31,
|                                                           |  |                         
|                                                           |  | 2000                     |          | 2001 |  | 2002
|                                                           |  |                          |          |      |  |     
|Adjusted pro forma basic net income (loss)                 |  | $                        | (292,321 | )    |  | $    | 541,356 |  |  | $ | 1,005,322 | 
|Adjusted pro forma basic net income
    (loss) per share   |  | $                        | (0.03    | )    |  | $    | 0.10    |  |  | $ | 0.26      | 
|Adjusted pro forma diluted net income
    (loss) per share |  | $                        | (0.03    | )    |  | $    | 0.09    |  |  | $ | 0.23      | 

Comprehensive
Income

In 1998, we adopted SFAS No. 130,
Reporting Comprehensive Income. SFAS No. 130
requires that all components of comprehensive income, including
net income, be reported in the financial statements in the
period they are recognized. Comprehensive income is defined as
the change in equity during a period from transactions and other
events and circumstances from non-owner sources. Net income and
other comprehensive income, 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. We have disclosed
comprehensive income in our financial statements accordingly.

Segment
Information

In 1998, we adopted SFAS No. 131,
Disclosures about Segments of an Enterprise and Related
Information. SFAS No. 131 amends the requirements for
public enterprises to report financial and

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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

descriptive information about their reportable
operating segments. Operating segments, as defined in SFAS
No. 131, 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 No. 131.

Recently
Issued Accounting Pronouncements

In December 2002, the FASB issued SFAS
No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure 
an Amendment of FASB Statement No. 123. This statement
amends SFAS No. 123 Accounting for Stock-Based
Compensation to provide alternative methods of
voluntarily transitioning to the fair value based method of
accounting for stock-based employee compensation. SFAS
No. 148 also amends the disclosure requirements of SFAS
No. 123 to require disclosure of the method used to account
for stock-based employee compensation and the effect of the
method on reported results in both annual and interim financial
statements. The disclosure provisions will be effective for us
beginning with our year ended December 31, 2003. We have
not yet completed the final evaluation of the options presented
by SFAS No. 148. However, within this fiscal year, we
expect to reach a determination of whether and, if so, when to
change our existing accounting for stock-based compensation to
the fair value method in accordance with the transition
alternatives of SFAS No. 148.

In June 2002, the FASB issued SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal.
SFAS No. 146 addresses financial accounting and reporting
for costs associated with exit or disposal activities and
nullifies EITF Issue No. 94-3, Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a
Restructuring). The principal difference between SFAS
No. 146 and Issue 94-3 relates to SFAS No. 146s
requirements for recognition of a liability for a cost
associated with an exit or disposal activity. SFAS No. 146
requires that a liability for a cost associated with an exit or
disposal activity be recognized when the liability is incurred.
Under Issue 94-3, a liability for an exit cost as generally
defined in Issue 94-3 was recognized at the date of an
entitys commitment to an exit plan. The provisions of SFAS
No. 146 are effective for exit or disposal activities that
are initiated after December 31, 2002, with early
application encouraged. We will adopt SFAS No. 146
effective January 1, 2003. We do not expect that the
adoption of SFAS No. 146 will have a material impact on our
financial statements.

2.     Financial
Statement Information

Investments

We have classified all of our investment
securities as available-for-sale. The following table summarizes
available-for-sale securities at December 31, 2001 and 2002:

|                                   |  |      |           |            |  |            |        |            |  |   |       |  |  |   |           | 
|---------------------------------- |  | ---- | --------- | ---------- |  | ---------- | ------ | ---------- |  | - | ----- |  |  | - | --------- | 
|                                   |  |      |           | Gross      |  | Gross      |        |           
|                                   |  |      |           | Unrealized |  | Unrealized |        | Estimated 
|                                   |  | Cost |           | Gains      |  | Losses     |        | Fair Value
|                                   |  |      |           |            |  |            |        |           
|December 31, 2001                  |  |      |           |            |  |            |        |            |  |   |       |  |  |   |           | 
|U.S. government agency obligations |  | $    | 5,664,527 |            |  | $          | 73,139 |            |  | $ | 1,466 |  |  | $ | 5,736,200 | 
|                                   |  |      |           |            |  |            |        |            |  |   |       |  |  |   |           | 
|December 31, 2002                  |  |      |           |            |  |            |        |            |  |   |       |  |  |   |           | 
|U.S. government agency obligations |  | $    | 6,218,244 |            |  | $          | 76,594 |            |  | $ |      |  |  | $ | 6,294,838 | 
|                                   |  |      |           |            |  |            |        |            |  |   |       |  |  |   |           | 

