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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, 2003

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)

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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

Preferred Stock Purchase Rights

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

Indicate by a 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 an accelerated filer (as defined in Rule 12b-2 of the
Exchange Act).    Yes  x    No ̈

The aggregate market value of voting stock held by non-affiliates of the Registrant, as of April 30, 2003 was approximately $436,530,160 (based upon the
closing price for shares of the Registrants common stock as reported by the Nasdaq National Market for the last trading date prior to that date). 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 January 6, 2004, approximately 63,953,445 shares of the Registrants common stock, $0.001 par value, were outstanding.

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DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrants Proxy Statement for the 2003 Annual Meeting of Stockholders to be held on March 23, 2004 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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PART I



In addition to the historical information contained in this document, the discussion in 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, that involve risks and uncertainties, such as statements of the Companys plans,
objectives, expectations and intentions. Statements that include the use of terminology such as may, will, expects, plans, anticipates, estimates, potential, or
continue, or the negative thereof or other comparable terminology are forward-looking statements. 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, without limitation, statements regarding the intended purpose of the ATE production test systems, our intention to keep pace with rapid advances
in IC design and test, our intention to continually enhance our existing systems, our intention to continue to build close working relationships with IC manufacturers, EDA software vendors and ATE machine vendors, our anticipation that international
business will continue to account for a significant portion of net sales, our belief that order cancellations and shipment delays will continue, our intention to continue to scrutinize our inventory, our continued development of stabilitzation
techniques, our intention to focus our research and development efforts on the Octet product line, our intention to continue to invest significant resources in development of new products and enhancements, our anticipation that revenue levels will
continue to remain under pressure, our anticipation that significant portion of orders may depend upon demand from semiconductor device manufacturers building or expanding fabrication facilities and new devise testing requirements, our intention to
pursue additional acquisitions, our anticipation that we will not pay any dividends on our common stock, our expectation that gross margins will improve, our anticipation that R&D expenses will remain significant, our expectation that SG&A
expenses will be flat to slightly higher, the effect of the adoption of certain accounting policies, the expectation as to the maturity of the Emiscope II product, the ultimate liability for pending claims, our continuing to defer certain revenue,
our intent to sublease the Fremont space, and the use of proceeds from our $180 million convertible note offering.



Our actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences 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 otherwise, expenses associated with acquisitions and alliances, 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, regulatory changes and
outbreaks of hostilities and other factors set forth in Risk Factors and elsewhere herein.



Item 1.Business



We design, manufacture, sell and service engineering validation test equipment, emission-based optical diagnostics and failure analysis products and automatic test equipment, or ATE, used for testing semiconductor
integrated circuits, or ICs. We also develop, license and distribute software products that provide automation solutions in the IC design and test flow fields. 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, radio frequency, volatile, and static and non-volatile memory 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, emission-based optical 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



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are produced in high volume. Our software products enable design and test engineers to develop and troubleshoot production test programs prior to fabrication
of the device prototype. Collectively, our customers include major semiconductor manufacturers, fabless design houses, foundries and assembly and test services companies.



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 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 R. Detwiler, the Companys Senior Vice President, Chief Financial Officer and Secretary at the Companys headquarters at
1421 California Circle, Milpitas, California 95035. Credence Systems Corporation, Credence, IMS, Fluence, SC, ValStar, Quartet, Octet,
Electra, Vanguard, Wavebridge, MemBIST, TDS, TDX, BOST, MemBOST, Kalos, DUO, TMT, MVNA,
Opmaxx, DirectTest, Virtual Test, Optonics, Emiscope, and SZ are certain of our trademarks. This Annual Report on Form 10-K also includes trademarks of other companies.



Background



The semiconductor industrys successful production of increasingly
smaller, faster and more sophisticated ICs has made semiconductor devices available for a wide range of applications resulting in semiconductor content growth in almost all appliances ranging from dishwashers to automobiles, cell phones to PDAs and
laptops to servers. At the same time, semiconductors have emerged as the building blocks of the communications, internet and telephony infrastructures. IC proliferation, together with a competitively driven reduction in device average selling
prices, has forced IC manufacturers to continually drive to reduce manufacturing costs while improving their time to volume production and profit.



The process of designing and manufacturing ICs is complex and capital-intensive, involving stages of design, prototype manufacture, engineering validation
test of the prototypes, device manufacture and production test. Each stage in this process has come under pressure as ICs have increased in complexity and speed. At the design stage, advances in electronic design automation, or EDA, software have
allowed design engineers to work with IC designs at increasingly higher levels of abstraction, permitting engineers to design significantly more complex ICs in less time. The ability to design more complex and capable circuits, together with
advances in manufacturing processes, has resulted in an approximate doubling of chip speed and complexity every two years. However, as ICs have become more complex and as device manufacturers have increasingly sought ways to introduce products to
market more rapidly, critical limitations have become increasingly apparent in the IC design-to-production process flow.



Today, IC design and manufacturing is, to a large extent, a serial process that crosses organizational, functional and often geographical boundaries. In
general, a design has to be complete before prototypes can be built; prototypes have to be built before they can be tested; and prototypes have to be production-ready before production test software can be debugged and refined. Production test
software can take significant time to debug and refine, so the need to wait until a physical part has been produced to perform that process delays an ICs introduction to the market. Even then, test failures can raise the question of whether
the IC itself is flawed, or the test has an error. In addition, an ICs design may be so sophisticated that some or all of its functionality cannot effectively be tested. Designs that are discovered to be un-testable when produced require
another iteration of the



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IC process flow. These challenges are further exacerbated within semiconductor manufacturers by traditional organizational boundaries where design
responsibilities end at pre-silicon verification and ownership is transferred to test engineering to create suitable test programs to uncover faults that may occur in production and by the increased level of outsourcing which physically separates
the design and test functions. Additionally, the process and technology used to develop and debug production test programs has often been inefficient and inadequate.



The equipment used in the engineering validation test stage has often been unable to effectively verify and characterize
increasingly complex ICs. To perform specialized tests on prototypes, engineers turned to ATE machines to verify and characterize prototypes. However, ATE machines are designed for volume production testing and in many cases lack the flexibility or
versatility to efficiently test whether, and within what limits, a given part works, or efficiently analyze why it fails to work.



Production testing is a principal element in the cost structure of semiconductors. Purchasers of production testers now examine more carefully the total
cost of ownership of ATE comprising of the initial purchase price of the tester, as well as the testers reliability, flexibility, size, power and air conditioning requirements, ability to upgrade, maintenance costs and spare parts.



As assembly and packaging have become increasingly expensive compared with
the cost of the semiconductor die, so that their costs may exceed the cost of the die itself, semiconductor manufacturers continue to shift performance testing increasingly toward wafer probe. By subjecting devices to performance testing earlier,
defective die are detected and eliminated before assembly and packaging costs are incurred. This trend has imposed new demands on ATE. Wafer probe testing, where production testing may now occur, requires that the device under test be located in
close physical proximity to the measuring circuits of the tester in order to minimize potential signal distortions that can negatively impact testing yields. Smaller testers can more easily be placed in close physical proximity to the circuits. In
addition, wafer probe test typically occurs in a clean room where potential contaminants must be continually removed and temperatures kept constant. These special maintenance requirements make clean rooms expensive to operate. Smaller testers occupy
less floor space and therefore assist in reducing clean room costs. In addition, smaller testers that consume less power generally have reduced air conditioning requirements.



There are two dominant process technologies used to develop the ICs used in ATE: emitter-coupled logic, or ECL, and
complementary metal oxide semiconductor, or CMOS. Although CMOS technology allows higher functionality per chip and requires less power to operate, ATE based exclusively on CMOS technology has been limited by the inability of CMOS to meet the timing
and measurement demands of semiconductor testing. Historically, although the speed of CMOS was acceptable, its timing stability was not. This problem results from the tendency of CMOS circuits to experience timing drift as a function of temperature
and voltage variation during tests. To fully benefit from the economic and other advantages of CMOS technology, the challenge has been to control this drift characteristic in order to produce semiconductors for ATE that meet the performance
requirements of semiconductor testing.



These technical,
economic and market trends have created a significant need for an integrated design to production test flow that includes Built in Self Test, or BIST, circuitry, photo emission based optical diagnostic tools, specialized engineering validation test
products and high performance, cost effective ATE. Additionally, the market is requiring solutions that enable engineers to develop and debug production test software and ATE interface equipment, or fixtures, in parallel with the design and
validation of IC prototypes to increase the process parallelism and improve device time to market.



The Credence Solution and Strategy



We provide high performance IC engineering solutions that address the engineering, debug and validation requirements of increasingly complex devices. Our engineering validation test systems test logic devices,
mixed-signal devices that combine both analog and digital functionality, and memory devices. Our engineering



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validation test systems can also be used to test selected functions of highly integrated, system-on-a-chip, or SoC, devices. By keeping pace with the
industrys advances in speed and pin count requirements, our solutions enable customers to reduce the time required for verification, characterization and failure analysis. This generally results in lower cost of design, reduced time-to-market
and increased competitiveness for the companies designing todays increasingly complex ICs. Our validation systems give engineers a more flexible and cost-effective way to verify and characterize prototype ICs and to perform failure analysis.
Each validation system integrates the functions of a variety of individual test instruments into a single system consisting of both hardware and software that offers increased verification and characterization performance with significant cost
savings. Our engineering validation test technology allows our systems to send and receive data from an IC at the same speeds the circuit will experience in actual use. As a result, design and test engineers can better identify failures, assess
areas of concern, run rapid diagnostic sequences to pinpoint the causes of failure and identify changes needed to correct design errors or weaknesses. With our acquisition of Optonics, we now add unique debug and diagnostic capabilities to our
engineering solutions to provide advanced silicon debug, characterization and device failure analysis. Incorporating innovative time resolved emission technology for the backside timing measurement of a wide range of devices from complex multi-layer
metal devices in flip-chip packages, to more traditional devices with conventional wire bond and tape automated bonding packaging technologies, this technology helps semiconductor manufacturers bring products to market faster with fewer mask
re-designs and at a lower cost. Additionally, our engineering solutions accelerate failure analysis problem resolution with integrated test and diagnostic systems and integrated feedback to the major EDA manufacturers. Our solutions provide IC
manufacturers shorter design cycles and faster failure resolution, improving profit opportunities and minimizing failure impact.



We have developed proprietary CMOS stabilization methods that minimize the drift characteristic of CMOS and enable us to produce ATE production test
systems that are smaller and require less power than those based on ECL technology. These testers are intended to provide a lower total cost of ownership than many competing products currently available while meeting the performance demands of
todays ATE market. CMOS technology allows the circuits used in our testers to be reduced, or scaled down in size, as IC process technology improves. This scalability feature enables us to develop and manufacture smaller, higher performance
circuits for use in our testers at what we believe to be a lower cost, and with a potentially shorter development cycle, than traditional process technologies.



We believe our software solutions enable test engineers to develop, refine and debug production test software early in the IC design and production
process, even before a prototype of the IC is produced. By allowing production test programs to be developed and debugged while the IC is being designed and validated, our software can significantly reduce the time required to introduce ICs to
market.



Our objective is to be the leading supplier of design
through production test solutions. This includes high performance IC engineering validation test systems, compelling silicon debug and diagnostic systems, cost-effective ATE for production testing of ICs used in high volume applications, and
software solutions and other innovations to decrease the cycle time from circuit design to high volume manufacturing. Our business strategy incorporates the following key elements:



| |  | Maintain Technology Competitiveness. We believe that our proprietary CMOS stabilization technology enables the development of ATE that is designed to meet the performance and
cost of ownership requirements of semiconductor manufacturers and assembly and test services companies. In addition, we believe the scalability of this technology will allow us to offer new products and enhancements in a potentially shorter time and
at a lower cost than many of our competitors that base their products on traditional less-scalable architecture.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Provide Innovative Solutions to Test Increasingly Complex Devices. We intend to keep pace with rapid advances in IC circuit design and test by introducing new engineering
validation test systems, optical debug and diagnostic systems and related software designed to test higher speed, more complex and higher pin count devices. We intend to continually enhance our existing systems to add valuable features and functions
that meet our customers evolving needs.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | Lower Total Cost of Ownership. We seek to provide ATE to our customers at a lower total cost of ownership than many competing products currently available while meeting the
performance requirements of our customers. We believe that the system price, reliability, flexibility, size, power and air conditioning requirements, upgradeability and maintenance costs, including spare parts, of our testers enable our customers to
more cost effectively test ICs.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Provide Integrated Design to Production Test Solutions to Reduce Time-to-Market. We believe that our customers require increasing levels of sophisticated hardware and
software tools to integrate the design to production test flow, assist in the utilization of ATE and minimize time-to-market. We currently are focusing our software efforts on internal development and acquisition of companies or businesses that
develop such tools. Through previous acquisitions of Fluence Technology, Inc., or Fluence, and Integrated Measurement Systems, Inc., or IMS, we have a large installed base of automatic test program development software and technology in the areas of
analog design, optimization and fault analysis technology and Built in Self Test or BIST. We have developed a next generation test program development product, TestDeveloper, that combines the best of the previous TDS and TDX product lines and
extends the capability of the application. The acquisition of IMS added Virtual Test Software designed to develop and debug test programs and model the tester and test environment. With our acquisition of Optonics, we offer a unique silicon debug,
diagnostic and failure analysis methodology that enables transistor-level failure location. Incorporating leading high-speed opto-electronic IR detection and imaging technology, our Emiscope product line provides critical information to rapidly
locate timing problems in new or failing devices. We believe our acquisitions together with our new software product lines that integrate design and test, will enable us to lead the integrated design to test flow.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Target Diverse, High-Volume Markets. Our products target the testing of digital logic, analog mixed-signal, SoC, memory and radio frequency devices that are used in a broad
range of growing end-user market segments. Our products are designed to test semiconductors that are manufactured in high volume and are used in a variety of applications such as automobiles, appliances, personal computers, personal communications
products, networking products, digital televisions and multimedia hardware and communications infrastructure.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Leverage Relationships with Industry Leaders to Enhance Market Position. We currently intend to continue to build close working relationships with integrated circuit
manufacturers, EDA software vendors and ATE machine vendors to enhance our market position. Working closely with integrated circuit manufacturers helps us anticipate their needs and incorporate specific value-added functionality into our products.
We believe our relationships with leading EDA software vendors allow us to design and offer products that can access the device models created with EDA software and effectively use this data to perform validation tests and debug and refine
production test programs. Our relationships with several leading ATE vendors strengthen our ability to develop ATE machine simulations, and we believe these relationships have led to increased customer acceptance of our TDS and virtual test software
products.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Worldwide Technical Support and Customer Service. As semiconductor manufacturers expand their operations worldwide, they require that their test suppliers have the capability
to provide global support, service and training. To meet this requirement, we utilize a combination of direct sales, service and support personnel and a broad network of independent distributors located in close proximity to major customer sites. We
and our distributors currently maintain locations throughout the world to service and support our customers.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Products



We currently offer a wide variety of products that test digital logic, analog, mixed-signal, SoC, static random access memory, or SRAM, non-volatile or
Flash memory and radio frequency wireless ICs. Digital logic semiconductors produce discrete on and off logical sequences that control functions, store data, retrieve data and



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move and manipulate data at high rates of speed. Analog semiconductors control external functions such as sound, graphics, and motor controls by producing
continuous varying voltage or current signals. When these analog functions are combined onto a digital IC, the resulting device is considered a mixed-signal device and as the levels of integration increase, the circuit is termed an SoC device. For
memory devices, dynamic random access memory, or DRAM, loses data without power while non-volatile memory, or NVM, semiconductors retain their data when the power is turned off. RF wireless ICs are the devices that receive, transmit and
convert radio frequency signals typically used in cellular telephones and other communications devices.



Our CMOS-based ATE productsthe SC, Quartet and Octet seriesare designed to test high speed devices used in applications such as networking and
personal computing as well as multimedia, digital television, high-definition television and personal communications. Our memory product line, the Kalos Series, tests non-volatile memory, or NVM, devices, including ROM, EPROM, EEPROM and Flash
memories, which are used in high volume applications in the consumer, automotive and telecommunications markets.



During fiscal 2003, we introduced Verity, an integrated test and debug platform for the engineering and failure analysis area, and the Personal Kalos 2
and Kalos 2, our next generation NVM test systems. Also during fiscal 2003 we acquired the principal assets of SZ Testsystems AG, SZ Testsystems GmbH and SZ Testsysteme Japan Limited, or, collectively, SZ, and Optonics, Inc., or Optonics. The SZ ATE
products, which are produced in Amerang, Germany, are focused on the advanced analog, power automotive and communications markets. Optonics, based in Mountain View, California, is a major supplier of integrated solutions for emission-based optical
diagnostics and failure analysis.



During fiscal 2002, we
introduced five new products, or modifications to existing products. The Octet series high performance configurable SoC test platform retains compatibility with the earlier generation Quartet but provides twice the pin count with 1024 channels and
four times the performance with 800Mb/sec data rates. The Octet is targeted toward high performance SoC devices. The ASL 3000 extends our ASL product line providing digital capability on the analog-focused product line. The ASL 3000 is targeted
toward cost-sensitive mixed signal applications. To address the high performance, low cost RF IC market, we introduced the ASL 3000RF, which incorporates our proprietary Modulated Vector Network Analyzer, or MVNA technology. In the engineering
validation market, we introduced the Gemini MS product that combines digital performance with new analog measurement technologies. Adding to our design to test portfolio, we introduced a new version of our Test Developer product with improved
cyclization and software algorithms.



