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

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# FORM 10-K

# [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE 
SECURITIES EXCHANGE ACT OF 1934 
For the fiscal year ended December 31, 2003

# [  ] TRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE 
SECURITIES EXCHANGE ACT OF 1934 
For the transition period from ________________ TO ________________.

Commission file number: 000-30203

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# NUANCE COMMUNICATIONS,
INC.

(Exact name of registrant as specified in
its charter)

|DELAWARE                                                       | 94-3208477                             
|-------------------------------------------------------------- | ---------------------------------------
|(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification Number)

|1005 Hamilton Court, Menlo Park, California | 94025     
|------------------------------------------- | ----------
|(Address of principal office)               | (Zip code)

Registrant's telephone  number, including area code: (650) 847-0000

Securities registered pursuant to section 12(b) of the act: None

Securities registered pursuant to section 12(g) of the act: Common stock, $0.001 par value Rights to Purchase Series A Preferred Stock, $0.001 par value

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

Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is
not contained herein, and will not be contained, to the best of the 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.  No  [ ]

Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Act). Yes |X| No [ ]

The
aggregate market value of the voting stock held by non-affiliates of the registrant was
approximately $150,600,000 as of June 30, 2003 based on the closing price of the Common
Stock as reported on the NASDAQ National Market System as of the last business day of the
registrants most recently completed second fiscal quarter. Shares of Common Stock
held by each executive officer and director and by each person who owns 5% or more of the
outstanding Common Stock have been excluded in that such persons may be deemed to be
affiliates. The determination of affiliate status is not necessarily a conclusive
determination for other purposes.

There
were 35,100,394 shares of the Registrants Common Stock issued and outstanding on
February 29, 2004.

# DOCUMENTS INCORPORATED
BY REFERENCE

Certain
sections of Nuance Communications, Inc.s definitive Proxy Statement for the 2004
Annual Meeting of Stockholders are incorporated by reference in Part III of this Form 10-K
to the extent stated herein.

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# PART I

This
Annual Report on Form 10-K contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934, including, but not limited to, statements regarding the timing of release of our
products, the growth of our sales, the success of our selling models and the market for
our products in general. Words such as anticipates, expects,
intends, may, will, plans,
believes, seeks, projected, assumes and
estimates and other similar expressions are intended to identify
forward-looking statements. These forward looking statements are not guarantees of future
performance and actual actions or results may differ materially. These statements are
based on information available to us on the date hereof, and we assume no obligation to
update any such statements. These statements involve risks and uncertainties and actual
results could differ materially from those anticipated in these forward-looking statements
as a result of a number of factors, including, but not limited to, those set forth in
Company Risk Factors and elsewhere in this Annual Report on Form 10-K and in
other reports or documents filed by us from time to time with the Securities and Exchange
Commission. In particular, see Company Risk Factors, pages 6 through 8, below.

# ITEM
1.    BUSINESS

Nuance  Communications,  Inc.  (with its  subsidiaries,  the "Company") was  incorporated  in July,  1994, in the state of
California, and subsequently reincorporated in March 2000 in the state of Delaware.

# Industry Background

One
of the greatest challenges facing companies today is managing interactions with customers,
prospects, employees, vendors and the third-party resellers. These interactions are
increasing in volume, especially via the telephone. Managing this growing number of
interactions using human customer service agents creates significant expense.

Many
businesses have invested in touch-tone based interactive voice response (IVR)
systems in order to address this problem. The touch-tone method, however, typically does
not maximize automation potential. Because touch-tone interfaces can be ineffective and
frustrating, user satisfaction can be low and dissatisfied users tend to opt out of the
system to reach a live agent. Similarly, many businesses have invested billions of dollars
in Web self-service systems in the hope that consumers would use the Internet instead of
the telephone as a means to obtain information and transact business. According to
industry analysts, however, the overwhelming majority of all interactions between
businesses and customers still happen via the telephone.

Industry
research reveals that consumers prefer the telephone as a means of interacting with
businesses regardless of the age, gender or profession of the consumer. In order to handle
the growing volume of customer interactions cost effectively, businesses need to automate
telephone interactions. Automating these interactions using speech software is one of the
most powerful, user-friendly and efficient means by which to accomplish this goal.

# The Nuance Solution

We
develop, market and support voice automation solutions for conducting interactions over
the telephone for a range of industries and applications. Our products include speech
recognition software, which is used to recognize what a person says, deliver responses and
information and perform transactions; text-to-speech synthesis software, which converts
information, for example, from a database, email or web page into an audio signal for
delivery over the telephone; voice authentication software, which is used to provide
secure access to information, on a relatively secure basis, by verifying the identity of
speakers using the unique qualities of their voices; pre-packaged speech applications,
that, for instance, efficiently route callers to specific destinations within a company,
and reduce deployment time and cost; and a standards-based software platform designed as a
foundation for voice system deployment and management.

We
seek to actively support both emerging industry standards as well as proprietary
development environments. Our software is designed to work with Voice eXtensible Markup
Language, referred to in this document as (VoiceXML), the recognized industry
standard language for the creation of voice-driven products and services. We also offer a
range of consulting, support and education services that enable our customers and
third-party resellers and channel partners to develop voice automation applications that
use our software products.

# Products and Services

Our
product line consists of speech recognition, voice authentication and text-to-speech
engines, a voice platform and pre-packaged applications. We also offer professional
services to facilitate the development, implementation and support of applications
operating with our software.

Engines

1

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The
Nuance speech recognition software provides speech recognition and natural language
understanding capabilities, enabling recognition and understanding of both simple,
directed responses, such as yes and no, as well as complex,
conversational requests, such as I want to find out how much I owe on my
account or How do I find a store near me?". The software is designed to
operate on standard CPU hardware architectures and operating systems, such as UNIX and
Windows, within a variety of leading touch tone IVR systems. Nuance 8 offers numerous
advanced features and capabilities that enable the highly accurate, engaging and
easy-to-use applications. For example, applications built using Nuances Say
Anythingtechnology allow callers to speak more freely and naturally when
interacting with voice-driven systems. Listen & Learnenables speech
recognition systems to automatically adapt to the unique speech characteristics of a broad
customer base. Finally, AccuBurst optimizes the utilization of system
resources during non-peak periods for improved performance.

Nuance
Verifier software uses the unique characteristics of a persons voice to authenticate
their identity. Users enroll voiceprints by speaking information requested by the
application. The software is then able to authenticate the callers claimed identity
by comparing his speech to the previously enrolled voiceprint. Nuance Verifier is tightly
integrated with Nuances speech recognition engine and operates within the same
distributed architecture, allowing for scalability and robustness, as well as simultaneous
recognition and identity verification.

Nuance
Vocalizer software converts text to speech. This software enables companies to deploy new
and complex applications that require the reading of text from a variety of data sources
and devices. Applications such as reading email, reviewing appointments from a desktop
calendar, checking sales data or accessing stock quotes and bank accounts can be created
with the Nuance Vocalizer product. Nuance Vocalizer eliminates the jarring transition
between recorded prompts and text-to-speech output in speech based applications with our
Speak As One feature. Speak As One uses the same voice
for text-to-speech synthesis as it uses for the recorded prompts, creating a virtually
seamless caller experience.

Voice Platforms

The
Nuance Voice Platform (NVP) is an open, standards-based software platform,
optimized for speech solutions. It leverages the success of Nuance Voice Web Server, the
companys first generation platform, and is tightly integrated with Nuances
speech technology to ensure access to our most advanced features. It also takes full
advantage of VoiceXML and the cost benefits of off-the-shelf hardware. The Nuance Voice
Platform is comprised of four major components:

| | Nuance
Conversation Server:    The Nuance Conversation Server allows the
system to integrate with the telephony network, and enables VoiceXML based speech
interactions by leveraging Nuances industry leading speech technologies.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Nuance
Management Station:    Powerful and secure operations,
administration and maintenance (OA&M) capabilities are available with the Nuance
Management Station. Advanced performance management and reporting features allow system
administrators and operators to efficiently manage and maintain all aspects of their
speech systems to ensure high service availability. At the same time, business managers
can assess how well the system is delivering on key company objectives through features
like the ROI Tracker.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Nuance
Application Environment:    The Nuance Application Environment
accelerates the creation of voice applications with intuitive easy-to-use development
tools that accommodate touch tone IVR application developers, as well as those more
familiar with Web technologies and programming. In addition, the Nuance Application
Environment facilitates integration with back-end web-based infrastructure and legacy
systems.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Nuance
Computer Telephony Integration (CTI) Gateway: Enables rapid integration of the Nuance
Voice Platform with CTI systems provided by a range of vendors.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------

Applications

In
2003, Nuance introduced its first pre-packaged application, Nuance Call Steering. With
Nuance Call Steering, callers can speak naturally and then be routed quickly to the
correct destination.

Nuance
Call Steering serves as a gateway to an organizations contact center, enabling
companies to establish a single point of contact for customers. The product is robust and
flexible, and provides enterprises and telecommunications service providers with the
ability to rapidly and cost-effectively gain the benefits of voice automation. Purchasers
of technical support for Nuance Call Steering can receive ongoing improvements to the
application.

Services

Professional
Services.We offer professional services for customer projects,
and believe that our experience in the design and deployment of voice interface systems is
of substantial value to our customers, providing us with a competitive advantage.
Professional services offerings include prototype development, user interface design,
grammar development, system testing, performance optimization and end-user acceptance
studies, as well as education services through our Speech University program.

2

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Technical
Support and Maintenance.   We offer technical support services for
customers and third-party resellers to assist with development, integration and operation
of our software products. For example, we go on-site to customers, to help them configure
and install the NVP platform. We also offer maintenance services to our customers, which
consist of upgrades and enhancements to our software, as well as telephone support.

# Customers

We
license our software to a broad range of companies and organizations, including those in
the telecommunications, banking and financial services, travel, retail, insurance and
utilities industries. As of December 31, 2003, we had licensed software and/or services to
more than 1,000 corporate enterprises and telecommunications carriers around the world.

# Sales

We
license our products both directly through our sales force and indirectly through
third-party resellers. As of December 31, 2003, we had 70 employees in sales and marketing
serving the United States market and 27 employees in sales and marketing serving
international markets. We also had sales offices in twelve different countries. We license
our products to customers in the United States, Canada, the United Kingdom and other
countries in Europe, China (primarily Hong Kong) and other countries in Asia and Latin
America. International revenues were $21.7 million, $15.6 million and $16.3 million for
2003, 2002 and 2001, respectively. As a percentage of total revenue, international
revenues were 39%, 35% and 42% in 2003, 2002 and 2001, respectively. We anticipate that
markets outside of the United States will continue to represent a significant portion of
total future revenue. We support sales and marketing activities with respect to
international licensing of our software and provision of our services. Almost all
international sales are currently denominated in U.S. dollars. However, we may denominate
increasing amounts of sales in foreign currencies in the future. The majority of our
business is held in the United States and Canada.

Our
sales force focuses on generating demand for our products and services that is fulfilled
either directly by Nuance or indirectly through our third-party resellers. In 2003, 2002
and 2001, indirect sales contributed approximately 58%, 74% and 75%, respectively, of the
companys total revenues and direct sales accounted for the remaining 42%, 26% and
25%, respectively, of total revenues. We believe that, as the market for speech software
solutions continues to develop, sales through our indirect channel will continue to
represent meaningful percentages of our revenues. However, many customers have expressed
an interest in having a direct relationship with Nuance. Nuance is responding to this
customer interest and exploring markets where the Company can most effectively employ its
speech expertise, products and services directly to the end user customer.

Our
third-party resellers increase our geographic sales coverage and address a range of market
and application opportunities for our software. In addition, these third-party resellers
provide end users of our software products with access to additional resources to design,
install and customize applications. Our five largest resellers, based on revenue in 2003,
were Intervoice, Nortel Networks, Edify (a subsidiary of S1 Corporation), Avaya
Communication and Comverse.

For
the year ended December 31, 2003, Telus Communications accounted for 12% of total revenue;
for the year ended December 31, 2002, Nortel Networks accounted for 10% of total revenue;
for the year ended December 31, 2001, Nortel Networks accounted for 18% of total revenue.

The
following is a summary of license, service and maintenance revenue by geographic region
(in thousands):

|                     | Year ended December 31, | 
|-------------------- | ----------------------- | 
|                     |                         | 
|License Revenue:     |                         | 
|United States        |                         | 
|Canada               |                         | 
|Europe               |                         | 
|Asia                 |                         | 
|Latin America        |                         | 
|Australia            |                         | 
|Total                |                         | 
|Service Revenue:     |                         | 
|United States        |                         | 
|Canada               |                         | 
|Europe               |                         | 
|Asia                 |                         | 
|Latin America        |                         | 
|Australia            |                         | 
|Total                |                         | 
|Maintenance Revenue: |                         | 
|United States        |                         | 
|Canada               |                         | 
|Europe               |                         | 
|Asia                 |                         | 
|Latin America        |                         | 
|Australia            |                         | 
|Total                |                         | 
|Total revenue:       |                         | 
|United States        |                         | 
|Canada               |                         | 
|Europe               |                         | 
|Asia                 |                         | 
|Latin America        |                         | 
|Australia            |                         | 
|Total revenue        |                         | 

3

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# Marketing

Our
marketing programs are designed to create awareness for our products and services and
support our direct and indirect sales efforts. We have implemented an integrated mix of
marketing activities, including product marketing, third-party reseller and channel
partner marketing, corporate marketing and industry marketing.

# Research and Development

To
remain competitive in the voice software industry, we must continue to improve our speech
products. Since our formation, we have invested significantly in developing and improving
our core technologies, and related products. Our current research and development
activities include improvements to all products including our speech recognition, voice
authentication and text-to-speech engines, software platform and software applications.
Our research and development expenses were $15.3 million, $14.2 million and $17.7 million
in 2003, 2002 and 2001, respectively. As of December 31, 2003, we had 99 employees
dedicated primarily to research and development.

# Competition

A
number of companies have developed, or are expected to develop, products that compete with
our products. Competitors with respect to speech technologies include Scansoft (which
acquired Speechworks International during 2003), IBM and Microsoft. With respect to our
software platform, there are several vendors, including some of our third-party reseller, who market and sell platforms for voice systems. Furthermore, our competitors
may combine with each other, and other companies may enter our markets by acquiring or
entering into strategic relationships with our competitors. Current and potential
competitors have established, or may establish, cooperative relationships among themselves
or with third parties to increase the abilities of their advanced speech and language
technology products to address the needs of our prospective customers.

Many
of our current and potential competitors have longer operating histories, significantly
greater financial, technical, product development and marketing resources, greater name
recognition and larger customer bases than we do. Our present or future competitors may be
able to develop products comparable or superior to those we offer, adapt more quickly than
we do to new technologies, evolving industry trends and standards or customer
requirements, devote greater resources to the development, promotion and sale of their
products than we do, or leverage their efficiencies or take other actions to compete with
us on the basis of price. Accordingly, competition may intensify and future competition
may harm our business.

We
believe that the principal competitive factors affecting our market include the breadth
and depth of available speech solutions, product quality and performance, core technology,
product scalability and reliability, product features, customer service, the ability to
implement solutions, the value of a given solution, the creation of a base of
referenceable customers and the strength and breadth of third-party reseller and channel
partner relationships. Although we believe that our products and solutions and selling
model currently compete favorably with respect to these factors, the speech market is
relatively new and is changing rapidly. In addition, historically, only a small portion of
our business was comprised of providing complete solutions directly to the market, and our
decision to expand this selling model represents a new business practice for the company.

# Intellectual Property

4

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We
rely upon a combination of patent, copyright, trade secret and trademark laws, as well as
contractual protections, to protect our intellectual property. We have sought to increase
our intellectual property rights by, among other actions, filing multiple U.S. patent
applications, resulting in the issuance of six patents. We have acquired a set of two
additional U.S. patents relevant to our technology. We have taken steps to preserve
certain of our patent rights in various foreign countries. We have issued registrations
and pending applications for our Nuance trademark in the United States and in
our certain foreign markets. In addition, we have issued registrations and pending
applications in the United States for most of our key products. Although we rely on such
protections, we believe that factors such as the technological and creative skills of our
employees, new product developments, frequent product enhancements and reliable product
maintenance are just as important to establishing and maintaining a technology leadership
position. However, we cannot guarantee that others will not develop technologies that are
similar or superior to our technologies.

To
protect our trade secrets, technical know-how and other proprietary information, our
employees are required to enter into agreements providing for the maintenance of
confidentiality and assignment of rights to inventions made by them while employed by us.
We also enter into non-disclosure agreements to protect our confidential information
delivered to third parties and control access to and distribution of our proprietary
information. Despite our efforts to protect our proprietary rights, unauthorized parties
may attempt to copy or otherwise to obtain and use our technology or to develop products
with the same functionality as our products. Monitoring unauthorized use of our
proprietary information and technology is difficult, and we cannot be certain that the
actions we have taken to do so will always prevent misappropriation of our technology,
particularly in foreign countries where the laws may not protect proprietary rights as
fully as do the laws of the United States.

The
software industry is characterized by the existence of a large number of patents and
frequent litigation based on allegations of patent infringement and the violation of
intellectual property rights. Although we attempt to avoid infringing known proprietary
rights of third parties, we may become subject to legal proceedings and claims
for alleged infringement by us or our licensees of third-party proprietary rights, such as
patents, trade secrets, trademarks or copyrights, from time to time in the ordinary course
of business. Any claims relating to the infringement of third-party proprietary rights,
even if not successful or meritorious, could result in costly litigation, divert
managements attention to our business or require us to enter into royalty or license
agreements that can be costly or otherwise disadvantageous to us. In addition, parties making these claims may
be able to obtain injunctions, which could prevent us from selling our products.
Furthermore, although we take precautions, former employers of our employees may assert
that our employees have improperly or unwittingly disclosed confidential or proprietary
information to us without our knowledge. Any of these occurrences could harm our business.
We may be increasingly subject to infringement claims as the number and features of our products increase.

# Employees

As
of December 31, 2003, we had 308 full time employees, comprised of 212 domestic employees
and 96 international employees. We also typically retain a varying number of
independent technical contractors and temporary employees. Except for two employees in
Brazil, none of our employees are represented by a labor union or are subject to a
collective bargaining agreement. We have not experienced any work stoppages and we
consider our relations with our employees to be good.

# Available Information

The
Company is required to file annual, quarterly and special reports, proxy statements and
other information with the SEC. Investors may read and copy any document that the Company
files, including this Annual Report on Form 10-K, at the SECs Public Reference Room
at 450 Fifth Street, N.W. Washington, D.C. 20549. Investors may obtain information on the
operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition,
the SEC maintains an Internet site at www.sec.gov that contains reports, proxy and
information statements, and other information regarding issuers that file electronically
with the SEC, from which investors can electronically access the Companys SEC
filings.

The
Company makes available free of charge on or through its website (www.nuance.com),
its Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form
8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d)
of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable
after it electronically files such material with, or furnishes the material to SEC. The
information on the Companys website is not, and shall not be deemed to be, a part of
this Report or incorporated into any other filings the Company makes with the SEC.

# RISK FACTORS

Investing in our common stock
involves a high degree of risk.  The risks described below are not the only ones
facing our company.  Additional risks not presently known to us or that we deem
immaterial may also impair our business operations.  Any of the following risks could
materially adversely affect our business, operating results and financial condition.

OUR ABILITY TO ACCURATELY FORECAST
OUR QUARTERLY SALES IS LIMITED, OUR SHORT TERM COSTS ARE RELATIVELY FIXED, AND WE EXPECT
OUR BUSINESS TO BE AFFECTED BY SEASONALITY. AS A RESULT, OUR QUARTERLY OPERATING RESULTS
MAY FLUCTUATE.

Our quarterly operating results have
varied significantly in the past and we expect that they will vary significantly from
quarter to quarter in the future. As a result, our quarterly operating results are
difficult to predict. These quarterly variations are caused by a number of factors,
including:

 United States and global
economic and political conditions;

 delays or cancellations in
expected orders by customers who are reducing or deferring spending or adjusting project
plans;

 delays in orders due to the
complex nature of large telephony systems and the associated implementation projects;

 timing of product deployments
and completion of project phases, particularly for large orders and large solution
projects;

 delays in recognition of
revenue in accordance with applicable accounting principles;

 our ability to develop,
introduce, ship and support new and/or enhanced products, such as new versions of our
software platform and applications, that respond to changing technology trends in a timely
manner, and our ability to manage product transitions;

 rate of market adoption for
speech technology and our products, such as our software platform and applications;

 changes in our selling model,
including focus of certain sales representatives on direct sales to end user customers and
the resulting potential for channel conflict;

 unexpected customer
non-renewal of maintenance contracts or lower renewal instances than anticipated;

5

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 delays in the negotiation and
documentation of orders;

 the amount and
timing of our expenses; and

 the utilization rate of our
professional services personnel, which is dependent upon acquisition of new projects as
large scale, multi-quarter projects near completion.

Due in part to these factors, because
the market for our software is relatively new and rapidly changing, and because our
business model is evolving, our ability to accurately forecast our quarterly sales is
limited. In addition, most of our costs are relatively fixed in the short term, even as we
endeavor to manage these costs. We do not know whether our business will grow rapidly
enough to absorb our expenses. If we have a shortfall in revenue in relation to our
expenses, we may be unable to reduce our expenses quickly enough to avoid lower quarterly
operating results. As a result, our quarterly operating results could fluctuate
significantly and unexpectedly from quarter to quarter.

We also expect to experience
seasonality in the sales of our products. For example, we anticipate that sales may be
lower in the first and third quarters of each year due to patterns in the capital
budgeting and purchasing cycles of our current and prospective customers. We also expect
that sales may decline during summer months. These seasonal variations in our sales may
lead to fluctuations in our quarterly operating results. It is difficult for us to
evaluate the degree to which this seasonality may affect our business.

WE DEPEND ON A LIMITED NUMBER OF
CUSTOMERS FOR A SUBSTANTIAL PORTION OF OUR REVENUE DURING ANY GIVEN PERIOD. THE LOSS OF,
OR DELAY IN, A SUBSTANTIAL ORDER COULD SUBSTANTIALLY REDUCE OUR REVENUE IN ANY GIVEN
PERIOD AND HARM OUR BUSINESS.

We derive a significant portion of
our revenue in each period from a limited number of direct and indirect customers. For
example, for the year ended December 31, 2003, our top ten customers accounted for 53 % of
our total revenue. One customer accounted for more than 10% of our total revenue for the
year ended December 31, 2003.

We expect that a small number of
customers with significant customer orders for software product and professional services
will continue to account for a substantial portion of our revenue in any given period.
Generally, customers who make significant purchases from us are not expected to make
subsequent, equally large purchases in the short term, and therefore we must attract new
customers or new significant orders from other customers in order to maintain or increase
our revenues. If we experience delays or cancellations in orders from a major customer, if
an anticipated sale is not made or is deferred, or if our professional services team does
not complete the work on large projects ratably over the quarter or if we fail to
regularly obtain major new customers, our revenue in a given period could be impacted
negatively and our business could be harmed.

WE DEPEND UPON THIRD-PARTY
RESELLERS FOR A SIGNIFICANT PORTION OF OUR SALES. THE LOSS OF KEY THIRD-PARTY RESELLERS,
OR A DECLINE IN THIRD-PARTY RESELLERS RESALE OF OUR PRODUCTS AND SERVICES, COULD
LIMIT OUR ABILITY TO SUSTAIN AND GROW OUR REVENUE.

In 2001, 75% of our revenue was
achieved by indirect sales through third-party resellers. The percentage of revenue
through indirect sales decreased to 74% in 2002 and 58% in 2003. Though this percentage
may decrease in the future, we intend to continue to rely on third-party resellers for a
substantial portion of our future sales. As a result, our revenues are dependent upon the
viability and financial stability of our third-party resellers, as well as upon their
continued interest and success in selling our products. In addition, some of our
third-party resellers are thinly capitalized or otherwise experiencing financial
difficulties. The loss of a significant third-party reseller or our failure to develop new
and viable third-party reseller relationships could limit our ability to sustain and grow
our revenue. Furthermore, significant expansion of our internal sales force in an effort
to replace the loss of a significant third-party reseller would require increased
management attention and higher expenditures.

Our contracts with third-party
resellers do not require a third-party reseller to purchase our products or services. In
fact, many of the third-party resellers with whom we do business offer the products of
some of our competitors, as well as our products. We cannot guarantee that any of our
third-party resellers will continue to market our products or devote significant resources
to doing so. In addition, although we are actively working to manage potential channel
conflicts and maintain strong third-party reseller relationships, certain third-party
reseller relationships may be adversely affected by the introduction of our own platform
product and /or our direct sales activities, either of which may have an unfavorable
impact on revenue from certain third-party resellers. Furthermore, we will, from time to
time, terminate or adjust some of our relationships with third-party resellers in order to
address changing market conditions, adapt such relationships to our business strategy,
resolve disputes, or for other reasons. Any such termination or adjustment could have a
negative impact on our relationships with third-party resellers and our business, and
result in decreased sales through third-party resellers or threatened or actual
litigation. If our third-party resellers do not successfully market and sell our products
or services for these or any other reasons, our sales could be adversely affected and our
revenue could decline. Finally, our third-party resellers possess confidential information
concerning our products and services, product release schedules and sales, marketing and
third-party reseller operations. Although we have nondisclosure agreements with our
third-party resellers, we cannot guarantee that any third-party reseller would not use our
confidential information to compete with us.

6

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SPEECH SOFTWARE PRODUCTS
GENERALLY, AND OUR PRODUCTS AND SERVICES IN PARTICULAR, MAY NOT ACHIEVE WIDESPREAD
ACCEPTANCE, WHICH COULD REQUIRE US TO MODIFY OUR SALES AND MARKETING EFFORTS AND COULD
LIMIT OUR ABILITY TO SUCCESSFULLY GROW OUR BUSINESS.

The market for speech software
products is relatively new and rapidly changing. In addition, some of our products are new
to the market or, once released, will be new to the market. Our ability to increase
revenue in the future depends on the acceptance by our customers, third-party resellers
and end users of speech software solutions generally and our products and services in
particular. The adoption of speech software products could be hindered by the perceived
costs and deployment risks of this relatively new technology, as well as the reluctance of
enterprises that have invested substantial resources in existing call centers or
touch-tone-based systems to replace their current systems with this new technology.
Accordingly, in order to achieve commercial acceptance, we may have to educate prospective
customers, including large, established enterprises and telecommunications companies,
about the uses and benefits of voice interface software in general and our products in
particular. We may need to modify or increase our sales and marketing efforts, or adopt
new marketing strategies, to achieve such education. If these efforts fail or prove
excessively costly or otherwise unmanageable, or if speech software generally does not
achieve commercial acceptance, our business could be harmed.

The continued development of the
market for our products will depend upon the following factors, among others:

 widespread and successful deployment
of speech software applications;

 customer demand for services
and solutions having a voice user interface;

 acceptance by businesses of
the benefits of speech technology;

 demand for new uses and
applications of speech software technology, including adoption of voice user interfaces by
companies that operate web-based and touch tone IVR self service solutions;

 adoption of industry standards
for speech software and related technologies; and

 continuing improvements in
hardware and telephony technology that may reduce the costs of speech software solutions.

OUR PRODUCTS CAN HAVE A LONG SALES
AND IMPLEMENTATION CYCLE AND, AS A RESULT, OUR QUARTERLY REVENUES AND OPERATING RESULTS
MAY FLUCTUATE.

The sales cycles for our products
have typically ranged from three to twelve months, depending on the size and complexity of
the order, the amount of services to be provided by us and whether the sale is made
directly by us or indirectly through a third-party reseller.

Speech products often require a
significant expenditure by a customer. Accordingly, a customers decision to purchase
our products typically requires a lengthy pre-purchase evaluation. We may spend
significant time educating and providing information to prospective customers regarding
the use and benefits of our products. During this evaluation period, we may expend
substantial sales, technical, marketing and management resources in such efforts. Because
of the lengthy of the evaluation period, we are likely to experience a delay, occasionally
significant, between the time we incur these expenditures and the time we generate
revenues, if any, from such expenditures. Furthermore, the incurring of such expenditures
may not result in a sale of our products.

After purchase by a customer, it may
take time and resources to implement our software and to integrate it with the
customers existing systems. If we are performing services that are essential to the
functionality of the software, in connection with its implementation, we recognize license
and service revenues based on the percentage of services completed, using contract
accounting. In cases where the contract specifies milestones or acceptance criteria, we
may not be able to recognize either license or service revenue until these conditions are
met. We have in the past experienced, and may in the future experience, such delays in
recognizing revenue. Consequently, the length of our sales and implementation cycles, the
scheduled implementation of our products and the terms and conditions of our license and
service arrangements often make it difficult to predict the quarter in which revenue
recognition may occur and may cause license and service revenue and our operating results
to vary significantly from period to period.

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OUR CURRENT AND POTENTIAL
COMPETITORS, SOME OF WHOM HAVE GREATER RESOURCES AND EXPERIENCE THAN WE DO, MAY MARKET OR
DEVELOP PRODUCTS, SERVICES AND TECHNOLOGIES THAT MAY CAUSE DEMAND FOR, AND THE PRICES OF,
OUR PRODUCTS TO DECLINE.

A number of companies have developed,
or are expected to develop, products that compete with our products. Competitors with
respect to speech technologies include SpeechWorks International and Scansoft, which have
merged, IBM and Microsoft. With respect to our software platform, there are many vendors,
including some of our third-party resellers and channel partners, who market and sell
platforms for voice systems. We expect additional competition from other companies in the
platform market. We also have competition in the applications market. Our competitors may
combine with each other, and other companies may enter our markets by acquiring or
entering into strategic relationships with our competitors. Current and potential
competitors may have established, or may establish, cooperative relationships among
themselves or with third parties to increase the abilities of their advanced speech and
language technology products, platforms and applications to address the needs of our
prospective customers.

