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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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FORM 10-K

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FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934



(Mark One)



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

| | SECURITIES EXCHANGE ACT OF 1934
| | -------------------------------



For the fiscal year ended October 31, 2006



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
|- | --------------------------------------------------------

| | SECURITIES EXCHANGE ACT OF 1934
| | -------------------------------



For the transition period fromto



0-22366

(Commission file number)

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CREDENCE SYSTEMS CORPORATION

(Exact name of registrant as specified in its charter)

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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 94-2878499                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|1421 California Circle, Milpitas, California                   |  | 95035                               
|(Address of principal executive office)                        |  | (Zip Code)                          



(408) 635-4300

(Registrants telephone number, including area code)



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



|                    |  |                                          
|------------------- |  | -----------------------------------------
|Title of each class |  | Name of each exchange on which registered
|None                |  | None                                     



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



Common Stock, $0.001 par value

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



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



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



Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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.  x



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



Large accelerated filer ̈Accelerated filer  x                        Non-accelerated filer ̈



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



The aggregate market value of the voting stock held by non-affiliates of the Registrant, as of April 28, 2006 was approximately $513,480,644 (based upon the closing price for shares of the Registrants
common stock as reported by the Nasdaq National Market as of that date of $7.09). Shares of common stock held by each officer, director and holder of 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to
be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.



On December 31, 2006, approximately 100,612,071 shares of the Registrants common stock, $0.001 par value, were outstanding.



DOCUMENTS INCORPORATED BY REFERENCE



Portions of the Registrants Proxy Statement for the 2007 Annual
Meeting of Stockholders to be held on March 15, 2007 are incorporated by reference into Part III of this report. Except as expressly incorporated by reference, the Registrants Proxy Statement shall not be deemed to be a part of this
report.

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##### Table of Contents

FORM 10-K



TABLE OF CONTENTS



|         |  |                                                                                                                  |  |     
|-------- |  | ---------------------------------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                                                  |  | Page
|PART I  
|Item 1.  |  | Business                                                                                                         |  | 5   
|Item 1A. |  | Risk Factors                                                                                                     |  | 12  
|Item 1B. |  | Unresolved Staff Comments                                                                                        |  | 26  
|Item 2.  |  | Properties                                                                                                       |  | 26  
|Item 3.  |  | Legal Proceedings                                                                                                |  | 27  
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                              |  | 27  
|        
|PART II 
|Item 5.  |  | Market for the Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |  | 30  
|Item 6.  |  | Selected Financial Data                                                                                          |  | 30  
|Item 7.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                            |  | 32  
|Item 7A. |  | Quantitative and Qualitative Disclosures About Market Risk                                                       |  | 50  
|Item 8.  |  | Financial Statements and Supplementary Data                                                                      |  | 52  
|Item 9.  |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                             |  | 96  
|Item 9A. |  | Controls and Procedures                                                                                          |  | 96  
|Item 9B. |  | Other Information                                                                                                |  | 97  
|        
|PART III
|Item 10. |  | Directors and Executive Officers of the Registrant                                                               |  | 98  
|Item 11. |  | Executive Compensation                                                                                           |  | 98  
|Item 12. |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters                   |  | 98  
|Item 13. |  | Certain Relationships and Related Transactions                                                                   |  | 100 
|Item 14. |  | Principal Independent Registered Public Accounting Firm Fees and Services                                        |  | 100 
|        
|PART IV 
|Item 15. |  | Exhibits and Financial Statement Schedule                                                                        |  | 101 
|         |  | Signatures                                                                                                       |  | 102 



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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, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, including statements using terminology such as believes, may, will, expects, plans, anticipates,
goals, estimates, potential, or continue, or the negative thereof or other comparable terminology regarding beliefs, plans, expectations or intentions regarding the future. The cautionary statements
made in this Annual Report on Form 10-K should be read as being applicable to all related forward-looking statements whenever they appear in this Annual Report on Form 10-K. Forward-looking statements include statements regarding our objective to be
the leading supplier of test solutions from design through production test; the increasing importance of assembly and test service companies in the ATE market; our dependence upon the success of our major customers; our dependence on obtaining
orders from new and current customers and the general global economy; international business continuing to account for a significant portion of our net sales; our belief that order cancellations and customer-requested shipment delays will occur in
the future; our development of long-term relationships with major customers; our focus on increased cycle time, accuracy and pin counts of our tester products and co-development of technology between our product groups; our continued efforts to
provide solutions that allow a more rapid, cost-effective development of ATE test programs; our dedication to continue to invest significant resources in the development of new products and enhancements; the possibility that litigation may be
necessary to enforce our patents and other intellectual property rights; our manufacturing objective to produce engineering validation test systems and ATE that conform to our customers requirements at the lowest commercially practical
manufacturing cost; management of our inventory through agreements with both suppliers and subcontractors; our belief that we compete favorably with respect to throughput, tools for reducing customer product time-to-market, product performance and
total cost of ownership; our future results being dependent on attracting and retaining highly skilled workers; our dependence on continued significant expenditures related to new products, capital equipment purchases and worldwide training and
customer service and support; our belief that our net sales and operating results will continue to fluctuate; our intention to introduce new products and product enhancements; our belief that our gross margins on systems sales will continue to vary
significantly; our expectation that our top ten customers in the aggregate will continue to account for a large portion of our net sales for the foreseeable future, and the loss of one or more of these customers will harm our business and operating
results; our intent to continue to address the need to develop new products and enhance existing products through acquisitions of other companies, product lines, technologies and personnel; our existing cash and short-term investments being
sufficient to meet our cash requirements for the foreseeable future; our dependence on the capital expenditures of manufacturers of semiconductors and other companies; significant portions of our new orders being dependent upon demand from
semiconductor device manufacturers building or expanding fabrication facilities and new device testing requirements; our belief that stock options and other long-term equity incentives directly motivate our employees to maximize long-term
stockholder value and, through the use of vesting, encourage employees to remain with us; our dependence upon obtaining orders for systems to be shipped in the same quarter in which the order is received; the continued acceptance, volume production,
timely delivery and customer satisfaction of our newer digital, mixed signal and non-volatile memory testers being of critical importance to our future financial results; investment of significant resources in the development and completion of new
products and product enhancements; investment of significant resources in property and equipment, purchased and leased facilities, inventory and other cost; the possibility that we may repatriate additional cash from our foreign subsidiaries; our
ability to maintain or increase sales levels in Taiwan; our anticipation that international sales will continue to account for a significant portion of our total net sales; our expectation that we will continue to receive notice of third party
claims for infringement and that litigation expenses with respect to those claims may continue to be an expensive and time consuming process for us; our expectation that our expenses will increase as a result of our response to requirements of the
Sarbanes-Oxley Act of 2002; our expectation that the Sarbanes-Oxley Act of 2002 will continue to make it more difficult and more expensive for us to obtain director and officer liability insurance; our dependence on the continued service of our
executive officers and key personnel; our dependence upon our ability to attract and retain qualified personnel; our existing properties, including both owned and leased sites, being in good condition and adequate to meet our current and foreseeable
future requirements; our



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belief that our tax positions are consistent with the tax positions in the jurisdictions in which we conduct business; our belief that claims brought in the
ordinary course of business will not have a materially adverse effect on our business, financial condition or results of operation; our anticipation that net sales will be $118 million to $122 million in the first quarter of fiscal year 2007; our
belief that gross margin percent could be flat to slightly higher in the first quarter; our anticipation that R&D expenses in absolute dollars for fiscal 2007 will be lower in the first quarter compared to the fourth quarter of fiscal 2006; our
expectation that SG&A expenses in absolute dollars for fiscal 2007 will be lower in the first quarter compared to the fourth quarter of fiscal 2006; our anticipation that our annual amortization for purchased intangible assets will be $17.9
million and $15.9 million for the fiscal years ending in 2007 and 2008, respectively; our expectation that we will record a full valuation allowance on domestic tax benefits; our belief that investment in inventory will continue to represent a
significant portion of our working capital; the highly cyclical semiconductor industry which experiences downturns; our expectation that a 10% change in the interest rate will not have any material effect on our interest income or expense; our
revenue recognition practices regarding new products; our expectation that we will not recognize any significant tax benefits in our results of operations; our belief that our current cash positions will be sufficient to meet our anticipated
business requirements for the next 12 months; estimated future restructuring payments; our dependence on generating sufficient taxable income in future years to realize net deferred tax assets; future minimum lease payments; minimum contractual cash
obligations and the effect of such obligations in future periods; the highly competitive nature of the automatic test equipment industry which is subject to rapid technological change; the impact of the adoption of certain accounting pronouncements
on the Companys financial positions or results of operations; our need for continued significant expenditures for research and development, marketing and other expenses for new products; our expectation of continuing volatility in order
activity; our belief that it is probable that orders will be canceled and delayed in the future; our intent to maintain the rapid pace of product innovation on scalable platforms; our improving yield and increasing throughput; our intent to continue
focusing on the high growth opportunities of the SoC ATE market; our intent to continue focusing on emerging opportunities for profitable growth; our intent to leverage our relationships with industry leaders to enhance market position; our intent
to lower total cost of ownership; our intent to continue delivering an outstanding total customer experience throughout the product life cycle; our intent to optimize our operating model to generate sustainable profitability; our belief that a
significant portion of investments will provide the marketing, administration and after-sales service and support required for these new products; our intent to maintain the Disclosure Controls as dynamic systems that change as conditions warrant;
our intent to make public disclosure of our Code of Ethics by posting our information on our website in accordance with SEC rules; our plan to continue recognizing compensation expense for all share-based payment awards; and our intent to outsource
in the future and our expectation that we will achieve operational flexibility and costs savings as a result of outsourcing.



These forward-looking statements involve important factors that could cause our actual results to differ materially from those in the forward-looking
statements. Such important factors involve risks and uncertainties including, but not limited to difficulties in utilizing different technologies; delays in bringing products to market due to development problems; difficulties in developing new
engineering validation test systems; the possibility that our existing systems will become obsolete; excessively high costs in the future related to enhancing our existing systems; significant changes in customer preferences; difficulties in
integrating acquired technology with our product lines; the possibility that competitors will introduce products faster than us; unanticipated difficulties in building close working relationships with vendors; difficulties in developing the Sapphire
platform; less sales of the Sapphire platform products than anticipated; product defects sustained during the manufacturing process; the risk that we may not be successful in obtaining new orders from major customers; unanticipated decreases in
demand for our products in foreign countries; difficulties in providing extensive support to major customers; unanticipated difficulties in manufacturing and delivering new products, enhancement tools; unanticipated difficulties in integrating our
products with customers operations; unanticipated difficulties in integrating developed technology; substantial technological changes in the semiconductor industry; a lack of the required resources to invest in the development of new products;
uncertainties as to the current products provided by our competitors; unanticipated difficulties in locating and evaluating potential product lines, technologies and business to acquire; the viability of legal claims brought against us; our failure
to accurately predict the effect of



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the ultimate outcome of claims on our business, financial condition or results of operations; lower than expected revenues; the risk that we may be required
to expend more cash in the future than anticipated; difficulties in obtaining orders from manufacturers of semiconductors and companies that specialize in contract packaging and/or testing of semiconductors; the timing of orders; an unanticipated
lack of resources to invest in property, plant and equipment, purchased and leased facilities, inventory, personnel and other costs; changing market conditions in Taiwan; inaccuracies in our assumptions regarding our tax positions; uncertainties as
to the nature and extent of any potential cyclical downturn in the semiconductor industry; uncertainties as to the prospect of future orders and sales levels; changes in laws applicable to us regarding revenue recognition practices relating to our
new products; uncertainties as to the future level of sales and revenues; unanticipated budgetary constraints; uncertainties as to the assumptions underlying our calculations regarding estimated annual amortization expenses for purchased intangible
assets; uncertainties as to the effects of the adoption by us of certain accounting policies; the risk that our future working capital will not be sufficient to invest significant portions of such working capital in inventories; uncertainties as to
the effect of the adoption of certain accounting pronouncements; unanticipated difficulties in the remediation of internal control deficiencies; ability of the Company to maintain the requisite level of assets under its deferred compensation plan;
increased fragmentation in the ATE industry; cost overruns, delayed deliveries, shortages, quality issues or other problems resulting from outsourcing; and other factors set forth in Risk Factors and elsewhere herein. Reference is made
to the discussion of risk factors detailed in our filings with the Securities and Exchange Commission, including our reports on Form 10-K and 10-Q. All projections in this annual report on Form 10-K are based on limited information
currently available to us, which is subject to change. Although any such projections and the factors influencing them will likely change, we will not necessarily update the information, since we are only to provide guidance at certain points during
the year. Actual events or results could differ materially and no reader of this annual report on Form 10-K should assume that the information provided today will still be valid in the future. Such information speaks only as of the date of this
annual report on Form 10-K.



|Item 1. | Business
|------- | --------



We are a leading provider of test and diagnostics solutions for the consumer age integrated circuit industry. We design, manufacture, sell and service
engineering validation test equipment, diagnostics and failure analysis products and automatic test equipment, or ATE, used for testing semiconductor integrated circuits, or ICs. We utilize our proprietary technologies to design products that enable
the flexibility needed by our customers to meet their challenging time to market needs, at a lower total cost of ownership and improved yield learning cycles. Our products help bridge the communication gap between design teams, the foundries used to
manufacture their products, and the test and diagnostics groups involved in characterization and debug for their products. This improves their ability to bring products from concept to yield in todays challenging nano-chip
environment. By applying leading-edge technology to create flexibility and lower the overall cost-of-test, we are committed to deliver innovative technology at a competitive cost and performance advantages to integrated device manufacturers, or
IDMs, wafer foundries, outsource assembly and test suppliers or OSATs and fabless chip companies worldwide.



We were incorporated in California in March 1982 and were reincorporated in Delaware in October 1993. Credence or the Company,
we, us and our refers to Credence Systems Corporation and our subsidiaries. Our principal executive offices are located at 1421 California Circle, Milpitas, California and our telephone number is
(408) 635-4300. Our worldwide website address is www.credence.com. On our Investor Relations page on this web site we post the following filings as soon as reasonably practicable after they are electronically filed with or furnished to the
Securities and Exchange Commission: our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the
Securities Exchange Act of 1934. All such filings on our Investor Relations web page are available to be viewed on this page free of charge. Information contained on our web site is not part of this annual report on Form 10-K or our other filings
with the Securities and Exchange Commission. We assume no obligation to update or revise any forward-looking statements in this annual report on Form 10-K, whether as a result of new information, future events or otherwise, unless we are



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required to do so by law. A copy of this annual report on Form 10-K is available without charge upon written request to: Mr. John Batty, the
Companys Senior Vice President, Chief Financial Officer and Secretary, at the Companys headquarters at 1421 California Circle, Milpitas, California 95035. 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. Credence Systems Corporation, Credence, IMS, Fluence, SC,
ValStar, Quartet, Octet, Sapphire, ITS9000, ASAP, SPP, Electra, Vanguard, Kalos, DUO, TMT,
MVNA, Virtual Test, Optonics, Emiscope and SZ are certain of our trademarks. This Annual Report on Form 10-K also includes trademarks of other companies.



Industry Overview



The design and manufacture of semiconductor devices is a complex and capital-intensive multi-step process, involving many
different types of equipment to manufacture, assemble and test semiconductor devices. The continuing evolution of semiconductor devices to smaller line width geometries, higher in unit production and more complex multi-level circuitry has
significantly increased the cost and performance requirements of the capital equipment used to manufacture these devices. Semiconductor designers and manufacturers are under increasing pressure to bring high quality, smaller and increasingly
complex integrated circuits, or ICs, to market faster and at lower cost. Semiconductor test equipment plays an important role in enabling semiconductor designers and manufacturers to lower their overall costs and get products to market quickly in
addition to improving the quality and reliability of the end product. As a direct result of the increasing pressure placed on semiconductor designers and manufacturers, semiconductor test equipment and services suppliers are facing new challenges in
meeting the demand for equally sophisticated test equipment.



The rapid growth in consumer electronics targeted end-user products requires the development of next generation device technologies. For example, access to information is migrating from the stand-alone desktop computer, which might be
physically linked to a local network, to the seamless, virtual network of the Internet, which is accessible from anywhere by a variety of new portable electronic communication products. To enable the rapid introduction of new system capability,
designers utilize session initiation on protocol, or SIP technologies that support the changing configurations needed at a lower cost, smaller size and higher performance by combining advanced digital, analog and embedded memory
technologies on a single package. These discrete technologies were historically available only on several separate semiconductor devices, each performing a specific function. By integrating these functions in a single package, SIP enables lower
cost, smaller size, higher performance, and lower power consumption while supporting rapid innovation. Credences flexible platform allows high flexibility in device configuration while our high performance IC engineering validation test
systems enable customers to bring next generation device technologies quickly, cost-efficiently and successfully to market.



Semiconductor manufacturers continue to strive for manufacturing and process improvements in order to satisfy the demand for smaller, better performing
and lower cost semiconductors. Semiconductor manufacturers are aggressively pursuing strategies to reduce their overall cost-of-test by increasing the throughput of their test systems. Cost-of-test includes the initial ATE and ancillary equipment
purchase price, as well as set-up and operating costs, and is often the most significant manufacturing cost, particularly for high-volume, low-cost devices. For these types of devices, ATE throughput, or the number of devices that can be tested in a
given unit of time on a single test system, is a key determinant of cost-of-test per device and of a manufacturers ability to compete profitably.



The Credence Solution and Strategy



Our objective is to be a leading supplier of semiconductor test and diagnostics solutions for consumer ICs, providing the highest return on our
customers investment in test equipment. This includes high performance IC engineering validation test systems, compelling silicon debug and diagnostic systems, and high flexibility cost-effective ATE for production testing of ICs used in high
volume applications. Semiconductors tested by our



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systems are incorporated into a wide range of products in high-growth markets, including consumer markets such as digital cameras, MP3 players, cellular
telephones, video/ multimedia products, automotive electronics, computer peripherals, and notebook and desktop computers.



Key aspects of our solution and strategy are:



| |  |  | maintaining the rapid pace of product innovation on flexible scalable platforms;
| | - |  | --------------------------------------------------------------------------------



| |  |  | improving yield and increase throughput;
| | - |  | ----------------------------------------



| |  |  | focusing on the high growth opportunities of the system-on-chip, or SoC, ATE market such as the high volume consumer market and computing, networking and wireless
products;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | continuing to focus on emerging opportunities for profitable growth;
| | - |  | --------------------------------------------------------------------



| |  |  | leveraging relationships with industry leaders to enhance market position;
| | - |  | --------------------------------------------------------------------------



| |  |  | lowering total cost of ownership;
| | - |  | ---------------------------------



| |  |  | continuing to deliver an outstanding total customer experience throughout the product life cycle; and
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | optimizing our operating model to generate sustainable profitability.
| | - |  | ---------------------------------------------------------------------



Products



Credence offers an array of test products including mixed-signal analog to digital applications and wireless and SoC devices. Our production and
diagnostics test portfolio delivers increased reliability and superior functionality. Furthermore, our suite of world-class debug, characterization and production test systems helps ensure quality and cost management through every stage of design,
first-silicon validation and high-volume manufacturing.



Analog Mixed Signal Products



Diamond.    Introduced in fiscal year 2005, the Diamond platform is the industrys most cost effective test solution addressing the more cost driven markets such as personal consumer devices,
micro-controllers, digital-baseband and display driver technologies. Utilizing a cPCI based architecture, the Diamond platform is highly configurable and supports high extendibility and scalability. Its Ethernet ring based communication architecture
supports massive multi-site testing with very low overhead, which results in a superior cost of test model for our customers. The Diamond platform leverages electronics integration and air-cooling to produce a compact form factor and utilizes high
density technology in a variety of instruments for digital, mixed signal and RF tests. It is used for engineering as well as wafer sort and final production testing. The Diamond platform includes the Diamond 10 mixed signal ATE.



ASL 3000.    Introduced in fiscal year 2002, the
ASL 3000 is an extension of the ASL product line featuring an increased number of mixed signal instruments, expansion to 64 pins of digital capability and DSP based mixed signal test. The ASL 3000 is capable of testing more complex devices and more
devices in parallel and targets a wide range of ICs used in personal communications. Our RF wireless test products provide tools to IC manufacturers for use in characterization and production test of high performance, cost sensitive RF devices.
Incorporating our proprietary Modulated Vector Network Analysis, or MVNA, technology to test RF devices, the ASL 3000RF is targeted at cost effective testing of RF front-end devices that are typically manufactured using Gallium Arsenide (GaAs),
Bi-polar (Bi-CMOS) technology. The devices, power amplifiers, or PAs, low noise amplifiers, or LNAs, synthesizers, mixers and switches and integrated combinations of these, or base band chips, are used in both digital and analog cell phones.
Providing capability to test devices compliant with Bluetooth and 802.11 standards, the ASL 3000RF delivers high performance, high throughput and leading cost of test economics.



ASL 1000.    The ASL 1000 product line tests the traditional analog function blocks such as
amplifiers, regulators, switches and converters either as individual ICs or as larger function ICs such as battery power management devices in portable electronics devices. The ASL 1000 was introduced in fiscal year 1996. This



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system is highly configurable and targeted at testing the traditional analog building block ICs. As the traditional analog or linear device producers move to
more efficient manufacturing, the multi-site test capability of the ASL 1000 has proven to be very effective at reducing their cost of test.



Falcon.    The Falcon is a high-performance analog and mixed-signal test system that offers unique analog, Digital Signal
Processing, or DSP, and other digital capabilities for automotive, smart power and consumer devices. Falcon delivers high throughput with a 200 MHz digital sequencer per channel architecture and reduces test costs through its high-speed
computer/tester interface, and parallel, multi-site and concurrent test capabilities. The Falcon offers an innovative tester-per-pin technology for analog and digital applications, as well as special automotive pins offering a voltage swing up to a
30 V. The Falcon also features Gigalink, a new high-speed serial bus system and AWT, a new analog wave tool.



Piranha.    The Piranha is an analog and mixed-signal test system that provides a cost-effective solution for high volume
devices with low and medium pin counts. The Piranha uses the same technology as the Falcon in a smaller housing without a test head. With frequencies up to 50 MHz digital and up to 64 pins, the Piranha also features multi-site and parallel test
capabilities to lower test costs.



System on Chip
Products



Sapphire.    Sapphire is the first scalable platform to be brought to market for testing high performance microprocessors, chipsets and consumer devices. This high performance SoC configurable test platform first
shipped in December 2003. It is designed to be a highly reconfigurable and scalable functional and structural tester for a wide range of high performance ICs. All of Sapphires test electronics are integrated in the test head and interconnected
by a proprietary high bandwidth bus, which results in a lower cost platform and a smaller footprint. Sapphire is used for silicon debug and validation, characterization, wafer sort and final test. The scalable platform allows a variety of digital
and mixed signal instruments to be easily configured to test devices demanding compelling performance (e.g., PCI Express 2 on graphics chips or very high-speed serial front side buses on state of the art microprocessors).



Diagnostics & Characterization Products



EmiScope.    A configurable, expandable platform
for non-invasive, transistor-level internal signal probing of silicon ICs. The EmiScope is the industry-leading solution for debug of flip-chip packaged and multi-metal layer devices. Using innovative time-resolved photon emission detection
technology, the system enables semiconductor manufacturers to perform debug and characterization more quickly and effectively, thus bringing products to market faster, with fewer design re-spins. The systems high-bandwidth electronics,
high-resolution imaging, and data management capabilities enable semiconductor manufacturers to perform timely design debug, failure analysis and characterization. The EmiScope offers multiple user options, including five lens sets for a variety of
package types, high-power cooling, flexible fixture and software data analysis modules.



OptiFIB.    The OptiFIB is a Focused Ion Beam product used for circuit edit and repair. The OptiFIB is unique because it combines ion and photon optics in a single coaxial column with a CAD
navigation interface, which enables the user to align FIB and CAD images simultaneously, increasing the accuracy of circuit modification. In failure analysis, the OptiFIB can identify and repair circuit layout at inner metal layers. The system can
provide the option to edit 300mm wafers.



Meridian.    The Meridian is a next generation electrical failure analysis platform combining an emission microscope and a laser scanning microscope that provide unmatched sensitivity in fault identification and
defect localization for developers of advanced, low-voltage, high-density semiconductor devices.



Ruby.    The Ruby is an integrated back side laser voltage probing tool used for design debug and failure analysis. The system
includes laser scanning microscope, IR laser, PDP optical blocks and imaging optics. It is configured with GaAs SIL which provides a superior optical resolution for advanced process technology.



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Customers, Markets and Applications



We focus on digital logic, analog, mixed-signal, RF and device manufacturers that serve the fast growing consumer
electronics IC market. Our customers design, manufacture and test semiconductors in high volume for use in applications such as automobiles, appliances, personal computers, mobile consumer electronics, digital televisions, wireless Local Area
Network, or LAN, and multimedia hardware.



In addition to
marketing our products to major semiconductor manufacturers, we have developed relationships with numerous assembly and test services companies. Semiconductor manufacturers and fabless semiconductor companies utilize these subcontractors as a means
of lowering their fixed production costs, thus minimizing the effects of cyclicality inherent in the semiconductor industry. As a result, these assembly and test services companies are an increasingly important segment of the ATE market.



Advanced Micro Devices, Inc., headquartered in the United States,
accounted for 23% and 14% of our net sales in fiscal years 2006 and 2005, respectively. Intel Corporation, headquartered in the United States, accounted for 15% and 25% of our net sales in fiscal years 2006 and 2005, respectively. STMicroelectronics
N.V., headquartered in Europe, accounted for 15% of our net sales in fiscal year 2004. In addition, one of our major distributors, Spirox Corporation, accounted for 13% and 14% of our net sales in fiscal years 2006 and 2005, respectively.



We believe that our success depends in large part upon the
success of our major customers. The loss of, or any reduction in, orders by a significant customer (including the potential for reductions in orders by assembly and test services companies which that customer may utilize), including reductions due
to market, economic or competitive conditions in the semiconductor industry or in other industries that manufacture products utilizing semiconductors has materially adversely affected and may continue to materially adversely affect our business,
financial condition and results of operations. Our ability to increase sales in the future will depend in part upon our ability to obtain orders from new customers as well as upon the financial condition and success of our customers and the general
global economy. There can be no assurance that our sales will not decrease in the future or that we will be able to retain existing customers or to attract new ones.



For information on our geographic data and major customers, see Note 12Industry Segments and Concentration of
Risks, of the Notes to the Consolidated Financial Statements included elsewhere herein. Our international sales are primarily denominated in United States dollars. We anticipate that our international business will continue to account for a
significant portion of net sales in the foreseeable future. See Risk FactorsOur international business exposes us to additional risks.



Backlog



We schedule production of our systems based upon order backlog and order forecast. We include in our backlog only those customer orders for systems (including upgrades) for which we have accepted purchase orders and
assigned shipment dates in approximately the following six months. Substantially all of our orders are subject to cancellation or rescheduling by the customer with limited or no penalties. Our backlog at any particular date may not necessarily be
representative of actual sales for any succeeding period due to orders received for systems to be shipped in the same quarter, possible changes in system delivery schedules, cancellation of orders and potential delays in system shipments. As of
October 31, 2006, our order backlog for systems, exclusive of orders for spare parts, service and support, was approximately $117.1 million plus an additional $10.4 million of deferred revenue under Staff Accounting Bulletin 104, Revenue
Recognition, (SAB 104) as compared with $134.9 and $8.8 million, respectively, as of October 31, 2005. We have historically experienced order cancellations and customer-requested shipment delays in connection with cyclical downturns in
the semiconductor industry. We believe it is probable that order cancellations and customer-requested shipment delays will continue to occur in the future.



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Sales, Service and Support



We currently market and sell our products in the United States and Europe principally through our direct sales organization,
with direct sales employees and representatives in over 14 locations. Outside the United States and Europe, we utilize both direct sales employees and a broad network of distributors, with direct sales employees and distributors in over 18
countries. Shipments through distributors represented approximately 19%, 20% and 35%, of net sales during fiscal years 2006, 2005 and 2004, respectively.



We and our distributors have sales and support centers located in the United States, Middle East, Europe and Asia from which both direct Credence
personnel and independent sales and service representatives sell and support our products. We believe that field support is critical to our customers. Support encompasses many of the components of the total cost of ownership for test equipment. We
seek to develop long-term relationships with major customers through extensive support consisting of teams of professional sales, applications, training and service personnel. These personnel are located in close physical proximity to key customer
sites in order to provide the required support in a timely fashion. The sales process includes consultations with customers to help them purchase the most cost-effective equipment for their needs, to help develop custom test programs to optimize
production throughput, to assist in long-term self-sufficiency through training of customer test engineering personnel and to provide the service capacity and preventive maintenance to reduce downtime for customers systems. Customer support
includes field personnel and in-house applications personnel who work closely with design engineering groups to modify existing equipment to meet the latest performance requirements.



Our standard policy is to warrant our new systems against defects in design, materials and workmanship for one year for
parts and labor. We offer customers additional support after the warranty period in the form of maintenance contracts for specified time periods. Such contracts include various options such as board replacement, priority response, planned preventive
maintenance, scheduled one-on-one training, daily on-site support and monthly system and performance analysis.



Research and Development



The engineering validation test, emission-based optical diagnostics, failure analysis and ATE markets are subject to rapid technological change and new product introductions. Our ability to be competitive in this market will depend in
significant part upon our ability to successfully develop and introduce new products, enhancements and related tools on a timely and cost-effective basis. This will enable customers to integrate our products into their operations as they begin
volume manufacturing of the next generation of semiconductors.



Our ongoing research and development efforts include focusing on increased cycle speed, accuracy, jitter and pin counts of our testers, as well as joint use of technology among our products group. We will continue to focus efforts on
providing solutions that allow more rapid, cost-effective development of ATE test programs that reduce time-to-market of customer integrated circuit designs. We will continue to invest significant resources in the development of new products and
enhancements for the foreseeable future.



Research and
development expenses were $91.4 million in fiscal year 2006, $92.5 million in fiscal 2005 and $80.5 million in fiscal year 2004 (excluding acquisition related charges of $7.9 million for in-process research and development, or IPR&D).



Proprietary Rights



We attempt to protect our intellectual property rights through patents,
copyrights, trademarks and maintenance of trade secrets and other measures. Our current patent portfolio includes approximately 302 United States patents plus foreign counterparts. Our patent portfolio reflects a combination of pursuing our ongoing
patent filing and prosecution activities and the acquisition of patents as part of our merger activities. Our patents relate to a range of technologies including features of our products. From time to time we grant licenses under our patents and
technology and receive licenses under patents and technology from others.



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There can be no assurance that others will not independently develop equivalent intellectual property or
that we can meaningfully protect our intellectual property. There can be no assurance that any patent we own will not be invalidated, circumvented or challenged, that the rights granted thereunder will provide competitive advantages to us or that
any of our pending patent applications will be issued. Furthermore, there can be no assurance that others will not develop similar products, duplicate our products or design around the patents owned by us. In addition, litigation has been and may
continue to be necessary to enforce our patents and other intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity.
In addition, from time to time we encounter disputes over rights and obligations concerning intellectual property. We cannot assume that we will prevail in any such intellectual property disputes. For additional information with respect to our
intellectual property, review the information set forth under Risk FactorsIf the protection of proprietary rights is inadequate, our business could be harmed and Our business may be harmed if we are found to infringe
proprietary rights of others.



Manufacturing and Suppliers



Our manufacturing objective is to produce engineering
validation test systems and ATE that conform to our customers requirements at the lowest commercially practical manufacturing cost. We rely on outside vendors to manufacture certain components and subassemblies including several custom ICs. We
seek to manage our inventory levels through agreements with both suppliers and subcontractors that provide just-in-time delivery of these components and subassemblies. We assemble these components and subassemblies to create finished testers in the
configurations specified by our customers. In general, we use standard components and prefabricated parts available from numerous suppliers. However, some components and subassemblies necessary for the manufacture of our testers are obtained from a
sole supplier or a limited group of suppliers. Our reliance on a sole or a limited group of suppliers and on outside subcontractors involves certain risks, including a potential inability to obtain an adequate supply of required components, and
reduced control over pricing and timely delivery of components. See Risk FactorsThere are limitations on our ability to find the supplies and services necessary to run our business.



Competition



The ATE industry is intensely competitive. We face substantial competition throughout the world, primarily from ATE
manufacturers located in the United States and Japan, as well as from some of our customers. These competitors include, among others, Advantest Corporation, Eagle Test Systems, Inc., LTX Corporation, Nextest Systems Corporation, Teradyne Inc. and
Verigy Ltd. and, with respect to certain of our diagnostics and characterization products, FEI Company and Hamamatsu Corporation.



The principal elements of competition in our markets and the basis upon which our customers select engineering validation testers and ATE include
throughput, tools for reducing customer product time-to-market, product performance and total cost of ownership. We believe that we compete favorably with respect to these factors. See Risk FactorsThe ATE industry is intensely
competitive which can adversely affect our ability to maintain our current net sales and our revenue growth.



Employees



As of October 31, 2006, we had a total of 1,438 direct employees and 75 temporary or contract employees. Of the 1,438 direct employees, 532 employees
are in manufacturing and customer service, 536 employees are in research and development and 370 employees are in selling, general and administrative functions. Our employees are highly skilled, and we believe our future results of operations will
depend in large part on our ability to attract and retain such employees. None of our domestic employees are represented by a labor union, and we have not experienced any work stoppages. We consider our employee relations to be good.



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|Item 1A. | Risk Factors
|-------- | ------------



Our operating results have fluctuated significantly which has adversely affected and may continue to adversely affect our stock price.



LOGO



A variety of factors could affect
our results of operations. The above graph illustrates that our quarterly net sales and operating results have fluctuated significantly. We believe they will continue to fluctuate for several reasons, including:



| |  |  | worldwide economic conditions in the semiconductor industry in general and capital equipment industry specifically;
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | loss of certain key customers who account for large portions of our revenue;
| | - |  | ----------------------------------------------------------------------------



| |  |  | patterns of capital spending by our customers, including delays, cancellations or reschedulings of customer orders due to customer financial difficulties or otherwise;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | market acceptance of our new products and enhanced versions of existing products;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | changes in overhead absorption levels due to changes in the number of systems manufactured, the timing and shipment of orders, availability of components including custom integrated
circuits, or ICs, subassemblies and services, customization and reconfiguration of our systems and product reliability;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our manufacturing capacity and ability to volume produce systems, including our newest systems, and to meet customer requirements;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



| |  |  | manufacturing inefficiencies associated with the start-up of our new products, changes in our pricing or payment terms and cycles, and those of our competitors, customers and
suppliers;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to attract and retain qualified employees in a competitive market;
| | - |  | ------------------------------------------------------------------------------



| |  |  | timing of new product announcements and new product releases by us or our competitors;
| | - |  | --------------------------------------------------------------------------------------



| |  |  | write-offs of excess and obsolete inventories and accounts receivable that are not collectible;
| | - |  | -----------------------------------------------------------------------------------------------



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| |  |  | labor and materials supply constraints;
| | - |  | ---------------------------------------



| |  |  | expenses associated with acquisitions and alliances, including expenses charged for any impaired acquired intangible assets;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  |  | operating expense reductions associated with cyclical industry downturns, including costs relating to facilities consolidations and related expenses;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the proportion of our direct sales and sales through third parties, including distributors and OEMs, the mix of products sold, the length of manufacturing and sales cycles, and
product discounts; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | natural disasters, political and economic instability, currency fluctuations, regulatory changes and outbreaks of hostilities, especially in Asia.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------



We intend to introduce new products and product enhancements in the future,
the timing and success of which will affect our business, financial condition and results of operations. Our gross margins on systems sales have varied significantly and will continue to vary significantly based on a variety of factors including:



| |  |  | long-term pricing decreases by us and our competitors and pricing by our suppliers;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | manufacturing volumes;
| | - |  | ----------------------



| |  |  | manufacturing inefficiencies;
| | - |  | -----------------------------



| |  |  | hardware product sales mix;
| | - |  | ---------------------------



| |  |  | absorption levels and the rate of capacity utilization;
| | - |  | -------------------------------------------------------



| |  |  | inventory write-downs;
| | - |  | ----------------------



| |  |  | new product introductions;
| | - |  | --------------------------



| |  |  | product reliability;
| | - |  | --------------------



| |  |  | customization and reconfiguration of systems;
| | - |  | ---------------------------------------------



| |  |  | possible sale of inventory previously written-down;
| | - |  | ---------------------------------------------------



| |  |  | international and domestic sales mix and field service margins; and
| | - |  | -------------------------------------------------------------------



| |  |  | ceasing investment in underperforming or redundant product lines.
| | - |  | -----------------------------------------------------------------



New and enhanced products typically have lower gross margins in their early stages of commercial introduction and production, and we may build substantial
finished goods inventories of such new products. If delays in or cancellations of orders for those products occur, it may require a future inventory write-down, which would negatively affect our future financial performance. Although we have
recorded and continue to record inventory write-downs, product warranty costs, and deferred revenue, we cannot be certain that our estimates will be adequate.



We cannot forecast with any certainty the impact of these and other factors on our sales and operating results in any future period. Results of
operations in any period, therefore, should not be considered indicative of the results to be expected for any future period. Because of this difficulty in predicting future performance, our operating results may fall below the expectations of
securities analysts or investors in some future quarter or quarters. Our failure in the past to meet these expectations has adversely affected the market price of our common stock and may continue to do so. In addition, our need for continued
significant expenditures for research and development, marketing and other expenses for new products, capital equipment purchases and worldwide training and customer service and support will impact our sales and operations results in the future.
Other significant expenditures may make it difficult for us to reduce our significant fixed expenses in a particular period if we do not meet our net sales goals for that period. Many of our expenses are fixed and will be difficult to reduce in a
particular period if our net sales goal for that period is not met. As a result, we cannot be certain that we will be profitable in the future.



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Some of our net sales are generated from a small number of key customers and the loss of a key customer or material
reductions in capital spending by a key customer could substantially reduce our revenues and be perceived as a loss of momentum in our business.



Over time, we have expanded our base of customers; however, a large portion of our net sales are generated from a small number of key customers. In
particular, two customers, Advanced Micro Devices, Inc. and Intel Corporation accounted for 23% and 15% of our net sales for fiscal year 2006, respectively. For fiscal year 2005, Intel Corporation and Advanced Micro Devices, Inc. accounted for 25%
and 14% of our net sales, respectively. For fiscal year 2004, STMicroelectronics N.V. accounted for 15% of our net sales. Our top ten customers accounted for 65%, 66% and 55% of our net sales for fiscal years 2006, 2005 and 2004, respectively. We
expect that our top ten customers in the aggregate will continue to account for a large portion of our net sales for the foreseeable future, and the loss of one or more of these customers or collaborative partners or material reductions in capital
spending by one or more of these customers or collaborative partners would harm our business and operating results. The loss of a significant customer could also be perceived as a loss of momentum in our business and an adverse impact on our
financial results, and this may cause the market price of our common stock to fall.



Increased reliance on outsourced manufacturing and logistics may affect our business.



We are increasingly outsourcing manufacturing and logistics activities to third-party service providers, which decreases our control over the performance
of these functions.



We have already outsourced certain
manufacturing and spare parts logistics functions to third-party service providers, and we may outsource more of those functions in the future. While we expect to achieve operational flexibility and cost savings as a result of this outsourcing,
outsourcing has a number of risks and reduces our control over the performance of the outsourced functions. Significant performance problems by these third-party service providers could result in cost overruns, delayed deliveries, shortages, quality
issues or other problems that could result in significant customer dissatisfaction and could materially and adversely affect our business, financial condition and results of operations.



If for any reason one or more of these third-party service providers becomes unable or unwilling to continue to provide
services of acceptable quality, at acceptable costs and in a timely manner, our ability to deliver our products or spare parts to our customers could be severely impaired. We would quickly need to identify and qualify substitute service providers or
increase our internal capacity, which could be expensive, time-consuming and difficult, and could result in unforeseen operations problems. Substitute service providers might not be available or, if available, might be unwilling or unable to offer
services on acceptable terms.



Compliance with current and future
environmental regulations may be costly which could impact our future earnings.



We may be subject to environmental and other regulations due to our production and marketing of products in certain states and countries. We also face increasing complexity in our product design and procurement
operations as we adjust to new and upcoming requirements relating to the materials composition of our products, including the restrictions on lead and certain other substances in electronics that apply to specified electronics products put on the
market in the European Union as of July 1, 2006 (Restriction of Hazardous Substances in Electrical and Electronic Equipment Directive (EU RoHS)). The European Union has also finalized the Waste Electrical and Electronic Equipment Directive
(WEEE), which makes producers of electrical goods financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. The deadline for enacting and implementing this directive by individual
European Union governments was August 13, 2004 (WEEE Legislation), although extensions were granted in some countries. Producers became financially responsible under the WEEE Legislation beginning in August 2005. Other countries, such as the
United States, China and Japan, have enacted or may enact laws or regulations similar to the EU RoHS or WEEE Legislation. These and other environmental regulations may require us to reengineer certain of our existing



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products and develop new strategies for the design of new products to utilize components which are more environmentally compatible. Such reengineering and
component substitution may result in delays in product design and manufacture and could cause us to incur additional costs. Although we currently do not anticipate any material adverse effects based on the nature of our operations and the effect of
such laws, there is no assurance that such existing laws or future laws will not have a material adverse effect on our business.



The semiconductor industry is cyclical.