During fiscal 2001 we
acquired the principal assets of Rich Rabkin & Associates, Inc., or Rabkin, and IMS. Rabkin specializes in providing interface solutions and test head positioning devices for the semiconductor test market through its patented solution for high
parallel memory testing. Rabkin was integrated into our Mobile Products Group to offer test solutions that we believe increase manufacturing efficiencies and provide faster time to market for our customers. IMS designs, manufactures, markets and
services high-performance engineering validation test systems. These systems are used to test, at the prototype stage, complex digital, mixed-signal and memory devices. In addition, IMS develops, markets and supports a line of virtual test software
that we believe enables design and test engineers to develop and debug production test software prior to fabricating the prototype of the actual device. During fiscal 2001, we merged our wholly owned subsidiary, Fluence, into IMS. During fiscal
2002, we merged IMS into the Company.



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The following table sets forth our current product offerings, their features and examples of typical
devices tested by each product. Included in some of the basic features are the anticipated cycle speed in megahertz, timing accuracy in either picoseconds (ps) or nanoseconds (ns), the number and characteristics of the pins and the density, in
megabits(Mb), of the device that can be tested:



|                  |  |                  |  |                                             |  |                                                                                                   |  |                                                                                                                                  
|----------------- |  | ---------------- |  | ------------------------------------------- |  | ------------------------------------------------------------------------------------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------
|                 
|                  |  |                  |  |                                            
|Product           |  | Series           |  | Models                                      |  | Market and Basic Features                                                                         |  | Typical Devices Tested                                                                                                           
|                 
|Digital           |  | SC               |  | SC312 SC Micro                              |  | ATE: 50-100 MHz 64-304 Pins + 350-500 ps accuracy                                                 |  | Microcontrollers, ASSPs, DSPs and FPGAs                                                                                          
|                 
|                  |  | IMS     Vanguard |  | 300 500 550                                 |  | Engineering validation test: Up to
1Gbs +/- 200 ps accuracy 16-512 Pins                           |  | Microprocessors, Network Processors, Chipsets, ASICs, Multi-Chip Modules                                                         
|                 
|Mixed-Signal, SOC |  | Octet            |  | Octet 200 Octet 400 Octet 800               |  | ATE: 1024 digital pins 200-800 Mbs +/- 150 ps accuracy Analog, Video, Audio                       |  | Multimedia devices, mass storage, DSPs, ASICs, Datacom and specialty devices, mobile communication devices, complex audio devices
|                 
|                  |  | Quartet          |  | Quartet                                     |  | ATE: 512 digital pins 200 MHz +/- 175 ps accuracy Analog, Video, Audio                            |  | Multimedia devices, mass storage, DSPs, ASICs, Datacom and specialty devices, mobile communication devices, complex audio devices
|                 
|                  |  | ASL              |  | ASL 3000                                    |  | ATE: Up to 32 analog instruments with expansion for up to 64 pins of digital and DSP instruments. |  | Personal communications, A/D and D/A converters as well as multi-site test of traditional linear devices                         
|                 
|                  |  | SZ Falcon        |  |                                             |  | ATE: Up to 32 analog instruments with expansion for up to 64 pins of digital and DSP instruments. |  | Automotive and mixed signal devices                                                                                              
|                 
|                  |  | SZ Piranha       |  |                                             |  | ATE: Up to 64 pins 50 MHz digital                                                                 |  | Automotive and mixed signal devices                                                                                              
|                 
|                  |  | IMS Electra      |  | Electra, Electra MX                         |  | Engineering validation test: 16-576
digital pins 200 MHz Digital 2.4GHz Analog                    |  | High pin count SoCs, A/D and D/A converters, PLLs                                                                              
|                 
|                  |  | IMS Gemini       |  | Gemini MS                                   |  | Engineering validation test: 336
digital pins 330 MHz Digital 2.4GHz Analog                       |  |                                                                                                                                  
|                 
|Memory            |  | KALOS 1          |  | Kalos, Kalos xw, Kalos (xp), Personal Kalos |  | ATE: 50/70 MHz Up to 1G fail memory +/- 1ns Accuracy                                              |  | Flash memories, EEPROM, EPROM, MROM, Microcontrollers and NVM ASICs                                                              
|                 



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|------------------------------------------ |  | -------------- |  | ------------------------ |  | ------------------------------------------------------------------------------------------------------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------
|                                          
|                                           |  |                |  |                         
|Product                                    |  | Series         |  | Models                   |  | Market and Basic Features                                                                                           |  | Typical Devices Tested                                                                                                                         
|                                          
|                                           |  | KALOS 2        |  | Personal Kalos 2 Kalos 2 |  | ATE: 72 independent sites 100/400 MHz
Up to 2G fail memory +/-350 ps accuracy                                       |  | Flash memories, EEPROM, EPROM, MROM, Microcontrollers and NVM ASICs                                                                            
|                                          
|                                           |  | IMS Orion      |  | Orion                    |  | Engineering validation test: 200MHz 48-80 Pins 1 Gbit fail memory                                                   |  | SRAM, DRAM, Rambus                                                                                                                             
|                                          
|Mixed Signal Analog Test Products          |  | ASL            |  | ASL 1000                 |  | ATE: Up to 19 analog instruments
with 32 14MHz digital pins                                                         |  | Analog or Linear IC such as battery power management IC. Traditional linear devices such as op-amps, comparators and regulators                
|                                          
|Mixed Signal Radio Frequency (RF) Wireless |  | ASL            |  | ASL 3000RF               |  | ATE: Up to 8 ports of 6GHz RF with Analog and
digital instruments. MVNA technology                                  |  | Wireless communications IC such as PAs, Low Noise Amplifiers, Mixers and synthesizers. Bluetooth, CDMA, GSM, and 802.11 WLAN compatible devices
|                                          
|Emission Based Optical Probers             |  | Emiscope       |  | EmiScope I               |  | Debug and failure analysis: Backside timing
measurement for complex devices during debug and failure analysis       |  | All flip chip devices with multi-level metal                                                                                                   
|                                          
|                                           |  |                |  | EmiScope I GP            |  | Debug and failure analysis: Long working distance
lens for backside timing analysis of traditional packaged devices |  | Traditional packaged devices with design rules down to 0.1 micron                                                                              
|                                          
|                                           |  |                |  | EmiScope II              |  | Debug and failure analysis: 0.25 micron image
resolution for leading-edge device backside timing analysis           |  | All devices with design rules down to 65 nanometer                                                                                             
|                                          
|Software                                   |  | Design to Test |  | Test Developer           |  | Generates tester specific files from simulation (EDA) files. Verifies timing specification                          |  | Tools apply to digital logic circuits                                                                                                          
|                                          
|                                           |  | Design to Test |  | Virtual Test             |  | Accelerates the development and debug of test programs                                                              |  | Tools apply to digital logic devices                                                                                                           
|                                          
|                                           |  | Design to Test |  | MS BIST                  |  | BIST generation for digital, analog and mixed-signal devices                                                        |  | Tools apply to analog, high-speed digital and mixed-signal devices                                                                             
|                                          



9



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Digital Products



SC. In fiscal 1997, we expanded the SC series by introducing and shipping the SC 312, which runs at a higher speed
(100 MHz) and has improved accuracy over its predecessor, the SC 212. The SC Micro is a cost-reduced version of the SC 312. This system offers our customers a full capability test system at a price currently below $2,000 per digital pin channel.
This per channel price has previously been available only in test systems with reduced functionality-requiring users to compromise the quality of their device testing. The SC Micro retains the customers test quality while lowering its test
costs. The purchase price of these testers typically ranges from $200,000 to $500,000 depending upon configuration.



IMS Vanguard. The IMS Vanguard, our flagship engineering validation test product introduced by IMS in 1999, can send and receive data from ICs
under test at up to 1 Gbs and accounted for the majority of logic family sales in 2002 and 2003. The logic engineering validation test system family includes the Vanguard 500, 330 and most recently introduced 550. The IMS Vanguard systems sell for
between $0.7 million and $2.3 million depending on configuration.



SoC and Mixed-Signal Products



Octet.
Octet is our latest generation, high performance SoC configurable test platform. Introduced in July 2002 and first shipped in October 2002. Octet targets high performance SoC chips used in chipsets, graphics, audio, video, mass storage and wireless
baseband markets. Featuring up to 1024 digital pins and a selection of high performance analog instruments, the Octet is a production ready, high performance tester and meets the market requirements for low cost of test. Prices range from $1.0
million to $2.5 million depending on configuration.



Quartet. Quartet is our high performance mixed-signal product series. The Quartet was introduced in 1998 and started shipping in early fiscal 1999. Quartet builds on the Duo series by addressing the needs of device manufacturers
serving the consumer mixed-signal, or CMS, marketplace. CMS devices combine the power of digital processors with CD quality audio, broadcast video and wireless communications onto a single, cost-sensitive SoC. The Quartet, the first of the Quartet
series, addresses all four of these requirements in an integrated, ready for volume production package. With 200 MHz digital, 20 bit audio and 300 MHz video, Quartet is designed to meet the demands of the most complex SoC devices. With typical
system prices between $0.5 million and $1.5 million depending on configuration, the Quartet provides a low cost of test required by the CMS market.



ASL 3000. Introduced in fiscal 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. The
purchase price of the ASL 3000 ranges from $150,000 to $350,000 depending on configuration.



SZ Falcon. The SZ Falcon is a high-performance analog and mixed-signal test system that offers unique analog, DSP and digital capabilities for automotive, smart power, and consumer devices. SZ 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 SZ 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 SZ Falcon also features Giglink, a new high-speed serial bus system, and AWT, a new analog wave tool.



SZ Piranha. The SZ 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 SZ Piranha uses the same hardware and software technology as the SZ Falcon in a smaller housing without a test head. With
frequencies up to 50 MHz digital and up to 64 pins, the SZ Piranha also features multi-site and parallel test capabilities to lower test costs. The purchase price of the SZ Piranha ranges from $250,000 to $550,000.



10



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IMS Gemini MS. Our mixed-signal engineering validation test systems are used by customers to
verify the designs of complex ICs containing both digital and analog functionality. These mixed-signal ICs are used in applications such as cellular phones, internet appliance, set top boxes and cable modems. The IMS Gemini MS is also used to test
selected functions of highly-integrated, or SoC, designs. Depending on configuration, the system can send and receive data ICs under test at up to 330 MHz. The IMS Gemini MS sells for between $0.7 million and $1.5 million depending on configuration.



IMS Electra. The Electra system can send and receive
data from ICs under test at up to 200 MHz. Our Electra series includes the Electra, which can test mixed-signal ICs with up to 224 pins, and the Electra MX, which can test mixed-signal ICs with up to 576 pins. Our Electra series systems sell for
between $0.3 million and $2.1 million.



Memory Products



Kalos. Introduced in November 1997, the Kalos is a
highly integrated, parallel system designed to test flash memory. Running at 50 MHz, it provides multi-site testing and is designed to lower the customers cost of test. The Kalos features a unique tester-on-a-card architecture, which places
all test functions for each site on a single card and thus reduces floor space and power consumption while increasing performance. The typical purchase price of the Kalos ranges from $0.4 million to $1.2 million depending on configuration.



Kalos (xp). Introduced in fiscal 1999, the Kalos (xp)
is based upon the Kalos tester. The Kalos (xp) features a wider, 96 pin test site enabling testing of high pin count NVM and flash memory core microcontroller devices. Kalos (xp) provides up to eight site-in-parallel test capabilities in a small
footprint tester package.



Kalos xw. Introduced in
fiscal 2000, the KalosXWis based upon the Kalos tester and features 32 test sites, twice as many test sites as the
standard Kalos system.



Personal Kalos. Personal Kalos
is a desktop engineering version of the high-throughput Kalos tester. The typical price for a Personal Kalos ranges from $50,000 to $120,000 depending on configuration.



Kalos 2. Personal Kalos 2 and Kalos 2 were introduced in fiscal year 2003 and represent the next generation
non-volatile memory testers. With industry leading speed and innovative tester on a chip (ToC) architecture, the Kalos 2 products provide the highest level of parallel test capabilities. Coupled with minimal footprint and complete engineering to
production test coverage, and Kalos 2 delivers the lowest overall cost of test for NVM devices.



IMS Orion. The IMS Orion is used by our customers to verify the designs of the most common types of memory integrated circuits, including complex
SRAMs and DRAMs. The IMS Orion will send and receive data from integrated circuits under test at speeds up to 200 MHz/400 Mbs. Depending on configuration, these memory validation systems sell for between $400,000 and $600,000.



Analog Test Products



The acquisition of TMT in fiscal 2000 extended the market that we serve to
include analog dominant ICs that are made up of traditional analog function blocks such as amplifiers, regulators, switches and converters. The ASL product line tests these traditional devices either as individual ICs or as larger function ICs such
as battery power management devices in portable electronics devices.



ASL 1000. The ASL 1000 was introduced in fiscal 1996. This system is highly configurable and targeted at testing the traditional analog building block ICs. As the traditional analog or linear device manufactures 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. The purchase price of the ASL 1000 ranges from $90,000 to $250,000 depending on configuration.



11



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RF Wireless Test Products



Our RF wireless test products provide tools to IC manufacturers for use in characterization and production test of high
performance, cost sensitive RF devices.



ASL 3000RF.
Introduced in early 2002 and first shipped in May 2002, the ASL 3000RF extends the ASL 3000 product line by incorporating proprietary 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, or GaAs, Bi-polar or 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. Prices
range from $400,00 to $750,000 depending on configuration.



Emission based optical probers



EmiScope-I.An industry-leading solution for backside timing measurement of flip-chip packaged and complex multi-metal layer devices, the EmiScope-I provides interactive tools to perform transistor level timing measurements in the engineering, debug and
failure analysis environments. Using innovative time-resolved emission technology, the system enables semiconductor manufacturers to bring products to market faster, at a lower cost, and accelerate failure analysis problem resolution. Prices range
from $1,000,000 to $1,500,000.



EmiScope-I-GP.The EmiScope-I-GP extends time-resolved emission capability to devices packaged with wire bond and tape automated bonding technologies. Featuring a long working distance objective to accommodate the needs of traditional packaging, the system
enables probing in a variety of load board and package configurations. Prices range from $1,000,000 to $1,400,000.



EmiScope-II.A next-generation system for transistor-level backside analysis of complex IC designs with both flip-chip and wire bond packaging
technologies. Featuring a new Solid Immersioin Lens (SIL), EmiScope-II provides an industry-leading sub-0.25 micron image resolution and enhanced data acquisition rate to enable analysis of device performance at the critical node level. The
systems high-speed acquisition and data processing capabilities enable semiconductor manufacturers to quickly perform design debug, failure analysis and characterization, improving time-to-market and lowering device development costs. Prices
range from $1,200,000 to $2,000,000.



Software Products



Our software products for IC manufacturers and test and
assembly contractors help create detailed tests to ensure product quality and shorten time-to-market.



TestDeveloper. This product simplifies the complex SoC test program development task for the semiconductor industry by taking waveform data from
simulator-specific representations in the design environment, analyzing this data and then transforming the data into specific tester environments to be used in either device verification or production test. TestDeveloper connects design to test by
interfacing to commonly used design simulators, and by offering numerous TesterBridge modules available for a variety of ATE models.



VirtualTest Software. To address the need for shorter test development times and lower cost, this product accelerates the development and debug of
a test program, creates a model of the test environment, develops and tests fixtures and documents the entire test process. VirtualTest Software simulates the ATE environment enabling test engineers to develop and debug test programs in parallel
with the design, prototype manufacturing and engineering validation test processes. With VirtualTest Software, test development work can begin before the device design is completed.



12



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MSBIST. The mixed-signal built-in self-test product line generates on-chip testing of
analog-to-digital converters, digital-to-analog converters and high precision jitter measurements for advanced devices by inserting proprietary test techniques into the design before it is manufactured.



Customers, Markets and Applications



We target digital logic, analog, mixed-signal, dynamic random access memory,
non-volatile memory device, RF and SoC manufacturers that serve a broad range of growing end-user market segments. Our customers design, manufacture and test semiconductors in high volume for use in applications such as automobiles, appliances,
personal computers, personal communications products, networking products, digital televisions, wireless 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.



One customer, Spirox Corporation (a distributor in Taiwan), accounted for 19%, 20% and 13% of the Companys net sales in fiscal 2003, 2002 and 2001,
respectively. STMicroelectronics, headquartered in Europe, accounted for 10% of our net sales in fiscal 2003. Intel, headquartered in the USA, accounted for 20% of the Companys net sales in fiscal 2002. Tom Franz, one of our Directors, is a
Corporate Vice President of Intel. STMicroelectronics and Philips Semiconductors, headquartered in Europe accounted for approximately 13% and 11%, respectively, of our net sales in fiscal 2001.



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 or 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 4 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.



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, 2003, our order
backlog for systems, exclusive of orders for software, spare parts, service and support, was approximately $52.5 million plus an additional $9.4 million of deferred revenue under Staff Accounting Bulletin 101, or SAB 101, as compared with $51.2 and
$9.4 million, respectively, as of October 31, 2002. During fiscal years 2001 through 2003, we experienced order cancellations and customer-requested shipment delays in connection with the cyclical downturn in the semiconductor industry. We believe
it is probable that order cancellations and customer-requested shipment delays will continue to occur in the future.



13



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Sales, Service and Support



We currently market and sell our products in the United States principally through our direct sales organization, with
direct sales employees and representatives in over 14 locations. Outside the United States, 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 28%, 35%, and 44% of net sales during fiscal years 2003, 2002, and 2001, respectively.



Our distributors and we have sales and support centers located in the United States, Europe, Israel, and throughout 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.