Many of our current and potential
competitors have longer operating histories, significantly greater financial, technical,
product development and marketing resources, greater name recognition and larger customer
bases than we do. Our present or future competitors may be able to develop products
comparable or superior to those we offer, adapt more quickly than we do to new
technologies, evolving industry trends and standards or customer requirements, or devote
greater resources than we do to the development, promotion and sale of speech products.
Accordingly, we may not be able to compete effectively in our markets, competition may
intensify and future competition may cause us to reduce prices and/or otherwise harm our
business.

USE OF OUR PRODUCTS MAY INFRINGE
THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS. INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS
AGAINST OUR CUSTOMERS OR US COULD BE COSTLY TO US. SUCH CLAIMS COULD ALSO SLOW OUR SALES
CYCLE AND/OR MARKET ADOPTION GENERALLY.

The software industry in general, and
the field of speech and voice technologies in particular, are characterized by the
existence of a significant number of patents. Litigation and threats of litigation based
on allegations of patent infringement and the violation of intellectual property rights
are normal in software markets and appear to be increasing. We attempt to avoid infringing
known proprietary rights of third parties. However, we may be subject to claims and legal
proceedings for alleged infringement of third-party proprietary rights, such as patents,
trade secrets, trademarks or copyrights, with respect to our products either by us or our
customers. In addition, former employers of our employees may assert that these employees
have improperly disclosed confidential or proprietary information to us.

We typically indemnify our customers
against claims by third parties that our products infringe their intellectual property
rights. Any claims relating to the infringement of third-party proprietary rights, even if
not successful or meritorious, could result in costly litigation, divert managements
attention to our business and require us and/or our customers to enter into royalty or
license agreements that are costly and otherwise disadvantageous to us. Any such claims
could also require us to defend our customer against the claim and indemnify our customer
for all of its damages as a result of the claim. Any of these effects could have a
material adverse effect on our business and results of operations. Further, parties making
these claims may be able to obtain injunctions, which could prevent us from selling our
products. These types of claims could also slow our sales cycle and/or market adoption
generally with respect to the affected product, which could harm our business. We may be
increasingly subject to infringement claims as the number and features of our products
grow, we extend our speech application business and the speech market grows.

We understand that holders of a
substantial number of patents have alleged that certain of their patents cover a wide
range of automated services in the call center and computer telephony areas. We believe
that one of such holders has sent letters to many providers of such automated services,
including some of our customers, suggesting that a license under its portfolio is required
in order to provide the automated services. That holder has also sued a number of such
entities, alleging patent infringement. A number of the entities against which that holder
has made such claims have entered into license agreements with respect to the
holders patents. None of our customers have notified us that any of such holders has
claimed that any of our products or service deliverables infringe any claims of any of its
patents. Nor has any of such holders made any such claim against us. It is possible,
however, that one or more of our customers, in response to an infringement claim by any of
such holders, might assert indemnity rights against us, whether or not meritorious. It is
also possible that one or more of such holders might make a claim against us directly,
even if not meritorious. The costs associated with resolving any such disputes, regardless
of the legal outcome, could be substantial and could materially and adversely affect our
operating results.

WE HAVE A HISTORY OF LOSSES. WE
EXPECT TO CONTINUE TO INCUR LOSSES IN THE NEAR TERM, AND WE MAY NOT ACHIEVE OR MAINTAIN
PROFITABILITY.

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We have incurred losses since our
inception, including a net loss of approximately $19.3 million for the fiscal year ended
December 31, 2003. As of December 31, 2003, we had an accumulated deficit of approximately
$258.0 million. We presently expect to have net losses and negative cash flow until the
second half of 2004. We expect to continue to spend significant amounts to develop and
enhance our products, services and technologies and to enhance our delivery capabilities.
As a result, we will need to generate increasing revenue to achieve profitability. Even if
we achieve profitability, we may not be able to sustain or increase profitability on a
quarterly or annual basis. No assurances can be given that the Company will be profitable
or have positive cash flow at any time in the future.

SALES TO CUSTOMERS OUTSIDE THE
UNITED STATES ACCOUNT FOR A SIGNIFICANT PORTION OF OUR REVENUE, WHICH EXPOSES US TO RISKS
INHERENT IN INTERNATIONAL OPERATIONS.

International sales represented
approximately 39%, 35% and 42% of our total revenue in 2003, 2002 and 2001, respectively.
We anticipate that revenue from markets outside the United States will continue to
represent a meaningful portion of our total revenue for the foreseeable future. We are
subject to a variety of risks associated with conducting business internationally, any of
which could harm our business. These risks include:

 difficulties and costs of
staffing and managing foreign operations;

 the difficulty in establishing
and maintaining an effective international third-party reseller network;

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

 longer sales and payment
cycles than we experience in the United States;

 political and economic
instability outside the United States;

 import or export licensing and
product certification requirements;

 tariffs, duties, price
controls or other restrictions on foreign currencies or trade barriers imposed by foreign
countries;

 potential adverse tax
consequences, including higher marginal rates and withholding taxes;


the impact of foreign exchange translations on the expense of our foreign operations; and

 limited ability, and
significant costs, to enforce agreements, intellectual property rights and other rights in
some foreign countries.

# WE ARE EXPOSED TO
GENERAL ECONOMIC CONDITIONS, WHICH MAY CONTINUE TO HARM OUR BUSINESS.

There has been a global economic
downturn over the past several years, which did not begin to improve until late in 2003.
If United States or global economic conditions deteriorate in the future, it is likely
that capital spending will decline and our sales will be adversely affected. If such
unfavorable economic conditions persist or worsen in the United States or internationally,
such conditions will have a material adverse impact on our business, operating results and
financial condition.

# OUR STOCK PRICE MAY BE
VOLATILE, DUE TO FACTORS OUTSIDE OF OUR CONTROL.

Since our initial public offering in
April 2000, our stock price has been extremely volatile. During that time, the stock
market in general, and The Nasdaq National Market and the securities of technology
companies in particular, have experienced extreme price and trading volume fluctuations.
These fluctuations have often been unrelated or disproportionate to the operating
performance of individual companies. The following factors, among others, could cause our
stock price to fluctuate:

 actual or anticipated
variations in operating results;

 announcements of operating
results and business conditions by our customers, suppliers or competitors;

 announcements by our
competitors relating to new customers, technological innovations or new services;

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 announcements by us of new
product lines and/or shifts in business focus or sales and distribution models;

 material increases in our
plans for, or actual rate of, capital expenditures for infrastructure, information
technology and other similar capital expenditures;

 economic developments in our
industry as a whole;

 general market and economic
conditions; and

 general decline and other
changes in information technology and capital spending plans.

These broad market fluctuations may
materially adversely affect our stock price, regardless of our operating results.
Furthermore, our stock price may fluctuate due to variations in our operating results.

ANY DEFECTS IN OR OTHER PROBLEMS
WITH OUR PRODUCTS COULD HARM OUR BUSINESS AND RESULT IN LITIGATION.

Complex software products such as
ours may contain errors, defects and bugs. During the development of any product, we may
discover errors, defects and bugs and, as a result, our products may take longer than
expected to develop. In addition, we may discover that remedies for errors, defects or
bugs may be technologically unfeasible. Delivery of products with undetected errors,
defects or bugs, or reliability, quality, or compatibility problems, could damage our
reputation. The existence of errors, defects or bugs, or reliability, quality or
compatibility problems, could also cause interruptions, delays or cessations of sales to
our customers. We could, as well, be required to expend significant capital and other
resources to remedy these problems. In addition, customers whose businesses are disrupted
by these errors, defects and bugs, or reliability, quality or compatibility problems,
could bring claims against us, the defense of which, even if successful, would likely be
time-consuming and costly for us. Furthermore, if such defense was not successful, we
might be obligated to pay substantial damages, which could materially and adversely affect
our operating results.

IF WE ARE UNABLE TO EFFECTIVELY
MANAGE OUR OPERATIONS AND RESOURCES IN ACCORDANCE WITH MARKET AND ECONOMIC CONDITIONS, OUR
BUSINESS COULD BE HARMED.

Our operations have changed
significantly over time, due in part to volatility in our business, and may continue to
change in the future. We experienced significant growth in the past. However, between
April 2001 and August 2003, in four separate restructuring actions, we reduced our
workforce by approximately 45%. We may be required to expand or contract our business
operations in the future to adapt to the market environment, and as a result may need to
expand or contract our management, operational, sales, marketing, financial, engineering
or other human resources, as well as management information systems and controls, to align
and support any such growth or contraction. Our failure to successfully manage these types
of changes would place a substantial burden on our business, our operations and our
management team, and could negatively impact sales, customer relationships and other
aspects of our business.

In addition, a significant portion of
our restructuring accrual is represented by a lease loss created by our decision not to
occupy our leased Pacific Shores facility. The accrual assumptions for such loss are based
upon estimates of real estate market conditions and values. These market conditions are
subject to wide fluctuations, and market values could decline further, which may require
an additional restructuring accrual. We have attempted to sublease the Pacific Shores
facility, but, to date, have not been successful in those efforts. There can be no
assurances that we will be able to sublease the facility at a lease rate approximating our
estimate of its lease value, or at all.

WE RELY ON THE SERVICES OF OUR KEY
PERSONNEL, WHOSE KNOWLEDGE OF OUR BUSINESS AND TECHNICAL EXPERTISE WOULD BE DIFFICULT TO
REPLACE.

We rely upon the continued service
and performance of a relatively small number of key technical and senior management
personnel. Our future success will be impacted by our ability to retain these key
employees. We cannot guarantee that we will be able to retain all key personnel. Other
than Charles Berger, our President, none of our key technical or senior management
personnel have employment agreements with the Company, and, as a result, are more likely
to leave with little or no prior notice. If we lose any of our key technical and senior
management personnel, replacing them could be difficult and costly. If we are not able to
successfully and rapidly replace such personnel, our business could be materially harmed.
We do not have key personnel life insurance policies covering any of our employees.

OUR FAILURE TO SUCCESSFULLY
RESPOND TO AND MANAGE RAPID CHANGE IN THE MARKET FOR SPEECH SOFTWARE COULD CAUSE US TO
LOSE REVENUE AND HARM OUR BUSINESS. IT IS ESSENTIAL THAT WE CONTINUE TO DEVELOP NEW
PRODUCTS THAT ACHIEVE COMMERCIAL ACCEPTANCE.

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The speech software industry is
relatively new and rapidly changing. Our future success will depend substantially upon our
ability to enhance our existing products and to develop and introduce, on a timely and
cost-effective basis, new products and features that meet changing third-party reseller
and end-user requirements and incorporate technological advancements, such as products
that speed deployment and accelerate customers return on investment, as well as
achieve commercial acceptance. Commercial acceptance of new products and technologies we
may introduce will depend, among other things, on: the ability of our services, products
and technologies to meet and adapt to the needs of our target markets; the performance and
price of our products and services and our competitors products and services; and
our ability to deliver speech solutions, customer service and professional services
directly and through our third-party resellers. If we are unable to develop new products
and enhance functionalities or technologies to adapt to these changes, we may be unable to
retain existing customers or attract new customers, which could materially harm our
business. In addition, as we develop new products, sales of existing products may
decrease. If we cannot offset a decline in revenue from existing products with sales of
new products, our business would suffer.

SPEECH PRODUCTS ARE NOT 100%
ACCURATE AND WE COULD BE SUBJECT TO CLAIMS RELATED TO THE PERFORMANCE OF OUR PRODUCTS. ANY
CLAIMS, WHETHER SUCCESSFUL OR UNSUCCESSFUL, COULD RESULT IN SIGNIFICANT COSTS AND COULD
DAMAGE OUR REPUTATION.

Speech recognition, natural language
understanding and authentication technologies, including our own, are not able to perform
accurately in every instance. Our customers, including several financial institutions, use
our products to provide important services to their customers, including transferring
funds to accounts and buying and selling securities. Any misrecognition of voice commands
or incorrect authentication of a users voice in connection with these financial or
other transactions could result in claims against our customers or us for losses incurred.
Although our contracts usually contain provisions designed to limit our exposure to such
liability claims, a claim brought against us based on misrecognition or incorrect
authentication, even if unsuccessful, could be time-consuming, divert managements
attention, result in costly litigation and harm our reputation. If any such claim is
successful, we could be exposed to an award of substantial damages and our reputation
could be harmed greatly. Moreover, existing or future laws or unfavorable judicial
decisions could limit the enforceability of limitations of liability, disclaimers of
warranty or other protective provisions contained in our contracts.

WE MAY INCUR A VARIETY OF COSTS TO
ENGAGE IN FUTURE ACQUISITIONS OF COMPANIES, PRODUCTS OR TECHNOLOGIES, AND THE ANTICIPATED
BENEFITS OF THOSE ACQUISITIONS MAY NEVER BE REALIZED.

As a part of our business strategy,
we may make acquisitions of, or significant investments in, complementary companies,
products or technologies. For instance, in November 2000 we acquired SpeechFront, a
Canadian company. For the year ended December 31, 2001, the Company evaluated the carrying
value of the assets related to the SpeechFront acquisition and recorded an asset
impairment. In February 2001, we acquired non-exclusive intellectual property rights from
a third-party. For the year ended December 31, 2001, the Company performed an impairment
analysis and determined that asset related to the SpeechFront acquisition was impaired and
was subsequently written down to its estimated fair value. Any future acquisitions of
companies or technologies would be accompanied by risks such as:

 difficulties in assimilating
the operations, personnel and technologies of acquired companies;

 diversion of our
managements attention from ongoing business concerns;

 our potential inability to
maximize our financial and strategic position through the successful incorporation of
acquired technology and rights into our products and services;

 additional expense associated
with impairments of acquired assets, such as goodwill or acquired workforce;

 maintenance of uniform
standards, controls, procedures and policies; and

 impairment of existing relationships
with employees, suppliers and customers as a result of the integration of new management
personnel.

We cannot guarantee that we will be
able to successfully integrate any business, products, technologies or personnel that we
might acquire in the future. Our inability to integrate successfully any business
products, technologies or personnel we may acquire in the future could materially harm our
business.

WE MAY HAVE DIFFICULTY COLLECTING
AMOUNTS OWED TO US.

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Certain of our customers and
third-party resellers have experienced, and may in the future experience credit-related
issues. We perform ongoing credit evaluations of customers, but do not require collateral.
We grant payment terms to most customers ranging from 30 to 90 days. However, in some
instances we may provide longer payment terms. Should more customers than we anticipate
experience liquidity issues, or if payment is not received on a timely basis, our
business, operating results and financial condition could be adversely impacted.

# IF REQUIREMENTS RELATING
TO ACCOUNTING TREATMENT FOR EMPLOYEE STOCK OPTIONS ARE CHANGED, WE MAY BE FORCED TO
CHANGE OURBUSINESS PRACTICES.

We currently account for the issuance
of stock options under Accounting Principles Board (APB) Opinion No. 25,
Accounting for Stock Issued to Employees. The Financial Accounting Standards
Board is expected to issue an exposure draft that may require companies to include a
compensation expense in their statement of operations relating to the issuance of employee
stock options. The change in accounting for stock options is presently anticipated to
become effective in April 2005. As a result, we could decide to decrease the number of
employee stock options that we would grant. This could affect our ability to retain
existing employees and attract qualified candidates for open positions, and increase the
cash compensation we would have to pay to them. Conversely, issuing a comparable number of
stock options could adversely impact our results of operations under the new accounting
requirements, once they take effect.

INTERNATIONAL SALES OPPORTUNITIES
MAY REQUIRE US TO DEVELOP LOCALIZED VERSIONS OF OUR PRODUCTS. IF WE ARE UNABLE TO DO SO
TIMELY, OUR ABILITY TO GROW OUR INTERNATIONAL REVENUE AND EXECUTE OUR INTERNATIOANAL
BUSINESS STRATEGY WILL BE ADVERSELY AFFECTED.

International sales opportunities may
require investing significant resources in creating and refining different language models
for particular languages or dialects. These language models are required to create
versions of our products that allow end users to speak the local language or dialect and
be understood and authenticated. If we fail to develop needed localized versions of our
products on a timely basis, our ability to address international market opportunities and
to grow our international business will be adversely affected. However, even if we expend
resources to develop localized versions of our products, there can be no assurance that we
will be able to recognize sufficient revenues from these localized versions to make them
profitable.

IF THE INDUSTRY STANDARDS WE HAVE
SELECTED TO SUPPORT ARE NOT ADOPTED AS THE STANDARDS FOR SPEECH SOFTWARE, CUSTOMERS MIGHT
NOT USE OUR SPEECH SOFTWARE PRODUCTS FOR DELIVERY OF APPLICATIONS AND SERVICES.

The market for speech software is
relatively new and emerging and industry standards are still being established. We may not
be competitive unless our products support changing industry standards. The emergence of
industry standards, whether through adoption by official standards committees or
widespread usage, could require costly and time-consuming redesign of our products. If
these standards become widespread and our products do not support them, our customers and
potential customers may not purchase our products. Multiple standards in the marketplace
could also make it difficult for us to ensure that our products will support all
applicable standards, which could in turn result in decreased sales of our products.
Furthermore, the existence of multiple standards could chill the market for speech
software in general, until a dominant standard emerges.

Our pre-packaged applications,
V-Builder applications-building tool and our Nuance Voice Platform software are each
designed to work with the recently adopted VoiceXML standard. There are currently other,
similar standards in development, some of which may become more widely adopted than
VoiceXML. If VoiceXML is not widely accepted by our target customers or if another
competing standard were to become widely adopted, then sales of our products could decline
and our business would be materially harmed. In that case, we may find it necessary to
redesign our existing products or design new products that are compatible with alternative
standards that are widely adopted or that replace VoiceXML. This design or redesign could
be costly and time-consuming. If a third party proprietary technology were to become a
standard, we might be precluded from developing products to conform to that standard
unless we are able to enter into agreements to license the rights to develop such
products. Any such license could require us to pay substantial royalties, whether upfront
or based on sales of such products, which could materially adversely affect our margins
for such products and, as a result, our results of operations.

# ANY INABILITY TO
ADEQUATELY PROTECT OUR PROPRIETARY TECHNOLOGY COULD HARM OUR ABILITY TO COMPETE.

Our future success and ability to
compete depends in part upon our proprietary technology and our trademarks, which we
attempt to protect with a combination of patent, copyright, trademark and trade secret
laws, as well as with our confidentiality procedures and contractual provisions. These
legal protections afford only limited protection and may be time-consuming and expensive
to obtain, maintain or enforce. Further, despite our efforts, we may be unable to prevent
third parties from infringing upon or misappropriating our intellectual property or to
recover adequate compensation from any such infringers.

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Although we have filed multiple U.S.
patent applications, we have currently only been issued a small number of patents. There
is no guarantee that more patents will be issued with respect to our current or future
patent applications. Any patents that are issued to us could be circumvented or
challenged. If challenged, a patent might be invalidated or its claims might be
substantially narrowed. Our intellectual property rights may not be adequate to provide us
with a competitive advantage and, in any event, are not likely to prevent competitors from
entering the markets for our products. Additionally, our competitors could independently
develop non-infringing technologies that are competitive with, equivalent to, or superior
to our technology.

Monitoring infringement and
misappropriation of intellectual property can be difficult, and there is no guarantee that
we would detect any infringement or misappropriation of our proprietary rights. Even if we
do detect infringement or misappropriation of our proprietary rights, litigation to
enforce these rights could cause us to divert financial and other resources away from our
business operations. Further, we license our products internationally, and the laws of
some foreign countries do not protect our proprietary rights to the same extent as do the
laws of the United States.

OUR CHARTER AND BYLAWS AND
DELAWARE LAW CONTAIN PROVISIONS WHICH MAY DELAY OR PREVENT A CHANGE OF CONTROL OF NUANCE.

Our Shareholder Rights Plan, as well
as provisions of our charter and bylaws, may make it more difficult for a third party to
acquire, or may discourage a third party from attempting to acquire, control of Nuance.
These provisions could limit the price that investors might be willing to pay in the
future for shares of our common stock. These provisions include:

 the Companys Shareholder
Rights Plan adopted in December 2002;

 the division of the board of
directors into three separate classes;

 the elimination of cumulative
voting in the election of directors;

  prohibitions on our stockholders
 acting by written consent and calling special meetings;

 procedures for advance
notification of stockholder nominations and proposals; and

 the ability of the board of
directors to alter our bylaws without stockholder approval.

In addition, our board of directors
has the authority to issue up to 5,000,000 shares of preferred stock and to determine the
price, rights, preferences, privileges and restrictions, including voting rights, of those
shares without any further vote or action by the stockholders. The issuance of preferred
stock, while providing flexibility in connection with possible financings or acquisitions
or other corporate purposes, could have the effect of making it more difficult for a third
party to acquire a majority of our outstanding voting stock.

Since the completion of our initial
public offering in April 2000, we have been subject to the anti-takeover provisions of the
Delaware General Corporation Law, including Section 203, which may deter potential
acquisition bids for our company. Under Delaware law, a corporation may opt out of Section
203. We do not presently intend to opt out of the provisions of Section 203.

OUR FACILITIES ARE LOCATED NEAR
KNOWN EARTHQUAKE FAULT ZONES, AND THE OCCURRENCE OF AN EARTHQUAKE OR OTHER NATURAL
DISASTER COULD CAUSE DAMAGE TO OUR FACILITIES AND EQUIPMENT, WHICH COULD REQUIRE US TO
CURTAIL OR CEASE OPERATIONS.

Our facilities are located in the San
Francisco Bay Area, near known earthquake fault zones, and are vulnerable to damage from
earthquakes. In October 1989, a major earthquake struck this area, causing significant
property damage and a number of fatalities. We are also vulnerable to damage from other
types of disasters, including fire, floods, power loss, communications failures and
similar events. If any disaster were to occur, our ability to operate our business at our
facilities could be seriously, or completely, impaired.

WE RELY ON A CONTINUOUS POWER
SUPPLY TO CONDUCT OUR OPERATIONS, AND AN ENERGY CRISIS COULD DISRUPT OUR OPERATIONS AND
INCREASE OUR EXPENSES.

We currently do not have backup
generators or alternate sources of power in the event of a blackout, and our current
insurance does not provide coverage for any damages we, or our customers, may suffer as a
result of any interruption in our power supply. If blackouts interrupt our power supply,
we would be temporarily unable to continue operations at our facilities. Any such
interruption in our ability to continue operations at our facilities could damage our
reputation, harm our ability to retain existing customers and to obtain new customers, and
could result in lost revenue, any of which could substantially harm our business and
results of operations.

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INFORMATION THAT WE MAY PROVIDE TO
INVESTORS FROM TIME TO TIME IS ACCURATE ONLY AS OF THE DATE WE DISSEMINATE IT AND WE
UNDERTAKE NO OBLIGATION TO UPDATE THE INFORMATION.

From time to time, we may publicly
disseminate forward-looking information or guidance in compliance with Regulation FD
promulgated by the Securities and Exchange Commission. This information or guidance
represents our outlook only as of the date that we disseminated it, and we undertake no
obligation to provide updates to this information or guidance in our filings with the
Securities and Exchange Commission or otherwise.

ITEM 2.      PROPERTIES

Our
headquarters are located in Menlo Park, California in three office buildings in which we
lease an aggregate of approximately 60,000 square feet. The leases on three office
buildings expire in August 2004. We are in the process of negotiating a new lease on the
buildings. The new lease is for three office buildings in which we intend to lease an
aggregate of approximately 49,000 square feet for a lease term of 5 years, starting April
1, 2004. In May 2000, we signed a lease for a new 141,000 square-foot headquarters
facility in Redwood City, California. The lease term is for eleven years, which began in
August 2001. In April 2001, in conjunction with a restructuring plan, management decided
not to occupy this corporate headquarter facility, but rather market the property for
sublease (see Note 11 to the consolidated financial statements).

In
January 2000, we signed a lease, which was amended in August 2000, for approximately
36,000 square feet of office space in Montreal, Canada for our Montreal operations. The
lease term is for seven years from the lease inception date of November 1, 2000. In
January 2003, this lease was subsequently amended and the leased area was reduced to
18,000 square feet. In January 2001, we signed a lease for approximately 9,400 square feet
of office space in Ottawa, Canada in relation to an existing facility previously leased by
SpeechFront. The lease term is for two and a half years from the lease inception date of
January 1, 2001. This lease was terminated in November 2002 due to the consolidation of
the Ottawa operations with our Montreal operations. We also lease facilities with lease
terms ranging from two to three years in Brazil, Hong Kong and Japan. In addition, we also
lease, on a short-term basis, office space in Oakbrook, Illinois, Germany, Canada and the
United Kingdom. Other than in Canada and our Menlo Park, California headquarters, all of
our offices are sales offices. We do not own any real estate.

# ITEM 3.    LEGAL
PROCEEDINGS

In
August 2001, the first of a number of complaints was filed, in The United States District
Court for the Southern District of New York, on behalf of a purported class of persons who
purchased Nuance stock between April 12, 2000, and December 6, 2000. Those complaints have
been consolidated into one action. The complaint generally alleges that various investment
bank underwriters engaged in improper and undisclosed activities related to the allocation
of shares in our initial public offering of securities. The complaint makes claims for
violation of several provisions of the federal securities laws against those underwriters,
and also against us and some of directors and officers. Similar lawsuits, concerning more
than 250 other companies initial public offerings, were filed in 2001. In February
2003, the Court denied a motion to dismiss with respect to the claims against Nuance. In
the third quarter of 2003, a proposed settlement in principle was reached among the
plaintiffs, issuer defendants (including the Company) and the issuers insurance
carriers. The settlement calls for the dismissal and release of claims against the issuer
defendants, including the Company, in exchange for a contingent payment to be paid, if
necessary, by the issuer defendants insurance carriers and an assignment of certain
claims. The timing of the conclusion of the settlement remains unclear, and the settlement
is subject to a number of conditions, including finalization of appropriate documentation
and approval of the Court. The settlement is not expected to have any material impact upon
the Company, as payments, if any, are to be made by insurance carriers, rather than by the
Company. In the event a settlement is not concluded, we intend to defend the litigation
vigorously. We believe that we have meritorious defenses to the claims against us.

On
January 16, 2001, Nuance filed an opposition proceeding in the European community against
a Community Trade Mark application for NUANCE, owned by Nuance Global Traders, Ltd. The
opposition is still pending. The parties have agreed upon a settlement which will become
final upon, among other things, completion of final settlement documents.

In
March 2001, the first of a number of stockholder class action complaints were filed, in
the United States District Court for the Northern District of California, against Nuance
and certain of its officers and directors. The lawsuits were consolidated and an amended
complaint was filed on behalf of a purported class of people who purchased our stock
during the period January 31, 2001, through March 15, 2001, alleging false and misleading
statements and insider trading in violation of the federal securities laws. The plaintiffs
were seeking unspecified damages. In April 2003, in response to our motion to dismiss,
certain of the plaintiffs claims were dismissed with prejudice. However, plaintiffs
were permitted to file a further amended complaint with respect to several remaining
claims. In November 2003, a settlement and dismissal of the action was approved by the
Court. The settlement was funded entirely by the defendants insurers in August and
September 2003.

In
mid 2001, putative shareholder derivative actions were filed in California state alleging
breaches of fiduciary duty and insider trading by various of our directors and officers.
As we are named as nominal defendant, the lawsuits did not appear to seek any recovery
against us. The settlement and dismissal of these actions were approved by the Court in
November 2003. The settlement did not provide for any monetary payments by the defendants.

We
are subject to various legal proceedings, claims and litigation that arise in the
normal course of business. While the outcome of these matters is currently
not determinable, management does not expect that the ultimate costs to resolve these
matters will have a material adverse effect on our consolidated financial position,
results of operations, or cash flows.

14

---

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

During
the fourth quarter of fiscal 2003, there were no matters submitted to a vote of securities
holders, through the solicitation of proxies or otherwise.

15

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# PART II

# ITEM 5.    MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock has been quoted on the Nasdaq National
          Market under the symbol NUAN since April 13, 2000. The
          following table presents, for the periods indicated, the high and low closing
          prices per share of the common stock as reported on the Nasdaq National Market.

|               | High | Low      
|-------------- | ---- | ---------
|               |      |          
|Fiscal 2003    |      |          
|First Quarter  |      | $   2.67 
|Second Quarter |      | $   5.43 
|Third Quarter  |      | $   6.38 
|Fourth Quarter |      | $   9.06 
|Fiscal 2002    |      |          
|First Quarter  |      | $   10.57
|Second Quarter |      | $   7.25 
|Third Quarter  |      | $   4.11 
|Fourth Quarter |      | $   3.26 

As
of February 29, 2004, there were approximately 396 holders of record of our common stock
based on data obtained from our transfer agent. Because many shares of our common stock
are held by brokers and other institutions on behalf of stockholders, we are unable to
estimate the total number of stockholders represented by these record holders.

# Dividend Policy

We
have never declared or paid any dividends on our common stock or other securities. We do
not anticipate paying any cash dividends in the foreseeable future. We currently intend to
retain future earnings, if any, to finance operations and to expand our business. Any
future determination to pay cash dividends will be at the discretion of the board of
directors and will depend upon our financial condition, operating results, capital
requirements and other factors the board of directors deems relevant.

# ITEM 6.    SELECTED
FINANCIAL DATA

Set
forth below is a summary of certain consolidated financial information with respect to
Nuance as of the dates and for the periods indicated. The consolidated statement of
operations data set forth below for the fiscal years ended December 31, 2003, 2002, 2001,
2000 and 1999 and the consolidated balance sheet data as of December 31, 2003, 2002, 2001,
2000 and 1999 have been derived from our consolidated financial statements, which have
been audited.