F-12



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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The amortized cost and estimated fair value of
available-for-sale securities at December 31, 2002, by
contractual maturity, are shown below:

|                                       |  |      |           |            |  |   |           | 
|-------------------------------------- |  | ---- | --------- | ---------- |  | - | --------- | 
|                                       |  |      |           | Estimated 
|                                       |  | Cost |           | Fair Value
|                                       |  |      |           |           
|Due in one year or less                |  | $    | 3,780,424 |            |  | $ | 3,812,769 | 
|Due after one year through three years |  |      | 2,437,820 |            |  |   | 2,482,069 | 
|                                       |  |      |           |            |  |   |           | 
|                                       |  | $    | 6,218,244 |            |  | $ | 6,294,838 | 
|                                       |  |      |           |            |  |   |           | 

Property and
Equipment

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

|                                               |  |      |            |      |  |   |            |  
|---------------------------------------------- |  | ---- | ---------- | ---- |  | - | ---------- | -
|                                               |  | 2001 |            | 2002
|                                               |  |      |            |     
|Computer equipment                             |  | $    | 1,358,695  |      |  | $ | 1,201,270  |  
|Office equipment                               |  |      | 311,889    |      |  |   | 268,478    |  
|Office furniture and fixtures                  |  |      | 448,175    |      |  |   | 404,268    |  
|Leasehold improvements                         |  |      | 523,423    |      |  |   | 523,423    |  
|                                               |  |      |            |      |  |   |            |  
|                                               |  |      | 2,642,182  |      |  |   | 2,397,439  |  
|Less accumulated depreciation and amortization |  |      | (1,463,582 | )    |  |   | (1,615,565 | )
|                                               |  |      |            |      |  |   |            |  
|                                               |  | $    | 1,178,600  |      |  | $ | 781,874    |  
|                                               |  |      |            |      |  |   |            |  

The cost of equipment acquired under capital
leases totaled $176,715 at December 31, 2001 and 2002, with
accumulated depreciation of $173,773 and $176,715 at
December 31, 2001 and 2002, respectively.

Deferred
Revenue

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

|                     |  |      |           |      |  |   |           | 
|-------------------- |  | ---- | --------- | ---- |  | - | --------- | 
|                     |  | 2001 |           | 2002
|                     |  |      |           |     
|Annual license fees  |  | $    | 7,378,097 |      |  | $ | 8,600,284 | 
|Initial license fees |  |      | 353,998   |      |  |   | 465,000   | 
|Services and other   |  |      | 119,575   |      |  |   | 624,490   | 
|                     |  |      |           |      |  |   |           | 
|                     |  | $    | 7,851,670 |      |  | $ | 9,689,774 | 
|                     |  |      |           |      |  |   |           | 