The semiconductor equipment industry is highly cyclical. Our business and results of operations depend largely upon the capital expenditures of
manufacturers of semiconductors and companies that specialize in contract packaging and/or testing of semiconductors. This includes manufacturers and contractors that are opening new or expanding existing fabrication facilities or upgrading existing
equipment, which in turn depends upon the current and anticipated market demand for semiconductors and products incorporating semiconductors. The timing, length and severity of the up-and-down cycles in the semiconductor equipment industry are
difficult to predict. This cyclical nature of the industry in which we operate affects our ability to accurately predict future revenue and, thus, future expense levels. When cyclical fluctuations result in lower than expected revenue
levels, operating results may be adversely affected and cost reduction measures may be necessary in order for us to remain competitive and financially sound. During a down cycle, we must be in a position to adjust our cost and expense structure
to prevailing market conditions and to continue to motivate and retain our key employees. In addition, during periods of rapid growth, we must be able to increase manufacturing capacity and personnel to meet customer demand. We can provide no
assurance that these objectives can be met in a timely manner in response to industry cycles. If we fail to respond to industry cycles, our business could be seriously harmed.



As a result of the cyclical nature of the semiconductor industry, we have experienced shipment delays, delays in commitments
and restructured purchase orders by customers and we expect this activity to continue. Accordingly, we cannot be certain that we will be able to achieve or maintain our current or prior level of sales or rate of growth. We anticipate that a
significant portion of new orders may depend upon demand from semiconductor device manufacturers building or expanding fabrication facilities and new device testing requirements that are not addressable by currently installed test equipment, and
there can be no assurance that such demand will develop to a significant degree, or at all. In addition, our business, financial condition or results of operations may continue to be materially adversely affected by any factor materially adversely
affecting the semiconductor industry in general or particular segments within the semiconductor industry.



Implementation or changes to our enterprise resource planning system and other related systems may affect our business.



We may experience difficulties in implementing, making changes or enhancements to our enterprise resource planning or ERP system and other related
systems that could disrupt our ability to timely and accurately process and report key components of the results of our consolidated operations, our financial position and cash flows. Any disruptions or difficulties that may occur in connection with
implementing, making changes or enhancements to our ERP system or any future systems could also adversely affect our ability to complete the evaluation of our internal controls and attestation activities pursuant to Section 404 of the
Sarbanes-Oxley Act of 2002. System failure or malfunctioning may result in disruption of operations and the inability to process transactions and could adversely affect our financial results.



Changes to financial accounting standards may affect our reported results of operations.



A change in accounting standards or practices can have a
significant effect on our reported results and may even affect our reporting of transactions completed before the change is effective. New accounting pronouncements and varying interpretations of accounting pronouncements have occurred and may occur
in the future. Changes to existing standards or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business.



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For example, since our inception, we have used stock options and other long-term equity incentives as a
fundamental component of our employee compensation packages. We believe that stock options and other long-term equity incentives directly motivate our employees to maximize long-term stockholder value and, through the use of vesting, encourage
employees to remain with Credence. The FASB issued changes to U. S. GAAP that requires us to record a charge to earnings for new and unvested employee stock option grants beginning on November 1, 2005. This regulation has made it more expensive
to grant stock options to employees and has negatively impacted our reported earnings by $3.3 million for the fiscal year 2006.



We have a limited backlog and obtain most of our net sales from products that typically range in price from $100,000 to $5.0 million and generally ship products
generating most of our net sales near the end of each quarter, which can result in fluctuations of quarterly results.



We obtain most of our net sales from the sale of a relatively few number of systems that typically range in selling price from $100,000 to $5.0 million.
This has resulted and could continue to result in our net sales and operating results for a particular period being significantly impacted by the timing of recognition of revenue from a single transaction. Our net sales and operating results for a
particular period could also be materially adversely affected if an anticipated order from just one customer is not received in time to permit shipment during that period. Backlog at the beginning of a quarter typically does not include all orders
necessary to achieve our sales objectives for that quarter. Orders in backlog are subject to cancellation, delay, deferral or rescheduling by customers with limited or no penalties. Throughout the recent fiscal years, we have experienced
customer-requested shipment delays and order cancellations, and we believe it is probable that orders will be canceled and delayed in the future. Consequently, our quarterly net sales and operating results have in the past, and will in the future,
depend upon our obtaining orders for systems to be shipped in the same quarter in which the order is received.



In the past, some of our customers have placed orders with us for more systems than they ultimately required. We believe that in the future some of our
customers may, from time to time, place orders with us for more systems than they will ultimately require, or they will order a more rapid delivery than they will ultimately require. For this reason, our backlog may include customer orders in excess
of those that will actually be delivered.



Furthermore, we
generally ship products generating most of our net sales near the end of each quarter. Accordingly, our failure to receive an anticipated order or a delay or rescheduling in a shipment near the end of a particular period or a delay in receiving
customer acceptance from a customer may cause net sales in a particular period to fall significantly below expectations, which could have a material adverse effect on our business, financial condition or results of operations. The relatively long
manufacturing cycle of many of our testers has caused and could continue to cause future shipments of testers to be delayed from one quarter to the next. Furthermore, as our competitors announce new products and technologies, and as we complete
acquisitions of similar technologies, customers may defer or cancel purchases of our existing systems. We cannot forecast the impact of these and other factors on our sales and operating results.



We may continue to experience delays in development, introduction, production in volume,
and recognition of revenue from sales of our products.



We
have in the past experienced significant delays in the development, introduction, volume production and sales of our new systems and related feature enhancements. These delays related to our inability to successfully complete product hardware
engineering within the time frame originally anticipated, including design errors and redesigns of ICs. As a result, some customers have experienced significant delays in receiving and using our testers in production. Delays in introducing a product
or delays in our ability to obtain customer acceptance, if they occur in the future, will delay the recognition of revenue and gross profit by us. We cannot be certain that these or additional difficulties will not continue to arise or that delays
will not continue to materially adversely



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affect customer relationships and future sales. Moreover, we cannot be certain that we will not encounter these or other difficulties that could delay future
introductions or volume production or sales of our systems or enhancements. In the past, we have incurred and we may continue to incur substantial unanticipated costs to increase feature sets in our systems. If our systems experience reliability,
quality or other problems, or the market perceives our products to be feature deficient, we may continue to suffer reduced orders, higher manufacturing costs, delay in collecting accounts receivable and higher service, support and warranty expenses,
and/or inventory write-offs, among other effects. Our failure to have a competitive test system available when required by a customer could make it substantially more difficult for us to sell testers to that customer for a number of years. We
believe that the continued acceptance, volume production, timely delivery and customer satisfaction of our newer digital and mixed signal testers are of critical importance to our future financial results. As a result, our inability to correct any
technical, reliability, parts shortages or other difficulties associated with our systems or to manufacture and ship the systems on a timely basis to meet customer requirements could damage our relationships with current and prospective customers
and would continue to materially adversely affect our business, financial condition and results of operations. In addition, the consolidation of our manufacturing operations in a single site exposes us to the increased risk of manufacturing delays
or disruption in the event of natural disasters or other calamities at the site. Any delays or disruptions could materially adversely affect our business, financial condition and results of operations.



Competition in the ATE market requires rapid technological enhancements and new products
and services.



Our ability to compete in the Automatic
Test Equipment, or ATE, market depends upon our ability to successfully develop and introduce new products and enhancements with enhanced features on a timely and cost-effective basis, including products under development internally as well as
products obtained in acquisitions. Our customers require test systems with additional features, higher performance and other capabilities. Therefore, it is necessary for us to develop new systems and/or enhance the performance and other capabilities
of our existing systems to adequately address these requirements. Any success we may have in developing new and enhanced systems and new features to our existing systems will depend upon a variety of factors, including:



| |  |  | product selection;
| | - |  | ------------------



| |  |  | timely and efficient completion of product design;
| | - |  | --------------------------------------------------



| |  |  | implementation of manufacturing and assembly processes;
| | - |  | -------------------------------------------------------



| |  |  | product performance;
| | - |  | --------------------



| |  |  | reliability in the field;
| | - |  | -------------------------



| |  |  | effective worldwide sales and marketing; and
| | - |  | --------------------------------------------



| |  |  | labor and supply constraints.
| | - |  | -----------------------------



Because we must make new product development commitments well in advance of sales, new product decisions must anticipate both future demand and the
availability of technology to satisfy that demand. We cannot be certain that we will be successful in selecting, developing, manufacturing and marketing new hardware products or enhancements. Our inability to introduce new products that contribute
significantly to net sales, gross margins and net income would have a material adverse effect on our business, financial condition and results of operations. New product or technology introductions by our competitors could cause a decline in sales
or loss of market acceptance of our existing products. If we introduce new products, existing customers may curtail purchases of the older products resulting in inventory write-offs and they may delay new product purchases. In addition, capacity
utilization at outsourced assembly and test houses, while improving, continues at low levels which is likely to depress our non-integrated device manufacturers, or IDM business until such time that demand and supply conditions improve. Any decline
in demand for our hardware products could have a material adverse effect on our business, financial condition or results of operations.



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We are continuing to invest significant resources in the expansion of our product lines and there is no certainty that
our net sales will increase or remain at historical levels or that new products will contribute to revenue growth.



We are currently devoting and intend to continue to devote significant resources to the development, enhancement, production and commercialization of new
products and technologies. During fiscal years 2006 and 2005, we introduced several enhancements as well as new products that are evolutions or derivatives of existing products as well as products that were largely new. Under our revenue recognition
policy adopted in accordance with Staff Accounting Bulletin No. 104, Revenue Recognition, (SAB 104) we defer revenue for transactions that involve newly introduced products or when customers specify acceptance criteria that cannot
be demonstrated prior to the shipment. This results in a delay in the recognition of revenue as compared to the historic norm of recognizing revenue upon shipment. Product introduction delays, if they occur in the future, will delay the recognition
of revenue and gross profit and may result in delayed cash receipts by us that could materially adversely affect our business, financial condition and results of operations. We invested and continue to invest significant resources in property, plant
and equipment, purchased and leased facilities, inventory, personnel and other costs to begin or prepare to increase production of these products. A significant portion of these investments will provide the marketing, administration and after-sales
service and support required for these new products. Accordingly, we cannot be certain that gross profit margin and inventory levels will not continue to be materially adversely affected by delays in new product introductions or start-up costs
associated with the initial production and installation of these new product lines. We also cannot be certain that we can manufacture these systems per the time and quantity required by our customers. The start-up costs include additional
manufacturing overhead, additional inventory and warranty reserve requirements and the enhancement of after-sales service and support organizations. In addition, the increases in inventory on hand for new product development and customer support
requirements have increased and will continue to increase the risk of significant inventory write-offs. We cannot be certain that our net sales will increase or remain at historical levels or that any new products will be successfully commercialized
or contribute to revenue growth or that any of our additional costs will be covered.



The ATE industry is intensely competitive which can adversely affect our ability to maintain or increase our net sales and revenues growth.



With the substantial investment required to develop test application and interfaces, we believe that once a semiconductor manufacturer has selected a
particular ATE vendors tester, the manufacturer is likely to use that tester for a majority of its testing requirements for the market life of that semiconductor and, to the extent possible, subsequent generations of similar products. As a
result, once an ATE customer chooses a system for the testing of a particular device, it is difficult for competing vendors to achieve significant ATE sales to such customer for similar use. Our inability to penetrate any particular large ATE
customer or achieve significant sales to any ATE customer could have a material adverse effect on our business, financial condition or results of operations.



We face substantial competition from ATE manufacturers throughout the world. A substantial portion of our net sales is derived from sales of mixed-signal
testers. We face in some cases seven and in other cases nine competitors in our primary market segments of digital, mixed signal, and RF wireless ATE. We believe that the ATE industry in total has not been profitable for the last three years,
indicating a very competitive and volatile marketplace. Several of these competitors have substantially greater financial and other resources with which to pursue engineering, manufacturing, marketing and distribution of their products. In addition,
three of our competitors recently completed initial public offerings. The success of these companies could make the competitive environment substantially more severe. Certain competitors have introduced or announced new products with certain
performance or price characteristics equal or superior to products we currently offer. These competitors have introduced products that compete directly against our products. We believe that if the ATE industry continues to consolidate through
strategic alliances or acquisitions, we will continue to face significant additional competition from larger competitors that may offer product lines and services more complete than ours. Our competitors are continuing to improve the performance of
their current products and to introduce new



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products, enhancements and new technologies that provide improved cost of ownership and performance characteristics. New product introductions by our
competitors could cause a decline in our sales or loss of market acceptance of our existing products.



Moreover, our business, financial condition or results of operations will continue to be materially adversely affected by continuing competitive pressure
and continued intense price-based competition. We have experienced and continue to experience significant price competition in the sale of our products. In addition, pricing pressures typically have become more intense during cyclical downturns when
competitors seek to maintain or increase market share, at the end of a products life cycle and as competitors introduce more technologically advanced products. We believe that, to be competitive, we must continue to expend significant
financial resources in order to, among other things, invest in new product development and enhancements and to maintain customer service and support centers worldwide. We cannot be certain that we will be able to compete successfully in the future.



We may not be able to deliver custom hardware options to satisfy specific
customer needs in a timely manner.



We must develop and
deliver customized hardware to meet our customers specific test requirements. The market requires us to manufacture these systems on a timely basis. Our test equipment may fail to meet our customers technical or cost requirements and may
be replaced by competitive equipment or an alternative technology solution. Our inability to meet such hardware requirements could impact our ability to recognize revenue on the related equipment. Our inability to provide a test system that meets
requested performance criteria when required by a device manufacturer would severely damage our reputation with that customer. This loss of reputation may make it substantially more difficult for us to sell test systems to that manufacturer for a
number of years, which could have a material adverse effect on our business, financial condition or results of operations.



We rely on Spirox Corporation and customers in Taiwan for a significant portion of our revenues and the termination of this distribution relationship would materially
adversely affect our business.



Spirox Corporation, a
distributor in Taiwan that sells to end-user customers in Taiwan and China, accounted for approximately 13%, 14% and 23% of our net sales in the fiscal years ended October 31, 2006, 2005 and 2004, respectively. Our agreement with Spirox has no
minimum purchase commitment and can be terminated for any reason on 180 days prior written notice. On May 31, 2005, we entered into an agreement with Spirox to combine our Taiwan operation with Spiroxs T1 division into a corporation named
Credence Spirox Integration Corporation, an operation owned 90% by Spirox and 10% by us. This new corporation is dedicated to supporting our products in the Taiwan region. Consequently, our business, financial condition and results of operations
could be materially adversely affected by the loss of or any reduction in orders by Spirox, any termination of the Spirox relationship, or the loss of any significant Spirox customer, including the potential for reductions in orders by assembly and
tester service companies due to technical, manufacturing or reliability problems with our products or continued slow-downs in the semiconductor industry or in other industries that manufacture products utilizing semiconductors. Our ability to
maintain or increase sales levels in Taiwan will depend upon:



| |  |  | our ability with Spirox to obtain orders from existing and new customers;
| | - |  | -------------------------------------------------------------------------



| |  |  | our ability to manufacture systems on a timely and cost-effective basis;
| | - |  | ------------------------------------------------------------------------



| |  |  | our ability to timely complete the development of our new hardware products;
| | - |  | ----------------------------------------------------------------------------



| |  |  | Spirox and its end-user customers financial condition and success;
| | - |  | -------------------------------------------------------------------



| |  |  | general economic conditions; and
| | - |  | --------------------------------



| |  |  | our ability to meet increasingly stringent customer performance and other requirements and shipment delivery dates.
| | - |  | -------------------------------------------------------------------------------------------------------------------



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We have substantial indebtedness and if we need additional financing, it could be difficult to obtain.



As of October 31, 2006, we had $145 million principal amount of 1.5%
Convertible Subordinated Notes, or 1.5% Notes, due in May 2008. We may incur substantial additional indebtedness in the future.



On December 15, 2006, we entered into separate privately negotiated agreements with certain holders of our outstanding 1.50% Notes due 2008 to
exchange $72.5 million aggregate principal amount of 1.5% Notes for an equivalent principal amount of a new series of 3.50% Convertible Senior Subordinated Notes, or 3.5% Notes, due 2010 and to purchase an additional $50 million aggregate principal
amount of the new series of 3.50% Notes due 2010 (together, the New Notes). The New Notes contain provisions known as net share settlement which require that, upon conversion of the New Notes, we will pay holders in cash up to the
principal amount of the converted New Notes. Any amounts in excess of this cash amount will be settled in shares of our common stock. The initial conversion price is $8.25.



The level of indebtedness, among other things, could:



| |  |  | make it difficult for us to make payments on our debt and other obligations, particularly upon maturity of the 1.5% Notes in May 2008 and the maturity or conversion of the New
Notes, due 2010 if we were unable to cause the conversion of this debt into equity;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | make it difficult for us to obtain any necessary future financing for working capital, capital expenditures, debt service requirements or other purposes;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | require the dedication of a substantial portion of any cash flow from operations to service the indebtedness, thereby reducing the amount of cash flow available for other purposes,
including capital expenditures;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | limit our flexibility in planning for, or reacting to changes in our business and the industries in which we compete;
| | - |  | ---------------------------------------------------------------------------------------------------------------------



| |  |  | place us at a possible competitive disadvantage with respect to less leveraged competitors and competitors that have better access to capital resources; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | make us more vulnerable in the event of a further downturn in our business.
| | - |  | ---------------------------------------------------------------------------



There can be no assurance that we will be able to meet our debt service obligations, including our obligations under the 1.5% Notes or the New Notes.



We expect that our existing cash and short-term investments
will be sufficient to meet our cash requirements to fund operations and expected capital expenditures for the next twelve months. In the event we may need to raise additional funds, we cannot be certain that we will be able to obtain such additional
financing on favorable terms if at all. Further, if we issue additional equity securities, stockholders may experience additional dilution or the new equity securities may have rights, preferences or privileges senior to those of existing holders of
common stock. Future financings may place restrictions on how we operate our business. If we cannot raise funds on acceptable terms, if and when needed, we may not be able to develop or enhance our products and services, take advantage of future
business opportunities, grow our business or respond to competitive pressures, which could seriously harm our business.



We require a significant amount of cash, and our ability to generate cash may be affected by factors beyond our control.



Our business may not generate cash flow in an amount sufficient to enable us
to fund our liquidity needs, including payment of the principal of, or interest on, our indebtedness, working capital, capital expenditures, product development efforts, strategic acquisitions, investments and alliances and other general corporate
requirements. Our ability to generate cash is subject to general economic, financial, competitive, legislative,



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regulatory and other factors that are beyond our control. We cannot be assured that our business will generate sufficient cash flow from operations or that
future borrowings or other sources of funding will be available to us, in amounts sufficient to enable us to fund our liquidity needs or with terms that are favorable to us.



We may repatriate cash from our foreign subsidiaries, which could result in additional income taxes that could negatively impact our
results of operations and financial position. In addition, if foreign countries currency policies limit our ability to repatriate the needed funds, our business and results of operations could be adversely impacted.



One or more of our foreign subsidiaries hold a portion of our cash and cash
equivalents. If we need additional cash to acquire assets or technology, or to support our operations in the United States, and if the currency policies of these foreign countries allow us, we may repatriate some of our cash from these foreign
subsidiaries to the United States. For example, during the fourth quarter of fiscal year 2006, we repatriated $23.0 million from our Singapore subsidiary. Depending on our financial results and the financial results of our subsidiaries at the time
that the cash is repatriated, we may incur additional income taxes from the repatriation, which could negatively affect our results of operations and financial position. In addition, if the currency policies of these foreign countries prohibit or
limit our ability to repatriate the needed funds, our business and results of operations could be adversely impacted.



Our long and variable sales cycle depends upon factors outside of our control and could cause us to expend significant time and resources prior to earning associated
revenues.



Sales of our systems depend in part upon the
decision of semiconductor manufacturers to develop and manufacture new semiconductor devices or to increase manufacturing capacity. As a result, sales of our products are subject to a variety of factors we cannot control. The decision to purchase
our products generally involves a significant commitment of capital, with the attendant delays frequently associated with significant capital expenditures. For these and other reasons, our systems have lengthy sales cycles during which we may expend
substantial funds and management effort to secure a sale, subjecting us to a number of significant risks, including a risk that our competitors may compete for the sale, a further downturn in the economy or other economic factors causing our
customers to withdraw or delay their orders or a change in technological requirements of the customer. As a result, our business, financial condition and results of operations would be materially adversely affected by our long and variable sales
cycle and the uncertainty associated with expending substantial funds and effort with no guarantee that a sale will be made.



There are limitations on our ability to find the supplies and services necessary to run our business.



We obtain certain components, subassemblies and services necessary for the
manufacture of our testers from a limited group of suppliers. We do not maintain long-term supply agreements with most of our vendors, and we purchase most of our components and subassemblies through individual purchase orders. The manufacture of
certain of our components and subassemblies is an extremely complex process. We also rely on outside vendors to manufacture certain components and subassemblies and to provide certain services. We have experienced and continue to experience
significant reliability, quality and timeliness problems with several critical components including certain custom ICs. We cannot be certain that these or other problems will not continue to occur in the future with our suppliers or outside
subcontractors. Our reliance on a limited group of suppliers and on outside subcontractors involves several risks, including an inability to obtain an adequate supply of required components, subassemblies and services and reduced control over the
price, timely delivery, reliability and quality of components, subassemblies and services. Shortages, delays, disruptions or terminations of the sources for these components and subassemblies have delayed and in the future may delay shipments of our
systems and new products and could have a material adverse effect on our business. Our continuing inability to obtain adequate yields or timely deliveries or any other circumstance that would require us to seek alternative sources of supply or to
manufacture such components internally could also have a material adverse effect on our business, financial condition or results of operations. Such delays, shortages and disruptions would also damage



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relationships with current and prospective customers and have and could continue to allow competitors to penetrate our customer accounts. We cannot be
certain that our internal manufacturing capacity or that of our suppliers and subcontractors will be sufficient to meet customer requirements.



Our international business exposes us to additional risks.



International sales accounted for approximately 69%, 69% and 72% of our total net sales in the fiscal years ended October 31, 2006, 2005 and 2004,
respectively. We anticipate that international sales will continue to account for a significant portion of our total net sales in the foreseeable future. These international sales will continue to be subject to certain risks, including:



| |  |  | changes in regulatory requirements;
| | - |  | -----------------------------------



| |  |  | tariffs and other barriers;
| | - |  | ---------------------------



| |  |  | political and economic instability;
| | - |  | -----------------------------------



| |  |  | adverse effects of fears surrounding any health risks on our business and sales and that of our customers, especially in Taiwan, Hong Kong and China;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | outbreak of hostilities in markets where we sell our products, including Korea and Israel;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | integration and management of foreign operations of acquired businesses;
| | - |  | ------------------------------------------------------------------------



| |  |  | foreign currency exchange rate fluctuations;
| | - |  | --------------------------------------------



| |  |  | difficulties with distributors, original equipment manufacturers, foreign subsidiaries and branch operations;
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | potentially adverse tax consequences;
| | - |  | -------------------------------------



| |  |  | possibility of difficulty in accounts receivable collection;
| | - |  | ------------------------------------------------------------



| |  |  | greater difficulty in maintaining United States accounting standards; and
| | - |  | -------------------------------------------------------------------------



| |  |  | greater difficulty in protecting intellectual property rights.
| | - |  | --------------------------------------------------------------



We are also subject to the risks associated with the imposition of domestic and foreign legislation and regulations relating to the import or export of
semiconductor equipment products. We cannot predict whether the import and export of our products will be adversely affected by changes in or new quotas, duties, taxes or other charges or restrictions imposed by the United States or any other
country in the future. Any of these factors or the adoption of restrictive policies could have a material adverse effect on our business, financial condition or results of operations. Net sales to the Asia-Pacific region accounted for approximately
51%, 47% and 52% of our total net sales for the fiscal years ended October 31, 2006, 2005 and 2004, respectively, and thus demand for our products is subject to the risk of economic instability in that region and health risks. Countries in the
Asia-Pacific region, including Korea and Japan, have experienced weaknesses in their currency, banking and equity markets in the recent past. These weaknesses could continue to adversely affect demand for our products, the availability and supply of
our product components and our consolidated results of operations.



No single end-user customer headquartered in Asia accounted for more than 10% of our net sales during the fiscal years ended October 31, 2006, 2005 and 2004. No single end-user customer headquartered in Europe accounted for more than
10% of our net sales during the fiscal years ended October 31, 2006 and 2005, except for STMicroelectronics N.V., which accounted for 15% of our net sales in fiscal year 2004. Two customers headquartered in the United States, Advanced Micro
Devices, Inc. and Intel Corporation accounted for 23% and 15% of our net sales fiscal year ended October 31, 2006, respectively. Intel Corporation and Advanced Micro Devices, Inc. accounted for 25% and 14% of our net sales fiscal year ended
October 31, 2005, respectively.



In addition, one of our
major distributors, Spirox Corporation, which accounted for 13%, 14% and 23% of our net sales in the fiscal years ended October 31, 2006, 2005 and 2004, respectively, is a Taiwan-based



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company. This subjects a significant portion of our receivables and future revenues to the risks associated with doing business in a foreign country,
including political and economic instability, currency exchange rate fluctuations, fears related to health risks and regulatory changes. Disruption of business in Asia caused by the previously mentioned factors could continue to have a material
impact on our business, financial condition or results of operations.



We
operate in a volatile industryindicators of goodwill and other long-lived assets impairment under SFAS 142 and SFAS 144 may be present from time-to-time.



Effective November 1, 2002, we adopted Statement of Financial Accounting Standard No. 142, Goodwill and
Other Intangible Assets (SFAS 142), which was issued by the FASB in July 2001. Under this standard, we ceased amortizing goodwill and acquired workforce costs effective November 1, 2002.



As mandated by SFAS 142, we test goodwill for possible impairment on an
annual basis and at any other time if events occur or circumstances indicate that the carrying amount of goodwill may not be recoverable. Circumstances that could trigger an impairment test include but are not limited to: our market value falling
below our net book value for a significant period of time, a significant adverse change in the business climate or legal factors; unanticipated competition; loss of key personnel; a significant change in direction with respect to investment in a
product or market segment; the likelihood that a significant portion of the business will be sold or disposed of; or the results of testing for recoverability of a significant asset group within a reporting unit determined in accordance with SFAS
142.



Based on a combination of factors that came into
existence and were identified during the third quarter of fiscal year 2006, particularly: (1) our changed current and projected operating results reflecting lower demand from major customers; and (2) our current market capitalization which
was significantly less than our book value for the preceding 10 weeks prior to the end of the third quarter, we concluded there were sufficient indicators to require us to assess whether any portion of our recorded goodwill balance was impaired. We
determined, based on our estimates of forecasted discounted cash flows and our market capitalization, that our goodwill was impaired at July 31, 2006. Further analysis indicated that goodwill impaired and charges of $423.9 million were recorded
in the third quarter of fiscal year 2006. Other long-lived assets were assessed for impairment prior to the performance of the SFAS 142 analysis and were determined not to be impaired.



If economic conditions in our industry continue to deteriorate and adversely affect our business, we could be required to
record impairment charges related to our long-lived assets in accordance with SFAS 144, Accounting for Impairment or Disposal for Long-Lived Assets, which could have a material adverse effect on our results of operations and financial
condition.



Future acquisitions may be difficult to integrate, disrupt our
business, dilute stockholder value or divert management attention.



Our growth depends upon market growth, our ability to enhance our existing products, and our ability to introduce new products on a timely basis. We intend to continue to address the need to develop new products and enhance existing
products through acquisitions of other companies, product lines, technologies, and personnel. Acquisitions involve numerous risks, including the following:



| |  |  | Difficulties in integrating the operations, technologies, products, and personnel of the acquired companies;
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | Diversion of managements attention from normal daily operations of the business;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | Potential difficulties in completing projects associated with in-process research and development;
| | - |  | --------------------------------------------------------------------------------------------------



| |  |  | Difficulties in entering markets in which we may have no or limited direct prior experience and where competitors in such markets may have stronger market positions;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Initial dependence on unfamiliar supply chains or relatively small supply partners;
| | - |  | -----------------------------------------------------------------------------------



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| |  |  | Insufficient revenue to offset increased expenses associated with acquisitions; and
| | - |  | -----------------------------------------------------------------------------------



| |  |  | Potential loss of key employees of the acquired companies.
| | - |  | ----------------------------------------------------------



Acquisitions may also cause us to:



| |  |  | Issue common stock that would dilute our current shareholders percentage ownership;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | Assume liabilities;
| | - |  | -------------------



| |  |  | Record goodwill and non-amortizable intangible assets that will be subject to impairment testing on a regular basis and potential periodic impairment charges;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Incur amortization expenses related to certain intangible assets;
| | - |  | -----------------------------------------------------------------



| |  |  | Incur large and immediate write-offs and restructuring and other related expenses; and
| | - |  | --------------------------------------------------------------------------------------



| |  |  | Become subject to intellectual property or other litigation.
| | - |  | ------------------------------------------------------------



Mergers and acquisitions of high-technology companies are inherently risky, and no assurance can be given that our previous or future acquisitions will be
successful and will not materially adversely affect our business, operating results, or financial condition. Failure to manage and successfully integrate acquisitions could materially harm our business and operating results. Prior acquisitions have
resulted in a wide range of outcomes, from successful introduction of new products and technologies to an inability to do so. Even when an acquired company has already developed and marketed products, there can be no assurance that product
enhancements will be made in a timely fashion or that pre-acquisition due diligence will have identified all possible issues that might arise with respect to such products.



From time-to-time, we have made acquisitions that resulted in in-process research and development expenses being charged in
a single quarter. These charges may occur in any quarter, contributing to variability in our quarterly earnings. Risks related to new product development also apply to acquisitions.



Our executive officers and certain key personnel are critical to our business.



Our future operating results depend substantially upon the continued service
of our executive officers and key personnel. Our chief executive officer, Lavi A. Lev, recently joined us and has limited experience in our business. Our future operating results also depend in significant part upon our ability to attract and retain
qualified management, manufacturing, technical, engineering, marketing, sales and support personnel. Competition for qualified personnel is intense, and we cannot ensure success in attracting or retaining qualified personnel. There may be only a
limited number of persons with the requisite skills to serve in these positions and it may be increasingly difficult for us to hire personnel over time. Our business, financial condition and results of operations could be materially adversely
affected by the loss of any of our key employees, by the failure of any key employee to perform in his or her current position, or by our inability to attract and retain skilled employees.



If the protection of our proprietary rights is inadequate, our business could be harmed.



We attempt to protect our intellectual property rights
through patents, copyrights, trademarks, maintenance of trade secrets and other measures, including entering into confidentiality agreements. However, we cannot be certain that others will not independently develop substantially equivalent
intellectual property or that we can meaningfully protect our intellectual property. Nor can we be certain that our patents will not be invalidated, deemed unenforceable, circumvented or challenged, or that the rights granted thereunder will provide
us with competitive advantages, or that any of our pending or future patent applications will be issued with claims of the scope we seek, if at all. Furthermore, we cannot be certain that others will not develop similar products, duplicate our
products or design around our patents, or that foreign intellectual property laws, or agreements into which we have entered will protect our intellectual property rights. Inability or failure to protect our intellectual property rights could have a
material adverse effect upon our business, financial condition and results of operations. In



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addition, from time to time we encounter disputes over rights and obligations concerning intellectual property, including disputes with parties with whom we
have licensed technologies. We cannot assume that we will prevail in any such intellectual property disputes. We have been involved in extensive, expensive and time-consuming reviews of, and litigation concerning, patent infringement claims.



Our business may be harmed if we are found to infringe proprietary rights
of others.



We have at times been notified that we may be
infringing intellectual property rights of third parties and we have litigated patent infringement claims in the past. We expect to continue to receive notice of such claims in the future. We cannot be certain of the success in defending patent
infringement claims or claims for indemnification resulting from infringement claims.



We cannot be certain of success in defending current or future patent or other infringement claims or claims for indemnification resulting from infringement claims. Our business, financial condition and results of
operations could be materially adversely affected if we must pay damages to a third party or suffer an injunction or if we expend significant amounts in defending any such action, regardless of the outcome. With respect to any claims, we may seek to
obtain a license under the third partys intellectual property rights. We cannot be certain, however, that the third party will grant us a license on reasonable terms or at all. We could decide, in the alternative, to continue litigating such
claims. Litigation has been and could continue to be extremely expensive and time consuming, and could materially adversely affect our business, financial condition or results of operations, regardless of the outcome.



We may be materially adversely affected by legal proceedings.



We have been and may in the future be subject to various legal proceedings,
including claims that involve possible infringement of patent or other intellectual property rights of third parties. It is inherently difficult to assess the outcome of litigation matters, and there can be no assurance that we will prevail in any
litigation. Any such litigation could result in substantial cost and diversion of our efforts, which by itself could have a material adverse effect on our financial condition and operating results. Further, adverse determinations in such litigation
could result in loss of our property rights, subject us to significant liabilities to third parties, require us to seek licenses from third parties or prevent us from manufacturing or selling our products, any of which could materially adversely
affect our business, financial condition or results of operations.



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



Recently enacted and proposed changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002,
have increased and will continue to increase our expenses as we evaluate the implications of new rules and devote resources to respond to the new requirements. Sarbanes-Oxley Act mandates, among other things, that companies adopt new corporate
governance measures and imposes comprehensive reporting and disclosure requirements, sets stricter independence and financial expertise standards for audit committee members and imposes increased civil and criminal penalties for companies, their
chief executive officers and chief financial officers and directors for securities law violations. In particular, we incurred and expect to incur additional administrative expense as we implement Section 404 of the Sarbanes-Oxley Act, which
requires management to report on, and our independent registered public accounting firm to attest to, our internal control over financial reporting. In addition, The Nasdaq Global Select Market, on which our common stock is listed, has also adopted
comprehensive rules and regulations relating to corporate governance. These laws, rules and regulations have increased and will continue to increase the scope, complexity and cost of our corporate governance, reporting and disclosure practices,
which could harm our results of operations and divert managements attention from business operations. We also expect these developments continue to make it more difficult and more expensive for us to obtain director and officer liability
insurance in the future, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. Further, our board members, Chief Executive Officer and Chief Financial Officer could face an



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increased risk of personal liability in connection with the performance of their duties. As a result, we may have difficultly attracting and retaining
qualified board members and executive officers, which would adversely affect our business.



We are subject to the internal control evaluation and attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002.



Section 404 of the Sarbanes-Oxley Act of 2002 requires that we include in our annual report our assessment of the
effectiveness of our internal control over financial reporting and our audited financial statements as of the end of each fiscal year. Furthermore, our independent registered public accounting firm, or Firm, is required to attest to whether our
assessment of the effectiveness of our internal control over financial reporting is fairly stated in all material respects and separately report on whether it believes we maintained, in all material respects, effective internal control over
financial reporting as of the end of each fiscal year. We successfully completed our assessment and obtained our Firms attestation as to the effectiveness of our internal control over financial reporting as of October 31, 2006 and 2005.
In future years, if we fail to timely complete this assessment, or if our Firm cannot timely attest to our assessment, we could be subject to regulatory sanctions and a loss of public confidence in our internal control. In addition, any failure to
implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to timely meet our regulatory reporting obligations.



Terrorist attacks, terrorist threats, geopolitical instability and government responses
thereto, may negatively impact all aspects of our operations, revenues, costs and stock price.



The terrorist attacks in September 2001 in the United States and ensuing events and the resulting decline in consumer confidence had a material adverse
effect on the economy.



Any similar future events may disrupt
our operations or those of our customers and suppliers. Our markets currently include Taiwan, Korea and Israel, which are experiencing political instability. In addition, these events have had and may continue to have an adverse impact on the United
States and world economy in general and consumer confidence and spending in particular, which could harm our sales. Any of these events could increase volatility in the United States and world financial markets, which could harm our stock price and
may limit the capital resources available to us and our customers or suppliers. This could have a significant impact on our operating results, revenues and costs and may result in increased volatility in the market price of our common stock.



We are subject to anti-takeover provisions that could delay or prevent an
acquisition of our company.



Provisions of our amended and
restated certificate of incorporation, equity incentive plans, bylaws and Delaware law may discourage transactions involving a change in corporate control. In addition to the foregoing, our classified board of directors and the ability of our board
of directors to issue preferred stock without further stockholder approval could have the effect of delaying, deferring or preventing a third party from acquiring us and may adversely affect the voting and other rights of holders of our common
stock.



|Item 1B. | Unresolved Staff Comments
|-------- | -------------------------



None.



|Item 2. | Properties
|------- | ----------



Our headquarters are located on an owned site in Milpitas, California. This headquarters facility consists of 180,000 square feet on approximately 14
acres of land. We also own our manufacturing facilities, which are primarily test and assembly operations, in Hillsboro, Oregon in the U.S. and in Amerang, Germany. Our



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manufacturing facility in Hillsboro, Oregon is located in an 180,000 square foot facility, comprised of two buildings on approximately twenty-six acres of
land. In addition, we lease offices and facilities in several U.S. and international locations, including the United Kingdom, France, Singapore and Japan.



We believe our existing properties, including both owned and leased sites, are in good condition and are adequate to meet our current and foreseeable
future requirements.



For additional information regarding
obligations under leases, see Note 5Commitments and Contingencies, of the Consolidated Financial Statements.



|Item 3. | Legal Proceedings
|------- | -----------------



The Company also is involved in various claims arising in the ordinary course of business, none of which, in the opinion of management, if determined
adversely against the Company, will have a material adverse effect on the Companys business, financial condition or results of operations.



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



There were no matters submitted to a vote of stockholders during the fourth quarter of fiscal year 2006.



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EXECUTIVE OFFICERS AND KEY EMPLOYEES



Our executive officers and key employees and their ages and positions as of December 31, 2006, are as
follows:



|                   |  |      |  |                                                              |  |  |  |         
|------------------ |  | ---- |  | ------------------------------------------------------------ |  |  |  | --------
|                   |  | Name |  | Age                                                          |  |  |  | Position
|Executive Officers |  |      |  |                                                             
|Dave House         |  | 63   |  | Executive Chairman of the Board and Director                
|Lavi A. Lev        |  | 50   |  | President and Chief Executive Officer                       
|John C. Batty      |  | 51   |  | Senior Vice President, Chief Financial Officer and Secretary
|Byron W. Milstead  |  | 50   |  | Senior Vice President and General Counsel                   
|Ofir Baharav       |  | 38   |  | Senior Vice President, Products                             
|Bryan Hoadley      |  | 41   |  | Senior Vice President, World Wide Field Operations          
|Rance Hale         |  | 46   |  | Senior Vice President, Manufacturing Operations             
|                   |  |     
|Key Employees      |  |      |  |                                                             
|Itzik Goldberger   |  | 54   |  | Vice President, Strategy & Business Development             
|Michael Vedda      |  | 41   |  | Vice President, Chief Information Officer                   
|Laura Buzzell      |  | 46   |  | Vice President, Human Resources                             



Dave House has
served as Executive Chairman of the Board and a Director since December 2005. Mr. House served as executive chairman of Brocade Communications Systems, a position he held from January 2004 until his transition to a non executive chairman role
in December 2005. Mr. House served as Chairman, President, and CEO of Allegro Networks from 2001 to 2003. From 1998 until 1999, he served as President of Nortel Networks. He served as Chairman and Chief Executive Officer of Bay Networks from
1996 until its merger with Nortel Networks in 1998. Prior to 1996, Mr. House served in a number of senior managerial positions with Intel Corporation for 22 years.



Lavi A. Levhas served as President and Chief Executive Officer since December 2006. Prior to joining Credence,
Mr. Lev served as Executive Vice President and General Manager at Cadence Design Systems from January 2000 to December 2004. Prior to that, Mr. Lev served as Senior Vice President, Engineering for MIPS Technologies from 1996 to 2000. Prior
to joining MIPS Technologies, Mr. Lev held various engineering and management roles at Sun Microsystems, Intel and National Semiconductor.



John C. Batty has served as Senior Vice President and Chief Financial Officer since joining the Company in December 2004. Prior to joining
Credence, Mr. Batty served as Chief Financial Officer, Secretary and Chief Operating Officer at Network Equipment Technologies from December 1999. Mr. Batty served as Vice President of Finance and Chief Financial Officer at Verilink
Corporation from 1997 to 1999. Prior to joining Verilink, Mr. Batty spent over 10 years at VLSI as Controller, Director of Corporate Financial Planning and Vice President and Treasurer prior to its acquisition by Phillips Semiconductor. From
1982 to 1986, Mr. Batty held various finance positions with Intel Corporation.



Byron W. Milstead has served as Senior Vice President and General Counsel since December 2005. Prior to that, he was Vice President and General Counsel from November 2000. Before joining Credence,
Mr. Milstead was a partner with the Portland, Oregon law firm of Ater Wynne LLP. Prior to joining Ater Wynne LLP in 1996, Mr. Milstead was an associate and partner in the Portland, Oregon office of Bogle & Gates PLLC.
Mr. Milstead has practiced law since 1982.



Ofir
Baharav has served as Senior Vice President, Products since June 2006. Previously, Mr. Baharav served as Vice President, Memory Product Group, or MPG since March 2006. Prior to that, Mr. Baharav served as Vice President
Diagnostics & Characterization Group since February 2005. From December 2001 through February 2005, Mr. Baharav served in several key engineering and management positions including Senior Director, General Manager EmiScope Products,
and Senior Director Diagnostics & Characterization Group. Mr. Baharav joined Credence in January 2003 through the acquisition of Optonics, Inc., where he acted as



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President. Before joining Optonics, Mr. Baharav led and participated in a variety of early stage technology companies spanning the fields of computer
security systems, healthcare informatics, rapid modeling and digital printing.