In fiscal 2003 we purchased Credence Capital Corporation, or CCC. The assets of CCC consist primarily of a portfolio of
leases of our equipment and associated lease related liabilities. We presently operate CCC as a wholly-owned subsidiary to provide leasing and other financing solutions to our customers.



In fiscal 2002 we combined our separate Japan operations under our joint venture with Innotech Corporation. Both companies
originally formed this joint venture in 1997 to engage in the customization and manufacture of ATE products for sale in Japan. In March 1996, we established a service and support subsidiary in Korea. We also have a relationship with Itek, Inc., a
distributor of our products in Korea.



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 software tools on a timely and cost-effective basis. This will enable customers to integrate such products into their operations as they begin volume manufacturing of the next generation of semiconductors.



Historically we have pursued a technology acquisition strategy to complement
our internal research and development efforts. This strategy has included the acquisitions of businesses, product lines, instruments and technology. Recent acquisitions include:



| |  | in May 2000, we acquired TMT, which added lower-end analog and mixed signal testing capability, particularly in the communications segment;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------



| |  | in August 2000, we acquired MI, which added radio frequency test technology;
| | - | ----------------------------------------------------------------------------



14



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| |  | in February 2001, we acquired the principal assets of Rabkin, which provides interface solutions and test head positioning devices for the semiconductor test market through patented
solutions for high parallel memory testing;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | in August 2001, we acquired IMS, which designs, manufactures, markets and services high-performance integrated circuit engineering validation test systems. These systems are used to
test, at the prototype stage, complex digital, mixed-signal and memory devices;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | in January 2003, we acquired Optonics, which added emission-based optical diagnostics and failure analysis products.
| | - | --------------------------------------------------------------------------------------------------------------------



| |  | in January 2003, we purchased substantially all of the assets of SZ Testsysteme AG and SZ Testsysteme GmbH. The SZ products are focused on the advanced analog, power automotive, and
communications markets for ATE.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Our ASL product
lines originally came from the TMT acquisition in fiscal 2000. Since then this product line has evolved to include the ASL3000MS which is a mixed signal version that utilizes technology from Credence. The ASL3000RF product is the technical
integration of the original TMT product, the RF instrumentation acquired in the MI acquisition (also acquired in fiscal 2000), and digital and mixed signal technology that was developed by us.



The IMS product group is currently sharing technology development with the
Quartet/Octet product family. The ASL product group is currently co-developing technology with the SZ product group. And there are many other examples of technology sharing within the Company. We believe it is essential for our product groups to
continue to share developed technology. This allows us to accelerate our development cycles and minimize our investment in research and development.



The CMOS stabilization methods developed by us as well as the methods acquired from Tektronix in the early 1990s provides a different solution to
the tendency of CMOS to experience timing drift as a function of temperature and voltage variation. The first proprietary solution uses a timing phase detection circuit combined with a voltage control mechanism to compensate for thermal, voltage and
process drift. The second uses a unique combination of counters and heating circuits to provide stability through thermal means. These methods allow our CMOS-based ICs to achieve the timing repeatability necessary to meet the performance
requirements of ATE and to realize the economic and other advantages of CMOS technology over ECL technology. CMOS circuits use less space than those based on ECL as the circuits require less power and can be more closely packed together. In addition
to these acquired stabilization methods, we have also developed and continue to develop new and/or improved stabilization techniques for our tester products.



During the past two fiscal years, we developed the Octet family of products, targeted at the high performance, high volume production SoC market.
Incorporating greater digital capability and testing at increased data rates, the Octet is our flagship production test product. We presently intend to focus our research and development efforts on the Octet product line to ensure that our products
have the ability to efficiently test state-of-the-art customer devices which combine analog, high speed digital logic, and memory on a single IC.



Our ongoing research and development efforts also include focusing on increased cycle speed, accuracy and pin counts of our testers. In addition, we are
working on a software development program that is intended to provide for upward compatibility through our products. We will also continue to focus efforts on providing software solutions that allow more rapid, cost-effective development of ATE test
programs that reduce time-to-market of customer integrated circuit designs. We currently intend to continue to invest significant resources in the development of new products and enhancements for the foreseeable future.



Research and development expenses were $73.5 million in fiscal 2003, $85.4
million in fiscal 2002 and $86.4 million in fiscal 2001 (excluding charges for in-process research and development, or IPR&D).



15



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Proprietary Rights



We currently hold 141 United States patents, which expire over time through March 2022. In addition, we currently have 62 foreign patents, which expire
over time through April 2021. Two of our United States patents, acquired from ASIX and Tektronix, underlying our proprietary CMOS stabilization methods expire in February 2007 and December 2007, respectively. From time to time we grant licenses
under our patents and technology and receive licenses under patents and technology of others.



In 1993, we granted a cross license to Tektronix with respect to patents obtained in the acquisition of the STS Division of Textronix, and certain other intellectual property rights, the Tektronix Rights, including a
patent covering one of our proprietary CMOS stabilization technologies, that were assigned to us by Tektronix in 1993. Tektronix has a worldwide, perpetual, irrevocable, non-exclusive, royalty free, fully-paid, sublicensable and transferable license
to the Tektronix Rights. Tektronix may not grant rights under the Tektronix Rights to make, use, sell or otherwise distribute ATE for testing ICs to any entity other than a Tektronix joint venture affiliate and to a successor-in-interest to
Tektronix. Tektronix may not grant or assign such rights to any other party that is a Credence competitor. In addition, Tektronix may not knowingly sell components incorporating the Tektronix Rights to any other party. We and Tektronix have granted
to each other a worldwide, perpetual, irrevocable, non-exclusive, royalty free, fully-paid, sublicensable and transferable license to all improvements, enhancements, modifications or derivative works created before August 1996, or the Improvements,
of intellectual property that was licensed or assigned pursuant to a Technology Agreement dated December 31, 1990, as amended on August 12, 1993, including the Tektronix Rights, to make, use and sell ATE for testing ICs. Tektronixs license to
the improvements is subject to the same restrictions as its license to the Tektronix Rights.



We attempt to protect our intellectual property rights through patents, copyrights, trademarks and maintenance of trade secrets and other measures. 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 configuration 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 and we are in the process of qualifying a second source for some of those components. There can be no assurance that such alternative source will be
qualified or available. 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.



16



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Competition



The ATE industry is intensely competitive. We face substantial competition throughout the world, primarily from ATE manufacturers located in the United
States, Europe and Japan, as well as from some of our customers. Our competitors in the digital semiconductor testing market include:



| |  | Advantest Corp.;
| | - | ----------------



| |  | Agilent Technologies, Inc.;
| | - | ---------------------------



| |  | Yokagawa.;
| | - | ----------



| |  | LTX Corp.;
| | - | ----------



| |  | NPTest Holding Corporation; and
| | - | -------------------------------



| |  | Teradyne, Inc.
| | - | --------------



In the mixed-signal and analog semiconductor testing market our competitors include:



| |  | Advantest Corp.;
| | - | ----------------



| |  | Agilent Technologies, Inc.;
| | - | ---------------------------



| |  | Eagle Test Systems, Inc.;
| | - | -------------------------



| |  | LTX, Corp.;
| | - | -----------



| |  | Yokagawa.;
| | - | ----------



| |  | NPTest Holding Corporation; and
| | - | -------------------------------



| |  | Teradyne, Inc.
| | - | --------------



In the non-volatile memory testing market our competitors include:



| |  | Advantest, Corp.;
| | - | -----------------



| |  | Agilent, Inc.; and
| | - | ------------------



| |  | Nextest, Inc.
| | - | -------------



In the RF wireless device testing market our competitors include:



| |  | Advantest, Corp.;
| | - | -----------------



| |  | Agilent, Inc.;
| | - | --------------



| |  | Eagle Test Systems, Inc.;
| | - | -------------------------



| |  | LTX, Corp.;
| | - | -----------



| |  | Rohde and Schwarz GmbH and Co. KG.;
| | - | -----------------------------------



| |  | Roos Instruments, Inc.; and
| | - | ---------------------------



| |  | Teradyne, Inc.
| | - | --------------



In the emission based optical prober market our principle competitors include:



| |  | NPTest Holding Corporation
| | - | --------------------------



The principal competitors in the software design to test market are:



| |  | Simutest, Inc.;
| | - | ---------------



| |  | Test Insight Ltd.; and
| | - | ----------------------



| |  | in-house applications developed by companies in the semiconductor industry.
| | - | ---------------------------------------------------------------------------



17



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The competitors in the BIST market place include:



| |  | LogicVision, Inc.
| | - | -----------------



In addition to the competitors listed above, we face competition from various start-up companies in our markets. 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 revenue growth.



Employees



As of October 31, 2003, we had a total of 1,042 direct employees and 33 temporary or contract employees. 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 employees is represented by a labor union, and we have not experienced any work stoppages. We
consider our employee relations to be good.



18



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RISK FACTORS



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



LOGO



A variety of factors 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;
| | - | -------------------------------------------------------------------------------------------------------------------



| |  | patterns of capital spending by our customers, 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;
| | - | ---------------------------------------------------------------------------------



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



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



| |  | 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;
| | - | -----------------------------------------------------------------------------------------------



19



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| |  | 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;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  | 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 and of Severe Acute Respiratory Syndrome, or SARS,
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 system sales have varied significantly and will continue to vary
significantly based on a variety of factors including:



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



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



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



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



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



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



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



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



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



| |  | the possible sale of inventory previously written-off;
| | - | ------------------------------------------------------



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



| |  | facility relocations and closures.
| | - | ----------------------------------



New and enhanced products typically have lower gross margins in the early stages of commercial introduction and production. Although we have recorded and
continue to record inventory write-offs, 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 have fallen and may continue to fall below the
expectations of securities analysts or investors in some future quarter or quarters. Our failure 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 these 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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The semiconductor industry has been cyclical.



Our revenue growth has been materially adversely affected by the cyclical downturn in the semiconductor industry and its
resulting impact upon the semiconductor equipment sector. There is uncertainty as to if and when the next cyclical growth phase will occur. The downturn has contributed to weakened order activity, order cancellation activity, and customer-requested
shipment delays from our existing backlog. This business weakness is worldwide, but we see it in particular with customers in Asia. Until such time as we return to a growth period, we expect a continuing volatility in order activity. We anticipate
revenue levels to continue to remain under pressure throughout fiscal 2004 due to the prolonged cyclical downturn and uncertainty over the start of the next cyclical growth phase. Revenues may decline thereafter due to the uncertainty of a
sustainable recovery in the semiconductor and related capital equipment industry. As a result of the cyclical downturn, in fiscal 2001 we reduced our worldwide workforce by approximately 23%, or more than 400 people. In fiscal 2002, we reduced our
worldwide workforce by 21%, or about 225 people. In fiscal 2003, we reduced our worldwide workforce by approximately 70 people in the first quarter and another 163 people in the third quarter excluding the effect of the acquisitions for a total of
20% over the 2003 fiscal year. We took charges related to these reductions in force of approximately $2.2 million in the third quarter of fiscal 2003 and $1.2 million in the first quarter of fiscal 2003, approximately $5.7 million in the fourth
quarter of fiscal 2002, and approximately $3.2 million throughout fiscal 2001. Additionally, remaining employees were required to take time off during certain periods throughout fiscal 2001-2003. Other initiatives during these three fiscal years
included a temporary domestic and European pay cut during 2001 and 2002, a domestic salary realignment in 2003, a four-day work week for most manufacturing and some operating employees, the consolidation and reorganization of certain functions and
operations, and the curtailment of discretionary expenses. If we continue to reduce our workforce or adopt additional cost-saving measures, it may adversely impact our ability to respond rapidly to any renewed growth opportunities in the future
should they occur.



As a result of the rapid and steep decline
in revenue during this latest downturn, we continue to monitor our inventory levels in light of product development changes and a possible eventual upturn. We recorded a charge of $9.4 million in the fourth fiscal quarter of 2002 for the write-off
of excess inventories. We recorded special charges in cost of goods sold of $1.9 million in the third fiscal quarter of 2003 related to a settlement with an inventory supplier and spare part write-offs associated with a discontinued product line. At
October 31, 2003, approximately 17% and 8% of the net inventory balances are for our older Quartet mixed signal and Kalos non-volatile memory product families, respectively. With the recent introduction of the Kalos II the Company will continue to
scrutinize the value of the current Kalos I inventory in light of the upcoming product transition to Kalos II. In particular, the value of the Kalos inventory will depend on factors such as the general economic conditions of the Flash memory IC
market, product development schedules for the production versions of the Kalos II and ultimately the success of the Kalos II product in the marketplace. We may be required to take additional charges for excess and obsolete inventory and impairment
of fixed assets if this prolonged industry downturn causes further reductions to our current inventory valuations, value of our long-term assets, or changes our current product development plans.



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 depend upon the current and anticipated market demand for semiconductors and products incorporating semiconductors. The semiconductor industry has been highly cyclical with recurring periods of oversupply,
which often has had a severe effect on the semiconductor industrys demand for test equipment, including the systems we manufacture and market. We believe that the markets for newer generations of semiconductors will also be subject to similar
fluctuations.



As a result of the cyclical downturn 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



21



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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.



We have a limited backlog and obtain most of our net sales from products that typically range in price from $0.2 million to $2 million and we generally ship products
generating most of our net sales near the end of each quarter, which can result in fluctuations of quarterly results.



Other than certain memory products and software products, for which the price range is typically below $50,000, we obtain most of our net sales from the
sale of a relatively few number of systems that typically range in selling price from $0.2 million to $2.0 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, 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 product.



We have in the past experienced significant delays in the development, introduction, volume production and sales of our new systems and related feature enhancements. In the past, we experienced significant delays in
the introduction of our Octet, ValStar 2000 and Kalos series testers as well as certain enhancements to our other testers. The Octet tester was first shipped in October 2002 and minimal revenue has been recognized from the Octet product family
through October 31, 2003. These delays have been primarily related to our inability to successfully complete product hardware and software 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. In addition, under our revenue recognition policy that is in accordance with SAB 101, 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



22



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the recognition of revenue as compared to the historic norm of generally recognizing revenue upon shipment. We have introduced several new systems and
products during fiscal 2003. Revenues from sales of those new systems and products may be deferred until the revenue recognition requirements of our revenue recognition policy are satisfied. 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 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 and related software tools. In the past, we have incurred and we may continue to incur substantial unanticipated costs to ensure the functionality and reliability of our testers and to increase feature sets. If our systems continue to
have 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, delays 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 tester and related software tools 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, mixed signal and non-volatile memory 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.



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 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.



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 hardware and software products and enhancements and related software tools 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 testers and software products with additional features and higher performance and other capabilities.
Therefore, it is necessary for us to enhance the



23



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performance and other capabilities of our existing systems and software products and related software tools, or develop new systems and software products and
related software tools, to adequately address these requirements. Any success we may have in developing new and enhanced systems and software products and new features to our existing systems and software products will depend upon a variety of
factors, including:



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



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



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



| |  | successful coding and debugging of software;
| | - | --------------------------------------------



| |  | 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 and software products or enhancements and related software tools. Our inability to
introduce new products and related software tools 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, weakness in IC demand may cause integrated device manufacturers, or IDMs, to curtail or discontinue the outsourcing of testing to test houses, relying instead on in-house testing. Because less of
our market share is from the IDMs, this trend may reduce the demand for our products. Any decline in demand for our hardware or software products could have a materially adverse effect on our business, financial condition or results of operations.



The fluctuations in our sales and operations have placed and are continuing
to place a considerable strain on our management, financial, manufacturing and other resources.



Over the last several years we have experienced significant fluctuations in our operating results. In fiscal 2003, our net sales increased by 11% from
those recorded in fiscal 2002; however, in fiscal 2002, our net sales fell 45.6% from those recorded in fiscal 2001 as the semiconductor industry continued in a steep cyclical downturn. Since 1993, except for the recent and current cost-cutting
efforts and those during fiscal 1998 and the first half of fiscal 1999, we have overall significantly increased the scale of our operations to support periods of generally increased sales levels and expanded product offerings and have expanded
operations to address critical infrastructure and other requirements, including the hiring of additional personnel, significant investments in research and development to support product development, acquisition of the new facilities in Oregon and
California, further investments in our ERP system and numerous acquisitions. These fluctuations in our sales and operations have placed and are continuing to place a considerable strain on our management, financial, manufacturing and other
resources. In order to effectively deal with the changes brought on by the cyclical nature of the industry, we have been required to implement and improve a variety of highly flexible operating, financial and other systems, procedures and controls
capable of expanding, or contracting consistent with our business. However, we cannot be certain that any existing or new systems, procedures or controls, including our ERP system, will be adequate to support fluctuations in our operations or that
our systems, procedures and controls will be cost-effective or timely. Any failure to implement, improve and expand or contract such systems, procedures and controls efficiently and at a pace consistent with our business could have a material
adverse effect on our business, financial condition or results of operations.



24



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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, production and commercialization of new products and
technologies. During fiscal 2001, we primarily introduced products that are either evolutions or derivatives of existing products. During fiscal 2002 and 2003, we introduced several products that are evolutions or derivatives of existing products as
well as products that are largely new. Under our revenue recognition policy adopted in accordance with SAB 101, 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 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 hardware and software 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 our current net sales and our revenue growth.



With the substantial investment required to develop test application software 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.
We do not currently compete in the production testing of high-end microprocessors or DRAMs. Moreover, a substantial portion of our net sales is derived from sales of mixed-signal testers. As noted in the Competition section of Item 1 above, we face
in some cases six and in other cases seven 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 marketplace. Several of these competitors have substantially greater financial and other resources with which to pursue engineering, manufacturing, marketing and distribution of their products. 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 products, enhancements and new



25



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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 and software applications to satisfy specific customer needs in a timely manner.