F-13



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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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, 2000    |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Sales to unaffiliated customers |  | $             | 15,859,272 |        |  | $            | 1,532,215 |        |  | $ |        |   |  | $ | 17,391,487 |  
|Sales to affiliates             |  |               | 2,859,786  |        |  |              | 2,327,654 |        |  |   |        |   |  |   | 5,187,440  |  
|                                |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Revenues                        |  | $             | 18,719,058 |        |  | $            | 3,859,869 |        |  | $ |         |   |  |   |           |  
|                                |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Operating income (loss)         |  | $             | (551,081   | )      |  | $            | 135,465   |        |  | $ |        |   |  | $ | (415,616   | )
|                                |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Identifiable assets             |  | $             | 31,264,827 |        |  | $            | 248,233   |        |  | $ | (16,666 | ) |  | $ | 31,496,394 |  
|                                |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Year ended December 31, 2001    |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Sales to unaffiliated customers |  | $             | 16,949,144 |        |  | $            | 1,045,804 |        |  | $ |        |   |  | $ | 17,994,948 |  
|Sales to affiliates             |  |               | 2,495,863  |        |  |              | 1,628,826 |        |  |   |        |   |  |   | 4,124,689  |  
|                                |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Revenues                        |  | $             | 19,445,007 |        |  | $            | 2,674,630 |        |  | $ |        |   |  | $ | 22,119,637 |  
|                                |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Operating income                |  | $             | 320,977    |        |  | $            | 38,369    |        |  | $ |        |   |  | $ | 359,346    |  
|                                |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Identifiable assets             |  | $             | 19,530,350 |        |  | $            | 192,488   |        |  | $ | (16,666 | ) |  | $ | 19,706,172 |  
|                                |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Year ended December 31, 2002    |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Sales to unaffiliated customers |  | $             | 17,846,745 |        |  | $            | 1,232,859 |        |  | $ |        |   |  | $ | 19,079,604 |  
|Sales to affiliates             |  |               | 2,063,877  |        |  |              | 1,942,298 |        |  |   |        |   |  |   | 4,006,175  |  
|                                |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Revenues                        |  | $             | 19,910,622 |        |  | $            | 3,175,157 |        |  | $ |        |   |  | $ | 23,085,779 |  
|                                |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Operating income                |  | $             | 1,052,746  |        |  | $            | 119,802   |        |  | $ |        |   |  | $ | 1,172,548  |  
|                                |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  
|Identifiable assets             |  | $             | 20,975,455 |        |  | $            | 225,877   |        |  | $ | (16,666 | ) |  | $ | 21,184,666 |  
|                                |  |               |            |        |  |              |           |        |  |   |         |   |  |   |            |  

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

4.     Commitments

We lease our headquarters in Carlsbad, California
under an operating lease expiring on February 28, 2005.
Under the terms of the lease, effective March 1, 1999,
monthly rental payments will be increased annually by 4%. 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 4%. 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 Paris,

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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

France and Milwaukee, Wisconsin are under
operating leases expiring on April 15, 2004 and
June 30, 2003, respectively. Annual future minimum lease
payments as of December 31, 2002 are as follows:

|                          |  |   |         | 
|------------------------- |  | - | ------- | 
|Years ending December 31, |  |  
|                          |  |  
|2003                      |  | $ | 368,716 | 
|2004                      |  |   | 350,781 | 
|2005                      |  |   | 72,413  | 
|                          |  |   |         | 
|                          |  | $ | 791,910 | 
|                          |  |   |         | 

Rent expense for the years ended
December 31, 2000, 2001 and 2002 was $492,886, $545,202 and
$460,347 respectively.

Effective January 16, 2002, we entered into
a formal two-year development services and referral agreement
with Objectiva. We have committed to pay Objectiva
$3.1 million over the two-year term of the agreement for
development services to be provided by a dedicated team. The
agreement is cancelable within 30 days due to material
breach or with 90 days notice if all scheduled work has
been completed. We would prorate the two-year fee in the case of
early termination. We owe 12 monthly payments of $129,166
through January 15, 2004. Objectiva is a software
engineering company headquartered in Carlsbad, California.

5.     Stockholders
Equity

Stock

As of December 31, 2002, 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 incentive and nonstatutory options to purchase
common shares to eligible employees, officers, directors and
consultants. Our 1993 and 1995 Stock Option Plans (the
Plans) provided for the issuance of up to
2,279,250 shares. These Plans have been amended to provide
for the issuance of an additional 2,100,000 shares. The
Board of Directors, subject to the provisions of the 1995 Plan,
determines the terms of stock purchase or stock option
agreements, including vesting requirements. The maximum term of
the options granted under the Plans is ten years. The exercise
price of incentive stock options must equal at least the fair
market value on the date of grant. The exercise price of
nonstatutory stock options and stock issued under purchase
rights must equal at least 85% of the fair market value on the
date of grant or time of issuance.