Bryan D. Hoadley has served as Vice President, World Wide Field Operations since March 2006. Previously, Mr. Hoadley served as Vice President, European Field Operations since September 2003. From August
1994 through September 2003, Mr. Hoadley served in several key sales and management positions including, Senior Sales Director, European Field Operations, Senior Director, North American Field Operations, Director, Western Region Sales, South
West Regional Sales Manager and Account Manager. Prior to joining Credence, Mr. Hoadley held positions at Micro Component Technology, Inc. and Lockheed Missiles & Space Systems.



Rance Hale has served as Senior Vice President, Manufacturing
Operations since joining the Company in April 2006. Prior to joining Credence, Mr. Hale served in several key management positions at KLA-Tencor, including, Vice President of Operations, Electron Beam Inspection Technology; Vice President of
Operations, Films and Surface Technology; Senior Director of NPI Operations, Wafer Inspection Group; Director of Operations, SEMSpec, Electron Microscope and Senior Manufacturing/Customer Acceptance Manager, Wafer Inspection. Prior to joining
KLA-Tencor, Mr. Hale held various increasing roles in operations at XICOR, Inc.



Itzik Goldberger has served as Vice President, Strategy and Business Development since March 2006. Prior to that, Mr. Goldberger served as Vice President, IREM Group in the Diagnostics &
Characterization Group since August 2005. Mr. Goldberger joined Credence in January 2003 through the acquisition of Optonics, Inc. where he was the Vice President of Marketing. Prior to joining Optonics, Inc., Mr. Goldberger held the
position of Vice President Marketing for @Themoment.com.



Laura A. Buzzell has served as Vice President, Human Resources since joining the Company in August 2006. Prior to joining Credence, Ms. Buzzell served as Human Resources Director at Fortinet from December 2005. From October 1999
through December 2005, Ms. Buzzell served in various human resources positions at Credence. Prior to joining Credence in October 1999, Ms. Buzzell held various human resources and finance positions at KLA-Tencor.



Michael Vedda has served as Vice President, Chief Information Officer
since joining the Company in December 2006. Prior to joining Credence, Mr. Vedda served in various information technology and management roles. Most recently, Mr. Vedda held the position of Vice President of Operations and Chief
Information Officer at S1EDIFY, where he was employed from April 1996 until its merger with Intervoice in December 2005.



Officers serve at the discretion of the Board of Directors, until their successors are appointed. There are no family relationships among our executive
officers or directors.



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PART II



|Item 5. | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
|------- | ------------------------------------------------------------------------------------------------------------



Our common stock is traded on the Nasdaq National Market under the symbol
CMOS. High and low closing stock prices for the last two fiscal years were:



|              |  |      |      |      |   |      |  |     |       |  |   |     
|------------- |  | ---- | ---- | ---- | - | ---- |  | --- | ----- |  | - | ----
|              |  | 2006 |      | 2005
|Quarter Ended |  | High |      | Low  |   | High |  | Low
|January 31    |  | $    | 9.05 |      | $ | 6.72 |  | $   | 9.65  |  | $ | 7.20
|April 30      |  | $    | 8.95 |      | $ | 7.00 |  | $   | 9.35  |  | $ | 6.16
|July 31       |  | $    | 7.24 |      | $ | 2.74 |  | $   | 10.94 |  | $ | 5.83
|October 31    |  | $    | 3.29 |      | $ | 1.83 |  | $   | 10.50 |  | $ | 7.36



There were
approximately 204 stockholders of record at December 31, 2006. To date, we have not declared or paid any cash dividends on our common stock. We do not anticipate paying any dividends on our common stock in the foreseeable future.



The information required by this item regarding equity compensation plans is
incorporated by reference to the information set forth in Item 12 of this Form 10-K.



|Item 6. | Selected Financial Data
|------- | -----------------------



The selected consolidated financial data below should be read in conjunction with Managements Discussion and Analysis of Financial Condition
and Results of Operations and our consolidated financial statements and the related notes. The selected consolidated statements of operations data for the years ended October 31, 2006, 2005 and 2004 and the selected consolidated balance
sheet data as of October 31, 2006 and 2005, are derived from, and are qualified by reference to, the audited consolidated financial statements included elsewhere in this annual report on Form 10-K. The financial information for fiscal year 2004
included results of operations of NPTest beginning on May 29, 2004. The financial information for fiscal year 2003 included results of operations of Optonics beginning on January 23, 2003. The selected consolidated statement of operations
data for the fiscal years ended prior to October 31, 2004, and the selected consolidated balance sheet data prior to October 31, 2005, are derived from our audited consolidated financial statements that are not included in this annual
report on Form 10-K. The historical results presented below are not necessarily indicative of future results.



|                                           |  |                                          |          |   |      |   |           |      |  |   |           |   |  |      |          |   |  |   |          |  
|------------------------------------------ |  | ---------------------------------------- | -------- | - | ---- | - | --------- | ---- |  | - | --------- | - |  | ---- | -------- | - |  | - | -------- | -
|                                           |  | Fiscal Year Ended October 31,            |         
|                                           |  | 2006                                     |          |   | 2005 |   |           | 2004 |  |   | 2003      |   |  | 2002 |         
|                                           |  | (in thousands, except per share amounts) |         
|Consolidated Statement of Operations Data: |  |                                          |          |   |      |   |           |      |  |   |           |   |  |      |          |   |  |   |          |  
|Net sales                                  |  | $                                        | 474,424  |   |      | $ | 429,320   |      |  | $ | 439,803   |   |  | $    | 182,414  |   |  | $ | 164,209  |  
|Operating loss                             |  |                                          | (476,712 | ) |      |   | (110,160  | )    |  |   | (79,788   | ) |  |      | (114,278 | ) |  |   | (173,194 | )
|Loss before income tax provision           |  |                                          | (475,701 | ) |      |   | (108,543  | )    |  |   | (60,415   | ) |  |      | (112,059 | ) |  |   | (163,632 | )
|Net loss                                   |  |                                          | (481,585 | ) |      |   | (119,932  | )    |  |   | (64,478   | ) |  |      | (113,112 | ) |  |   | (170,481 | )
|Net loss per basic share                   |  | $                                        | (4.82    | ) |      | $ | (1.28     | )    |  | $ | (0.88     | ) |  | $    | (1.80    | ) |  | $ | (2.81    | )
|Net loss per diluted share                 |  | $                                        | (4.82    | ) |      | $ | (1.28     | )    |  | $ | (0.88     | ) |  | $    | (1.80    | ) |  | $ | (2.81    | )
|Consolidated Balance Sheet Data:           |  |                                          |          |   |      |   |           |      |  |   |           |   |  |      |          |   |  |   |          |  
|Working capital                            |  | $                                        | 153,760  |   |      | $ | 207,086   |      |  | $ | 277,887   |   |  | $    | 349,260  |   |  | $ | 224,694  |  
|Total assets                               |  |                                          | 517,594  |   |      |   | 1,046,305 |      |  |   | 1,173,106 |   |  |      | 698,493  |   |  |   | 582,249  |  
|Long-term debt                             |  |                                          | 145,000  |   |      |   | 180,000   |      |  |   | 180,000   |   |  |      | 181,058  |   |  |   |         |  
|Accumulated deficits                       |  |                                          | (850,836 | ) |      |   | (369,251  | )    |  |   | (249,319  | ) |  |      | (184,841 | ) |  |   | (71,728  | )
|Stockholders equity                       |  | $                                        | 212,726  |   |      | $ | 682,029   |      |  | $ | 788,288   |   |  | $    | 430,627  |   |  | $ | 519,237  |  



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Supplementary Consolidated Financial Information (Unaudited)



Quarterly 2006



|                                                                      |  |                                          |         |   |           |   |         |          |  |   |             |   |  |   |         |  
|--------------------------------------------------------------------- |  | ---------------------------------------- | ------- | - | --------- | - | ------- | -------- |  | - | ----------- | - |  | - | ------- | -
|                                                                      |  | 2006 Quarter Ended                       |        
|                                                                      |  | January 31,                              |         |   | April 30, |   |         | July 31, |  |   | October 31, |  
|                                                                      |  | (in thousands, except per share amounts) |        
|Net sales                                                             |  | $                                        | 118,168 |   |           | $ | 124,767 |          |  | $ | 109,592     |   |  | $ | 121,897 |  
|Gross margin                                                          |  |                                          | 54,369  |   |           |   | 44,010  |          |  |   | 23,814      |   |  |   | 55,085  |  
|Research and development                                              |  |                                          | 24,148  |   |           |   | 24,123  |          |  |   | 22,576      |   |  |   | 20,525  |  
|Selling, general and administrative                                   |  |                                          | 27,914  |   |           |   | 27,520  |          |  |   | 28,988      |   |  |   | 26,082  |  
|Amortization of purchased intangibles and deferred stock compensation |  |                                          | 4,254   |   |           |   | 4,117   |          |  |   | 4,338       |   |  |   | 4,528   |  
|Reduction of goodwill                                                 |  |                                          |        |   |           |   |        |          |  |   | 423,875     |   |  |   |        |  
|Restructuring charges                                                 |  |                                          | 314     |   |           |   | 1,060   |          |  |   | 1,792       |   |  |   | 7,836   |  
|Operating loss                                                        |  |                                          | (2,261  | ) |           |   | (12,810 | )        |  |   | (457,755    | ) |  |   | (3,886  | )
|Loss before income tax provision                                      |  |                                          | (2,415  | ) |           |   | (13,128 | )        |  |   | (459,256    | ) |  |   | (902    | )
|Net loss                                                              |  |                                          | (4,046  | ) |           |   | (14,231 | )        |  |   | (461,366    | ) |  |   | (1,942  | )
|Net loss per basic share                                              |  | $                                        | (0.04   | ) |           | $ | (0.14   | )        |  | $ | (4.61       | ) |  | $ | (0.02   | )
|Net loss per diluted share                                            |  | $                                        | (0.04   | ) |           | $ | (0.14   | )        |  | $ | (4.61       | ) |  | $ | (0.02   | )



Quarterly 2005



|                                                                      |  |                                          |         |   |           |   |         |          |  |   |             |   |  |   |         |  
|--------------------------------------------------------------------- |  | ---------------------------------------- | ------- | - | --------- | - | ------- | -------- |  | - | ----------- | - |  | - | ------- | -
|                                                                      |  | 2005 Quarter Ended                       |        
|                                                                      |  | January 31,                              |         |   | April 30, |   |         | July 31, |  |   | October 31, |  
|                                                                      |  | (in thousands, except per share amounts) |        
|Net sales                                                             |  | $                                        | 93,883  |   |           | $ | 101,944 |          |  | $ | 111,925     |   |  | $ | 121,568 |  
|Gross margin                                                          |  |                                          | 29,114  |   |           |   | 43,145  |          |  |   | 29,743      |   |  |   | 48,274  |  
|Research and development                                              |  |                                          | 22,328  |   |           |   | 22,728  |          |  |   | 23,849      |   |  |   | 23,633  |  
|Selling, general and administrative                                   |  |                                          | 31,356  |   |           |   | 31,844  |          |  |   | 31,317      |   |  |   | 32,306  |  
|Amortization of purchased intangibles and deferred stock compensation |  |                                          | 6,696   |   |           |   | 6,340   |          |  |   | 5,663       |   |  |   | 4,771   |  
|Restructuring charges                                                 |  |                                          | 1,351   |   |           |   | 440     |          |  |   | 9,654       |   |  |   | 6,160   |  
|Operating loss                                                        |  |                                          | (32,617 | ) |           |   | (18,207 | )        |  |   | (40,740     | ) |  |   | (18,596 | )
|Loss before income tax provision                                      |  |                                          | (32,850 | ) |           |   | (16,298 | )        |  |   | (39,702     | ) |  |   | (19,693 | )
|Net loss                                                              |  |                                          | (36,302 | ) |           |   | (19,473 | )        |  |   | (41,677     | ) |  |   | (22,480 | )
|Net loss per basic share                                              |  | $                                        | (0.41   | ) |           | $ | (0.21   | )        |  | $ | (0.43       | ) |  | $ | (0.23   | )
|Net loss per diluted share                                            |  | $                                        | (0.41   | ) |           | $ | (0.21   | )        |  | $ | (0.43       | ) |  | $ | (0.23   | )



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|Item 7. | Managements Discussion and Analysis of Financial Condition and Results of Operations
|------- | -------------------------------------------------------------------------------------



Overview



We design, manufacture, sell and service engineering validation test equipment, diagnostics and failure analysis products
and automatic test equipment, or ATE, used for testing semiconductor integrated circuits, or ICs. We serve a broad spectrum of the semiconductor industrys testing needs through a wide range of products that test digital logic, mixed-signal,
system-on-a-chip and radio frequency semiconductors. We utilize our proprietary technologies to design products which are intended to provide a lower total cost of ownership than many competing products currently available while meeting the
increasingly demanding performance requirements of todays engineering validation test, diagnostics and failure analysis and ATE markets. Our hardware products are designed to test semiconductors at two stages of their lifecycle; first, at the
prototype stage, and, second, as they are produced in high volume. Collectively, our customers include major semiconductor manufacturers, fabless design houses, foundries and assembly and test services companies.



Major business developments during and subsequent to fiscal year 2006
include:



| |  |  | David House, a forty-year veteran of the computing, communication and semiconductor industries with twenty-two years in management positions at Intel Corporation, was appointed
executive chairman of our board of directors, effective December 9, 2005.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We adopted Statement of Financial Accounting Standard No. 123(R), Share-Based Payment, (SFAS 123(R)).
| | - |  | -------------------------------------------------------------------------------------------------------



| |  |  | We made a decision to discontinue the development of our next generation memory product due to the continued weakening in demand for these products and the decision by one of our
large customers to significantly decrease capital spending. As a result, we wrote down approximately $11.8 million of inventory during the second quarter of fiscal year 2006.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We reviewed and evaluated our inventory against our forecast and determined that some of our legacy products demands had decreased. As a result, we recorded charges of
approximately $24.2 million associated with the write-down of inventory and order cancellation charges during the third quarter of fiscal year 2006.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We performed analyses and determined that goodwill impairment charges of $423.9 million were necessary, which we recorded in the third quarter of fiscal year 2006.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | In July 2006, we introduced the latest addition to our industry-leading Sapphire platform, the Sapphire D-40. The Sapphire D-40 enables the analog and mixed-signal scalability needed to balance device manufacturers
challenges for SiP and MCP device integration and test costs.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Lavi A. Lev, with more than twenty years of experience in the design tool and semiconductor industries at companies including National Semiconductor, Intel, Sun Microsystems,
Silicon Graphics, MIPS Technologies and Cadence, was appointed president and chief executive officer, effective December 7, 2006.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | On December 20, 2006, we completed the exchange in an aggregate principal amount of $72.5 million of our 1.5% Convertible Subordinated Notes due in May 2008 for a new series of
3.5% Convertible Senior Subordinated Notes due in May 2010, as well as the issuance of new 3.5% Convertible Senior Subordinated Notes with an aggregate principal amount of $50.0 million.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Our sales, gross margins and operating results have in the past fluctuated
significantly and will, in the future, fluctuate significantly depending upon a variety of factors. The factors that have caused and will continue to cause our results to fluctuate include cyclicality or downturns in the semiconductor market and the
markets served by our customers, the timing of new product announcements and releases by us or our competitors, market acceptance of new products and enhanced versions of our products, manufacturing inefficiencies associated with the start up of new
products, changes in pricing by us, our competitors, customers or suppliers, the ability to volume produce systems and meet customer requirements, excess and obsolete inventory, patterns of capital spending by customers, delays, cancellations or
rescheduling of orders due to customer financial difficulties or



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otherwise, expenses associated with acquisitions and alliances, our ability to effectively integrate acquisitions, product discounts, product reliability,
the proportion of direct sales and sales through third parties, including distributors and original equipment manufacturers, the mix of products sold, the length of manufacturing and sales cycles, natural disasters, political and economic
instability, new accounting pronouncements (e.g., FAS 123(R)), regulatory changes and outbreaks of hostilities. Due to these and additional factors, historical results and percentage relationships discussed in this Annual Report on Form 10-K will
not necessarily be indicative of the results of operations for any future period. For a further discussion of our business, and risk factors affecting our results of operations, please refer to the section entitled Risk Factors included
elsewhere herein.



Critical Accounting Policies and Estimates



Our discussion and analysis of our financial condition
and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, as well as the disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related
to revenue recognition, allowance for doubtful accounts, inventory valuation and residual values related to leased products, long-lived assets valuation, warranty accrual, deferred taxes, restructuring charges and stock-based compensation. We base
our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We discuss the development and selection of the critical accounting estimates with the audit committee of our board of
directors on a quarterly basis, and the audit committee has reviewed our disclosure relating to them in this annual report on Form 10-K.



We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated
financial statements.



Revenue Recognition:



Under Securities and Exchange Commissions Staff Accounting Bulletin
No. 104, Revenue Recognition, (SAB 104), we recognize revenue on the sale of semiconductor manufacturing equipment when title and risk of loss have passed to the customer, there is persuasive evidence of an arrangement, delivery has
occurred or services have been rendered, the sales price is fixed or determinable, collectibility is reasonably assured and customer acceptance criteria have been successfully demonstrated. Revenue recognition policies are applied consistently among
our semiconductor manufacturing equipment product lines. Product revenue is recognized upon shipment only when achieving the customer acceptance criteria can be demonstrated prior to shipment, which generally occurs with mature products. Revenue
related to the fair value of the installation obligation is recognized upon completion of the installation. Service revenues are generally recognized upon performance of the activities requested by the customers. Products are classified as mature
after several different customers have accepted similar systems. When the customer acceptance criteria cannot be demonstrated prior to shipment, revenue and the related cost of goods sold are deferred until customer acceptance. For some customers in
certain countries where collection may be an issue, we may require a letter of credit to be established or cash receipt in advance before revenue can be recognized. Lease revenue is recorded in accordance with Statement of Financial Accounting
Standard No. 13, Accounting for Leases, (SFAS No. 13), which requires that a lessor account for each lease by either the sales-type or operating method. Revenue from sales-type leases is recognized at the net present value of
future lease payments. Revenue from operating leases is recognized over the lease period.



During fiscal years 2006 and 2005, we introduced several new enhancements, systems and products. Certain revenues from sales of these new enhancements, systems and products during fiscal years 2006 and 2005 were
deferred until the revenue recognition requirements of our revenue recognition policy are satisfied. This practice will continue in the future. In the past, we experienced significant delays in the introduction and acceptance of



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new testers as well as certain enhancements to our existing testers. Delays in introducing a product or delays in our ability to obtain customer acceptance,
if they occur in the future, will delay the recognition of revenue and gross profit by us.



With respect to arrangements with multiple deliverables, we follow the guidance in Emerging Issue Task Force No. 00-21, Revenue Arrangements with Multiple Deliverables (EITF 00-21), to determine whether
there is more than one unit of accounting. To the extent that the deliverables are separable into multiple units of accounting, we then allocate the total fee on such arrangements to the individual units of accounting using the residual method. We
then recognize revenue for each unit of accounting depending on the nature of the deliverable(s) comprising the unit of accounting (principally following SAB 104).



Sales in the United States are principally through our direct sales organization consisting of direct sales employees and
representatives. Sales outside the United States utilize both direct sales employees and distributors. There are no significant differences in revenue recognition policies based on the sales channel, due to the business practices that have been
adopted with our distributor relationships. Because of these business practices, we do not use price protection, stock rotation or similar programs with our distributors. In general, we sell product to the distributor on the
basis of a purchase order received from an end customer. We evaluate any revenue recognition issues, in such cases, based on the characteristics of the end customer.



Our semiconductor manufacturing equipment includes embedded software. We believe this embedded software is incidental to our
products and therefore it is excluded from the scope of Statement of Position 97-2, Software Revenue Recognition, (SOP 97-2). Also, the embedded software in our products is not sold separately, cannot be used on another vendors
products, and we cannot fundamentally enhance or expand the capability of the equipment with new or revised embedded software. In addition, the equipments principal performance characteristics are governed by digital speed and pin count which
are primarily a function of the hardware.



Deferred revenue
includes deferred revenue related to maintenance contracts (and other undelivered services) and to extended warranties where products were sold with more than the standard one-year warranty. Deferred profit is related to equipment that was shipped
to certain customers, but for which the revenue and cost of goods sold are not recognized because the customer-specified acceptance criteria has not been met as of the fiscal period end or because the customer is deemed to be a high credit risk and
payment has not been received as of the fiscal period end.



We
warrant our products to our customers generally for one year from the date of shipment. In addition to the provision of standard warranties, we may offer customer paid extended warranty services with a fixed fee. The fixed fees are recognized as
revenue on a straight-line basis over the applicable term of the contract. Related costs are recorded either as incurred or when related liabilities are determined to be probable and estimable.



For certain customers, typically those with whom we have long-term
relationships, we may grant extended payment terms. Certain of our receivables have due dates in excess of 90 days, and we have a history of successfully collecting these extended payment term accounts receivable.



Allowance for Doubtful Accounts:



We, along with our sales and distribution partners, perform ongoing credit
evaluations of our customers financial condition. We maintain allowances for doubtful accounts for estimated losses resulting from the inability or unwillingness of our customers to make required payments. We record our bad debt expenses as
selling, general and administrative expenses. When we become aware that a specific customer is unable to meet its financial obligations to us, generally because of bankruptcy or deterioration in the customers operating results or financial
position, we record a specific allowance to reflect the level of credit risk in the customers outstanding receivable balance. In addition, we record additional allowances based on certain percentages of our aged receivable balances. These
percentages are determined by a variety of factors including, but not limited to,



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current economic trends, historical payment and bad debt write-off experience. We are not able to predict

changes in the financial condition of our customers or changes in general economic conditions, and if circumstances related to our customers deteriorate, our estimates of
the recoverability of our trade receivables could be materially affected and we may be required to record additional allowances. Alternatively, if we provide more allowances than we need, we may reverse a portion of such provisions in future periods
based on our actual collection experience.



Inventory
Valuation and Residual Values Related to Leased Products:



We evaluate our inventory levels and valuations based on our estimates and forecasts of the next cyclical period in our industry. These forecasts require us to estimate our ability to sell current and future products in the next cyclical
industry period and compare those estimates with our current inventory levels. If these forecasts or estimates change, or our product roadmaps change, then we would need to adjust our assessment of the inventory valuations. Once inventories are
written down, we carry that inventory at its reduced value until it is scrapped or otherwise disposed of.



We monitor our inventory levels in light of product development changes and expectations of the cyclical period ahead. During the four years period ended
October 31, 2006, we have recorded a total of $144.7 million in write down of excess and obsolete inventories. We do not as a matter of course scrap all inventory that is identified as excess or obsolete. Our products are capital goods
with potentially long economic lives and, historically, the opportunity to sell these products has both arisen and fallen unexpectedly. We have occasionally encountered unexpected demand for old products as well as the inability to transition
customers to newer products. We closely monitor the inventories that have been written down but not scrapped, so that if any sales of these items occur and affect our reported gross margins, the effect, if material, is disclosed. We may be required
to take additional charges for excess and obsolete inventory if a downturn causes further reductions to our current inventory valuations or if our current product development plans change.



We consign a portion of our finished goods to both external and internal
customers primarily for the purpose of customer demonstration or applications development. This inventory is categorized as other long-term assets on our condensed consolidated balance sheets. We depreciate all consigned inventories during the
period that they are held on consignment over periods ranging from 18 months to 36 months. The depreciation expense for consigned inventory is charged to selling, general and administrative expense.



Residual values assigned to our products that are leased to customers are
based on their remaining economic life at the end of the lease terms. The amounts assigned to the residual values are evaluated periodically based on technological change and the forecasted business cycle.



Long-Lived Asset Valuation:



Our long-lived assets consist of property and equipment and identified
intangible assets.



As required by Statement of Financial
Accounting Standard No. 142, Goodwill and Other Intangible Assets, (SFAS 142), we test goodwill for possible impairment on an annual basis and at any other time events occur or circumstances indicate that the carrying amount of
goodwill may not be recoverable. Circumstances that could trigger an impairment test include but are not limited to: our market value falling below our net book value for a significant period of time; a significant adverse change in the business
climate or legal factors; unanticipated competition; loss of key personnel; a significant change in direction with respect to investment in a product or market segment; the likelihood that a significant portion of the business will be sold or
disposed of; or the results of testing for recoverability of a significant asset group within a reporting unit determined in accordance with SFAS 142.



The impairment test for goodwill involves a two-step process: step one consists of a comparison of the fair value of a reporting unit with its carrying
amount, including the goodwill allocated to each reporting unit. If the



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carrying amount is in excess of the fair value, step two requires the comparison of the implied fair value of the

reporting unit goodwill with the carrying amount of the reporting unit goodwill. Any excess of the carrying value of the reporting unit goodwill over the implied fair
value of the reporting unit goodwill will be recorded as an impairment loss.



The determination as to whether a write down of goodwill is necessary involves significant judgment based on the short-term and long-term projections of our operations. The assumptions supporting the estimated future
cash flows of the reporting unit, including profit margins, long-term forecasts of the amounts and timing of overall market growth and our percentage of that market, discount rates and terminal growth rates, reflect our best estimates.



As mandated by SFAS 142, we completed our annual goodwill impairment test
as of July 31, 2005 during the fourth quarter of the fiscal year. We determined that, based on market capitalization and on the test which indicated that the sum of the expected future discounted cash flows from the assets exceeded the earning
value of those assets, the goodwill was not impaired.



Based on
a combination of factors that came into existence and were identified during the third quarter of fiscal year 2006, particularly: (1) our changed current and projected operating results reflecting lower demand from major customers; and
(2) our current market capitalization which was significantly less than our book value for the preceding 10 weeks prior to the end of the third quarter, we concluded there were sufficient indicators to require us to assess whether any portion
of our recorded goodwill balance was impaired. We determined, based on our estimates of forecasted discounted cash flows and our market capitalization, that our goodwill was impaired at July 31, 2006. Further analysis indicated that the entire
goodwill balance was impaired and charges of $423.9 million were necessary in the third quarter of fiscal year 2006. Other long-lived assets were assessed for impairment prior to the performance of SFAS 142 analysis and were determined not to be
impaired.



We evaluate the carrying value of our long-lived
assets, consisting primarily of purchased intangible assets, and property and equipment, in accordance with SFAS 144, Accounting for the Impairment or Disposal for Long-Lived Assets, whenever certain events or changes in circumstances
indicate that the carrying amount of these assets may not be recoverable, or at least annually. Such events or circumstances include, but are not limited to, a prolonged industry downturn, a significant decline in our market value, or significant
reductions in projected future cash flows. In assessing the recoverability of our long-lived assets, we compare the carrying value to the undiscounted future cash flows the assets are expected to generate. If the total of the undiscounted future
cash flows is less than the carrying amount of the assets, we write down such assets based on the excess of the carrying amount over the fair value of the assets. Fair value is generally determined by calculating the discounted future cash flows
using a discount rate based upon our weighted average cost of capital. Significant judgments and assumptions are required in the forecast of future operating results used in the preparation of the estimated future cash flows, including profit
margins, long-term forecasts of the amounts and timing of overall market growth and our percentage of that market, groupings of assets, discount rates and terminal growth rates. In addition, significant estimates and assumptions are required in the
determination of the fair value of our tangible long-lived assets, including replacement cost, economic obsolescence, and the value that could be realized in liquidation. Changes in these estimates could have a material adverse effect on the
assessment of our long-lived assets, thereby requiring us to write down the assets. We make certain assessments with respect to the determination of all identifiable assets to be used in the business as well as research and development activities as
of an acquisition date. Each of these activities was evaluated by both interviews and data analysis to determine our state of development and related fair value. The purchased intangibles consist of purchased technology, customer relations,
trademarks, patents and non-compete agreements, and they typically have estimated useful lives of one to ten years.



Warranty Accrual:



We provide reserves for the estimated costs of product warranties at the time revenue is recognized. We estimate the costs of our warranty obligations
based on our historical experience of known product failure rates,



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use of materials to repair or replace defective products and service delivery costs incurred in correcting product failures. In addition, from time to time,
specific warranty accruals may be made if unforeseen technical problems arise. Should our actual experience relative to these factors differ from our estimates, we may be required to record additional warranty reserves. Alternatively, if we provide
more reserves than we need, we may reverse a portion of such provisions in future periods.



Deferred Taxes:



When
we prepare our consolidated financial statements, we calculate our income taxes based on the various jurisdictions where we conduct business. This requires us to calculate our actual current tax exposure and to assess temporary differences that
result from different treatment of certain items for tax and accounting purposes. The temporary differences result in deferred tax assets and liabilities, which we show on our audited consolidated balance sheets. The net deferred tax assets are
reduced by a valuation allowance if, based upon weighted available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.



Our net deferred tax asset balance as of October 31, 2006 was $0.4 million which relates to taxable income generated at
our foreign subsidiaries. Our domestic tax assets reflect a full valuation allowance due to uncertainties surrounding our ability to generate future taxable income and our corresponding ability to utilize our deferred tax assets.



We are a U. S.-based multinational company subject to tax in multiple U. S.
and foreign tax jurisdictions. Our effective tax rate is based on net income, statutory rates and enacted tax rules, including transfer pricing. Significant judgment is required in determining our effective tax rate and in evaluating our tax
positions on a worldwide basis. We believe our tax positions, including intercompany transfer pricing policies, are consistent with the tax laws in the jurisdictions in which we conduct our business. It is possible that these positions may be
challenged which may have an impact on our effective tax rate.



Restructuring Charges:



During previous years,
we have recorded restructuring charges as we rationalized operations in light of customer demand declines and the economic downturn. These measures, which included major changes in senior management, workforce reduction, facilities consolidation and
changes to the strategic focus of a number of sites, were largely intended to align our capacity and infrastructure to anticipate customer demand and to transition our operations to lower cost regions. The restructuring charges include employee
severance and benefit costs, write-offs of property and equipment and costs related to leased facilities vacated and subleased. Severance and benefit costs and other costs associated with restructuring activities were recorded in accordance with
Statement of Financial Accounting Standard No. 146, Accounting for Costs Associated with Exit or Disposal Activities, (SFAS 146). We also record severance and benefit costs in accordance with Statement of Financial Accounting
Standard No. 112, Employers Accounting for Post Employment Benefits, (SFAS 112), as we conclude that (a) we have a substantive post employment benefit obligation that is attributed to prior services rendered,
(b) rights to those benefits have vested, and (c) payment is probable and the amount can be reasonably estimated. The current accounting for restructuring costs requires us to record provisions and charges when we have a formal and
committed restructuring plan.



Given the significance of, and
the timing of the execution of such activities, this process is complex and involves periodic reassessments of original estimates. We continually evaluate the adequacy of the remaining liabilities under our restructuring initiatives. Although we
believe that these estimates accurately reflect the costs of our restructuring and other plans, actual results may differ, thereby requiring us to record additional provisions or reverse a portion of such provisions.



Stock-Based Compensation:



In December 2004, the FASB issued Statement of Financial Accounting
Standard No. 123(R), Share Based Payment, (SFAS 123(R)). This statement requires that the cost resulting from all share-based payment



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transactions be recognized in the consolidated financial statements. In March 2005, the Securities and Exchange Commission (SEC) released SEC Staff
Accounting Bulletin No. 107, Share-Based Payment (SAB No. 107). SAB No. 107 provides the SECs staffs position regarding the application of SFAS No. 123(R) and certain SEC rules and
regulations, and also provides the staffs views regarding the valuation of share-based payment arrangements for public companies. We adopted SFAS 123(R), utilizing the modified prospective method and will continue to evaluate the impact
of SFAS 123(R) on our operating results and financial condition. Our assessment of the estimated compensation charges is affected by our stock price as well as assumptions regarding a number of complex and subjective variables and the related
tax impacts. These variables include, but are not limited to, our stock price volatility and employee stock option exercise behaviors. See Note 7 Stock-Based Compensation of the Notes to the consolidated financial statements for further
discussion.



We estimate the fair value of options granted
using the Black-Scholes-Merton option valuation model and the assumptions discussed in Note 7, Stock-Based Compensation, of the consolidated financial statements. We estimate the expected term of options granted based on historical
experience of similar awards, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior. We estimate the volatility of our common stock at the date of grant based on a
combination of historical and implied volatilities, consistent with SFAS 123(R) and SEC SAB No. 107. Prior to the adoption of SFAS 123(R), we relied exclusively on the historical prices of our common stock in the calculation of expected
volatility. We base the risk-free interest rate that we use in the Black-Scholes-Merton option valuation model on the implied yield in effect at the time of option grant. We have never paid any cash dividends on our common stock and we do not
anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes-Merton option valuation model. We use historical data to estimate pre-vesting option forfeitures and record
stock-based compensation expense only for those awards that are expected to vest. For options granted before November 1, 2005, we estimated the fair value using the multiple option approach and we are amortizing the fair value on a graded
vesting basis. For options granted on or after November 1, 2005, we estimate the fair value using a single option approach and amortize the fair value on a straight-line basis. All options are amortized over the requisite service periods of the
awards, which are generally the vesting periods. We may elect to use different assumptions under the Black-Scholes-Merton option valuation model in the future if our current experience indicates that a different measure is preferable, which could
materially affect our net income or loss and net income or loss per share.



On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3 Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards (FSP 123(R)-3). We adopted the
alternative transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R) in fiscal year 2006. The alternative transition method includes simplified methods to establish the
beginning balance of the additional paid-in capital pool (APIC pool) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax
effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R). The adoption did not have a material impact on our results of operations and financial condition.



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Results of Operations



The following table sets forth certain operating data as a percentage of net sales for the fiscal years indicated:



|                                            |  |                               |    |  |      |    |  |      |   
|------------------------------------------- |  | ----------------------------- | -- |  | ---- | -- |  | ---- | --
|                                            |  | Fiscal Years EndedOctober 31, |   
|                                            |  | 2006                          |    |  | 2005 |    |  | 2004 |   
|Net sales                                   |  | 100                           | %  |  | 100  | %  |  | 100  | % 
|Cost of goods sold                          |  | 63                            |    |  | 65   |    |  | 65   |   
|                                            |  |                               |    |  |      |    |  |      |   
|Gross margin                                |  | 37                            |    |  | 35   |    |  | 35   |   
|                                            |  |                               |    |  |      |    |  |      |   
|Operating expenses:                         |  |                               |    |  |      |    |  |      |   
|Research and development                    |  | 19                            |    |  | 22   |    |  | 18   |   
|Selling, general and administrative         |  | 24                            |    |  | 30   |    |  | 28   |   
|Amortization of purchased intangible assets |  | 4                             |    |  | 5    |    |  | 4    |   
|In-process research and development         |  |                              |    |  |     |    |  | 2    |   
|Reduction of goodwill                       |  | 89                            |    |  |     |    |  |     |   
|Restructuring charges                       |  | 2                             |    |  | 4    |    |  | 1    |   
|                                            |  |                               |    |  |      |    |  |      |   
|Total operating expenses                    |  | 138                           |    |  | 61   |    |  | 53   |   
|                                            |  |                               |    |  |      |    |  |      |   
|Operating loss                              |  | (101                          | )% |  | (26  | )% |  | (18  | )%
|                                            |  |                               |    |  |      |    |  |      |   
|Net loss                                    |  | (102                          | )% |  | (28  | )% |  | (15  | )%
|                                            |  |                               |    |  |      |    |  |      |   



2006 vs. 2005



Net sales.    Net sales
consist of revenues from systems sales, upgrades, spare parts sales, maintenance contracts and lease income. Net sales increased 11% to $474.4 million in fiscal year 2006 from $429.3 million in fiscal year 2005. The increase in net sales was due
primarily to increased demand of our analog mixed signal products. Furthermore, net sales have increased as our products gained market acceptance. The increase in net sales was offset by a decrease of net sales of our memory products as a result of
our decision to shift resources away from the development of our next generation memory product in the third quarter of fiscal year 2006. Sustainability of our revenue levels is dependent upon the economic and geopolitical climate as well as other
risks described under the title Risk Factors herein. We anticipate net sales will be $118.0 million to $122.0 million for the first quarter of fiscal year 2007.



Our net sales by product line in fiscal years 2006 and 2005 consisted of:



|                              |  |      |   |  |      |  
|----------------------------- |  | ---- | - |  | ---- | -
|                              |  | 2006 |   |  | 2005 |  
|SoC                           |  | 35   | % |  | 37   | %
|Analog Mixed Signal           |  | 30   |   |  | 22   |  
|Memory                        |  | 2    |   |  | 3    |  
|Design Characterization Group |  | 9    |   |  | 11   |  
|Service                       |  | 24   |   |  | 27   |  
|                              |  |      |   |  |      |  
|Total                         |  | 100  | % |  | 100  | %
|                              |  |      |   |  |      |  



For the fiscal year
2006, net sales from our SoC and analog mixed signal net sales increased to $308.9 million representing an increase of 22% from $252.3 million from the same period of fiscal 2005. The increase in net sales was offset by a 33% decrease in net sales
of our memory products from $13.1 million in fiscal year 2005 to $8.8 million during fiscal year 2006. Furthermore, our net sales for diagnostics and characterization products for the fiscal year 2006 decreased 14% to $41.1 million from $47.9
million during fiscal year 2005.



International net sales
accounted for approximately 69% of total net sales in both fiscal years 2006 and 2005. Our net sales to the Asia Pacific region accounted for approximately 51% and 47% of total net sales in



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fiscal years 2006 and 2005, respectively. The demand for automated test and engineering capital equipment in Asian markets historically has been highly
volatile, and in some Asian regions there has been geopolitical unrest, both of which have resulted in economic instabilities. These potential economic instabilities could materially adversely affect demand for our products.



Gross Margin.    Our gross margin has been and
will continue to be affected by a variety of factors, including manufacturing efficiencies, excess and obsolete inventory write downs, sell through of previously written down inventory, pricing by competitors or suppliers, new product introductions,
product sales mix, production volume, customization and reconfiguration of systems, international and domestic sales mix and field service margins. Our gross margin as a percentage of net sales increased to 37% in fiscal year 2006 from 35% for
fiscal year 2005. Gross margin for the fiscal year 2006 increased due to improved manufacturing efficiencies resulting from the consolidation of our manufacturing facilities offset by inventory write-downs charges of $36.1 million attributable to
decreased demand for our memory and other legacy products as compared to inventory write-downs charges of $29.1 million in fiscal year 2005. In addition, the stock-based compensation expense of $0.7 million related to employee stock options and
employee stock purchases under SFAS 123(R) was charged to costs of good sold in fiscal year 2006. Our gross margin benefited by approximately $2.2 million or 1% and $6.2 million or 4% from the sale of fully reserved inventory during the fiscal years
ended October 31, 2006 and 2005, respectively. Our gross margin has been and will continue to be affected by a variety of factors, including manufacturing efficiencies, excess and obsolete inventory write downs, sale through of previously
written down inventory, pricing by competitors or suppliers, new product introductions, product sales mix, production volume, customization and reconfiguration of systems, international and domestic sales mix and field service margins. We believe
gross margin percent could be flat to slightly higher in the first quarter of fiscal year 2007 compared to the fourth quarter of fiscal year 2006.



Research and Development.    Research and development, or R&D, expenses were $91.4 million in fiscal year 2006, compared to
$92.5 million in the prior fiscal year, a decrease of 1%. The decrease in R&D expenses in fiscal year 2006 was primarily attributable to a decrease in compensation expense of approximately $3.8 million due to previous headcount reductions and a
decrease in travel expenses of $0.3 million partially offset by accelerated new product development investment costs of approximately $1.4 million. In addition, stock-based compensation expense of $1.9 million related to employee stock options and
employee stock purchases under SFAS 123(R) was charged to R&D in fiscal year 2006. R&D expenses as a percentage of net sales were 19% and 22% in fiscal years 2006 and 2005, respectively. The decrease in R&D expenses as a percentage of
net sales is primarily attributable to lower R&D expenses and higher net sales during fiscal year 2006 as compared to fiscal year 2005. We anticipate that R&D expenses in absolute dollars will be lower in the first quarter of fiscal year
2007 compared to the fourth quarter of fiscal year 2006.



Selling, General and Administrative.    Selling, general and administrative, or SG&A, expenses were $110.5 million in fiscal year 2006, compared to $126.8 million in the prior fiscal year, a decrease of 13%.
The decrease in SG&A expenses for fiscal year 2006 as compared to fiscal year 2005 was primarily due to a decrease in audit and Sarbanes-Oxley compliance related costs of $2.7 million, integration expense in fiscal year 2005 of $10.3 million
with no comparable charges in fiscal year 2006, a decrease in depreciation expenses of $1.6 million, a decrease in rent expense of $2.5 million, a decrease in consigned product amortization expense of $1.7 million, a decrease in bad debt expenses of
$3.1 million, a decrease in consulting and outside services of $0.8 million and a decrease in commission expenses of $0.7 million. The decrease in SG&A expenses was offset by an increase in compensation expense of $0.6 million, an increase in
maintenance contract expenses of $0.6 million, an increase in postage and other general expenses of $1.0 million and an increase in stock-based compensation expense of $3.0 million related to employee stock options and employee stock purchases under
SFAS 123(R) charged to SG&A in fiscal 2006. As a percentage of net sales, SG&A expenses were 23% and 30% in fiscal years 2006 and 2005, respectively. The decrease in SG&A expenses as a percentage of net sales is primarily attributable to
lower SG&A expenses coupled with higher net sales levels during fiscal year 2006 as compared to fiscal year 2005. We expect SG&A expenses in absolute dollars will be lower in the first quarter of fiscal year 2007 compared to the fourth
quarter of fiscal year 2006.