We must develop and deliver customized hardware and
software 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 and software 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 19%, 20% and 13% of our net sales in fiscal years 2003, 2002 and 2001, respectively. Our agreement with Spirox has no minimum purchase commitment
and can be terminated for any reason on 180 days prior written notice. 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 and software 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.
| | - | -------------------------------------------------------------------------------------------------------------------



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



26



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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.



When we engage in
acquisitions, we will incur a variety of costs, and the anticipated benefits of the acquisitions may never be realized.



We have developed in large part through mergers and acquisitions of other companies and businesses. We intend in the future to pursue additional
acquisitions of product lines, technologies and businesses. We may utilize cash or we may continue to issue debt or equity securities to pay for future acquisitions, which may be dilutive to then current stockholders. We have also incurred and may
continue to incur certain liabilities or other expenses in connection with acquisitions, which have affected and could continue to materially adversely affect our business, financial condition and results of operations.



In addition, acquisitions involve numerous other risks, including:



| |  | difficulties assimilating the domestic and international operations, personnel, technologies, sales channels and products of the acquired companies;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------



| |  | diversion of our managements attention from other business concerns;
| | - | ---------------------------------------------------------------------



| |  | increased complexity and costs associated with international and domestic internal management structures;
| | - | ---------------------------------------------------------------------------------------------------------



| |  | risks of entering markets in which we have no or limited experience; and
| | - | ------------------------------------------------------------------------



| |  | the potential loss of key employees or key business relationships of the acquired companies.
| | - | --------------------------------------------------------------------------------------------



For these reasons, we cannot be certain what effect future acquisitions may have on our business, financial condition and
results of operations.



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



We prepare our
financial statements to conform to generally accepted accounting principles, or GAAP. GAAP are subject to interpretation by the American Institute of Certified Public Accountants, the SEC and various bodies formed to interpret and create appropriate
accounting policies. A change in those policies can have a significant effect on our reported results and may even affect our reporting of transactions completed before a change is announced. Accounting rules affecting many aspects of our business,
including rules relating to accounting for business combinations, asset impairment, revenue recognition, restructuring or disposal of long-lived assets, arrangements involving multiple deliverables, consolidation of variable interest entities,
employee stock purchase plans and stock option grants have recently been revised or are currently under review. Changes to those rules or current interpretation of those rules may have a material adverse effect on our reported financial results or
on the way we conduct our business. For example, effective November 1, 1999, we changed our method of accounting for systems revenue based on guidance provided in SAB 101. Adoption of SAB 101 required us to restate our quarterly results for the
seven fiscal quarters ended July 31, 2001 (see Note 1 of the Notes to the Consolidated Financial Statements in this Annual Report on Form 10-K for further discussion). In addition, the preparation of our financial statements in accordance with GAAP
requires that we make estimates and assumptions that affect the recorded amounts of assets and liabilities, disclosure of those assets and liabilities at the date of the financial statements and the recorded amounts of expenses during the reporting
period. A



27



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change in the facts and circumstances surrounding those estimates could result in a change to our estimates and could impact our future operating results.



Also, on June 29, 2001, the Financial Accounting Standards
Board (FASB) pronounced under Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (FAS 142) that purchased goodwill should not be amortized, but rather, it should be periodically
reviewed for impairment. Such impairment could be caused by internal factors as well as external factors beyond our control. The FASB has further determined that at the time goodwill is considered impaired an amount equal to the impairment loss
should be charged as an operating expense in the statement of operations. The timing of such an impairment (if any) of goodwill acquired in past and future transactions is uncertain and difficult to predict. Our results of operations in periods
following any such impairment could be materially adversely affected.



In addition, there has been an ongoing public debate whether employee stock option and employee stock purchase plans shares should be treated as a compensation expense and, if so, how to properly value such charges. If we were to elect or
were required to record an expense for our stock-based compensation plans using the fair value method, we could have significant compensation charges. Although we are currently not required to record any compensation expense using the fair value
method in connection with option grants that have an exercise price at or above fair market value and for shares issued under our employee stock purchase plan, it is possible that future laws or regulations will require us to treat all stock-based
compensation as a compensation expense using the fair value method. See Notes 1 and 7 to the Consolidated Financial Statements for a discussion of stock-based compensation.



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, none of whom are bound by an employment or non-competition agreement. 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.



Our international business exposes us to additional risks.



International sales accounted for approximately 64%, 55%, and 61% of our total net sales for fiscal 2003, 2002 and 2001, 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;
| | - | -----------------------------------



| |  | the adverse effect of fears surrounding any recurrence of SARS on our business and sales and that of our customers, especially in Taiwan, Hong Kong and China;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | an 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, joint venture partners, original equipment manufacturers, foreign subsidiaries and branch operations;
| | - | -------------------------------------------------------------------------------------------------------------------------------------



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



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



| |  | greater difficulty in maintaining U.S. 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 and software 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 38%, 42% and 38% of our total net sales in fiscal years 2003, 2002 and 2001, respectively, and thus demand for our products is subject to the risk of economic instability in that region and fears surrounding SARS and could continue to
be materially adversely affected. 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. Further, many of our customers in the Asia-Pacific region built up capacity in ATE during fiscal 2000 in anticipation of a
steep ramp up in wafer fabrication. However, this steep ramp up in output has not fully materialized leaving some customers with excess capacity.



One end-user customer headquartered in Europe accounted for 10% of our net sales in fiscal 2003. No single foreign end-user customer accounted for more
than 10% of our net sales in fiscal 2002. Two end-user customers headquartered in Europe accounted for approximately 13% and 11%, respectively, of our net sales in fiscal 2001.



In addition, one of our major distributors, Spirox Corporation, is a Taiwan-based 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 SARS 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.



If the protection of 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 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.



29



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Some of our customers have received notices from Mr. Jerome Lemelson alleging that the manufacture of
semiconductor products and/or the equipment used to manufacture semiconductor products infringes certain patents issued to Mr. Lemelson. We have been notified by customers that we may be obligated to defend or settle claims that our products
infringe Mr. Lemelsons patents, and that if it is determined that the customers infringe Mr. Lemelsons patents, those customers may intend to seek indemnification from us for damages and other related expenses.



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.



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 has had a material
adverse effect on the economy. If consumer confidence does not fully recover, our revenues and profitability will continue to be adversely impacted in fiscal 2004 and beyond.



In addition, 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 U.S. 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 U.S. 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.



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



The Sarbanes-Oxley Act of 2002 that became law in July 2002 requires changes
in some of our corporate governance and securities disclosure or compliance practices. That Act also requires the SEC to promulgate new rules on a variety of subjects, in addition to rule proposals already made, and Nasdaq has revised and continues
to revise its requirements for companies that are Nasdaq-listed. We expect these developments to increase our legal compliance and financial reporting costs. We expect these developments to make it more difficult and more expensive for us to obtain
director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. These developments could make it more difficult



30



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for us to attract and retain qualified members of our board of directors, or qualified executive officers. We are presently evaluating and monitoring
regulatory developments and cannot estimate the timing or magnitude of additional costs we may incur as a result.



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,
shareholders rights plan, 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, our shareholder rights plan 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 2.Properties



With the expiration of the lease for our corporate
headquarters in Fremont, California occurring in early 2004, and the dramatic decline in commercial real estate prices in the Bay region of Northern California, we pursued the purchase of a new headquarters facility. In August 2002, we acquired two
buildings to be used for office space and manufacturing in Milpitas, California for approximately $21.8 million. We have invested an additional $10.6 million in these facilities for structural improvements as well as tenant improvements. The
Milpitas buildings and structural and tenant improvements will start depreciating in February 2004. This headquarters facility comprises 180,000 square feet on approximately 14 acres of land. In January 2004, we completed the relocation of our
corporate headquarters to this facility. These owned facilities now contain corporate administration, sales, marketing, applications, local customer support, and research & development and manufacturing for our mobile products group.



Until December 2003, we maintained our corporate headquarters in Fremont,
California. These leased facilities, comprised of four buildings totaling 166,600 square feet, contained corporate administration, sales, marketing, applications, local customer support, and research & development and manufacturing for our
mobile products group. The lease for three of the four buildings expired around December 2003. The lease on the fourth building, consisting of 27,000 square feet, expires in June 2005. We are attempting to sublease this building.



Our SoC products group, as well as additional administration, marketing,
applications, engineering and customer support functions, are located in a 180,000 square foot facility, comprised of two buildings in Hillsboro, Oregon, which is owned by the Company. This property is on approximately twenty-nine acres of land and
was purchased during fiscal 2000. In addition, the Company owns approximately eighteen acres of land less than a mile from the Hillsboro facility.



As part of the purchase of Optonics, we have leased office and production facilities with approximately 13,600 square feet in Mountain View, California,
which lease expires in September 2005. As part of the purchase of SZ, we acquired leases for office and production facilities totaling 61,000 square feet in Amerang, Germany that expire in December 2005. We maintain various remote sales and service
offices in the United States including approximately 18,000 square feet in Austin, Texas and 26,000 square feet in Colorado Springs, Colorado. We also lease various smaller facilities worldwide for our sales offices.



Item 3.Legal Proceedings



We are involved in various claims arising in the ordinary course of
business, none of which, in the opinion of management, if determined adversely against us, will have a material adverse effect on our business, financial condition or results of operations.



Item 4.Submission of Matters to a Vote of Securityholders



None.



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EXECUTIVE OFFICERS AND KEY EMPLOYEES



Our executive officers and key employees and their ages and positions as of December 31, 2003, are as follows:



|Name                  |  | Age |  | Position                                                     
|--------------------- |  | --- |  | -------------------------------------------------------------
|Executive Officers    |  |     |  |                                                              
|Dr. Graham J. Siddall |  | 57  |  | Chairman of the Board and Chief Executive Officer            
|David A. Ranhoff      |  | 48  |  | President and Chief Operating Officer                        
|John R. Detwiler      |  | 44  |  | Senior Vice President, Chief Financial Officer, and Secretary
|Fred Hall             |  | 54  |  | Senior Vice President, Human Resources                       
|                      |  |    
|Key Employees         |  |     |  |                                                              
|Carlos Lazalde        |  | 46  |  | Senior Vice President, Mobile Products Group                 
|Gary Smith            |  | 57  |  | Senior Vice President, SoC Products Group                    
|Bart Freedman         |  | 46  |  | Senior Vice President, Worldwide Field Operations            
|Glyn Davies           |  | 41  |  | Vice President, Corporate Marketing                          
|Byron Milstead        |  | 47  |  | Vice President and General Counsel                           
|William Steele        |  | 56  |  | Vice President, Information Technology                       
|Brian Sereda          |  | 43  |  | Vice President Finance and Corporate Controller              
|Walter Karstad        |  | 57  |  | Vice President, Customer Services Division                   
|Earl Biddlecome       |  | 46  |  | Vice President, Supply Line Management                       
|John McCoy            |  | 53  |  | Vice President, Corporate Quality and Reliability            



Dr. Graham J.
Siddall has served as the Chairman of the Board and Chief Executive Officer since August 2001 and prior to that was our President, Chief Executive Officer and a Director from July 1999 to August 2001. His current term as a Director ends in 2005.
Dr. Siddall joined us from KLA-Tencor where he had been Executive Vice President of the Wafer Inspection Group from May 1997 to May 1999. From December 1995 until May 1997, he served as Executive Vice President and chief operating officer of Tencor
Instruments, Inc. Previously, Dr. Siddall served as Senior Vice President for the Tencor Wafer Inspection Division from November 1994 to December 1995. He joined Tencor as a vice president in 1988. Prior to joining Tencor, Dr. Siddall served in a
number of key roles at GCA Corporation, Hewlett Packard Laboratories and Rank Taylor Hobson.



David A. Ranhoff has served as President and Chief Operating Officer since August 2001 and prior to that he was our Executive Vice President and Chief Operating Officer since November 1999. Mr. Ranhoff was
Executive Vice President, Sales and Marketing from January 1997 to November 1999 and was named to the Office of the President from December 1998 until July 1999. Mr. Ranhoff served as Senior Vice President Sales and Marketing from July 1996 to
January 1997, as Senior Vice President, Sales, Marketing and Service from July 1995 to June 1996, as Senior Vice President, Sales and Service from August 1993 to July 1995 and as Vice President, Sales from January 1993 to August 1993. He served as
Vice President, European Operations from July 1990 to December 1992. From March 1988 to June 1990, Mr. Ranhoff served as Managing Director of European Operations of the Company and as National Sales Manager from July 1985 to March 1988. Prior to
joining the Company, Mr. Ranhoff served for eight years in various sales and management positions for GenRad, Inc.



John R. Detwiler has served as our Senior Vice President, Chief Financial Officer and Secretary since February 2001. Prior to that he was interim
Chief Financial Officer and Secretary from December 2000 to February 2001. Prior to that he served as Vice President, Corporate Controller from April 1999 to December 2000. Mr. Detwiler joined us from Silicon Wireless, Ltd., a start-up in the
wireless infrastructure products business, where he was the Vice President of Finance from April 1998 to March 1999. From August 1992 to March 1998, Mr. Detwiler was at Madge Networks N.V., a developer and manufacturer of LAN and WAN equipment,
where he was the Senior Director of Finance. Prior to Madge, Mr. Detwiler held positions of increasing responsibility in the audit and consulting practices of Price Waterhouse LLP in Denver Colorado, Saudi Arabia and London.



32



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Fred Hall has served as Senior Vice President, Human Resources since October 2001. Prior to that
he was the Chief Financial Officer, Secretary and Treasurer of IMS from 1998 to October 2001. Mr. Hall was Vice President, Finance and CFO of Naiad Technologies, Inc., a biotechnology start-up company from 1997 until joining IMS in 1998. From
October 1994 until 1997, Mr. Hall served as Vice President, CFO, Treasurer and Assistant Secretary for CFI ProServices, Inc., a provider of integrated, PC-based software for financial institutions. From June 1992 until October 1994, Mr. Hall served
as Vice President, Finance and CFO, Secretary and Treasurer of Itronix Corporation, a manufacturer of hand held computers.



Carlos Lazaldehas served as Senior Vice President, Mobile Products Group, or MPG since August 2002. Mr. Lazalde joined us in July 2002 as the Vice
President, General Manager of the Memory Products Division, or MPD. Prior to joining us, Mr. Lazalde held a variety of senior level positions, including President of the Automatic Test Equipment Division of Schlumberger, currently NP Test. Mr.
Lazalde has over 23 years of experience in the semiconductor equipment industry.



Gary Smith has served as Senior Vice President of the SoC Products Group or SPG since August 2002. Prior to that Mr. Smith was the Vice President & GM, of the Industrial, Communications and Entertainment
Test Division since April 2001. Prior to this position, Mr. Smith was the Vice President of the Low Cost Performance Line since December 1998. Prior to that Mr. Smith was Marketing Director for the ValStar and SC Series products from February 1996
to December 1998. Prior to joining us, from September 1985 to February 1996 Mr. Smith has held various senior management positions in sales, marketing, and operations at Schlumberger Technologies, Inc.



Bart Freedman has served as Senior Vice President, Worldwide Field
Operations since August 2001 and prior to that was the Vice President, Worldwide Field Operations from January 2000 to August 2001. From October 1996 to January 2000, he was our Vice President of Asian Operations. From 1994 to 1996, Mr. Freedman
served as Vice President of North American Sales for Schlumberger. From 1985 to 1994, Mr. Freedman held a variety of senior level positions at Tektronix, Inc., including U.S. Regional Sales Manager for the Semiconductor Test Systems Division that we
bought in December 1990. From 1980 through 1985, Mr. Freedman was a design engineer and applications manager for Teradyne, Inc.



Glyn Davieshas served as Vice President, Corporate Marketing since October 2000. Prior to joining us, Mr. Davies held various roles through a
ten-year career at KLA-Tencor, most recently serving as the Senior Director of Business Development in the Yield Management Software Division. Prior to joining KLA-Tencor, Mr. Davies held various marketing and applications engineering positions
including marketing manger at Optical Specialties, Inc. and product manager at Cambridge Instruments. Mr. Davies has over 16 years of experience in the semiconductor equipment industry.



Byron Milsteadhas served as Vice President and General Counsel since November 2000. Prior to that 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.



William Steelehas served as Vice President,
Information Technology since December 2003. Prior to joining us, Mr. Steele held various positions of increasing responsibility with Network Computing Devices over a ten-year period, most recently Director of Operations, Information Technology and
Controller from 2001 to 2003. Prior to joining Network Computing Devices, Mr. Steele held positions with InterChip Solutions, Inc., Forest Grove Industries, Inc., Tektronix, Inc., Miniscribe Corp., NBI Inc. and Hewlett Packard Company.



Brian Sereda has served as Vice President, Finance & Corporate
Controller since April 2002. From 2001 to 2002, Mr. Sereda was Treasurer for Handspring, Inc. From 1999 to 2001, Mr. Sereda served as Treasurer for Sygen plc. From 1993 through 1998, Mr. Sereda worked for Lam Research Corporation and held various
positions of increasing responsibility including Assistant Treasurer.



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Walter Karstad has served as the Vice President of the Customer Services Division since February
2002. Prior to joining us, Mr. Karstad was the Vice President of the Customer Service Division at Integrated Measurement Systems, Inc. from March 2001. Prior to this position, Mr. Karstad was the Customer Service Operations Manager at Electro
Scientific Industries, Inc. from November 1999. From December 1975 to September 1999, Mr. Karstad held various customer service positions of increasing responsibility at Tektronix, Inc.