F-15



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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following table summarizes stock option
activity under the stock incentive plans:

|                             |           |             |           |              |   |                  |            |             |  |   |      |      | 
|---------------------------- | --------- | ----------- | --------- | ------------ | - | ---------------- | ---------- | ----------- |  | - | ---- | ---- | 
|                             |           | Number of   |           |              |   | Weighted Average
|                             |           | Shares      |           | Option Price |   | Exercise Price  
|                             |           | Outstanding |           | Per Share    |   | Per Share       
|                             |           |             |           |              |   |                 
|Balance at December 31, 2000 |           |             | 1,634,914 |              |   | $                | .03-$10.00 |             |  | $ | 2.17 |     
|                             | Granted   |             |           | 520,150      |   |                  | $          | .91-$ 2.64  |  |   | $    | 1.50 | 
|                             | Exercised |             |           | (44,406      | ) |                  | $          | .03-$ 1.97  |  |   | $    | 0.27 | 
|                             | Canceled  |             |           | (395,943     | ) |                  | $          | 1.13-$10.00 |  |   | $    | 2.27 | 
|                             |           |             |           |              |   |                  |            |             |  |   |      |     
|Balance at December 31, 2001 |           |             | 1,714,715 |              |   | $                | .17-$10.00 |             |  | $ | 1.98 |     
|                             | Granted   |             |           | 341,800      |   |                  | $          | 1.99-$ 3.09 |  |   | $    | 2.48 | 
|                             | Exercised |             |           | (45,030      | ) |                  | $          | .17-$ 2.38  |  |   | $    | 0.64 | 
|                             | Canceled  |             |           | (85,547      | ) |                  | $          | 1.50-$10.00 |  |   | $    | 2.33 | 
|                             |           |             |           |              |   |                  |            |             |  |   |      |     
|Balance at December 31, 2002 |           |             | 1,925,938 |              |   | $                | .17-$10.00 |             |  | $ | 2.08 |     
|                             |           |             |           |              |   |                  |            |             |  |   |      |     

As of December 31, 2002, 769,711 shares
were available for future grant. Following is a breakdown of the
options outstanding and exercisable as of December 31, 2002:

|                 |  |             |           |               |  |             |      |             |  |             |      |  |  |  |           |  |  |   |      | 
|---------------- |  | ----------- | --------- | ------------- |  | ----------- | ---- | ----------- |  | ----------- | ---- |  |  |  | --------- |  |  | - | ---- | 
|                 |  |             |           |               |  | Weighted    |      |             |  | Weighted   
|                 |  |             |           |               |  | Average     |      |             |  | Average    
|                 |  |             |           | Weighted      |  | Exercise    |      |             |  | Exercise   
|                 |  |             |           | Average       |  | Price of    |      |             |  | Price of   
|Range of         |  | Options     |           | Remaining     |  | Options     |      | Options     |  | Options    
|Exercise Prices  |  | Outstanding |           | Life in years |  | Outstanding |      | Exercisable |  | Exercisable
|                 |  |             |           |               |  |             |      |             |  |            
|$0.17            |  |             | 11,033    |               |  |             | 1.71 |             |  | $           | 0.17 |  |  |  | 11,033    |  |  | $ | 0.17 | 
|$0.67-$1.61      |  |             | 727,600   |               |  |             | 7.78 |             |  | $           | 1.45 |  |  |  | 438,841   |  |  | $ | 1.46 | 
|$1.70-$4.00      |  |             | 1,141,246 |               |  |             | 7.22 |             |  | $           | 2.29 |  |  |  | 713,928   |  |  | $ | 2.22 | 
|$4.69-$10.00     |  |             | 46,059    |               |  |             | 4.40 |             |  | $           | 7.13 |  |  |  | 42,777    |  |  | $ | 7.30 | 
|                 |  |             |           |               |  |             |      |             |  |             |      |  |  |  |           |  |  |   |      | 
|Total or Average |  |             | 1,925,938 |               |  |             | 7.33 |             |  | $           | 2.08 |  |  |  | 1,206,579 |  |  | $ | 2.11 | 
|                 |  |             |           |               |  |             |      |             |  |             |      |  |  |  |           |  |  |   |      | 

F-16



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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Our 1997 Employee Stock Purchase Plan provided
for the issuance of shares of our common stock, up to a total of
350,000 shares, to eligible employees. The price of the
common shares purchased under the Plan was equal to 85% of the
fair market value of the common shares on the first or last day
of the offering period, whichever was lower. Employees who chose
to participate in the plan could withhold between one and ten
percent of their wages. However, an employee could not purchase
more than 5,000 shares in any one offering period. As of
December 31, 2002, all 350,000 had been purchased on this
plan and no shares were available for issuance.