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Amortization of Purchased Intangible Assets and Deferred
Compensation.    Amortization of purchased intangible assets and deferred compensation expenses were $17.2 million in fiscal year 2006, compared to $23.5 million in the prior fiscal year, a decrease of 27%. Upon the adoption
of SFAS 123(R), we discontinued the amortization of our deferred stock compensation, which was approximately $3.0 million in fiscal year 2005. Of the $23.5 million recorded in fiscal year 2005, amortization of purchased intangibles was $20.5
million. The decrease in amortization of purchased intangible assets in fiscal year 2006 from fiscal year 2005 was due primarily to certain purchased intangible assets including trademark, purchase product backlog, patents and non-compete agreements
that became fully amortized during fiscal year 2006. Remaining estimated annual amortization expense for purchased intangible assets is expected to be $17.9 million and $15.9 million in fiscal years 2007 and 2008, respectively.



Reduction of Goodwill.    Effective
November 1, 2002, we adopted SFAS 142, which was issued by the FASB in July 2001. Under this standard, we ceased amortizing goodwill effective November 1, 2002.



It is required that we test goodwill for possible impairment on an annual basis and at any other time if events occur or
circumstances indicate that the carrying amount of goodwill may not be recoverable. Circumstances that could trigger an impairment test include but are not limited to: a significant adverse change in the business climate or legal factors;
unanticipated competition; loss of key personnel; a significant change in direction with respect to investment in a product or market segment; the likelihood that a significant portion of the business will be sold or disposed of; or the results of
testing for recoverability of a significant asset group within a reporting unit determined in accordance with SFAS 142.



The impairment test for goodwill involves a two-step process: step one consists of a comparison of the fair value of a reporting unit with its carrying
amount, including the goodwill allocated to each reporting unit. If the carrying amount is in excess of the fair value, step two requires the comparison of the implied fair value of the reporting unit goodwill with the carrying amount of the
reporting unit goodwill. Any excess of the carrying value of the reporting unit goodwill over the implied fair value of the reporting unit goodwill will be recorded as an impairment loss.



The determination as to whether a write-down of goodwill is necessary involves significant judgment based on short-term and
long-term projections of our operations. The assumptions supporting the estimated future cash flows of the reporting unit, including profit margins, long-term forecasts of the amounts and timing of overall market growth and our percentage of that
market, discount rates and terminal growth rates, reflect our best estimates.



Based on a combination of factors that came into existence and were identified during the third quarter of fiscal year 2006, particularly: (1) our changed current and projected operating results reflecting lower
demand from major customers; and (2) our current market capitalization which was less than our book value for the preceding 10 weeks prior to the end of the third quarter, we concluded there were sufficient indicators to require us to assess
whether any portion of our recorded goodwill balance was impaired. We concluded based on our estimates, forecasted discounted cash flows, as well as our market capitalization, that our goodwill was impaired at July 31, 2006. Further analysis
indicated that goodwill impairment charges of $423.9 million were necessary in the third quarter of fiscal year 2006. Other long-lived assets were assessed for impairment prior to the performance of the SFAS 142 analysis and were determined not to
be impaired.



We performed the first step of the interim SFAS
No. 142 analysis, consisting of a comparison of the fair value of the reporting unit with our carrying amount, including the goodwill. The fair value was determined based on a combination of the Income Approach, which estimates the fair value
based on the future discounted cash flows, and Market Approach, which estimates the fair value based on market prices of comparable companies. Under the Income Approach, we assumed a forecasted cash flow period of 5 years, long-term annual
growth rates of 0% to 12%, a discount rate of 20% and terminal value growth rates of 5%. We also considered our total market capitalization as of July 31, 2006, and our average market capitalization for the quarter in order



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to assess volatility of our market capitalization on that day. Based on the first step of the analysis, we determined that the carrying amount was in excess
of its fair value. As such, we were required to perform the second step analysis to determine the amount of the impairment loss. The second step of the analysis consisted of comparing the implied fair value of the goodwill with the carrying amount
of the goodwill, with an impairment charge resulting from any excess of the carrying value of the goodwill over the implied fair value of the goodwill based on a hypothetical allocation of the estimated fair value of the Company to the
Companys tangible and intangible assets (other than goodwill). Based on the second step of the analysis, we concluded that all of our recorded goodwill ($423.9 million) was impaired and as such recorded a noncash charge to continuing
operations during the third quarter of fiscal year 2006.



Restructuring Charges.    In fiscal year 2006, we recorded total restructuring charges of approximately $11.0 million. The restructuring charges were for severance expenses related to headcount reduction,
facilities, fixed assets write-off and other liabilities related to the discontinuance of our memory product and overall alignment of our corporate strategy. Of the $11.0 million, approximately $9.7 million was for severance and other related
charges which accounted for a headcount reduction of approximately 270 employees. The affected employees were across all business functions throughout the world. The discontinuation of our memory product generated approximately $0.7 million and $0.2
million charges related to contract cancellation and write down of our property and equipment, respectively.



In fiscal year 2005, we recorded total restructuring charges of approximately $17.6 million. Of the $17.6 million, $5.0 million was for severance and
other related charges which accounted for a headcount reduction of 110 employees. Of the $5.0 million, the amount recorded under FAS 112 at October 31, 2005 was $1.5 million. The affected employees were primarily in research and development and
selling general and administrative functions throughout the world. Write-off of property and equipment of $1.1 million resulted from our decision to halt additional research and development investment in one of our products that was rendered
redundant by the acquisition of NPTest. Operating lease and leasehold restoration charges of $11.5 million, which are net of expected sublease rentals, resulted from vacating the former NPTest headquarters facilities in San Jose. Outsource IT
contract cancellation charges amounted to $1.4 million. These charges were offset by deferred rent write-off of $0.7 million and prior accrual adjustment of $0.6 million, primarily related to severance and related charges. See Note
4Restructuring Charges, of the notes to the consolidated financial statements for further discussion.



Interest Income.    We generated interest income of $3.7 million and $2.8 million in fiscal years 2006 and 2005, respectively.
The increase in fiscal year 2006 was primarily due to higher interest rates compared to fiscal year 2005, partially offset by lower cash, cash equivalents and short-term investment balances in fiscal year 2006 as compared to fiscal year 2005.



Interest Expense.    Interest
expense was $2.8 million and $3.2 million in fiscal years 2006 and 2005, respectively. Interest expense in fiscal years 2006 and 2005 primarily represents interest on our convertible debt. The decrease in interest expense was primarily due to the
repayment of our $5.0 million bank loan as well as no trade accounts receivable factored in fiscal year 2006 partially offset by the interest on the note payable resulted from the lease buyout in fiscal year 2006.



Other Income and Expenses, Net.    Other income,
net was $27,000 and $2.1 million in fiscal years 2006 and 2005, respectively, a decline of $2.1 million. The change to other income in fiscal year 2006 from other net income in fiscal year 2005 was primarily due to the mark up to fair value of an
acquired liability in fiscal year 2005 of $1.2 million owed to the former parent of NPTest, an unfavorable change in foreign currency valuation from fiscal year 2005 to fiscal year 2006 of approximately $1.5 million and the write off of impaired
equity investment of $0.9 million and higher loss on disposal of fixed assets of approximately $0.9 million during fiscal year 2006 as compared to fiscal year 2005. These were offset by a gain of $2.8 million in the convertible bonds buy-back and a
gain on the sale of an equity investment of $0.3 million in fiscal year 2006. The acquired liability was settled during the third quarter of fiscal year 2005 for a total settlement value of $9.0 million. See Note 2Acquisitions, of
the notes to the consolidated financial statements for further discussion.



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Income Taxes.    We recorded an income tax provision of $5.9 million and $11.4
million in fiscal years 2006 and 2005, respectively. The income tax expense for the periods consists primarily of foreign tax expense on earnings generated from our foreign operations.



At October 31, 2006, we had unused net operating loss and research tax credit carryforwards for federal income tax
purposes of approximately $432.1 million and $9.2 million, respectively, which expire in 2012 through 2026. At October 31, 2006, we also had unused foreign tax credits of $6.0 million related to the Singapore repatriation, which expires in
2016. Utilization of the net operating loss and tax credit carryforwards will be subject to annual limitations due to the ownership change limitations provided by the Internal Revenue Code of 1986, as amended, and similar state provisions. The
annual limitations may result in expiration of net operating loss and tax credit carryforwards before full utilization.



Realization of the net deferred tax assets is dependent on our generating sufficient taxable income in future years in appropriate tax jurisdictions to
obtain reversals of temporary differences, net operating loss and tax credit carryforwards. Our net deferred tax asset balance as of October 31, 2006 was $0.4 million which relates to taxable income generated at our foreign subsidiaries. Our
domestic tax assets reflect a full valuation allowance due to uncertainties surrounding our ability to generate future taxable income and our corresponding ability to utilize our deferred tax assets. Until such time, we do not expect to recognize
any significant tax benefits in our results of operations.



Stock Options
and Incentive Plan



We have a stock-based compensation
program that provides our board of directors broad discretion in creating employee equity incentives. This program includes incentive and non-statutory stock options granted under various plans, the majority of which are stockholder approved. Stock
options are generally time-based, vesting 25% on each annual anniversary of the hire date over four years and expire seven years from the grant date. Additionally, we have an Employee Stock Purchase Plan (ESPP) that allows employees to purchase
shares of common stock at 85% of the fair market value at the lower of either the date of enrollment or the date of purchase. Shares issued as a result of stock option exercises and our ESPP are generally from our new or treasury shares. As of
October 31, 2006, we had approximately 4.7 million shares of common stock reserved for future issuance under the stock option plans and ESPP.



On November 1, 2005, we adopted the provision of Statement of Financial Accounting Standard No. 123(R) (SFAS 123(R)), Share-Based
Payment, for our share-based compensation plans. Under SFAS 123(R), we are required to recognize stock-based compensation costs based on the estimated fair value at the grant date for our share-based awards. We previously accounted for our
employee stock option and employee ESPP under the intrinsic value recognition and measurement principles of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related Interpretations, and
adopted the disclosure-only provisions of Statement of Financial Accounting Standard No. 123, Accounting for Stock-Based Compensation, (SFAS 123), as amended by Statement of Financial Accounting Standard No. 148,
Accounting for Stock-Based CompensationTransition and Disclosures, (SFAS 148).



We elected to use the modified prospective transition method as permitted by SFAS 123(R), and therefore, have not restated our financial results for prior
periods. In conjunction with the adoption of SFAS 123(R), we changed our method of attributing the value of stock-based compensation to expense from the accelerated multiple-option approach to the straight-line single option method. Compensation
expense for all share-based payment awards granted prior to November 1, 2005 will continue to be recognized using the accelerated multiple-option approach while compensation expense for all share-based payment awards granted on or subsequent to
November 1, 2005 is recognized using the straight-line single-option approach.



As a result of adopting SFAS 123(R), our losses before income taxes and net loss for the fiscal year 2006 was $3.3 million higher than if we had continued to account for share-based compensation under APB 25. Basic



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and diluted net loss per share for the fiscal year, 2006 would have been $0.03 lower if we were able to continue to follow APB 25 accounting. There was no
effect on the consolidated statements of cash flows from adopting SFAS 123(R).



In August 2005, our board of directors approved the accelerated vesting of certain unvested and out-of-the-money non-qualified stock options previously awarded to employees and officers with option
exercise prices equal to or greater than $9.15. Options held by non-employee directors were excluded from the vesting acceleration. In addition, in order to prevent executive officers from unintended personal benefits, our executive officers agreed
to the imposition of restrictions on any shares received through the exercise of accelerated options. Those restrictions prevent the sale of any shares received from the exercise of an accelerated option until the earlier of the original vesting
date of the option or the executive officers termination of employment. The $9.15 price was selected because it was higher than the closing price of our common stock of $8.84 on August 29, 2005, the date of this acceleration. The
accelerated options represented approximately 15% or approximately 2.8 million shares of the total of all outstanding options on August 29, 2005. The acceleration was intended to reduce the stock option expense we would be required to
record after the adoption of SFAS 123(R). This acceleration reduced approximately $10.0 million of stock option expenses under SFAS 123(R) which would have been recognized as an expense through December 2008.



At October 31, 2006, there was $9.0 million of unrecognized stock-based
compensation expense related to non-vested options that is expected to be recognized over a weighted-average period of 2.8 years. At October 31, 2006, there was $0.5 million of unrecognized stock-based compensation expense related to
outstanding ESPP shares that is expected to be recognized over a four-month period.



See Note 7 Stock-Based Compensation of the notes to the consolidated financial statements for further discussion.



2005 vs. 2004



Net sales.    Net sales decreased 2% to $429.3 million in fiscal year 2005 from $439.8 million in fiscal year 2004. For the
fiscal year ended October 31, 2005, net sales from our SoC and DCG product lines and Service increased 62% to $323.5 million from $199.3 million in fiscal year 2004. This increase resulted primarily from the May 2004 acquisition of NPTest, but
also represented the increasing acceptance of the Sapphire and DCG tools as well as an increase in our installed base of systems. Net sales from our analog mixed signal and memory products declined 56% to $105.8 million during the fiscal year ended
October 31, 2005 from $240.5 million during the same period of fiscal year 2004. The decline results from the cyclically low demand in these markets, particularly for the memory products which are directed at the NOR memory group. The decline
was softened somewhat by improved volumes for the analog mixed signal products in the second half of fiscal year 2005.



International net sales accounted for approximately 69% and 72% of total net sales in fiscal year 2005 and 2004, respectively. Our net sales to the Asia
Pacific region accounted for approximately 47% and 52% of total net sales in fiscal year 2005 and 2004, respectively.



Our net sales by product line in fiscal year 2005 and 2004 consisted of:



|                                       |  |      |   |  |      |  
|-------------------------------------- |  | ---- | - |  | ---- | -
|                                       |  | 2005 |   |  | 2004 |  
|SoC                                    |  | 37   | % |  | 22   | %
|Analog Mixed Signal                    |  | 22   |   |  | 32   |  
|Memory                                 |  | 3    |   |  | 23   |  
|Diagnostics and Characterization Group |  | 11   |   |  | 4    |  
|Service and Other                      |  | 27   |   |  | 19   |  
|                                       |  |      |   |  |      |  
|Total                                  |  | 100  | % |  | 100  | %
|                                       |  |      |   |  |      |  



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Gross Margin.    Our gross margin as a percentage of net sales remained at 35%
for fiscal year 2004 and 2005. Gross margin in fiscal year 2005 was affected by $29.1 million related to the write down of Kalos II inventory due to our decision to invest in the next generation memory product as well as to lack of demand, obsolete
revisions of Sapphire inventory resulting from our decision to market Sapphire as our sole solution for the high end SoC market and excess and obsolete Octet and Vanguard II inventory and assets due to our decision to discontinue significant future
investment in these redundant product lines stemming from the acquisition of NPTest. Gross margin in fiscal year 2004 was affected by $49.6 million related to the write down of obsolete Octet and Quartet inventory and assets, again due to our
decision to discontinue significant future investment in these redundant product lines stemming from the acquisition of NPTest. Gross margin declined from fiscal year 2004 to fiscal year 2005 principally because we replaced higher margin analog
mixed signal and memory revenues with somewhat lower margin Sapphire revenues. The decline was less than it otherwise might have been because of the efficiencies gained when we consolidated our three principal manufacturing facilities into one in
the second and third fiscal quarter of 2005. In addition, during the fiscal year ended October 31, 2005 and 2004, our gross margin benefited by approximately 4.3% and 1.1%, respectively, from the sale of fully reserved inventory.



Research and Development.    Research and
development, or R&D, expenses were $92.5 million in fiscal year 2005, compared to $80.5 million in the prior fiscal year, an increase of 15%. The increase in spending in fiscal year 2005 resulted primarily from the significant resources invested
in the development of new products and product enhancements of approximately $14.7 million offset by a $2.2 million decrease in bonuses earned and a $0.5 million decline in licenses fees. R&D expenses as a percentage of net sales were 21.6% and
18.3% in fiscal year 2005 and fiscal year 2004, respectively. The increase in R&D expenses as a percentage of net sales is primarily attributable to higher R&D expenses as well as lower net sales during fiscal year 2005 as compared to fiscal
year 2004.



Selling, General and
Administrative.    Selling, general and administrative, or SG&A, expenses were $126.8 million in fiscal year 2005, compared to $121.2 million in the prior fiscal year, an increase of 5%. The increase was primarily due to
activities resulting from the acquisition of NPTest in May 2004, including an increase in integration expense of $5.1 million, an increase in product consignment expense of $4.9 million due to the number of Sapphire systems consigned and an increase
in compensation costs of $2.8 million. In addition, we incurred approximately $6.4 million of costs associated with our Sarbanes-Oxley compliance program, expenses related to salaries, consulting and audit fees. These increases were offset by a
decrease in marketing spending of $1.2 million, a decrease in distributors and sales person commissions of $8.2 million, a decrease in other variable compensation of $2.4 million and decrease in fringe benefits costs of $2.1 million. These decreases
were caused by the decrease in net sales as well as a focused effort to decrease spending. As a percentage of net sales, SG&A expenses were 29.5% and 27.6% in fiscal year 2005 and fiscal year 2004, respectively. The increase in SG&A expenses
as a percentage of net sales is primarily attributable to a full year of NPTest and associated integration spending in fiscal year 2005 versus five months in fiscal year 2004 as well as lower sales levels during fiscal year 2005 as compared to
fiscal year 2004.



Amortization of Purchased Intangible
Assets and Deferred Compensation.    Amortization of purchased intangible assets and deferred compensation expenses were $23.5 million in fiscal year 2005, compared to $17.4 million in the prior fiscal year, an increase of
35%. Amortization of purchased intangible assets was higher in fiscal year 2005 due primarily to the acquisition of NPTest in May 2004.



Restructuring Charges.    In fiscal year 2005, we recorded total restructuring charges of approximately $17.6 million. Of the
$17.6 million, $5.0 million was for severance and other related charges which accounted for a headcount reduction of 110 employees. Of the $5.0 million, the amount recorded under SFAS 112 at October 31, 2005 was $1.5 million. The affected
employees were primarily in research and development and selling, general and administrative functions throughout the world. Write-off of property and equipment of $1.1 million resulted from our decision to halt additional research and development
investment in one of our products that was rendered redundant by the acquisition of NPTest. Operating lease and leasehold restoration charges of



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$11.5 million, which are net of expected sublease rentals, resulted from vacating the former NPTest headquarters facilities in San Jose. Outsource IT
contract cancellation charges amounted to $1.4 million. These charges were offset by a deferred rent write-off of $0.7 million and a prior accrual adjustment of $0.6 million, primarily related to severance and related charges. See Note
4Restructuring Charges, of the notes to the consolidated financial statements for further discussion.



Interest Income.    We generated interest income of $2.8 million and $3.3 million in fiscal year 2005 and 2004, respectively.
The decline from fiscal year 2004 was primarily due to lower average investment balances in fiscal year 2005 as compared to fiscal year 2004 offset by a higher average interest rate.



Interest Expense.    Interest expenses were $3.2 million and $3.2 million in fiscal year 2005 and
2004, respectively. The interest expense in fiscal years 2005 and 2004 was primarily attributable to interest expense related to the convertible subordinated notes that we issued in June 2003.



Other Income and Expenses, Net.    Other income,
net was $2.1 million and $19.3 million in fiscal year 2005 and 2004, respectively, a decline of $17.2 million. The decrease in other income, net, from fiscal year 2004 to 2005 was primarily due to the fair value adjustment of an acquired liability
owed to the former parent of NPTest, Schlumberger Limited (Schlumberger). This liability was settled during the third quarter of fiscal year 2005 for a total settlement value of $9.0 million. As of October 31, 2004, this liability was $10.3
million. See Note 2Acquisitions, of the notes to the consolidated financial statements for further discussion.



Income Taxes.    We recorded an income tax provision of $11.4 million and $4.0 million in fiscal years 2005 and 2004,
respectively. The income tax expense for the period consisted of net U.S. current income tax expense of $0.1 million and foreign tax expense on earnings and foreign withholding taxes of $11.3 million generated from our foreign operations.



Liquidity and Capital Resources



Net cash used for operating activities during fiscal year 2006 was $8.0
million. The primary use of this cash resulted from a net loss of $481.6 million. The use of cash was offset by reduction of goodwill of $423.9 million, depreciation and amortization of $52.5 million, non-cash charges related to inventory
write-downs and restructuring charges of $37.9 million, stock-based compensation expense related to employee stock options and employee stock purchases under SFAS 123(R) of $5.8 million, and impairment of an equity investment of $0.9 million. The
net cash used in operating activities was offset in part by the increases in net changes in operating assets and liabilities of $44.3 million.



Investing activities used net cash of approximately $7.2 million in fiscal year 2006, primarily attributable to cash used of $31.6 million to purchase
available-for-sale securities, $4.6 million used to acquire Hypervision and $5.8 million to purchase property and equipment to support our business. Net cash used in investing activities was partially offset by sales and maturities of
available-for-sale securities of $32.3 million, proceeds from the sale of property and equipment of $2.5 million which mainly reflected the sale of surplus land located in Oregon and proceeds from the sales of our equity investment of $0.5 million.



Financing activities used net cash of $32.0 million in fiscal
year 2006, primarily attributed to the repurchase of our 1.5% convertible subordinated notes with a maturity date of May 2008 of $31.9 million, payment of bank loan of $5.0 million, partially offset by cash provided from the issuance of common stock
related to our employee equity plans of $4.9 million.



In
August 2006, we implemented a plan to repatriate cash. In October 2006, we repatriated approximately $23.0 million in unremitted foreign earnings.



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In August 2006, our Board of Directors authorized our management to repurchase debt not to exceed $35.0
million in principal amount in partial or full tranches based on available cash and market conditions during the fourth quarter of fiscal year 2006. As of October 31, 2006, we had repurchased $35.0 million of the outstanding 1.5% convertible
subordinated notes with a maturity date of May 2008 for $32.0 million in cash.



On December 20, 2006, we completed the exchange in an aggregate principal amount of $72.5 million of our 1.5% Convertible Subordinated Notes due in May 2008 for a new series of 3.5% Convertible Senior
Subordinated Notes due in May 2010, as well as the issuance of new 3.5% Convertible Senior Subordinated Notes (the New Notes) with an aggregate principal amount of $50.0 million. The New Notes contain provisions known as net share
settlement which required that, upon conversion of the New Notes, we will pay holders in cash for up to the principal amount of the converted New Notes. Any amount in excess of this cash will be settled in shares of our common stock, or at our
option, cash.



As of October 31, 2006, we had working
capital of approximately $153.8 million, including cash, cash equivalents and short-term investments of $102.8 million, and accounts receivable and inventories totaling $170.0 million. We believe that because of the relatively long manufacturing
cycles of many of our testers and the new products we presently offer and plan to introduce, investments in inventories will also continue to represent a significant portion of our working capital. The semiconductor industry has historically been
highly cyclical and has experienced downturns, which have had a material adverse effect on the semiconductor industrys demand for automatic test equipment, including equipment manufactured and marketed by us. In addition, the automatic test
equipment industry is highly competitive and subject to rapid technological change. Events related to these factors may occur in the near term, which would cause a change to our estimate of the net realizable value of receivables, inventories or
other assets, and the adequacy of accrued liabilities.



We
believe our current cash and investment positions will be sufficient to meet our anticipated business requirements for the next 12 months.



We lease some of our facilities and equipment under operating leases that expire through 2010. The approximate future minimum lease payments at
October 31, 2006 are as follows (in thousands):



|           |  |                                |       |                                             |   |                                   |  |   |      
|---------- |  | ------------------------------ | ----- | ------------------------------------------- | - | --------------------------------- |  | - | -----
|           |  | Committed Gross Lease Payments |       | Leases Written Off in Restructuring Charges |   | Net EstimatedFuture Lease Expense
|2007       |  | $                              | 3,160 |                                             | $ | 277                               |  | $ | 2,883
|2008       |  |                                | 1,805 |                                             |   | 50                                |  |   | 1,755
|2009       |  |                                | 1,274 |                                             |   |                                  |  |   | 1,274
|2010       |  |                                | 487   |                                             |   |                                  |  |   | 487  
|2011       |  |                                | 264   |                                             |   |                                  |  |   | 264  
|Thereafter |  |                                | 440   |                                             |   |                                  |  |   | 440  
|           |  |                                |       |                                             |   |                                   |  |   |      
|           |  | $                              | 7,430 |                                             | $ | 327                               |  | $ | 7,103
|           |  |                                |       |                                             |   |                                   |  |   |      



The leases written off
in special charges of $0.3 million are accounted for in our accrued expenses and other liabilities balance on the consolidated balance sheets at October 31, 2006.



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The following summarizes our minimum contractual cash obligations and other commitments at
October 31, 2006, and the effect of such obligations in future periods (in thousands):



|                                                          |  |       |         |      |   |        |  |      |         |      |   |       |  |            |     |  |   |     |  |   |    
|--------------------------------------------------------- |  | ----- | ------- | ---- | - | ------ |  | ---- | ------- | ---- | - | ----- |  | ---------- | --- |  | - | --- |  | - | ---
|                                                          |  | Total |         | 2007 |   | 2008   |  | 2009 |         | 2010 |   | 2011  |  | Thereafter
|Contractual Obligations:                                  |  |       |         |      |   |        |  |      |         |      |   |       |  |            |     |  |   |     |  |   |    
|Facilities and equipment operating leases (1)             |  | $     | 7,430   |      | $ | 3,160  |  | $    | 1,805   |      | $ | 1,274 |  | $          | 487 |  | $ | 264 |  | $ | 440
|Convertible subordinated notes (2)                        |  |       | 145,000 |      |   |       |  |      | 145,000 |      |   |      |  |            |    |  |   |    |  |   |   
|Interest on convertible subordinated notes                |  |       | 3,353   |      |   | 2,175  |  |      | 1,178   |      |   |      |  |            |    |  |   |    |  |   |   
|Minimum commitment under Technology Development Agreement |  |       | 940     |      |   | 940    |  |      |        |      |   |      |  |            |    |  |   |    |  |   |   
|Open non-cancelable purchase order commitments            |  |       | 71,352  |      |   | 68,405 |  |      | 2,854   |      |   | 93    |  |            |    |  |   |    |  |   |   
|                                                          |  |       |         |      |   |        |  |      |         |      |   |       |  |            |     |  |   |     |  |   |    
|Total contractual cash and other obligations              |  | $     | 228,075 |      | $ | 74,680 |  | $    | 150,837 |      | $ | 1,367 |  | $          | 487 |  | $ | 264 |  | $ | 440
|                                                          |  |       |         |      |   |        |  |      |         |      |   |       |  |            |     |  |   |     |  |   |    



---

|(1) | Approximately $0.3 million of this total has been accrued for as restructuring charge in the consolidated balance sheets as accrued expenses and other liabilities.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | This amount is recorded on the consolidated balance sheets as convertible subordinated notes.
|--- | ---------------------------------------------------------------------------------------------



Some of the components that we purchase are unique to us and must be purchased in relatively high minimum quantities with
long (four and five month) lead times. These purchases can lead us to holding relatively high inventory levels and associated risks. In addition, purchase commitments for unique components are relatively inflexible in terms of deferral or
cancellation. At October 31, 2006, we had open and committed non-cancelable purchase orders totaling approximately $71.4 million. The contractual cash obligations and commitments table presented above contains our minimum obligations at
October 31, 2006 under these arrangements and others. Actual expenditures will vary based on the volume of transactions and length of contractual service provided. In addition to minimum spending commitments, certain of these arrangements
provide for potential cancellation charges.



As of
October 31, 2006, our principal sources of liquidity consisted of approximately $95.6 million of cash and cash equivalents and short-term investments of $7.2 million.



Off-Balance Sheet Arrangements.    As of October 31, 2006, we did not have any; (i) material
off-balance-sheet arrangements; (ii) material commitments for capital expenditures; and (iii) special purpose entities.



Recent Accounting Pronouncements



In December 2004, the FASB issued Statement of Financial Accounting Standard No. 153, Exchanges of Non-monetary Assets, (SFAS 153), an
amendment of APB Opinion No. 29. SFAS 153 addresses the measurement of exchanges of non-monetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS 153 was effective for
non-monetary asset exchanges beginning in the first quarter of fiscal year 2006. The adoption of SFAS 153 did not have a material effect on our consolidated financial position or results of operations.



In March 2005, the FASB issued Interpretation No. 47, Accounting
for Conditional Asset Retirement Obligations, (FIN 47) which clarifies that the term conditional asset retirement obligation as used in Statement of Financial Accounting Standard No. 143, Accounting for Asset Retirement
Obligations



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(SFAS 143), refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a
future event that may or may not be within the control of the entity. However, the obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or method of settlement. FIN 47 requires that
the uncertainty about the timing and/or method of settlement of a conditional asset retirement obligation be factored into the measurement of the liability when sufficient information exists. FIN 47 also clarifies when an entity would have
sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. The adoption of FIN 47 in fiscal year 2006 did not have a
material effect on our consolidated financial position or results of operations.



In May 2005, the FASB issued Statement of Financial Accounting Standard No. 154, Accounting Changes and Error Corrections, (SFAS 154) effective with fiscal years beginning after December 15, 2005
and will only impact the consolidated financial statements in periods in which a change in accounting principle is made. This statement replaces APB Opinion No. 20, Accounting Changes, and Statement of Financial Accounting Standard
No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. Under this pronouncement changes are required to be
retrospectively applied to prior financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. Retrospective application means the application of a different accounting
principle to prior accounting periods as if that principle had always been used or as the adjustment of previously issued financial statements to reflect a change in the reporting entity. This statement addresses restatement of previously issued
financial statements to reflect the correction of an error. This statement requires that the retrospective application of a change in accounting principle be limited to the direct effects of the change. This statement also requires that a change in
depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate affected by a change in accounting principle. We do not believe the adoption of SFAS 154 will have a material
effect on our consolidated financial position or results of operations.



On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3 Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards (FSP 123(R)-3). We adopted the alternative transition method
provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R) in fiscal year 2006. The alternative transition method includes simplified methods to establish the beginning balance of the
additional paid-in capital pool (APIC pool) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax effects of employee stock-based
compensation awards that are outstanding upon adoption of SFAS 123(R). The adoption did not have a material impact on our results of operations and financial condition.



In November 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position FAS 115-1 and 124-1,
The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (FSP 115-1 and 124-1), which provides guidance on determining when investments in certain debt and equity securities are considered impaired,
whether that impairment is other-than-temporary, and on measuring such impairment loss. FSP 115-1 and 124-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures
about unrealized losses that have not been recognized as other-than-temporary impairments. FSP115-1 is effective for reporting periods beginning after December 15, 2005. The adoption of FSP 115-1 and 124-1 did not have a material effect on our
consolidated financial position or results of operations.



In
April 2006, the FASB issued FASB Staff Position No. FIN 46(R)-6 (FSP FIN 46(R)-6), which addresses how a reporting enterprise should determine the variability to be considered in applying FASB Interpretation No. 46, Consolidation of
Variable Interest Entities, as amended (FIN 46(R)). The variability that is considered in applying FIN 46(R) affects the determination of (a) whether the entity is a variable interest entity, (b) which interests are variable
interests in the entity and (c) which party, if any, is the primary beneficiary of the variable



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interest entity. That variability will affect any calculation of expected losses and expected residual returns, if such a calculation is necessary. FSP FIN
46(R)-6 provides additional guidance to consider for determining variability. FSP FIN 46(R)-6 was effective beginning the fourth quarter of fiscal year 2006. The adoption of FSP FIN 46(R)-6 did not have a material effect on our financial
position, results of operations and cash flows.



In June 2006,
the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes, which clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with SFAS No. 109,
Accounting for Income Taxes. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This
interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. We are
currently evaluating the impact of adopting this interpretation.



In September 2006, FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting
principles, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective for the fiscal year beginning November 1, 2008. We are currently evaluating the impact of the provisions of SFAS 157 on our financial
position, results of operations and cash flows and do not believe the impact of the adoption will be material.



In September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plansan
amendment of FASB Statements No. 87, 88, 106 and 132(R), (SFAS 158). SFAS 158 requires an employer to recognize the over-funded or under-funded status of a defined benefit pension and other postretirement plan (other than a multiemployer
plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income of a business entity. SFAS 158 is effective for fiscal years
ending after December 15, 2006. We are currently evaluating the impact of the provisions of SFAS 158 on our financial position, results of operations and cash flows and do not believe the impact of the adoption will be material.



|Item 7A. | Quantitative and Qualitative Disclosures About Market Risk
|-------- | ----------------------------------------------------------



Our exposure to market risk from changes in interest rates relates primarily to our cash equivalents and investment
portfolio. We maintain a strict investment policy, which ensures the safety and preservation of our invested funds by limiting default risk, market risk, and reinvestment risk. Our investments consist primarily of commercial paper, medium term
notes, asset backed securities, United States Treasury notes and obligations of United States Government agencies, bank certificates of deposit, auction rate preferred securities, corporate bonds and municipal bonds. The table below presents
notional amounts and related weightedaverage interest rates by year of maturity for our investment portfolio (in thousands, except percent amounts).



|                   |  |                        |         |   |                        |   |         |                                                           |  |   |         |   |  |      |       |      |  |            |  |   |  |  
|------------------ |  | ---------------------- | ------- | - | ---------------------- | - | ------- | --------------------------------------------------------- |  | - | ------- | - |  | ---- | ----- | ---- |  | ---------- |  | - |  | -
|                   |  |                        |         |   |                        |   |         | Future maturities of investments held at October 31, 2006
|                   |  | BalanceOctober 31,2005 |         |   | BalanceOctober 31,2006 |   |         | 2007                                                      |  |   | 2008    |   |  | 2009 |       | 2010 |  | Thereafter
|Cash equivalents   |  |                        |         |   |                        |   |         |                                                           |  |   |         |   |  |      |       |      |  |            |  |   |  |  
|Amounts            |  | $                      | 142,180 |   |                        | $ | 95,635  |                                                           |  | $ | 95,635  |   |  | $    |      |      |  |           |  |  |  | 
|Average rate       |  |                        | 2.29    | % |                        |   | 3.62    | %                                                         |  |   | 3.62    | % |  |      |      |      |  |           |  |  |  | 
|Investments        |  |                        |         |   |                        |   |         |                                                           |  |   |         |   |  |      |       |      |  |            |  |   |  |  
|Amounts            |  | $                      | 7,425   |   |                        | $ | 7,177   |                                                           |  | $ | 5,181   |   |  |      | 1,996 |      |  |           |  |  |  | 
|Average rate       |  |                        | 3.84    | % |                        |   | 5.04    | %                                                         |  |   | 4.90    | % |  |      | 5.38  | %    |  |           |  |  |  | 
|                   |  |                        |         |   |                        |   |         |                                                           |  |   |         |   |  |      |       |      |  |            |  |   |  |  
|Total investment   |  | $                      | 149,605 |   |                        | $ | 102,812 |                                                           |  | $ | 100,816 |   |  | $    | 1,996 |      |  |           |  |  |  | 
|Average rate       |  |                        | 2.37    | % |                        |   | 3.72    | %                                                         |  |   | 3.69    | % |  |      | 5.38  | %    |  |           |  |  |  | 
|Equity instruments |  | $                      | 391     |   |                        | $ |        |                                                           |  | $ |        |   |  |      |      |      |  |           |  |  |  | 



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We mitigate default risk by attempting to invest in high credit quality securities and by constantly
positioning our portfolio to respond appropriately to a significant reduction in a credit rating of any investment issuer or guarantor. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio
liquidity and maintains a prudent amount of diversification.



The sensitivity analysis model used by us for interest rate exposure compares interest income on current investment interest rates versus current investment levels at current interest rates with a 10% increase. Based on this model, a 10%
increase or decrease would result in an increase or a decrease in interest income of approximately $10,000. There can be no assurances that the above projected interest rate increase will materialize. Fluctuations of interest rates are beyond our
control.



Foreign Exchange



We generate a significant portion of our sales from customers located
outside the United States, principally in Asia and to a lesser extent Europe. International sales are made mostly to foreign distributors and some foreign subsidiaries and are typically denominated in U.S. dollars, but occasionally are denominated
in the local currency for European and Japanese customers. The subsidiaries also incur most of their expenses in the local currency. Our SZ product line is developed and manufactured in Germany and, thus, those expenses are Euro based. Accordingly,
some of our foreign subsidiaries use the local currency as their functional currency. For the fiscal years ended October 31, 2006 and 2005, we recorded foreign currency losses of $0.6 million and foreign currency gains of $1.6 million,
respectively.



Our international business is subject to risks
typical of an international business including, but not limited to: differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and foreign exchange rate volatility. Accordingly, our
future results could be materially adversely impacted by changes in these or other factors. We do not currently use derivatives, but will continue to assess the need for these instruments in the future.



Interest Rate Risk



Our 1.5% Convertible Subordinated Notes with a maturity date of May 2008
bear interest at a fixed rate of 1.5%, and therefore changes in interest rates do not impact our interest expense on this debt, likewise, the financing that took place in December 2006. We, from time to time, have outstanding short-term borrowings
with variable interest rates. The total average amount of these borrowings outstanding annually has been insignificant. Therefore, we expect that a 10% change in interest rate will not have any material effect on our interest expense.



51



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|Item 8. | Financial Statements and Supplementary Data
|------- | -------------------------------------------



For the years ended October 31, 2006, 2005 and 2004.



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                                                                     |  |     
|---------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                     |  | Page
|Report of Independent Registered Public Accounting Firm                                              |  | 53  
|Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting |  | 54  
|                                                                                                     | 
|Consolidated Balance SheetsOctober 31, 2006 and 2005                                                |  | 55  
|Consolidated Statements of OperationsYears Ended October 31, 2006, 2005 and 2004                    |  | 56  
|Consolidated Statements of Stockholders EquityYears Ended October 31, 2006, 2005 and 2004          |  | 57  
|Consolidated Statements of Cash FlowsYears Ended October 31, 2006, 2005 and 2004                    |  | 58  
|Notes to Consolidated Financial Statements                                                           |  | 59  



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors and Stockholders of

Credence Systems Corporation



We have audited the accompanying consolidated balance sheets of Credence Systems Corporation as of October 31, 2006 and 2005, and the related consolidated statements of operations, stockholders equity, and cash flows for each of
the three years in the period ended October 31, 2006. Our reports also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and schedule are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.



We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for
our opinion.



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



We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Credence Systems Corporations internal control over financial
reporting as of October 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated January 8, 2007 expressed an
unqualified opinion thereon.



As discussed in Note 7 to the
Notes to Consolidated Financial Statements, under the heading Stock-Based Compensation, in fiscal 2006 Credence Systems Corporation changed its method of accounting for stock-based compensation.



/s/    ERNST &
YOUNG LLP



San Jose, California

January 8, 2007



53



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING



The Board of Directors and Stockholders of

Credence Systems Corporation



We have audited managements assessment, included in the accompanying Managements Report on Internal Control Over Financial Reporting, that Credence Systems Corporation maintained effective internal control over financial
reporting as of October 31, 2006, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Credence Systems
Corporations management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on
managements assessment and an opinion on the effectiveness of the companys internal control over financial reporting based on our audit.



We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial
reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit
provides a reasonable basis for our opinion.



A companys
internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted
accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions
and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that
receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.



Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.



In our opinion, managements assessment that Credence Systems
Corporation maintained effective internal control over financial reporting as of October 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Credence Systems Corporation maintained, in all
material respects, effective internal control over financial reporting as of October 31, 2006, based on COSO criteria.



We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets
of Credence Systems Corporation as of October 31, 2006 and 2005, and the related consolidated statements of operations, stockholders equity and cash flows for each of the three years in the period ended October 31, 2006 of Credence
Systems Corporation, and our report dated January 8, 2007 expressed an unqualified opinion thereon.