Earl Biddlecome has served as Vice President of Supply Line Management since joining us in June 2001. Prior to
joining us, Mr. Biddlecome was the North America Manufacturing Operations Manager of the Business Computer Organization with Hewlett Packard from July 1998. From June 1987 to July 1998 Mr. Biddlecome was General Manager of World Wide Operations for
Unisys, NT Products Group. From July 1985 to June 1987 Mr. Biddlecome was Production Manager for Schlumberger. Prior to this position, he held various manufacturing positions of increasing responsibility at General Electric Corporation.



John McCoyhas served as Vice President, Corporate Quality and
Reliability since August 2003. Prior to that, Mr. McCoy was our Senior Director of Quality and Reliability. Prior to joining us, Mr. McCoy held positions of Vice President of Worldwide Manufacturing and Senior Director of Manufacturing at Integrated
Measurement Systems from 1997 to 2001. Mr. McCoy served as Vice President of Manufacturing, Director of Manufacturing and Director of Quality Assurance at Metheus Corporation from 1983 to 1996. From 1972 to 1983, Mr. McCoy held manufacturing and
engineering positions of increasing responsibility with Tektronix Inc., National Semiconductor, and Fairchild Semiconductor.



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 and Related Stockholder Matters



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:



|              |  | 2003 |       | 2002
|------------- |  | ---- | ----- | ----
|Quarter Ended |  | High |       | Low 
|January 31    |  | $    | 11.80 |     
|April 30      |  |      | 8.10  |     
|July 31       |  |      | 10.30 |     
|October 31    |  |      | 16.59 |     



There were
approximately 248 stockholders of record at January 2, 2004. To date, we have not declared or paid any cash dividends on its common stock. We do not anticipate paying any dividends on our common stock in the foreseeable future.



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, 2001, 2002 and 2003 and the selected consolidated balance sheet data as of October 31, 2002 and 2003, 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 historical financial information for all periods includes the operations of Integrated Measurement Systems, Inc., which we acquired in August 2001. The transaction was accounted for using the pooling-of-interests method. The
selected consolidated statement of operations data for the fiscal years ending prior to October 31, 2001, and the selected consolidated balance sheet data prior to October 31, 2002, 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.



|                                                                    |  | Year Ended October 31,                  
|------------------------------------------------------------------- |  | ----------------------------------------
|                                                                    |  | 2003                                    
|                                                                    |  | (in thousands, except per share amounts)
|Consolidated Statement of Operations Data:                          |  |                                         
|Net sales                                                           |  | $                                       
|Operating income (loss)                                             |  |                                         
|Income (loss) before taxes                                          |  |                                         
|Net income (loss) before extraordinary items                        |  |                                         
|Net income (loss) before cumulative effect of accounting change (a) |  |                                         
|Net income (loss)                                                   |  |                                         
|Net income (loss) per basic share                                   |  | $                                       
|Net income (loss) per diluted share                                 |  | $                                       
|Consolidated Balance Sheet Data:                                    |  |                                         
|Working capital                                                     |  | $                                       
|Total assets                                                        |  |                                         
|Long-term debt                                                      |  |                                         
|Retained earnings                                                   |  |                                         
|Stockholders equity                                                |  |                                         

---

|(a) | Effective November 1, 1999, the Company changed its method of accounting for systems revenue based on guidance provided in SEC Staff Accounting Bulletin No. 101, Revenue
Recognition in Financial Statements, or SAB 101. The restatement for SAB 101 has been reflected in the above table for fiscal years 2000 and 2001.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Quarterly 2003



|                                            |  | 2003 Quarter Ended                       |        
|------------------------------------------- |  | ---------------------------------------- | -------
|                                            |  | January 31,                              |        
|                                            |  | (in thousands, except per share amounts) |        
|                                            |  | (unaudited)                              |        
|Net sales                                   |  | $                                        | 36,672 
|Gross margin                                |  |                                          | 12,464 
|Research and development                    |  |                                          | 19,496 
|Selling, general and administrative         |  |                                          | 20,566 
|Amortization of purchased intangible assets |  |                                          | 1,590  
|In-process research and development         |  |                                          | 1,510  
|Restructuring                               |  |                                          | 1,392  
|Operating income (loss)                     |  |                                          | (32,090
|Income (loss) before taxes                  |  |                                          | (30,163
|Net income (loss)                           |  |                                          | (30,164
|Net income (loss) per basic share           |  | $                                        | (0.49  
|Net income (loss) per diluted share         |  | $                                        | (0.49  



Quarterly 2002



|                                                         |  | 2002 Quarter Ended                       |        
|-------------------------------------------------------- |  | ---------------------------------------- | -------
|                                                         |  | January 31,                              |        
|                                                         |  | (in thousands, except per share amounts) |        
|                                                         |  | (unaudited)                              |        
|Net sales                                                |  | $                                        | 34,627 
|Gross margin                                             |  |                                          | 13,161 
|Research and development                                 |  |                                          | 20,492 
|Selling, general and administrative                      |  |                                          | 21,649 
|Amortization of purchased goodwill and intangible assets |  |                                          | 5,146  
|Restructuring                                            |  |                                          |       
|Special charges                                          |  |                                          |       
|Operating income (loss)                                  |  |                                          | (34,126
|Income (loss) before taxes                               |  |                                          | (30,755
|Net income (loss)                                        |  |                                          | (20,101
|Net income (loss) per basic share                        |  | $                                        | (0.33  
|Net income (loss) per diluted share                      |  | $                                        | (0.33  



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



Overview



We believe
that most of the major ATE industry participants have not been profitable for the last three years, indicating a very competitive marketplace. Our revenue remained relatively weak throughout fiscal 2002 and began to grow sequentially beginning in
the second quarter of fiscal 2003. The test and assembly sector of the semiconductor equipment industry continues to be impacted by a severe downturn that began in fiscal 2001. Although there has been recent sequential improvements in the business
environment, there is uncertainty as to the strength and length of the next cyclical growth phase. Until such time as we return to a period of sustainable growth and due to continued low visibility, we maintain a cautious outlook for future orders
and sales levels.



Critical Accounting Policies and Estimates



Our discussion and analysis of our financial condition
and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally



36



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accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, as well as the disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, inventories, investments, leased equipment residual
values, intangible assets, income taxes, warranty obligations, restructuring, and contingencies and litigation. 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 SAB 101, 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. Our
revenue recognition policies are applied consistently among our semiconductor manufacturing equipment product lines. Product revenue is recognized upon shipment when the product is classified as mature and the customer acceptance criteria can be
demonstrated prior to shipment. Revenue related to the fair value of the installation obligation is recognized upon completion of the installation. Products are classified as mature after several different customers have accepted similar systems.
For sales of new products or when the customer acceptance criteria cannot be demonstrated prior to shipment, revenue and the related cost of goods sold are deferred until customer acceptance. Lease revenue is recorded in accordance with FAS No. 13,
Accounting for Leases which requires that a lessor account for each lease by either the direct financing, 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.



Under the SAB 101 revenue recognition policy, we defer revenue for transactions that involve newly introduced products or when customers specify acceptance criteria that cannot be demonstrated prior to the shipment. During fiscal 2002 and
2003, we introduced several new systems and products. Certain revenues from sales of these new systems and products during fiscal 2003 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 new testers as well as certain enhancements to our existing testers. As a result, some customers have experienced significant
delays in receiving and accepting 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.



When we are able to separate multiple deliverables from one
another we recognize revenue for each deliverable, based on each deliverables fair value, when the revenue recognition criteria for that specific deliverable is achieved. In the vast majority of cases, our orders are shipped complete. In rare
instances when there are multiple shipments due to materials shortages, revenue and related cost of sales are recognized only for the line items that are physically shipped. If the items not shipped on an order are required for the functionality of
the delivered items, revenue and related cost of sales are deferred on the delivered items and recognized only upon the shipment of the required items. If there are specific customer acceptance criteria, revenue is deferred until the specified
performance has been completed in accordance with our revenue recognition policy. Installation in the majority of the cases occurs within two weeks of shipment. Installation is considered to be inconsequential and perfunctory. The cost of
installation can be reliably estimated and is accrued at shipment. In order to comply with Emerging Issues Task Force Accounting for Revenue Arrangements with Multiple



37



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Deliverables, (EITF 00-21), beginning in the fourth quarter of fiscal 2003, revenue related to the total value of installations not completed at the
end of the period was deferred.



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 our revenue
recognition policies based on the sales channel, due to the business practices that we have adopted with our distributor relationships. Because of these business circumstances we do not use price protection, stock rotation or
similar programs with our distributors. We do not typically sell inventory into our distributors for eventual sale to end-users, but rather we sell product to the distributors on the basis of a purchase order received from an end-user. We evaluate
any revenue recognition issues with respect to the end customer in light of our revenue recognition policy and in accordance with SAB 101.



We sell stand-alone software products and the revenue recognition policies related to these sales fall within the scope of AICPA Statement of Position No.
97-2 (SOP 97-2), Software Revenue Recognition. The stand-alone software products are applications for IC manufacturers and test and assembly contractors to help improve quality and shorten development lead times. We also have embedded
software in our semiconductor manufacturing equipment. We believe this embedded software is incidental to our products and therefore it is excluded from the scope of SOP 97-2 since 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 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.



Allowance for Doubtful Accounts:



Our sales
and distribution partners and we 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, for example because of bankruptcy or deteriorations
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, 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. See Schedule II of this Form 10-K for an
analysis of our historic bad debt expense.



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 industry upturn. These forecasts require us to estimate our ability to sell current and future products in the next industry upturn
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 off, we
carry that inventory at its reduced value until it is scrapped or otherwise disposed of. At October 31, 2003, approximately 17% and 8% of the net inventory balances were for our older Quartet mixed signal and Kalos non-volatile memory product
families, respectively. With the recent introduction of the Kalos II, the Company intends to continue to review the value of the current Kalos I inventory in light of the anticipated product transition to Kalos II. In particular, the value of the
Kalos inventory will depend on factors such as the economic condition of the Flash memory IC market, product development schedules for the production versions of the Kalos II and ultimately the success of the Kalos II product in the marketplace.



38



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Due to the dramatic decline in the semiconductor business cycle and corresponding impact on revenue since
early in fiscal 2001 and continued uncertainty regarding the timing of the upturn, if any, in semiconductor equipment sales, we continue to monitor our inventory levels in light of product development changes and expectations of an eventual market
upturn. In the third quarter of fiscal 2003, we recorded special charges to cost of goods sold of $1.3 million due to a legal settlement on cancelled purchase contracts with an inventory vendor and $0.6 million due to spare parts write-offs related
to our Valstar product line. We recorded a charge of $9.4 million in the fourth quarter of fiscal 2002, and charges of $45.0 million and $38.0 million in the second and fourth quarters of fiscal 2001, respectively, for the write-offs of excess
inventories. We may be required to take additional charges for excess and obsolete inventory if the current industry downturn causes further reductions to our current inventory valuations or our current product development plans change.



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 based on technological change and the forecasted business cycle.



Long-Lived Asset Valuation:



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



Effective November 1, 2002, we
adopted Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, or SFAS 142, which was issued by the FASB in July 2001. Under this standard, we ceased amortizing goodwill effective November 1, 2002. In
addition, on adoption, we reclassified certain intangibles with a net book value of $0.4 million, consisting of acquired workforce, which is no longer defined as an acquired intangible under SFAS 142 to goodwill. Accordingly, there was no
amortization of acquired workforce in acquisition costs recognized during fiscal 2003. In fiscal 2003, goodwill also increased by approximately $2.8 million due to our acquisition of Optonics, Inc. See Note 1 to the Consolidated Financial Statements
for further discussion.



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.



As mandated by SFAS No. 142, we completed our first annual goodwill
impairment test as of July 31, 2003 and determined that no potential impairment existed as of the end of the third quarter of fiscal 2003. As a result, we recognized no impairment loss in fiscal 2003 in connection with the adoption of SFAS No. 142.
However, no assurances can be given that future evaluations of goodwill will not result in charges as a result of future impairment. We will continue to evaluate goodwill on an annual basis and at such other times as events and changes in
circumstances suggest that the carrying amount may not be recoverable from its estimated future cash flow.



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
future performance of the reporting unit to which the goodwill is attributed. The assumptions supporting the estimated future cash flows of the reporting units, including discount rate used and estimated terminal value reflect our best estimates.



We evaluate the carrying value of our long-lived assets,
consisting primarily of our facilities, identifiable intangible assets, and property, plant and equipment, 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 our market value, or significant reductions in projected future cash flows. In assessing the recoverability of our long-lived assets, we compare
the



39



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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 made 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 the 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 two to ten years.



Other intangible assets subject to amortization were as follows (in thousands):



|October 31, 2003       |  | Cost |        | Accumulated Amortization |   |         | Net
|---------------------- |  | ---- | ------ | ------------------------ | - | ------- | ---
|Purchased technology   |  | $    | 54,906 |                          | $ | (27,001 | )  
|Customer relations     |  |      | 7,702  |                          |   | (5,708  | )  
|Trademarks             |  |      | 2,053  |                          |   | (1,437  | )  
|Patents                |  |      | 862    |                          |   | (560    | )  
|Non-compete agreements |  |      | 750    |                          |   | (282    | )  
|                       |  |      |        |                          |   |         |    
|Total                  |  | $    | 66,273 |                          | $ | (34,988 | )  
|                       |  |      |        |                          |   |         |    
|                       |  |      |       
|October 31, 2002       |  | Cost |        | Accumulated Amortization |   |         | Net
|Purchased technology   |  | $    | 41,791 |                          | $ | (20,780 | )  
|Customer relations     |  |      | 6,051  |                          |   | (3,782  | )  
|Trademarks             |  |      | 2,054  |                          |   | (1,027  | )  
|Patents                |  |      | 862    |                          |   | (388    | )  
|Assembled workforce    |  |      | 2,079  |                          |   | (1,652  | )  
|                       |  |      |        |                          |   |         |    
|Total                  |  | $    | 52,837 |                          | $ | (27,629 | )  
|                       |  |      |        |                          |   |         |    



The change in the
other intangible assets between October 31, 2003 and October 31, 2002 was due to additional intangibles associated with the purchase of Optonics, Inc. (see Note 2 to the Consolidated Financial Statements for further discussion), as well as the
reclassification of $0.4 million of acquired workforce, which is no longer defined as an acquired intangible asset under SFAS 142, to goodwill.



Amortization expense for the other intangible assets was $9.5 million for fiscal 2003. Estimated annual amortization expense for the other intangible
assets will be $8.7 million for the fiscal year ending October 31, 2004, $6.1 million for the fiscal year ending October 31, 2005, $5.1 million for the fiscal year ending October 31, 2006, and $11.4 million cumulatively for the fiscal years ending
October 31, 2007 and thereafter.



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,



40



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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.



The following table represents the activity in the warranty accrual for the twelve months ended October 31, 2003 (in thousands):



|Balance at October 31, 2002                           |  | $ | 4,316  |  
|----------------------------------------------------- |  | - | ------ | -
|Add: Accruals for warranties issued during the period |  |   | 5,443  |  
|Acquired pre-existing warranty obligations            |  |   | 1,030  |  
|Less: Warranty spending                               |  |   | (5,288 | )
|                                                      |  |   |        |  
|Balance at October 31, 2003                           |  | $ | 5,501  |  
|                                                      |  |   |        |  



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 estimate our actual current tax exposure and to assess temporary differences that result from differing treatment of certain items for tax
and accounting purposes. These differences result in deferred tax assets and liabilities, which we show on our consolidated balance sheet. The net deferred tax assets are reduced by a valuation allowance if, based upon 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, 2003 was subject to 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. See Note 9 to the Consolidated Financial Statements.



Special Charges:



The current accounting for restructuring costs requires us to record provisions and charges when we have a formal and committed restructuring plan. In
connection with restructuring activities, we recorded estimated special charges in our operating expenses for severance and facility consolidations of approximately $1.4 million in the first quarter of fiscal 2003 and $2.2 million in the third
quarter of fiscal 2003.



In addition, we recorded special
charges to cost of sales of $1.9 million in the third quarter of fiscal 2003 due to a $1.3 million settlement reached with an inventory supplier relating to cancelled purchase orders and $0.6 million for spare part write-offs associated with our
Valstar product line. 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 and other special charges. 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.



Results of Operations



In August 2001, we completed a merger with IMS. This
transaction was accounted for as a pooling of interests and, therefore, the consolidated financial statements as of October 31, 2001 and for the year then ended, were restated as if the merger took place at the beginning of such period.



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



|                                            |  |                                |    |  |      |    |  |      |   
|------------------------------------------- |  | ------------------------------ | -- |  | ---- | -- |  | ---- | --
|                                            |  | Fiscal Years Ended October 31, |   
|                                            |  | 2003                           |    |  | 2002 |    |  | 2001 |   
|Net sales                                   |  | 100                            | %  |  | 100  | %  |  | 100  | % 
|Cost of goods soldon net sales             |  | 63                             |    |  | 62   |    |  | 48   |   
|Cost of goods soldspecial charges          |  | 1                              |    |  | 6    |    |  | 28   |   
|                                            |  |                                |    |  |      |    |  |      |   
|Gross margin                                |  | 36                             |    |  | 32   |    |  | 24   |   
|                                            |  |                                |    |  |      |    |  |      |   
|Operating expenses:                         |  |                                |    |  |      |    |  |      |   
|Research and development                    |  | 40                             |    |  | 52   |    |  | 29   |   
|Selling, general and administrative         |  | 50                             |    |  | 55   |    |  | 34   |   
|Amortization of purchased intangible assets |  | 5                              |    |  | 12   |    |  | 8    |   
|In-process research and development         |  | 1                              |    |  |     |    |  |     |   
|Special charges                             |  | 2                              |    |  | 19   |    |  | 10   |   
|                                            |  |                                |    |  |      |    |  |      |   
|Total operating expenses                    |  | 98                             |    |  | 138  |    |  | 81   |   
|                                            |  |                                |    |  |      |    |  |      |   
|Operating income (loss)                     |  | (62                            | )% |  | (106 | )% |  | (57  | )%
|                                            |  |                                |    |  |      |    |  |      |   
|Net income (loss)                           |  | (62                            | )% |  | (104 | )% |  | (33  | )%
|                                            |  |                                |    |  |      |    |  |      |   



2003 vs. 2002



Net sales.Net sales consist of revenues from
systems sales, upgrades, spare parts sales, maintenance contracts, lease and rental income and software sales. Net sales increased 11%, primarily due to the $21.6 million in net sales derived from the products obtained in our acquisitions of
Optonics and SZ, to $182.4 million in fiscal 2003 from $164.2 million in fiscal 2002.