The
following selected financial data should be read in conjunction with our consolidated
financial statements and related notes and Managements Discussion and Analysis
of Financial Condition and Results of Operations included elsewhere in this report.
The historical results presented below are not necessarily indicative of future results
(in thousands except per share data):

|                                                                | Year Ended December 31,
|--------------------------------------------------------------- | -----------------------
|                                                                |                        
|Consolidated Satement of Operations Data:                       |                        
|Total revenue                                                   |                        
|Gross profit                                                    |                        
|Loss from operations                                            |                        
|Net loss                                                        |                        
|Basic and diluted net loss per share                            |                        
|Shares used to compute basic and diluted net loss per share (*) |                        

(*)    For a description of shares used in computing basic and diluted net loss per share, see Note 2
to the                 
        consolidated financial statements.

16

---

|                                           | As of December 31,
|------------------------------------------ | ------------------
|                                           |                   
|Consolidated Balance Sheet Data:           |                   
|Cash and cash equivalents                  |                   
|Short-term and long-term investment        |                   
|Working capital                            |                   
|Total assets                               |                   
|Current portion of restructuring accrual   |                   
|Long-term portion of restructuring accrual |                   
|Current portion of capital lease           |                   
|Long-term portion of capital lease         |                   
|Total stockholders' equity                 |                   

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

The
following discussion should be read in conjunction with the condensed consolidated
financial statements and related notes included elsewhere in this report. The results
shown herein are not necessarily indicative of the results to be expected for any future
periods.

The
section entitled Managements Discussion and Analysis of Financial Condition
and Results of Operations set forth below contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934, including but not limited to our expectations for results during the
current fiscal year, statements regarding revenue and expense trends and cash positions,
statements regarding our sales and marketing, hiring activities, product development and
our outlook for the Company, as well as our expectations, beliefs, intentions or
strategies regarding the future. Words such as anticipates,
expects, intends, may, will,
plans, believes, seeks, projected,
assumes and estimates and other similar expressions are intended
to identify forward-looking statements. These statements are not guarantees of future
performance and actual actions or results may differ materially. These statements are
based on information available to us on the date hereof, and the Company assumes no
obligation to update any such forward-looking statements. These statements involve risks
and uncertainties and actual results could differ materially from those anticipated in
these forward-looking statements as a result of a number of factors, including, but not
limited to, those set forth in Company Risk Factors and elsewhere in this
Annual Report on Form 10-K and in other reports or documents filed by us from time to time
with the Securities and Exchange Commission.

# OVERVIEW

We
develop, market and support speech software products for automating interactions over the
telephone for a range of industries and applications. Our products include: speech
recognition software, which is used to recognize what a person says, deliver responses and
information and perform transactions; text-to-speech synthesis software, which converts
text, for example, from a database, email or web page into an audio signal to deliver
speech over the telephone; voice authentication software, which can be used to verify the
identity of speakers by the unique qualities of their voices; grammars, which define the
dictionary of possible caller responses for use in applications; and a standards-based
software platform designed as a foundation for speech application deployment and
management and a packaged speech routing application product. Two of these products are
new and were released in 2003: Nuance Voice Platform (NVP), an open,
standards-based software platform optimized for speech solutions, was released in the
first quarter 2003 and Nuance Call Steering (NCS), a packaged application
designed to accurately and cost-effectively route phone calls to the correct customer care
destinations, was released in the second quarter of 2003. We plan to add additional
applications for key industries, which, like NCS, will be designed to leverage the
features inherent in our engines and platform while reducing deployment time and cost.

We
seek to actively support both emerging industry standards as well as proprietary
development environments. Our software is designed to work with VoiceXML, the recognized
industry standard language for the creation of voice-driven products and services.

We
also offer a range of consulting, support and education services that enable our customers
and third-party resellers to develop and maintain voice-driven applications that use our
software products.

We
sell our products both directly through our sales force and indirectly through third-party
resellers. We sell our products to customers in the United States, Canada, the United
Kingdom and other countries in Europe, China and other countries in Asia, and Latin
America. We anticipate that markets outside of the United States will continue to
represent a significant portion of total future revenue.

# OVERVIEW OF 2003
OPERATIONS

Our
growth and anticipated profitability are heavily dependent upon general economic
conditions and demand for information technology. Our growth has traditionally been fueled
by sales to the telecommunications and financial services industries. Some industries have
sustained slowdowns over the past several years. Even though information technology
spending remains improved recently due to growth in the economy, it is difficult to
predict the information technology spending trend for the foreseeable future.

17

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In
response to the challenging business environment, we have evolved and continue to evolve
our strategic direction in a way that we believe will improve our business performance.
Our strategic objectives include:

|  |                                                                                                                                                                      
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
|. | focusing resources on geographic and industry targets believed to have the highest potential for revenue,                                                            
|  |                                                                                                                                                                      
|. | evolving our voice  platform and  development  tools to increase the speed and ease of deployment  and reduce the total
         cost of ownership of speech systems,
|  |                                                                                                                                                                      
|. | developing speech applications designed to reduce deployment time and lower maintenance requirements,                                                                
|  |                                                                                                                                                                      
|. | developing and strengthening a multi-channel selling model, and                                                                                                      
|  |                                                                                                                                                                      
|. | developing  advanced  speech  technologies  that deliver  customer  value and maintain our  leadership  position in the
         speech industry.                    

Some
specific operating changes have already been accomplished, such as the restructuring
actions taken in 2001, 2002 and 2003, two newly released products in 2003, NVP in March
2003 and NCS in June 2003, the sales execution with a multi-channel strategy, the
development of the new platform Value Added Resale (VAR) channel, and our
focus on driving complete speech solutions into the large telecom and enterprise call
center markets. We plan to introduce certain new applications in the future. Other
operating activities, including new products and changes to selling and delivery channels,
will continue to evolve over the next several years. We are making these strategic shifts
because we believe that they will enhance our business performance, however, some of the
actions we are taking, such as the introduction of new products, present inherent risks.
We believe that these new products will make speech systems faster and easier to deploy,
and will create value for our customers. The success of these products depends upon
certain market factors such as information technology spending, market acceptance of
packaged software applications and industry adoption of VoiceXML and related standards.

In
addition, we are responding to customers requests to work more directly with them
and provide them greater access to Nuances speech expertise across all levels of
their speech solutions. We believe that increasing our direct relationships with end users
and delivering more complete solutions will allow us to reap greater value from these
sales transactions. However, this new sales and delivery model may also present increased
costs and risks such as increased liability for complete solution delivery, costs and
risks of subcontractors, and possible delays in recognition of revenue. Further, we may
experience periodic fluctuations in our consulting services revenues when long-term
consulting projects come to completion. In addition, while we are actively working to
manage potential channel conflicts and maintain strong third-party reseller relationships,
certain third-party reseller relationships may be adversely affected by our introduction
of our own platform product and application product and/or our direct sales activities,
which may have an unfavorable impact on revenue from certain third-party resellers.

We
are committed to a multi-channel sales approach and third-party resellers have been and
will continue to be instrumental in delivering speech engines, applications and services
to our end customers. We are actively working to maintain and build strong relationships
with existing third-party resellers as well as new third-party resellers. We will continue
to focus efforts on fostering a strong third-party reseller channel, particularly to
leverage complementary capabilities in order to speed and ease deployment of speech
solutions. We may encounter difficulties or delays in finding third-party reseller
partners having such complementary capabilities and/or establishing third-party reseller
partner relationships with such entities.

In
addition, competition exists in the speech technology market. We believe that our business
and technology has the ability to compete effectively, however, the speech market is
relatively new and susceptible to change. Our competitors may be able to develop superior
technologies or may combine with each other to leverage complimentary technologies or
relationships. Current and potential competitors may be larger than Nuance and may be able
to invest greater resources in competitive efforts and/or may establish relationships
among themselves or with third parties to increase their technological and/or selling and
marketing abilities.

# CRITICAL ACCOUNTING
POLICIES AND ESTIMATES

The
preparation of financial statements in accordance with accounting principles generally
accepted in the United States of America requires that management make a number of
assumptions and estimates that affect the reported amounts of assets and liabilities at
the date of the financial statements and the reported amounts of revenue and expenses
during the periods presented in our consolidated financial statements and accompanying
notes. Management bases its estimates on historical experience and various other
assumptions believed to be reasonable. Such estimates include percentage of completion on
certain revenue contracts, uncollectible accounts receivable, restructuring accrual for
leases, taxes and contingencies. Although these estimates are based on managements
best knowledge of current events and actions that may impact us in the future, actual
results may differ from these estimates and assumptions.

18

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Our
critical accounting policies are those that affect our financial statements materially and
involve a significant level of judgment by management. Those policies are as follows:

|  |                                           
|- | ------------------------------------------
|. | revenue recognition;                      
|  |                                           
|. | restructuring and impairment charges;     
|  |                                           
|. | valuation allowance for doubtful accounts;
|  |                                           
|. | income taxes;                             
|  |                                           
|. | valuation of long-lived assets.           

Revenue Recognition

Revenues
are generated from licenses, services and maintenance. All revenues generated from our
worldwide operations are approved at our corporate headquarters, located in the United
States. We apply the provisions of Statement of Position (SOP) No. 97-2,
Software Revenue Recognition, as amended by SOP No. 98-9, Modification
of SOP No. 97-2, Software Revenue Recognition, With Respect to Certain Transactions
to all transactions involving the sale of software products. We also recognize some
revenue based on SOP No. 81-1, Accounting for Performance of Construction-Type and
Certain Production-Type Contracts and Emerging Issues Task Force (EITF)
Issue No. 03-05 Applicability of American Institute of Certified Public Accountant
Statement of Position 97-2 to Non-software Deliverables in an Arrangement Containing More
Than Incidental Software.

Our
license revenue consists of license fees for our software products. The license fees for
our software products are calculated primarily by determining the maximum number of calls
that may be simultaneously connected to our software.

For
licensed products requiring significant customization, we recognize license revenue using
the percentage-of-completion method of accounting over the period that services are
performed. For all license and service agreements accounted for under the
percentage-of-completion method, we determine progress to completionbased on
actual direct labor hours incurred to date as a percentage of the estimated total direct
labor hours required to complete the project. We periodically evaluate the actual status
of each project to ensure that the estimates to complete each contract remain accurate. A
provision for estimated losses on contracts is made in the period in which the loss
becomes probable and can be reasonably estimated. To date, these losses have not been
significant. Costs incurred in advance of billings are recorded as costs incurred exceed
the related billings on uncompleted contracts. If the amount of revenue recognized exceeds
the amounts billed to customers, the excess amount is recorded as unbilled accounts
receivable. If the amount billed exceeds the amount of revenue recognized, the excess
amount is recorded as deferred revenue. Revenue recognized in any period is dependent on
our percentage completion of projects in progress. Significant management judgment and
discretion are used to estimate total direct labor hours. Any changes in or deviation from
these estimates could have a material effect on the amount of revenue we recognize in any
period.

For
licensed products which do not require significant customization of components, we
recognize revenue from the sale of software licenses when:

|  |                                                                        
|- | -----------------------------------------------------------------------
|. | persuasive evidence of an arrangement exists;                          
|  |                                                                        
|. | the software and corresponding authorization codes have been delivered;
|  |                                                                        
|. | the fee is fixed and determinable;                                     
|  |                                                                        
|. | collection of the resulting receivable is probable.                    

We
use a signed contract and either 1) a purchase order, 2) order form or 3) royalty report
as evidence of an arrangement.

Products
delivered with acceptance criteria or return rights are not recognized as revenue until
all revenue recognition criteria are achieved. If undelivered products or services exist
that are essential to the functionality of the delivered product in an arrangement,
delivery is not considered to have occurred. Delivery is accomplished through electronic
distribution of the authorization codes or keys. Occasionally the customer
will require that we secure their acceptance of the system in addition to the delivery of
the keys. Such acceptance, when required, typically consists of a demonstration to the
customer that, upon implementation, the software performs in accordance with specified
system parameters, such as recognition accuracy or task completion rates. In the absence
of such required acceptance, we will defer revenue recognition until signed acceptance is
obtained.

We
consider the fee is fixed and determinable when the price is not subject to refund or
adjustments.

We
assess collectibility of the transaction based on a number of factors, including the
customers past payment history and its current financial position. If we determine
that collection of a fee is not probable, we defer recognition of the revenue until the
time collection becomes reasonably assured, which is upon receipt of the cash payment.

19

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We
use the residual method to recognize revenue when a license agreement includes one or more
elements to be delivered at a future date if vendor specific objective evidence of the
fair value of all undelivered elements exists. Vendor-specific objective evidence of fair
value is based on the price charged when the element is sold separately, or if not yet
sold separately, is established by authorized management. In situations where
vendor-specific objective evidence of fair value for undelivered elements does not exist,
the entire amount of revenue from the arrangement is deferred and recognized when
vendor-specific objective evidence of fair value can be established for all undelivered
elements or when all such elements are delivered. In situations where the only undelivered
element is maintenance and vendor specific objective evidence of fair value for
maintenance does not exist, the entire amount of revenue from the arrangement is
recognized ratably over the maintenance period. As a general rule, license revenue from
third-party resellers is recognized when product has been sold through to an end user and
such sales have been reported to us. However, certain third-party reseller agreements
include time-based provisions on which we base revenue recognition. In these instances,
there is no right of return possible.

The
timing of license revenue recognition is affected by whether we perform consulting
services in the arrangement and the nature of those services. In the majority of cases, we
either perform no consulting services or we perform services that are not essential to the
functionality of the software. When we perform consulting and implementation services that
are essential to the functionality of the software, we recognize both license and
consulting revenue utilizing contract accounting based on the percentage of the consulting
services that have been completed. This calculation is done in conformity with SOP No.
81-1; however, judgment is required in determining the percentage of the project that has
been completed.

We
have also explored the markets for complete speech solutions and delivering through
combined product and services, where we are required to use contract accounting and
recognize the bundled license and service revenue based upon percentage of completion.
This method of accounting is subject to certain judgments by us regarding amount of
revenue allocated to percentage of work completed. Typically, we would recognize revenue
based upon the proportional level of effort expended to complete certain milestones
defined in the customer contract or statement of work.

Service
revenue consists of revenue from providing consulting, training and other revenue. Other
revenue consists primarily of reimbursements for consulting out-of-pocket expenses
incurred and recognized, in accordance with Emerging Issues Task Force (EITF)
No. 01-14, Income Statement Characterization of Reimbursements Received for
Out-of-Pocket Expenses Incurred. For services revenue, we require 1) a
signed contract and 2) statement of work and 3) purchase order prior to recognizing any
services revenue. Our consulting service contracts are bid either on a fixed-fee basis or
on a time-and-materials basis. For a fixed-fee contract, we recognize revenue using the
percentage of completion method. For time-and-materials contracts, we recognize revenue as
services are performed. Training service revenue is recognized as services are performed.
Losses on service contracts, if any, are recognized as soon as such losses become known.

Maintenance
revenue consists of fees for providing technical support and software upgrades. We require
a signed contract and purchase order prior to recognizing any maintenance revenue. We
recognize all maintenance revenue ratably over the contract term. Most customers have the
option to renew or decline maintenance agreements annually for the contract term.

Our
standard payment terms are net 30 to 90 days from the date of invoice. Thus, a significant
portion of our accounts receivable balance at the end of a quarter is primarily comprised
of revenue from that quarter.

Restructuring and Asset
Impairment Charges

Through
December 31, 2003, we have accrued for restructuring costs when management approved and
committed to a firm plan. Historically the main components of our restructuring plans have
been related to workforce reductions, lease losses as a result of a decision not to occupy
certain leased property and asset impairments. Workforce-related charges were accrued
based on an estimate of expected benefits that would be paid out to the employees. To
determine the sublease loss, after our cost recovery efforts from subleasing the building,
certain assumptions were made related to the (1) time period over which the building would
remain vacant (2) sublease terms (3) sublease rates. We established the reserves at the
low end of the range of estimable cost against outstanding commitments, net of estimated
future sublease income. These estimates were derived using the guidance provided in Staff
Accounting Bulletin (SAB) No. 100, Restructuring and Impairment
Charges, EITF No. 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a
Restructuring) and FASB No.146 Accounting for Costs Associated with Exit or
Disposal Activities. These reserves were based upon managements estimate of
the time required to sublet the property and the amount of sublet income that might be
generated between the date the property was not occupied and expiration of the lease for
the unoccupied property. These estimates are reviewed and revised quarterly and
may result in a substantial increase or decrease to restructuring expense should different
conditions prevail than were anticipated in original management estimates.

20

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Valuation Allowance for
Doubtful Accounts

We
perform ongoing credit evaluations of our customers and adjust credit limits based upon
payment history and the customers current creditworthiness, as determined by our
review of their current credit information. We continuously monitor collections and
payments from our customers and maintain a provision for estimated credit losses based on
a percentage of our accounts receivable, our historical experience and any specific
customer collection issues that we have identified. While such credit losses have
historically been within our expectations and appropriate reserves have been established,
we cannot guarantee that we will continue to experience the same credit loss rates that we
have experienced in the past. Material differences may result in the amount and timing of
revenue and or expenses for any period if management made different judgments or utilized
different estimates.

Income Taxes

In
preparing our consolidated financial statements, we are required to estimate our income
taxes in each of the jurisdictions in which we operate. This process involves estimating
actual current tax exposures together with assessing tax credits and with assessing
temporary differences resulting from differing treatment of items, such as deferred
revenue, for tax and accounting purposes. These differences result in deferred tax assets
and liabilities, which are included within the consolidated balance sheet. We then assess
the likelihood that deferred tax assets will be recovered from future taxable income, and
to the extent we believe that recovery is not likely, we must establish a valuation
allowance. To the extent we establish a valuation allowance or increase this allowance in
a period, we include an expense within the tax provision in our consolidated statement of
operations.

Significant
management judgment is required in determining our provision for income taxes, income tax
credits, our deferred tax assets and liabilities and any valuation allowance recorded
against our net deferred tax assets. We have recorded a valuation allowance due to
uncertainties related to our ability to utilize some of our deferred tax assets, primarily
consisting of the utilization of certain net operating loss carry forwards and foreign tax
credits before they expire. The valuation allowance is based on estimates of taxable
income by the jurisdictions in which we operate and the period over which deferred tax
assets will be recoverable. In the event that actual results differ from these estimates
or we adjust these estimates in future periods, we may need to establish an additional
valuation allowance, which could impact our financial position and results of operations.

Valuation of Long-lived Assets

We
have assessed the recoverability of long-lived assets, including intangible assets other
than goodwill, by determining whether the carrying value of such assets will be recovered
through undiscounted future cash flows according to the guidance of SFAS No. 144
Accounting for the Impairment of Disposal of Long Lived Assets. SFAS No. 144
superceded SFAS No. 121 Accounting for the impairment or Disposal of Long-lived
Assets in 2002. We assess the realizability of long-lived assets, including
intangibles in accordance with the provisions of SFAS No. 144. We assess the impairment of
goodwill in accordance with SFAS No. 142 Goodwill and Other Intangible Assets,
which became effective in 2002. For assets to be held and used, including acquired
intangibles, we initiate our review annually or whenever events or changes in
circumstances indicate that the carrying amount of a long-lived asset may not be
recoverable. Recoverability of an asset is measured by comparison of its carrying amount
to the expected future undiscounted cash flows (without interest charges) that the asset
is expected to generate. Any impairment to be recognized is measured by the amount by
which the carrying amount of the asset exceeds its fair value. Significant management
judgment is required in the forecasting of future operating results which are used in the
preparation of projected discounted cash flows and should different conditions prevail,
material write downs of net intangible assets and/or goodwill could occur.

It
is reasonably possible that the estimates of anticipated future gross revenue, the
remaining estimated economic life of the products and technologies, or both, could differ
from those used to assess the recoverability of these costs and result in a write-down of
the carrying amount or a shortened life of acquired intangibles in the future. As of and
for the years ended December 31, 2003 and 2002, we have no goodwill balance and no
impairment of intangibles was recorded. For the year ended December 31, 2001, we recorded
goodwill and work force impairments. (See Note 12 to the consolidated financial
statements.)

# RESULTS OF OPERATIONS

Revenues
are generated from three primary sources: (1) sale of new software licenses, (2) services,
which include consulting services and training services, and (3) maintenance, which
includes software license updates and customer technical support.

Software
license revenues represent all fees earned from granting customers licenses to use our
technology and applications software and exclude revenues derived from software license
updates, which are included in maintenance revenue. The vast majority of our software
license arrangements include software license updates and product support, which are
recognized ratably over the terms of the arrangement, typically one year. Software license
updates provide customers with rights to unspecified software product upgrades,
maintenance releases and patches released during the term of the support period. Product
support services include Internet access to technical content, as well as Internet and
telephone access to technical support personnel. Software license updates and product
support are priced as a percentage of the net new software license fees. Most of our
customers renew the software license updates and product support rights annually.

21

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Cost
of license revenue consists primarily of fees payable on third party software, inventory
write-downs and amortization of purchased technology. Cost of service and maintenance revenue consists
primarily of compensation and related overhead costs from employees engaged in consulting and training
services, software license updates and customer technical support, and
amounts paid to subcontractors.

Our
operating expenses are classified into seven general categories: sales and marketing,
research and development, general and administrative, amortization of goodwill and
workforce, non-cash compensation, restructuring charges and asset impairments. We classify
all charges to these operating expense categories based on the nature of the expenditures.
The sales and marketing, research and development, general and administrative categories
consist primarily of the following expenses: compensation, employee benefits, recruiting
costs, equipment costs, travel and entertainment costs, insurance, facilities costs and
third-party professional services fees. We allocate the total costs for information
technology services and facilities to each functional area that uses information
technology services and facilities based on headcount. These allocated costs include rent
and other facility-related costs for our offices, communication charges and depreciation
expense for property and equipment, and computer hardware and software maintenance.

From
our inception through December 31, 2003, we have incurred approximately $444.8 million of
operating expenses, including $79.9 million of restructuring charges and $29.0 million of
asset impairments. Approximately $94.7 million of research and development expenditures
were used to develop our current and future software products. Costs incurred in the
research and development of software products are expensed as incurred until technological
feasibility has been established, which usually occurs close to the completion of the
software. Once established, these costs would be capitalized. Amounts that could have been
capitalized were insignificant and, therefore, no software development costs have been
capitalized to date. As a result of these and other operating expenditures, we have
incurred net operating losses in each year since inception.

We
believe that period-to-period comparisons of our historical operating results are not
necessarily meaningful and should not be relied upon as being indicative of future
performance. Our prospects must be considered in light of the risks, expenses and
difficulties frequently experienced by companies in early stages of development,
particularly companies in new and rapidly changing markets. We have experienced both
significant revenue growth and revenue declines in the past. Furthermore, we may not
achieve or maintain profitability in the future.

22

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|                                                    | For the Years Ended December 31,
|--------------------------------------------------- | --------------------------------
|                                                    |                                 
|                                                    |                                 
|Revenue:                                            |                                 
|License                                             |                                 
|Service                                             |                                 
|Maintenance                                         |                                 
|Total revenue                                       |                                 
|Cost of revenue:                                    |                                 
|License                                             |                                 
|Service and maintenance                             |                                 
|Total cost of revenue                               |                                 
|Gross profit                                        |                                 
|Operating expenses:                                 |                                 
|Sales and marketing                                 |                                 
|Research and development                            |                                 
|General and administrative                          |                                 
|Amortization of goodwill and
        workforce      |                                 
|Non-cash compensation expense                       |                                 
|Restructuring charges and asset
        impairments |                                 
|Total operating expenses                            |                                 
|Loss from operations                                |                                 
|Interest and other income, net                      |                                 
|Loss before income taxes                            |                                 
|Provision for (benefit from) income
        taxes   |                                 
|Net loss                                            |                                 

The
following table presents selected financial data for the periods indicated as a percentage
of total revenue:

|                                            | For the years ended December 31,
|------------------------------------------- | --------------------------------
|                                            |                                 
|Revenue:                                    |                                 
|License                                     |                                 
|Service                                     |                                 
|Maintenance                                 |                                 
|Total revenue                               |                                 
|Cost of revenue:                            |                                 
|License                                     |                                 
|Service and maintenance                     |                                 
|Total cost of revenue                       |                                 
|Gross profit                                |                                 
|Operating expenses:                         |                                 
|Sales and marketing                         |                                 
|Research and development                    |                                 
|General and administrative                  |                                 
|Amortization of goodwill and workforce      |                                 
|Non-cash compensation expense               |                                 
|Restructuring charges and asset impairments |                                 
|Total operating expenses                    |                                 
|Loss from operations                        |                                 
|Interest and other income, net              |                                 
|Loss before income taxes                    |                                 
|Provision for (benefit from) income taxes   |                                 
|Net loss                                    |                                 

|                                             | For the years ended December 31,
|-------------------------------------------- | --------------------------------
|                                             |                                 
|Gross profits:                               |                                 
|License revenue gross profit                 |                                 
|Service and maintenance revenue gross profit |                                 
|Total revenue gross profit                   |                                 

Summary of 2003 versus 2002

Total
revenue increased 25% from 2002 to 2003. This increase was primarily attributable to
increases in service and maintenance revenue. Total revenue from customers in Canada
increased by $7.6 million from $4.0 million in 2002 to $11.6 million in 2003, primarily
from sales of products and services to customers in the telecommunications industry. Total
revenue from customers in the United States increased $4.8 million from $28.5 million in
2002 to $33.3 million in 2003, primarily from increases in service and maintenance
revenue. Total revenue from customers in Latin America declined $2.2 million from $3.0
million in 2002 to $0.8 million in 2003, due to Latin America countries political
restrictions and unstable economic situations. In 2003, we depended on a limited number of
customers for a substantial portion of our revenue. We may not continue to recognize
significant revenue from these customers, or replace them with other significant customers in 2004.

23

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When
the Company performs consulting and implementation services that are essential to the
functionality of the software, the Company recognizes both license and service revenue
utilizing contract accounting based on the percentage of the consulting services that have
been completed. Revenue recognized for such contracts were significant, totaling $5.1
million or approximately 9% of total revenue for the year ended December 31, 2003.

Gross
profit increased from 74% in 2002 to 77% in 2003, primarily due to higher service and maintenance
revenue, as well as a $1.4 million increase in license revenue with no increase in cost of license revenue.
Service and maintenance margins increased substantially from 36% in 2002 to 53% in 2003 as a result of
improved utilization of our service employees and relatively constant maintenance costs.

Operating
expense decreased 39% from 2002 to 2003, primarily due to lower employee-related expenses
and net incremental savings from our restructuring efforts. We have reduced expenses to
better align resources with revenue opportunities anticipated in the current economic
market. Additionally, we have reduced the use of outside professional services in 2003.

Loss
from operations as a percentage of total revenues improved from (166%) to (40%) from 2002
to 2003, primarily due to the increase in service revenue and maintenance revenue, as well
as the reduced expenses and restructuring charges.

We
recognized state and foreign income tax provisions for the years ended December 31, 2003,
2002, and 2001 of $(1.8) million, $0.8 million and $0.6 million respectively. For the year
ended December 2003, we recorded a tax benefit of $1.8 million of state and foreign taxes,
in which a tax benefit of $1.4 million resulted from the reversal of a prior year accrual
related to tax assessments and penalties from the France Tax Authorities the for tax years
ended 1999, 2000 and 2001. Unrelated to the French tax, we recorded a tax benefit of $0.6
million due to the recognition of research and development tax credits from our Canadian
operations.

Summary of 2002 versus 2001

Total
revenue increased 12% from 2001 to 2002, primarily attributable to the increase in license
revenue of 29% from 2001 to 2002 and maintenance revenue of 19% from 2001 to 2002. A
significant portion of the increase is primarily generated in the North American region
comprising of 74% increase in total revenue in Canada and 24%, increase in total revenue
in the United States.

Gross
profit as a percentage of total revenues increased from 59% in 2001 to 74% in 2002,
primarily due to increase in maintenance revenue of $1.4 million, while reducing the cost
of the service and maintenance revenue by $4.9 million from 2001 to 2002.

Operating
expense decreased 25% from 2001 to 2002, primarily due to reduction in charges for
amortization of goodwill and workforce of $1.9 million, reduction in non-cash compensation
charges of $4.4 million and reduction in asset impairments of $27.2 million.

Operating
margins loss as a percentage of total revenues improved from (299%) to (166%) from 2001 to
2002, primarily due to the increase in revenue, combined with the reduction of cost of
revenue, operating expenses and the reductions in charges for amortization of goodwill and
workforce of $1.9 million, reduction in non-cash compensation charges of $4.4 million and
reduction in asset impairments of $27.2 million.

Comparison of the years ended
December 31, 2003, 2002 and 2001

Revenue and cost of revenue

2003 vs. 2002

Total
revenue increased 25% from 2002 to 2003. License revenue increased 5%, while service
revenue increased 74% and maintenance revenue increased 38% from 2002 to 2003. In 2003 we
depended on a limited number of customers for a substantial portion of our revenue. We may
not continue to recognize significant revenue from these customers, or replace them with
other significant customers in 2004.

License revenue and cost
of license revenue

License
sales in Canada improved substantially, an increase of $3.1 million in 2003 over 2002,
primarily from purchases made by the telecommunications sector. License sales in Latin
America declined substantially from $2.1 million in 2002 to $0.2 million in 2003 as the
economy in Latin America continued to experience difficulty. Our license sales in the
United States, Europe, and Australia produced modest absolute growth or minor declines in
each of these regions. Our license sales in Asia in 2003, primarily in China, produced an
additional $0.5 million in license sales over 2002.

24

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We
continued to market and license our speech engines in 2003 and released two new speech
products: NVP in March 2003 and NCS in June 2003. The NVP gained market acceptance in the
telecommunications sector. These new products were primarily sold directly to end user
customers and accounted for a significant portion of the increase in license sales sold
directly to customers. Direct license revenue increased $4.9 million to $11.0 million in
2003 from $6.1 million in 2002. Indirect license revenue, primarily our speech engine products sold
through our third-party resellers, declined $3.4 million to $17.2 million in 2003 from
$20.6 million in 2002.