/s/    ERNST & YOUNG LLP



San Jose, California

January 8, 2007



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CREDENCE SYSTEMS CORPORATION



CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)



|                                                                                                                                                      |  |             |           |   |      |   |           |  
|----------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------- | --------- | - | ---- | - | --------- | -
|                                                                                                                                                      |  | October 31, |          
|                                                                                                                                                      |  | 2006        |           |   | 2005 |  
|ASSETS                                                                                                                                                |  |             |           |   |      |   |           |  
|Current assets:                                                                                                                                       |  |             |           |   |      |   |           |  
|Cash and cash equivalents                                                                                                                             |  | $           | 95,635    |   |      | $ | 142,180   |  
|Short-term investments                                                                                                                                |  |             | 7,177     |   |      |   | 7,816     |  
|Accounts receivable, net of allowances of $1,591 and $4,325, respectively                                                                             |  |             | 114,796   |   |      |   | 114,042   |  
|Inventories                                                                                                                                           |  |             | 55,200    |   |      |   | 79,054    |  
|Income tax receivable                                                                                                                                 |  |             | 275       |   |      |   |          |  
|Deferred income taxes                                                                                                                                 |  |             | 9,875     |   |      |   | 9,473     |  
|Prepaid expenses and other current assets                                                                                                             |  |             | 14,511    |   |      |   | 18,506    |  
|                                                                                                                                                      |  |             |           |   |      |   |           |  
|Total current assets                                                                                                                                  |  |             | 297,469   |   |      |   | 371,071   |  
|Property and equipment, net                                                                                                                           |  |             | 87,175    |   |      |   | 96,691    |  
|Goodwill                                                                                                                                              |  |             |          |   |      |   | 424,080   |  
|Other intangible assets, net of accumulated amortization of $88,170 and $70,934, respectively                                                         |  |             | 83,878    |   |      |   | 96,439    |  
|Other assets                                                                                                                                          |  |             | 49,072    |   |      |   | 58,024    |  
|                                                                                                                                                      |  |             |           |   |      |   |           |  
|Total assets                                                                                                                                          |  | $           | 517,594   |   |      | $ | 1,046,305 |  
|                                                                                                                                                      |  |             |           |   |      |   |           |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                  |  |             |           |   |      |   |           |  
|Current liabilities:                                                                                                                                  |  |             |           |   |      |   |           |  
|Bank loans                                                                                                                                            |  | $           |          |   |      | $ | 5,000     |  
|Accounts payable                                                                                                                                      |  |             | 32,477    |   |      |   | 45,846    |  
|Accrued expenses and other liabilities                                                                                                                |  |             | 37,251    |   |      |   | 39,756    |  
|Accrued payroll and related liabilities                                                                                                               |  |             | 17,496    |   |      |   | 18,336    |  
|Deferred revenue                                                                                                                                      |  |             | 21,935    |   |      |   | 17,716    |  
|Income tax payable                                                                                                                                    |  |             | 14,893    |   |      |   | 18,800    |  
|Accrued warranty                                                                                                                                      |  |             | 13,514    |   |      |   | 13,419    |  
|Deferred profit                                                                                                                                       |  |             | 6,143     |   |      |   | 5,112     |  
|                                                                                                                                                      |  |             |           |   |      |   |           |  
|Total current liabilities                                                                                                                             |  |             | 143,709   |   |      |   | 163,985   |  
|Convertible subordinated notes (1.50%, due 2008, convertible into common stock at conversion price of $11.31 per share)                               |  |             | 145,000   |   |      |   | 180,000   |  
|Long-term deferred income taxes                                                                                                                       |  |             | 9,473     |   |      |   | 9,473     |  
|Long-term restructuring liabilities                                                                                                                   |  |             | 2,545     |   |      |   | 7,261     |  
|Other liabilities                                                                                                                                     |  |             | 4,141     |   |      |   | 3,557     |  
|Commitments and contingencies (Note 5)                                                                                                                |  |             |           |   |      |   |           |  
|                                                                                                                                                      |  |            
|Stockholders equity:                                                                                                                                 |  |             |           |   |      |   |           |  
|Preferred stock:                                                                                                                                      |  |             |           |   |      |   |           |  
|Authorized shares41,304 ($0.001 par value); Issued shareszero shares issued and outstanding in 2006 and 2005                                        |  |             |          |   |      |   |          |  
|Common stock:                                                                                                                                         |  |             |           |   |      |   |           |  
|Authorized shares150,000 ($0.001 par value); Issued shares100,610 in 2006 and 99,448 in 2005; Outstanding shares100,610 in
2006 and 99,448 in 2005 |  |             | 101       |   |      |   | 100       |  
|Additional paid-in capital                                                                                                                            |  |             | 1,061,342 |   |      |   | 1,054,854 |  
|Deferred compensation                                                                                                                                 |  |             |          |   |      |   | (4,183    | )
|Accumulated other comprehensive income                                                                                                                |  |             | 2,119     |   |      |   | 509       |  
|Accumulated deficit                                                                                                                                   |  |             | (850,836  | ) |      |   | (369,251  | )
|                                                                                                                                                      |  |             |           |   |      |   |           |  
|Total stockholders equity                                                                                                                            |  |             | 212,726   |   |      |   | 682,029   |  
|                                                                                                                                                      |  |             |           |   |      |   |           |  
|Total liabilities and stockholders equity                                                                                                            |  | $           | 517,594   |   |      | $ | 1,046,305 |  
|                                                                                                                                                      |  |             |           |   |      |   |           |  



See accompanying notes.



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CREDENCE SYSTEMS CORPORATION



CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)



|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|--------------------------------------------------------------------------------------------------- |  | ---------------------- | -------- | - | ---- | - | -------- | ---- |  | - | ------- | -
|                                                                                                    |  | Year Ended October 31, |         
|                                                                                                    |  | 2006                   |          |   | 2005 |   |          | 2004 | 
|Net sales:                                                                                          |  |                        |          |   |      |   |          |      |  |   |         |  
|Systems and upgrades                                                                                |  | $                      | 358,769  |   |      | $ | 313,362  |      |  | $ | 358,157 |  
|Service and spare parts                                                                             |  |                        | 115,655  |   |      |   | 115,958  |      |  |   | 81,646  |  
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|Total net sales                                                                                     |  |                        | 474,424  |   |      |   | 429,320  |      |  |   | 439,803 |  
|Cost of goods sold:                                                                                 |  |                        |          |   |      |   |          |      |  |   |         |  
|Systems and upgrades (including stock-based compensation expense of $703 (1))                       |  |                        | 226,990  |   |      |   | 208,463  |      |  |   | 233,333 |  
|Service and spare parts                                                                             |  |                        | 70,156   |   |      |   | 70,581   |      |  |   | 52,935  |  
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|Gross margin                                                                                        |  |                        | 177,278  |   |      |   | 150,276  |      |  |   | 153,535 |  
|Operating expenses:                                                                                 |  |                        |          |   |      |   |          |      |  |   |         |  
|Research and development (including stock-based compensation expense of $1,932 (1))                 |  |                        | 91,372   |   |      |   | 92,538   |      |  |   | 80,535  |  
|Selling, general and administrative (including stock-based compensation expense of $3,036 (1))      |  |                        | 110,504  |   |      |   | 126,823  |      |  |   | 121,226 |  
|Amortization of purchased intangible assets & deferredcompensation (2)                              |  |                        | 17,237   |   |      |   | 23,470   |      |  |   | 17,353  |  
|In-process research and development                                                                 |  |                        |         |   |      |   |         |      |  |   | 7,900   |  
|Reduction of goodwill                                                                               |  |                        | 423,875  |   |      |   |         |      |  |   |        |  
|Restructuring charges                                                                               |  |                        | 11,002   |   |      |   | 17,605   |      |  |   | 6,309   |  
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|Total operating expenses                                                                            |  |                        | 653,990  |   |      |   | 260,436  |      |  |   | 233,323 |  
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|Operating loss                                                                                      |  |                        | (476,712 | ) |      |   | (110,160 | )    |  |   | (79,788 | )
|Interest income                                                                                     |  |                        | 3,744    |   |      |   | 2,777    |      |  |   | 3,320   |  
|Interest expense                                                                                    |  |                        | (2,760   | ) |      |   | (3,226   | )    |  |   | (3,209  | )
|Other income and expenses, net                                                                      |  |                        | 27       |   |      |   | 2,066    |      |  |   | 19,262  |  
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|Loss before income tax provision                                                                    |  |                        | (475,701 | ) |      |   | (108,543 | )    |  |   | (60,415 | )
|Income tax provision                                                                                |  |                        | 5,884    |   |      |   | 11,389   |      |  |   | 3,989   |  
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|Loss before minority interest                                                                       |  |                        | (481,585 | ) |      |   | (119,932 | )    |  |   | (64,404 | )
|Minority interest                                                                                   |  |                        |         |   |      |   |         |      |  |   | 74      |  
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|Net loss                                                                                            |  | $                      | (481,585 | ) |      | $ | (119,932 | )    |  | $ | (64,478 | )
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|Net loss per share                                                                                  |  |                        |          |   |      |   |          |      |  |   |         |  
|Basic                                                                                               |  | $                      | (4.82    | ) |      | $ | (1.28    | )    |  | $ | (0.88   | )
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|Diluted                                                                                             |  | $                      | (4.82    | ) |      | $ | (1.28    | )    |  | $ | (0.88   | )
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|Number of shares used in computing per share amounts                                                |  |                        |          |   |      |   |          |      |  |   |         |  
|Basic                                                                                               |  |                        | 99,981   |   |      |   | 93,864   |      |  |   | 73,058  |  
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|Diluted                                                                                             |  |                        | 99,981   |   |      |   | 93,864   |      |  |   | 73,058  |  
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|(1)    Stock-based compensation charges from SFAS No. 123(R) adoption.                              |  |                        |          |   |     
|(2)    Amortization of deferred compensation related to the following expense categories by
period: |  |                        |          |   |     
|                                                                                                    |  |                        |         
|Cost of goods sold                                                                                  |  | $                      |         |   |      | $ | 379      |      |  | $ | 250     |  
|Research and development                                                                            |  |                        |         |   |      |   | 612      |      |  |   | 358     |  
|Selling, general and administrative                                                                 |  |                        |         |   |      |   | 2,036    |      |  |   | 1,570   |  
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  
|Total amortization of deferred compensation                                                         |  | $                      |         |   |      | $ | 3,027    |      |  | $ | 2,178   |  
|                                                                                                    |  |                        |          |   |      |   |          |      |  |   |         |  



See accompanying notes.



56



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CREDENCE SYSTEMS CORPORATION



CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

(in thousands)



|                                                                          |  |                 |   |  |              |     |                          |        |         |                |   |     |                      |   |           |                                     |  |      |                           |  |   |                          |   |  |   |        |   |  |   |        |   |  |   |          |   |  |   |          |  
|------------------------------------------------------------------------- |  | --------------- | - |  | ------------ | --- | ------------------------ | ------ | ------- | -------------- | - | --- | -------------------- | - | --------- | ----------------------------------- |  | ---- | ------------------------- |  | - | ------------------------ | - |  | - | ------ | - |  | - | ------ | - |  | - | -------- | - |  | - | -------- | -
|                                                                          |  | Preferred Stock |   |  | Common Stock |     | AdditionalPaid-inCapital |        |         | Treasury Stock |   |     | DeferredCompensation |   |           | AccumulatedOtherComprehensiveIncome |  |      | RetainedEarnings(Deficit) |  |   | TotalStockholdersEquity |  
|                                                                          |  | Shares          |   |  | Amount       |     |                          | Shares |         | Amount         |   |     | Shares               |   |           | Amount                              |  |      |                           |  |  
|Balance at October 31, 2003                                               |  |                |   |  | $            |    |                          |        | 64,374  |                | $ | 64  |                      | $ | 628,762   |                                     |  | (542 | )                         |  | $ | (13,195                  | ) |  | $ | (1,685 | ) |  | $ | 1,522  |   |  | $ | (184,841 | ) |  | $ | 430,627  |  
|                                                                          |  |                 |   |  |              |     |                          |        |         |                |   |     |                      |   |           |                                     |  |      |                           |  |   |                          |   |  |   |        |   |  |   |        |   |  |   |          |   |  |   |          |  
|Issuance of common stock for acquisition of NPTest                        |  |                |   |  |              |    |                          |        | 19,661  |                |   | 20  |                      |   | 231,391   |                                     |  |     |                           |  |   |                         |   |  |   | (9,967 | ) |  |   |       |   |  |   |         |   |  |   | 221,444  |  
|Issuance of preferred stock for acquisition of NPTest                     |  | 12,328          |   |  |              | 12  |                          |        |        |                |   |    |                      |   | 145,091   |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   |       |   |  |   |         |   |  |   | 145,103  |  
|Issuance of common stock under employee equity plans                      |  |                |   |  |              |    |                          |        | 1,378   |                |   | 2   |                      |   | 3,187     |                                     |  | 413  |                           |  |   | 10,635                   |   |  |   |       |   |  |   |       |   |  |   |         |   |  |   | 13,824   |  
|Issuance of stock options to non-employee                                 |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   | 165       |                                     |  |     |                           |  |   |                         |   |  |   | (165   | ) |  |   |       |   |  |   |         |   |  |   |         |  
|Assumed NPTest stock options                                              |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   | 38,108    |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   |       |   |  |   |         |   |  |   | 38,108   |  
|Amortization of deferred compensation                                     |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   | 2,178  |   |  |   |       |   |  |   |         |   |  |   | 2,178    |  
|Write-off of deferred compensation                                        |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   | (1,039    | )                                   |  |     |                           |  |   |                         |   |  |   | 1,039  |   |  |   |       |   |  |   |         |   |  |   |         |  
|Net loss                                                                  |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   |       |   |  |   | (64,478  | ) |  |   | (64,478  | )
|Net unrealized loss on securities, net of tax                             |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   | (314   | ) |  |   |         |   |  |   | (314     | )
|Plus: reclassification adjustment for realized gains included in earnings |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   | 93     |   |  |   |         |   |  |   | 93       |  
|Currency translation adjustment, net of tax                               |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   | 1,623  |   |  |   |         |   |  |   | 1,623    |  
|Total comprehensive loss                                                  |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   |       |   |  |   |         |   |  |   | (63,076  | )
|                                                                          |  |                 |   |  |              |     |                          |        |         |                |   |     |                      |   |           |                                     |  |      |                           |  |   |                          |   |  |   |        |   |  |   |        |   |  |   |          |   |  |   |          |  
|Balance at October 31, 2004                                               |  | 12,328          |   |  |              | 12  |                          |        | 85,413  |                |   | 86  |                      |   | 1,045,665 |                                     |  | (129 | )                         |  |   | (2,560                   | ) |  |   | (8,600 | ) |  |   | 2,924  |   |  |   | (249,319 | ) |  |   | 788,208  |  
|                                                                          |  |                 |   |  |              |     |                          |        |         |                |   |     |                      |   |           |                                     |  |      |                           |  |   |                          |   |  |   |        |   |  |   |        |   |  |   |          |   |  |   |          |  
|Schlumberger Liability Settlement                                         |  |                |   |  |              |    |                          |        | 615     |                |   | 1   |                      |   | 4,999     |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   |       |   |  |   |         |   |  |   | 5,000    |  
|Conversion of preferred stock to common stock                             |  | (12,328         | ) |  |              | (12 | )                        |        | 12,328  |                |   | 12  |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   |       |   |  |   |         |   |  |   |         |  
|Issuance of common stock under employee equity plans                      |  |                |   |  |              |    |                          |        | 1,092   |                |   | 1   |                      |   | 5,580     |                                     |  | 129  |                           |  |   | 2,560                    |   |  |   |       |   |  |   |       |   |  |   |         |   |  |   | 8,141    |  
|Amortization of deferred compensation                                     |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   | 3,027  |   |  |   |       |   |  |   |         |   |  |   | 3,027    |  
|Write-off of deferred compensation                                        |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   | (1,390    | )                                   |  |     |                           |  |   |                         |   |  |   | 1,390  |   |  |   |       |   |  |   |         |   |  |   |         |  
|Net loss                                                                  |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   |       |   |  |   | (119,932 | ) |  |   | (119,932 | )
|Net unrealized loss on securities, net of tax                             |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   | (566   | ) |  |   |         |   |  |   | (566     | )
|Plus: reclassification adjustment for realized gains included in earnings |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   | 283    |   |  |   |         |   |  |   | 283      |  
|Currency translation adjustment, net of tax                               |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   | (2,132 | ) |  |   |         |   |  |   | (2,132   | )
|Total comprehensive loss                                                  |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   |       |   |  |   |         |   |  |   | (122,347 | )
|                                                                          |  |                 |   |  |              |     |                          |        |         |                |   |     |                      |   |           |                                     |  |      |                           |  |   |                          |   |  |   |        |   |  |   |        |   |  |   |          |   |  |   |          |  
|Balance at October 31, 2005                                               |  |                |   |  |              |    |                          |        | 99,448  |                |   | 100 |                      |   | 1,054,854 |                                     |  |     |                           |  |   |                         |   |  |   | (4,183 | ) |  |   | 509    |   |  |   | (369,251 | ) |  |   | 682,029  |  
|                                                                          |  |                 |   |  |              |     |                          |        |         |                |   |     |                      |   |           |                                     |  |      |                           |  |   |                          |   |  |   |        |   |  |   |        |   |  |   |          |   |  |   |          |  
|Issuance of common stock under employee equity plans                      |  |                |   |  |              |    |                          |        | 1,162   |                |   | 1   |                      |   | 4,880     |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   |       |   |  |   |         |   |  |   | 4,881    |  
|Share-based compensation                                                  |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   | 5,791     |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   |       |   |  |   |         |   |  |   | 5,791    |  
|Reclassification of deferred compensation upon adoption of SFAS 123(R)    |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   | (4,183    | )                                   |  |     |                           |  |   |                         |   |  |   | 4,183  |   |  |   |       |   |  |   |         |   |  |   |         |  
|Net loss                                                                  |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   |       |   |  |   | (481,585 | ) |  |   | (481,585 | )
|Net unrealized loss on securities, net of tax                             |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   | (401   | ) |  |   |         |   |  |   | (401     | )
|Plus: reclassification adjustment for realized gains included in earnings |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   | 191    |   |  |   |         |   |  |   | 191      |  
|Currency translation adjustment, net of tax                               |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   | 1,820  |   |  |   |         |   |  |   | 1,820    |  
|Total comprehensive loss                                                  |  |                |   |  |              |    |                          |        |        |                |   |    |                      |   |          |                                     |  |     |                           |  |   |                         |   |  |   |       |   |  |   |       |   |  |   |         |   |  |   | (480,459 | )
|                                                                          |  |                 |   |  |              |     |                          |        |         |                |   |     |                      |   |           |                                     |  |      |                           |  |   |                          |   |  |   |        |   |  |   |        |   |  |   |          |   |  |   |          |  
|Balance at October 31, 2006                                               |  |                |   |  | $            |    |                          |        | 100,610 |                | $ | 101 |                      | $ | 1,061,342 |                                     |  |     |                           |  | $ |                         |   |  | $ |       |   |  | $ | 2,119  |   |  | $ | (850,836 | ) |  | $ | 212,726  |  
|                                                                          |  |                 |   |  |              |     |                          |        |         |                |   |     |                      |   |           |                                     |  |      |                           |  |   |                          |   |  |   |        |   |  |   |        |   |  |   |          |   |  |   |          |  



See accompanying notes.



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CREDENCE SYSTEMS CORPORATION



CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|--------------------------------------------------------------------------- |  | ---------------------- | -------- | - | ---- | - | -------- | ---- |  | - | -------- | -
|                                                                            |  | Year Ended October 31, |         
|                                                                            |  | 2006                   |          |   | 2005 |   |          | 2004 | 
|Cash flows from operating activities:                                       |  |                        |          |   |      |   |          |      |  |   |          |  
|Net loss                                                                    |  | $                      | (481,585 | ) |      | $ | (119,932 | )    |  | $ | (64,478  | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                        |          |   |      |   |          |      |  |   |          |  
|Depreciation and amortization                                               |  |                        | 52,508   |   |      |   | 68,825   |      |  |   | 61,316   |  
|Inventory write downs and non-cash charges related to restructuring         |  |                        | 37,944   |   |      |   | 35,481   |      |  |   | 57,432   |  
|Reduction of goodwill                                                       |  |                        | 423,875  |   |      |   |         |      |  |   |         |  
|In-process research and development                                         |  |                        |         |   |      |   |         |      |  |   | 7,900    |  
|Provision for allowance for doubtful accounts                               |  |                        | (83      | ) |      |   | 2,985    |      |  |   | (1,460   | )
|Stock-based compensation charges                                            |  |                        | 5,791    |   |      |   | 3,027    |      |  |   | 2,178    |  
|Loss on disposal of property and equipment                                  |  |                        | 44       |   |      |   | 111      |      |  |   |         |  
|Loss on impaired investment                                                 |  |                        | 945      |   |      |   |         |      |  |   | (588     | )
|Gain repurchases of convertible subordinated notes                          |  |                        | (2,777   | ) |      |   |         |      |  |   |         |  
|Realized net loss (gain) from investments                                   |  |                        | (302     | ) |      |   |         |      |  |   | 369      |  
|Minority interest                                                           |  |                        |         |   |      |   |         |      |  |   | 55       |  
|Changes in operating assets and liabilities:                                |  |                        |          |   |      |   |          |      |  |   |          |  
|Accounts receivable, net                                                    |  |                        | 92       |   |      |   | 4,579    |      |  |   | (19,044  | )
|Inventories                                                                 |  |                        | (13,877  | ) |      |   | 14,817   |      |  |   | (60,106  | )
|Income tax receivable and payable                                           |  |                        | (4,370   | ) |      |   | 6,466    |      |  |   | 2,136    |  
|Prepaid expenses and other assets                                           |  |                        | (8,596   | ) |      |   | (13,097  | )    |  |   | (6,166   | )
|Accounts payable                                                            |  |                        | (13,794  | ) |      |   | (5,670   | )    |  |   | 7,959    |  
|Accrued expenses and other current liabilities                              |  |                        | (4,801   | ) |      |   | 1,737    |      |  |   | (9,750   | )
|Deferred profit                                                             |  |                        | 1,031    |   |      |   | (4,611   | )    |  |   | 5,117    |  
|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|Net cash used in operating activities                                       |  |                        | (7,955   | ) |      |   | (5,282   | )    |  |   | (17,130  | )
|                                                                            |  |                        |         
|Cash flows from investing activities:                                       |  |                        |          |   |      |   |          |      |  |   |          |  
|Purchases of available-for-sale securities                                  |  |                        | (31,581  | ) |      |   | (100,775 | )    |  |   | (247,526 | )
|Sales and maturities of available-for-sale securities                       |  |                        | 32,297   |   |      |   | 162,552  |      |  |   | 503,319  |  
|Acquisition of property and equipment                                       |  |                        | (5,756   | ) |      |   | (14,812  | )    |  |   | (24,400  | )
|Acquisition of business, net of cash and cash equivalents acquired          |  |                        | (4,643   | ) |      |   |         |      |  |   | (159,913 | )
|Acquisition of other assets                                                 |  |                        |         |   |      |   |         |      |  |   | (919     | )
|Proceeds from sale of property and equipment and leased equipment           |  |                        | 2,515    |   |      |   | 809      |      |  |   | 1,612    |  
|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|Net cash (used in) provided by investing activities                         |  |                        | (7,168   | ) |      |   | 47,774   |      |  |   | 72,173   |  
|                                                                            |  |                        |         
|Cash flows from financing activities:                                       |  |                        |          |   |      |   |          |      |  |   |          |  
|Issuance of common & treasury stock                                         |  |                        | 4,881    |   |      |   | 8,141    |      |  |   | 13,824   |  
|Payments of bank loans and notes payable related to leased products         |  |                        | (5,000   | ) |      |   | (1,058   | )    |  |   | (2,815   | )
|Repurchases of convertible subordinated notes                               |  |                        | (31,850  | ) |      |   |         |      |  |   |         |  
|Other                                                                       |  |                        |         |   |      |   |         |      |  |   | (213     | )
|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|Net cash (used in) provided by financing activities                         |  |                        | (31,969  | ) |      |   | 7,083    |      |  |   | 10,796   |  
|Effects of exchange rate on cash and cash equivalents                       |  |                        | 547      |   |      |   | (1,447   | )    |  |   | 895      |  
|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|Net (decrease) increase in cash and cash equivalents                        |  |                        | (46,545  | ) |      |   | 48,128   |      |  |   | 66,734   |  
|Cash and cash equivalents at beginning of the period                        |  |                        | 142,180  |   |      |   | 94,052   |      |  |   | 27,318   |  
|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|Cash and cash equivalents at end of the period                              |  | $                      | 95,635   |   |      | $ | 142,180  |      |  | $ | 94,052   |  
|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|Supplemental disclosures of cash flow information:                          |  |                        |          |   |      |   |          |      |  |   |          |  
|Interest paid                                                               |  | $                      | 2,913    |   |      | $ | 3,007    |      |  | $ | 2,632    |  
|Income taxes paid (received)                                                |  | $                      | 10,822   |   |      | $ | 3,992    |      |  | $ | (74      | )
|                                                                            |  |                        |         
|Noncash investing activities:                                               |  |                        |          |   |      |   |          |      |  |   |          |  
|Net transfers of inventory to property and equipment                        |  | $                      | 2,905    |   |      | $ | 640      |      |  | $ | 2,157    |  
|Acquisition of NPTest using Credence common stock and assumption of options |  | $                      |         |   |      | $ |         |      |  | $ | 414,622  |  
|Schlumbergers liability settlement using Credence common stock             |  | $                      |         |   |      | $ | 5,000    |      |  |   |         |  
|Unrealized loss on securities                                               |  | $                      | (210     | ) |      | $ | (283     | )    |  | $ | (213     | )
|                                                                            |  |                        |         
|Noncash financing activities:                                               |  |                        |          |   |      |   |          |      |  |   |          |  
|Customer lease payments on liabilities guaranteed by Credence               |  | $                      |         |   |      | $ |         |      |  | $ | (1,535   | )

---

|(1) | During fiscal year 2006, the Company recorded a total of $5,791,000 in stock-based compensation expense of which $120,000 was capitalized as inventory at October 31, 2006 from
SFAS No. 123(R) adoption.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



See accompanying
notes.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Note
1Organization and Summary of Significant Accounting Policies



Organization



Credence Systems Corporation
(Credence or the Company) was incorporated under the laws of the State of California in March 1982 to succeed a sole proprietorship and was reincorporated in Delaware in October 1993. The principal business activity of the
Company is the design, development, manufacture, sale and service of integrated test solutions throughout the design, validation and production processes for semiconductors.



The Company has subsidiaries in Singapore, Taiwan, China and Japan engaged in sales, marketing and service of the
Companys products and subsidiaries in Korea, Malaysia, and the Philippines engaged in service of the Companys products. The Company also has European subsidiaries, which principally distribute, service, and support Credence products in
Europe and the Middle East. The Company maintains research and development in the U.S., France, Germany, and the UK, and manufacturing in the U.S. and Germany.



Basis of Presentation



The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany
transactions and balances have been eliminated. Certain prior year amounts in the consolidated financial statements and related notes have been reclassified to conform to the current years presentation.



Minority InterestThe Company liquidated Credence-Innotech
Corporation, its joint venture with Innotech Corporation in Japan during the third quarter of fiscal year 2004. The loss recognized upon liquidation was immaterial for fiscal year 2004.



Use of Estimates



The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements.



Actual results inevitably will differ from those estimates and such differences may be material to the financial statements. Estimates are used for, but not limited to, the accounting for revenue recognition,
allowance for doubtful accounts, inventory valuation, depreciation and amortization, share-based compensation valuation, residual values of leased assets, product maturity and receivable collectibility for purposes of revenue recognition, warranty
costs, restructuring costs, deferred taxes and contingencies.



The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability or unwillingness of its customers to make required payments. The Company records its bad debt expenses as selling, general and
administrative expenses. When the Company becomes aware that a specific customer is unable to meet its financial obligations to the Company, generally because of bankruptcy or deteriorations in the customers operating results or financial
position, the Company records a specific allowance to reflect the level of credit risk in the customers outstanding receivable balance. In addition, the Company records additional allowances based on certain percentages of its aged receivable
balances. These percentages are determined by a variety of factors including, but not limited to, current economic trends, historical payment and bad debt write-off experience.



Due to the cyclical nature of the semiconductor equipment industry, the Company monitors its inventory levels in light of
changes in the marketplace. In fiscal years 2006 and 2005, the Company recorded inventory



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



write-down totaling approximately $36.1 million and $34.5 million, respectively. The fiscal year 2006 inventory write-down related to decreased demand for
our memory and other legacy products. During fiscal year 2005, the Company evaluated the redundant product lines using internal and external marketing data, the development roadmap for each product line, existing and potential customers and demand
for the product.



Residual values assigned to the
Companys products that are leased to customers are based on their remaining useful economic life at the end of the lease terms. The amounts assigned to the residual values are evaluated periodically against technological change and the
forecasted business cycle.



Revenue Recognition



Under Securities and Exchange Commissions Staff Accounting Bulletin
No. 104, Revenue Recognition, (SAB 104), the Company recognizes revenue on the sale of semiconductor manufacturing equipment when title and risk of loss have passed to the customer, there is persuasive evidence of an arrangement,
delivery has occurred or services have been rendered, the sales price is fixed or determinable, collectibility is reasonably assured and customer acceptance criteria have been successfully demonstrated. Revenue recognition policies are applied
consistently among the Companys semiconductor manufacturing equipment product lines. Product revenue is recognized upon shipment only when achieving the customer acceptance criteria can be demonstrated prior to shipment, which generally occurs
with mature product. Revenue related to the fair value of the installation obligation is recognized upon completion of the installation. Service revenues are generally recognized upon performance of the activities requested by the customers.
Products are classified as mature after several different customers have accepted similar systems. When the customer acceptance criteria cannot be demonstrated prior to shipment, revenue and the related cost of goods sold are deferred until customer
acceptance. For some customers in certain countries where collections may be an issue, the Company may require a letter of credit to be established or cash receipt in advance before revenue can be recognized. Lease revenue is recorded in accordance
with Statement of Financial Accounting Standard No. 13, Accounting for Leases, (SFAS No. 13), which requires that a lessor account for each lease by either the sales-type or operating method. Revenue from sales-type leases is
recognized at the net present value of future lease payments. Revenue from operating leases is recognized over the lease period.



During fiscal years 2006 and 2005, the Company introduced several new enhancements, systems and products. Certain revenue from sales of these new systems
and products during fiscal years 2006 and 2005 were deferred until the revenue recognition requirements of the Companys revenue recognition policy are satisfied. This practice will continue in the future. In the past, the Company experienced
significant delays in the introduction and acceptance of new testers as well as certain enhancements to the Companys existing testers. Delays in introducing a product or delays in the Companys ability to obtain customer acceptance, if
they occur in the future, will delay the recognition of revenue and gross profit by the Company.



With respect to arrangements with multiple deliverables, the Company follows the guidance in Emerging Issue Task Force No. 00-21, Revenue
Arrangements with Multiple Deliverables (EITF 00-21), to determine whether there is more than one unit of accounting. To the extent that the deliverables are separable into multiple units of accounting, the Company then allocates the total fee
on such arrangements to the individual units of accounting using the residual method. The Company then recognizes revenue for each unit of accounting depending on the nature of the deliverable(s) comprising the unit of accounting (principally
following SAB 104).



Sales in the United States are principally
made through the Companys direct sales organization consisting of direct sales employees and representatives. Sales outside the United States utilize both direct sales employees and distributors. There are no significant differences in revenue
recognition policies based on the sales channel, due to the business practices that have been adopted with the Companys distributor relationships. Because of these business circumstances, the Company does not use price protection,
stock rotation or similar programs



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



with its distributors. In general, the Company sells products to the distributor on the basis of a purchase order received from an end customer. The Company
evaluates any revenue recognition issues, in such cases, based on the characteristics of the end customer.



The Company has embedded software in its semiconductor manufacturing equipment. The Company believes this embedded software is incidental to its products
and therefore it is excluded from the scope of Statement of Position 97-2, Software Revenue Recognition (SOP 97-2), since the embedded software in the Companys products is not sold separately, cannot be used on another
vendors products, and the Company cannot fundamentally enhance or expand the capability of the equipment with new or revised embedded software. In addition, the equipments principal performance characteristics are governed by digital
speed and pin count, which are primarily a function of the hardware.



Deferred revenue includes deferred revenue related to maintenance contracts (and other undelivered services) and to extended warranties where products were sold with more than the standard one-year warranty. Deferred profit is related to
equipment that was shipped to certain customers, but for which the revenue and cost of goods sold are not recognized because the customer-specified acceptance criteria has not been met as of the fiscal period end or because the customer is deemed to
be a high credit risk and payment has not been received as of the fiscal period end.



The Company warrants its products to its customers generally for one year from the date of shipment. In addition to the provision of standard warranties, the Company may offer customers paid extended warranty services
with a fixed fee. The fixed fees are recognized as revenue on a straight-line basis over the applicable term of the contract. Costs related to extended warranty services are recorded as incurred.



For certain customers, typically those with whom the Company has long-term
relationships, the Company may grant extended payment terms. Certain of the Companys receivables have due dates in excess of 90 days and the Company has a history of successfully collecting these extended payment term accounts receivable.



Advertising



Advertising costs are expensed as incurred and included in selling, general
and administrative expenses in the consolidated statements of operations. Advertising expenses were approximately $128,000, $201,000 and $346,000 in fiscal years 2006, 2005 and 2004, respectively.



Derivative Instruments and Hedging Activities



In the first quarter of fiscal 2001, the Company adopted Statement of
Financial Accounting Standards No. 133 Accounting for Derivative Instruments and Hedging Activities, (SFAS 133), as amended by SFAS 137 and SFAS 138, which establishes accounting and reporting standards for derivative instruments
and for hedging activities. SFAS 133 requires that an entity recognize derivatives as either assets or liabilities on the balance sheet and measure those instruments at fair value. The accounting for changes in the fair value of a derivative depends
on the intended use of the derivative and the resulting designation. The Company does not currently use derivatives, but will continue to assess the need for these instruments in the future.



Foreign Currency Translation



The Companys international subsidiaries operate primarily using local
functional currencies. Accordingly, all assets and liabilities of these subsidiaries are translated using exchange rates in effect at the end of the period, and revenues and costs are translated using average rates for the period. The resulting
cumulative translation adjustments are presented as a separate component of stockholders equity. Realized and unrealized exchange gains or losses from transaction adjustments are reflected in operations and have not been material.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Guarantees



The Company accounts for guarantees in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34 (FIN 45). Accordingly, the Company
evaluates its guarantees to determine whether (a) the guarantee is specifically excluded from the scope of FIN 45, (b) the guarantee is subject to FIN 45 disclosure requirements only, but not subject to the initial recognition and
measurement provisions, or (c) the guarantee is required to be recorded in the financial statements at fair value. The Company has evaluated its guarantees and has concluded that they are either not within the scope of FIN 45 or do not require
recognition in the financial statements.



The Companys
corporate by-laws require that the Company indemnify its officers and directors, as well as those who act as directors and officers of other entities at the Companys request, against expenses, judgments, fines, settlements and other amounts
actually and reasonably incurred in connection with any proceedings arising out of their services to the Company. In addition, the Company has entered into separate indemnification agreements with each director and each executive officer of the
Company that provide for indemnification of these directors and officers under similar circumstances and under additional circumstances. The indemnification obligations are more fully described in the by-laws and the indemnification agreements. The
Company purchases standard directors and officers insurance to cover claims or a portion of the claims made against its directors and officers. Since a maximum obligation is not explicitly stated in the Companys by-laws or in the
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, the Company has not been required to make
payments related to these obligations, and the fair value for these obligations is zero on the consolidated balance sheet as of October 31, 2006.



As is customary in the Companys industry and as provided for under local law in the United States and other jurisdictions, many of the
Companys standard contracts provide remedies to customers and others with whom the Company does business, such as defense, settlement, or payment of judgment for intellectual property claims related to the use of the Companys products.
From time to time, the Company indemnifies customers, as well as the Companys suppliers, contractors, lessors under operating lease agreements for environmental matters, lessees, companies that purchase the Companys businesses or assets
and others with whom the Company enters into contracts, against combinations of loss, expense, or liability arising from various triggering events related to the sale and the use of the Companys products and services such as warranty, the use
of their goods and services, the use of facilities and state of the Companys owned 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.
Based on past experience, claims made under such indemnifications are rare and the associated estimated fair value of the liability is not material.



Cash, Cash Equivalents, and Short-Term Investments



For purposes of cash flow reporting, the Company considers all highly liquid investments with minimum yield risks and original maturity dates of three
months or less to be cash equivalents. Short-term investments consist primarily of U.S. Treasury notes and obligations of U.S. Government agencies, carried at amortized costs adjusted to fair market value.



At October 31, 2006 and 2005, the Company classified all investments as
available-for-sale and reported their fair market value. Unrealized gains or losses on available-for-sale securities, if material, are included, net of tax, in equity until disposition.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Realized gains, losses and declines in value judged to be other-than-temporary on available-for-sale
securities are included in interest income. The Company reviews all marketable equity securities for other than temporary declines in fair value. In doing so, the Company evaluates the length of the time and the extent to which the market value has
been less than cost, the financial condition and near-term prospects of the portfolio company, and its intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in market value. The Company
considers circumstances where, as of the end of any quarter, the carrying value of a marketable equity security has been greater than its market value for the last six consecutive months, to be de-facto evidence of other than temporary impairment.
The Company performs its evaluation of other than temporary impairment on a quarterly basis. Based on the Companys evaluation, if a security is considered to be other than temporarily impaired, an impairment charge is recognized in Other
income and expenses, net in the consolidated statements of operations. There was no impairment charge recorded in fiscal years 2006, 2005 and 2004. In addition, the cost of securities sold is based on the specific identification method.



Gross unrealized gains and losses were not significant in
fiscal years 2006 and 2005. The realized profits (losses) and interest of $0.3 million, $0 million and $(0.4) million are included in interest income in the consolidated statements of operations for fiscal years 2006, 2005 and 2004, respectively.
Unrealized gains and losses are reflected as a separate component of comprehensive income and are included in the consolidated statements of stockholders equity.



The fair market value of cash equivalents, short-term and long-term debt investments represents the quoted market prices at
the balance sheet dates. Cash and cash equivalents are categorized as follows (in thousands):



|                          |  |             |        |      |   |        
|------------------------- |  | ----------- | ------ | ---- | - | -------
|                          |  | October 31,
|                          |  | 2006        |        | 2005
|Money market              |  | $           | 44,058 |      | $ | 91,769 
|Cash                      |  |             | 51,577 |      |   | 50,411 
|                          |  |             |        |      |   |        
|Cash and cash equivalents |  | $           | 95,635 |      | $ | 142,180
|                          |  |             |        |      |   |        



Short-term investments
mature in one year or less while long-term investments mature in more than one year from the balance sheet date. At October 31, 2006 and 2005, these investments are classified as available-for-sale and consist of the following (in thousands):



|                       |  |                |       |                                                       |   |                                                        |  |                    |   |  |   |      
|---------------------- |  | -------------- | ----- | ----------------------------------------------------- | - | ------------------------------------------------------ |  | ------------------ | - |  | - | -----
|                       |  | AmortizedCost  |       | UnrealizedGains inAccumulatedOtherComprehensiveIncome |   | UnrealizedLosses inAccumulatedOtherComprehensiveIncome |  | AggregateFairValue
|                       |  | (In thousands)
|October 31, 2006       |  |                |       |                                                       |   |                                                        |  |                    |   |  |   |      
|Auction rate preferred |  | $              | 7,177 |                                                       | $ |                                                       |  | $                  |  |  | $ | 7,177
|                       |  |                |       |                                                       |   |                                                        |  |                    |   |  |   |      
|Short-term investments |  | $              | 7,177 |                                                       | $ |                                                       |  | $                  |  |  | $ | 7,177
|                       |  |                |       |                                                       |   |                                                        |  |                    |   |  |   |      
|October 31, 2005       |  |                |       |                                                       |   |                                                        |  |                    |   |  |   |      
|Auction rate preferred |  | $              | 7,425 |                                                       | $ |                                                       |  | $                  |  |  | $ | 7,425
|Equity securities      |  |                | 200   |                                                       |   | 191                                                    |  |                    |  |  |   | 391  
|                       |  |                |       |                                                       |   |                                                        |  |                    |   |  |   |      
|Short-term investments |  | $              | 7,625 |                                                       | $ | 191                                                    |  | $                  |  |  | $ | 7,816
|                       |  |                |       |                                                       |   |                                                        |  |                    |   |  |   |      



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The estimated fair value of cash, cash equivalents and short-term investments classified by the
maturity date listed on the security is as follows (in thousands):



|                                                  |  |             |         |      |   |        
|------------------------------------------------- |  | ----------- | ------- | ---- | - | -------
|                                                  |  | October 31,
|                                                  |  | 2006        |         | 2005
|Due within 1 year                                 |  | $           | 100,816 |      | $ | 149,996
|Due in 2008                                       |  | $           | 1,996   |      |   |       
|                                                  |  |             |         |      |   |        
|Cash, cash equivalents and short-term investments |  | $           | 102,812 |      | $ | 149,996
|                                                  |  |             |         |      |   |        



Accounts Receivable Factoring
without Recourse



The Company had an agreement with a
commercial bank to sell certain of its trade receivables in non-recourse transactions. Under the terms of the agreement, the Company could sell up to $30.0 million of its trade receivables at any one time. The Company was retained by the bank to
service the collection aspect of the trade receivables sold. The trade receivables were sold at a discount plus administrative and other fees. The discount amount, administrative and other fees for the fiscal year 2005 of approximately $0.1 million
were accounted for in other income and expense, net in the consolidated statements of operations. The proceeds received were included as operating activities in the consolidated statements of cash flows. This facility was terminated during the
quarter ended July 31, 2005.