International net sales accounted for approximately 64% and 55% of total net sales in fiscal 2003 and 2002, respectively. Our net sales to the Asia Pacific region accounted for approximately 38% and 42% of total net
sales in fiscal 2003 and 2002, respectively, and thus are subject to the risk of economic instability in that region that materially adversely affected the demand for our products in 1998 and early 1999. Capital markets in Korea and other areas of
Asia have been historically highly volatile, resulting in economic instabilities. These instabilities may reoccur which could materially adversely affect demand for our products. In addition, the economic impact of geopolitical instabilities on the
Korean peninsula as well as recurrence the Severe Acute Respiratory Syndrome health risks in the Asian region may affect future orders to this region and the timing of or payment for shipments made to this region.



Our net sales by product line in fiscal 2003 and 2002 consisted of:



|                               |  |      |   |  |      |  
|------------------------------ |  | ---- | - |  | ---- | -
|                               |  | 2003 |   |  | 2002 |  
|Digital & Mixed-Signal         |  | 51   | % |  | 56   | %
|Memory                         |  | 17   |   |  | 18   |  
|Service                        |  | 23   |   |  | 22   |  
|Emission Based Optical Probers |  | 4    |   |  |     |  
|Software and other             |  | 5    |   |  | 4    |  
|                               |  |      |   |  |      |  
|Total                          |  | 100  | % |  | 100  | %
|                               |  |      |   |  |      |  



Revenues from software
were not material to our operations in fiscal 2003 and 2002, representing less than 4% of our net sales in each respective period. Operating lease and rental revenues were 4% and 1% of our net sales in fiscal 2003 and 2002, respectively.



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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-offs, sell through of previously written off inventory, pricing by competitors or suppliers, new product introductions, product sales mix, production volume, customization and
reconfiguration of systems, international and domestic sales mix, special charges, and field service margins. Our gross margin as a percentage of net sales increased to 35.6% in fiscal 2003 from 31.7% in fiscal 2002. The $12.9 million increase in
fiscal 2003 gross margins from fiscal 2002 levels primarily reflects the effect of special charges in fiscal 2003 cost of sales related to a $1.3 million legal settlement with an inventory supplier and $0.6 million spare part write-offs in our
Valstar product line compared to $9.4 million of write-offs of excess inventories in fiscal 2002. See Note 3 to the Consolidated Financial Statements. The excess inventory write-offs were recorded as a result of our response to a major downturn in
the business outlook for the ATE and related semiconductor equipment industries that began in fiscal 2001 and continued through fiscal 2003. We expect gross margins to improve for the foreseeable future primarily due to sales of a mix of higher
gross margin products and better manufacturing efficiencies resulting from higher business levels.



Research and Development. Research and development, or R&D, expenses as a percentage of net sales were 40.3% and 52.0%, in fiscal 2003 and
fiscal 2002, respectively. R&D expenses decreased in absolute dollars to $73.5 million in fiscal 2003 from $85.4 million in fiscal 2002, reflecting restructuring actions affecting R&D taken during the fourth quarter of fiscal 2002 and first
and third quarter of fiscal 2003 when compared to 2002. During the fourth quarter of fiscal 2002, we reduced our headcount by approximately 225 persons. Of this total, approximately 25 were in R&D. In the first quarter of fiscal 2003 the Company
reduced the headcount by a further 70 persons most of which were in SG&A functions and a small number in R&D. In the third quarter of fiscal 2003 the Company reduced the head count by a further 163 persons, of which approximately 77 were in
R&D functions. These headcount reductions reduced our 2003 R&D expenses by approximately $3.3 million. In addition, during fiscal 2003 the completion of the evaluation periods for several new products introduced during fiscal 2002 including
the Octet and ASL 3000 resulted in less non recurring engineering (NRE) expenses associated with the development of those products. These savings were partially offset by the ongoing investment in new products and R&D expenses
associated with the products obtained in the acquisitions of Optonics and SZ in early fiscal 2003. The SZ and Optonics acquisitions added a total of approximately 174 employees to the Company, of which about 30 percent perform R&D. The R&D
expenses associated with the acquired products represented approximately $4.3 million of the R&D expenses in fiscal 2003. We currently intend to continue to invest significant resources in the development and completion of new products and
product enhancements. Accordingly, we anticipate that R&D expenses will remain significant in absolute dollar terms and as a percentage of net sales in fiscal 2004.



Selling, General and Administrative. Selling, general and administrative expenses, or SG&A, increased
to $91.1 million in fiscal 2003 from $89.7 million in fiscal 2002, an increase of 2%. The slightly higher SG&A spending in fiscal 2003 was primarily due to added SG&A expenses of approximately $6.7 million from the Optonics and SZ
acquisitions and accelerated depreciation of $1.1 million for leasehold improvements and other fixed assets related to buildings we planned on vacating in the first quarter of fiscal 2004 when we moved to our new headquarters offset by decreases in
payroll related expenses resulting from a lower headcount and ongoing operating expense management. During the fourth quarter of fiscal 2002, we reduced our headcount by approximately 225 persons. Of this total, approximately 135 were in SG&A
functions. In the first quarter of fiscal 2003 the Company reduced the headcount by a further 70 persons most of which were in SG&A functions and a small number in R&D. In the third quarter of fiscal 2003 the Company reduced the head count
by a further 163 persons, of which approximately 48 were in SG&A functions. The SZ and Optonics acquisitions added a total of approximately 174 employees to the Company. As a percentage of net sales, SG&A expenses were 49.9% and 54.6% in
fiscal 2003 and fiscal 2002, respectively, reflecting the increase in business levels. We expect SG&A expenses for fiscal 2004 to be flat to slightly higher in absolute dollars when compared to those recorded in fiscal 2003.



Amortization of Goodwill and Purchased Intangibles. Amortization of
goodwill and purchased intangible expenses decreased to $9.5 million in fiscal 2003 from $19.7 million in fiscal 2002, a decrease of 52%. This decline was primarily the result of adopting SFAS 142 Goodwill and Other Intangible Assets as
of



43



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November 1, 2002. The adoption of SFAS 142 reduced the annual amortization expense by approximately $9.5 million. Under SFAS 142, goodwill and indefinite
lived intangible assets are no longer amortized, but are reviewed annually (or more frequently under certain circumstances) for impairment. Amortization of purchased intangibles increased by approximately $4.1 million on an annual basis beginning in
the second quarter of fiscal 2003 due to the acquisition of Optonics in January 2003.



In-process Research and Development and Special Charges.In January 2004, we relocated our corporate headquarters to our owned facilities in Milpitas, California and vacated our previously leased buildings in
Fremont, California. The lease for three of the buildings expired around December 31, 2003. We will attempt to sublease the final building, consisting of 27,000 square feet. This lease expires in June 2005. The Company estimates the above actions
will result in a restructuring charge during the first quarter of fiscal 2004 of approximately $1 million.



During the third fiscal quarter of 2003, we recorded restructuring charges of approximately $2.2 million as operating expenses related to headcount
reductions. The reduction in force included the elimination of approximately 163 positions or 15 percent of the Companys worldwide employee base. The majority of these positions were in the R&D function.



In the first quarter of fiscal 2003, we recorded a restructure charge of
approximately $1.4 million for severance charges, and a lease write-off that was included in operating expenses. These charges were associated with headcount reductions and the completion of the consolidation of our IMS facility in Beaverton, Oregon
into our Hillsboro, Oregon site. During the first fiscal quarter of fiscal 2003, we reduced our headcount by approximately 70 persons. The bulk of the affected employees were in SG&A functions and a smaller number were in R&D.



In addition, we also recorded a charge of $1.5 million in the first quarter
of fiscal 2003 for the write-off of in-process research and development resulting from the purchase of Optonics. See Note 2 to the Consolidated Financial Statements for discussion of the Optonics purchase price allocation. The charge was recorded as
an operating expense.



In the fourth quarter of fiscal 2002, we
recorded charges of approximately $19.0 million, consisting of $5.7 million, $9.1 million, and $4.2 million for severance charges, asset disposals, and lease write-offs, respectively, which were included in operating expenses. These charges were
associated with headcount reductions and facility consolidations we implemented in the fourth fiscal quarter. During the fourth fiscal quarter of 2002, we reduced our headcount by approximately 225 persons. Of this total, approximately 65 were in
manufacturing, 25 were in R&D and about 135 were in SG&A functions. As part of this reduction we discontinued our next-generation DRAM IMS product and closed the associated IMS facilities in Switzerland and Germany. We exited the IMS
facility in Beaverton, Oregon and consolidated these employees into our facility in Hillsboro, Oregon. Approximately $4.1 million of this charge required cash during the quarter, $4.2 million will require cash over the remaining lease terms of which
$2.8 million was paid out in cash during fiscal year 2003 and the remaining $10.7 million was non-cash write-offs. See Note 3 to the Consolidated Financial Statements.



We wrote-off notes receivable in the fourth fiscal quarter of 2002 by approximately $6.4 million. These impairment charges
were due to the decline in the fair value of the notes receivable and were judged to be other-than-temporary. The write-offs of these individual notes receivable consisted of a $5.0 million promissory note issued by Credence Capital Corporation, or
CCC, then owned, controlled and managed by the Garrett Capital Group, an unaffiliated party, and a $1.4 million promissory note from a customer issued in April 2002 as the result of a settlement on outstanding receivables. The timing of these
write-offs was largely driven by the continuation of the downtown experienced by the semiconductor equipment industry during 2002. In the case of CCC, formerly a non-affiliated company that provided lease, structured financing and other financing
alternatives to our customers, its continued financial weakness ultimately resulted in our decision to pursue control of CCC. This acquisition occurred in February 2003. In the case of the customers promissory note, the customers
principal venture capital investor threatened to initiate bankruptcy proceedings and we wrote-off this note as part of a restructured settlement on existing equipment leases.



44



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In the fourth quarter of fiscal 2002, we recorded a charge totaling $5.1 million associated with the
impairment of the goodwill and intangible assets obtained in the acquisition of DCI in January 2001. The charge consisted of $2.1 million for the remaining intangible assets related to customer lists and $3.0 million for remaining goodwill. This
impairment was based on the planned sale of the subsidiary to its management team effective November 1, 2002. DCI had been integrated into our memory products line at the height of the last business cycle in January 2001. The economic advantage of
maintaining the capabilities of DCI diminished as the operating results deteriorated dramatically with the onset of this current downturn. In addition, it became evident that it was unlikely the memory products business volume would increase to a
level where the operational advantages of DCI would be fully realized.



Interest Income. We generated interest income of $5.8 million and $12.3 million in fiscal 2003 and 2002, respectively. The decline in fiscal 2003 was primarily due to lower average interest rates in fiscal 2003 as well as a declining
investment balance throughout the fiscal years until June 2003 when we completed our Convertible Subordinated Notes offering. See Note 6 to the Consolidated Financial Statements.



Interest and Other Expenses. Interest and other expenses increased from $2.7 million in fiscal 2002 to $3.6 million
in fiscal 2003. The expense in fiscal 2003 is primarily attributable to $1.1 million of interest and $0.5 million of loan origination expenses related to the convertible subordinated notes that we issued in June 2003, $0.9 million of other interest
expenses, $1.4 million in net losses on sales of fixed assets, offset by a $0.5 million gain on the sale of a publicly traded equity security held as an available-for-sale investment. In 2002, we incurred a $1.6 million write down of a publicly
traded equity security held as an available-for-sale investment due to the decline in the fair value of this investment that was judged to be other-than-temporary.



Income Taxes. We recorded an income tax provision of $1.0 million and $7.2 million for fiscal 2003 and fiscal 2002,
respectively. The income tax expense in 2003 consists of foreign tax on earnings and foreign withholding taxes generated from our foreign operations. We expect to record a full valuation allowance on domestic tax benefits until we can reliably
forecast future profitability. Until such time, we would not expect to recognize any significant tax benefits in our results of operations. Our effective tax rate was 0.9% for fiscal 2003 and 4.4% for fiscal 2002. For fiscal 2002 and 2003, the
effective tax rate was greater than the expected federal statutory tax benefit rate of 35% primarily due to the establishment of a full valuation allowance against our net deferred tax assets.



2002 vs. 2001



Net sales. Net sales consist of revenues from system sales, upgrades,
spare parts sales, maintenance contracts, lease and rental income, and software sales. Net sales decreased 46% to $164.2 million in fiscal 2002 from $301.7 million in fiscal 2001. Our net sales decreased from $136.3 million in the first quarter of
fiscal 2001 to $43.2 million in the fourth quarter of fiscal 2002. During fiscal 2002, our net sales remained relatively low due in significant part to the cyclical downturn in the semiconductor industry that is in sharp contrast to the quarterly
increases in fiscal 2000.



International net sales accounted
for approximately 55% and 61% of total net sales in fiscal 2002 and 2001, respectively. Our net sales to the Asia Pacific region accounted for approximately 42% and 38% of total net sales in fiscal 2002 and 2001, respectively, and thus are subject
to the risk of economic instability in that region that materially adversely affected the demand for our products in 1998. Capital markets in Korea and other areas of Asia have been highly volatile, resulting from economic and geopolitical
instabilities. These instabilities may reoccur which could materially adversely affect demand for our products.



45



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Our net sales by product line in fiscal 2002 and 2001 consisted of:



|                     |  | 2002 |   |  | 2001 |  
|-------------------- |  | ---- | - |  | ---- | -
|Mixed-Signal         |  | 51   | % |  | 61   | %
|Digital              |  | 5    |   |  | 4    |  
|Memory               |  | 18   |   |  | 19   |  
|Service and software |  | 26   |   |  | 16   |  
|                     |  |      |   |  |      |  
|Total                |  | 100  | % |  | 100  | %
|                     |  |      |   |  |      |  



Revenues from software
were not material to our operations in fiscal 2002 and 2001, representing less than 4% of our net sales in each respective period.



Gross Margin. Our net gross margin as a percentage of net sales increased to 31.7% in fiscal 2002 from 24.2% in fiscal 2001. The increase in fiscal
2002 over fiscal 2001 is principally due to the $83.0 million write off of excess inventories recorded during fiscal 2001 compared to $9.4 million in fiscal 2002. See Note 3 to the Consolidated Financial Statements. These charges were recorded as a
result of our response to a major downturn in the business outlook for the ATE and related semiconductor and semiconductor equipment industries in fiscal 2001 and continuing through fiscal 2002. Excluding the effect of the write-offs, the lower
gross margins in fiscal 2002 were primarily attributed to lower manufacturing absorption resulting from the lower business levels in 2002 as well as lower average selling prices during fiscal 2002.



Research and Development. Research and development expenses as a
percentage of net sales were 52.0% and 28.7%, in fiscal 2002 and fiscal 2001, respectively. R&D expenses decreased in absolute dollars to $85.4 million in fiscal 2002 from $86.4 million in fiscal 2001, reflecting decreased spending in the
development of new products, and enhancements of existing product lines.



Selling, General and Administrative. Selling, general and administrative, or SG&A, expenses decreased to $89.7 million in fiscal 2002 from $104.2 million in fiscal 2001, a decrease of 14%. The lower
spending in fiscal 2002 in absolute dollars was primarily due to lower headcount, salary reductions and lower commission expenses. In February 2001 the Company reduced its headcount by approximately 14% or about 200 persons, in May 2001 the Company
reduced its headcount by approximately 7% or about 100 persons, and in August 2001 the Company reduced its headcount by approximately 5% or about 75 persons. These reductions were primarily in the manufacturing and SG&A functions. As a
percentage of net sales, SG&A expenses were 54.6% in fiscal 2002 compared to 34.5% in fiscal 2001, reflecting the decrease in business levels.



Amortization of Purchased Goodwill and Intangible Assets. Amortization of purchased goodwill and intangible asset expenses decreased to $19.7
million in fiscal 2002 from $23.2 million in fiscal 2001, a decrease of 15%. The decline was primarily attributable to the year-end write-off in fiscal 2001 of the NMS goodwill and intangible assets which resulted in an annual decline of
approximately $2.7 million in amortization expenses as well end of life of other intangible assets.



Special Charges. We wrote off notes receivable in the fourth fiscal quarter of 2002 by approximately $6.4 million. These impairment charges were
due to the decline in the fair value of these notes receivable and were judged to be other-than-temporary. The write-off of these individual notes receivable consisted of a $5.0 million promissory note issued by Credence Capital Corporation, or CCC,
then owned, controlled and managed by the Garrett Capital Group, an unaffiliated party, and a $1.4 million promissory note from a customer issued in April 2002 as the result of a settlement on outstanding receivables. The timing of these write-offs
was largely driven by the continuation of the downtown experienced by the semiconductor equipment industry during 2002. In the case of CCC, formerly a non-affiliated company that provided lease, structured financing, and other financing alternatives
to our customers, its continued financial weakness ultimately resulted in our decision to pursue control of CCC. This acquisition occurred in February 2003. In the case of the customers promissory note, the customers principal venture
capital investor threatened to initiate bankruptcy proceedings and we wrote-off this note as part of a restructured settlement on existing equipment leases.