We
also recognized license revenue of $1.1 million in 2003 and $2.7 million in 2002 from
revenue originally accounted for as deferred revenue when payment for these third-party
reseller contracts was received in prior periods. We originally deferred the revenue
primarily as a result of payments from customers received in advance of recognition of
revenue. This license revenue was recognized in 2003 and 2002 when an identified time
period expired or the customer or third-party resellers right to certain license was
forfeited. As of December 31, 2003, there were no further deferred license contracts of
this nature recorded as deferred revenue accounts.

The
cost of license revenue declined slightly, $0.3 million from 2002 to 2003. Gross profit
increased slightly to 99% in 2003 from 98% in 2002.

Service revenue

Service
revenue increased a substantial 74% in 2003 from 2002. This revenue grew primarily from a
few large multi-year service contracts in 2003 in the United States and Canada, primarily
supporting the telecommunications sector.

Maintenance revenue

Maintenance
revenue increased 38% from 2002 to 2003. The increased maintenance revenue was primarily
due to an increase in license revenue in 2002 over 2001. The increase in the sales of
licenses in prior years resulted in an increase in support contract renewals and a
one-time benefit from fees paid by customers or third-party resellers to reinstate support
contracts.

Cost of Service and Maintenance revenue

The
cost of service and maintenance revenues as a percentage of service and maintenance revenue decreased from
64% in 2002 to 47% in 2003.

Cost
of service revenue as a percentage of service revenue was 63% for 2003 and 94% for 2002.
Service revenue gross profit improved from 6% in 2002 to 37% in 2003, primarily due to the
increase in utilization of our professional service employees and the effective use of
subcontractors to deliver consulting work for our customers. Utilization was also improved
in 2003 as we completed several large projects, which allowed for more accurate scheduling
and minimal unplanned and unbilled time.

The
cost of maintenance revenue remained relatively flat from 2002 to 2003. Technical support
personnel required to provide customers with product support remained at a relatively
constant headcount from 2002 to 2003. Maintenance gross profit increased from 63% in 2002
to 72% in 2003.

2002 versus 2001

Total
revenue increased 12% from 2001 to 2002. License revenue increased 29%, while service
revenue decreased 25% and maintenance revenue increased 19%.

License revenue and cost
of license revenue

License
sales in the United States and Canada improved substantially, an increase of $5.8 million
in 2002 over 2001, primarily from purchases made by the telecommunications sector. License
sales in Australia declined $0.7 million from 2001. Our license sales in Europe, Asia and
Latin America produced modest absolute growth in each of these regions.

We
marketed and licensed our speech engines in 2001 and 2002 primarily through third-party
resellers. Direct license sales increased $1.5 million to $4.6 million in 2002 from $3.1
million in 2001. License revenue recorded from our third-party resellers increased $3.6
million to $19.5 million in 2002 from $15.8 million in 2001.

We
also recognized license revenue of $2.7 million in 2002 and $1.8 million in 2001 from
revenue originally accounted for as deferred revenue when payment for these third-party
reseller contracts was received in prior periods. We originally deferred the revenue
primarily as a result of payments from customers received in advance of recognition of
revenue. This license revenue was recognized in 2002 and 2001 when an identified time
period expired or the customer or third-party resellers right to certain licenses
was forfeited.

25

---

Cost
of licenses revenue increased $0.4 million from 2001 to 2002, resulted in the gross profit
decreasing from 99% in 2001 to 98% in 2002. During 2001, we purchased $550,000 of
third-party software to complement our core product line. For the year ended December 31,
2001, we evaluated the third party software and wrote off $275,000 of excess inventory
caused by lower-than-expected demand in 2001. For the year ended December 31, 2002, we
continued to assess the remaining carrying value of the inventory in relation to recovery
of future revenues and wrote off the remaining $275,000.

Service revenue

Service
revenue declined 25% in 2002 from 2001. Professional service revenue remained at higher
levels in the first two quarters of 2001 as our service contracts supported the relatively
large license contracts recorded in late 2000 were delivered. These service contracts
declined substantially in the latter half of 2001.

Maintenance revenue

Maintenance
revenue increased 19% from 2001 to 2002. The increased maintenance revenue was primarily
due to increases in licenses revenue in 2002 over 2001, an increase in support contract
renewals and a one-time benefit from fees paid by customers or third-party resellers to
reinstate support contracts.

Cost of service and maintenance revenue

The
cost of service and maintenance revenues declined $4.9 million from 2001 to 2002.

The
cost of service revenues declined $4.3 million from 2001 to 2002. We improved gross profit on service from a loss in 2001 of (10%) to a gross
profit of 6% in 2002. The decrease in professional services expenses in absolute dollar
amount was primarily due to a decrease in payroll and related costs resulting from the
reduction of 10 professional services personnel during the January 2002 and August 2002
reductions-in-force. Further reductions to service costs were attributed to the
reassignment of certain professional services employees to support the sales organization.
These decreases were offset by an increase in consulting costs in 2002 of $1.4 million
from the use of subcontractors in order to meet the demand of certain customers as the
level of consulting contracts increased again in the latter half of 2002.

The
cost of maintenance revenue decreased $0.6 million from 2001 to 2002. This decrease was
primarily due to the decrease in payroll and related costs from the reduction of six
employees during the January 2002 and August 2002 reductions- in-force.

Sales and Marketing

Sales
and marketing expenses consist primarily of compensation and related costs for sales and
marketing employees, travel costs and promotional expenditures, including public
relations, advertising, trade shows and marketing materials.

2003 versus 2002

The
decreases in expenses from 2002 to 2003 was primarily attributable to the $5.0 million
decrease in payroll and related expenses, $1.0 million decrease in annual V-World trade
show expenses and $1.1 million decrease in consulting expenses. The lower payroll and related
overhead costs resulted from the realization of the full benefit of the
reductions-in-force actions taken in the latter half of 2002. Sales headcount decreased by
9 employees, approximately 11%, from 80 employees at December 31, 2002 to 71 employees at
December 31, 2003.

2002 versus 2001

Sales
and marketing expense remained relatively constant from 2001 to 2002. While there was a
reduction of 70 sales and marketing personnel resulting from the January 2002 and August
2002 reductions-in-force, the payroll related cost savings were not fully realized until
the fourth quarter of 2002.

Research and Development

Research
and development expenses consist primarily of compensation and related costs for research
and development employees and contractors.

26

---

2003 versus 2002

The
increase from 2002 to 2003 was primarily attributable to the $0.8 million increase in
payroll and related expenses and a $0.3 million increase in external consulting service.
The increase in research and development expenses from 2002 to 2003 reflects our
continuing efforts and investment to develop and deliver enhancements to our core speech
engine products, to develop and deliver our new NVP product and NCS Application product.
Headcount for research and development personnel increased by 5 employees, approximately
5%, from 94 employees at December 31, 2002 to 99 employees at December 31, 2003.

2002 versus 2001

The
decrease in research and development expenses from 2001 to 2002 was primarily due to the
reduction of 14 research and development personnel from the January 2002 and August 2002
reductions-in-force, which resulted in a decrease in payroll and related costs of
$1.9 million. Other factors that contributed to the decrease were the decrease in
amortization costs for purchased technology of $1.0 million following the December
31, 2001 write-down of the impaired intangible asset and the decrease in infrastructure
headcount-related costs of $0.8 million.

General and Administrative

General
and administrative expenses consist primarily of compensation and related costs for
administrative employees, legal services, accounting services and other general corporate
expenses.

2003 versus 2002

The
decreases from 2002 to 2003 was primarily attributable to decreases in external consulting
services, decreases in payroll and related overhead costs as a result of the headcount
reduction in the first quarter 2002, the third quarter 2002 and the third quarter 2003, as
well as the decreases in rent, partially offset by the increases in audit and tax
services. In 2003, we realized the full benefit of the reduction-in-force actions taken in
2002. Headcount for general and administrative personnel decreased by 9 employees, a
reduction of approximately 16%, from 58 employees at December 31, 2002 to 49 employees at
December 31, 2003.

2002 versus 2001

The
increase from 2001 to 2002 was primarily the result of the increase in insurance costs.
Additionally, there was also an increase in payroll related costs. While there was a
reduction of 14 general and administrative personnel resulting from the January 2002 and
August 2002 reductions-in-force, the cost savings benefit on payroll-related expenses was
not fully realized in 2002 as majority of the general and administrative personnel
reductions occurred late in August 2002.

Amortization of Goodwill
and Workforce

We
adopted Statement of Financial Accounting Standards (SFAS) No. 142, 
Goodwill and Other Intangible Assets effective January 1, 2002. SFAS No. 142 had no
effect for the year ended December 31, 2002 as all previously acquired goodwill was
impaired or written off as of December 31, 2001 and no goodwill was acquired in 2002. The
amortization of goodwill and workforce relating to SpeechFront were $1.9 million for 2001.

Non-Cash Compensation

We
account for our stock-based awards to employees using the intrinsic value method in
accordance with APB No. 25. Accounting for Stock Issued to Employees.
Accordingly, we record deferred stock compensation equal to the difference between the
grant price and fair value of our common stock on the date of grant. In connection with
the grant of stock options prior to our initial public offering, we recorded deferred
stock compensation of approximately $8.7 million within stockholders equity,
representing the difference between the estimated fair value of the common stock for
accounting purposes and the option exercise price of these options at the date of grant.
This amount is presented as a reduction of stockholders equity and is being
amortized over the vesting period of the applicable options. Relating to approximately
3,152,000 stock options granted before our initial public offering at a weighted average exercise
price of $8.58, for the years ended December 31, 2003, 2002 and 2001, we recorded
amortization of deferred compensation of $0.2 million, $0.9 million and $2.3 million
respectively. During the same periods, we reversed excess amortization of deferred stock
compensation due to termination of employees of ($0.2) million, ($0.4) million and ($0.3)
million, resulting in no net expense for deferred compensation, $0.5 million and $2.0
million, respectively. For the year ended December 31, 2002, we reversed approximately
$0.1 million of deferred stock compensation into additional paid-in capital, representing
unamortized deferred stock compensation relating to forfeitures of stock options by
terminated employees. Deferred stock compensation was fully amortized as of December 31,
2003.

In
connection with our SpeechFront acquisition, we recorded deferred stock compensation of
$4.1 million. This amount was part of the purchase agreement and was payable to the
founders in common stock, equivalent to approximately 38,710 shares at acquisition date,
and contingent upon their continued employment. Of that amount, $1.7 million of stock,
equivalent to approximately 16,590 shares at acquisition date, related to retention of the
founders of SpeechFront and was released from escrow on the eighteen-month anniversary of
the acquisition date, which was May 2002. The remaining $2.4 million of stock, equivalent
to approximately 22,120 shares at acquisition date, also related to retention of the
founders and was released from escrow on the twelve-month anniversary of the acquisition
date, which was November 2001. These amounts were amortized over 18 months and 12
months, respectively. By May 2002, the SpeechFront founders had been issued all
38,710 shares of common stock. Amortization expense related to these deferred
compensation amounts were $0.4 million and $3.1 million for 2002 and 2001.
SpeechFront related deferred compensation was fully amortized as of December 31, 2002.

27

---

In
December 2000, we issued a warrant to a customer to purchase 100,000 shares of common
stock at an exercise price of $138.50 per share subject to certain anti-dilution
adjustments. The warrant was exercisable at the option of the holder, in whole or part, at
any time between January 2001 and August 2002. In January 2001, we valued the warrant at
$0.5 million, utilizing the Black-Scholes valuation model using the following assumptions:
risk-free interest rate of 5.5%, expected dividend yields of zero, expected life of 1.5
years and expected volatility of 80%. The warrant was fully amortized as of March 31,
2002. We amortized $0.2 million and $0.3 million for 2002 and 2001, respectively, related
to this warrant. We performed services of $39,000 for this customer during 2002, and as a
result, $18,000 was recorded as a reduction in warrant expense in the quarter ended March
31, 2002 and $21,000 was recorded as service revenue in the quarter ended June 30, 2002.
We performed services of $72,000 for this customer for 2001 and as a result, $72,000 of
amortization of the warrant was recorded as a reduction in warrant expense for the year
ended December 31, 2001. The warrant expired unexercised in August 2002.

In
July 2001, an employee was terminated effective September 2001. The employees stock
options continued to vest following termination which resulted in a pre-tax non-cash
compensation charge of $0.2 million in accordance with FASB Interpretation No. 44,
Accounting for Certain Transactions Involving Stock Compensation.

Restructuring Charges and Asset Impairments

Restructuring on
headcount level

We
had 308 full-time employees as of December 31, 2003. In 2001, our Board of Directors
approved a restructuring plan to align our expenses with revised anticipated demand and
create a more efficient organization. As a result, we reduced our workforce by 85
employees, with reductions ranging between 10% and 20% across all functional areas and
affecting several locations. In 2002, in conjunction with the January 2002 and August 2002
restructuring plans approved by our Board of Directors, we reduced our workforce by
another 33 and 81 employees, respectively, primarily to realign the sales organization, to
align our cost structure with changing market conditions and to create a more efficient
organization. In August 2003, we reduced our general and administrative workforce by 9%,
or 5 employees, to further realign the organization to the Companys structure. We
will continue to evaluate our resource and skills requirements and adjust our staffing
appropriately. We may, in the future be required to increase our workforce to respond to
changes or growth in our business, and as a result may need to expand our operational and
human resources, as well as information systems and controls, to support any such growth.
Such expansion may place significant demands on our management and operational resources.

Restructuring charges
based on different plans

Fiscal Year 2001

In
April 2001, with Board of Directors approval, we implemented a restructure plan to align
our expenses with revised anticipated demand and create a more efficient organization. In
connection with the restructuring plan, we recorded a restructuring charge of $34.1
million for lease loss and severance costs and an asset impairment charge of $20.4 million
on tenant improvements during 2001.

In
connection with the restructuring plan, we decided not to occupy a new leased facility
(Pacific Shores lease). This decision has resulted in a lease loss of $32.6
million for the year ended December 31, 2001, comprised of a sublease loss, broker
commissions and other facility costs. To determine the sublease loss, the loss after our
cost recovery efforts from subleasing the building, certain assumptions were made related
to the (1) time period over which the building will remain vacant (2) sublease terms
and (3) sublease rates. We established the reserves at the low end of the range of
estimable cost against outstanding commitments, net of estimated future sublease income.
These estimates were derived using the guidance provided in SAB No. 100,
Restructuring and Impairment Charges, and EITF 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 lease loss was increased
in August 2002 and September 2003 as described below and will continue to be adjusted in
the future upon triggering events (change in estimate of time to sublease, actual sublease
rates, etc.).

We
recorded $1.5 million in costs for the year ended December 31, 2001 associated with
severance and related benefits.

28

---

Fiscal Year 2002

In
January 2002, with Board of Directors approval, we implemented a restructuring plan to
reduce our workforce. The restructuring was primarily to realign the sales and
professional services organizations. We recorded a restructuring charge of $1.3 million
during the three months ended March 31, 2002, consisting primarily of payroll and related
expenses associated with reducing headcount. This amount was paid out as of December 31,
2002.

In
August 2002, with Board of Directors approval, we implemented a restructuring plan to
reduce our worldwide workforce to realign our expense structure with near term market
opportunities. In connection with the reduction of workforce, we recorded a charge of $2.6
million primarily for severance and related employee termination costs. As of December 31,
2003, it was fully paid out. For the third quarter 2003, we also reversed an excess
accrual for this restructuring plan, which resulted in recording of $0.2 million as a
credit to the Restructuring charge line in the consolidated statement of operations.

The
plan also included the consolidation of facilities through the closing of certain
international offices that resulted in a charge of $0.7 million. In addition, we recorded
an increase in the our previously reported real estate restructuring accrual related to
the new leased facility we do not occupy and which has not been subleased as a result of
continued declines in the condition of the San Francisco Bay Area real estate market. This
additional charge of $31.8 million resulted from an analysis of the time period during which
the California property is likely to remain vacant, sub-lease terms and sub-lease rates,
altogether reflecting continued softening of the local real estate market.

Fiscal Year 2003

In
the third quarter 2003, we reviewed the earlier estimate for the lease loss for the
unoccupied leased facility and the condition of the San Francisco Bay Area real estate
market. We estimated that it might take an additional 18 months to sublease this
unoccupied facility. We also lowered the estimates for the expected sublease rates. This
evaluation resulted in recording an additional lease loss of $10.4 million and was
recorded as part of the restructuring charges on the consolidated statement of operations.

For
the third quarter 2003, we reduced our general and administrative workforce to realign the
organization to our structure. We recorded a restructuring charge of $0.2 million
primarily for severance and termination costs relating to the reduction in workforce. As
of December 31, 2003, severance was fully paid out. In addition, we reversed the excess
accrual for the August 2002 restructuring plan, which resulted in a $0.2 million credit to
the restructuring charge line in the consolidated statement of operations.

The
restructuring charges and year-end balances for the year ended December 31, 2003 are as
follows (in thousands):

29

---

|                                                       | Lease Loss | Severance & Related | Asset Write Down | Total Restructuring
|------------------------------------------------------ | ---------- | ------------------- | ---------------- | -------------------
|2001 Plan                                              |            |                     |                  |                    
|Total charges for the year ending December 31, 2001    |            |                     | $                | 32,615             
|Amount utilized in the year ending December 31, 2001   |            |                     |                  | (3,572             
|Accrual balance at December 31, 2001                   |            |                     | $                | 29,043             
|Total charges for the year ending December 31, 2002    |            |                     | $                | 31,829             
|Amount utilized in the year ended December 31, 2002    |            |                     |                  | (9,342             
|Balance at December 31, 2002                           |            |                     | $                | 51,530             
|Total charges for
the year ending December 31, 2003    |            |                     | $                | 11,316             
|Amount utilized
in the year ending December 31, 2003   |            |                     |                  | (10,477            
|Balance at December 31, 2003                           |            |                     | $                | 52,369             
|Current restructuring accrual                          |            |                     | $                | 9,478              
|Long-term restructuring accrual                        |            |                     | $                | 42,891             
|Q1 2002 Plan                                           |            |                     |                  |                    
|Total charges for the year ending December 31, 2002    |            |                     | $                | --                 
|Amount utilized in the year ending December 31, 2002   |            |                     |                  | --                 
|Balance at December 31, 2002                           |            |                     |                  | --                 
|Q3 2002 Plan                                           |            |                     |                  |                    
|Total charges for the year ending December 31, 2002    |            |                     | $                | 673                
|Amount utilized in the year ending December 31, 2002   |            |                     |                  | (159               
|Balance at December 31, 2002                           |            |                     | $                | 514                
|Total charges for the year ending December 31, 2003    |            |                     | $                | (14                
|Amount utilized in the
year ending December 31, 2003   |            |                     |                  | (465               
|Balance at December 31, 2003                           |            |                     | $                | 35                 
|Current restructuring accrual                          |            |                     | $                | 35                 
|Q3 2003 Plan                                           |            |                     |                  |                    
|Total charges for the year ending December 31, 2003    |            |                     | $                | --                 
|Amount utilized in the year ending December 31, 2003   |            |                     |                  | --                 
|Balance at December 31, 2003                           |            |                     | $                | --                 
|Current restructuring accrual                          |            |                     | $                | --                 
|Balance at December 31, 2003 (All restructuring plans) |            |                     |                  |                    
|Total restructuring accrual: Current                   |            |                     | $                | 9,513              
|Total restructuring accrual: Long-term                 |            |                     | $                | 42,891             

We
expect the total cash outlay for the restructuring plans to be $81.7 million, of which
$29.2 million was paid through December 31, 2003 and $52.4 million remains accrued at
December 31, 2003. We expect $9.5 million of the lease loss to be paid out over the next
twelve months and remaining $42.9 million to be paid out over the remaining life of the
lease of approximately 9 years.

We
have recorded a lease loss related to future lease commitments of our Pacific Shores
lease, net of expected sublease income. However, under the condition of the San Francisco
Bay Area real estate market, we may be required to periodically reevaluate the components
of the expected sublease income, because it affects the estimated lease loss for the
unoccupied leased facility. Specifically, we are required to reevaluate the time that it
might take to sublease this unoccupied facility, as well as the expected sublease rates.
This evaluation may result in additional lease loss, and would likely increase the
restructuring charges on the consolidated statement of operations.

Asset impairments

In
2002, in connection with the August 2002 restructuring plan, we wrote off certain
fixed assets as a result of consolidating and closing of certain international offices and
recorded an asset impairment charge of $0.9 million.

In
February 2003, we received cash and recorded an asset impairment credit of $0.9
million related to a refund of tenant improvement costs for the building we do not occupy, following
the landlords reconciliation of tenant improvement costs. This
credit was recorded in restructuring charges and asset impairments in the consolidated
statements of operations.

In
connection with the acquisition of SpeechFront, Inc. (SpeechFront) on November
10, 2000, we allocated approximately $1.5 million of the purchase price to in-process
research and development projects. At December 31, 2001, we reviewed the current value of
the recorded assets relating to the SpeechFront acquisition based on existing business
conditions and determined that the voice instant messaging system technologies under
development during the year 2001 were not aligned with our revised strategy and will not
be utilized. As a result, we impaired the intangible assets and recorded a charge of $3.2
million.

The
total asset impairment recorded in 2001 was $28.0 million, which includes impairments of
goodwill and work force related to SpeechFront of $3.2 million charge (details above), the intangibles related to the purchased technology of $4.4 million charge and the
asset impairment charge of $20.4 million on tenant improvements.

Acquisitions

We
had no acquisitions in 2003.

In August
2002, we purchased a set of two patents for $375,000. The patents are being amortized over
the estimated useful life of five years. The amortization for 2003 and 2002 are $75,000
and $25,000, respectively. They were included in the research and development
expense line of the consolidated statement of operations.

During
2001, we entered into an agreement with a third-party that gives us non-exclusive
intellectual property rights to text to speech software code. We paid $7.0 million for
this purchased technology, which was capitalized and is being amortized over its estimated
useful life of five years. We amortized $1.2 million to research and development in
2001. We also performed an impairment analysis for the year ended December 31, 2001. The
asset was impaired and was written down by $4.4 million to its estimated fair value based
on estimated discounted future cash flows. For each of the years ended December 31, 2003
and 2002, we amortized $0.3 million. The agreement includes a royalty clause whereby we
pay 5% of all net revenue attributable to sublicenses of this technology to a third party.
The term of the royalty payments is eight years. There was no royalty payable for the
years ended December 31, 2003, 2002 and 2001.

30

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Interest and Other Income, Net

Interest
and other income, net, consists primarily of interest income earned on cash and cash
equivalents, short-term and long-term investments, interest expense, currency gain (loss)
related to the remeasurement of certain balance sheet accounts, and other miscellaneous
items.

The
year to year decrease in interest and other income, net was mainly caused by the reduction
of interest income, resulting from lower cash balances and decreased interest rates.

Provision for (benefit
from) Income Taxes

We
recorded state and foreign income tax for the years ended December 31, 2003, 2002, and
2001 of $(1.8) million, $0.8 million and $0.6 million, respectively. For the year ended
December 31, 2003, we recorded a tax benefit of $1.8 million of state and foreign taxes,
of which $1.4 million resulted from the reversal of a prior year accrual related to tax
assessments and penalties from the France Tax Authorities for the tax years ended December
31, 2001, 2000 and 1999, thereby settling all claims for those years. In addition, we
recorded a tax benefit of $0.6 million due to the recognition of research and development
tax credits from our Canadian operations.

A
valuation allowance of $113.3 million was required for the total gross deferred tax asset
for the period ended December 31, 2003 based upon our limited operating history, our lack
of profitability to date, and the uncertainty of future profitability at that time.
Management believes it is more likely than not that we will realize a deferred tax benefit
of $0.1 million from deferred tax assets.

Our
income taxes payable for federal and state purposes has been reduced, and the deferred tax
assets increased, by the tax benefits associated with taxable dispositions of employee
stock options. When an employee exercises a stock option issued under a nonqualified plan
or has a disqualifying disposition related to a qualified plan, we receive an income tax
benefit calculated as the difference between the fair market value of the stock issued at
the time of the exercise and the option price, tax effected. A portion of the valuation
allowance relates to the equity benefit of our net operating losses. We had approximately
$1.2 million, $0.7 million, and $10.5 million of taxable dispositions of employee stock
options for the years ended December 31, 2003, 2002 and 2001, respectively. A portion of
the valuation allowance, when reduced, will be credited directly to stockholders
equity.

Liquidity and Capital
Resources

Overall

Our
financial position remained strong at December 31, 2003, with cash and cash equivalents of
$40.2 million and short-term investments of approximately $66.6 million. We believe
that our current cash, cash equivalents, short-term investment and other financing
capabilities will be sufficient to satisfy our working capital, capital expenditure and
other liquidity needs through 2004.

We
have incurred losses since our inception, including a net loss of approximately $19.3
million for the year ended December 31, 2003. As of December 31, 2003, we had an
accumulated deficit of approximately $258.0 million.

Cash, cash equivalents
and short-term investments

Cash
and cash equivalents consist of highly liquid investments in time deposits held at major
banks, commercial paper, United States government agency notes and bonds, money market
mutual funds and other money market securities with original maturities of 90 days or
less. Short-term investments include similar highly liquid investments that mature by
December 31, 2004.

The
decrease in cash, cash equivalents and short-term investments in 2003 was primarily due to
the use of cash for our operating activities. The largest use of cash from investing
activity was $109.7 million for purchase of investments. The largest generation of cash
from financing activity was the proceeds of $1.8 million from the sale of common stock
through the Employee Stock Purchase Plan and through the exercise of stock options.

31

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Net cash used in operating
activities

Our
operating activities used cash of $21.6 million, $46.8 million and $29.6 million during
2003, 2002 and 2001, respectively. In 2003, accounts receivables used cash of $5.8
million, increased $4.5 million from $1.3 million in 2002. The increase of cash usage in
accounts receivable from 2002 to 2003 was mainly due to higher revenue amounts and a
longer collection cycle from 2002 to 2003. In 2003, accrued liability and other long-term
liabilities used cash of $2.2 million versus $1.2 million in 2002, mainly due to income
tax payable decreasing from $3.0 million in 2002 to $0.5 million in 2003, as a result of
the tax benefit of $1.8 million of state and foreign taxes, of which $1.4 million resulted
from the reversal of a prior year accrual related to tax assessments and penalties from
the France Tax Authorities for tax years ended December 31, 2001, 2000 and 1999. Unrelated
to the French tax, we recorded a tax benefit of $0.6 million due to the recognition of
research and development tax credits from our Canadian operations.

The
negative operating cash flow in 2002 resulted principally from our net losses, partially
offset by an increase in the restructuring accrual. The negative operating cash flow in
2001 resulted principally from our net losses, partially offset by a decrease in accounts
receivable and an increase in the restructuring accrual and the asset impairments.

We
adopted SFAS No. 142 effective January 1, 2002. SFAS No. 142 had no effect for the year
ended December 31, 2002 as all previously acquired goodwill was impaired or written off as
of December 31, 2001 and no goodwill was acquired in 2002. This was the primary cause of
the decline for Amortization of goodwill and intangible assets line, which
decreased from $3.5 million in 2001 to $0.6 million in 2002 to $0.4 million in 2003.

Net cash provided by
(used in) investing activities

Our
investing activities provided cash of $15.3 million in 2003, and used cash of $44.7
million and $64.3 million for 2002 and 2001, respectively. The use of cash for investing
activities in 2003 and 2002 and 2001 relates primarily to purchases of investments, offset
by the maturities of certain portion of investments. Another use of cash related to the
purchase of property and equipment. Investments in property and equipment continued to
decrease from $24.3 million in 2001 to $3.0 in 2002 million to $1.6 million in 2003. The
decrease over the years was driven by our overall strategy of tight spending controls and
cash conservation. The majority of the property and equipment purchases were related to
our investments in speech technology computer equipment, some of which were contributing to
new product development. We estimate the total cash outlays in 2004 for these initiatives
will be approximately $3.8 million.

Net
cash provided by financing activities

Our
financing activities generated cash of $1.8 million, $2.6 million and $7.6 million during
2003, 2002 and 2001 respectively. Net cash provided by financing activities in 2003, 2002
and 2001 related primarily to the proceeds from the sale of common stock through the
Employee Stock Purchase Plan and through the exercise of stock options. In 2003, the
proceeds from the sale of common stock through the employee stock purchase plan and
through the exercise of stock options were $1.2 million and $0.7 million, respectively. In
2002, the proceeds from the sale of common stock through the employee stock purchase plan
and through the exercise of stock options were $2.0 million and $0.5 million,
respectively. In 2001, the proceeds from the sale of common stock through the employee
stock purchase plan and through the exercise of stock options were $4.0 million and $4.1
million, respectively.

Other

We
have contractual commitments for non-cancelable operating leases. We provide letters of
credit as guarantees on these leases. The letter of credits underlying amount are
presented as Restricted cash on consolidated balance sheet. As of December 31,
2003, restricted cash balance was $11.1 million. It consisted of a $10.9 million
certificate of deposit required by the landlord as a rent deposit for our Pacific Shore lease in
California and $198,000 related to our Montreal lease. Except for this, we had no material guarantees or commitments.