Inventories



Inventories are stated at the lower of standard cost (which approximates
first-in, first-out cost) or market. Shipping and handling expenses for purchased inventory items are expensed to cost of goods sold. Inventories consist of the following (in thousands):



|                |  |             |        |      |   |       
|--------------- |  | ----------- | ------ | ---- | - | ------
|                |  | October 31,
|                |  | 2006        |        | 2005
|Raw materials   |  | $           | 36,436 |      | $ | 43,790
|Work-in-process |  |             | 14,097 |      |   | 21,121
|Finished goods  |  |             | 4,667  |      |   | 14,143
|                |  |             |        |      |   |       
|                |  | $           | 55,200 |      | $ | 79,054
|                |  |             |        |      |   |       



The Company makes
inventory commitments and purchase decisions based upon sales forecasts. Each year the Company forecasts an annual operating plan and a three-year strategic plan as part of its strategic planning process. The Company also has a 12-month rolling
forecast that estimates business levels for the next four quarters. These forecasts require the Company to estimate its ability to sell current and future products in the next cyclical period of the industry and compare those estimates with its
current inventory levels. It is difficult to predict the timing of the next recovery or recession as well as the strength of that recovery or recession. The Company sells capital equipment with relatively longer technological lives than many of the
components that are included in the manufacture of its products. Some of the components that the Company purchases are unique to the Company and must be purchased in relatively high minimum quantities with long (approximately four and five month)
lead times. These business circumstances can lead to the Company holding relatively high inventory levels with the associated risks. In addition, purchase commitments for unique components are relatively inflexible in terms of deferral or
cancellation. This resulted in the Company entering into a variety of purchase commitments in order to mitigate component supply constraints, capture purchasing efficiencies and obtain supplies of components that are nearing end of life.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The Company reviews excess and obsolete inventory on an annual basis in light of its three year
strategic planning process and then again on a quarterly basis for significant events that might have an impact on inventories. In evaluating the need for inventory write-offs, the Company considers a number of factors including anticipated product
life cycles, new product introductions, and expected future use of all raw materials, work-in-process, and finished goods on hand as well as purchase order commitments to purchase inventory. If the forecasts or estimates change, or product roadmaps
change, then the Company would need to adjust its assessment of the inventory valuations. The Company reviews inventory on a cyclical basis rather than a seasonal or annual basis because of the nature of its industry, the relatively long lives of
its products and the volatility of the business from quarter to quarter. Once the Company has identified excess or obsolete inventory materials, including purchase commitments, it considers alternative future uses for the items in question. In cases
where no alternative future uses have been identified, and if the Company concludes that it is probable that the costs associated with the excess or obsolete materials will not be recovered, then an appropriate write-off is recorded. The Company
then writes off 100% of the cost of inventory that it specifically identifies. The Company does not as a matter of course scrap all inventory that is identified as excess or obsolete. The Companys products are capital goods with potentially
long economic lives and historically the opportunity to sell these products has arisen or fallen unexpectedly. The Company has occasionally encountered unexpected demand for old products. The Company monitors the inventories that have been written
off or written down but not scrapped, so that if any sales of these items occur and affect our reported gross margins, the effect, if material is disclosed.



The Company consigns a portion of its finished goods inventory to both external and internal customers on a short-term basis primarily for the purpose of
customer demonstration. This inventory is categorized as other assets on the consolidated balance sheet. The Company depreciates all consigned inventories during the period that they are held on consignment over 18 to 36 months. The depreciation
expense for consigned inventory is charged to selling, general and administrative expense.



Property and Equipment, Net and Other Intangible Assets



Machinery and equipment, software and furniture and fixtures are stated at cost and are depreciated using the straight-line method over three years.
Personal computer equipment that meets the Companys capitalization threshold is depreciated over two years. Leasehold improvements are depreciated using the straight-line method over the shorter of seven years or the applicable lease term.
Tenant improvements in owned facilities are generally depreciated over seven years. Buildings are depreciated using the straight-line method over the assets estimated useful lives of thirty years. Assets under capitalized leases are amortized
using the straight-line method over the shorter of the estimated useful life of the asset or the lease term.



Property and equipment, net consists of the following (in thousands):



|                              |  |             |          |   |      |   |          |  
|----------------------------- |  | ----------- | -------- | - | ---- | - | -------- | -
|                              |  | October 31, |         
|                              |  | 2006        |          |   | 2005 |  
|Land                          |  | $           | 24,381   |   |      | $ | 26,835   |  
|Buildings                     |  |             | 35,876   |   |      |   | 35,746   |  
|Machinery and equipment       |  |             | 106,824  |   |      |   | 104,626  |  
|Software                      |  |             | 33,731   |   |      |   | 30,705   |  
|Leasehold improvements        |  |             | 40,734   |   |      |   | 39,106   |  
|Furniture and fixtures        |  |             | 10,696   |   |      |   | 10,456   |  
|                              |  |             |          |   |      |   |          |  
|                              |  |             | 252,242  |   |      |   | 247,474  |  
|Less accumulated depreciation |  |             | (165,067 | ) |      |   | (150,783 | )
|                              |  |             |          |   |      |   |          |  
|Net property and equipment    |  | $           | 87,175   |   |      | $ | 96,691   |  
|                              |  |             |          |   |      |   |          |  



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Depreciation expense was approximately $16.0 million, $24.6 million, and $27.9 million for the years
ended October 31, 2006, 2005 and 2004, respectively.



In
addition, the Company capitalizes a small number of finished systems into the manufacturing function for use in de-bug, quality control, and development as well as the sales function for use in demonstrations and application development.



Other intangible assets, excluding goodwill, consist of the following (in
thousands):



|                       |  |      |         |                          |   |         |     |  |   |       
|---------------------- |  | ---- | ------- | ------------------------ | - | ------- | --- |  | - | ------
|October 31, 2006       |  | Cost |         | Accumulated Amortization |   |         | Net
|Purchased technology   |  | $    | 128,481 |                          | $ | (60,977 | )   |  | $ | 67,504
|Customer relations     |  |      | 21,202  |                          |   | (11,958 | )   |  |   | 9,244 
|Maintenance contracts  |  |      | 13,800  |                          |   | (6,670  | )   |  |   | 7,130 
|Product backlog        |  |      | 4,900   |                          |   | (4,900  | )   |  |   |      
|Trademarks             |  |      | 2,053   |                          |   | (2,053  | )   |  |   |      
|Patents                |  |      | 862     |                          |   | (862    | )   |  |   |      
|Non-compete agreements |  |      | 750     |                          |   | (750    | )   |  |   |      
|                       |  |      |         |                          |   |         |     |  |   |       
|Total                  |  | $    | 172,048 |                          | $ | (88,170 | )   |  | $ | 83,878
|                       |  |      |         |                          |   |         |     |  |   |       
|                       |  |      |        
|October 31, 2005       |  | Cost |         | AccumulatedAmortization  |   |         | Net
|Purchased technology   |  | $    | 125,206 |                          | $ | (48,446 | )   |  | $ | 76,760
|Customer relations     |  |      | 19,802  |                          |   | (10,013 | )   |  |   | 9,789 
|Maintenance contracts  |  |      | 13,800  |                          |   | (3,910  | )   |  |   | 9,890 
|Product backlog        |  |      | 4,900   |                          |   | (4,900  | )   |  |   |      
|Trademarks             |  |      | 2,053   |                          |   | (2,053  | )   |  |   |      
|Patents                |  |      | 862     |                          |   | (862    | )   |  |   |      
|Non-compete agreements |  |      | 750     |                          |   | (750    | )   |  |   |      
|                       |  |      |         |                          |   |         |     |  |   |       
|Total                  |  | $    | 167,373 |                          | $ | (70,934 | )   |  | $ | 96,439
|                       |  |      |         |                          |   |         |     |  |   |       



Amortization expenses
for the other intangible assets were $17.2 million, $20.4 million and $15.5 million for fiscal 2006, 2005 and 2004, respectively.



The estimated future amortization expense of purchased intangible assets with definite lives for the next five years is as follows (in thousands):



|                        |  |        |       
|----------------------- |  | ------ | ------
|Year Ending October 31, |  | Amount
|2007                    |  | $      | 17,875
|2008                    |  |        | 15,926
|2009                    |  |        | 13,573
|2010                    |  |        | 10,109
|2011                    |  |        | 8,213 
|Thereafter              |  |        | 18,182
|                        |  |        |       
|Total                   |  | $      | 83,878
|                        |  |        |       



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Accounting for Asset Retirement Obligations



In fiscal year 2004, we adopted Statement of Financial Accounting Standards No. 143, or SFAS No. 143,
Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143
applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the assets. SFAS No. 143 requires that the fair value of a liability for an asset
retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The fair value of the liability is added to the carrying amount of the associated asset and this additional carrying amount
is depreciated over the life of the asset. The Company has various lease properties which leasehold improvements were completed at various times. As of October 31, 2006, the Company has a balance of $0.5 million recorded in Accrued
expenses and other liabilities in the consolidated balance sheets, to return the properties at these sites to their original condition upon lease termination.



Equity Investment



At October 31, 2006, the Company had one equity method investment in a privately held company that is intended to provide strategic technologies and
relationships to the Companys businesses. This privately held company is currently in the development stage. Based on this status, the Company has determined that this equity investment does not require consolidation, as it is not a variable
interest entity. The Companys maximum exposure to loss for this investment at October 31, 2006 is limited to its carrying amount of $0.7 million and a minimum product purchase commitment of approximately $0.9 million by December 31,
2008.



Post-Employment Benefits



Post-employment benefits accrued for workforce reductions related to
restructuring activities initiated in and after October 2004 are accounted for under Statement of Financial Accounting Standards No. 112, Employers Accounting for Post-employment Benefits, (SFAS 112). A liability for
post-employment benefits is recorded when payment is probable, the amount is reasonably estimable, and the obligation relates to rights that have vested or accumulated.



Bank Loan



The bank loan had an annual interest rate of prime (approximately 7.0% at November 2, 2005). The loan had a covenant requiring the Company to
maintain a minimum aggregated balance of cash, cash equivalents, and short and long-term investments of $100.0 million. The bank loan expired and was paid in full in November 2005 and was not renewed.



Other Balance Sheet Components



Prepaid expenses and other current assets consist of the following (in
thousands):



|                                                 |  |             |        |      |   |       
|------------------------------------------------ |  | ----------- | ------ | ---- | - | ------
|                                                 |  | October 31,
|                                                 |  | 2006        |        | 2005
|Short-term lease receivables                     |  | $           | 92     |      | $ | 1,227 
|Receivable from contract equipment manufacturers |  |             | 2,565  |      |   | 4,383 
|Other prepaid expenses                           |  |             | 11,854 |      |   | 12,896
|                                                 |  |             |        |      |   |       
|Total                                            |  | $           | 14,511 |      | $ | 18,506
|                                                 |  |             |        |      |   |       



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Other assets consist of the following (in thousands):



|                            |  |             |        |      |   |       
|--------------------------- |  | ----------- | ------ | ---- | - | ------
|                            |  | October 31,
|                            |  | 2006        |        | 2005
|Long-term lease receivables |  | $           | 314    |      | $ | 3,489 
|Equipment on lease          |  |             | 185    |      |   | 415   
|Field service spares        |  |             | 33,633 |      |   | 30,001
|Product consignment         |  |             | 9,811  |      |   | 16,439
|Other assets                |  |             | 5,129  |      |   | 7,680 
|                            |  |             |        |      |   |       
|Total                       |  | $           | 49,072 |      | $ | 58,024
|                            |  |             |        |      |   |       



Product spare parts
that are used in the Companys service business are classified as other assets and are depreciated using the straight-line method over five years. Amortization expense was approximately $10.9 million, $9.3 and $4.4 million for fiscal years
2006, 2005 and 2004, respectively.



Product consignments to
internal and external customers are classified as other assets and are depreciated using the straight-line method over 18 to 36 months. Amortization expense was approximately $7.9 million, $13.5 and $7.2 million for fiscal years 2006, 2005 and 2004,
respectively.



Accrued expenses and other liabilities consist
of the following (in thousands):



|                                |  |             |        |      |   |       
|------------------------------- |  | ----------- | ------ | ---- | - | ------
|                                |  | October 31,
|                                |  | 2006        |        | 2005
|Accrued distributor commissions |  |             | 2,724  |      |   | 2,010 
|Accrued bonuses                 |  |             | 5,914  |      |   | 5,073 
|Accrued restructuring expenses  |  |             | 8,305  |      |   | 10,178
|Accrued value added taxes       |  |             | 2,602  |      |   | 2,062 
|Accrued interest expense        |  |             | 993    |      |   | 1,238 
|Other accrued liabilities       |  |             | 16,713 |      |   | 19,195
|                                |  |             |        |      |   |       
|                                |  | $           | 37,251 |      | $ | 39,756
|                                |  |             |        |      |   |       



Recent Accounting Pronouncements



In December 2004, the FASB issued Statement of Financial
Accounting Standard No. 153, Exchanges of Non-monetary Assets, (SFAS 153), an amendment of APB Opinion No. 29. SFAS 153 addresses the measurement of exchanges of non-monetary assets and redefines the scope of transactions that
should be measured based on the fair value of the assets exchanged. SFAS 153 was effective for non-monetary asset exchanges beginning in the first quarter of fiscal year 2006. The adoption of SFAS 153 did not have a material effect on the
Companys consolidated financial position or results of operations.



In March 2005, the FASB issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations, (FIN 47) which clarifies that the term conditional asset retirement
obligation as used in Statement of Financial Accounting Standard No. 143, Accounting for Asset Retirement Obligations (SFAS 143), refers to a legal obligation to perform an asset retirement activity in which the timing and/or
method of settlement are conditional on a future event that may or may not be within the control of the entity. However, the obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or
method of settlement. FIN 47 requires that the uncertainty about the timing and/or method of settlement of a conditional



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



asset retirement obligation be factored into the measurement of the liability when sufficient information exists. FIN 47 also clarifies when an entity would
have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. The adoption of FIN 47 in fiscal year 2006 did not
have a material effect on the Companys consolidated financial position or results of operations.



In May 2005, the FASB issued Statement of Financial Accounting Standard No. 154, Accounting Changes and Error Corrections, (SFAS 154)
effective with fiscal years beginning after December 15, 2005 and will only impact the consolidated financial statements in periods in which a change in accounting principle is made. This statement replaces APB Opinion No. 20,
Accounting Changes, and Statement of Financial Accounting Standard No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in
accounting principle. Under this pronouncement changes are required to be retrospectively applied to prior financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change.
Retrospective application means the application of a different accounting principle to prior accounting periods as if that principle had always been used or as the adjustment of previously issued financial statements to reflect a change in the
reporting entity. This statement addresses restatement of previously issued financial statements to reflect the correction of an error. This statement requires that the retrospective application of a change in accounting principle be limited to the
direct effects of the change. This statement also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate affected by a change in accounting
principle. The Company does not believe the adoption of SFAS 154 will have a material effect on its consolidated financial position or results of operations.



On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3 Transition Election Related to Accounting for Tax Effects of
Share-Based Payment Awards (FSP 123(R)-3). We adopted the alternative transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R) in fiscal year 2006. The
alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (APIC pool) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact
on the APIC pool and consolidated statements of cash flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R). The adoption did not have a material impact on the Companys results of
operations and financial condition.



In November 2005, the
Financial Accounting Standards Board (FASB) issued FASB Staff Position FAS 115-1 and 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (FSP 115-1 and 124-1), which provides guidance on
determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other-than-temporary, and on measuring such impairment loss. FSP 115-1 and 124-1 also includes accounting considerations
subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP115-1 is effective for reporting periods beginning
after December 15, 2005. The adoption of FSP 115-1 and 124-1 did not have a material effect on the Companys consolidated financial position or results of operations.



In April 2006, the FASB issued FASB Staff Position No. FIN 46(R)-6 (FSP FIN 46(R)-6), which addresses how a reporting
enterprise should determine the variability to be considered in applying FASB Interpretation No. 46, Consolidation of Variable Interest Entities, as amended (FIN 46(R)). The variability that is considered in applying FIN 46(R)
affects the determination of (a) whether the entity is a variable interest entity, (b) which interests are variable interests in the entity and (c) which party, if any, is the primary beneficiary of the variable



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



interest entity. That variability will affect any calculation of expected losses and expected residual returns, if such a calculation is necessary. FSP FIN
46(R)-6 provides additional guidance to consider for determining variability. FSP FIN 46(R)-6 was effective beginning the fourth quarter of fiscal year 2006. The adoption of FSP FIN 46(R)-6 did not have a material effect on the Companys
financial position, results of operations and cash flows.



In
June 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes, which clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with SFAS
No. 109, Accounting for Income Taxes. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax
return. This interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for fiscal years beginning after December 15,
2006. The Company is currently evaluating the impact of adopting this interpretation.



In September 2006, FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally
accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective for the fiscal year beginning November 1, 2008. The Company is currently evaluating the impact of the provisions of
SFAS 157 on its financial position, results of operations and cash flows and does not believe the impact of the adoption will be material.



In September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plansan
amendment of FASB Statements No. 87, 88, 106 and 132(R), (SFAS 158). FAS 158 requires an employer to recognize the over-funded or under-funded status of a defined benefit pension and other postretirement plan (other than a multiemployer
plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income of a business entity. SFAS 158 is effective for fiscal years
ending after December 15, 2006. The Company is currently evaluating the impact of the provisions of SFAS 158 on its financial position, results of operations and cash flows and does not believe the impact of the adoption will be material.



Note 2Acquisitions



Hypervision, Inc.:



In May 2006, the Company acquired Hypervision, Inc. (Hypervision).
Hypervision designed, developed and manufactured system solutions, which involved emission emiscope and laser signal injection technology. The Company believes that the acquisition of Hypervision enables the Company to provide customers with various
emission microscopy products, supplementing the Companys current diagnostic and characterization products. Under the term of the agreement, the Company agreed to pay Hypervision $4.7 million in cash, of which $3.2 million was paid at closing.
In addition, the Company assumed approximately $1.8 million of liabilities, offset by $1.0 million in assets assumed. The Company has retained the remaining purchase price amount of $1.5 million for possible breach of general representations and
warranties and payment of $1.0 million of the retained amount is due approximately one year after the closing date, and the remaining $0.5 million approximately two years after the closing date in the event no such breach of general representations
or warranties exists. Of the $4.7 million to be paid, approximately $0.5 million was accounted for as goodwill. The goodwill was subsequently written off as part of the goodwill impairment analysis performed by the Company at July 31, 2006. See
Note 3, Goodwill and Other Intangible Assets, for further discussion.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The acquisition was accounted for as a purchase transaction in accordance with Statement of Financial
Accounting Standard No. 141, Business Combination, (SFAS 141), and accordingly, the tangible assets acquired and liabilities assumed were recorded at their estimated fair value at the date of the acquisition. The results of
operations of Hypervision have been included in the Companys financial statements subsequent to the date of acquisition. Pro forma results of operations have not been presented because the effect of the acquisition was not material.



The preliminary purchase price was allocated as follows (in
thousands):



|                                            |  |   |       |  
|------------------------------------------- |  | - | ----- | -
|Goodwill                                    |  | $ | 479   |  
|Developed technology                        |  |   | 3,700 |  
|Customer relationship                       |  |   | 1,400 |  
|Liabilities assumed, net of assets acquired |  |   | (813  | )
|                                            |  |   |       |  
|Total purchase price                        |  | $ | 4,766 |  
|                                            |  |   |       |  



The developed
technology will be amortized on a straight-line basis over a three-year period. The customer relationship will be amortized on a straight-line basis over an eight-year period.



NPTest Holding Corporation:



In May 2004, the Company acquired 100% of the outstanding common stock of NPTest Holding Corporation (NPTest), a company that designed, developed and
manufactured advanced semiconductor test and diagnostic systems and provided related services for the semiconductor industry. The addition of NPTest expands the Companys customer base and enables the Company to provide customers with a broader
portfolio of solutions. The acquisition resulted in a total cash payment to shareholders of NPTest of approximately $230 million and the right to receive approximately 32 million shares of the Companys common stock, including the assumed
conversion of 203,036 shares of the Companys preferred stock at a conversion ratio of 100 to 1, with an aggregate fair value at the acquisition date of approximately $376.5 million. As of the end of fiscal year 2005, all of the 32 million
shares were issued and outstanding as common stock. In fiscal year 2004, the former majority shareholder of NPTest converted 79,754 shares of the Companys non-voting convertible preferred stock into 7,975,400 shares of the Companys
common stock. During fiscal year 2005, the remaining 123,282 shares of the preferred stock were converted into approximately 12,328,200 shares of common stock. The common stock issued in the acquisition was valued using the average closing price of
the Companys common stock over a five-day trading period beginning two days before and ending two days after the date the transaction was announced. The Company also assumed all of the outstanding NPTest stock options with a fair value of
approximately $38.1 million. The options were valued using the Black-Scholes-Merton options pricing model with the following assumptions: dividend of $0, volatility of 0.77, expected life of 6.35 years, risk-free interest rate of 3.45% and a market
value of the Companys common stock of $11.77 per share, which was determined as described above. The Company also incurred direct costs associated with the acquisition of approximately $5.9 million. Below is a summary of the total purchase
price (in thousands):



|                           |  |   |        
|-------------------------- |  | - | -------
|Cash                       |  | $ | 229,950
|Common and preferred stock |  |   | 376,514
|Outstanding stock options  |  |   | 38,108 
|Direct acquisition costs   |  |   | 5,910  
|                           |  |   |        
|Total purchase price       |  | $ | 650,482
|                           |  |   |        



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The purchase price of NPTest was negotiated during a period in which market valuations of
semiconductor capital equipment companies, and semiconductor test equipment companies in particular, had increased significantly due to favorable net sales and operating results. For example, the market value of the Companys stock had
increased from a low of $6.44 per share in March 2003 to a value of $15.00 per share on January 15, 2004, the date the Company negotiated transaction terms with representatives of NPTest. Market valuations of the Companys competitors
similarly had risen significantly during this period. In addition, NPTest was the subject of an acquisition proposal by a Company competitor during the acquisition negotiations which contributed to the purchase price negotiated by the
parties. Furthermore, the Company received from its financial advisor an opinion as to the fairness, from a financial point of view, of the consideration to be paid by the Company to the holders of NPTest common stock in the merger. Such
advisor informed the Company that, as of such date, and based upon and subject to the assumptions, limitations and qualifications set forth in its written opinion, the consideration to be paid by the Company to the holders of NPTest common stock in
the merger was fair.



The majority owner of NPTest, who owned
approximately 63% of NPTests common stock, received 203,036 shares of non-voting convertible preferred stock of the Company as a result of the acquisition. Each share of NPTest common stock held by this majority owner was exchanged for 0.008
of a share of the Companys non-voting convertible stock. Each share of the non-voting convertible stock was convertible into 100 shares of the Companys common stock. The non-voting convertible stock was identical in all respects to the
Companys common stock except that, prior to conversion, it had no voting rights, but had a liquidation preference of $0.001 per share. The non-voting convertible stock is classified as preferred stock. During fiscal year 2005, the majority
owner converted all of the 203,036 shares of the Companys non-voting convertible preferred stock into 20,303,600 shares of the Companys common stock.



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In accordance with Statement of Financial Accounting Standard No. 141, Business
Combinations, (SFAS 141), the purchase was accounted for as a purchase transaction and the Company has included in its results of operations, for the fiscal year ended October 31, 2004, the result of NPTest beginning on May 29, 2004.
The Company allocated the purchase price to the tangible and intangible assets acquired, including in-process research and development, and liabilities assumed based on their estimated fair values, and to deferred stock compensation. The excess
purchase price over those fair values was recorded as goodwill. The fair value assigned to tangible and intangible assets acquired and liabilities assumed were based on estimates and assumptions provided by management, and other information compiled
by management, including valuations that utilize established valuation techniques appropriate for the high technology industry. Goodwill recorded as a result of these acquisitions is not expected to be deductible for tax purposes. In accordance with
Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, (SFAS 142), goodwill and purchased intangible assets with indefinite lives are not amortized but reviewed at least annually for impairment.
Purchased intangible assets with finite lives will be amortized on a straight-line basis over their respective estimated useful lives. The total purchase price has been allocated as follows (in thousands, except years):



|                                                |  |        |         |   |                     |   |                      |  |     
|----------------------------------------------- |  | ------ | ------- | - | ------------------- | - | -------------------- |  | ----
|                                                |  | Amount |         |   | Annual Amortization |   | Useful Lives (Years)
|Purchase Price Allocation:                      |  |        |         |   |                     |   |                      |  |     
|Net tangible assets assumed                     |  | $      | 175,552 |   |                     | $ |                     |  |    
|Intangible assets acquired:                     |  |        |         |   |                     |   |                      |  |     
|Developed technology                            |  |        | 70,300  |   |                     |   | 7,030                |  | 10  
|Maintenance agreements                          |  |        | 13,800  |   |                     |   | 2,760                |  | 5   
|Customer relationships                          |  |        | 12,100  |   |                     |   | 1,729                |  | 7   
|Product backlog                                 |  |        | 4,900   |   |                     |   | 4,900                |  | 1   
|                                                |  |        |         |   |                     |   |                      |  |     
|Total amortizable intangible assets             |  |        | 101,100 |   |                     |   | 16,419               |  |    
|In-process research and development             |  |        | 7,900   |   |                     |   |                     |  |    
|Deferred compensation on unvested stock options |  |        | 9,967   |   |                     |   | 3,067                |  | 3.25
|Deferred tax                                    |  |        | (29,362 | ) |                     |   |                     |  |    
|Goodwill                                        |  |        | 385,325 |   |                     |   |                     |  |    
|                                                |  |        |         |   |                     |   |                      |  |     
|Total purchase price                            |  | $      | 650,482 |   |                     | $ | 19,486               |  |     
|                                                |  |        |         |   |                     |   |                      |  |     



The purchase price
allocation changed by $0.7 million during the fiscal year 2006 due to the write down of other accrued expenses and liabilities related to relocation charges, estimated sublease proceeds from the Simi Valley facility and early termination of a lease.
The purchase price allocation changed by $1.1 million during the fiscal year 2005, primarily due to additional accrued expenses and liabilities recognized. The write up of additional accrued liabilities of $1.1 million during the fiscal year 2005
consisted of $1.7 million that pertained to severance and related charges, $1.0 million for the Simi Valley facility clean-up costs, and relocation and other charges of approximately $0.5 million for the Simi Valley facility, offset by $2.1 million
write-down of accrued liabilities related to pre-acquisition costs and other liabilities. These amounts were credited to goodwill in accordance with EITF Issue No. 95-3, Recognition of Liabilities in Connection with Purchase Business
Combinations (EITF Issue 95-3).



Net Tangible Assets



NPTests assets and liabilities as of May 28,
2004 were reviewed and adjusted, if necessary, to their fair value. Reserves and allowances were reviewed for appropriateness and approved by management. Management also reviewed the liabilities to ensure that the proper value was recorded based on
estimates at that date.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



In November 2004, the Board of Directors approved moving forward with a major component of
managements original integration plan, which involved closing the Simi Valley, California facility and moving all manufacturing activities at this site to Hillsboro, Oregon. As a part of the approved plan, during the fiscal year 2005, the
Company accrued charges related to the approved plan of $3.8 million. Of the total charges, severance and related charges for 100 employees accounted for $2.1 million, facilities leasehold restoration costs of $1.1 million and relocation expenses of
$0.6 million. The Company recognized these costs in accordance with EITF 95-3. The related facility lease charges will be paid through the end of the lease terms, which extend through June 2008, of which the majority of the payment related to the
Simi Valley facility, which ends in January 2007. As of October 31, 2006, $0.3 million remained to be paid for these charges. The following table illustrates the charges and the estimated timing of future payouts at October 31, 2006 (in
thousands):



|                                    |  |                             |        |   |         |   |          |  |             |       |                             |   |     |  |   |      |  
|----------------------------------- |  | --------------------------- | ------ | - | ------- | - | -------- |  | ----------- | ----- | --------------------------- | - | --- |  | - | ---- | -
|                                    |  | Balance at October 31, 2005 |        |   | Charges |   | Utilized |  | Adjustments |       | Balance at October 31, 2006 |  
|Severance                           |  | $                           | (231   | ) |         | $ |         |  | $           | 154   |                             | $ | 77  |  | $ |     |  
|Facilities                          |  |                             | (2,348 | ) |         |   |         |  |             | 1,506 |                             |   | 575 |  |   | (267 | )
|Relocation                          |  |                             | (182   | ) |         |   |         |  |             | 26    |                             |   | 156 |  |   |     |  
|                                    |  |                             |        |   |         |   |          |  |             |       |                             |   |     |  |   |      |  
|Total                               |  | $                           | (2,761 | ) |         | $ |         |  | $           | 1,686 |                             | $ | 808 |  | $ | (267 | )
|                                    |  |                             |        |   |         |   |          |  |             |       |                             |   |     |  |   |      |  
|Estimated timing of future payouts: |  |                             |        |   |         |   |          |  |             |       |                             |   |     |  |   |      |  
|Fiscal 2007                         |  |                             |        |   |         |   |          |  |             |       |                             |   |     |  | $ | 217  |  
|Fiscal 2008                         |  |                             |        |   |         |   |          |  |             |       |                             |   |     |  | $ | 50   |  
|                                    |  |                             |        |   |         |   |          |  |             |       |                             |   |     |  |   |      |  
|Total                               |  |                             |        |   |         |   |          |  |             |       |                             |   |     |  | $ | 267  |  
|                                    |  |                             |        |   |         |   |          |  |             |       |                             |   |     |  |   |      |  



As a result of the
NPTest acquisition, the Company was required to make a payment to Schlumberger Limited (Schlumberger), the former parent of NPTest, at a date in the future pursuant to a provision in the acquisition agreement between NPTest and Schlumberger under
which NPTest was acquired by Francisco Partners, L.P. from Schlumberger. The future payment date could have been triggered by various events, including certain distributions by NPTest Holding, LLC (an entity controlled by Francisco Partners, L.P.)
to its members, or, at Schlumbergers option, it could have been triggered on May 28, 2005. The payment amount was contingent upon the value of the Companys common stock at the time of distribution. If payment was triggered at
Schlumbergers option, the Company could have generally settled this payment in cash or stock. If payment was triggered by a distribution by NPTest Holding, LLC to its members, the payment to Schlumberger was required to be in the same form and
could have been made in cash, stock or both. This contingent liability was required to be marked to market at the end of each fiscal period until settled using the Companys closing stock price on the last day of the fiscal period, and the
changes in carrying value flow through other income and expense, net in the condensed consolidated statements of operations. In May 2005, the Company and Schlumberger reached a settlement, which required the Company to pay Schlumberger $4.0 million
in cash and 615,157 shares of the Companys common stock valued at $5.0 million. According to this settlement, the Company had fulfilled its obligation to Schlumberger and there were no outstanding liabilities related to this transaction at the
end of fiscal year 2005.



Amortizable Intangible Assets



Developed technology consists of products that have
reached technological feasibility. Developed technology was valued using the discounting forecasted cash flow (DCF) method. This method calculates the value of the intangible asset as being the net present value of the after tax cash flows
potentially attributable to it. The Company amortizes the fair value of the developed technology on a straight-line basis over the remaining estimated useful life of ten years.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Maintenance agreements represent the revenue generated by contracts with customers who pay for annual
maintenance and support. The DCF method was used to value the maintenance contracts, which includes estimating the beginning balance of customer service agreements, expected contract renewal rates, specific cost of sales estimates, and estimated
general and administrative costs. The Company amortizes the fair value of the maintenance agreements on a straight-line basis over the remaining estimated useful life of five years.



Customer relationships represent the value of the installed base of NPTests products and the relationships developed
over time with those customers. The customer relationships were valued using an income approach, which takes into account the loss of revenue if the existing customer relationships were not in place, and also the cost required to identify, pursue,
and secure the existing customer relationships. The Company amortizes the fair value of the customer relationships on a straight-line basis over the remaining estimated useful life of seven years.



Product backlog represents the value of the standing orders for products. The
product backlog was valued using the DCF method, which accounts for the expected profit related to the existing firm purchase orders in place at the time of acquisition. The Company amortizes the fair value of the product backlog on a straight-line
basis over the remaining estimated useful life of one year.



In-process Research and Development



In-process research and development (IPR&D) represents projects that have not reached technological feasibility and which have no alternative future use. Technological feasibility is determined when a product reaches the beta-phase, and
there is no remaining risk relating to the development. At the time of acquisition, NPTest had multiple IPR&D efforts under way for current product lines. These efforts included developing the next generation of the Sapphire product and OptiFIB
product. The Company utilized the DCF method to value the IPR&D, using discount rates ranging from 19% to 21%, depending on the estimated useful life of the technology. To determine the value of the technology in the development stage, the
Company considered, among other factors, the stage of development of each project, the time and resources needed to complete each project, expected income and associated risks. Associated risks included the inherent difficulties and uncertainties in
completing the project and thereby achieving technological feasibility, and the risks related to the viability of and potential changes to future target markets. In applying the DCF method, the analysis resulted in $7.9 million of the purchase price
being charged to acquired IPR&D. The next generation Sapphire and OptiFIB product were launched in 2005.



Deferred Compensation



Unvested stock options valued at approximately $10.0 million at the time of the NPTest acquisition have been allocated to deferred compensation in the
purchase price allocation and are being amortized to expense using the straight-line vesting method. The portion of the purchase price allocated to deferred compensation cost was based on the portion of the intrinsic value at the consummation date
related to the future vesting period. Options assumed in conjunction with the acquisition had exercise prices ranging from $5.86 to $13.56 per share, with a weighted-average exercise price of $6.71 per share and a weighted average remaining
contractual life of approximately 9.25 years. The Company is amortizing the fair value of the deferred compensation on a straight-line basis over the remaining vesting period of approximately 3.25 years. The Company assumed approximately
4.1 million stock options. Upon the adoption of SFAS 123(R), deferred compensation balance as of November 1, 2005 was reclassified and amortization ceased.



Pro Forma Results



The following pro forma financial information presents the combined results of operations of the Company and NPTest as if the acquisition had occurred as
of the beginning of the periods presented. Certain adjustments to



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



reflect charges to cost of goods sold for inventory and property and equipment write-up, charges to operating expense for the amortization of the intangible
assets, IPR&D, deferred compensation, restructuring charges, elimination of amortization associated with intangible assets previously acquired by NPTest, reduction of the investment income due to lower cash and investment balances due to the
cash used to pay for the acquisition, reduction of NPTest income tax benefits and inclusion of the gain on the Schlumbergers liability adjustment of $20.4 million and $85.0 million have been made to the combined results of operations for the
fiscal year ended October 31, 2004 and 2003, respectively. The unaudited pro forma financial information is not intended to represent or be indicative of the consolidated results of operations or financial condition of the Company that would
have been reported had the acquisition been completed as of the dates presented, and should not be taken as representative of the future consolidated results of operations or financial condition of the Company.



|                                         |  |                                   |         |  
|---------------------------------------- |  | --------------------------------- | ------- | -
|(in thousands, except per share amounts) |  | Fiscal Year EndedOctober 31, 2004 |        
|Net sales                                |  | $                                 | 553,454 |  
|Net loss                                 |  |                                   | (85,034 | )
|Basic net loss per share                 |  | $                                 | (0.95   | )
|                                         |  |                                   |         |  
|Diluted net loss per share               |  | $                                 | (0.95   | )
|                                         |  |                                   |         |  



The pro forma
financial information above includes the following material, non-recurring charges for all periods presented (in thousands):



|                                                              |  |   |       
|------------------------------------------------------------- |  | - | ------
|Cost of goods sold from inventory write-up                    |  | $ | 14,567
|Amortization of the product backlog intangible asset          |  | $ | 4,900 
|In-process research and development                           |  | $ | 7,900 
|Special cost of goods sold chargesdiscontinued product lines |  | $ | 49,565
|Restructuring charges                                         |  | $ | 6,309 
|Integration costs                                             |  | $ | 1,849 



The pro forma
information above for the fiscal year ended October 31, 2004 excluded the impact of material, non-recurring charges related to the acquisition of NPTest Inc. from Schlumberger by NPTest Holding Corporation, which was incorporated by Francisco
Partners, and the initial public offering effect on NPTest. Those charges include, among others, 1) the amortization of intangible assets, 2) amortization of tangible assets written up to fair value, 3) indirect costs associated with its initial
public offering such as preferred stock dividends, annual advisory fees to Francisco Partners and interest expense on the senior debt, and 4) the tax effect associated with excluding these charges which net to a gain of $69.9 million.



CredenceSZ GmbH:



In February 2004, the Company acquired all of the outstanding stock of
Credence-SZ GmbH (SZ GmbH) for approximately $649,000 in cash, and thereafter merged SZ GmbH with and into Credence-SZ System GmbH, a wholly-owned subsidiary of the Company. Of the $649,000 paid, approximately $537,000 was accounted for as goodwill
and included in the Companys consolidated balance sheet at October 31, 2004. SZ GmbH was the employer of the employees that were contracted to Credence-SZ System GmbH. Credence-SZ System GmbH is based in Amerang, Germany, with
approximately 135 employees and is managed within the Companys Mobile Products Group. The acquisition was accounted for as a purchase transaction in accordance with SFAS 141, and accordingly, the assets acquired and liabilities assumed were
recorded at their estimated fair value at the date of the acquisition. Pro forma results of operations have not been presented because the effect of the acquisition was not material.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Note 3Goodwill and Other Intangible Assets



Goodwill Impairment



Effective November 1, 2002, the Company adopted Statement of Financial
Accounting Standard No. 142, Goodwill and Other Intangible Assets, (SFAS 142), which was issued by the FASB in July 2001. Under this standard, the Company ceased amortizing goodwill effective November 1, 2002.



SFAS 142 makes use of the concept of reporting units. All acquisitions must
be assigned to a reporting unit or units. Reporting units have been defined under the standards to be the same as or one level below an operating segment, as defined in Statement of Financial Accounting Standard No. 131, Disclosures About
Segments of an Enterprise and Related Information, (SFAS 131). A reporting unit would be one level below the operating segment if a component of an operating segment is a business as described under United States Generally Accepted Accounting
Principles and (1) is a separable unit that engages in business activities for which discrete financial information is available, (2) has economic characteristics different from other components of the operating segment, and
(3) operating results of the component are reviewed regularly by the segment manager. The Company operates in one industry segment, advanced semiconductor test and diagnostic systems. The Company also has a single reporting unit for purposes of
SFAS 142, automated test equipment (ATE), primarily because all of the Companys ATE operations are subject to similar economic characteristics. In addition, all the Companys products have common production processes, customers, and
product life cycles.



The Company tests goodwill for possible
impairment on an annual basis and at any other time if events occur or circumstances indicate that the carrying amount of goodwill may not be recoverable. Circumstances that could trigger an impairment test include but are not limited to: a
significant adverse change in the business climate or legal factors; unanticipated competition; loss of key personnel, a significant change in direction with respect to investment in a product or market segment; the likelihood that a significant
portion of the business will be sold or disposed of; or the results of testing for recoverability of a significant asset group within a reporting unit determined in accordance with SFAS 142.



The impairment test for goodwill involves a two-step process: step one
consists of a comparison of the fair value of a reporting unit with its carrying amount, including the goodwill allocated to each reporting unit. If the carrying amount is in excess of the fair value, step two requires the comparison of the implied
fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill. Any excess of the carrying value of the reporting unit goodwill over the implied fair value of the reporting unit goodwill will be recorded as an
impairment loss.



The determination as to whether a write-down
of goodwill is necessary involves significant judgment based on short-term and long-term projections of the Company. The assumptions supporting the estimated future cash flows of the reporting unit, including profit margins, long-term forecasts of
the amounts and timing of overall market growth and the Companys percentage of that market, discount rates and terminal growth rates, reflect the Companys best estimates.



As mandated by SFAS 142, the Company completed its annual goodwill impairment test as of July 31, 2005 during the
fourth quarter of the 2005 fiscal year. The Company determined that, based on market capitalization and on the test which indicated that the sum of the expected future discounted cash flows from the assets exceeded the carrying value of those
assets, the goodwill was not impaired.



Based on a combination
of factors that came into existence and were identified during the third quarter of fiscal 2006, particularly: (1) the Companys changed current and projected operating results reflecting lower demand from major customers; and (2) the
Companys current market capitalization which was significantly less than its book value for the preceding 10 weeks prior to the end of the third quarter, the Company concluded there



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were sufficient indicators to require it to assess whether any portion of its recorded goodwill balance was impaired. The Company determined, based on its
estimates of forecasted discounted cash flows and its market capitalization, that its goodwill was impaired at July 31, 2006. Further analysis indicated that the entire balance of goodwill was impaired and an impairment charge of $423.9 million
was recorded in the third quarter of fiscal 2006. Other long-lived assets were assessed for impairment prior to the performance of the SFAS 142 analysis and were determined not to be impaired.



The Company performed the first step of the interim SFAS 142 analysis,
consisting of a comparison of the fair value of the reporting unit with its carrying amount, including the goodwill. The fair value was determined based on a combination of the Income Approach, which estimates the fair value based on the future
discounted cash flows, and Market Approach, which estimates the fair value based on market prices of comparable companies. Under the Income Approach, the Company assumed a forecasted cash flow period of 5 years, long-term annual growth rates of
0% to 12%, a discount rate of 20% and terminal value growth rates of 5%. The Company also considered its total market capitalization as of July 31, 2006, and its average market capitalization for the quarter in order to assess volatility of its
market capitalization on that day. Based on the first step analysis, the Company determined that the carrying amount was in excess of its fair value. As such, the Company was required to perform the second step analysis to determine the amount of
the impairment loss. The second step analysis consisted of comparing the implied fair value of the goodwill with the carrying amount of the goodwill, with an impairment charge resulting from any excess of the carrying value of the goodwill over the
implied fair value of the goodwill based on a hypothetical allocation of the estimated fair value of the Company to the Companys tangible and intangible assets (other than goodwill). Based on the second step analysis, the Company concluded
that all of its recorded goodwill ($423.9 million) was impaired and as such recorded a noncash charge to continuing operations during the third quarter of fiscal year 2006.



Other Acquisition-Related Intangible Assets Impairment



As of November 1, 2002, the Company adopted Statements of Financial Accounting Standards No. 144 Accounting
for the Impairment or Disposal of Long-Lived Assets, (SFAS 144).