6.     Income
Taxes

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

|              |  |                          |         |      |  |      |         |  |  |   |           | 
|------------- |  | ------------------------ | ------- | ---- |  | ---- | ------- |  |  | - | --------- | 
|              |  |                         
|              |  | Years Ended December 31,
|              |  |                         
|              |  | 2000                     |         | 2001 |  | 2002
|              |  |                          |         |      |  |     
|United States |  | $                        | 409,500 |      |  | $    | 601,898 |  |  | $ | 1,146,649 | 
|Foreign       |  |                          | 135,465 |      |  |      | 38,369  |  |  |   | 119,802   | 
|              |  |                          |         |      |  |      |         |  |  |   |           | 
|              |  | $                        | 544,965 |      |  | $    | 640,267 |  |  | $ | 1,266,451 | 
|              |  |                          |         |      |  |      |         |  |  |   |           | 

The provision (benefit) for income taxes is
as follows:

|                   |         |                          |        |        |  |      |       |       |  |   |          |          |  
|------------------ | ------- | ------------------------ | ------ | ------ |  | ---- | ----- | ----- |  | - | -------- | -------- | -
|                   |         |                         
|                   |         | Years Ended December 31,
|                   |         |                         
|                   |         | 2000                     |        | 2001   |  | 2002
|                   |         |                          |        |        |  |     
|Current:           |         |                          |        |        |  |      |       |       |  |   |          |         
|                   | Federal |                          | $      | 14,026 |  |      | $     | 1,807 |  |   | $        | 0        |  
|                   | Foreign |                          |        | 0      |  |      |       | 0     |  |   |          | 11,411   |  
|                   |         |                          |        |        |  |      |       |       |  |   |          |         
|                   | Federal |                          |        | 14,026 |  |      |       | 1,807 |  |   |          | 11,411   |  
|Deferred (credit): |         |                          |        |        |  |      |       |       |  |   |          |         
|                   | Federal |                          |        | 0      |  |      |       | 0     |  |   |          | (305,000 | )
|                   |         |                          |        |        |  |      |       |       |  |   |          |         
|                   |         | $                        | 14,026 |        |  | $    | 1,807 |       |  | $ | (293,589 | )       
|                   |         |                          |        |        |  |      |       |       |  |   |          |         

F-17



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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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,
|                               |                                                          |             
|                               |                                                          | 2000         |           | 2001      |   | 2002
|                               |                                                          |              |           |           |   |     
|Deferred tax assets:           |                                                          |              |           |           |   |      |           |           |   |   |           |          
|                               | Operating loss carryforwards                             |              | $         | 1,921,300 |   |      | $         | 1,853,600 |   |   | $         | 1,611,600 |  
|                               | Accrued liabilities                                      |              |           | 552,300   |   |      |           | 355,200   |   |   |           | 358,500   |  
|                               | Tax credits                                              |              |           | 431,600   |   |      |           | 490,800   |   |   |           | 581,200   |  
|                               |                                                          |              |           |           |   |      |           |           |   |   |           |          
|Total deferred tax assets      |                                                          |              | 2,905,200 |           |   |      | 2,699,600 |           |   |   | 2,551,300 |          
|Deferred tax liabilities:      |                                                          |              |           |           |   |      |           |           |   |   |           |          
|                               | Computer software development costs expensed for
    tax |              |           | (502,200  | ) |      |           | (421,200  | ) |   |           | (556,200  | )
|                               | Excess tax depreciation                                  |              |           | (138,800  | ) |      |           | (80,800   | ) |   |           | (43,800   | )
|                               |                                                          |              |           |           |   |      |           |           |   |   |           |          
|Total deferred tax liabilities |                                                          |              | (641,000  | )         |   |      | (502,000  | )         |   |   | (600,000  | )        
|                               |                                                          |              |           |           |   |      |           |           |   |   |           |          
|Net deferred tax assets        |                                                          |              | 2,264,200 |           |   |      | 2,197,600 |           |   |   | 1,951,300 |          
|Valuation allowance            |                                                          |              | 2,264,200 |           |   |      | 2,197,600 |           |   |   | 1,646,300 |          
|                               |                                                          |              |           |           |   |      |           |           |   |   |           |          
|Net deferred tax asset         |                                                          | $            | 0         |           |   | $    | 0         |           |   | $ | 305,000   |          
|                               |                                                          |              |           |           |   |      |           |           |   |   |           |          