The
following table summarizes our obligations and commercial commitments to make future
payments under contracts as of December 31, 2003 (in thousands):

32

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|Contractual obligations       | Total    | 2004    | 2005    | 2006    | 2007    | 2008    | Thereafter
|----------------------------- | -------- | ------- | ------- | ------- | ------- | ------- | ----------
|Operating leases              | $ 78,972 | $ 9,300 | $ 8,400 | $ 8,619 | $ 8,879 | $ 8,980 | $ 34,795  
|Capital lease                 | 34       | 34      | --      | --      | --      | --      | --        
|Total contractual obligations | $ 79,006 | $ 9,334 | $ 8,400 | $ 8,619 | $ 8,879 | $ 8,980 | $ 34,795  

|Other commercial commitments                                | Total    | Less than 1 year | 1-3 years | 4-5 years | After 5 years |  | 
|----------------------------------------------------------- | -------- | ---------------- | --------- | --------- | ------------- |  | 
|Standby letter of credit (California, Pacific Shores lease) | $ 10,908 | $      --        | $      -- | $      -- | $ 10,908      |  | 
|Standby letter of credit (Montreal lease)                   | $ 198    | $      --        | $      -- | $      -- | $ 198         |  | 
|Total other commercial commitments                          | $ 11,106 | $ --             | $ --      | $ --      | $ 11,106     

We
have recorded a lease loss related to future lease commitments of our Pacific Shores
lease, net of expected sublease income. However, as a result of the condition of the San
Francisco Bay Area real estate market, we may be required to periodically reevaluate the
components of the expected sublease income, because it affects the estimated lease loss
for the unoccupied leased facility. Specifically, we are required to reevaluate the time
that it might take to sublease this unoccupied facility, as well as the expected sublease
rates. This evaluation may result in additional lease losses.

Off balance sheet
arrangements

In
the normal course of business, we enter into contractual commitments to purchase materials
and components from suppliers in exchange for favorable pricing or more beneficial terms.
These non-cancelable purchase obligations for materials were not material as of December
31, 2003.

Capital expenditures

Our
capital requirements depend on numerous factors. We may continue to report significant
quarterly operating losses resulting in future negative operating cash flows. We do not
plan to spend more than $3.8 million on capital expenditures in the next 12 months. We
believe that our cash, cash equivalents and short-term investments will be sufficient to
fund our activities for at least the next 12 months. Thereafter, we may need to raise
additional funds in order to fund more rapid expansion, including increases in employees
and office facilities; to develop new or enhance existing products or services; to respond
to competitive pressures; or to acquire or invest in complementary businesses,
technologies, services or products. Additional funding may not be available on favorable
terms or at all. In addition, we may, from time to time, evaluate potential acquisitions
of other businesses, products and technologies. We may also consider additional equity or
debt financing, which could be dilutive to existing investors.

# Related Parties

Certain
members of the Companys Board of Directors also serve as directors for companies to
which the Company sells products in the ordinary course of its business. The Company
believes that the terms of its transactions with those companies are no less favorable to
the Company than the terms that would have been obtained absent those relationships. In
addition, certain members of the Companys Board of Directors serve as directors or
principals of entities that are investors in the Company.

One member of the Companys
Board of Directors is also on the Board of Directors at Wells Fargo, one of the
Companys customers. The Company generated $840,000 in revenues from Wells Fargo in
the year ended December 31, 2003, and $75,000 in revenues for the year ended December 31,
2002. The Company was owed $310,000 by this customer at December 31, 2003, and $21,000 at
December 31, 2002.

# Reclassifications and
Disclosures

Certain 2002
amounts have been reclassified to conform to the fiscal year 2003 presentation. We
have revised certain financial information presented in the accompanying consolidated
financial statements and related notes as of December 31, 2001 to conform to the
fiscal year 2002 presentation. These revisions consist of reclassifications and additional
disclosures as follows:

33

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Amortization expense of $250,000 recognized in 2001 was reclassified
from non-cash compensation expense to sales and marketing expense, related to amortization of an intangible.

Training
revenue totaling $900,000 for the years ended December 31, 2001, has been reclassified
from maintenance revenue to service revenue.

We
adopted EITF Issue No. 01-14, Income Statement Characterization of Reimbursements Received
for Out-of-Pocket Expenses Incurred, beginning January 1, 2002, and
comparative financial statements for 2001 have been reclassified to comply with the
guidance. The effect of this reclassification was an increase in maintenance and other
revenue and an increase in cost of service expense of $75,000 for the year ended December
31, 2001.

We
adopted SFAS No. 142, Goodwill and Other Intangible Assets beginning January 1, 2002. As
described in Note 8, the 2001 financial statements have been revised to include the
transitional disclosures required by SFAS 142. These disclosures provide a reconciliation
of adjusted net loss to reported net loss and the related loss-per-share amounts.

# Code of Business Conduct
and Ethics

We
maintain a code of business conduct and ethics for directors, officers and employees, and
will promptly disclose any waivers of the code for directors or executive officers. Our
code of business practices addresses conflicts of interest; confidentiality; compliance
with laws, rules and regulations (including insider trading laws); and related matters.

# Recently Issued
Accounting Pronouncements

In
December 2002, the Financial Accounting Standards Board issued SFAS No. 148,
Accounting for Stock-Based CompensationTransition and Disclosurean
Amendment of SFAS 123. SFAS 148 provides two additional transition methods for
entities that adopt the preferable method of accounting for stock-based compensation.
Further, the statement requires disclosure of comparable information for all companies
regardless of whether, when, or how an entity adopts the preferable, fair value based
method of accounting. These disclosures are now required for interim periods in addition
to annual disclosure. For the year ended December 31, 2003, we adopted the additional
disclosure provisions of SFAS 148. The transition provisions of SFAS 148 are currently not
applicable to us as it continues to account for options under APB 25.

On
January 1, 2003, we adopted SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities, (SFAS No. 146), which nullifies
Emerging Issues Task Force (EITF) 94-3,Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs
Incurred in a Restructuring) (EITF 94-3). SFAS No. 146 requires
that a liability be recognized for restructuring costs only when the liability is
incurred, that is, when it meets the definition of a liability in the Financial Accounting
Standards Boards (FASBs) conceptual framework. SFAS No. 146
also establishes fair value as the objective for initial measurement of liabilities
related to exit or disposal activities and is effective for exit or disposal activities
that are initiated after December 31, 2002. The adoption of SFAS No. 146 did not
have a material impact on our results of operations, financial position or cash flows.

On
January 1, 2003, we adopted FASB Interpretation (FIN) No. 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others. FIN No. 45 requires certain
guarantees to be recorded at fair value and requires a guarantor to make disclosures, even
when the likelihood of making any payments under the guarantee is remote. For those
guarantees and indemnifications that do not fall within initial recognition and
measurement requirements of FIN No. 45, we must continue to monitor the conditions
that are subject to the guarantees and indemnifications, as required under existing
generally accepted accounting principles, to identify if a loss has been incurred. If we
determine that it is probable that a loss has been incurred, any such estimable loss would
be recognized. The initial recognition and measurement requirements do not apply to our
product warranties or to the provisions contained in the majority of our software license
agreements that indemnify licensees of our software from damages and costs resulting from
claims alleging that our software infringes the intellectual property rights of a third
party. We have provided disclosures as required by FIN No. 45 in Note 9 to its
consolidated financial statements. The adoption of the liability recognition provisions
did not have a material impact on our financial position or results of operations.

34

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In
January 2003, the FASB issued FIN 46, Consolidation of Variable Interest
Entities, and a revised interpretation of FIN 46 (FIN 46R) in
December 2003 (collectively FIN 46). FIN 46 addresses consolidation of
variable interest entities. FIN 46 provides guidance for determining when a primary
beneficiary should consolidate a variable interest entity or equivalent structure that
functions to support the activities of the primary beneficiary. The provisions of FIN 46
are effective immediately for all variable interest entities created after January 31,
2003. It applies in the first year or interim period ending after December 15, 2003 to
variable interest entities in which an enterprise holds a variable interest that it
acquired before February 1, 2003. We did not have any variable interest entities as of
December 31, 2003, and do not expect the adoption of FIN 46 to have a material effect on
our financial statements.

The
EITF recently reached a consensus on two issues relating to the accounting for multiple
element arrangements: Issue No. 00-21  Change in Accounting Principle: Revenue
Arrangements with Multiple Deliverables, and Issue No. 03-05 Applicability of
AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing
More-Than-Incidental Software. The consensus opinion in EITF No. 03-05 clarifies the
guidance in EITF 00-21 and was reached on July 31, 2003. The transition provisions allow
either prospective application or a cumulative effect adjustment upon adoption. We adopted
prospectively as of July 1, 2003. EITF Nos. 00-21 and 03-05 did not have a material impact
on the consolidated financial statements.

# ITEM
7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

# Market Risk

The
following section describes our exposure to market risk related to changes in foreign
currency exchange rates and interest rates. This section contains forward-looking
statements that are subject to risks and uncertainties. Actual results could vary
materially as a result of a number of factors including those set forth in the risk
factors section of this Annual Report on Form 10-K.

# Foreign Currency
Exchange Rate Risk

To
date, all of our recognized revenues have been denominated in U.S. dollars and primarily
from customers in the United States, and our exposure to foreign currency exchange rate
changes has been immaterial. We expect, however, that future product license and services
revenues derived from international markets may be denominated in the currency of the
applicable market. As a result, our operating results may become subject to significant
fluctuations based upon changes in the exchange rates of certain currencies in relation to
the U.S. dollar. Furthermore, to the extent that we engage in international sales
denominated in U.S. dollars, an increase in the value of the U.S. dollar relative to
foreign currencies could make our products less competitive in international markets.
Although we will continue to monitor our exposure to currency fluctuations, and when
appropriate, may use financial hedging techniques to minimize the effect of these
fluctuations, we cannot assure you that exchange rate fluctuations will not adversely
affect our financial results in the future.

# Interest Rate Risk

As
of December 31, 2003, we had cash, cash equivalents and short-term investments of $106.8
million. Any decline in interest rates over time would reduce our interest income from our
short-term and long-term investments. Based upon our balance of cash and cash equivalents,
short-term investments and long-term investments, an absolute reduction in interest rates
of 0.5% would cause a corresponding decrease in our annual interest income by
approximately $0.5 million.

The
following table summarizes the types and maturities of our investments as of December 31,
2003 (in thousands):

|                        | As of December 31, 2003
|----------------------- | -----------------------
|Investment Type         |                        
|Government agency bonds |                        
|Corporate bonds         |                        
|Marketable securities   |                        
|Total                   |                        

# ITEM 8.    FINANCIAL
STATEMENTS AND SUPPLEMENTAL DATA

35

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Reference
is made to the Index to Consolidated Financial Statements that appears on page F-1 of this
report. The Report of Independent Public Accountants, Consolidated Financial Statements
and Notes to Consolidated Financial Statements which are listed in the Index to Financial
Statements and which appear beginning on page F-2 of this report are incorporated
into this Item 8.

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

On
April 11, 2002, the Company dismissed its independent accountants, Arthur Andersen LLP
(AA), and on April 12, 2002 engaged the services of Deloitte & Touche LLP
(Deloitte) as its new independent accountants for its fiscal year ended
December 31, 2002. The Audit Committee of the Companys Board of Directors (the
Board) recommended, and the Board approved, the dismissal of AA and the appointment of
Deloitte.

During
the fiscal year ended December 31, 2001 and the subsequent interim periods through April
11, 2002, there were no disagreements between the Company and AA on any matter of
accounting principles or practices, financial statement disclosure, or auditing scope or
procedure, which disagreements, if not resolved to AAs satisfaction, would have
caused AA to make reference to the subject matter of the disagreement in connection with
its reports; and there were no reportable events described under Item 304(a)(1)(v) of
Regulation S-K.

The
audit report of AA on the consolidated financial statements of the Company as of and for
the fiscal year ended December 31, 2001 did not contain any adverse opinion or disclaimer
of opinion, nor were they qualified or modified as to uncertainty, audit scope or
accounting principles.

During
the fiscal year ended December 31, 2001 and through April 11, 2002, the Company did not
consult with Deloitte with respect to the application of accounting principles to a
specified transaction, either completed or proposed, or the type of audit opinion that
might be rendered on our consolidated financial statements, or any other matter or
reportable events as set forth in Item 304(a)(2)(i) and (ii) of Regulation S-K.

# ITEM 9A.    
CONTROLS AND PROCEDURES

(a)  Evaluation
of disclosure controls and procedures.    Based on our
managements evaluation (with the participation of our principal executive officer
and principal financial officer) as of the end of the period covered by this Annual Report
on Form 10-K, except as specifically noted below, our disclosure controls and procedures (as defined in Rules 13a-15(e)
and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange
Act)) are effective to ensure that information required to be disclosed by us in
reports that we file, or submit, under the Exchange Act is recorded, processed, summarized
and reported within the time periods specified in the Securities and Exchange Commission
rules and forms.

During
the preparation of the Companys 2003 consolidated financial statements, the Company
discovered that its pro-forma footnote disclosure required by FAS 148 Accounting for
Stock-Based Compensation-Transition and Disclosure, with respect to the fair value
of its stock-based awards for its fiscal years ended December 31, 2002 and 2001, as set
forth in the Notes to its Consolidated Financial Statements for such years, was not
calculated correctly. The Company has corrected the disclosure for those years, as
described in Note 2 of Notes to Consolidated Financial Statements included in this Annual
Report on Form 10-K. In response to the discovery of this calculation error during the first quarter of 2004, the Company
has implemented processes and procedures intended to ensure that this calculation error is
not repeated.

(b)  Changes
in internal controls over financial reporting.    There was no
change in our internal control over financial reporting during the fourth quarter of
fiscal 2003 that has materially affected, or is reasonably likely to materially affect,
our internal control over financial reporting.

Internal
control over financial reporting consists of control processes designed to provide
assurance regarding the reliability of financial reporting and the preparation of our
financial statements in accordance with GAAP. To the extent that components of our
internal control over financial reporting are included in our disclosure controls, they
are included in the scope of the evaluation by our chief executive officer and chief
financial officer referenced above.

# PART III

The
information required by this Part III will be provided in our definitive proxy statement
for our 2004 Annual Meeting of Stockholders (involving the election of directors), which
definitive proxy statement will be filed pursuant to Regulation 14A not later than 120
days following our fiscal year ended December 31, 2003,and is incorporated herein by this
reference to the following extent:

# ITEM 10.    DIRECTORS AND EXECUTIVE
OFFICERS OF THE REGISTRANT

# Executive Officers and
Directors

The
information required by this item is incorporated by reference to the sections of our
proxy statement entitled Executive Officers and Information Regarding
Nominees and Other Directors.

36

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Compliance with Section
16 (a) of the Exchange Act

The information
required by this item is incorporated by reference to the section of our proxy statement
entitled Section 16(a) Beneficial Ownership Reporting Compliance

# Code of Ethics

The
information required by this item is incorporated by reference to the section of our proxy
statement entitled  Code of Business Conduct and Ethics.

# ITEM 11.    EXECUTIVE
COMPENSATION

The
information required by this item is incorporated by reference to the information set
forth in the section of our proxy statement entitled Executive Officer
Compensation.

# ITEM 12.    SECURITY OWNERSHIP
OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The
information required by this item is incorporated by reference to the section of our proxy
statement entitled Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters.

# ITEM 13.      CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this item
is incorporated by reference to the section of our proxy statement entitled Certain
Relationships and Related Transactions.

# ITEM 14.    PRINCIPAL
ACCOUNTANT FEES AND SERVICES

The
information required by this item is incorporated by reference to the section of our proxy
statement entitled Principal Accountant Fees and Services.

# PART IV

# ITEM 17.    EXHIBITS, FINANCIAL STATEMENT
SCHEDULES AND REPORTS ON FORM 8-K

(a)(1)  Index
to Financial Statements

|Nuance Communications, Inc.:                                           |     
|---------------------------------------------------------------------- | ----
|Independent Auditors' Report                                           | F-2 
|Copy of Report of Arthur Anderson LLP, Independent Public Accountants  | F-3 
|Consolidated Balance Sheets                                            | F-4 
|Consolidated Statements of Operations                                  | F-5 
|Consolidated Statements of Stockholders' Equity and Comprehensive Loss | F-6 
|Consolidated Statements of Cash Flows                                  | F-7 
|Notes to Consolidated Financial Statements                             | F-8 
|Schedule II--Valuation and Qualifying Accounts                         | F-30

(a)(2)  Consolidated
Financial Statement Schedules

Schedule IISchedule
of Valuation and Qualifying Accounts Schedule

Schedules
not listed have been omitted because the information required to be set forth therein is
not applicable or is included in the Financial Statements or notes thereto.

(a)(3) 
 Exhibits

See
the Exhibit Index of this Annual Report on Form 10K, which is incorporated into item 17 by
reference, for the exhibits filed as part of or incorporated by reference into this
report.

(b)Reports
on Form 8-K

Form
8-K furnished on October 22, 2003, reporting on October 22, 2003, under Item 7
Financial Statements and Exhibits and under Item 12 Results of
Operations and Financial Condition, our press release announcing financial results
for the three months ended September 30, 2003.

37

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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 report to be signed on its behalf by the undersigned,
thereunto duly authorized.

| |  | By:  /s/ CHARLES W.BERGER                             
| |  | ------------------------------------------------------
| |  | Charles W. BergerPresident and Chief Executive Officer
| |  |                                                       

Date: March 24, 2004

38

---

# POWER OF ATTORNEY

KNOW
ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes
and appoints Charles Berger and Karen Blasing, or either of them, his or her
attorneys-in-fact, for such person in any and all capacities, to sign any amendments to
this report and to file the same, with exhibits thereto, and other documents in connection
therewith, with the Securities and Exchange Commission, hereby ratifying and confirming
all that either of said attorneys-in-fact, or substitute or substitutes, may do or cause
to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act
of 1934, this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.

|Signature                                  | Title                                      | Date          
|------------------------------------------ | ------------------------------------------ | --------------
|/s/    CHARLES W. BERGER
Charles W. Berger | President and Chief Executive Officer      | March 24, 2004
|                                           |                                            |               
|/s/    KAREN BLASING
Karen Blasing         | Vice President
and Chief Financial Officer | March 24, 2004
|                                           |                                            |               
|/s/    RONALD CROEN
Ronald Croen           | Chairman of the Board of Directors         | March 24, 2004
|                                           |                                            |               
|/s/    CURTIS R. CARLSON
Curtis R. Carlson | Director                                   | March 24, 2004
|                                           |                                            |               
|/s/    VINTON CERF
Vinton Cerf             | Director                                   | March 24, 2004
|                                           |                                            |               
|/s/    IRWIN FEDERMAN
Irwin Federman       | Director                                   | March 24, 2004
|                                           |                                            |               
|/s/    ALAN HERZIG
Alan Herzig             | Director                                   | March 24, 2004
|                                           |                                            |               
|/s/    GARY MORGENTHALER
Gary Morgenthaler | Director                                   | March 24, 2004
|                                           |                                            |               
|/s/    PHIL QUIGLEY
Phil Quigley           | Director                                   | March 24, 2004
|                                           |                                            |               

39

---

# NUANCE COMMUNICATION
INC. & SUBSIDIARIES

# INDEX TO CONSOLIDATED
FINANCIAL STATEMENTS

|Nuance Communications, Inc.:                                           |     
|---------------------------------------------------------------------- | ----
|Independent Auditors' Report                                           | F-2 
|Copy of Report of Arthur Anderson LLP, Independent Public Accountants  | F-3 
|Consolidated Balance Sheets                                            | F-4 
|Consolidated Statements of Operations                                  | F-5 
|Consolidated Statements of Stockholders' Equity and Comprehensive Loss | F-6 
|Consolidated Statements of Cash Flows                                  | F-7 
|Notes to Consolidated Financial Statements                             | F-8 
|Schedule II--Valuation and Qualifying Accounts                         | F-30

F-1

---

# INDEPENDENT
AUDITORS REPORT

To the Board of Directors and
Stockholders of Nuance Communications, Inc. and Subsidiaries:

We
have audited the accompanying consolidated balance sheets of Nuance Communications, Inc.
and subsidiaries (the Company) as of December 31, 2003 and 2002, and the
related consolidated statements of operations, stockholders equity and comprehensive
loss, and cash flows for each of the years then ended. Our audit also included the 2003
and 2002 consolidated financial statement schedules listed in the index as Schedule II.
These financial statements and the financial statement schedules are the responsibility of
the Companys management. Our responsibility is to express an opinion on the 2003 and
2002 financial statements and financial statement schedules based on our audits. The
financial statements and financial statement schedule as of December 31, 2001, and for the
year then ended, before the reclassification adjustments and inclusion of the disclosures
discussed in Notes 2 and 8 to the financial statements were audited by other auditors who
have ceased operations. Those auditors expressed an unqualified opinion on those financial
statements and stated that such 2001 financial statement schedule, when considered in
relation to the 2001 basic financial statements taken as a whole, presented fairly, in all
material respects, the information set forth therein, in their report dated January 21,
2002 (January 24, 2002 and March 1, 2002 as to certain matters).

We
conducted our audits in accordance with auditing standards generally accepted in the
United States of America. 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 2003 and 2002 consolidated financial statements present fairly, in all
material respects, the financial position of the Company as of December 31, 2003 and 2002
and the results of its operations and its cash flows for each of the years then ended in
conformity with accounting principles generally accepted in the United States of America.
Also, in our opinion, the 2003 and 2002 consolidated financial statement schedules, when
considered in relation to the 2003 and 2002 basic consolidated financial statements taken
as a whole, present fairly, in all material respects, the information set forth therein.

As
discussed in Note 8 to the consolidated financial statements, in 2002 the Company changed
its method of accounting for goodwill and other intangible assets to conform to Statement
of Financial Accounting Standards No. 142.

As
discussed in Note 2, the consolidated financial statement information for the year ended December 31, 2002
has been revised to adjust pro forma stock based compensation expense.

As
discussed above, the consolidated financial statements of the Company for the year ended
December 31, 2001 were audited by other auditors who have ceased operations. The notes
related to these financial statements have been revised to include transitional
disclosures required by SFAS No. 142, which was adopted by the Company as of January 1,
2002. Our audit procedures with respect to the disclosures in Note 8 for 2001 included (i)
agreeing the previously reported net loss to the previously issued consolidated financial
statements and the adjustments to net loss representing amortization expense recognized in
periods related to goodwill to the Companys underlying records obtained from
management, and (ii) testing the mathematical accuracy of the reconciliation of the
adjusted net loss to reported net loss and the related loss-per-share amount. Also, as
described under sections Stock-based Compensation and
Reclassifications in Note 2, those financial statements have been revised. We
audited the adjustments in Stock-based Compensation, and reclassification
adjustments and disclosures described in Reclassifications in Note 2 that were
applied to revise the 2001 financial statements. Our audit procedures with respect to the
adjustments in Stock-based Compensation in Note 2 with respect to 2001
included (i) agreeing the previously reported net loss, stock based compensation expense
included in net loss, and basic and diluted net loss per share  as reported to the
previously issued financial statements and the total stock-based employee compensation
expense under the fair value method for all awards to the Companys underlying
records obtained from management, and (ii) testing the mathematical accuracy of the
reconciliation of pro forma net loss to reported net loss, and the related basic and
diluted net loss per share  pro forma amount. In addition, our audit procedures with
respect to Reclassifications in Note 2 with respect to 2001 included (i)
comparing reclassification adjustments to the Companys analysis obtained from
management, (ii) comparing the amounts of service revenue, maintenance revenue, cost of
service expense, sales and marketing expense, and non-cash compensation as presented in
the income statement to supporting documentation, and (iii) testing the mathematical
accuracy of the underlying documentation. In our opinion, the reclassification adjustments, and disclosures in Notes 2 and 8 are appropriate and have been properly
presented. However, we were not engaged to audit, review, or apply any procedures to the
2001 financial statements of the Company other than with respect to such reclassifications
adjustments and disclosures and, accordingly, we do not express an opinion or any other
form of assurance on the 2001 financial statements taken as a whole.

/s/  DELOITTE & TOUCHE LLP

San Jose, CaliforniaMarch 24, 2004

F-2

---

This
is a copy of the audit report previously issued by Arthur Andersen LLP in connection with
the Companys filing on Form 10-K for the year ended December 31, 2001. This audit
report has not been reissued by Arthur Andersen LLP nor has Arthur Andersen LLP provided a
consent to the inclusion of its report in this Form 10-K. The consolidated balance sheet
as of December 31, 2000, the consolidated statement of operations, stockholders
equity and cash flows for the years ended December 31, 2000 and 1999 and the information
in the schedule for 2000 and 1999 referred to in this report have not been included in the
accompanying financial statements or schedule.

# REPORT OF INDEPENDENT
PUBLIC ACCOUNTANTS

To the Board of Directors
of Nuance Communications, Inc:

We
have audited the accompanying consolidated balance sheets of Nuance Communications, Inc.
(a Delaware corporation) and subsidiaries as of December 31, 2001 and 2000, and the
related consolidated statement of operations, stockholders equity, and cash flows
for each of the three years in the period ended December 31, 2001. These financial
statements, and the schedule referred to below, are the responsibility of the
Companys management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.

We
conducted our audits in accordance with auditing standards generally accepted in the
United States of America. 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 financial position of Nuance Communications, Inc. and subsidiaries as of
December 31, 2001 and 2000, and the results of their operations and their cash flows for
each of the three years in the period ended December 31, 2001 in conformity with
accounting principles generally accepted in the United States of America.

Our
audit was made for the purpose of forming an opinion on the basic financial statements
taken as a whole. The schedule listed in the index of the financial statements is
presented for purposes of complying with the Securities and Exchange Commissions
rules and is not part of the basic financial statements. This schedule has been subjected
to the auditing procedures applied in the audit of the basic financial statements and, in
our opinion, fairly states in all material respects the financial data required to be set
forth therein in relation to the basic financial statements taken as a whole.

/s/  ARTHUR ANDERSEN LLP

San Jose, CaliforniaJanuary 21, 2002

(except with respect to the matters discussed 
in Note 17, as to which the dates are January 24,
2002 and March 1, 2002, respectively)

F-3

---

# NUANCE COMMUNICATIONS,
INC. & SUBSIDIARIES

# CONSOLIDATED BALANCE
SHEETS

# (in thousands, except
share and per share amounts)

|                                                                                                                                                                         | December 31,
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------
|
|ASSETS                                                                                                                                                                   |             
|Current assets:                                                                                                                                                          |             
|Cash and cash equivalents                                                                                                                                                |             
|Short-term investments                                                                                                                                                   |             
|Accounts receivable, net of allowance for doubtful accounts of $837    
             and $670, respectively                                                              |             
|Prepaid expenses and other current assets                                                                                                                                |             
|                                                                                                                                                                         |             
|Total current assets                                                                                                                                                     |             
|Property and equipment, net                                                                                                                                              |             
|Intangible assets, net                                                                                                                                                   |             
|Restricted cash                                                                                                                                                          |             
|Long-term investments                                                                                                                                                    |             
|Other assets                                                                                                                                                             |             
|                                                                                                                                                                         |             
|Total assets                                                                                                                                                             |             
|LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                                                                     |             
|Current liabilities:                                                                                                                                                     |             
|Accounts payable                                                                                                                                                         |             
|Accrued vacation                                                                                                                                                         |             
|Accrued liabilities                                                                                                                                                      |             
|Current restructuring accrual                                                                                                                                            |             
|Current deferred revenue                                                                                                                                                 |             
|Current portion of capital lease                                                                                                                                         |             
|Total current liabilities                                                                                                                                                |             
|Long-term deferred revenue                                                                                                                                               |             
|Long-term restructuring accrual                                                                                                                                          |             
|Other long-term liabilities                                                                                                                                              |             
|Total liabilities                                                                                                                                                        |             
|Commitments and contingencies (Note 12)                                                                                                                                  |             
|Stockholders Equity                                                                                                                                                     |             
|Common stock, $0.001 par value, 250,000,000 shares authorized;           
    34,995,000 shares and 34,182,000 shares issued and outstanding,   
           respectively |             
|Additional paid-in capital                                                                                                                                               |             
|Deferred stock compensation                                                                                                                                              |             
|Accumulated other comprehensive income                                                                                                                                   |             
|Accumulated deficit                                                                                                                                                      |             
|Total stockholders equity                                                                                                                                               |             
|Total liabilities and stockholders equity                                                                                                                               |             

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

F-4

---

# NUANCE COMMUNICATIONS,
INC. & SUBSIDIARIES

# CONSOLIDATED
STATEMENTS OF OPERATIONS

# (in thousands, except
per share data)

|                                                            | Year Ended December 31,
|----------------------------------------------------------- | -----------------------
|                                                            |                        
|Revenue:                                                    |                        
|License                                                     |                        
|Service                                                     |                        
|Maintenance                                                 |                        
|Total revenue                                               |                        
|Cost of revenue:                                            |                        
|License                                                     |                        
|Service and maintenance (1)                                 |                        
|Total cost of revenue                                       |                        
|Gross profit                                                |                        
|Operating expenses:                                         |                        
|Sales and marketing (1)                                     |                        
|Research and development (1)                                |                        
|General and administrative (1)                              |                        
|Amortization of goodwill and workforce                      |                        
|Non-cash compensation expense                               |                        
|Restructuring charges and asset impairments                 |                        
|Total operating expenses                                    |                        
|Loss from operations                                        |                        
|Interest and other income, net                              |                        
|Loss before income taxes                                    |                        
|Provision for (benefit from) income taxes                   |                        
|Net loss                                                    |                        
|Basic and diluted net loss per share                        |                        
|Shares used to compute basic and diluted net loss per share |                        
|(1) Excludes non-cash
compensation expense as follows:      |                        
|
|
|
|                                                            |                        
|Service and maintenance cost of revenue                     |                        
|Sales and marketing                                         |                        
|Research and development                                    |                        
|General and administrative                                  |                        
|Total non-cash compensation expense                         |                        