Prior to assessing goodwill for impairment, the Company evaluates the carrying value of its long-lived assets, consisting primarily of its facilities, purchased intangible assets, and property and equipment, in accordance with SFAS 144,
Accounting for the Impairment or Disposal for Long-Lived Assets, whenever certain events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Such events or circumstances include, but are
not limited to, a prolonged industry downturn, a significant decline in the Companys market value, or significant reductions in projected future cash flows. In assessing the recoverability of the Companys long-lived assets, the Company
compares the carrying value to the undiscounted future cash flows the assets are expected to generate. If the total of the undiscounted future cash flows is less than the carrying amount of the assets, such assets are written down based on the
excess of the carrying amount over the fair value of the assets. Fair value is generally determined by calculating the discounted future cash flows using a discount rate based upon the Companys weighted average cost of capital. Significant
judgments and assumptions are required in the forecast of future operating results used in the preparation of the estimated future cash flows, including profit margins, long-term forecasts of the amounts and timing of overall market growth and the
Companys percentage of that market, groupings of assets, discount rates and terminal growth rates. In addition, significant estimates and assumptions are required in the determination of the fair value of the Companys tangible long-lived
assets, including replacement cost, economic obsolescence, and the value that could be realized in liquidation. Changes in these estimates could have a material adverse effect on the assessment of the Companys long-lived assets, thereby
requiring the Company to write down the assets. The purchased intangibles consist of purchased technology, customer relations, trademarks, patents and non-compete agreements and they typically have estimated useful lives of one to ten years.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Based on the considerations outlined in the previous discussion on goodwill, in July 2006, the
Company also concluded that sufficient indicators existed to require it to perform an analysis to assess whether a portion of its other acquisition-related intangible assets was impaired. This analysis differs from the goodwill analysis in that an
impairment is only deemed to have occurred if the sum of the forecasted undiscounted future cash flows related to the asset are less than the carrying value of the intangible asset being tested for impairment. Since the forecasted cash flows
exceeded the carrying value, the Company concluded that there was no impairment to its long-lived assets at October 31, 2006.



In the quarter ended July 31, 2003, in accordance with SFAS No. 144, the Company accelerated the depreciation for leasehold improvements related
to buildings located in Fremont, California that the Company vacated in the first quarter of fiscal 2004 when the Company moved to its new headquarters in Milpitas, California. The amount of the accelerated depreciation related to these leasehold
improvements was approximately $1.7 million and was recognized over nine months ended January 31, 2004. In the first quarter of fiscal 2005, the Company began to accelerate the depreciation for leasehold improvements related to the San Jose and
Simi Valley, California buildings as part of the facilities consolidations. The amount of the accelerated depreciation related to these leasehold improvements was approximately $1.4 million and was recognized through May 2005. Accelerated
depreciation related to the leasehold improvements was recorded in operating expenses.



Note 4Restructuring Charges



During
previous years, the Company has recorded restructuring charges as it rationalized operations in light of customer demand declines and economic downturns. The measures, which included reducing the workforce, consolidating facilities and changing the
strategic focus of a number of sites, was largely intended to align the Companys capacity and infrastructure to anticipated customer demand and transition its operations for higher utilization of facility space. The restructuring charges
include employee severance and benefit costs, and costs related to leased facilities vacated, net of estimated sublease income. Severance and benefit costs and other costs associated with restructuring activities were recorded in compliance with
Statement of Financial Accounting Standard No. 146, Accounting for Costs Associated with Exit or Disposal Activities, (SFAS 146). During October 2004, the Company also adopted Statement of Financial Accounting Standard No. 112,
Employers Accounting for Post Employment Benefits, (SFAS 112), for severance and benefit costs as the Company concluded that (a) the Company has a substantive post employment benefit obligation that is attributed to prior
services rendered, (b) rights to those benefits have vested, and (c) payment is probable and the amount can be reasonably estimated. This accounting for restructuring costs requires the Company to record provisions and charges when it has
a formal and committed restructuring plan.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The following tables illustrate the restructuring cost activity for the year ended October 31,
2006 and the estimated timing of future payouts for the major restructuring categories (in thousands):



|                                    |  |                             |         |   |         |   |         |          |  |             |        |                             |   |     |  |   |         |  
|----------------------------------- |  | --------------------------- | ------- | - | ------- | - | ------- | -------- |  | ----------- | ------ | --------------------------- | - | --- |  | - | ------- | -
|                                    |  | Balance at October 31, 2005 |         |   | Charges |   |         | Utilized |  | Adjustments |        | Balance at October 31, 2006 |  
|Severance                           |  | $                           | (2,892  | ) |         | $ | (10,106 | )        |  | $           | 7,562  |                             | $ | 377 |  | $ | (5,059  | )
|Operating leases                    |  |                             | (10,415 | ) |         |   | (628    | )        |  |             | 5,288  |                             |   | 231 |  |   | (5,524  | )
|Other liabilities                   |  |                             | (1,369  | ) |         |   | (895    | )        |  |             | 2,245  |                             |   | 19  |  |   |        |  
|                                    |  |                             |         |   |         |   |         |          |  |             |        |                             |   |     |  |   |         |  
|Total                               |  | $                           | (14,676 | ) |         | $ | (11,629 | )        |  | $           | 15,095 |                             | $ | 627 |  | $ | (10,583 | )
|                                    |  |                             |         |   |         |   |         |          |  |             |        |                             |   |     |  |   |         |  
|Estimated timing of future payouts: |  |                             |         |   |         |   |         |          |  |             |        |                             |   |     |  |   |         |  
|Fiscal year 2007                    |  |                             |         |   |         |   |         |          |  |             |        |                             |   |     |  | $ | 8,088   |  
|Fiscal year 2008                    |  |                             |         |   |         |   |         |          |  |             |        |                             |   |     |  |   | 1,246   |  
|Fiscal year 2009                    |  |                             |         |   |         |   |         |          |  |             |        |                             |   |     |  |   | 1,249   |  
|                                    |  |                             |         |   |         |   |         |          |  |             |        |                             |   |     |  |   |         |  
|Total                               |  |                             |         |   |         |   |         |          |  |             |        |                             |   |     |  | $ | 10,583  |  
|                                    |  |                             |         |   |         |   |         |          |  |             |        |                             |   |     |  |   |         |  



During the fiscal year
2006, the Company recorded the following activity related to restructuring charges:



| |  |  | The severance and other related charges amounted to $9.7 million, which accounted for headcount reduction of approximately 270 employees. The affected employees were across all
business functions and throughout the world.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The property and equipment write off, amounting to $0.2 million, resulted from the Companys decision to discontinue its memory product.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The operating lease charges of $0.4 million resulted from vacating facilities related to the memory product.
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | Other liabilities of $0.7 million which represents cancellation fees of early termination of certain outsourcing contracts related to the memory product.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



In July 2006, the Company entered into a lease buyout agreement with the
landlord for the vacant San Jose building. The agreement terminated the initial lease arrangement whereby the Company would occupy and pay for the space through 2009. According to the terms of the agreement, the Company will pay $8.0 million over a
three years period of which $2.0 million was paid in early August 2006.



The following tables illustrate the restructuring cost activity for the year ended October 31, 2005 for the major restructuring categories (in thousands):



|                        |  |                             |        |   |         |   |         |          |  |   |             |   |  |                             |     |   |  |   |         |  
|----------------------- |  | --------------------------- | ------ | - | ------- | - | ------- | -------- |  | - | ----------- | - |  | --------------------------- | --- | - |  | - | ------- | -
|                        |  | Balance at October 31, 2004 |        |   | Charges |   |         | Utilized |  |   | Adjustments |   |  | Balance at October 31, 2005 |    
|Severance               |  | $                           | (3,019 | ) |         | $ | (4,958  | )        |  | $ | 4,467       |   |  | $                           | 618 |   |  | $ | (2,892  | )
|Operating leases        |  |                             | (1,043 | ) |         |   | (11,474 | )        |  |   | 2,146       |   |  |                             | (44 | ) |  |   | (10,415 | )
|Deferred rent write-off |  |                             |       |   |         |   | 709     |          |  |   | (709        | ) |  |                             |    |   |  |   |        |  
|Property and equipment  |  |                             |       |   |         |   | (1,089  | )        |  |   | 1,089       |   |  |                             |    |   |  |   |        |  
|Other liabilities       |  |                             | (32    | ) |         |   | (1,399  | )        |  |   | 30          |   |  |                             | 32  |   |  |   | (1,369  | )
|                        |  |                             |        |   |         |   |         |          |  |   |             |   |  |                             |     |   |  |   |         |  
|Total                   |  | $                           | (4,094 | ) |         | $ | (18,211 | )        |  | $ | 7,023       |   |  | $                           | 606 |   |  | $ | (14,676 | )
|                        |  |                             |        |   |         |   |         |          |  |   |             |   |  |                             |     |   |  |   |         |  



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



During the fiscal year 2005, the Company recorded the following activity related to restructuring
charges:



| |  |  | The severance and other related charges amounted to $5.0 million, which accounted for headcount reduction of 110 employees. Of the $5.0 million, the amount recorded under FAS 112 at
October 31, 2005 was $1.5 million. The affected employees were primarily in research and development and selling general and administrative functions throughout the world.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The property and equipment write off, amounting to $1.1 million, resulted from the Companys decision to halt additional research and development investment in one of its
products that was rendered redundant by the acquisition of NPTest.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The operating lease charges of $11.5 million, which are net of expected sublease rentals, resulted from vacating the former NPTest headquarters facilities in San Jose. The lease on
these facilities expires in October 2009.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Other liabilities of $1.4 million which represents cancellation fees of early termination of certain outsourcing contracts.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



Note 5Commitments and Contingencies



The Company leases some of its facilities and equipment under operating
leases that expire periodically through 2013 of which approximately $0.3 million, $11.5 million, and $0.7 million have been written off to operating expenses during fiscal years 2006, 2005 and 2004, respectively.



The future minimum lease payments at October 31, 2006 are as follows (in
thousands):



|           |  |                                |       |                                             |   |                                    |  |   |      
|---------- |  | ------------------------------ | ----- | ------------------------------------------- | - | ---------------------------------- |  | - | -----
|           |  | Committed Gross Lease Payments |       | Leases Written Off in Restructuring Charges |   | Net Estimated Future Lease Expense
|2007       |  | $                              | 3,160 |                                             | $ | 277                                |  | $ | 2,883
|2008       |  |                                | 1,805 |                                             |   | 50                                 |  |   | 1,755
|2009       |  |                                | 1,274 |                                             |   |                                   |  |   | 1,274
|2010       |  |                                | 487   |                                             |   |                                   |  |   | 487  
|2011       |  |                                | 264   |                                             |   |                                   |  |   | 264  
|Thereafter |  |                                | 440   |                                             |   |                                   |  |   | 440  
|           |  |                                |       |                                             |   |                                    |  |   |      
|           |  | $                              | 7,430 |                                             | $ | 327                                |  | $ | 7,103
|           |  |                                |       |                                             |   |                                    |  |   |      



Some of the components
that the Company purchases are unique to the Company and must be purchased in relatively high minimum quantities with long (four and five month) lead times. These business circumstances can lead to the Company holding relatively high inventory
levels and associated risks. In addition, purchase commitments for unique components are relatively inflexible in terms of deferral or cancellation. At October 31, 2006, the Company has open and committed non-cancelable purchase orders totaling
approximately $71.4 million.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The following summarizes the Companys minimum contractual cash obligations and other
commitments at October 31, 2006, and the effect of such obligations in future periods (in thousands):



|                                                          |  |       |         |      |   |        |  |      |         |      |   |       |  |            |     |  |   |     |  |   |    
|--------------------------------------------------------- |  | ----- | ------- | ---- | - | ------ |  | ---- | ------- | ---- | - | ----- |  | ---------- | --- |  | - | --- |  | - | ---
|                                                          |  | Total |         | 2007 |   | 2008   |  | 2009 |         | 2010 |   | 2011  |  | Thereafter
|Contractual Obligations:                                  |  |       |         |      |   |        |  |      |         |      |   |       |  |            |     |  |   |     |  |   |    
|Facilities and equipment operating leases (1)             |  | $     | 7,430   |      | $ | 3,160  |  | $    | 1,805   |      | $ | 1,274 |  | $          | 487 |  | $ | 264 |  | $ | 440
|Convertible subordinated notes (2)                        |  |       | 145,000 |      |   |       |  |      | 145,000 |      |   |      |  |            |    |  |   |    |  |   |   
|Interest on convertible subordinated notes                |  |       | 3,353   |      |   | 2,175  |  |      | 1,178   |      |   |      |  |            |    |  |   |    |  |   |   
|Minimum commitment under Technology Development Agreement |  |       | 940     |      |   | 940    |  |      |        |      |   |      |  |            |    |  |   |    |  |   |   
|Open non-cancelable purchase order commitments            |  |       | 71,352  |      |   | 68,405 |  |      | 2,854   |      |   | 93    |  |            |    |  |   |    |  |   |   
|                                                          |  |       |         |      |   |        |  |      |         |      |   |       |  |            |     |  |   |     |  |   |    
|Total contractual cash and other obligations              |  | $     | 228,075 |      | $ | 74,680 |  | $    | 150,837 |      | $ | 1,367 |  | $          | 487 |  | $ | 264 |  | $ | 440
|                                                          |  |       |         |      |   |        |  |      |         |      |   |       |  |            |     |  |   |     |  |   |    

---

|(1) | Approximately $0.3 million of this total has been accrued for as restructuring charge in the consolidated balance sheets as accrued expenses and other liabilities.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | This amount is recorded on the consolidated balance sheets as convertible subordinated notes.
|--- | ---------------------------------------------------------------------------------------------



Rent expense was approximately $3.3 million, $6.2 million, and $4.6 million for the years ended October 31, 2006, 2005,
and 2004, respectively.



The contractual cash obligations and
commitments table presented above contains the Companys minimum obligations at October 31, 2006 under these arrangements and others. Actual expenditures will vary based on the volume of transactions and length of contractual service
provided. In addition to minimum spending commitments, certain of these arrangements provide for potential cancellation charges.



There were no material commitments for capital expenditures at October 31, 2006.



The Company warrants its products to its customers generally for one year from the date of shipment. The Company provides
reserves for the estimated costs of product warranties at the time revenue is recognized. The Company estimates the costs of warranty obligations based on historical experience of known product failure rates, use of materials to repair or replace
defective products and service delivery costs incurred in correcting product failures.



The following table represents the activity in the warranty accrual for the twelve months ended October 31, 2006 and 2005 (in thousands):



|                                                      |  |                                |         |   |      |   |         |  
|----------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------- | -
|                                                      |  | For the year ended October 31, |        
|                                                      |  | 2006                           |         |   | 2005 |  
|Beginning balance                                     |  | $                              | 13,419  |   |      | $ | 15,314  |  
|Add: Accruals for warranties issued during the period |  |                                | 19,548  |   |      |   | 16,910  |  
|Less: Adjustments of accrual estimates                |  |                                | (1,280  | ) |      |   | (411    | )
|Warranty spending                                     |  |                                | (18,173 | ) |      |   | (18,394 | )
|                                                      |  |                                |         |   |      |   |         |  
|Ending balance                                        |  | $                              | 13,514  |   |      | $ | 13,419  |  
|                                                      |  |                                |         |   |      |   |         |  



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Note 6Convertible Subordinated Notes



In June 2003, the Company issued $180 million of 1.5% convertible subordinated notes (the Notes) due May 2008 in
a private placement. The Notes are unsecured obligations of the Company and are subordinated to all present and future senior indebtedness of the Company. Interest is payable semiannually on May 15 and November 15, commencing
November 15, 2003. The Notes are convertible into common stock of the Company at an initial conversion price of $11.31 per share, subject to adjustment in certain dilution events. The Notes do not include a beneficial conversion feature or
financial covenants. Expenses of $5.8 million associated with the offering were capitalized upon issuance and are included in other current assets and in other long-term assets. Such expenses are being amortized to interest expenses over the term of
the Notes. In September 2006, the Company purchased $35 million of the Notes for approximately $32 million in cash. This purchase generated a net gain of approximately $2.8 million which was recorded as other income and expenses, net in the
consolidated statement of operations.



Note 7 Stock-Based Compensation



Stock Option Plans



The Company has a stock-based compensation program that provides its Board
of Directors broad discretion in creating employee equity incentives. This program includes incentive and non-statutory stock options, restricted stock units and other types of equity granted under various plans, the majority of which are
stockholder approved. Stock options are generally time-based, vesting 25% on each annual anniversary of the hire date over four years and expire up to seven years from the grant date. Additionally, the Company has an Employee Stock Purchase Plan
(ESPP) that allows employees to purchase shares of common stock at 85% of the fair market value at the lower of either the date of enrollment or the date of purchase. The total number of shares authorized for grant of stock options is
7.4 million shares. The total number of shares authorized under the ESPP is 1.6 million shares subject to automatic increases. Shares issued as a result of stock option exercises and the Companys ESPP are generally from the
Companys new and treasury shares. As of October 31, 2006, the Company had approximately 4.7 million shares of common stock reserved for future issuance under the stock option plans and ESPP.



On August 9, 2000, the Board of Directors authorized the Companys
Supplemental Stock Option Plan (the 2000 Plan) and authorized 500,000 shares for issuance. This additional reserve of shares supplements the Companys 1993 Stock Option Plan and is for issuance to individuals employed by the Company
who are neither officers of the Company nor members of the Board. On November 27, 2000 the Board of Directors authorized an additional 500,000 shares for issuance under the Supplemental Stock Option Plan. In addition, on November 27, 2001,
the Board of Directors authorized an additional 500,000 shares for issuance under the Supplemental Stock Option Plan.



In fiscal year 2005, the Companys Board of Directors and stockholders approved the 2005 Stock Incentive Plan (the 2005 Plan) which
provides for the grant of options to purchase shares of the Companys common stock, stock appreciation rights and restricted stock to employees, members of the Board of Directors and consultants. The maximum number of shares available for grant
under the 2005 Plan is 5.9 million shares.



During fiscal
year 2005, the 1993 Stock Option Plan (the 1993 Plan), under which the Company previously granted options to employees and members of the Board of Directors, expired. However, outstanding options granted under the 1993 Plan remains
exercisable in accordance with the terms of the original grant agreements.



In August 2005, the Companys Board of Directors approved the accelerated vesting of certain unvested and out-of-the-money non-qualified stock options previously awarded to employees and officers with
option



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



exercise prices equal to or greater than $9.15. Options held by non-employee directors are excluded from the vesting acceleration. In addition, in order to
prevent executive officers from unintended personal benefits, the Companys executive officers have agreed to the imposition of restrictions on any shares received through the exercise of accelerated options. Those restrictions will prevent the
sale of any shares received from the exercise of an accelerated option until the earlier of the original vesting date of the option or the executive officers termination of employment. The $9.15 price was selected because it was higher than
the closing price of the Companys common stock of $8.84 on August 29, 2005, the date of this acceleration. The accelerated options represent approximately 15 percent or approximately 2.8 million shares of the total of all outstanding
Credence options on August 29, 2005. The acceleration was intended to reduce the stock option expense the Company would be required to record after the adoption of SFAS 123(R). This acceleration reduced approximately $10.0 million of stock
option expenses under SFAS 123(R) which would have been recognized as an expense through December 2008.



On November 1, 2005, the Company adopted Statement of Financial Accounting Standard No. 123(R) (SFAS 123(R)), Share-Based Payment,
for its share-based compensation plans. Under SFAS 123(R), the Company is required to recognize stock-based compensation costs based on the estimated fair value at the grant date for its share-based awards. In accordance with this standard, the
Company has elected to recognize the compensation cost of all share-based awards that ultimately vest on a straight-line basis over the vesting period of the award.



On November 10, 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position No. FAS 123(R)-3
Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards. The Company has elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of
stock-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (APIC pool) related to the tax effects of employee
stock-based compensation, and to determine the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R).



The Company previously accounted for its employee stock option and ESPP
under the recognition and measurement principles of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related Interpretations, and adopted the disclosure-only provisions of Statement of
Financial Accounting Standard No. 123, Accounting for Stock-Based Compensation, (SFAS 123), as amended by Statement of Financial Accounting Standard No. 148, Accounting for Stock-Based CompensationTransition and
Disclosures, (SFAS 148). As the ESPP was not compensatory under APB 25, no compensation expense was recorded in earnings for the awards granted under the ESPP. Compensation expense was recorded in earnings for the Companys stock options
if they were awarded with an exercise price less than the market price of the Companys stock on the date of grant. The pro forma effects on net loss and net loss per share for stock options and ESPP awards were instead disclosed in a footnote
to the consolidated financial statements.



The Company has
elected to use the modified prospective transition method as permitted by SFAS 123(R) and therefore has not restated its financial results for prior periods. Under this transition method, in fiscal year 2006, the compensation cost recognized
included the cost for all stock-based compensation awards granted prior to, but not yet vested as of November 1, 2005, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123 and the grant date fair
value estimated in accordance with the provisions of SFAS 123(R) for awards granted or modified on or after November 1, 2005 whose requisite service period was rendered during fiscal year 2006. The Company determines the fair value of stock
options using the single option approach under SFAS 123(R). Prior to the adoption of SFAS 123(R), the Company determined the fair value of stock options using the multiple option approach. In conjunction with the adoption of SFAS 123(R), the



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Company changed its method of attributing the value of stock-based compensation to expense from the accelerated multiple-option approach to the straight-line
single option approach for awards granted or modified on or after November 1, 2005. Compensation expense for all share-based payment awards granted prior to November 1, 2005 will continue to be recognized using the accelerated
multiple-option approach.



In calculating the compensation
cost, the Company estimates the fair value of each option grant on the date of grant using the Black-Scholes-Merton options pricing model. The Black-Scholes-Merton option pricing model was developed for use in estimating the fair value of traded
options that have no vesting restrictions and are fully transferable. In addition, the Black-Scholes-Merton model requires the input of highly subjective assumptions including the expected stock price volatility.



As a result of adopting SFAS 123(R), the Companys loss before income
taxes provision and net loss for fiscal year 2006 was $3.3 million higher, than if it had continued to account for share-based compensation under APB 25. Basic and diluted net loss per share for the fiscal year 2006 would have been $0.03 lower,
respectively, if the Company had not adopted SFAS 123(R). There was no effect on the condensed consolidated statements of cash flows from adopting SFAS 123(R).



The following table illustrates the stock-based compensation expense resulting from stock options and ESPP included in the condensed consolidated
statement of operations for the twelve months ended October 31, 2006 (in thousands):



|                                                             |  |   |      
|------------------------------------------------------------ |  | - | -----
|Cost of goods sold                                           |  | $ | 703  
|Research and development                                     |  |   | 1,932
|Selling, general and administrative                          |  |   | 3,036
|                                                             |  |   |      
|Stock-based compensation expense before income taxes benefit |  | $ | 5,671
|Income tax benefit                                           |  |   |     
|                                                             |  |   |      
|Stock-based compensation expense after income taxes benefit  |  | $ | 5,671
|                                                             |  |   |      



At October 31,
2006, the Company capitalized $0.1 million of stock-based compensation expense as inventory; therefore, excluded in the cost of goods sold amount above.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The following is a summary of activity under stock option plans at October 31, 2006 (in
thousands, except per share and years):



|                                               |  |                                            |   |  |                                              |   |  |                                           |       |                                          |   |                                                        |  |     
|---------------------------------------------- |  | ------------------------------------------ | - |  | -------------------------------------------- | - |  | ----------------------------------------- | ----- | ---------------------------------------- | - | ------------------------------------------------------ |  | ----
|                                               |  | Options Available for Grant (In thousands) |   |  | Number of Options Outstanding (In thousands) |   |  | Weighted Average Exercise Price per share |       | Aggregate Intrinsic Value (In thousands) |   | Weighted Average Remaining Contractual Life (In years)
|Balance at October 31, 2003                    |  | 2,354                                      |   |  | 13,195                                       |   |  | $                                         | 15.85 |                                          |   |                                                        |  |     
|Increase in authorized shares                  |  | 2,234                                      |   |  |                                             |   |  |                                           |      |                                          |   |                                                        |  |     
|Assumed NPTest options                         |  |                                           |   |  | 4,143                                        |   |  |                                           | 7.04  |                                          |   |                                                        |  |     
|Options granted                                |  | (4,665                                     | ) |  | 4,665                                        |   |  |                                           | 12.61 |                                          |   |                                                        |  |     
|Options canceled                               |  | 1,881                                      |   |  | (1,881                                       | ) |  |                                           | 17.45 |                                          |   |                                                        |  |     
|Options forfeited/expired                      |  | (434                                       | ) |  |                                             |   |  |                                           |      |                                          |   |                                                        |  |     
|Options exercised                              |  |                                           |   |  | (1,377                                       | ) |  |                                           | 7.34  |                                          |   |                                                        |  |     
|                                               |  |                                            |   |  |                                              |   |  |                                           |       |                                          |   |                                                        |  |     
|Balance at October 31, 2004                    |  | 1,370                                      |   |  | 18,745                                       |   |  | $                                         | 13.56 |                                          |   |                                                        |  |     
|Increase in authorized shares                  |  | 8,885                                      |   |  |                                             |   |  |                                           |      |                                          |   |                                                        |  |     
|Options granted                                |  | (2,603                                     | ) |  | 2,603                                        |   |  |                                           | 8.91  |                                          |   |                                                        |  |     
|Options canceled                               |  | 2,153                                      |   |  | (2,153                                       | ) |  |                                           | 15.38 |                                          |   |                                                        |  |     
|Options forfeited/expired                      |  | (3,714                                     | ) |  | (491                                         | ) |  |                                           |      |                                          |   |                                                        |  |     
|Options exercised                              |  |                                           |   |  | (546                                         | ) |  |                                           | 7.27  |                                          |   |                                                        |  |     
|                                               |  |                                            |   |  |                                              |   |  |                                           |       |                                          |   |                                                        |  |     
|Balance at October 31, 2005                    |  | 6,091                                      |   |  | 18,158                                       |   |  | $                                         | 12.87 |                                          |   |                                                        |  |     
|Options granted                                |  | (2,352                                     | ) |  | 2,301                                        |   |  |                                           | 6.48  |                                          |   |                                                        |  |     
|Options canceled                               |  | 32                                         |   |  | (32                                          | ) |  |                                           | 11.35 |                                          |   |                                                        |  |     
|Options forfeited/expired                      |  | 654                                        |   |  | (3,028                                       | ) |  |                                           |      |                                          |   |                                                        |  |     
|Options exercised                              |  |                                           |   |  | (307                                         | ) |  |                                           | 6.63  |                                          |   |                                                        |  |     
|                                               |  |                                            |   |  |                                              |   |  |                                           |       |                                          |   |                                                        |  |     
|Balance at October 31, 2006                    |  | 4,425                                      |   |  | 17,092                                       |   |  | $                                         | 12.48 |                                          | $ | 12,558                                                 |  | 5.40
|                                               |  |                                            |   |  |                                              |   |  |                                           |       |                                          |   |                                                        |  |     
|Vested or expected to vest at October 31, 2006 |  |                                            |   |  | 14,298                                       |   |  | $                                         | 13.50 |                                          | $ | 7,598                                                  |  | 5.27
|                                               |  |                                            |   |  |                                              |   |  |                                           |       |                                          |   |                                                        |  |     
|Exercisable at October 31, 2006                |  |                                            |   |  | 14,251                                       |   |  | $                                         | 13.50 |                                          | $ | 7,598                                                  |  | 5.40
|                                               |  |                                            |   |  |                                              |   |  |                                           |       |                                          |   |                                                        |  |     



Restricted stock units
are granted from the pool of options available for grant. The Companys plan requires that for every share of restricted stock unit issued, the Company will be counted against the plan limit as 1.4 shares in the above table.



The weighted-average grant date fair value per options granted during the
fiscal year 2006, 2005 and 2004 was $3.25, $5.63 and $7.64, respectively. The total intrinsic value of options exercised during the fiscal year 2006, 2005 and 2004 was $0.5 million, $1.1 million and $7.8 million, respectively. Cash proceeds from the
exercise of stock options were $2.1 million, $4.0 million and $11.2 million for the fiscal year 2006, 2005 and 2004, respectively. No income tax benefit was realized from the stock option exercises during the fiscal year 2006, 2005 and 2004,
respectively. Stock-based compensation expense related to stock options recognized under SFAS 123(R) for the fiscal year 2006 was $4.1 million. The Company generally settles employee stock option exercises with newly issued common shares. At
October 31, 2006, there was $9.0 million of unrecognized stock-based compensation expense related to non-vested options and is expected to be recognized over a weighted-average period of 2.8 years.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The fair value of option grants was estimated by using the Black-Scholes-Merton model with the
following weighted-average assumptions for the fiscal year 2006, 2005 and 2004, respectively:



|                         |  |      |   |  |      |   |  |      |  
|------------------------ |  | ---- | - |  | ---- | - |  | ---- | -
|                         |  | 2006 |   |  | 2005 |   |  | 2004 |  
|Expected volatility      |  | 54   | % |  | 73   | % |  | 74   | %
|Dividend yield           |  |     |   |  |     |   |  |     |  
|Risk-free interest rate  |  | 4.78 | % |  | 3.55 | % |  | 3.33 | %
|Expected term (in years) |  | 4.0  |   |  | 5.2  |   |  | 4.9  |  



Expected
Volatility:    The Companys computation of expected volatility for the fiscal year 2006 is based on a combination of implied volatilities from traded options on the Companys stock and historical volatility. Prior
to fiscal year 2006, the Company had used its historical stock price volatility in accordance with SFAS 123 for purposes of its pro forma information. The selection of a combination of the implied and historical volatility approach was based upon
the availability of actively traded options on the Companys stock and the Companys assessment that this combination is more representative of future stock price trends than historical volatility alone.



Dividend Yield:    The dividend yield assumption
is based on the Companys history and expectation of dividend payouts.



Risk-Free Interest Rate:    The risk-free interest rate is based on the United States Treasury yield curve in effect at the time of grant for the expected term of the option.



Expected Term:    The Companys expected term
represents the period that the Companys stock-based awards are expected to be outstanding and was determined for the fiscal year 2006 based on historical experience of similar awards, giving consideration to the contractual terms of the
stock-based awards, vesting schedules and expectations of future employee behavior.



Forfeitures Rate:    Compensation expense recognized in the consolidated statement of operations for the fiscal year 2006 is based on awards ultimately expected to vest and it reflects
estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to adoption of SFAS 123(R), the Company accounted
for forfeitures as they occurred.



Employee Stock Purchase Plan (ESPP)



In 1994, the Company adopted the 1994 Employee Stock
Purchase Plan (the 1994 Plan), which provides direct employees, employed with the Company for at least thirty consecutive days as of the entry date into any offering period, with the opportunity to acquire shares of the Companys
common stock. Employees may contribute up to 10% of their base salary to the plan. The Company has a one-year rolling plan with two six-month purchases within the offering period. The purchase price is 85% of the fair market value per share of
common stock at the beginning of the offering period or the end of the purchase period, whichever is lower. If the fair market value per share is lower on the purchase date than the beginning of the offering period, the current offering period will
terminate and a new one-year offering period will commence. The plan restricts the maximum number of shares that an employee can purchase to 1,500 shares each semi-annual period and to $25,000 worth of common stock each year. At October 31,
2006, there were 306,249 shares reserved for issuance under the 1994 Plan.



The fair value of issuances under the 1994 Plan is estimated on the issuance date by applying the principles of FASB Technical Bulletin 97-1 (FTB 97-1), Accounting under Statement 123 for Certain Employee Stock



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Purchase Plan with a Look Back Option and using the Black-Scholes-Merton options pricing model. During the fiscal years 2006, 2005 and 2004, the
Company issued 855,396 shares, 676,923 shares and 413,105 shares, respectively, under the 1994 Plan. Total cash received for the issuance of shares under the employee stock purchase plan was approximately $2.8 million, $4.1 million and $2.6 million
during the fiscal years 2006, 2005 and 2004, respectively. Stock-based compensation expense related to the 1994 Plan recognized under SFAS 123(R) in fiscal year 2006 was $1.6 million. At October 31, 2006, there was $0.5 million of unrecognized
stock-based compensation expense related to outstanding ESPP shares and is expected to be recognized over a four month period.



The fair value of awards granted under the 1994 Plan stock-based compensation was estimated by using the Black-Scholes-Merton model with the following
weighted-average assumptions for the fiscal years 2006, 2005 and 2004, respectively:



|                         |  |      |   |  |      |   |  |      |  
|------------------------ |  | ---- | - |  | ---- | - |  | ---- | -
|                         |  | 2006 |   |  | 2005 |   |  | 2004 |  
|Expected volatility      |  | 57   | % |  | 57   | % |  | 53   | %
|Dividend yield           |  |     |   |  |     |   |  |     |  
|Risk-free interest rate  |  | 4.95 | % |  | 2.71 | % |  | 1.52 | %
|Expected term (in years) |  | 0.5  |   |  | 0.5  |   |  | 0.5  |  





Prior to fiscal year 2006, the Company accounted for its employee stock option and employee stock purchase plans under the intrinsic value recognition and
measurement principles of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related Interpretations, and had adopted the disclosure-only provisions of Statement of Financial
Accounting Standard No. 123, Accounting for Stock-Based Compensation, (SFAS 123), as amended by Statement of Financial Accounting Standard No. 148, Accounting for Stock-Based CompensationTransition and
Disclosures, (SFAS 148). As the exercise price of the Companys employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense was recognized in the Companys financial
statements.



In calculating pro forma compensation, the fair
value of each option grant is estimated on the date of grant using the Black-Scholes-Merton options pricing model. The Black-Scholes-Merton option pricing model was developed for use in estimating the fair value of traded options that have no
vesting restrictions and are fully transferable. In addition, the Black-Scholes-Merton model requires the input of highly subjective assumptions including the expected stock price volatility. As the Companys stock-based awards to employees
have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in managements opinion, the existing models do not necessarily
provide a reliable single measure of its stock-based awards to its employees. Stock-based employee compensation expense already included in the reported net loss is a result of amortization of deferred compensation related to acquisitions.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Had the Company determined stock-based compensation costs based on the estimated fair value at the
grant date for its stock options and the estimated fair value at the issuance date for its Employee Stock Purchase Plan, the Companys net loss and net loss per share for the fiscal years ended October 31, 2005 and 2004 would have been as
follows (in thousands, except per share data):



|                                                                                                         |  |      |          |   |      |   |         |  
|-------------------------------------------------------------------------------------------------------- |  | ---- | -------- | - | ---- | - | ------- | -
|                                                                                                         |  | 2005 |          |   | 2004 |  
|Net loss as reported                                                                                     |  | $    | (119,932 | ) |      | $ | (64,478 | )
|Add: Stock-based employee compensation expense included in reported net loss                             |  |      | 3,027    |   |      |   | 2,178   |  
|Less: Stock-based employee compensation expense determined under fair value based methods for all awards |  |      | (34,685  | ) |      |   | (26,156 | )
|                                                                                                         |  |      |          |   |      |   |         |  
|Pro forma net loss                                                                                       |  | $    | (151,590 | ) |      | $ | (88,456 | )
|                                                                                                         |  |      |          |   |      |   |         |  
|Basic net loss per share as reported                                                                     |  | $    | (1.28    | ) |      | $ | (0.88   | )
|Basic net loss per share pro forma                                                                       |  | $    | (1.61    | ) |      | $ | (1.21   | )
|Diluted net loss per share as reported                                                                   |  | $    | (1.28    | ) |      | $ | (0.88   | )
|Diluted net loss per share pro forma                                                                     |  | $    | (1.61    | ) |      | $ | (1.21   | )



The basic and diluted
pro forma net loss per share for the fiscal year 2004 has been revised from the previously disclosed amounts in the Companys annual report on Form 10-K for the fiscal year ended 2004.



Net Loss Per Share



Basic and diluted net loss per share is based upon the weighted average number of common shares outstanding during the
period. Diluted net income per share would be based upon the weighted average number of common shares and dilutive-potential common shares outstanding during the period.



The following table sets forth the computation of basic and diluted loss per share for the fiscal years ended
October 31, (in thousands, except per share amounts):



|                                    |  |      |          |   |      |   |          |      |  |   |         |  
|----------------------------------- |  | ---- | -------- | - | ---- | - | -------- | ---- |  | - | ------- | -
|                                    |  | 2006 |          |   | 2005 |   |          | 2004 | 
|Numerator:                          |  |      |          |   |      |   |          |      |  |   |         |  
|Net loss                            |  | $    | (481,585 | ) |      | $ | (119,932 | )    |  | $ | (64,478 | )
|                                    |  |      |          |   |      |   |          |      |  |   |         |  
|Denominator:                        |  |      |          |   |      |   |          |      |  |   |         |  
|Weighted-average shares outstanding |  |      | 99,981   |   |      |   | 93,864   |      |  |   | 73,058  |  
|                                    |  |      |          |   |      |   |          |      |  |   |         |  
|Basic net loss per share            |  | $    | (4.82    | ) |      | $ | (1.28    | )    |  | $ | (0.88   | )
|Diluted net loss per share          |  | $    | (4.82    | ) |      | $ | (1.28    | )    |  | $ | (0.88   | )



During fiscal year
2006, the Company excluded options to purchase 17,091,749 shares of common stock and 12,820,513 shares issuable under the term of the convertible subordinated notes from the diluted loss per share calculation, as their effect was anti-dilutive.
During fiscal year 2005, the Company excluded options to purchase 18,158,000 shares of common stock and 15,915,119 shares issuable under the terms of the convertible subordinated notes from the diluted loss per share calculation, as their effect was
anti-dilutive. During fiscal year 2004, the Company excluded options to purchase 18,745,141 shares of common stock, 12,328,200 shares issuable upon conversion of convertible preferred stock and 15,915,119 shares issuable under the terms of the
convertible subordinated notes from the diluted loss per share calculation because they were anti-dilutive.



Deferred Compensation



Deferred compensation generally results when the Company, during an acquisition, assumes the obligation of stock option grants made by the acquired company. Deferred compensation is amortized as compensation cost



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



over the weighted average remaining future vesting period of unvested options related to the options assumed. The balance for the deferred compensation is
reflected as a contra-equity in the consolidated statements of shareholders equity.



The Company allocated approximately $10.0 million of the purchase price of NPTest to deferred compensation. The portion of the purchase price allocated to deferred compensation cost was based on the portion of the
intrinsic value at the consummation date related to the future vesting period of NPTest options assumed by the Company. Options assumed in conjunction with the acquisition had exercise prices ranging from $5.86 to $13.56 per share, with a
weighted-average exercise price of $6.71 per share and a weighted average remaining contractual life of approximately 9.25 years. The Company amortized the fair value of the deferred compensation on a straight-line basis over the remaining vesting
period of approximately 3.25 years. The Company assumed approximately 4.1 million stock options.



During the fiscal years ended October 31, 2005 and 2004, the Company recognized expense related to the deferred compensation of $3.0 million and $2.2
million, respectively.



Upon adopting SFAS 123(R), deferred
compensation balance of $4.2 million was charged to additional paid-in capital and amortization ceased.



Note 8Employee Benefit Plans



The Company maintains a 401(k) retirement savings plan for its full-time domestic employees, which allows them to contribute up to 20% of their pre-tax
wages subject to IRS limits. The Company contributed to this plan during the fiscal years ended October 31, 2006, 2005 and 2004 $1.8 million, $1.8 million and $0, respectively.



The Company assumed NPTests North America 401(k) plan as part of the acquisition occurred in May 2004. The plan
matches dollar-for-dollar, up to 4%, of an employees contribution per pay period. For the fiscal year 2004, the Company contributed approximately $0.6 million to the plan. During fiscal 2005, the Company contributed approximately $
0.3 million to the plan for the two months ended December 31, 2004. The NPTest plan was merged into the Companys plan effective January 1, 2005.



Outside of the U.S., the Company also assumed several defined benefit and defined contribution plans that cover
substantially all employees. Where applicable, employees are covered by statutory plans. For defined benefit plans, charges to expense are based upon costs computed by independent actuaries. These plans are substantially fully funded with trustees
in respect to past and current service. At October 31, 2006 and 2005, the pension liability was $0.5 million and $0.6 million, respectively. The expenses associated with these plans were not material during fiscal years 2006 and 2005,
respectively.



The Company has a deferred compensation for
certain employees (a Rabbi Trust or trust). The assets in the Rabbi Trust, consisting of cash equivalents and debt and equity securities, are recorded at current market prices. The trust assets are available to satisfy claims
of the Companys general creditors in the event of its bankruptcy. The trusts assets, included in other assets, and the corresponding deferred compensation liability, included in other liabilities were approximately $1.9 million and $2.4
million at October 31, 2006 and 2005, respectively.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Note 9Income Taxes



The tax provision (benefit) consisted of the following (in thousands):



|                     |  |                        |       |   |      |   |        |      |  |   |        |  
|-------------------- |  | ---------------------- | ----- | - | ---- | - | ------ | ---- |  | - | ------ | -
|                     |  | Year Ended October 31, |      
|                     |  | 2006                   |       |   | 2005 |   |        | 2004 | 
|Federal:             |  |                        |       |   |      |   |        |      |  |   |        |  
|Current              |  | $                      |      |   |      | $ | (180   | )    |  | $ | (602   | )
|Deferred             |  |                        |      |   |      |   |       |      |  |   |       |  
|                     |  |                        |       |   |      |   |        |      |  |   |        |  
|                     |  |                        |      |   |      |   | (180   | )    |  |   | (602   | )
|State:               |  |                        |       |   |      |   |        |      |  |   |        |  
|Current              |  |                        | 391   |   |      |   | 315    |      |  |   | (1,684 | )
|Deferred             |  |                        |      |   |      |   |       |      |  |   |       |  
|                     |  |                        |       |   |      |   |        |      |  |   |        |  
|                     |  |                        | 391   |   |      |   | 315    |      |  |   | (1,684 | )
|Foreign:             |  |                        |       |   |      |   |        |      |  |   |        |  
|Current              |  |                        | 5,895 |   |      |   | 11,254 |      |  |   | 6,275  |  
|Deferred             |  |                        | (402  | ) |      |   |       |      |  |   |       |  
|                     |  |                        |       |   |      |   |        |      |  |   |        |  
|Income tax provision |  | $                      | 5,884 |   |      | $ | 11,389 |      |  | $ | 3,989  |  
|                     |  |                        |       |   |      |   |        |      |  |   |        |  



Pre-tax income from
foreign operations was approximately $37.5 million, $44.0 million and $14.3 million in fiscal years 2006, 2005 and 2004, respectively.