At December 31, 2002, we had net deferred
tax assets of $2.0 million. Due to the uncertainty of
realizing a portion of these net deferred tax assets, we have
maintained a valuation allowance of $1.6 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. No valuation allowance has been recorded to offset
the remaining $305,000 of net deferred tax assets as we have
determined that it is more likely than not that these assets
will be realized during the year ending December 31, 2003.
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 record
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, 2002, we have federal net
operating loss carryforwards of approximately $4.7 million
that will begin expiring in 2018 unless previously utilized. At
December 31, 2002, we have federal and state research and
development tax credit carryforwards of approximately $489,400
and $78,000, respectively, that will begin expiring in 2012
unless previously utilized.

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.

F-18



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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The differences between our income tax provision
and the amounts computed by applying the statutory Federal
income tax rate of 35% in 2000, 2001 and 2002 to income before
income taxes are as follows:

|                                           |  |              |          |      |  |      |          |   |  |   |          |  
|------------------------------------------ |  | ------------ | -------- | ---- |  | ---- | -------- | - |  | - | -------- | -
|                                           |  |             
|                                           |  | December 31,
|                                           |  |             
|                                           |  | 2000         |          | 2001 |  | 2002
|                                           |  |              |          |      |  |     
|Provision at statutory rate                |  | $            | 185,829  |      |  | $    | 224,093  |   |  | $ | 443,258  |  
|Benefit for graduated rates                |  |              | (5,450   | )    |  |      | (6,402   | ) |  |   | (12,665  | )
|Increase (decrease) in valuation allowance |  |              | (103,600 | )    |  |      | (66,600  | ) |  |   | (551,300 | )
|Permanent differences and other            |  |              | (62,753  | )    |  |      | (149,284 | ) |  |   | (172,882 | )
|                                           |  |              |          |      |  |      |          |   |  |   |          |  
|Provision (benefit) for income taxes       |  | $            | 14,026   |      |  | $    | 1,807    |   |  | $ | (293,589 | )
|                                           |  |              |          |      |  |      |          |   |  |   |          |  

7.     Transactions
with Affiliates

We have distribution agreements with affiliates
providing the non-exclusive right to sub-license our software in
Canada, Australia and Brazil. The terms of the distributor
agreements provide that the affiliates receive a discount from
the list price of our licensed products and annual license fees.
Revenues from the affiliates under these agreements, net of
discounts, were $2.4 million, $2.1 million and
$1.7 million in 2000, 2001 and 2002, respectively. Included
in accounts receivable are $707,000, $762,600 and $504,100 from
these revenues at December 31, 2000, 2001 and 2002,
respectively.

We have distribution agreements with affiliates
providing the non-exclusive right to sub-license our software in
Europe. Revenues under these agreements were $2.3 million,
$1.6 million and $1.9 million in 2000, 2001 and 2002,
respectively. Related accounts receivable are $564,500, $660,400
and $661,900 at December 31, 2000, 2001 and 2002,
respectively.

We also license software to Xerox and affiliates
of Xerox in the United States. These revenues were $443,700,
$430,300 and $410,100 in 2000, 2001 and 2002, respectively.
Related accounts receivable are $332,600, $316,800 and $76,200
at December 31, 2000, 2001 and 2002, respectively.