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

F-5

---

# NUANCE COMMUNICATIONS,
INC. & SUBSIDIARIES

# CONSOLIDATED
STATEMENTS OF STOCKHOLDERS EQUITY AND COMPREHENSIVE LOSS

# (in thousands, except
share amounts)

|                                                                                     |  | Common stock shares |  |            | Common stock amount |  |      | Additional paid-in capital |  |           | Deferred stock compensation |  |          | Accumulated other comprehensive income (loss) |  |       | Accumulated deficit |  |             | Stockholders' equity |  |           | Comprehensive loss | 
|------------------------------------------------------------------------------------ |  | ------------------- |  | ---------- | ------------------- |  | ---- | -------------------------- |  | --------- | --------------------------- |  | -------- | --------------------------------------------- |  | ----- | ------------------- |  | ----------- | -------------------- |  | --------- | ------------------ | 
|Balance at January 1, 2001                                                           |  |                     |  | 32,158,875 |                     |  | $ 32 |                            |  | $ 316,958 |                             |  | $ (7,636 | )                                             |  | $ (16 | )                   |  | $ (57,347   | )                    |  | $ 251,991 |                    | 
|Exercise of common stock options                                                     |  |                     |  | 649,233    |                     |  | 1    |                            |  | 4,075     |                             |  | --       |                                               |  | --    |                     |  | --          |                      |  | 4,076     |                    | 
|Repurchase of common stock                                                           |  |                     |  | (68,947    | )                   |  | --   |                            |  | (365      | )                           |  | --       |                                               |  | --    |                     |  | --          |                      |  | (365      | )                  | 
|Issuance of OnStar warrant                                                           |  |                     |  | --         |                     |  | --   |                            |  | 526       |                             |  | --       |                                               |  | --    |                     |  | --          |                      |  | 526       |                    | 
|ESPP common stock issued                                                             |  |                     |  | 458,890    |                     |  | --   |                            |  | 3,960     |                             |  | --       |                                               |  | --    |                     |  | --          |                      |  | 3,960     |                    | 
|Non-cash compensation for change in stock options                                    |  |                     |  | --         |                     |  | --   |                            |  | 216       |                             |  | --       |                                               |  | --    |                     |  | --          |                      |  | 216       |                    | 
|Amortization of deferred stock compensation                                          |  |                     |  | --         |                     |  | --   |                            |  | ---       |                             |  | 5,105    |                                               |  | --    |                     |  | --          |                      |  | 5,105     |                    | 
|Deferred stock compensation adjustment                                               |  |                     |  | --         |                     |  | --   |                            |  | (999      | )                           |  | 999      |                                               |  | --    |                     |  | --          |                      |  | --        |                    | 
|Unrealized loss on available-for-sale securities                                     |  |                     |  | --         |                     |  | --   |                            |  | --        |                             |  | --       |                                               |  | (108  | )                   |  | --          |                      |  | (108      | )                  | 
|Foreign currency translation loss                                                    |  |                     |  | --         |                     |  | --   |                            |  | --        |                             |  | --       |                                               |  | (211  | )                   |  | --          |                      |  | (211      | )                  | 
|Net loss                                                                             |  |                     |  | --         |                     |  | --   |                            |  | --        |                             |  | --       |                                               |  | --    |                     |  | (110,365)   |                      |  | (110,365) |                    | 
|Balance at December 31, 2001                                                         |  |                     |  | 33,198,051 |                     |  | 33   |                            |  | 324,371   |                             |  | (1,532   | )                                             |  | (335  | )                   |  | (167,712    | )                    |  | 154,825   |                    | 
|Exercise of common stock options                                                     |  |                     |  | 307,330    |                     |  | --   |                            |  | 498       |                             |  | --       |                                               |  | --    |                     |  | --          |                      |  | 498       |                    | 
|Repurchase of common stock                                                           |  |                     |  | (3,355     | )                   |  | --   |                            |  | (11       | )                           |  | --       |                                               |  | --    |                     |  | --          |                      |  | (11       | )                  | 
|Reversal of issuance of stock repurchased in prior year                              |  |                     |  | 10,000     |                     |  | --   |                            |  | 72        |                             |  | --       |                                               |  | --    |                     |  | --          |                      |  | 72        |                    | 
|ESPP common stock issued                                                             |  |                     |  | 614,923    |                     |  | 1    |                            |  | 2,049     |                             |  | --       |                                               |  | --    |                     |  | --          |                      |  | 2,050     |                    | 
|Amortization of deferred stock compensation                                          |  |                     |  | --         |                     |  | --   |                            |  | ---       |                             |  | 928      |                                               |  | --    |                     |  | --          |                      |  | 928       |                    | 
|Deferred stock compensation adjustment                                               |  |                     |  | --         |                     |  | --   |                            |  | (383      | )                           |  | 383      |                                               |  | --    |                     |  | --          |                      |  | --        |                    | 
|Issuance of shares for representations
and warranties related to SpeechFront         |  |                     |  | 16,588     |                     |  | --   |                            |  | 1,743     |                             |  | --       |                                               |  | --    |                     |  | --          |                      |  | 1,743     |                    | 
|Issuance of shares relating to SpeechFront founders retention and
product milestones |  |                     |  | 38,707     |                     |  | --   |                            |  | --        |                             |  | --       |                                               |  | --    |                     |  | --          |                      |  | --        |                    | 
|Unrealized gain on available-for-sale securities                                     |  |                     |  | --         |                     |  | --   |                            |  | --        |                             |  | --       |                                               |  | 284   |                     |  | --          |                      |  | 284       |                    | 
|Foreign currency translation gain                                                    |  |                     |  | --         |                     |  | --   |                            |  | --        |                             |  | --       |                                               |  | 68    |                     |  | --          |                      |  | 68        |                    | 
|Net loss                                                                             |  |                     |  | --         |                     |  | --   |                            |  | --        |                             |  | --       |                                               |  | --    |                     |  | (71,184)    |                      |  | (71,184)  |                    | 
|Balance at December 31, 2002                                                         |  |                     |  | 34,182,244 |                     |  | 34   |                            |  | 328,339   |                             |  | (221     | )                                             |  | 17    |                     |  | (238,896    | )                    |  | 89,273    |                    | 
|Exercise of common stock options                                                     |  |                     |  | 226,828    |                     |  | --   |                            |  | 675       |                             |  | --       |                                               |  | --    |                     |  | --          |                      |  | 675       |                    | 
|ESPP common stock issued                                                             |  |                     |  | 586,179    |                     |  | 1    |                            |  | 1,154     |                             |  | --       |                                               |  | --    |                     |  | --          |                      |  | 1,155     |                    | 
|Amortization of deferred stock compensation                                          |  |                     |  | --         |                     |  | --   |                            |  | ---       |                             |  | 28       |                                               |  | --    |                     |  | --          |                      |  | 28        |                    | 
|Deferred stock compensation adjustment                                               |  |                     |  | --         |                     |  | --   |                            |  | (193      | )                           |  | 193      |                                               |  | --    |                     |  | --          |                      |  | --        |                    | 
|Unrealized loss on available-for-sale securities                                     |  |                     |  | --         |                     |  | --   |                            |  | --        |                             |  | --       |                                               |  | (155  | )                   |  | --          |                      |  | (155      | )                  | 
|Foreign currency translation gain                                                    |  |                     |  | --         |                     |  | --   |                            |  | --        |                             |  | --       |                                               |  | 886   |                     |  | --          |                      |  | 886       |                    | 
|Net loss                                                                             |  |                     |  | --         |                     |  | --   |                            |  | --        |                             |  | --       |                                               |  | --    |                     |  | (19,301)    |                      |  | (19,301)  |                    | 
|Balance at December 31, 2003                                                         |  |                     |  | 34,995,251 |                     |  | $ 35 |                            |  | $ 329,975 |                             |  | --       |                                               |  | $ 748 |                     |  | $ (258,197) |                      |  | $ 72,561  |                    | 

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

F-6

---

# NUANCE COMMUNICATIONS,
INC. & SUBSIDIARIES

# CONSOLIDATED
STATEMENTS OF CASH FLOWS

# (in thousands)

|                                                                                  | Year Ended December 31,
|--------------------------------------------------------------------------------- | -----------------------
|                                                                                  | 2003                   
|Cash flows from operating activities:                                             |                        
|Net loss                                                                          |                        
|Adjustments to reconcile net loss to net cash used in operating        activites: |                        
|Depreciation                                                                      |                        
|Loss on fixed asset disposals                                                     |                        
|Amortization of goodwill and intangible assets                                    |                        
|Non-cash compensation expense                                                     |                        
|Allowance for doubtful accounts                                                   |                        
|Deferred income taxes                                                             |                        
|Asset impairments                                                                 |                        
|Write-off of excess purchased software                                            |                        
|Changes in operating assets and liabilities:                                      |                        
|Accounts receivable                                                               |                        
|Prepaid expenses and other current assets                                         |                        
|Restructuring accrual                                                             |                        
|Accounts payable                                                                  |                        
|Accrued liabilities and other long-term liabilities                               |                        
|Deferred revenue                                                                  |                        
|Net cash used in operating activities                                             |                        
|Cash flows from investing activities:                                             |                        
|Purchase of investments                                                           |                        
|Maturities of investments                                                         |                        
|Purchase of property and equipment                                                |                        
|Purchase of intangible assets                                                     |                        
|Purchase of technology                                                            |                        
|(Increase) decrease in restricted cash                                            |                        
|Net cash prodided by (used in) investing activities                               |                        
|Cash flows from financing activities:                                             |                        
|Proceeds from Employee Stock Purchase Plan                                        |                        
|Proceeds from exercise of common stock options                                    |                        
|Reversal of issuance of stock purchased in prior year                             |                        
|Repurchase of common stock                                                        |                        
|Repayment of borrowings                                                           |                        
|Net cash provided by financing activities                                         |                        
|Effect of exchange rate fluctuations                                              |                        
|Net decrease in cash and cash equivalents                                         |                        
|Cash and cash equivalents, beginning of period                                    |                        
|Cash and cash equivalents, end of period                                          |                        
|Supplementary disclosures of cash flow information:                               |                        
|Cash paid during the period for:                                                  |                        
|Interest                                                                          |                        
|Income taxes                                                                      |                        
|Suplementary disclosures of non-cash transactions:                                |                        
|Unrealized gain (loss) on available-for-sale securities                           |                        
|Issuance of escrow shares                                                         |                        
|Warrant issued to GM OnStar                                                       |                        

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

F-7

---

# NUANCE COMMUNICATIONS,
INC. & SUBSIDIARIES

# NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

# 1.    ORGANIZATION AND
OPERATIONS

Nuance
Communications, Inc. and subsidiaries (the Company) was incorporated on July
15, 1994 in the state of California, and subsequently reincorporated in March 2000 in the
state of Delaware to develop, market and support software that enables enterprises and
telecommunications carriers to automate the delivery of information and services over the
telephone. Our software product lines consist of software servers that run on
industry-standard hardware and perform speech recognition, natural language understanding
and voice authentication. The Company sells its products through a combination of
third-party resellers, Original Equipment Manufacturers (OEM), system
integrators and directly to the end users.

# 2.    SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES

Principles of
Consolidation

The
consolidated financial statements include the accounts of the Company and its
subsidiaries. All significant inter-company transactions and balances have been
eliminated.

Use of Estimates

The
preparation of the consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and liabilities, the
disclosure of contingent assets and liabilities at the date of the consolidated financial
statements and the reported amounts of revenue and expenses during the reporting period.
Such estimates include, but are not limited to: allowance for doubtful accounts,
restructuring accrual, taxes, contingencies and percentage of completion of certain
revenue contracts. Actual results could differ from those estimates.

Certain Significant Risks
and Uncertainties

The
Company operates in a dynamic and highly competitive industry and believes that changes in
any of the following areas could have a material adverse effect on the Companys
future financial position, results of operations or cash flows: ability to obtain future
financing; volatility of and rapid change in the speech software industry; potential
competition from larger, more established companies in the form of newer and better
products; dependence on key employees for technology and support; failure to adopt or
develop products based on new industry standards; changes in the overall demand by
customers and consumers for products offered by the Company; changes in certain strategic
relationships or customer relationships; the loss of significant customers; litigation or
claims against the Company based on intellectual property, patent, product, regulatory or
other factors; risks associated with changes in domestic and international economic and/or
political conditions or regulations; the Companys ability to attract and retain
employees necessary to support its anticipated growth; liability with respect to its
software and related claims if software does not function as intended; a lengthy sales
cycle which could result in it not being able to obtain sales orders; the Companys
inability to protect its proprietary intellectual property rights or to avoid claims from
other companies.

Cash and Cash Equivalents

The
Company considers all highly liquid investments with an original maturity of three months
or less, when purchased, to be cash equivalents. Cash and cash equivalents consist of
money market accounts, certificates of deposit and deposits with banks. Cash and cash
equivalents are recorded at cost which approximates fair value.

Allowance for Doubtful
Accounts

The
Company performs ongoing credit evaluations of its customers and adjusts credit limits
based upon payment history and the customers current creditworthiness, as determined
by the Companys review of the customers current credit information. The
Company continuously monitors collections and payments from its customers and maintains a
provision for estimated credit losses based on a percentage of the Companys accounts
receivable, the Companys historical experience and any specific customer collection
issues that the Company has identified. While such credit losses have historically been
within the Companys expectations and appropriate reserves have been established, the
Company cannot guarantee that it will continue to experience the same credit loss rates
that the Company has experienced in the past.

F-8

---

Investments

The Companys investments are comprised of U.S. Treasury notes, U.S. Government agency
bonds, corporate bonds and commercial paper. Investments with remaining maturities of less
than one year are considered to be short-term. All investments are held in the
Companys name at major financial institutions. At December 31, 2003, all of the
Companys investments are classified as available-for-sale and carried at fair value,
which is determined based on quoted market prices, with net unrealized gains or losses
included in Accumulated other comprehensive income in the accompanying
consolidated balance sheets. Gains and losses are recognized in income when realized.

Property and Equipment

Property
and equipment are stated at cost and are depreciated using the straight-line method over
the estimated useful lives of the assets as follows:

| | Computer equipment and software | 2-3 years                                     
| | ------------------------------- | ----------------------------------------------
| | Furniture and fixtures          | 5 years                                       
| | Leasehold improvements          | Shorter of lease term or estimated useful life

Restricted Cash

The
restricted cash represents investments in certificates of deposit. The restricted cash
secures letters of credit required by landlords to meet rent deposit requirements for
certain leased facilities.

Intangible Assets

Intangible
assets are carried at cost less accumulated amortization. Amortization is computed using
the straight-line method over the estimated lives of the respective assets, generally 18
months to five years. The Company adopted Statement of Financial Accounting Standards
(SFAS) No. 142, Goodwill and Intangible Assets beginning on
January 1, 2002. As of that date, goodwill and intangible assets with indefinite lives are
not amortized but are tested for impairment at least annually using a fair value approach,
whenever there is an impairment indicator; other intangible assets are valued and
amortized over their estimated lives. Goodwill acquired subsequent to June 30, 2001 is not
subject to amortization. As of December 31, 2001, all of the Companys goodwill was
impaired or written off; for intangible assets, $4.4 million impairment charge was
recorded to the purchased text to speech technology; $3.2 million impairment charges was
recorded to the remaining asset balance resulted from SpeechFront acquisition.

Impairment
of Long-lived Assets

The
Company continually monitors events and changes in circumstances that could indicate
carrying amounts of the long-lived assets, including intangible assets, may not be
recoverable. When such events or changes in circumstances occur, the Company assesses the
recoverability of long-lived assets by determining whether the carrying value of such
assets will be recovered through undiscounted expected future cash flow. If the total of
the future undiscounted net cash flow is less than the carrying amount of these assets,
the Company recognizes an impairment loss based on the excess of the carrying amount over
the fair value of the assets in accordance with SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. (See Note 12 to the consolidated
financial statements).

Revenue Recognition

Revenues
are generated from licenses, services and maintenance. All revenues generated from the
Companys worldwide operations are approved at its corporate headquarters, located in
the United States. The Company applies the provisions of Statement of Position
(SOP) No. 97-2, Software Revenue Recognition, as amended by SOP
No. 98-9, Modification of SOP No. 97-2, Software Revenue Recognition, With Respect
to Certain Transactions to all transactions involving the sale of software products.
The Company also recognizes some revenue based on SOP No. 81-1, Accounting for
Performance of Construction-Type and Certain Production-Type Contracts and Emerging
Issues Task Force (EITF) Issue No. 03-05 Applicability of AICPA
Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing
More-Than-Incidental Software.

The
Companys license revenue consists of license fees for the Companys software
products. The license fees for the Companys software products are calculated
primarily by determining the maximum number of calls that may be simultaneously connected
to our software.

F-9

---

For
licensed products requiring significant customization, the Company recognizes license
revenue using the percentage-of-completion method of accounting over the period that
services are performed. For all license and service agreements accounted for under the
percentage-of-completion method, the Company determines progress to completionbased on actual direct labor hours incurred to date as a percentage of the estimated
total direct labor hours required to complete the project. The Company periodically
evaluates the actual status of each project to ensure that the estimates to complete each
contract remain accurate. A provision for estimated losses on contracts is made in the
period in which the loss becomes probable and can be reasonably estimated. To date, these
losses have not been significant. Costs incurred in advance of billings are recorded as
costs incurred exceed the related billings on uncompleted contracts. If the amount of
revenue recognized exceeds the amounts billed to customers, the excess amount is recorded
as unbilled accounts receivable. If the amount billed exceeds the amount of revenue
recognized, the excess amount is recorded as deferred revenue. Revenue recognized in any
period is dependent on our percentage completion of projects in progress. Significant
management judgment and discretion are used to estimate total direct labor hours. Any
changes in or deviation from these estimates could have a material effect on the amount of
revenue the Company recognizes in any period.

For
licensed products which do not require significant customization of components, the
Company recognizes revenue from the sale of software licenses when:

|  |                                                                        
|- | -----------------------------------------------------------------------
|. | persuasive evidence of an arrangement exists;                          
|  |                                                                        
|. | the software and corresponding authorization codes have been delivered;
|  |                                                                        
|. | the fee is fixed and determinable;                                     
|  |                                                                        
|. | collection of the resulting receivable is probable.                    

The
Company uses a signed contract and either 1) a purchase order, 2) order form or 3) royalty
report as evidence of an arrangement.

Products
delivered with acceptance criteria or return rights are not recognized as revenue until
all revenue recognition criteria are achieved. If undelivered products or services exist
that are essential to the functionality of the delivered product in an arrangement,
delivery is not considered to have occurred. Delivery is accomplished through electronic
distribution of the authorization codes or keys. Occasionally the customer
will require that the Company secure their acceptance of the system in addition to the
delivery of the keys. Such acceptance, when required, typically consists of a
demonstration to the customer that, upon implementation, the software performs in
accordance with specified system parameters, such as recognition accuracy or transaction
completion rates. In the absence of such required acceptance, the Company will defer
revenue recognition until signed acceptance is obtained.

The
Company considers the fee is fixed and determinable when the price is not subject to
refund or adjustments.

The
Company assesses collectibility of the transaction based on a number of factors, including
the customers past payment history and its current financial position. If the
Company determines that collection of a fee is not probable, the Company defers
recognition of the revenue until the time collection becomes reasonably assured, which is
upon receipt of the cash payment.

The
Company uses the residual method to recognize revenue when a license agreement includes
one or more elements to be delivered at a future date if vendor specific objective
evidence of the fair value of all undelivered elements exists. Vendor-specific objective
evidence of fair value is based on the price charged when the element is sold separately,
or if not yet sold separately, is established by authorized management. In situations
where vendor-specific objective evidence of fair value for undelivered elements does not
exist, the entire amount of revenue from the arrangement is deferred and recognized when
vendor-specific objective evidence of fair value can be established for all undelivered
elements or when all such elements are delivered. In situations where the only undelivered
element is maintenance and vendor specific objective evidence of fair value for
maintenance does not exist, the entire amount of revenue from the arrangement is
recognized ratably over the maintenance period. As a general rule, license revenue from
third-party resellers is recognized when product has been sold through to an end user and
such sales have been reported to us. However, certain third-party reseller agreements
include time-based provisions on which we base revenue recognition, in these instances,
there is no right of returns possible.

The
timing of license revenue recognition is affected by whether the Company performs
consulting services in the arrangement and the nature of those services. In the majority
of cases, the Company either performs no consulting services or the Company performs
services that are not essential to the functionality of the software. When the Company
performs consulting and implementation services that are essential to the functionality of
the software, the Company recognizes both license and consulting revenue utilizing
contract accounting based on the percentage of the consulting services that have been
completed. This calculation is done in conformity with SOP No. 81-1; however, judgment is
required in determining the percentage of the project that has been completed. Revenue
recognized from such contracts was significant for the year ended December 31, 2003.

F-10

---

The
Company has also explored the markets for complete speech solutions and delivering through
combined product and services, where the Company is required to use contract accounting
and recognize the bundled license and service revenue based upon percentage of completion.
This method of accounting is subject to certain judgments by the Company regarding amount
of revenue allocated to percentage of work completed. Typically, the Company would
recognize revenue based upon the proportional level of effort expended to complete certain
milestones defined in the customer contract or statement of work.

Service
revenue consists of revenue from providing consulting, training and other revenue. Other
revenue consists primarily of reimbursements for consulting out-of-pocket expenses
incurred and recognized, in accordance with Emerging Issues Task Force (EITF)
No. 01-14, Income Statement Characterization of Reimbursements Received for
Out-of-Pocket Expenses Incurred. For services revenue, the Company
requires 1) a signed contract and 2) statement of work and 3) purchase order prior to
recognizing any services revenue. The Companys consulting service contracts are bid
either on a fixed-fee basis or on a time-and-materials basis. For a fixed-fee contract,
the Company recognizes revenue using the percentage of completion method. For
time-and-materials contracts, the Company recognizes revenue as services are performed.
Training service revenue is recognized as services are performed. Losses on service
contracts, if any, are recognized as soon as such losses become known.

Maintenance
revenue consists of fees for providing technical support and software upgrades. The
Company requires a signed contract and purchase order prior to recognizing any maintenance
revenue. The Company recognizes all maintenance revenue ratably over the contract term.
Most customers have the option to renew or decline maintenance agreements annually for the
contract term.

The
Companys standard payment terms are net 30 to 90 days from the date of invoice.
Thus, a significant portion of the Companys accounts receivable balance at the end
of a quarter is primarily comprised of revenue from that quarter.

Deferred
Revenue

The
Company records deferred revenue primarily as a result of payments from customers received
in advance of recognition of revenue.

The
deferred revenue amount includes 1) unearned license revenues, which will be recognized as
revenue when the appropriate revenue recognition criteria have been met, 2) prepaid
maintenance and prepaid or unearned professional services that will be recognized as
revenue as the services are performed or contract expiration periods lapse, and 3) license
revenue subject to deferral as a result of applying percentage completion to certain
contracts.

Software Development Costs

Costs
incurred in the research and development of software products are expensed as incurred
until technological feasibility has been established. Once technological feasibility has
been established, these costs are capitalized. The establishment of technological
feasibility and the ongoing assessment of the recoverability of these costs requires
considerable judgment by management with respect to certain external factors, including,
but not limited to, anticipated future gross product revenues, estimated economic life and
changes in software and hardware technologies. Amounts that could have been capitalized
were insignificant and, therefore, no costs have been capitalized to date.

Foreign Currency Translation and Transactions

The
functional currency of the Companys foreign subsidiaries is deemed to be the local
countrys currency. Consequently, assets and liabilities recorded in foreign
currencies are translated at year-end exchange rates; revenues and expenses are translated
at average exchange rates during the year. The effects of foreign currency translation
adjustments are included in stockholders equity as a component of Accumulated
other comprehensive income  in the accompanying consolidated balance sheets. The
effects of foreign currency transactions are included in Interest and other income,
net in the accompanying consolidated statement of operations.

Comprehensive Loss

In
2001, the Company adopted SFAS No. 130, Reporting Comprehensive Income which
requires that an enterprise reports, by major components and in a single total, the change
in its net assets from non-owner sources, which for the Company, is foreign currency
translation and changes in unrealized gains and losses on investments.

F-11

---

Concentration of Credit Risks

Financial
instruments, which potentially subject the Company to concentrations of credit risk,
consist primarily of cash and cash equivalents and accounts receivable. Cash and cash
equivalents are held with financial institutions and consist of cash in bank accounts. The
Company does not require its customers to provide collateral or other security to support
accounts receivable. To reduce credit risk, management performs ongoing credit evaluations
of its customers financial condition and maintains allowances for estimated
potential bad debt losses.

Stock-based
Compensation.

The
Companyaccounted for stock-based awards to employees and directors using the
intrinsic value method of accounting in accordance with Accounting Principles Board
Opinion (APB) No. 25, Accounting for Stock Issued to Employees.
Under the intrinsic value method, the Company records compensation expense related to
stock options in the consolidated statement of operations when the exercise price of our
employee stock-based award is less than the market price of the underlying stock on the
date of the grant. Pro forma net loss and net loss per share information, as required by
SFAS No. 123,Accounting for Stock-Based Compensation, has been determined as
if the Company had accounted for all employee stock options granted, including shares
issuable to employees under the Employee Stock Purchase Plan, under SFAS No. 123s
fair value method.

The
pro forma effect of recognizing compensation expense in accordance with SFAS No. 123 is as
follows:

|                                                                                                       | Year Ended December 31,
|------------------------------------------------------------------------------------------------------ | -----------------------
|                                                                                                       |                        
|Net loss, as reported                                                                                  |                        
|Add: Stock-based employee compensation expense           included in net loss                          |                        
|Less: Total stock-based employee compensation expense under           fair value method for all awards |                        
|Pro forma net loss                                                                                     |                        
|Basic and diluted net loss per share - as reported                                                     |                        
|Basic and diluted net loss per share - pro forma                                                       |                        

During
the preparation of the Companys 2003 consolidated financial statements, management
determined that the pro forma loss and pro forma basic and diluted net loss per share for
2002 and 2001 had been calculated incorrectly. Accordingly, such pro forma amounts
presented above have been revised. The effect was to decrease the pro forma net loss for
2002 by $17.1 million and to increase the pro forma net loss for 2001 by $3.2 million. This
change did not impact the Companys consolidated financial position, results of
operations, or cash flows for any of the periods presented.

Net Loss Per Share

Net
loss per share is calculated under SFAS No. 128, Earnings Per Share. Basic net
loss per share on a historical basis is computed by dividing the net loss attributable to
common shareholders by the weighted average number of shares of common stock outstanding
for the period, excluding the weighted average common shares subject to repurchase.
Diluted net loss per share is equal to basic net loss per share for all periods presented
since potential common shares from conversion of the convertible preferred stock, stock
options, warrants and exchangeable shares held in escrow are anti-dilutive. Shares subject
to repurchase resulting from early exercises of options that have not vested are excluded
from the calculation of basic net loss per share. The total number of shares excluded from
diluted net loss per share was 9,523,000 shares, 7,371,000 shares and 8,181,000 shares for
fiscal years 2003, 2002 and 2001, respectively.

# Reclassifications and
Disclosures

Certain 2002
amounts have been reclassified to conform to the fiscal year 2003 presentation.The
Company has revised certain financial information presented in the accompanying
consolidated financial statements and related notes as of December 31, 2001 to
conform to the fiscal year 2002 presentation. These revisions consist of reclassifications
and additional disclosures as follows:

Amortization expense of $250,000 recognized in 2001 was reclassified from non-cash compensation expense to
sales and marketing expense, related to amortization of an intangible.

Training
revenue totaling $900,000 for the year ended December 31, 2001, has been reclassified
from maintenance revenue to service revenue.

F-12

---

The
Company adopted EITF No. 01-14, Income Statement Characterization of Reimbursements
Received for Out-of-Pocket Expenses Incurred, beginning January 1, 2002, and
comparative financial statements for the 2001 period have been reclassified to comply with
the guidance. The effect of this reclassification was an increase in maintenance and other
revenue and an increase in cost of service expense of $75,000 for the year ended December
31, 2001.

The
Company adopted SFAS No. 142, Goodwill and Other Intangible Assets beginning January 1,
2002. As described in Note 8, the 2001 financial statements have been revised to include
the transitional disclosures required by SFAS 142. These disclosures provide a
reconciliation of adjusted net loss to reported net loss and the related loss-per-share
amounts.

# 3.    RECENT
ACCOUNTING PRONOUNCEMENTS

In
December 2002, the Financial Accounting Standards Board (FASB) issued SFAS No.
148, Accounting for Stock-Based CompensationTransition and Disclosurean
Amendment of SFAS 123. SFAS 148 provides two additional transition methods for
entities that adopt the preferable method of accounting for stock-based compensation.
Further, the statement requires disclosure of comparable information for all companies
regardless of whether, when, or how an entity adopts the preferable, fair value based
method of accounting. These disclosures are now required for interim periods in addition
to annual disclosure. For the year ended December 31, 2003, the Company adopted the
additional disclosure provisions of SFAS 148. The transition provisions of SFAS 148 are
currently not applicable to the Company as it continues to account for options under APB
25.

On
January 1, 2003, the Company adopted SFAS No. 146, Accounting for Costs
Associated with Exit or Disposal Activities, (SFAS No. 146), which
nullifies Emerging Issues Task Force (EITF) 94-3,Liability Recognition
for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring)" (EITF 94-3). SFAS
No. 146 requires that a liability be recognized for restructuring costs only when the
liability is incurred, that is, when it meets the definition of a liability in the
Financial Accounting Standards Boards (FASBs) conceptual
framework. SFAS No. 146 also establishes fair value as the objective for initial
measurement of liabilities related to exit or disposal activities and is effective for
exit or disposal activities that are initiated after December 31, 2002. The adoption
of SFAS No. 146 did not have a material impact on our results of operations,
financial position or cash flows.