46



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In the fourth quarter of fiscal 2002, we recorded a charge totaling $5.1 million associated with the
impairment of the goodwill and intangible assets obtained in the acquisition of DCI in January 2001. The charge consisted of $2.1 million for the remaining intangible assets related to customer lists and $3.0 million for remaining goodwill. This
impairment was based on the planned sale of the subsidiary to its management team effective November 1, 2002. DCI had been integrated into our memory products line at the height of the last business cycle in January 2001. The economic advantage of
maintaining the capabilities of DCI diminished as the operating results deteriorated dramatically with the onset of this current downturn. In addition, it became evident that it was unlikely the memory products business volume would increase to a
level where the operational advantages of DCI would be fully realized.



In the second and third quarters of fiscal 2001 we recorded charges of approximately $3.2 million related to fees and expenses associated with the acquisition of IMS. An additional $16.9 million was recorded in the fourth quarter for the
closing of the IMS transaction and the integration of its operations with Credence and our subsidiary, Fluence. This charge included the write-down of $2.3 million of goodwill and purchased technology intangible assets of Opmaxx. The impairment was
recorded based on product decisions for the newly combined operations of Fluence and IMS. The elements of the IMS acquisition charges are as follows (in thousands):



|Fees and expenses                            |  | $ | 9,951 
|-------------------------------------------- |  | - | ------
|Write-down of tangible and intangible assets |  |   | 7,501 
|Lease and liability accruals                 |  |   | 1,390 
|Employee termination benefits                |  |   | 1,272 
|                                             |  |   |       
|                                             |  | $ | 20,114
|                                             |  |   |       



In the fourth quarter
of fiscal 2001 we recorded a $6.6 million charge for the impairment of the remaining intangible assets associated with the acquisition of NMS in October 2000. The impairment consisted of $3.0 million in purchased technology, $0.3 million in patents,
and $3.2 million in goodwill. This impairment was based on significant NMS employee turnover in fiscal 2001 as well as a change in the technological direction of the remaining research and development project that originated in NMS. The product
originally under development at NMS was abandoned and there are no current activities associated with NMS.



Restructuring Charges. In the fourth quarter of fiscal 2002 we recorded charges of approximately $19 million, consisting of $5.7 million, $9.1
million, and $4.2 million for severance charges, asset disposals, and lease write-offs, respectively, which was included in operating expenses. These charges were associated with headcount reductions and facility consolidations we implemented in the
fourth quarter of fiscal 2002. During the fourth fiscal quarter of 2002, we reduced our headcount by approximately 225 persons. Of this total, approximately 65 were in manufacturing, 25 were in R&D and about 135 were in SG&A. As part of this
reduction we discontinued our next-generation DRAM IMS product and closed the associated IMS facilities in Switzerland and Germany. We exited the IMS facility in Beaverton, Oregon and consolidated these employees into our facility in Hillsboro,
Oregon. Approximately $4.1 million of this charge required cash during the quarter, $4.2 million will require cash over the remaining lease terms and the remaining $10.7 million were non-cash write-downs. See Note 3 to the Consolidated Financial
Statements.



In the second quarter of fiscal 2001, we recorded
a charge of approximately $2.0 million for severance payments and asset disposals associated with headcount reductions we implemented in February 2001. These charges were recorded as a result of our response to a major downturn in the business
outlook for the ATE and related semiconductor and semiconductor equipment industries in 2001. In the third quarter of fiscal 2001 we recorded a further $1.0 million for severance payments and asset disposals associated with headcount reductions we
implemented in May and August 2001. In the fourth quarter of fiscal 2001, we recorded an additional $0.2 million for headcount reductions. We reduced headcount by more than 400 people during the fiscal year across all functional areas. Severance
payments were distributed during the year and the remaining accruals at October 31, 2001 were not significant.



47



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In the fourth quarter of fiscal 2001, we recorded a $2.3 million charge for the abandonment of the former
TMT facility in Sunnyvale, California as these operations were integrated into our Fremont, California facilities. This charge consisted of $1.8 in estimated future rental payments to be paid through February 2005 and $0.5 million for asset and
leasehold improvement write-downs.



Interest Income. We
generated interest income of $12.3 million and $19.3 million in fiscal 2002 and 2001, respectively. The decline in fiscal 2002 was primarily due to lower average interest rates in fiscal 2002 combined with lower average cash balances when compared
to fiscal 2001.



Interest and Other Expenses. Interest
and other expenses increased from $2.0 million in fiscal 2001 to $2.7 million in fiscal 2002. The higher expense in fiscal 2002 is primarily attributable to the $1.6 million write down of a publicly traded equity security held as an
available-for-sale investment. This charge was due to the decline in the fair value of this investment and was judged to be other-than-temporary.



Income Tax. Our effective tax rate was 4.4% for fiscal 2002. The effective tax rate was greater than the expected federal statutory tax benefit
rate of 35% primarily due to the establishment of a full valuation allowance against our net deferred tax assets. Our effective tax benefit rate was 37% for fiscal 2001. The effective tax benefit rate was less than the combined federal and state
statutory rate primarily due to non-deductible goodwill amortization.



Liquidity and Capital Resources



In fiscal
2003, the net cash outflows from operating activities was $66.3 million. The net cash flows used by operating activities for fiscal 2003 were primarily attributable to a net loss before depreciation and amortization of $73.1 million offset by cash
provided through reductions in net working capital.



Investing
activities used net cash of approximately $135.3 million in fiscal 2003 resulting primarily from the net purchases of available-for-sale securities of $118.7 million plus approximately $4.6 million for the acquisition of SZ assets, and $14.7 million
for the structural and tenant improvements of our new Milpitas headquarters and other property and equipment to support our business.



Financing activities provided net cash flows of $178.7 million in fiscal 2003. The cash in fiscal 2003 was primarily provided by $174.2 million net
proceeds from the issuance of Convertible Notes in the third quarter of fiscal 2003 and the $6.8 million issuance of our treasury and common stock relating to our employee equity plans during the year. These cash receipts were offset by the payments
of liabilities related to leased products of $1.6 million.



As
of October 31, 2003, we had working capital of approximately $367.9 million, including cash and short-term investments of $285.9 million, and accounts receivable and inventories totaling $149.0 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. It is reasonably possible that 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. See discussion of Critical Accounting Policies and Estimates.



We believe our current cash and investment positions combined with the ability to borrow funds will be sufficient to meet
our anticipated business requirements for the next 12 months and foreseeable future, including potential acquisitions or strategic investments, capital expenditures, and working capital requirements.



48



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In December 2002, we completed the acquisition of certain assets of SZ, located in Amerang, Germany, for
approximately $4.6 million in cash. In January 2003, we acquired Optonics, Inc. headquartered in Mountain View, California for approximately $21 million in an all-stock transaction. In February 2003, we acquired certain assets and liabilities of
CCC, a non-related leasing company. The assets of CCC consisted primarily of a portfolio of leases of our equipment and its liabilities included indebtedness of approximately $15.3 million associated with the lease portfolio. We operate CCC as a
wholly-owned subsidiary to provide leasing and other financing solutions to our customers. See Note 2 to the Condensed Consolidated Financial Statements for further discussion.



In August 2003, we acquired certain assets and liabilities of SZ Testsysteme Japan Limited, a distributor of automotive test
equipment, for approximately $1.0 million of cash. The acquisition will provide a distribution channel to Japanese customers for our existing products focused primarily on the Japanese automotive test market.



We lease our facilities and equipment under operating leases that expire
periodically through 2010 of which approximately $0.2 million have been written-off to special operating charges this fiscal year. The approximate future minimum lease payments at October 31, 2003 are as follows (in thousands):



|             |  |                                |       |                                      |   |                                    |  |   |      
|------------ |  | ------------------------------ | ----- | ------------------------------------ | - | ---------------------------------- |  | - | -----
|             |  | Committed Gross Lease Payments |       | Leases Written Off in SpecialCharges |   | Net Estimated Future Lease Expense
|2004         |  | $                              | 3,636 |                                      | $ | 1,366                              |  | $ | 2,270
|2005         |  |                                | 1795  |                                      |   | 946                                |  |   | 849  
|2006         |  |                                | 546   |                                      |   | 56                                 |  |   | 490  
|2007         |  |                                | 151   |                                      |   | 0                                  |  |   | 151  
|2008 to 2010 |  |                                | 212   |                                      |   | 0                                  |  |   | 212  
|             |  |                                |       |                                      |   |                                    |  |   |      
|             |  | $                              | 6,340 |                                      | $ | 2,368                              |  | $ | 3,972
|             |  |                                |       |                                      |   |                                    |  |   |      



The following
summarizes the Companys minimum contractual cash obligations and other commitments at October 31, 2003, and the effect of such obligations in future periods (in thousands):



|                                                   |  |       |         |      |   |        |  |      |        |      |   |       |  |            |       |  |   |         |  |   |    
|-------------------------------------------------- |  | ----- | ------- | ---- | - | ------ |  | ---- | ------ | ---- | - | ----- |  | ---------- | ----- |  | - | ------- |  | - | ---
|                                                   |  | Total |         | 2004 |   | 2005   |  | 2006 |        | 2007 |   | 2008  |  | Thereafter
|Contractual Obligations:                           |  |       |         |      |   |        |  |      |        |      |   |       |  |            |       |  |   |         |  |   |    
|Facilities and equipment operating leases          |  | $     | 6,340   |      | $ | 3,636  |  | $    | 1,795  |      | $ | 546   |  | $          | 151   |  | $ | 69      |  | $ | 143
|Liabilities related to leased products             |  |       | 10,419  |      |   | 9,362  |  |      | 1,057  |      |   |      |  |            |      |  |   |        |  |   |   
|Interest on liabilities related to leased products |  |       | 404     |      |   | 396    |  |      | 8      |      |   |      |  |            |      |  |   |        |  |   |   
|Convertible subordinated notes                     |  |       | 180,000 |      |   |       |  |      |       |      |   |      |  |            |      |  |   | 180,000 |  |   |   
|Interest on convertible subordinated notes         |  |       | 12,263  |      |   | 2,700  |  |      | 2,700  |      |   | 2,700 |  |            | 2,700 |  |   | 1,463   |  |   |   
|Minimum payable for information technology         |  |       | 16,096  |      |   | 6,784  |  |      | 9,312  |      |   |      |  |            |      |  |   |        |  |   |   
|Open non-cancelable purchase order commitments     |  |       | 42,091  |      |   | 42,091 |  |      |       |      |   |      |  |            |      |  |   |        |  |   |   
|                                                   |  |       |         |      |   |        |  |      |        |      |   |       |  |            |       |  |   |         |  |   |    
|Total contractual cash and other obligations       |  | $     | 267,613 |      | $ | 64,969 |  | $    | 14,872 |      | $ | 3,246 |  | $          | 2,851 |  | $ | 181,532 |  | $ | 143
|                                                   |  |       |         |      |   |        |  |      |        |      |   |       |  |            |       |  |   |         |  |   |    



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



49



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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. In addition to the above lease commitments, at October 31, 2003, we have open and committed purchase orders totaling approximately $42.1 million.



Net transfer of inventory to property and equipment was $3.3 million. Mature
product spare parts that are used in the Companys service business are classified as property and equipment. In addition, the Company capitalizes a small number of finished systems into the manufacturing function for use in de-bug, quality
control, and software development as well as the sales function for use in demonstrations and application development. When capitalized spare parts and finished goods are sold to third parties the transaction is recorded as a sale of a fixed asset.



As of October 31, 2003, our principal sources of liquidity
consisted of approximately $27.3 million of cash and cash equivalents, and short-term investments of $258.6 million. In addition, we had $50.7 million of available-for-sale securities, classified as long-term investments at October 31, 2003.



Recent Accounting Pronouncements



In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 141, Business Combinations, or SFAS 141 and Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, or SFAS 142.



SFAS 141 supersedes APB Opinion No. 16, Business Combinations,
and eliminates the pooling-of-interests method of accounting for business combinations, thus requiring that all business combinations be accounted for using the purchase method. In addition, in applying the purchase method, SFAS 141 changes the
criteria for recognizing intangible assets other than goodwill and states that the following criteria should be considered in determining the classification of intangible assets: (1) whether the intangible asset arises from contractual or other
legal rights, or (2) whether the intangible asset is separable or dividable from the acquired entity and capable of being sold, transferred, licensed, rented, or exchanged. If neither criteria is met, the intangible assets are classified as goodwill
and are not amortized. We applied the requirements of SFAS 141 to all business combinations initiated after June 30, 2001. Our purchase of Optonics during the quarter ended January 31, 2003, was subject to these requirements.



SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other
Intangible Assets, make 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 SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. A reporting unit would be one level below the operating segment if a component of an operating segment is a business as described under U.S. GAAP 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.



Assets and
liabilities will be allocated to each reporting unit if the asset will be employed in, or the liability relates to, the operation of a reporting unit or the asset or liability will be considered in determining the fair value of the reporting unit.
Goodwill should be allocated to the reporting units that are expected to benefit from the synergies of the combination. To the extent that a reporting units carrying amount exceeds its fair value, an indication exists that the reporting
units goodwill may be impaired.



Under SFAS No. 131, we
stated in our prior Form 10-K for fiscal 2002 that we operated in two industry segments: (1) the design, development, manufacture, sale and service of Automatic Test Equipment or ATE and (2) the design, development, sale and service of software that
assists in the development of test programs used in ATE. Revenues from the software segment were not material to the Companys operations in fiscal years 2002 and 2001. During 2003, the software segment was significantly decreased in size and
the remaining software



50



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operations were merged with the ATE segment. Currently we operate in just one industry segment, ATE. We also have a single reporting unit, ATE, primarily
because all of the components of our ATE segment are subject to similar economic characteristics. In addition, all our products have common production processes, customers, and product life cycles.



Total goodwill amortization expense, including impairments, was $9.7 million
in fiscal 2002, $10.0 million in fiscal 2001 and $1.8 million in fiscal 2000. We adopted the remaining elements of this new standard in the first quarter of fiscal 2003 and therefore ceased goodwill amortization for acquisitions made prior to July
1, 2001. As of the date of adoption of SFAS 142 on November 1, 2002, we had an unamortized acquired intangible assets balance of approximately $25.2 million excluding the balance of approximately $430,000 for acquired workforce reclassified to
goodwill. As of that date, we also had an unamortized goodwill balance of approximately $34.3 million.



In the quarter ended April 30, 2003, we completed the first step of the transitional goodwill impairment test and determined that no potential impairment
existed as of October 31, 2002. The first step is a review for potential impairment, while the second step measures the amount of the impairment, if any. We engaged an outside professional appraiser to evaluate goodwill to complete our annual
impairment test and as of the end of the third quarter of fiscal 2003, we again determined that no potential impairment exists. To complete the impairment test, we identified our reporting units and determined the carrying value for each of them by
assigning asset and liabilities, including existing goodwill and intangible assets, to those reporting units. We then determined the fair value of each reporting unit and compared it to the reporting units carrying value. To the extent that a
reporting units carrying amount exceeds its fair value, an indication exists that the reporting units goodwill may be impaired and we must perform the second step of the transitional impairment test. In the second step, if required, we
must compare the implied fair value of the reporting units goodwill to its carrying amount. As a result of our completed impairment tests, we recognized no impairment loss in fiscal 2003 in connection with the adoption of SFAS No. 142.
However, no assurances can be given that future evaluations of goodwill will not result in charges as a result of future impairment. We will continue to evaluate goodwill at least on an annual basis and whenever events and changes in circumstances
suggest that the carrying amount may not be recoverable from its estimated future cash flow.



The following table presents a reconciliation of current and previously reported net loss per share to the amounts adjusted to exclude goodwill and acquired workforce amortization for the fiscal years 2003, 2002 and
2001 (in thousands, except per share data):



|                                                 |  | 2003 |          |   | 2002 |   |          | 2001 | 
|------------------------------------------------ |  | ---- | -------- | - | ---- | - | -------- | ---- | 
|Net income (loss) as reported                    |  | $    | (113,112 | ) |      | $ | (170,481 | )    | 
|Goodwill amortization                            |  |      |         |   |      |   | 9,690    |      | 
|Acquired workforce amortization                  |  |      |         |   |      |   | 820      |      | 
|                                                 |  |      |          |   |      |   |          |      | 
|Pro forma net loss                               |  | $    | (113,112 | ) |      | $ | (159,971 | )    | 
|                                                 |  |      |          |   |      |   |          |      | 
|Basic and diluted net loss per share as reported |  | $    | (1.80    | ) |      | $ | (2.81    | )    | 
|Goodwill amortization                            |  |      |         |   |      |   | 0.16     |      | 
|Acquired workforce amortization                  |  |      |         |   |      |   | 0.01     |      | 
|                                                 |  |      |          |   |      |   |          |      | 
|Basic and diluted pro forma net loss per share   |  | $    | (1.80    | ) |      | $ | (2.64    | )    | 
|                                                 |  |      |          |   |      |   |          |      | 



In August 2001, the
FASB issued Statement of Financial Accounting Standards No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets, or SFAS 144. SFAS 144 supersedes SFAS 121, Accounting for the Impairment of Long-Lived Assets and
Long-Lived Assets to be Disposed Of  and the accounting and reporting provisions of Accounting Principles Board Opinion No. 30, Reporting the Results of OperationsReporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business. SFAS 144 establishes a single accounting model for assets to be disposed of by sale whether previously held and used or
newly acquired. SFAS No. 144 retains the



51



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provisions of APB No. 30 for presentation of discontinued operations in the income statement, but broadens the presentation to include a component of an
entity. We have adopted SFAS 144 effective November 1, 2002. In the quarter ended July 31, 2003, in accordance with SFAS No. 144, we accelerated the depreciation remaining for leasehold improvements related to buildings located in Fremont,
California that we plan on vacating in the first quarter of fiscal 2004 when we move to our new headquarters in Milpitas, California. The amount of the accelerated depreciation related to these leasehold improvements was approximately $1.7 million
and is being recognized over the three fiscal quarters ending January 31, 2004. Accelerated depreciation related to the leasehold improvements is classified in SG&A expense.