On February 16, 2001, we commenced a self
tender offer for 6,000,000 shares of our outstanding common
stock. Xerox tendered all of its shares of Document Sciences
common stock in the offer. The tender offer expired on
March 23, 2001. In April 2001, we completed our tender
offer and purchased 6,000,000 shares of our outstanding
common stock for $2.00 per share.

On February 16, 2001, Xerox also granted us
an option to purchase up to 2,000,000 additional shares of our
stock it owned after completion of the tender offer at the
tender offer price. On April 16, 2001, we executed two
promissory notes payable to Xerox pursuant to our exercise of
the option to purchase 1,139,600 shares of our common stock
owned by Xerox at $2.00 per share. Both notes were paid in
February 2002.

As a result of our tender offer and our exercise
of the option to purchase additional shares of Xerox, Xerox
presently owns less than 20% of our outstanding shares.

8.     Sales
Commitments

Beginning in 1999 through December 31, 2001,
we selectively licensed software to a subset of our customers
for non-cancelable three-year terms. Where we provided extended
payment terms to customers (allowing them to make payments on a
quarterly or annual basis), we recognized license revenue when
invoices came due, as SOP 97-2 precluded us from recognizing the
portion of these licenses that was not currently due from the
customer. In 2002, we have not licensed any software in this
manner.

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DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

We also began signing customers to non-cancelable
three-year maintenance agreements, which we recognize ratably
over the service period. Amounts to be invoiced are not
initially reflected on our Balance Sheet and are identified
below. As we invoice against these agreements, the invoiced
amounts are recorded first to Deferred Revenue and are then
recognized as revenue ratably over the service period.

The following table summarizes these multi-year
license and maintenance agreement activities showing ending
balances not reflected on our Balance Sheet at December 31,
2002:

|                                          |  |                              |          |             |  |        |            |   |  |   |            |  
|----------------------------------------- |  | ---------------------------- | -------- | ----------- |  | ------ | ---------- | - |  | - | ---------- | -
|                                          |  |                             
|                                          |  | Unrecognized Revenue Backlog
|                                          |  |                             
|                                          |  |                              |          | Maintenance |  |       
|                                          |  | Licenses                     |          | Agreements  |  | Totals
|                                          |  |                              |          |             |  |       
|Balances at December 31, 1999             |  | $                            | 841,030  |             |  | $      | 2,925,517  |   |  | $ | 3,766,547  |  
|2000 additions                            |  |                              | 66,329   |             |  |        | 3,171,475  |   |  |   | 3,237,804  |  
|Invoiced and included in deferred revenue |  |                              | (419,295 | )           |  |        | (2,674,323 | ) |  |   | (3,093,618 | )
|                                          |  |                              |          |             |  |        |            |   |  |   |            |  
|Balances at December 31, 2000             |  |                              | 488,064  |             |  |        | 3,422,669  |   |  |   | 3,910,733  |  
|2001 additions                            |  |                              | 23,334   |             |  |        | 2,830,831  |   |  |   | 2,854,165  |  
|Invoiced and included in deferred revenue |  |                              | (484,257 | )           |  |        | (3,193,020 | ) |  |   | (3,677,277 | )
|                                          |  |                              |          |             |  |        |            |   |  |   |            |  
|Balances at December 31, 2001             |  |                              | 27,141   |             |  |        | 3,060,480  |   |  |   | 3,087,621  |  
|2002 additions                            |  |                              | -0-      |             |  |        | 2,508,365  |   |  |   | 2,508,365  |  
|Invoiced and included in deferred revenue |  |                              | (27,141  | )           |  |        | (3,011,460 | ) |  |   | (3,038,601 | )
|                                          |  |                              |          |             |  |        |            |   |  |   |            |  
|Balances at December 31, 2002             |  | $                            | -0-      |             |  | $      | 2,557,385  |   |  | $ | 2,557,385  |  
|                                          |  |                              |          |             |  |        |            |   |  |   |            |  

All revenue from the unrecognized revenue backlog
will have been recognized by the end of the second quarter of
2006.