On
January 1, 2003, the Company adopted FIN No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others. FIN No. 45 requires certain guarantees to be recorded at fair value and
requires a guarantor to make disclosures, even when the likelihood of making any payments
under the guarantee is remote. For those guarantees and indemnifications that do not fall
within initial recognition and measurement requirements of FIN No. 45, the Company
must continue to monitor the conditions that are subject to the guarantees and
indemnifications, as required under existing generally accepted accounting principles, to
identify if a loss has been incurred. If the Company determines that it is probable that a
loss has been incurred, any such estimable loss would be recognized. The initial
recognition and measurement requirements do not apply to the Companys product
warranties or to the provisions contained in the majority of the Companys software
license agreements that indemnify licensees of the Companys software from damages
and costs resulting from claims alleging that the Companys software infringes the
intellectual property rights of a third party. The Company has provided disclosures as
required by FIN No. 45 in Note 9 to its consolidated financial statements. The
adoption of the liability recognition provisions did not have a material impact on the
companys financial position or results of operations.

In
January 2003, the FASB issued FIN 46, Consolidation of Variable Interest
Entities, and a revised interpretation of FIN 46 (FIN 46R) in
December 2003 (collectively FIN 46). FIN 46 addresses consolidation of
variable interest entities. FIN 46 provides guidance for determining when a primary
beneficiary should consolidate a variable interest entity or equivalent structure that
functions to support the activities of the primary beneficiary. The provisions of FIN 46
are effective immediately for all variable interest entities created after January 31,
2003. It applies in the first year or interim period ending after December 15, 2003 to
variable interest entities in which an enterprise holds a variable interest that it
acquired before February 1, 2003. The Company did not have any variable interest entities
as of December 31, 2003, and does not expect the adoption of FIN 46 to have a material
effect on the Companys financial statements.

F-13

---

The
EITF recently reached a consensus on two issues relating to the accounting for multiple
element arrangements: Issue No. 00-21  Change in Accounting Principle: Revenue
Arrangements with Multiple Deliverables, and Issue No. 03-05 Applicability of
AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing
More-Than-Incidental Software. The consensus opinion in EITF No. 03-05 clarifies the
guidance in EITF 00-21 and was reached on July 31, 2003. The transition provisions allow
either prospective application or a cumulative effect adjustment upon adoption. The
Company adopted prospectively as of July 1, 2003. EITF Nos. 00-21 and 03-05 did not have a
material impact on the consolidated financial statements.

# 4.    
          ACQUISITIONS

In
August 2002, the Company purchased a set of two patents for $375,000. The patents are
being amortized over the estimated useful life of five years. The amortization for 2003
and 2002 are $75,000 and $25,000, respectively and were included in the research and
development of the companys consolidated statement of operations.

During
2001, the Company entered into an agreement with a third-party that gives the Company
non-exclusive intellectual property rights to text to speech software code. The Company
paid $7.0 million for this purchased technology, which was capitalized and is being
amortized over its estimated useful life of five years. The Company amortized
$1.2 million to research and development in 2001. The Company also performed an
impairment analysis for the year ended December 31, 2001. The asset was impaired and was
written down by $4.4 million to its estimated fair value based on estimated discounted
future cash flows. For each of the years ended December 31, 2003 and 2002, the Company
amortized $0.3 million. The agreement includes a royalty clause whereby the Company pays
5% of all net revenue attributable to sublicenses of this technology to a third party. The
term of the royalty payments is eight years. There was no royalty payment payable for the
years ended December 31, 2003, 2002 and 2001.

# 5.    CONCENTRATIONS

Credit
risk with respect to accounts receivable is diversified due to the large number of
entities comprising our customer base and their dispersion across many different
industries and geographies. The Company performs ongoing credit evaluations of our
customers financial condition.

As
of December 31, 2003, three customers accounted for, individually, 13%, 12% and 12% of the
accounts receivable balance. As of December 31, 2002, no customer accounted for more than
10% of the accounts receivable balance.

For
the year ended December 31, 2003, one customer accounted for 12% of total revenue; for the
year ended December 31, 2002, one customer accounted for 10% of total revenue; and for the
year ended December 31, 2001, one customer accounted for 18% of total revenue.

In
2003, 2002 and 2001, the Companys revenue attributable to indirect sales through
third-party resellers was 58%, 74% and 75%, respectively. For the year ended December 31,
2003, no third-party reseller accounted for more than 10% of total revenue; for the year
ended December 31, 2002, one third-party reseller accounted for 10% of total revenue; for
the year ended December 31, 2001, one third-party reseller accounted for more than 10% of
total revenue.

# 6.    BALANCE SHEET
DETAIL

Purchased Software

In
2001, the Company purchased $0.6 million of third-party software to complement its core
platform. The software was recorded in prepaid expenses and other current assets at the
lower of cost or market. At December 31, 2001, the Company evaluated the third party
software and charged the excess to cost of goods sold of $0.3 million, which was caused by
lower-than-expected demand. In 2002, the Company assessed the remaining carrying value of
the software in relation to recovery of future revenues and wrote off the remaining
balance of $0.3 million.

F-14

---

Property and Equipment

|                                                | As of December 31,
|----------------------------------------------- | ------------------
|                                                |                   
|
|Computer equipment and software.                |                   
|leasehold improvements                          |                   
|Furniture and fixtures                          |                   
|Total property and equipment.                   |                   
|Less: accumulated depreciation and amortization |                   
|Total                                           |                   

Accrued
Liabilities

|                          | As of December 31,
|------------------------- | ------------------
|                          |                   
|
|Accrued compensation      |                   
|Accrued expenses          |                   
|Income tax payable        |                   
|Other accrued liabilities |                   
|Total                     |                   

# 7.    INVESTMENTS

The
Company classifies investment securities based on managements intention on the date
of purchase and reevaluates such designation as of each balance sheet date. Securities are
classified as available-for-sale and carried at fair value, which is determined based on
quoted market prices, with net unrealized gains and losses included in Accumulated
other comprehensive income (loss) in the accompanying consolidated balance sheet.

The
components of the Companys marketable securities were as follows (in thousands):

|                                | As of December 31, 2003
|------------------------------- | -----------------------
|Investment Type                 |                        
|U.S. government notes and bonds |                        
|Corporate bonds                 |                        
|Marketable securities           |                        
|Total                           |                        
|Short-term investments          |                        
|Long-term investments           |                        
|Total                           |                        

|                            | As of December 31, 2002
|--------------------------- | -----------------------
|Investment Type             |                        
|U.S. Government notes bonds |                        
|Corporate bonds             |                        
|Marketable securities       |                        
|Total                       |                        
|Short-term investments      |                        
|Long-term investments       |                        
|Total                       |                        

The Companys
investments will mature as follows (in thousands):

|                        | As of December 31, 2003
|----------------------- | -----------------------
|Investment Type         |                        
|Government agency bonds |                        
|Corporate bonds         |                        
|Marketable securities   |                        
|Total                   |                        

F-15

---

# 8.    INTANGIBLE
ASSETS

Information
regarding the Companys intangible assets follows (in thousands):

|                    | As of December 31, 2003
|------------------- | -----------------------
|                    |                        
|Patents Purchased   |                        
|Purchased Technolgy |                        
|Total               |                        

The total estimated amortization of the Patents Purchased and Purchased technology for
each of the four fiscal years subsequent to December 31, 2003 is as follows (in
thousands):

|Year Ended December 31, |   | Amortization Expense
|----------------------- | - | --------------------
|2004                    | $ | 413                 
|2005                    |   | 413                 
|2006                    |   | 117                 
|2007                    |   | 50                  
|Total                   | $ | 993                 

The
Company adopted SFAS No. 142,  Goodwill and Other Intangible Assets. effective
January 1, 2002. SFAS No. 142 had no effect for the year ended December 31, 2002 as all
previously acquired goodwill was impaired or written off as of December 31, 2001 and no
goodwill was acquired in 2003 or 2002. The following table presents the impact of SFAS No.
142 on net loss and net loss per share had the standard been in effect starting for the
year ended 2001 (in thousands, except per share amounts):

|                                                   | Year Ended December 31,
|-------------------------------------------------- | -----------------------
|                                                   |                        
|Net loss, as reported                              |                        
|Add back SFAS 142 adjustments:                     |                        
|Goodwill amortization                              |                        
|Acquired workforce amortization                    |                        
|Net loss, as adjusted                              |                        
|Net loss per share, basic and diluted, as reported |                        
|Add back amortization of:                          |                        
|Goodwill                                           |                        
|Acquired workforce                                 |                        
|Net loss per share, basic and diluted, as adjusted |                        

# 9.    GUARANTEES

Guarantees

As
of December 31, 2003, our financial guarantees consist of standby letters of credit
outstanding, representing the restricted cash requirements collateralizing our lease
obligations. The maximum amount of potential future payment under the arrangement at
December 31, 2003 were $10.9 million related to our Pacific Shores lease in California and
$198,000 related to our Montreal lease, totaling $11.1 million presented as Restricted
cash on our consolidated balance sheets at December 31, 2003.

Warranty

The
Company does not maintain a general warranty reserve for estimated costs of product
warranties at the time revenue is recognized due to the effectiveness of our extensive
product quality program and processes.

Indemnifications to
Customers

F-16

---

The
Company defends and indemnifies our customers for specified liabilities incurred in
any suit or claim brought against them, alleging that our products infringe a U.S. patent (worldwide, in some instances), copyright, trade secret or similar right. If a product
becomes the subject of an infringement claim, the Company has an obligation to, at our option:
(i) replace the product with another non-infringing product that provides
substantially similar performance; (ii) modify the infringing product so that it no
longer infringes but remains functionally equivalent; (iii) obtain the right for the
customer to continue using the product at our expense and for the third-party reseller to
continue selling the product; or (iv) take back the infringing product and refund to
customer the purchase price paid, less depreciation amortized on a straight line basis. The
Company has not, to date, been required to make material payments pursuant to these indemnification provisions. The Company has not identified any losses that are probable under these
provisions and, accordingly, the Company has not recorded a liability related to these
indemnification provisions.

Indemnifications to
Officers and Directors

The
Companys corporate by-laws require that the Company indemnify our officers and
directors, as well as those who act as directors and officers of other entities at our
request, against expenses, judgments, fines, settlements and other amounts actually and
reasonably incurred in connection with any proceedings arising out of their services to
Nuance. In addition, the Company has entered into separate indemnification agreements with
each director and each board-appointed officer of Nuance, which provides for
indemnification of these directors and officers under similar circumstances. The
indemnification obligations are more fully described in the by-laws and the
indemnification agreements. The Company purchases insurance to cover claims or a portion
of the claims made against our directors and officers. Since a maximum obligation is not
explicitly stated in our by-laws or in our indemnification agreements and will depend on
the facts and circumstances that arise out of any future claims, the overall maximum
amount of the obligations cannot be reasonably estimated. Historically, we have not made
payments related to these obligations, and the estimated fair value for these obligations
is zero on the consolidated balance sheets as of December 31, 2003.

Other Indemnifications

As
is customary in our industry and as provided for in local law in the U.S. and other
jurisdictions, many of our standard contracts provide remedies to others with whom the
Company enters into contracts, such as defense, settlement, or payment of judgment for
intellectual property claims related to the use of our products. From time to time, the
Company indemnifies its suppliers, contractors, lessors, lessees and others with whom the
Company enters into contracts, against combinations of loss, expense, or liability arising
from various trigger events related to the sale and the use of our products and services,
the use of their goods and services, the use of facilities, the state of the assets and
businesses that the Company sells and other matters covered by such contracts, usually up
to a specified maximum amount. In addition, from time to time the Company also provides
protection to these parties against claims related to undiscovered liabilities, additional
product liability or environmental obligations. In our experience, claims made under such
indemnifications are rare and the associated estimated fair value of the liability is not
material. At December 31, 2003, there were no claims for such indemnifications.

# 10.    NET LOSS PER
 SHARE

The
following table presents the calculation of basic and diluted net loss per share (in
thousands, except per share data):

|                                                                                         | Year Ended December 31,
|---------------------------------------------------------------------------------------- | -----------------------
|                                                                                         |                        
|Net loss attributable to common stockholders                                             |                        
|Calculation of loss per share - basic and diluted:                                       |                        
|Weighted average shares of commmon stock outstanding - basic and diluted                 |                        
|Less: Weighted average shares of commmon stock subject to repurchase - basic and diluted |                        
|Weighted average shares used in computing net loss per share - basic and diluted         |                        
|Basic and diluted net loss per share                                                     |                        

The
total number of shares excluded from diluted net loss per share were 9,523,000 shares,
7,371,000 shares and 8,181,000 shares for fiscal years 2003, 2002 and 2001, respectively.

F-17

---

# 11.    RESTRUCTURING CHARGES AND ASSET IMPAIRMENTS

Restructuring on
headcount level

The
Company had 308 full-time employees as of December 31, 2003. In 2001, the Companys
Board of Directors approved a restructuring plan to align our expenses with revised
anticipated demand and create a more efficient organization. As a result, in 2001the
Company reduced its workforce by 80 employees, with reductions ranging between 10% and 20%
across all functional areas and affecting several locations. In 2002, in conjunction with
the January 2002 and August 2002 restructuring plans approved by its Board of Directors,
the Company reduced its workforce by another 33 and 81 employees, respectively, primarily
to realign the sales organization, to align the Companys cost structure with
changing market conditions and to create a more efficient organization. In August 2003,
the Company reduced its general and administrative workforce by 9%, or 5 employees, to
further realign the organization to the Companys structure. The Company will
continue to evaluate its resource and skills requirements and adjust its staffing
appropriately. The Company may, in the future be required to increase the Companys
workforce to respond to changes or growth in its business, and as a result may need to
expand its operational and human resources, as well as information systems and controls,
to support any such growth. Such expansion may place significant demands on its management
and operational resources.

Restructuring charges
based on different plans

Fiscal Year 2001

In
April 2001, with Board of Directors approval, the Company implemented a restructure plan
to align its expenses with revised anticipated demand and create a more efficient
organization. In connection with the restructuring plan, the Company recorded a
restructuring charge of $34.1 million for lease loss and severance costs and an asset
impairment charge of $20.4 million on tenant improvements during 2001.

In
connection with the restructuring plan, the Company decided not to occupy a new leased
facility (Pacific Shores lease). This decision has resulted in a lease loss of
$32.6 million for the year ended December 31, 2001, comprised of a sublease loss, broker
commissions and other facility costs. To determine the sublease loss, the loss after our
cost recovery efforts from subleasing the building, certain assumptions were made related
to the (1) time period over which the building will remain vacant (2) sublease terms
and (3) sublease rates. The Company established the reserves at the low end of the range
of estimable cost against outstanding commitments, net of estimated future sublease
income. These estimates were derived using the guidance provided in Staff Accounting
Bulletin (SAB) No. 100, Restructuring and Impairment Charges, and
EITF 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 lease loss was increased in August 2002 and September 2003 as
described below and will continue to be adjusted in the future upon triggering events
(change in estimate of time to sublease, actual sublease rates, etc.).

The
Company recorded $1.5 million in costs for the year ended December 31, 2001 associated
with severance and related benefits.

Fiscal Year 2002

In
January 2002, with Board of Directors approval, the Company implemented a restructuring
plan to reduce its workforce. The restructuring was primarily to realign the sales and
professional services structure. The Company recorded a restructuring charge of $1.3
million during the three months ended March 31, 2002, consisting primarily of payroll and
related expenses associated with reducing headcount. This amount was paid out as of
December 31, 2002.

In
August 2002, with Board of Directors approval, the Company implemented a restructuring
plan to reduce its worldwide workforce to realign its expense structure with near term
market opportunities. In connection with the reduction of workforce, the Company recorded
a charge of $2.6 million primarily for severance and related employee termination costs.
As of December 31, 2003, it was fully paid out. For the third quarter 2003, it also
reversed an excess accrual for this restructuring plan, which resulted in recording of
$0.2 million as a credit to the Restructuring charge line in the consolidated statement of
operations.

The
plan also included the consolidation of facilities through the closing of certain
international offices that resulted in a charge of $0.7 million. In addition, it recorded
an increase in its previously reported real estate restructuring accrual related to the
new leased facility we do not occupy and which has not been subleased as a result of
continued declines in the condition of the San Francisco Bay Area real estate market. This
additional charge of $31.8 million resulted from an analysis of the time period by which
the California property will remain vacant, sub-lease terms and sub-lease rates,
altogether reflecting continued softening of the local real estate market.

F-18

---

Fiscal Year 2003

In
the third quarter 2003, the Company reviewed the earlier estimate for the lease loss for
the unoccupied leased facility and the condition of the San Francisco Bay Area real estate
market. The Company estimated that it might take an additional 18 months to sublease this
unoccupied facility. The Company also reduced the estimates for the expected sublease
rates. This evaluation resulted in recording an additional lease loss of $10.4 million and
was recorded as part of the restructuring charges on the consolidated statement of
operations.

For
the third quarter 2003, the Company reduced its general and administrative workforce to
realign the organization to its structure. The Company recorded a restructuring charge of
$0.2 million primarily for severance and termination costs relating to the reduction in
workforce. As of December 31, 2003, severance was fully paid out. In addition, the Company
revised the estimate for the August 2002 restructuring plan, which resulted in a $0.2
million credit to the restructuring charge line in the consolidated statement of
operations.

The
restructuring charges and year-end balances for the year ended December 31, 2003 are as
follows (in thousands):

|                                                       | Lease Loss | Severance & Related | Asset Write Down | Total Restructuring
|------------------------------------------------------ | ---------- | ------------------- | ---------------- | -------------------
|2001 Plan                                              |            |                     |                  |                    
|Total charges for the year ending December 31, 2001    |            |                     | $                | 32,615             
|Amount utilized in the year ending December 31, 2001   |            |                     |                  | (3,572             
|Accrual balance at December 31, 2001                   |            |                     | $                | 29,043             
|Total charges for the year ending December 31, 2002    |            |                     | $                | 31,829             
|Amount utilized in the year ended December 31, 2002    |            |                     |                  | (9,342             
|Balance at December 31, 2002                           |            |                     | $                | 51,530             
|Total charges for
the year ending December 31, 2003    |            |                     | $                | 11,316             
|Amount utilized
in the year ending December 31, 2003   |            |                     |                  | (10,477            
|Balance at December 31, 2003                           |            |                     | $                | 52,369             
|Current restructuring accrual                          |            |                     | $                | 9,478              
|Long-term restructuring accrual                        |            |                     | $                | 42,891             
|Q1 2002 Plan                                           |            |                     |                  |                    
|Total charges for the year ending December 31, 2002    |            |                     | $                | --                 
|Amount utilized in the year ending December 31, 2002   |            |                     |                  | --                 
|Balance at December 31, 2002                           |            |                     |                  | --                 
|Q3 2002 Plan                                           |            |                     |                  |                    
|Total charges for the year ending December 31, 2002    |            |                     | $                | 673                
|Amount utilized in the year ending December 31, 2002   |            |                     |                  | (159               
|Balance at December 31, 2002                           |            |                     | $                | 514                
|Total charges for the year ending December 31, 2003    |            |                     | $                | (14                
|Amount utilized in the
year ending December 31, 2003   |            |                     |                  | (465               
|Balance at December 31, 2003                           |            |                     | $                | 35                 
|Current restructuring accrual                          |            |                     | $                | 35                 
|Q3 2003 Plan                                           |            |                     |                  |                    
|Total charges for the year ending December 31, 2003    |            |                     | $                | --                 
|Amount utilized in the year ending December 31, 2003   |            |                     |                  | --                 
|Balance at December 31, 2003                           |            |                     | $                | --                 
|Current restructuring accrual                          |            |                     | $                | --                 
|Balance at December 31, 2003 (All restructuring plans) |            |                     |                  |                    
|Total restructuring accrual: Current                   |            |                     | $                | 9,513              
|Total restructuring accrual: Long-term                 |            |                     | $                | 42,891             

F-19

---

The
Company expects the total cash outlay for the restructuring plans to be $81.7 million, of
which $29.3 million was paid through December 31, 2003 and $52.4 million remains
accrued at December 31, 2003. The Company expects $9.6 million of the lease loss to be
paid out over the next twelve months and remaining $42.9 million to be paid out over the
remaining life of the lease of approximately nine years.

The
Company has recorded a lease loss related to future lease commitments of our Pacific
Shores lease, net of expected sublease income. However, under the condition of the San
Francisco Bay Area real estate market, the Company may be required to periodically
reevaluate the components of the expected sublease income, because it affects the
estimated lease loss for the unoccupied leased facility. Specifically, the Company is
required to reevaluate the time that it might take to sublease this unoccupied facility,
as well as the expected sublease rates. This evaluation may result in additional lease
loss, which would increase the restructuring charges on the consolidated statement of
operations.

Asset impairments

In
2002, in connection with the August 2002 restructuring plan, the Company wrote off certain
fixed assets as a result of consolidating and closing of certain international offices and
recorded an asset impairment charge of $0.9 million.

In
February 2003, the Company received cash and recorded an asset impairment credit of $0.9
million related to a refund of tenant improvement costs for the building the Company does
not occupy, following the landlords reconciliation of tenant improvement costs. This
credit was recorded in restructuring charges and asset impairments in the consolidated
statements of operations.

In
2001, in connection with the restructuring plan, the Company decided not to occupy its new
headquarters facility and recorded an asset impairment charge of $20.4 million on related
tenant improvements.

In
2001, the Company recorded $7.0 million related to the purchased text to speech
technology. In the fourth quarter ended December 31, 2001, the Company evaluated the value
of these intangible assets based on an analysis which considered existing business
conditions and economic declines including the overall declines in industry growth rates
that have negatively impacted expected future revenue. Based on consideration of these
factors, the Company performed an impairment evaluation and it indicated that the asset
was impaired, accordingly, such asset was written down by $4.4 million to estimated fair
value based on estimated discounted future cash flows.

# 12.    COMMITMENTS AND
 CONTINGENCIES

Lease commitments

Operating
leases

The
Company leases its facilities under non-cancelable operating leases with various
expiration dates through July 2012. As of December 31, 2003, future minimum lease payments
under these agreements (excluding sublease income), including the Companys
unoccupied facilities lease and lease loss portion of the restructuring charges, are as
follows (in thousands):

|                             |   |       
|---------------------------- | - | ------
|
|2004                         | $ | 9,300 
|2005                         |   | 8,400 
|2006                         |   | 8,619 
|2007                         |   | 8,879 
|2008                         |   | 8,980 
|Thereafter                   |   | 34,795
|Total minimum lease payments | $ | 78,972

In
May 2000, the Company entered into a lease for a new headquarters facility. The lease has
an eleven-year term, which began in August 2001, and provides for monthly rent payments
starting at approximately $600,000. A $10.9 million certificate of deposit secures a
letter of credit required by the landlord for a rent deposit. In conjunction with the
April 2001 and August 2002 restructuring plans, the Company decided not to occupy this new
leased facility, as well as to close certain international offices and recorded lease
losses through December 31, 2002 totaling $65.8 million related to future lease
commitments, net of expected sublease income. For the year ended December 31, 2003, the
Company reviewed its earlier estimate for the sublease loss and estimated that there may
be an additional 18 months that the property will remain vacant. The Company also lowered
the estimates for the expected sublease rental rates. This evaluation resulted in
recording an additional lease loss of $10.4 million. The future minimum lease payments
table referenced above does not include estimated sublease income as there are no sublease
commitments as of December 31, 2003.

F-20

---

Rent
expense for the years ended December 31, 2003, 2002 and 2001 was approximately $2.2
million, $2.7 million and $2.8 million, respectively.

Capital leases

In
June 2002, the Companys Canadian subsidiary entered into a lease for certain
equipment for approximately $138,000, which is accounted for as a capital lease. This
lease bears interest at a rate of 11.2%, and expires in August 2004. Future minimum lease
payments under the agreement, as of December 31, 2003, are as follows (in thousands):

|Year Ended December 31,                           |  | Capital Lease
|------------------------------------------------- |  | -------------
|Minimum lease payments due in 2004                |  | $ 34         
|Amount representing interest (11.2%)              |  | (1)          
|Present value of minimum lease payments - current |  | 33           

Asset
under capital lease had a cost basis of $168,000 and accumulated depreciation of $79,000
as of December 31, 2003.

In
November 2000, in connection with the SpeechFront acquisition (See Note 4 to the
consolidated financial statements), the Company assumed certain capital leases of
approximately $45,500. These leases bore interest at rates ranging from 17% to 22% and
were paid off in February 2001.

Legal

In
August 2001, the first of a number of complaints was filed, in the United States District
Court for the Southern District of New York, on behalf of a purported class of persons who
purchased the Company stock between April 12, 2000, and December 6, 2000. Those complaints
have been consolidated into one action. The complaint generally alleges that various
investment bank underwriters engaged in improper and undisclosed activities related to the
allocation of shares in our initial public offering of securities. The complaint makes
claims for violation of several provisions of the federal securities laws against those
underwriters, and also against the company and some of directors and officers. Similar
lawsuits, concerning more than 250 other companies initial public offerings, were
filed in 2001. In February 2003, the Court denied a motion to dismiss with respect to the
claims against the Company. In the third quarter of 2003, a proposed settlement in
principle was reached among the plaintiffs, issuer defendants (including the Company) and
the issuers insurance carriers. The settlement calls for the dismissal and release
of claims against the issuer defendants, including the Company, in exchange for a
contingent payment to be paid, if necessary, by the issuer defendants insurance
carriers and an assignment of certain claims. The timing of the conclusion of the
settlement remains unclear, and the settlement is subject to a number of conditions,
including finalization of appropriate documentation and approval of the Court. The
settlement is not expected to have any material impact upon the Company, as payments, if
any, are to be made by insurance carriers, rather than by the Company. In the event a
settlement is not concluded, the Company intends to defend the litigation vigorously. The
Company believes that it has meritorious defenses to the claims against itself

On
January 16, 2001, the Company filed an opposition proceeding in the European community
against a Community Trade Mark application for NUANCE, owned by Nuance Global Traders,
Ltd. The opposition is still pending. The parties have agreed upon a settlement which will
become final upon, among other things, completion of final settlement documents.

In
March 2001, the first of a number of stockholder class action complaints were filed, in
the United States District Court for the Northern District of California, against the
Company and certain of its officers and directors. The lawsuits were consolidated and an
amended complaint was filed on behalf of a purported class of people who purchased our
stock during the period January 31, 2001, through March 15, 2001, alleging false and
misleading statements and insider trading in violation of the federal securities laws. The
plaintiffs were seeking unspecified damages. In April 2003, in response to the
companys motion to dismiss, certain of the plaintiffs claims were dismissed
with prejudice. However, plaintiffs were permitted to file a further amended complaint
with respect to several remaining claims. In November 2003, a settlement and dismissal of
the action was approved by the Court. The settlement was funded entirely by the
Companys insurers in August and September 2003.

In
mid 2001, putative shareholder derivative actions were filed in California state alleging
breaches of fiduciary duty and insider trading by various of the Companys directors
and officers. As the Company is named as nominal defendant, the lawsuits did not appear to
seek any recovery against us. The settlement and dismissal of these actions were approved
by the Court in November 2003. The settlement did not provide for any monetary payments by
the Company.

The
Company is subject to various legal proceedings, claims and litigation that arise in
the normal course of business. While the outcome of these matters is currently not
determinable, management does not expect that the ultimate costs to resolve these matters
will have a material adverse effect on its consolidated financial position, results of
operations, or cash flows.

F-21

---

# 13.    STOCKHOLDERS'
EQUITY

Stock Purchase Rights

In
December 2002 the Board of Directors approved a Stock Purchase Rights Plan, which declared
a dividend distribution of one Preferred Stock Purchase Right for each outstanding share
of Common Stock, $0.001 par value, of the Company. The distribution was paid, as of
January 3, 2003, to stockholders of record on that date. Each Right entitles the
registered holder to purchase from the Company one one-thousandth of a share of our Series
A Preferred Stock, $0.001 par value, at a price of $22.00 per share.

WarrantGM Onstar

On
December 4, 2000, the Company issued to GM OnStar, a customer, a warrant to purchase
100,000 shares of common stock at an exercise price of $138.50 per share subject to
certain anti-dilution adjustments. The warrant was exercisable at the option of the
holder, in whole or part, at any time between January 17, 2001 and August 2002. In January
2001, the Company valued the warrant at $0.5 million, utilizing the Black-Scholes
valuation model using the following assumptions; risk-free interest rate of 5.5% expected
dividend yields of zero, expected life of 1.5 years, and expected volatility of 80%. The
Company amortized $0.2 million and $0.3 million related to this warrant in 2002 and 2001,
respectively. The warrant was fully amortized and expired unexercised in August 2002.

1994 and 1998 Stock Option Plans

On
September 1, 2000, the 1994 Flexible Stock Incentive Plan was terminated. Upon termination
of the plan, all unissued options were cancelled.

In
August 1998, the Board of Directors approved the 1998 Stock Plan, which terminated upon
the Companys initial public offering on April 13, 2000. As a result of the
termination, the shares remaining available for grant under the 1998 Stock Plan were
transferred to the Companys 2000 Stock Plan. Options issued under the 1998 Stock
Plan have a term of ten years from the date of grant and generally vest 25% after one
year, then ratably on a monthly basis over the remaining three years. Due to the
termination of the 1998 Stock Plan, options issued to employees that expire or become
unexercisable will not be available for future distribution under the 2000 Stock Plans.

2000 Stock Plan

In
February 2000, the Board of Directors and stockholders approved the 2000 Stock Plan. The
2000 Stock Plan, which became effective as of the Companys IPO on April 12, 2000,
assumed the remaining shares reserved under the 1998 Stock Plan. Accordingly, no future
grants will be made under the 1998 Stock Plan. Under the 2000 Stock Plan, the Board of
Directors may grant options to purchase the Companys common stock to employees,
directors, or consultants at an exercise price of not less than 100% of the fair value of
the Companys common stock at the date of grant, as determined by the Board of
Directors. The 2000 Stock plan will terminate automatically in January 2010, unless
terminated earlier by the Companys Board of Directors. Options issued under the 2000
Stock Plan have a term of ten years from the date of grant and vest 25% after one year,
then ratably on a monthly basis over the remaining three years. The number of shares
reserved under the 2000 Stock Plan will automatically be increased each year, beginning on
January 1, 2001, in an amount equal to the lesser of (a) 4,000,000 shares, (b) 6% of the
Companys shares outstanding on the last day of the preceding fiscal year, or (c) a
lesser amount determined by the Board of Directors. The plan is increased by 2,050,934
shares, 1,991,883 shares and 1,689,776 shares in 2003, 2002 and 2001, respectively.