In the fourth quarter of fiscal year 2006, the Company repatriated $23.0 million in foreign earnings. There was no tax effect of this distribution as it
was offset by the Companys net operating losses carryforward.



Cumulative unremitted foreign earnings that are considered to be permanently invested outside the U. S. and on which no U.S. taxes have been provided, are approximately $41.8 million as of October 31, 2006. The residual U.S. tax
liability, if such amounts were remitted, would be nominal.



Reconciliation between the Companys effective tax rate of (1.24%) in fiscal year 2006, 10.5% in fiscal year 2005, and 6.6% in fiscal year 2004 and the U.S. statutory rate of 35% is as follows (in thousands):



|                                                   |  |                        |          |   |      |   |         |      |  |   |         |  
|-------------------------------------------------- |  | ---------------------- | -------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                   |  | Year Ended October 31, |         
|                                                   |  | 2006                   |          |   | 2005 |   |         | 2004 | 
|Tax computed at statutory rate                     |  | $                      | (166,496 | ) |      | $ | (37,990 | )    |  | $ | (21,145 | )
|State income tax                                   |  |                        | 391      |   |      |   | 315     |      |  |   | (1,684  | )
|U.S. losses not benefited                          |  |                        | 15,747   |   |      |   | 53,380  |      |  |   | 23,369  |  
|Non-deductible in-process research and development |  |                        |         |   |      |   |        |      |  |   | 2,765   |  
|Foreign rate differential                          |  |                        | (7,630   | ) |      |   | (4,136  | )    |  |   | 1,286   |  
|Goodwill impairment                                |  |                        | 148,356  |   |      |   |        |      |  |   |        |  
|Repatriation                                       |  |                        | 14,904   |   |      |   |        |      |  |   |        |  
|Other items                                        |  |                        | 612      |   |      |   | (180    | )    |  |   | (602    | )
|                                                   |  |                        |          |   |      |   |         |      |  |   |         |  
|Income tax provision                               |  | $                      | 5,884    |   |      | $ | 11,389  |      |  | $ | 3,989   |  
|                                                   |  |                        |          |   |      |   |         |      |  |   |         |  



The income tax
provision in fiscal years 2006, 2005 and 2004 consists primarily of foreign tax on earnings and foreign withholding taxes generated from our foreign operations.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Significant components of the Companys deferred tax assets are as follows (in thousands):



|                                            |  |             |          |   |      |   |          |  
|------------------------------------------- |  | ----------- | -------- | - | ---- | - | -------- | -
|                                            |  | October 31, |         
|                                            |  | 2006        |          |   | 2005 |  
|Deferred tax assets:                        |  |             |          |   |      |   |          |  
|Accounting for inventories                  |  | $           | 46,102   |   |      | $ | 44,353   |  
|Allowance for doubtful accounts             |  |             | 524      |   |      |   | 721      |  
|Accruals not currently deductible           |  |             | 25,620   |   |      |   | 24,730   |  
|Net operating loss and credit carryforwards |  |             | 187,614  |   |      |   | 165,895  |  
|Book over tax depreciation                  |  |             | 3,251    |   |      |   | 4,392    |  
|Deferred revenue/profit/commissions         |  |             | 3,369    |   |      |   | 3,717    |  
|Foreign deferred                            |  |             | 402      |   |      |   |         |  
|                                            |  |             |          |   |      |   |          |  
|Total deferred tax assets                   |  |             | 266,882  |   |      |   | 243,808  |  
|Valuation allowance for deferred tax assets |  |             | (238,698 | ) |      |   | (210,137 | )
|                                            |  |             |          |   |      |   |          |  
|                                            |  |             | 28,184   |   |      |   | 33,671   |  
|Deferred tax liability:                     |  |             |          |   |      |   |          |  
|Intangibles                                 |  |             | (27,432  | ) |      |   | (33,671  | )
|Prepaid expense                             |  |             | (350     | ) |      |   |         |  
|                                            |  |             |          |   |      |   |          |  
|Total deferred tax liabilities              |  |             | (27,782  | ) |      |   | (33,671  | )
|Net deferred tax assets                     |  | $           | 402      |   |      | $ |         |  
|                                            |  |             |          |   |      |   |          |  



At October 31,
2006, the Company has unused net operating loss and research tax credit carryforwards for federal income tax purposes of approximately $432.1 million and $9.2 million, respectively, which if not utilized will expire in 2012 through 2026. At
October 31, 2006, we also had unused foreign tax credit of $6.0 million related to the Singapore repatriation, which expires in 2016. Utilization of the Companys net operating loss and tax credit carryforwards will be subject to annual
limitations due to the ownership change limitations provided by the Internal Revenue Code of 1986, as amended, and similar state provisions. The annual limitations may result in expiration of net operating loss and tax credit carryforwards before
full utilization.



Realization of the net deferred tax assets
is dependent on the Company generating sufficient taxable income in future years in appropriate tax jurisdictions to obtain reversals of temporary differences, net operating loss and tax credit carryforwards. Due to uncertainties in the timing and
amount of such realization of its deferred tax assets, the Company has provided a valuation allowance equal to its domestic net deferred tax assets at October 31, 2006 and October 31, 2005. The Company had a net increase in the valuation
allowance of $28.6 million in fiscal year 2006 due primarily to the increase in net operating loss and tax credit carryforwards; an increase of $57.1 million in fiscal year 2005 due to current year change of non-deductible accruals, reserves and
increase of net operating loss; and a net increase of $48.3 million in the valuation allowance in fiscal year 2004 due to build of non deductible accruals, reserves and the NPTest acquisition. Approximately $5.8 million of the valuation allowance
for deferred tax assets is attributable to stock option deductions, the benefit of which will be credited to equity when realized. Approximately $10.0 million in the valuation allowance for deferred tax assets is related to the acquisition of NPTest
during fiscal year 2004, the benefit of which will be credited to goodwill when realized.



Note 10Legal Matters



The Company also is involved in various claims arising in the ordinary course of business, none of which, in the opinion of management, if determined adversely against the Company, will have a material adverse effect on the Companys
business, financial condition or results of operations.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Note 11Accumulated Other Comprehensive Income



The Companys accumulated other comprehensive income consists of the
accumulated net unrealized gains or losses on available-for-sale investments and foreign currency translation adjustments. At October 31, 2006 and 2005, the Company had a balance of net unrealized losses of $18,000 and net unrealized gains of
$0.2 million, respectively, on available-for-sale investments. Additionally, at October 31, 2006 and 2005, the Company had a balance of $2.1 million and $0.3 million, respectively, of net foreign currency translation gains.



Accumulated other comprehensive income and changes thereto consist of (in
thousands):



|                                                             |  |                        |       |   |      |   |        |      |  |   |       |  
|------------------------------------------------------------ |  | ---------------------- | ----- | - | ---- | - | ------ | ---- |  | - | ----- | -
|                                                             |  | Year Ended October 31, |      
|                                                             |  | 2006                   |       |   | 2005 |   |        | 2004 | 
|Beginning balance, net of tax                                |  | $                      | 509   |   |      | $ | 2,924  |      |  | $ | 1,522 |  
|Unrealized loss on available-for-sale securities, net of tax |  |                        | (210  | ) |      |   | (283   | )    |  |   | (221  | )
|Currency translation adjustment, net of tax                  |  |                        | 1,820 |   |      |   | (2,132 | )    |  |   | 1,623 |  
|                                                             |  |                        |       |   |      |   |        |      |  |   |       |  
|Ending balance, net of tax                                   |  | $                      | 2,119 |   |      | $ | 509    |      |  | $ | 2,924 |  
|                                                             |  |                        |       |   |      |   |        |      |  |   |       |  



Note 12Industry Segments and
Concentration of Risks



Credit Risk, Product Line and
Segment/Geographic Data



Financial instruments that
potentially subject the Company to concentrations of credit risk consist principally of investments in cash equivalents, short-term investments and trade receivables. Credit risk evaluations, including Dun & Bradstreet ratings, are
performed on all new customers, and subsequent to credit application approval, the Company monitors its customers financial statements and payment performance. The Company is exposed to credit risks in the event of default by the financial
institutions or customers to the extent of the amounts recorded on the consolidated balance sheets. In general, the Company does not require collateral on sales except in certain circumstances where a letter of credit is required to be established
prior to shipping product.



Operating segments are business
units that have separate financial information and are separately reviewed by the Companys chief decision makers. The Companys chief decision makers are the Chief Executive Officer and Chief Financial Officer. The Company and its
subsidiaries currently operate in a single industry segment: the design, development, manufacture, sale and service of advanced semiconductor test and diagnostic systems used in the production of semiconductors. All of the Companys advanced
semiconductor test and diagnostic systems operations are subject to similar economic characteristics, have similar production processes, have common customers, and are distributed using the same channels.



The Companys net sales by product line consisted of:



|                              |  |                        |   |  |      |   |  |      |  
|----------------------------- |  | ---------------------- | - |  | ---- | - |  | ---- | -
|                              |  | Year Ended October 31, |  
|                              |  | 2006                   |   |  | 2005 |   |  | 2004 |  
|SoC                           |  | 35                     | % |  | 37   | % |  | 22   | %
|Analog Mixed Signal           |  | 30                     |   |  | 22   |   |  | 32   |  
|Memory                        |  | 2                      |   |  | 3    |   |  | 23   |  
|Design Characterization Group |  | 9                      |   |  | 11   |   |  | 4    |  
|Service                       |  | 24                     |   |  | 27   |   |  | 19   |  
|                              |  |                        |   |  |      |   |  |      |  
|Total net sales               |  | 100                    | % |  | 100  | % |  | 100  | %
|                              |  |                        |   |  |      |   |  |      |  



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The Company sells its products primarily to distributors and semiconductor manufacturers located in
the United States, Asia Pacific and Europe. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. The Company maintains reserves for potential credit losses and such losses historically have been
within managements expectations.



Most of the
Companys products are manufactured in the U.S. Export sales from the U.S. are primarily denominated in U.S. dollars but occasionally denominated in Japanese Yen or in the Euro. The Automotive product line is manufactured in Germany and these
sales are denominated in U.S. dollars, Japanese Yen and the Euro. All of the Companys products are shipped to the Companys customers throughout North America, Asia Pacific, Europe, and the Middle East. Sales by the Company to customers
in different geographic areas, expressed as a percentage of revenue, for the periods ended were:



|                     |  |                        |   |  |      |   |  |      |  
|-------------------- |  | ---------------------- | - |  | ---- | - |  | ---- | -
|                     |  | Year Ended October 31, |  
|                     |  | 2006                   |   |  | 2005 |   |  | 2004 |  
|North America        |  | 31                     | % |  | 31   | % |  | 28   | %
|Taiwan               |  | 11                     |   |  | 12   |   |  | 20   |  
|China                |  | 6                      |   |  | 5    |   |  | 7    |  
|Southeast Asia       |  | 29                     |   |  | 20   |   |  | 20   |  
|Rest of Asia Pacific |  | 5                      |   |  | 10   |   |  | 5    |  
|Europe & Middle East |  | 18                     |   |  | 22   |   |  | 20   |  
|                     |  |                        |   |  |      |   |  |      |  
|Total net sales      |  | 100                    | % |  | 100  | % |  | 100  | %
|                     |  |                        |   |  |      |   |  |      |  



A distributor in
Taiwan, Spirox Corporation, accounted for 13%, 14% and 23% of the Companys net sales in fiscal years 2006, 2005 and 2004, respectively. Spirox Corporation accounted for 12% and 19% of gross accounts receivable at October 31, 2006 and
2005, respectively.



In fiscal year 2006, two end-user
customers headquartered in the U.S. accounted for 23% and 15% of the Companys net sales, respectively, and 36% and 10% of the Companys gross receivables, respectively.



In fiscal year 2005, two end-user customers headquartered in the U.S. accounted for 25% and 14% of the Companys net
sales, respectively, and 22% and 20% of the Companys gross receivables, respectively. One end-user customer headquartered in Europe accounted for 15% of the Companys net sales in fiscal year 2004.



This concentration subjects a significant portion of the Companys
receivables and future revenues to the risks associated with doing business in foreign countries, including political and economic instability, currency exchange rate fluctuations and regulatory changes. Disruption of business in Asia caused by the
previously mentioned factors could have a material impact on the Companys business, financial condition or results of operations.



As of October 31, 2006 and 2005, the majority of the Companys long-lived assets were attributable to its U.S. operations.



Note 13Related Party Transactions



Dr. William G. Howard Jr., a director of the Company, is a
director of Xilinx, Inc. (Xilinx). For the fiscal years ended October 31, 2006, 2005 and 2004, the Company sold approximately $0.7 million, $0.6 million, and $1.7 million, respectively, of products and services to Xilinx. For the years ended
October 31, 2006, 2005, and 2004, the Company purchased goods and services of approximately $3,000, $0, and $1,000, respectively, from Xilinx. The Company had no amounts owed from or to Xilinx at October 31, 2006, 2005 and 2004,
respectively.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Richard Beyer, a director of the Company since September 2003, is President, Chief Executive Officer
and a Director of Intersil. For the fiscal years ended October 31, 2006, 2005 and 2004, the Company sold approximately $6,900, $4,100 and $15,000 of products and services to Intersil, respectively. There were no receivable balances from
Intersil at October 31, 2006 and 2005, respectively.



Dipanjan Deb, a director of the Company until March 2006, is a Director of AMI Semiconductor (AMIS Holdings, Inc.). For the fiscal years ended October 31, 2006, 2005 and 2004, the Company sold approximately $1.4 million, $3.5 million
and $4.0 million of product and services to AMI Semiconductor, respectively. The amounts of receivables from AMI Semiconductor were approximately $212,000 and $449,000 at October 31, 2006 and 2005, respectively. Mr. Deb is also a director
of Conexant Systems. For the fiscal years ended October 31, 2005 and 2004, the Company sold approximately $0 and $110,000 of product and services to Conexant Systems, respectively. The Company had no amounts owed from Conexant Systems at
October 31, 2005. Prior to the Companys acquisition of NPTest, pursuant to an amended advisory agreement with Francisco Partner, L.P., NPTest made certain payments to Francisco Partners, L.P., for services provided to NPTest.



Thomas Franz, a director of the Company until October 22, 2004, is a
Corporate Vice President of Intel Corporation. For the fiscal year ended October 31, 2004 the Company sold approximately $47.8 million of products and services to Intel.



Note 14Subsequent Event



On December 14, 2006, the Company entered into separate exchange and purchase agreements with certain holders of its existing 1.5% Convertible
Subordinated Notes due 2008 (the Old Notes), pursuant to which holders of an aggregate of $72.5 million of the Old Notes agreed to (a) exchange their Old Notes for $72.5 million in aggregate principal amount of a new series of
3.5% Convertible Senior Subordinated Notes due 2010 (the New Notes), plus accrued and unpaid interest on the Old Notes at the day prior to the closing of the exchange and (b) purchase additional New Notes in an aggregate principal
amount of $50 million. The New Notes contain provisions known as net share settlement which require that, upon conversion of the New Notes, the Company will pay holders in cash for up to the principal amount of the converted New Notes. Any amounts
in excess of this cash amount will be settled in shares of the Companys common stock, or at the Companys option, cash. In addition, the New Notes have a 2010 maturity date versus the 2008 maturity date on the Old Notes. The coupon on the
New Notes is 3.5% versus the 1.5% coupon on the Old Notes.



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



Not applicable.



|Item 9A. | Controls and Procedures
|-------- | -----------------------



Attached as exhibits to this Form 10-K are certifications of Credences Chief Executive Officer (CEO) and Chief Financial Officer (CFO), which are
required in accordance with Rule 13a-14 of the Securities Exchange Act of 1934, as amended (the Exchange Act). This Controls and Procedures section includes information concerning the controls and controls evaluation referred to in the
certifications. Part II, Item 8 of this Form 10-K sets forth the report of Ernst & Young LLP, our independent registered public accounting firm, regarding its audit of Credences internal control over financial reporting and of
managements assessment of internal control over financial reporting set forth below in this section. This section should be read in conjunction with the certifications and the Ernst & Young LLP report for a more complete understanding
of the topics presented.



Evaluation of Disclosure Controls
and Procedures.    We conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (Disclosure Controls) as of the end of the period covered by this Form 10-K.
The controls evaluation was conducted under the supervision and with the participation of management, including our CEO and CFO. Disclosure Controls are controls and procedures designed to reasonably assure that information required to be disclosed
in our reports filed under the Exchange Act, such as this Form 10-K, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commissions (SECs) rules and forms. Disclosure
Controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Our quarterly evaluation of
Disclosure Controls includes an evaluation of some components of our internal control over financial reporting, and internal control over financial reporting is also separately evaluated on an annual basis for purposes of providing the management
report which is set forth below.



The evaluation of our
Disclosure Controls included a review of the controls objectives and design, the Companys implementation of the controls and the effect of the controls on the information generated for use in this Form 10-K. In the course of the controls
evaluation, we reviewed identified data errors or control problems and sought to confirm that appropriate corrective actions, including process improvements, were being undertaken. This type of evaluation is performed on a quarterly basis so that
the conclusions of management, including the CEO and CFO, concerning the effectiveness of the Disclosure Controls can be reported in our periodic reports on Form 10-Q and Form 10-K. Many of the components of our Disclosure Controls are also
evaluated on an ongoing basis by us. The overall goals of these various evaluation activities are to monitor our Disclosure Controls, and to modify them as necessary. Our intent is to maintain the Disclosure Controls as dynamic systems that change
as conditions warrant.



Based upon the controls evaluation, our
CEO and CFO have concluded that, subject to the limitations noted in this Part II, Item 9A, as of the end of the period covered by this Form 10-K, our Disclosure Controls were effective to provide reasonable assurance that information required
to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the SEC, and that material information relating to Credence and its consolidated subsidiaries is made known to
management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared.



Managements Report on Internal Control over Financial Reporting.    Our management is responsible for establishing and
maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally
accepted accounting principles. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and
dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in



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accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with
authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Companys assets that could have a material
effect on the financial statements.



Management assessed our
internal control over financial reporting as of October 31, 2006, the end of our fiscal year. Management based its assessment on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Managements assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies, and our overall
control environment.



Based on our assessment, management has
concluded that our internal control over financial reporting was effective as of the end of the fiscal year to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external
reporting purposes in accordance with generally accepted accounting principles. We reviewed the results of managements assessment with the Audit Committee of our Board of Directors.



Our independent registered public accounting firm, Ernst & Young LLP, audited managements assessment and
independently assessed the effectiveness of the Companys internal control over financial reporting. Ernst & Young LLP has issued an attestation report which is included in Part II, Item 8 of this Form 10-K.



Changes in Internal Control over Financial
Reporting.    There have been no changes in our internal control over financial reporting during the fourth quarter of fiscal year 2006 that have materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting.



Inherent
Limitations on Effectiveness of Controls.    The Companys management, including the CEO and CFO, does not expect that our Disclosure Controls or our internal control over financial reporting will prevent or detect all
error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control systems objectives will be met. The design of a control system must reflect the fact that
there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements
due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that
breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is
based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls
effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.



|Item 9B. | Other Information
|-------- | -----------------



None



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PART III



|Item 10. | Directors and Executive Officers of the Registrant
|-------- | --------------------------------------------------



The information required by this item relating to the Companys directors and nominees and disclosure relating to compliance with Section 16(a)
of the Securities Exchange Act of 1934 is included under the captions Election of Directors and Compliance with Section 16(a) of the Securities Exchange Act of 1934 in the Companys Proxy Statement for the 2007
Annual Meeting of Stockholders and is incorporated herein by reference. The information required by this item relating to the Companys executive officers and key employees is included under the caption Executive Officers and Key
Employees in Part I of this Form 10-K Annual Report.



The
Company has adopted a Code of Ethics that applies to its principal executive officer, principal financial officer and controller and a Code of Business Conduct and Ethics within the meaning of Section 406 of the Sarbanes-Oxley Act of 2002 and
the rules promulgated thereunder that applies to all Company employees. A copy of the Code of Ethics or the Code of Business Conduct and Ethics is available at the Companys website: www.credence.com, and without charge upon written
request to: Mr. John C. Batty, the Companys Senior Vice President, Chief Financial Officer and Secretary at the Companys headquarters at 1421 California Circle, Milpitas, California 95035. To the extent required by law,
amendments to, and waivers from, any provision of our code of ethics will promptly be disclosed to the public. To the extent permitted by such legal requirements, the Company intends to make such public disclosure by posting such information on the
Companys website in accordance with SEC rules.



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



The information required by this item will be included under the caption Executive Compensation and Related Information in the Companys
Proxy Statement for the 2007 Annual Meeting of Stockholders and is incorporated herein by reference.



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



The information required by this item is included under the caption
Ownership of Securities in the Companys Proxy Statement for the 2007 Annual Meeting of Stockholders and is incorporated herein by reference.



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Equity Compensation Plan Information



The following table provides information as of October 31, 2006 with respect to the shares of the Companys Common
Stock that may be issued under the Companys existing equity compensation plans. The table does not include information with respect to shares subject to outstanding options granted under equity compensation plans assumed by the Company in
connection with mergers and acquisitions of the companies that originally granted those options and outstanding options granted under the 1993 Plan. Footnote (5) to the table sets forth the total number of shares of the Companys Common
Stock issuable upon the exercise of those assumed options as of October 31, 2006, and the weighted average exercise price of those options. No additional options may be granted under those assumed plans.



|                                                           |  |                                                                        |  |                                                        |       |                                                                                                                                               |          
|---------------------------------------------------------- |  | ---------------------------------------------------------------------- |  | ------------------------------------------------------ | ----- | --------------------------------------------------------------------------------------------------------------------------------------------- | ---------
|                                                           |  | A                                                                      |  | B                                                      |       | C                                                                                                                                            
|Plan Category                                              |  | Number of Securities to be Issued Upon Exercise of Outstanding Options |  | Weighted Average Exercise Price of Outstanding Options |       | Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column A) (4)
|Equity Compensation Plans Approved by Stockholders (1)(3)  |  | 2,048,380                                                              |  | $                                                      | 7.91  |                                                                                                                                               | 3,722,425
|Equity Compensation Plans Not Approved by Stockholders (2) |  | 702,966                                                                |  | $                                                      | 12.71 |                                                                                                                                               | 702,634  
|                                                           |  |                                                                        |  |                                                        |       |                                                                                                                                               |          
|Total                                                      |  | 2,751,346                                                              |  | $                                                      | 11.37 |                                                                                                                                               | 4,425,059
|                                                           |  |                                                                        |  |                                                        |       |                                                                                                                                               |          

---

|(1) | Consists of the 2005 Stock Option Plan (the 2005 Plan).
|--- | ---------------------------------------------------------

|(2) | Consists solely of the Supplemental Stock Option Plan. Options under this Plan are not held by any directors or executive officers of the Company.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Excludes employee stock purchase rights accruing under the 1994 Employee Stock Purchase Plan. Under the 1994 Plan, each eligible employee may purchase up to 1,500 shares of Common
Stock at semi-annual intervals on February 28th and August 31st each year at a purchase price per share equal to 85% of the lower of (i) the closing selling price per share of Common Stock on the employees entry date into the
offering period in which that semi-annual purchase date occurs or (ii) the closing selling price per share on the semi-annual purchase date.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Consists of shares available for future issuance under the Plans. As of October 31, 2006, an aggregate of 306,249 shares of Common Stock were available for issuance under the
1994 Plan and 3,722,425 shares of Common Stock were available for issuance under the 2005 Plan. However, pursuant to the automatic share increase provisions of the 1994 Plan, the number of shares reserved for each such plan will automatically
increase on the first trading day of each fiscal year over the term of the relevant plan by a number of shares equal to one half of one percent (0.5%) of the total number of shares of Common Stock outstanding on the last trading day of the
immediately preceding fiscal year. In no event, however, may any such annual increase to the share reserve of the 1994 Plan exceed 500,000 shares, as adjusted from time to time to reflect any subsequent stock dividends or stock splits.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | The table does not include information for equity compensation plans assumed by the Company in connection with mergers and acquisitions of the companies that originally established
those plans. As of October 31, 2006, a total of 2,960,621 shares of the Companys Common Stock were issuable upon exercise of outstanding options under those assumed plans. The weighted average exercise price of those outstanding options
is $8.79 per share. No additional options may be granted under those assumed plans.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



A Supplemental Stock Option Plan (the Supplemental Plan) was implemented by the Board on August 9, 2000. The Supplemental Plan is a
non-shareholder approved plan under which options may be granted to employees of the Company (or any parent or subsidiary corporation) who are neither officers nor Board members at the time of grant. 1,500,000 shares of Common Stock have been
authorized by the Board for issuance under the Supplemental Plan. All option grants will have an exercise price per share equal to the fair market value per share of Common Stock on the grant date. Each option will vest in installments over the
optionees period of



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service with the Company. The options will vest on an accelerated basis in the event the Company is acquired and those options are not assumed or replaced by
the acquiring entity. Each option will have a maximum term (not to exceed 10 years) set by the plan administrator (either the Board or a Board committee) at the time of grant, subject to earlier termination following the optionees cessation of
employment. All options are non-statutory options under the Federal tax law.



Share issuances under the 2005 Plan will not reduce or otherwise affect the number of shares of Common Stock available for issuance under the Supplemental Plan, and share issuances under Supplemental Plan will not
reduce or otherwise affect the number of shares of Common Stock available for issuance under the 2005 Plan.



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



The information required by this item will be included under the caption Certain Relationships and Related Transactions in the Companys
Proxy Statement for the 2007 Annual Meeting of Stockholders and is incorporated herein by reference.



|Item 14. | Principal Independent Registered Public Accounting Firm Fees and Services
|-------- | -------------------------------------------------------------------------



The information required by this item will be included under the caption Principal Independent Registered Public
Accounting Firm Fees and Services in the Companys Proxy Statement for the 2007 Annual Meeting of Stockholders and is incorporated herein by reference.



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PART IV



|Item 15. | Exhibits and Financial Statement Schedules
|-------- | ------------------------------------------



(a) The following documents are filed as part of the Annual Report on Form 10-K:



1.Financial Statements.    The following Consolidated Financial
Statements of Credence Systems Corporation are included in Item 8 of this Annual Report on Form 10-K:



|                                                                                                     |  |     
|---------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                     |  | Page
|Report of Independent Registered Public Accounting Firm                                              |  | 53  
|Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting |  | 54  
|                                                                                                     | 
|Consolidated Balance SheetsOctober 31, 2006 and 2005                                                |  | 55  
|Consolidated Statements of OperationsYears Ended October 31, 2006, 2005 and 2004                    |  | 56  
|Consolidated Statements of Stockholders EquityYears Ended October 31, 2006, 2005 and 2004          |  | 57  
|Consolidated Statements of Cash FlowsYears Ended October 31, 2006, 2005 and 2004                    |  | 58  
|Notes to Consolidated Financial Statements                                                           |  | 59  



2.Financial Statement Schedule.    The following financial statement schedule of Credence Systems Corporation, for the years ended October 31, 2006, 2005 and 2004, is filed as part of this Annual
Report on Form 10-K and should be read in conjunction with the Consolidated Financial Statements of Credence Systems Corporation:



|                                              |  |     
|--------------------------------------------- |  | ----
|                                              |  | Page
|Schedule IIValuation and Qualifying Accounts |  | 104 



Schedules other than
the one listed above have been omitted since they are either not required, are not applicable or the required information is shown in the consolidated financial statements or related notes.



3.Exhibits.    See
Exhibit Index on page 105.



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SIGNATURES



Pursuant to the
requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, as of January 11, 2007.



CREDENCE SYSTEMS CORPORATION (Registrant)By:

/S/    LAVI A.
LEVLavi A. Lev President and Chief Executive OfficerBy:

/S/    JOHN C.
BATTYJohn C. Batty Chief Financial Officer




POWER OF
ATTORNEY



KNOW ALL PERSONS BY THESE PRESENTS, that each
person whose signature appears below constitutes and appoints Lavi A. Lev and Byron W. Milstead, and each of them, as his true and lawful attorneys-in-fact and agents, with full power of substitution and re-substitution, for him and in his name,
place and stead, in any and all capacities, to sign any and all amendments to this Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission,
granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might
or could do in person, hereby ratifying and confirming that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully 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/    LAVI A.
LEVLavi A. Lev           |  | President, Chief Executive Officer (Principal Executive Officer)                                          |  | January 11, 2007
|                                        |  |                                                                                                          
|/S/    JOHN C.
BATTYJohn C.
Batty       |  | Senior Vice President, Chief Financial Officer and Secretary (Principal Financial and Accounting
Officer) |  | January 11, 2007
|                                        |  |                                                                                                          
|/S/    DAVID
HOUSEDavid House           |  | Executive Chairman and Director                                                                           |  | January 11, 2007
|                                        |  |                                                                                                          
|/S/    RICHARD M.
BEYERRichard M.
Beyer |  | Director                                                                                                  |  | January 11, 2007
|                                        |  |                                                                                                          
|/S/    HENK J.
EVENHUISHenk J.
Evenhuis |  | Director                                                                                                  |  | January 11, 2007



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|                                                    |  |          |  |                 
|--------------------------------------------------- |  | -------- |  | ----------------
|Signature                                           |  | Title    |  | Date            
|                                                    |  |         
|/S/    LORI
HOLLANDLori
Holland                     |  | Director |  | January 11, 2007
|                                                    |  |         
|/S/    WILLIAM G. HOWARD,
JR.William G. Howard,
Jr. |  | Director |  | January 11, 2007
|                                                    |  |         
|/S/    JON D.
TOMPKINSJon D.
Tompkins               |  | Director |  | January 11, 2007
|                                                    |  |         
|/S/    BRUCE R.
WRIGHTBruce R.
Wright               |  | Director |  | January 11, 2007
|                                                    |  |         
|/S/    PING
YANGPing Yang                           |  | Director |  | January 11, 2007



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##### Table of Contents

Item 15(a)(2).



Schedule II



CREDENCE SYSTEMS
CORPORATION



VALUATION AND QUALIFYING ACCOUNTS

(In thousands)



|                                |  |                              |       |           |   |       |            |  |                        |       |  |   |      
|------------------------------- |  | ---------------------------- | ----- | --------- | - | ----- | ---------- |  | ---------------------- | ----- |  | - | -----
|                                |  | Balance at Beginning of Year |       | Additions |   |       | Write-offs |  | Balance at End of Year
|Year ended October 31, 2006     |  |                              |       |           |   |       |            |  |                        |       |  |   |      
|Allowance for doubtful accounts |  | $                            | 4,325 |           | $ | (83   | )*         |  | $                      | 2,651 |  | $ | 1,591
|Year ended October 31, 2005     |  |                              |       |           |   |       |            |  |                        |       |  |   |      
|Allowance for doubtful accounts |  | $                            | 1,607 |           | $ | 2,985 |            |  | $                      | 267   |  | $ | 4,325
|Year ended October 31, 2004     |  |                              |       |           |   |       |            |  |                        |       |  |   |      
|Allowance for doubtful accounts |  | $                            | 2,444 |           | $ | (118  | )**        |  | $                      | 719   |  | $ | 1,607

---

|* | This amount consisted of an additional allowance of approximately $9,000 and reversal of the beginning allowance amount of approximately $92,000.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------

|** | This amount consisted of an additional allowance of approximately $74,000, reversal of the beginning allowance amount of approximately $1,534,000 and assumption of the allowance for
former NPTests accounts receivable of approximately $1,342,000.
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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EXHIBIT INDEX



|                  |  |                                                                                                                                                                          
|----------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit    Number |  |                                                                                                                                                                          
|3.1(3)            |  | Amended and Restated Certificate of Incorporation of the Company, as currently in effect.                                                                                
|                  | 
|3.2(5)            |  | Amended and Restated Bylaws of the Company, as currently in effect.                                                                                                      
|                  | 
|4.1(9)            |  | Certificate of Designation for the Non-Voting Convertible Stock of the Registrant.                                                                                       
|                  | 
|4.2(2)            |  | Indenture, dated as of June 2, 2003 between the Company and The Bank of New York, as Trustee.                                                                            
|                  | 
|4.3(2)            |  | Form of Global Note (included in Exhibit 4.3).                                                                                                                           
|                  | 
|4.4(17)           |  | Indenture, dated as of December 20, 2006, between the Company and The Bank of New York, as Trustee.                                                                      
|                  | 
|4.5(17)           |  | Form of Global Note (included in Exhibit 4.4).                                                                                                                           
|                  | 
|10.1(14)          |  | Form of Indemnification Agreement between the Company and each of its officers and directors.                                                                            
|                  | 
|10.2(6)           |  | 1993 Stock Option Plan, as Amended and Restated through March 19, 2003.                                                                                                  
|                  | 
|10.3(1)           |  | Form of Notice of Grant to be generally used in connection with the 1993 Stock Option Plan.                                                                              
|                  | 
|10.4(1)           |  | Form of Stock Option Agreement to be generally used in connection with the 1993 Stock Option Plan.                                                                       
|                  | 
|10.5(1)           |  | Addendum to the Stock Option Agreement (Special Tax Elections).                                                                                                          
|                  | 
|10.6(1)           |  | Addendum to the Stock Option Agreement (Limited Stock Appreciation Rights).                                                                                              
|                  | 
|10.7(1)           |  | Addendum to the Stock Option Agreement (Change in Control).                                                                                                              
|                  | 
|10.8(1)           |  | Addendum to the Stock Option Agreement (Financial Assistance).                                                                                                           
|                  | 
|10.9(1)           |  | Form of Notice of Grant of Stock Option (Non-Employee Director) to be generally used in connection with the automatic option grant program of the 1993 Stock Option Plan.
|                  | 
|10.10(1)          |  | Form of Stock Option Agreement (Non-Employee Director) to be generally used in connection with the automatic option grant program of the 1993 Stock Option Plan.         
|                  | 
|10.11(18)         |  | Employee Stock Purchase Plan, as Amended and Restated through May 17, 2000.                                                                                              
|                  | 
|10.12(1)          |  | Form of Stock Purchase Agreement.                                                                                                                                        
|                  | 
|10.13(1)          |  | Form of Enrollment/Change Form.                                                                                                                                          
|                  | 
|10.14(4)          |  | Supplemental Stock Option Plan, as amended and restated through November 27, 2000.                                                                                       
|                  | 
|10.15(7)          |  | Registration Rights Agreement, dated as of June 2, 2003, by and between Credence Systems Corporation and Citigroup Global Markets, Inc.                                  
|                  | 
|10.16(11)         |  | Executive Employment Agreement, dated as of September 9, 2004, and effective May 28, 2004, by and between the Company and Byron Milstead.                                
|                  | 
|10.17(12)         |  | Executive Succession Agreement, dated as of November 5, 2004, and effective January 1, 2005, by and between the Company and Graham J. Siddall.                           
|                  | 
|10.18(12)         |  | Amended Executive Employment Agreement, dated as of November 5, 2004, and effective January 1, 2005, by and between the Company and David A. Ranhoff.                    



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|                  |  |                                                                                                                                                                                                                           
|----------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit    Number |  |                                                                                                                                                                                                                           
|                  | 
|10.21(13)         |  | Amended and Restated Executive Employment Agreement, dated as of March 11, 2006, by and between the Company and John Batty.                                                                                               
|                  | 
|10.22(13)         |  | Amended and Restated Executive Employment Agreement, dated as of March 11, 2006, by and between the Company and Brett Hooper.                                                                                             
|                  | 
|10.23(10)         |  | Settlement Agreement dated May 26, 2005, by and among Schlumberger Technology Corporation, Schlumberger Technologies, Inc., Schlumberger B.V., NPTest Holding Corporation, NPTest
Acquisition Corporation and the Company.
|                  | 
|10.24(10)         |  | 2005 Stock Incentive Plan, as amended.                                                                                                                                                                                    
|                  | 
|10.25(15)         |  | Resale Restriction Agreement with respect to certain stock option award agreements issued under the Companys 1993 Stock Option Plan.                                                                                     
|                  | 
|10.26(16)         |  | Executive Employment Agreement, dated as of December 9, 2005, by and between the Company and David House.                                                                                                                 
|                  | 
|10.27(8)          |  | Fiscal Year 2006 Incentive Plan.                                                                                                                                                                                          
|                  | 
|10.28(8)          |  | Lease and Sublease Termination Agreement between the Registrant and CARR NP Properties LLC.                                                                                                                               
|                  | 
|10.29(17)         |  | Form of Exchange and Purchase Agreement dated as of December 14, 2006 between the Company and Certain Holders of 3.5% Convertible Senior Subordinated Notes due 2010.                                                     
|                  | 
|10.30(17)         |  | Registration Rights Agreement dated as of December 14, 2006 between the Company and Certain Holders of 3.5% Convertible Senior Subordinated Notes due 2010.                                                               
|                  | 
|12.1              |  | Statement of Computation of Ratio of Earnings to Fixed Charges.                                                                                                                                                           
|                  | 
|21.1              |  | Subsidiaries of the Company.                                                                                                                                                                                              
|                  | 
|23.1              |  | Consent of Independent Registered Public Accounting Firm.                                                                                                                                                                 
|                  | 
|24.1              |  | Power of Attorney (reference is made to the signature page of this report).                                                                                                                                               
|                  | 
|31.1              |  | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.                                                                                        
|                  | 
|31.2              |  | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.                                                                                        
|                  | 
|32.1              |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                
|                  | 
|32.2              |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                

---

|(1) | Exhibits 10.3 through 10.10 and Exhibits 10.12 and 10.13 are incorporated herein by reference to Exhibits 99.2, 99.3, 99.4, 99.5, 99.6, 99.7, 99.8, 99.9, 99.11 and 99.12,
respectively, to the Companys Registration Statement on Form S-8 (File No. 333-27499) declared effective with the Securities and Exchange Commission on May 20, 1997.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference to Exhibit 4.3 to the Companys Registration Statement on Form S-3 (File No. 333-108069) as filed with the Commission on August 19, 2003.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated by reference to Exhibit 3.1 to the Companys Quarterly Report on Form 10-Q (Filed No. 000-22366) for the quarterly period ended April 30, 2000.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------



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|(4) | Incorporated by reference to Exhibit 99.1 to the Companys Registration Statement on Form S-8 (File No. 333-58100), as filed with the Commission on April 2, 2001.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Incorporated by reference to Exhibit 3.01 to the Companys Current Report on Form 8-K (File No. 000-22366) filed on August 29, 2005.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

|(6) | Incorporated by reference to Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q (Filed No. 000-22366) for the quarterly period ended April 30, 2003.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) | Incorporated herein by reference to Exhibit 4.5 to the Companys Registration Statement on Form S-3 (File No. 333-108069) declared effective with the Securities and
Exchange Commission on November 26, 2003.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) | Incorporated by reference to Exhibit 10.26 to the Companys Report on Form 10-K (File No. 000-22366) filed on January 17, 2006.
|--- | -------------------------------------------------------------------------------------------------------------------------------

|(9) | Incorporated by reference to Exhibit 4.7 to the Companys Registration Statement on Form S-4 (File No. 333-113990) filed on March 29, 2004.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------

|(10) | Exhibits 10.23 and 10.24 are incorporated herein by reference to Exhibits 10.1 and 10.2, respectively, to the Companys Quarterly Report on Form 10-Q (File No. 000-22366) for
the quarterly period ended April 30, 2005.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(11) | Exhibits 10.12 is incorporated herein by reference to Exhibit 10.4, to the Companys Report on Form 8-K (File No. 000-22366) filed on September 14, 2004.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------

|(12) | Exhibits 10.17 and 10.18 are incorporated herein by reference to Exhibits 10.1 and 10.2, respectively, to the Companys Report on Form 8-K (File No. 000-22366) filed on
November 8, 2004.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(13) | Exhibit 10.21 and 10.22 are incorporated by reference to Exhibit 10.4 and 10.5 to the Companys Quarterly Report on Form 10-Q (File No. 000-22366) filed on March 10, 2006.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(14) | Exhibit 10.1 is incorporated herein by reference to Exhibit 10.1 to the Companys Annual Report on Form 10-K for the fiscal year ended October 31, 2003.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------

|(15) | Exhibit 10.25 is incorporated herein by reference to Exhibit 1.01 to the Companys Current Report on Form 8-K (File No. 000-22366) filed on September 1, 2005.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------

|(16) | Exhibit 10.25 is incorporated herein by reference to Exhibit 1.01 to the Companys Current Report on Form 8-K (File No. 000-22366) filed on December 13, 2005.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------

|(17) | Exhibits 4.5, 4.5, 10.30 and 10.31 are incorporated herein by reference to Exhibit 4.1, 4.2, 10.1 and 10.2 to the Companys Current Report on Form 8-K (File No. 000-22366)
filed on December 21, 2006.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(18) | Incorporated by reference to Exhibit 10.11 to the Companys Report on 10-K for the period ended October 31, 2005.
|---- | -----------------------------------------------------------------------------------------------------------------



107