9.     Employee
Retirement Plan



| |            
| | -----------
| | 401(k) Plan

We have an employee savings and retirement plan
(the 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, 2000, 2001 and
2002, we made discretionary contributions of $358,222, $304,146
and $275,469, respectively.

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##### Table of Contents



DOCUMENT SCIENCES CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

10.     Financial
Statements and Supplementary Data

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

|                                |  |                |           |         |  |              |           |             |  |   |           |  |  |   |           | 
|------------------------------- |  | -------------- | --------- | ------- |  | ------------ | --------- | ----------- |  | - | --------- |  |  | - | --------- | 
|                                |  |               
|                                |  | Quarters Ended
|                                |  |               
|                                |  | March 31       |           | June 30 |  | September 30 |           | December 31
|                                |  |                |           |         |  |              |           |            
|2001                            |  |                |           |         |  |              |           |             |  |   |           |  |  |   |           | 
|Revenues                        |  | $              | 5,257,439 |         |  | $            | 5,654,141 |             |  | $ | 5,032,409 |  |  | $ | 6,175,648 | 
|Cost of revenues                |  |                | 1,683,494 |         |  |              | 1,394,637 |             |  |   | 1,337,854 |  |  |   | 1,570,307 | 
|Net income                      |  |                | (351,582  | )       |  |              | 723,488   |             |  |   | 196,118   |  |  |   | 70,436    | 
|Basic income per share          |  |                | (0.03     | )       |  |              | 0.19      |             |  |   | 0.05      |  |  |   | 0.02      | 
|Diluted income per share        |  |                | (0.03     | )       |  |              | 0.19      |             |  |   | 0.05      |  |  |   | 0.02      | 
|2002                            |  |                |           |         |  |              |           |             |  |   |           |  |  |   |           | 
|Revenues                        |  | $              | 4,846,631 |         |  | $            | 5,649,725 |             |  | $ | 5,995,030 |  |  | $ | 6,594,393 | 
|Cost of revenues                |  |                | 1,403,313 |         |  |              | 1,399,741 |             |  |   | 1,563,443 |  |  |   | 1,353,629 | 
|Net income (loss)               |  |                | (588,926  | )       |  |              | 491,943   |             |  |   | 551,031   |  |  |   | 1,105,992 | 
|Basic income (loss) per share   |  |                | (0.15     | )       |  |              | 0.13      |             |  |   | 0.14      |  |  |   | 0.29      | 
|Diluted income (loss) per share |  |                | (0.15     | )       |  |              | 0.12      |             |  |   | 0.13      |  |  |   | 0.26      | 

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SCHEDULE II

DOCUMENT SCIENCES CORPORATION






VALUATION AND QUALIFYING ACCOUNTS


|                             |                                 |            |   |            |  |            |   |             |  |  |   |         |  |  |   |           | 
|---------------------------- | ------------------------------- | ---------- | - | ---------- |  | ---------- | - | ----------- |  |  | - | ------- |  |  | - | --------- | 
|                             |                                 | Balance at |   | Charged to |  |            |   |            
|                             |                                 | Beginning  |   | Costs and  |  |            |   | Balance at 
|                             |                                 | of Year    |   | Expenses   |  | Deductions |   | End of Year
|                             |                                 |            |   |            |  |            |   |            
|Year Ended December 31, 2000 |                                 |            |   |            |  |            |   |             |  |  |   |         |  |  |   |          
|                             | Allowance for doubtful accounts |            | $ | 765,873    |  |            | $ | 658,165     |  |  | $ | 411,861 |  |  | $ | 1,012,177 | 
|Year Ended December 31, 2001 |                                 |            |   |            |  |            |   |             |  |  |   |         |  |  |   |          
|                             | Allowance for doubtful accounts |            |   | 1,012,177  |  |            |   | 113,000     |  |  |   | 697,494 |  |  |   | 427,683   | 
|Year Ended December 31, 2002 |                                 |            |   |            |  |            |   |             |  |  |   |         |  |  |   |          
|                             | Allowance for doubtful accounts |            |   | 427,683    |  |            |   | -0-         |  |  |   | 94,117  |  |  |   | 333,566   | 

S-1