2001
Non-statutory Stock Option Plan

In
May 2001, the Board of Directors approved the 2001 Non-statutory Stock Option Plan. The
Company reserved a total of 500,000 shares of our common stock for issuance under this
Plan. On November 7, 2002, the Board of Directors authorized an additional 850,000 shares
of our common stock for issuance under the Plan. Under the 2001 Non-statutory Stock Option
Plan, the Board of Directors may grant options to purchase the Companys common stock
to employees and consultants. Options may not be granted to Officers and Directors, except
in connection with an Officers initial service to the Company. The Plan will expire
by its own terms in 2011, unless terminated sooner by the Board. Options issued under the
2001 Non-statutory Stock Option Plan have a term of ten years from the date of grant and
vest 25% after one year, then ratably on a monthly basis over the remaining three years.

F-22

---

Stock Option Exchange
Program

On
March 1, 2002, the Company filed a tender offer document with the SEC for an employee
Stock Exchange Program. This was a voluntary stock option exchange program for all
qualified employees. The exchange program was not available to executive officers,
directors, consultants or former employees. Under the program, employees were given the
opportunity to elect to cancel outstanding stock options that had an exercise price of
$15.00 or greater under the 1998 Stock Plan and 2000 Stock Plan held by them in exchange
for new options to be granted under the 2000 Stock Plan at a future date at the then
current fair market value. The new options were to be granted no earlier than the first
business day that is six months and one day after the cancellation date of the exchanged
options. The exercise price per share of the new options was to be 100% of the fair market
value on the date of grant, as determined by the closing price of our common stock
reported by NASDAQ National Market for the last market trading day prior to the date of
grant. These elections were made by March 29, 2002 and were required to include all
options granted during the prior six-month period. In April 1, 2002, stock options in the
amount of 1,492,389 were cancelled relating to this program. On October 4, 2002, employees
who participated in the stock option exchange program were granted new options under the
2000 Stock Plan with an exercise price of $1.65. There were 967,012 stock options for
common stock granted relating to this program. All the stock option grants were vested at
1/8 of the shares subject to the option at the date of grant and 1/48th of the shares
subject to the option shall vest each month thereafter. Under the provisions of APB No. 25
no compensation expense has been, or will be, recognized in our consolidated statement of
operations for the issuance of the replacement options.

Employee Stock Purchase
Plan

In
February 2000, the Board of Directors and stockholders approved the 2000 Employee Stock
Purchase Plan (the Purchase Plan). The Company reserved a total of 1,000,000
shares of common stock for issuance under this plan, which became effective as of the
Companys initial public offering on April 13, 2000. The Purchase Plan is
administered over offering periods of 24 months each, with each offering period divided
into four consecutive six-month purchase periods beginning November 1 and May 1 of each
year. Eligible employees can contribute up to 15% of their compensation each pay period
for the purchase of common stock, not to exceed 2,000 shares per six-month period. On the
last business day of each purchase period, shares of common stock are purchased with the
employees payroll deductions accumulated during the six months, at a purchase price
per share of 85% of the market price of the common stock on the employees entry date
into the applicable offering period or the last day of the applicable offering period,
whichever is lower.

The
number of shares reserved under the Purchase Plan will automatically be increased each
year, beginning on January 1, 2001, in an amount equal to the lesser of (a) 1,500,000
shares, (b) 2% of the Companys shares outstanding on the last day of the preceding
fiscal year, or (c) any lesser amount determined by the Board of Directors. The plan
increased by 683,644 shares and 663,961 shares for 2003 and 2002, respectively.

In
2003, 2002 and 2001, approximately 586,000 shares, 615,000 shares and 459,000 shares were
issued under this plan, respectively, representing employee contributions of approximately
$1.2 million, $2.0 million and $4.0 million, respectively. As of December 31, 2003,
approximately 1,172,825 shares were available for issuance under the Employee Stock
Purchase Plan.

Option
activity under the Stock Option Plans is as follows (in thousands, except per share data):

|                                                                                                         |  | OptionsOutstanding
|-------------------------------------------------------------------------------------------------------- |  | ------------------
|                                                                                                         |  |                   
|January 1, 2001 (959,000
 shares exercisable at weighted average exercise price of $5.69 per share)      |  |                   
|Authorized                                                                                               |  |                   
|Options granted (weighted average
fair value of $12.62 per           share)                              |  |                   
|Options exercised                                                                                        |  |                   
|Options cancelled                                                                                        |  |                   
|Options terminated                                                                                       |  |                   
|December 31, 2001 (2,330,000
 shares exercisable at weighted average exercise price of $24.32 per share) |  |                   
|Authorized                                                                                               |  |                   
|Options granted (weighted average
fair value of $2.24 per           share)                               |  |                   
|Options exercised                                                                                        |  |                   
|Options cancelled                                                                                        |  |                   
|Options terminated                                                                                       |  |                   
|December 31, 2002 (2,895,000
 shares exercisable at weighted average exercise price of $12.80 per share) |  |                   
|Authorized                                                                                               |  |                   
|Options granted (weighted average
fair value of $2.69 per           share)                               |  |                   
|Options exercised                                                                                        |  |                   
|Options cancelled                                                                                        |  |                   
|Options terminated                                                                                       |  |                   
|December 31, 2003 (4,573,000 shares exercisable at weighted average
exercise price of $9.07 per share)   |  |                   

F-23

---

As
of December 31, 2003, the Company had reserved 13,137,210 shares of its common stock for
future issuance.

The
following table summarizes the stock options outstanding and exercisable as of December
31, 2003:

|                               | Options Outstanding | Options Exercisable
|------------------------------ | ------------------- | -------------------
|Range of Exercise Prices(in $) |                     |                    
|$ 0.00 - 5.0                   |                     |                    
|5.0 - 10.0                     |                     |                    
|10.0 - 13.0                    |                     |                    
|13.0 - 17.0                    |                     |                    
|17.0 - 35.0                    |                     |                    
|35.0 - 52.5                    |                     |                    
|52.5 - 70.0                    |                     |                    
|70.0 - 105.0                   |                     |                    
|105.0 - 122.5                  |                     |                    
|                               |                     |                    

The
following table summarizes the detailed information for each plan:

|                                                                            |  | 1994 option plan |  |         | 1998 option plan |  |           | 2000 option plan |  |           | 2001 option plan |  |           | All option plans total |  |           | Employee Stock Purchase Plan | 
|--------------------------------------------------------------------------- |  | ---------------- |  | ------- | ---------------- |  | --------- | ---------------- |  | --------- | ---------------- |  | --------- | ---------------------- |  | --------- | ---------------------------- | 
|Number of shares to be issued upon the      exercise of outstanding options |  |                  |  | 121,956 |                  |  | 2,214,652 |                  |  | 5,978,752 |                  |  | 1,207,742 |                        |  | 9,523,102 |                              | 
|Weighted average exercise price of the      outstanding options             |  |                  |  | $  1.21 |                  |  | $  9.95   |                  |  | $  6.34   |                  |  | $  3.49   |                        |  | $  6.75   |                              | 
|Number of shares available for future      issuance                         |  |                  |  | --      |                  |  | 1,005,446 |                  |  | 2,329,226 |                  |  | 138,778   |                        |  | 3,473,450 |                              | 

In
July 2001, an employee was terminated effective September 2001. The employee was allowed
to continue to vest in his stock options which resulted in a pre-tax non-cash compensation
charge of $0.2 million in accordance with the FIN No. 44, Accounting for Certain
Transactions Involving Stock Compensation.

Deferred Stock
Compensation

The
Company accounts for its stock-based awards to employees using the intrinsic value method
in accordance with APB No. 25. Accordingly, the Company records deferred stock
compensation equal to the difference between the grant price and fair value of the
Companys common stock on the date of grant. In connection with the grant of stock
options prior to our initial public offering, the Company recorded deferred stock
compensation of approximately $8.7 million within stockholders equity, representing
the difference between the estimated fair value of the common stock for accounting
purposes and the option exercise price of these options at the date of grant. This amount
was presented as a reduction of stockholders equity and being amortized over the
vesting period of the applicable options. Relating to approximately 3,152,000 stock
options granted before initial public offer at a weighted average exercise price of $8.58,
for the years ended December 31, 2003, 2002 and 2001, the Company recorded amortization of
deferred compensation of $0.2 million, $0.9 million and $2.3 million. During the same
periods, the Company reversed excess amortization of deferred stock compensation due to
termination of employees of ($0.2) million, ($0.4) million and ($0.3) million, resulting
in no net expense for deferred compensation, $0.5 million and $2.0 million, respectively.
For the year ended December 31, 2002, the Company reversed approximately $0.1 million of
deferred stock compensation into additional paid-in capital, representing unamortized
deferred stock compensation relating to forfeitures of stock options by terminated
employees.

F-24

---

In
connection with the SpeechFront acquisition, the Company recorded deferred compensation
expense $0.4 million and $3.1 million for the year ended December 31, 2002 and 2001
respectively. SpeechFront related deferred compensation was fully amortized as of December
31, 2002.

SFAS No. 123 Fair Value
Disclosures

Since
the Company continues to account for its stock-based awards to employees using the
intrinsic value method in accordance with APB No. 25, SFAS No. 123 requires the disclosure
of pro forma net income (loss) as if the Company had adopted the fair value method. Under
SFAS No. 123, the fair value of stock-based awards is calculated through the use of option
pricing models, even though such models were developed to estimate the fair value of
freely tradable, fully transferable options without vesting restrictions, which
significantly differ from the Companys stock option awards. The Companys
calculations were made using the Black-Scholes option pricing model, which requires
subjective assumptions, including expected time to exercise, which greatly affects the
calculated values and the resulting pro forma compensation cost may not be representative
of that to be expected in future periods.

The
following weighted average assumptions were used in the estimated grant date fair value
calculation for the Company stock option awards:

|                                   | Stock Options | Employee Stock Purchase Plan
|---------------------------------- | ------------- | ----------------------------
|
|                                   |               |                             
|Risk-free interest rate            |               |                             
|Expected dividend yield            |               |                             
|Expected life of option (in years) |               |                             
|Volatility                         |               |                             

Under
the above Black-Scholes option valuation model assumptions,

|. | the weighted  average fair value of stock  options
granted  during  2003, 2002 and 2001 was $2.69, $2.24 and $12.62, respectively. The fair value
of each option grant was estimated on the date of grant.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                           
|. | the weighted  average fair value of purchase
rights  granted  pursuant to the Employee  Stock Purchase Plan was $ 3.79, $ 0.98 and $3.87 for the year 2003,
2002 and 2001, respectively.                  

F-25

---

14.    401(k) PLAN

The
Company has a defined contribution savings plan under Section 401(k) of the Internal
Revenue Code. The plan provides for tax-deferred salary deductions and after-tax employee
contributions. The Company does not make contributions to the plan.

15.     INCOME TAXES

The
total provision for (benefit from) income taxes consists of the following components (in
thousands):

|                          |  |  |  | 2003   |   |  | 2002 |   |  | 2001 |  
|------------------------- |  |  |  | ------ | - |  | ---- | - |  | ---- | -
|Current                   |  |  |  |        |   |  |      |   |  |      |  
|State                     |  |  |  | 16     |   |  | 114  |   |  | --   |  
|Foreign                   |  |  |  | (1,451 | ) |  | 827  |   |  | 812  |  
|Total                     |  |  |  | (1,435 | ) |  | 941  |   |  | 812  |  
|Deferred                  |  |  |  |        |   |  |      |   |  |      |  
|Foreign                   |  |  |  | (371   | ) |  | (141 | ) |  | (238 | )
|Total provision (benefit) |  |  |  | (1,806 | ) |  | 800  |   |  | 574  |  

The
components of the net deferred income tax asset as of December 31 were as follows (in
thousands):

|                                         |  |  |   | 2003     |   |   | 2002     |  
|---------------------------------------- |  |  | - | -------- | - | - | -------- | -
|Deferred tax assets                      |  |  |   |          |   |   |          |  
|Net operating loss carryforwards         |  |  | $ | 73,883   |   | $ | 65,131   |  
|Tax credit carryforwards                 |  |  |   | 4,069    |   |   | 4,156    |  
|Capital loss carryforwards - foreign     |  |  |   | 2,370    |   |   | --       |  
|Asset impairment on purchased technology |  |  |   | 2,115    |   |   | 2,176    |  
|Deferred revenue                         |  |  |   | 463      |   |   | 1,682    |  
|Accrued restructuring charges            |  |  |   | 27,996   |   |   | 30,101   |  
|Accruals and reserves                    |  |  |   | 2,525    |   |   | 3,104    |  
|Gross deferred tax asset                 |  |  |   | 113,421  |   |   | 106,350  |  
|Valuation allowance                      |  |  |   | (113,304 | ) |   | (105,861 | )
|Net deferred tax asset                   |  |  | $ | 117      |   | $ | 489      |  

As
of December 31, 2003 and 2002, the net deferred tax asset consists of foreign
subsidiary temporary differences on accruals and reserves. As of December 31, 2003 and 2002, the Company had no significant deferred tax liabilities.

As
of December 31, 2003, the Company has cumulative net operating loss carry forwards for
federal and California income tax reporting purposes of approximately $186.1 million and
$50.9 million respectively. The federal net operating loss carry forwards expire through
December 2023 and the California net operating loss carry forwards expire through December
2013. In addition, the Company has carry forwards of research and experimentation tax
credits for federal and California income tax purposes of approximately $2.4 million and
$2.5 million, respectively, as of December 31, 2003. The federal research and
experimentation tax credits expire through December 2023. The state research and
experimentation credits can be carried forward indefinitely. Under current tax law, net
operating loss carry forwards available in any given year may be limited upon the
occurrence of certain events, including significant changes in ownership interest of the
Company resulting from significant stock transactions.

The
Companys income taxes payable for federal and state purposes has been reduced, and
the deferred tax assets increased, by the tax benefits associated with taxable
dispositions of employee stock options. When an employee exercises a stock option issued
under a nonqualified plan or has a disqualifying disposition related to a qualified plan,
the Company receives an income tax benefit calculated as the difference between the fair
market value of the stock issued at the time of the exercise and the option price, tax
effected. A portion of the valuation allowance relates to the equity benefit of our net
operating losses. The Company had approximately $1.2 million and $0.7 million of taxable dispositions of employee stock options for the years ended December 31,
2003 and 2002, respectively. A portion of the valuation allowance, when reduced,
will be credited directly to stockholders equity.

F-26

---

The
Company recorded state and foreign income tax total provisions for (benefit from) the
years ended December 31, 2003, 2002 and 2001 of $(1.8) million, $0.8 million and $0.6 million, respectively. For the year ended December 31, 2003, the Company recorded a tax
benefit of $1.8 million of state and foreign taxes, of which $1.4 million resulted from
the reversal of a prior year accrual related to tax assessments and penalties from the
France Tax Authorities for the tax years ended December 31, 2001, 2000 and 1999, thereby
settling all claims for those years. In addition, the Company recorded a tax benefit of
$0.6 million due to the recognition of research and development tax credits from the
Companys Canadian operations.

Income
(loss) before provision for income taxes consisted of (in thousands):

|              |  |  | December 31,
|------------- |  |  | ------------
|              |  |  |             
|United States |  |  | $           
|Foreign       |  |  |             
|Total         |  |  | $           

The
actual provision for income taxes differs from the statutory U.S. federal income tax rate
as follows (in thousands):

|                                              |  |  | December 31,
|--------------------------------------------- |  |  | ------------
|                                              |  |  |             
|Provision at U.S.statutory rate of 35%        |  |  | $           
|State income taxes, net of federal benefit    |  |  |             
|Change in valuation allowance                 |  |  |             
|Effect of foreign income tax at various rates |  |  |             
|Research and development tax credit           |  |  |             
|Deferred stock compensation                   |  |  |             
|Other                                         |  |  |             
|Total                                         |  |  | $           

16.      SEGMENT REPORTING

Effective
January 1, 1998, the Company adopted the provisions of SFAS No. 131, Disclosures
about Segments of an Enterprise and Related Information. SFAS No. 131 establishes
standards for the way companies report information about operating segments in financial
statements. It also establishes standards for related disclosures about products and
services, geographic areas and major customers. The Companys operating segments are
defined as components of the Company about which separate financial information is
available that is evaluated regularly by the chief operating decision maker, or decision
making group, in deciding how to allocate resources and in assessing performance. The
Companys chief operating decision maker is the Chief Executive Officer of the
Company.

The
Company derives revenues from three primary sources: 1) license, 2) service and 3)
maintenance. Revenue and cost of revenue for the segments are identical to those presented
on the accompanying consolidated statement of operations. The Company does not track
expenses nor derive profit or loss based on these segments. The Company also does not
track assets by segments.

Sales
of licenses, as well as services and maintenance through December 31, 2003 occurred
through third-party resellers and direct sales representatives located in the
Companys headquarters in Menlo Park, California, and in other locations. These sales
were supported through the Menlo Park location. The Company does not separately report
costs by region internally.

Revenues
are based on the country in which the end-user is located. The following is a summary of
license, service and maintenance revenue by geographic region (in thousands):

F-27

---

|                     | Year ended December 31, | 
|-------------------- | ----------------------- | 
|                     |                         | 
|License Revenue:     |                         | 
|United States        |                         | 
|Canada               |                         | 
|Europe               |                         | 
|Asia                 |                         | 
|Latin America        |                         | 
|Australia            |                         | 
|Total                |                         | 
|Service Revenue:     |                         | 
|United States        |                         | 
|Canada               |                         | 
|Europe               |                         | 
|Asia                 |                         | 
|Latin America        |                         | 
|Australia            |                         | 
|Total                |                         | 
|Maintenance Revenue: |                         | 
|United States        |                         | 
|Canada               |                         | 
|Europe               |                         | 
|Asia                 |                         | 
|Latin America        |                         | 
|Australia            |                         | 
|Total                |                         | 
|Total revenue:       |                         | 
|United States        |                         | 
|Canada               |                         | 
|Europe               |                         | 
|Asia                 |                         | 
|Latin America        |                         | 
|Australia            |                         | 
|Total revenue        |                         | 

Total
long-lived assets by international locations as of December 31 are as follows (in
thousands):

|                             |  |  |   | 2003   |  |   | 2002   | 
|---------------------------- |  |  | - | ------ |  | - | ------ | 
|Long-Lived Assets:           |  |  |   |        |  |   |        | 
|Property and equipment, net: |  |  |   |        |  |   |        | 
|United States                |  |  | $ | 2,566  |  | $ | 4,643  | 
|Europe                       |  |  |   | 33     |  |   | 65     | 
|Asia                         |  |  |   | 62     |  |   | 122    | 
|Australia                    |  |  |   | 4      |  |   | 12     | 
|Canada                       |  |  |   | 1,270  |  |   | 1,485  | 
|Latin America                |  |  |   | 2      |  |   | 3      | 
|Total                        |  |  | $ | 3,937  |  | $ | 6,330  | 
|                             |  |  |   |        |  |   |        | 
|Intangible Assets:           |  |  |   |        |  |   |        | 
|United States                |  |  | $ | 993    |  | $ | 1,405  | 
|Total                        |  |  | $ | 993    |  | $ | 1,405  | 
|                             |  |  |   |        |  |   |        | 
|Other Long Term Assets:      |  |  |   |        |  |   |        | 
|United States                |  |  | $ | 11,582 |  | $ | 14,626 | 
|Total                        |  |  |   | 11,582 |  |   | 14,626 | 
|                             |  |  |   |        |  |   |        | 
|Total Long-Lived Assets:     |  |  | $ | 16,512 |  | $ | 22,361 | 

17.    RELATED PARTIES

Certain
members of the Companys Board of Directors also serve as directors for companies to
which the Company sells products in the ordinary course of its business. The Company
believes that the terms of its transactions with those companies are no less favorable to
the Company than the terms that would have been obtained absent those relationships. In
addition, certain members of the Companys Board of Directors serve as directors or
principals of entities that are investors in the Company.

One member of the Companys
Board of Directors is also on the Board of Directors at Wells Fargo, one of the
Companys customers. The Company generated $840,000 in revenues from Wells Fargo in
the year ended December 31, 2003, and $75,000 in revenues for the year ended December 31,
2002. The Company was owed $310,000 by this customer at December 31, 2003, and $21,000 at
December 31, 2002.

F-28

---

18.    
           SUPPLEMENTARY DATA: QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

Summarized
quarterly financial information is as follows (in thousands, except per share data):

|                                                            | Year 2003 Three Months Ended
|----------------------------------------------------------- | ----------------------------
|                                                            |                             
|Net revenue                                                 |                             
|Gross profit                                                |                             
|Loss from operations                                        |                             
|Net loss                                                    |                             
|Basic and diluted net loss per share                        |                             
|Shares used to compute basic and diluted net loss per share |                             

|                                                            | Year 2002 Three Months Ended
|----------------------------------------------------------- | ----------------------------
|                                                            |                             
|Net revenue                                                 |                             
|Gross profit                                                |                             
|Loss from operations                                        |                             
|Net loss                                                    |                             
|Basic and diluted net loss per share                        |                             
|Shares used to compute basic and diluted net loss per share |                             

F-29

---

# SCHEDULE II

# NUANCE COMMUNICATIONS,
INC.

# SCHEDULE OF VALUATION
AND QUALIFYING ACCOUNTS AT DECEMBER 31, 2003

|                                |  |  |                | Balanceat Begin of Period |  |   | Charged to Expenses |  |   | Deduction |   |   | Balanceat Endof Period | 
|------------------------------- |  |  | -------------- | ------------------------- |  | - | ------------------- |  | - | --------- | - | - | ---------------------- | 
|                                |  |  | (in thousands)
|Year ended December 31, 2001    |  |  |                |                           |  |   |                     |  |   |           |   |   |                        | 
|Allowance for Doubtful Accounts |  |  | $              | 1,823                     |  | $ | 521                 |  | $ | (1,032    | ) | $ | 1,312                  | 
|Year ended December 31, 2002    |  |  |                |                           |  |   |                     |  |   |           |   |   |                        | 
|Allowance for Doubtful Accounts |  |  |                | 1,312                     |  |   | 59                  |  |   | (701      | ) |   | 670                    | 
|Year ended December 31, 2000    |  |  |                |                           |  |   |                     |  |   |           |   |   |                        | 
|Allowance for Doubtful Accounts |  |  |                | 670                       |  |   | 343                 |  |   | (176      | ) |   | 837                    | 

F-30

---

# EXHIBIT INDEX

|Exhibit number | Description                                                                                                                                                                                                
|-------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|               |                                                                                                                                                                                                            
|3.1(1)         | Restated Certificate of Incorporation of Registrant, as currently in effect.                                                                                                                               
|               |                                                                                                                                                                                                            
|3.2(6)         | Bylaws of Registrant, as amended, as currently in effect.                                                                                                                                                  
|               |                                                                                                                                                                                                            
|4.1(6)         | Rights Agreement,  dated as of
December 10,  2002,  by and between the Company and Mellon  Investors Services LLC, as Rights Agent.                                                                        
|               |                                                                                                                                                                                                            
|4.2(1)         | Form of Registrant's Common Stock Certificate.                                                                                                                                                             
|               |                                                                                                                                                                                                            
|4.3(1)         | Amended and Restated  Investors'  Rights
Agreement,  dated as of October 1, 1999, among the Registrant and the parties named therein.                                                                      
|               |                                                                                                                                                                                                            
|4.4(1)         | Warrant to Purchase Stock dated April 1, 1996 issued to Phoenix Leasing.                                                                                                                                   
|               |                                                                                                                                                                                                            
|4.6(5)         | Amendment to the Amended and  Restated  Investors'  Rights  Agreement,  dated as of October 1, 1999,  among the
                Registrant and the parties named therein.                                  
|               |                                                                                                                                                                                                            
|4.7(5)         | Exchange Agreement dated November 10, 2000 between Registrant,  1448451 Ontario,  Inc., Shawn Griffin,  William
                Love and Warren Gallagher.                                                 
|               |                                                                                                                                                                                                            
|10.1(1)(*)     | Form of Indemnification Agreement entered into by Registrant with each of its directors and executive officers.                                                                                            
|               |                                                                                                                                                                                                            
|10.2(1)(*)     | 1994 Flexible Stock Incentive Plan.                                                                                                                                                                        
|               |                                                                                                                                                                                                            
|10.3(1)(*)     | 1998 Stock Plan.                                                                                                                                                                                           
|               |                                                                                                                                                                                                            
|10.4(1)(*)     | 2000 Stock Plan.                                                                                                                                                                                           
|               |                                                                                                                                                                                                            
|10.5(2)(*)     | 2000 Employee Stock Purchase Plan, as amended, and related subscription agreement.                                                                                                                         
|               |                                                                                                                                                                                                            
|10.6(1)        | Lease Agreement dated May 27, 1997, and related  agreements by and between  Registrant and Lincoln Menlo IV & V
                 Associates Limited.                                                       
|               |                                                                                                                                                                                                            
|10.7(1)(*)     | Form of Stock Option  Agreement,  as amended,
between  Registrant and each executive  officer other than Donna Allen Taylor.                                                                               
|               |                                                                                                                                                                                                            
|10.8(1)        | Assignment and Assumption Agreement, and related agreements by and between Registrant and CBT Systems USA, Ltd.                                                                                            
|               |                                                                                                                                                                                                            
|10.9(1)        | Memorandum of Agreement of Lease, 2000 Peel Street, Suite 900, Montreal,  Quebec, dated January 1, 2000, by and
                 between Registrant and Cite De L'Ile Development Inc.                     
|               |                                                                                                                                                                                                            
|10.11(1)(**)   | License Agreement dated December 20, 1994, by and between Registrant and SRI International.                                                                                                                
|               |                                                                                                                                                                                                            
|10.12(1)(*)    | Form of Stock Option Agreement  entered into
between  Registrant and Donna Allen Taylor.                                                                                                                   
|               |                                                                                                                                                                                                            
|10.13(1)       | Amendment dated August 23, 1995 to License Agreement dated December 20, 1994 by and between  Registrant and SRI
                 International.                                                            
|               |                                                                                                                                                                                                            
|10.15(4)       | Addendum dated August 9, 2000 to Memorandum of Lease Agreement dated January 1, 2000, by and between
                 Registrant and Societe en Commandite Duke-Wellington.                                
|               |                                                                                                                                                                                                            
|10.16(5)(**)   | Value-Added Reseller Agreement dated August 31,
2000, by and between Registrant and Nortel Networks Limited.                                                                                               
|               |                                                                                                                                                                                                            
|10.17 (7)(*)   | Executive Employee Agreement by and between the Company and Ronald A. Croen dated as of January 1, 2003.                                                                                                   
|               |                                                                                                                                                                                                            
|10.18 (7)(*)   | Executive Employee Agreement by and between the Company and Charles W. Berger dated as of March 31, 2003.                                                                                                  
|               |                                                                                                                                                                                                            
|21.1           | Subsidiaries of Registrant                                                                                                                                                                                 
|               |                                                                                                                                                                                                            
|23.1           | Consent of Deloitte & Touche LLP, Independent Public Accountants                                                                                                                                           
|               |                                                                                                                                                                                                            
|24.1           | Power of Attorney                                                                                                                                                                                          
|               |                                                                                                                                                                                                            
|31.1           | Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 (a) of the Sarbanes - Oxley Act of
           2002, by Charles W. Berger, President and Chief Executive Officer.      
|               |                                                                                                                                                                                                            
|31.2           | Certification  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 (a) of the Sarbanes - Oxley Act of
              2002, by Karen Blasing, Vice President and Chief Financial Officer. 
|               |                                                                                                                                                                                                            
|32.1           | Certification  pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley  Act of
           2002, by Charles W. Berger, President and Chief Executive Officer         
|               |                                                                                                                                                                                                            
|32.2           | Certification  pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley  Act of
           2002, by Karen Blasing, Vice President and Chief Financial Office         
|               |                                                                                                                                                                                                            
|(1)            | Incorporated  by  reference  to the  Registrant's  Registration  Statement  on Form S-1 (File No.  333-96217)  as declared
      effective by the Securities and Exchange Commission on February 4, 2000.  
|               |                                                                                                                                                                                                            
|(2)            | Incorporated by reference to the Registrant's Registration Statement on Form S-8 filed on June 2, 2000.                                                                                                    
|               |                                                                                                                                                                                                            
|(3)            | Incorporated by reference to the Registrant's Form 10-Q for the period ended June 30, 2000 filed on August 14, 2000.                                                                                       
|               |                                                                                                                                                                                                            
|(4)            | Incorporated  by  reference  to the  Registrant's  Registration  Statement  on Form S-1 (File No.  333-45128)  as declared
      effective by the Securities and Exchange Commission on September 26, 2000.
|               |                                                                                                                                                                                                            
|(5)            | Incorporated by reference to the Registrant's Amendment No. 1 to Form 10-K for the year
ended December 31, 2000 filed on october 19, 2001.                                                                 
|               |                                                                                                                                                                                                            
|(6)            | Incorporated by reference to the Registrant's Form 8-K (File No. 000-30203) as filed on December 13, 2002.                                                                                                 
|               |                                                                                                                                                                                                            
|(7)            | Incorporated by reference to the Registrant's Form 10-Q for the period ended on March 31, 2003 filed on May 15, 2003.                                                                                      
|               |                                                                                                                                                                                                            
|(*)            | Represents a management contract or a compensatory plan, contract or arrangement.                                                                                                                          
|               |                                                                                                                                                                                                            
|(**)           | Confidential treatment has been requested for portions of this exhibit.