In July 2002, the FASB approved Statement of Financial Accounting Standards No. 146 Accounting for Costs Associated
with Exit or Disposal Activities, or SFAS 146. SFAS 146 addresses the financial accounting and reporting for obligations associated with an exit activity, including restructuring, or with a disposal of long-lived assets. Exit activities
include, but are not limited to, eliminating or reducing product lines, terminating employees and contracts and relocating manufacturing facilities or personnel. SFAS 146 specifies that a company will record a liability for a cost associated with an
exit or disposal activity only when that liability is incurred and can be measured at fair value. Therefore, commitment to an exit plan or a plan of disposal expresses only managements intended future actions and, therefore, does not meet the
requirement for recognizing a liability and the related expense. SFAS 146 is effective prospectively for exit or disposal activities initiated after December 31, 2002. Our severance and related costs recorded in the quarter ended July 31, 2003 were
recorded in accordance with SFAS 146.



In November 2002, the
EITF reached a consensus on Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products,
services and/or rights to use assets. The provisions of EITF Issue No. 00-21 apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of this EITF has not had a material impact on our consolidated
results of operations and financial condition since we are able to separate multiple deliverables from one another and we recognize revenue for each deliverable, based on each deliverables fair value, when the revenue recognition criteria for
that specific deliverable is achieved. In order to comply with EITF 00-21, beginning in our fourth quarter of fiscal 2003, revenue of approximately $65,000 was deferred for the value of installation services not completed at the end of the quarter.



In January 2003, the Financial Accounting Standards Board
(FASB) issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 addresses consolidation by business enterprises of variable interest entities. Under that interpretation, certain entities known as
Variable Interest Entities (VIEs) must be consolidated by the primary beneficiary of the entity. The primary beneficiary is generally defined as having the majority of the risks and rewards arising from the VIE. For VIEs in which a
significant (but not majority) variable interest is held, certain disclosures are required. We have not entered into any arrangements or made any investments which qualify as a VIE after January 31, 2003 and therefore the initial implementation of
FIN 46 had no impact on our financial statements. For VIEs acquired before February 1, 2003, we are required to apply the accounting and disclosure rules set forth in FIN 46 in the first quarter of fiscal 2004. We have determined that the adoption
of FIN 46 will not have any impact on our financial position or results of operations.



In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, or SFAS 149. SFAS 149 amends and clarifies
accounting for derivative instruments and hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS 149 provides guidance relating to decisions made (a) as part of the Derivatives
Implementation Group process, (b) in connection with other FASB projects dealing with financial instruments and (c) regarding implementation issues raised in the application of the definition of a derivative and the characteristics of a derivative
that contains financing components. SFAS 149 is effective for contracts entered into or modified and for hedging relationships designated after June 30, 2003. The adoption of SFAS 149 did not have a material impact on our financial condition or
results of operations.



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In May 2003, the FASB issued Statement of Financial Accounting Statndards No. 150 Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and Equity, or SFAS 150. SFAS 150 requires freestanding financial instruments such as mandatorily redeemable shares, forward purchase contracts and written put options to
be reported as liabilities by their issuers as well as related new disclosure requirements. The provisions of SFAS 150 are effective for instruments entered into or modified after May 31, 2003 and pre-existing instruments as of the beginning of the
first interim period that commences after June 15, 2003. The adoption of SFAS 150 did not have a material impact on our financial condition or results of operations.



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, U.S. Treasury notes and obligations of U.S. 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, 2003
|                       |  | Balance October 31,2002 |         |   | 2003                                                      |   |         | 2004 |  |   | 2005    |   |  | 2006 |        |   | 2007 |   | Thereafter
|Cash equivalents       |  |                         |         |   |                                                           |   |         |      |  |   |         |   |  |      |        |   |      |   |            |   |  |   |  |  
|Fixed rate             |  | $                       | 50,192  |   |                                                           | $ | 27,318  |      |  |   |        |   |  |      |       |   |      |   |           |   |  |  |  | 
|Average rate           |  |                         | 2.07    | % |                                                           |   | 0.46    | %    |  |   |        |   |  |      |       |   |      |   |           |   |  |  |  | 
|Short term investments |  |                         |         |   |                                                           |   |         |      |  |   |         |   |  |      |        |   |      |   |            |   |  |   |  |  
|Fixed rate             |  | $                       | 82,223  |   |                                                           | $ | 112,977 |      |  | $ | 145,601 |   |  |      |       |   |      |   |           |   |  |  |  | 
|Average rate           |  |                         | 4.98    | % |                                                           |   | 1.69    | %    |  |   | 3.91    | % |  |      |       |   |      |   |           |   |  |  |  | 
|Long term investments  |  |                         |         |   |                                                           |   |         |      |  |   |         |   |  |      |        |   |      |   |            |   |  |   |  |  
|Fixed rate             |  | $                       | 108,231 |   |                                                           |   |        |      |  | $ | 4,754   |   |  | $    | 38,500 |   |      | $ | 6,930      |   |  |  |  | 
|Average rate           |  |                         | 4.56    | % |                                                           |   |        |      |  |   | 7.00    | % |  |      | 3.36   | % |      |   | 6.10       | % |  |  |  | 
|                       |  |                         |         |   |                                                           |   |         |      |  |   |         |   |  |      |        |   |      |   |            |   |  |   |  |  
|Total investment       |  | $                       | 240,646 |   |                                                           | $ | 140,295 |      |  | $ | 150,355 |   |  | $    | 38,500 |   |      | $ | 6,930      |   |  |  |  | 
|Average rate           |  |                         | 4.19    | % |                                                           |   | 1.45    | %    |  |   | 4.01    | % |  |      | 3.36   | % |      |   | 6.10       | % |  |  |  | 
|Equity instruments     |  | $                       | 1,016   |   |                                                           | $ | 498     |      |  |   |        |   |  |      |       |   |      |   |           |   |  |  |  | 



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.



Foreign Exchange



We generate a significant portion of our sales from sales to 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 and occasionally are denominated in the local currency for European and Japanese customers. The
subsidiaries also incur most of their expenses in the local currency. Accordingly, some of our foreign subsidiaries use the local currency as their functional currency.



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. The Company does not currently use derivatives, but will continue to assess the need for these instruments in the future.



Item 8.Financial Statements and Supplementary Data



For the years ended October 31, 2003, 2002 and 2001.



53



---

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                                                            |  | Page
|------------------------------------------------------------------------------------------- |  | ----
|Report of Ernst & Young LLP, Independent Auditors                                           |  | 55  
|                                                                                            | 
|Consolidated Balance SheetsOctober 31, 2003 and 2002                                       |  | 56  
|Consolidated Statements of OperationsYears Ended October 31, 2003, 2002 and 2001           |  | 57  
|Consolidated Statements of Stockholders EquityYears Ended October 31, 2003, 2002 and 2001 |  | 58  
|Consolidated Statements of Cash FlowsYears Ended October 31, 2003, 2002 and 2001           |  | 59  
|Notes to Consolidated Financial Statements                                                  |  | 60  



54



---

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS



The Board of Directors and Stockholders

Credence Systems Corporation



We have audited the accompanying consolidated balance sheets of Credence Systems Corporation as of October 31, 2003 and 2002, and the related consolidated statements of operations, stockholders equity, and cash flows for each of the
three years in the period ended October 31, 2003. Our audits also included the financial statement schedule listed in the index at Item 15(a)(2). These consolidated financial statements and schedule are the responsibility of the Companys
management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.



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



In our opinion, the consolidated financial statements referred
to above present fairly, in all material respects, the consolidated financial position of Credence Systems Corporation at October 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in
the period ended October 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken
as a whole, presents fairly in all material respects the information set forth therein.



As discussed in Note 1 to the accompanying consolidated financial statements, in 2003, Credence Systems Corporation changed its method of accounting for goodwill and intangible assets.



/s/ Ernst & Young LLP



San Jose, California

November 21, 2003



55



---

CREDENCE SYSTEMS CORPORATION



CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)



|                                                                                                                                                    |  | October 31, |         
|--------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------- | --------
|                                                                                                                                                    |  | 2003        |         
|ASSETS                                                                                                                                              |  |             |         
|Current assets:                                                                                                                                     |  |             |         
|Cash and cash equivalents                                                                                                                           |  | $           | 27,318  
|Short-term investments                                                                                                                              |  |             | 258,578 
|Accounts receivable, net of allowances of $2,444 and $5,388, respectively                                                                           |  |             | 65,627  
|Inventories                                                                                                                                         |  |             | 83,356  
|Income tax receivable                                                                                                                               |  |             | 581     
|Prepaid expenses and other current assets                                                                                                           |  |             | 15,400  
|                                                                                                                                                    |  |             |         
|Total current assets                                                                                                                                |  |             | 450,860 
|Long-term investments                                                                                                                               |  |             | 50,682  
|Property and equipment, net                                                                                                                         |  |             | 102,111 
|Goodwill                                                                                                                                            |  |             | 37,531  
|Other intangible assets, net of accumulated amortization of $34,988 and $27,629                                                                     |  |             | 31,285  
|Other assets                                                                                                                                        |  |             | 26,024  
|                                                                                                                                                    |  |             |         
|Total assets                                                                                                                                        |  | $           | 698,493 
|                                                                                                                                                    |  |             |         
|LIABILITY AND STOCKHOLDERS EQUITY                                                                                                                  |  |             |         
|                                                                                                                                                    |  |            
|Current liabilities:                                                                                                                                |  |             |         
|Bank loans and notes payableleased products                                                                                                        |  | $           | 9,350   
|Accounts payable                                                                                                                                    |  |             | 23,303  
|Other accrued expenses and liabilities                                                                                                              |  |             | 13,698  
|Accrued payroll and related liabilities                                                                                                             |  |             | 9,009   
|Deferred revenue                                                                                                                                    |  |             | 9,981   
|Income tax payable                                                                                                                                  |  |             | 7,581   
|Accrued warranty                                                                                                                                    |  |             | 5,501   
|Deferred profit                                                                                                                                     |  |             | 4,556   
|                                                                                                                                                    |  |             |         
|Total current liabilities                                                                                                                           |  |             | 82,979  
|Convertible subordinated notes (1.50%, due 2008, convertible into common stock at conversion price of $11.31 per
share)                             |  |             | 180,000 
|Notes payableleased products                                                                                                                       |  |             | 1,058   
|Other liabilities                                                                                                                                   |  |             | 3,829   
|                                                                                                                                                    |  |            
|Commitments and contingencies (Note 5)                                                                                                              |  |             |         
|                                                                                                                                                    |  |            
|Stockholders equity:                                                                                                                               |  |             |         
|Preferred stock:                                                                                                                                    |  |             |         
|Authorized shares1,000 ($0.001 par value); no shares issued                                                                                        |  |             |        
|Common stock:                                                                                                                                       |  |             |         
|Authorized shares150,000 ($0.001 par value); Issued shares64,347 in 2003 and 61,901 in 2002; Outstanding
shares63,805 in 2003 and 60,914 in 2002 |  |             | 64      
|Additional paid-in capital                                                                                                                          |  |             | 628,762 
|Treasury stock, at cost, 542 shares in 2003 and 987 shares in 2002                                                                                  |  |             | (13,195 
|Accumulated other comprehensive income                                                                                                              |  |             | 1,522   
|Deferred compensation                                                                                                                               |  |             | (1,685  
|Accumulated deficit                                                                                                                                 |  |             | (184,841
|                                                                                                                                                    |  |             |         
|Total stockholders equity                                                                                                                          |  |             | 430,627 
|                                                                                                                                                    |  |             |         
|Total liabilities and stockholders equity                                                                                                          |  | $           | 698,493 
|                                                                                                                                                    |  |             |         



See accompanying notes.



56



---

CREDENCE SYSTEMS CORPORATION



CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)



|                                                     |  | Year Ended October 31, |         
|---------------------------------------------------- |  | ---------------------- | --------
|                                                     |  | 2003                   |         
|Net sales:                                           |  |                        |         
|Systems, upgrades, software                          |  | $                      | 141,209 
|Service, spare parts                                 |  |                        | 41,205  
|                                                     |  |                        |         
|Total net sales                                      |  |                        | 182,414 
|Cost of goods sold:                                  |  |                        |         
|Systems, upgrades, and software                      |  |                        | 89,923  
|Service and spare parts                              |  |                        | 25,643  
|Special charges                                      |  |                        | 1,927   
|                                                     |  |                        |         
|Gross margin                                         |  |                        | 64,921  
|Operating expenses:                                  |  |                        |         
|Research and development                             |  |                        | 73,520  
|Selling, general and administrative                  |  |                        | 91,124  
|Amortization of purchased intangible assets          |  |                        | 9,456   
|In-process research and development                  |  |                        | 1,510   
|Special charges                                      |  |                        |        
|Restructuring charges                                |  |                        | 3,589   
|                                                     |  |                        |         
|Total operating expenses                             |  |                        | 179,199 
|                                                     |  |                        |         
|Operating loss                                       |  |                        | (114,278
|Interest income                                      |  |                        | 5,832   
|Interest and other expenses, net                     |  |                        | (3,613  
|                                                     |  |                        |         
|Loss before income tax provision (benefit)           |  |                        | (112,059
|Income tax (benefit)                                 |  |                        | 1,006   
|                                                     |  |                        |         
|Loss before minority interest                        |  |                        | (113,065
|Minority interest (benefit)                          |  |                        | 47      
|                                                     |  |                        |         
|Net loss                                             |  | $                      | (113,112
|                                                     |  |                        |         
|Net loss per share                                   |  |                        |         
|Basic                                                |  | $                      | (1.80   
|                                                     |  |                        |         
|Diluted                                              |  | $                      | (1.80   
|                                                     |  |                        |         
|Number of shares used in computing per share amounts |  |                        |         
|Basic                                                |  |                        | 62,737  
|                                                     |  |                        |         
|Diluted                                              |  |                        | 62,737  
|                                                     |  |                        |         



See accompanying notes.



57



---

CREDENCE SYSTEMS CORPORATION



CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

(in thousands)



|                                                            |  | Common Stock |   |  | AdditionalPaid-inCapital |    |   | Treasury Stock |        |         | RetainedEarnings(Deficit) |        |        | DeferredCompensation |  |   | AccumulatedComprehensiveIncome (loss) |   |  | TotalStockholdersEquity |         
|----------------------------------------------------------- |  | ------------ | - |  | ------------------------ | -- | - | -------------- | ------ | ------- | ------------------------- | ------ | ------ | -------------------- |  | - | ------------------------------------- | - |  | ------------------------ | --------
|                                                            |  | Shares       |   |  | Amount                   |    |   |                | Shares |         |                           | Amount |        |                      |  |   |                                      
|Balance at October 31, 2000                                 |  | 60,806       |   |  | $                        | 61 |   |                | $      | 593,691 |                           |        | (1,176 | )                    |  | $ | (18,560                               | ) |  | $                        | 197,428 
|                                                            |  |              |   |  |                          |    |   |                |        |         |                           |        |        |                      |  |   |                                       |   |  |                          |         
|Purchase of common stock                                    |  | (77          | ) |  |                          | (1 | ) |                |        | (1,080  | )                         |        | (325   | )                    |  |   | (6,485                                | ) |  |                          |        
|Issuance of common stock under employee equity plans        |  | 697          |   |  |                          | 1  |   |                |        | 9,607   |                           |        | 201    |                      |  |   | 1,510                                 |   |  |                          |        
|Income tax benefit-stock plans                              |  |             |   |  |                          |   |   |                |        | 2,230   |                           |        |       |                      |  |   |                                      |   |  |                          |        
|Amortization of deferred compensation                       |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          |        
|Issuance of options to employees at below fair market value |  |             |   |  |                          |   |   |                |        | 1,035   |                           |        |       |                      |  |   |                                      |   |  |                          |        
|Net loss                                                    |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          | (98,676 
|Unrealized gain on securities, net                          |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          |        
|Currency translation adjustment                             |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          |        
|Comprehensive loss                                          |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          |        
|                                                            |  |              |   |  |                          |    |   |                |        |         |                           |        |        |                      |  |   |                                       |   |  |                          |         
|Balance at October 31, 2001                                 |  | 61,426       |   |  |                          | 61 |   |                | $      | 605,483 |                           |        | (1,300 | )                    |  |   | (23,535                               | ) |  |                          | 98,752  
|                                                            |  |              |   |  |                          |    |   |                |        |         |                           |        |        |                      |  |   |                                       |   |  |                          |         
|Issuance of common stock under employee equity plans        |  | 475          |   |  |                          | 1  |   |                |        | 5,544   |                           |        | 313    |                      |  |   | 2,349                                 |   |  |                          |        
|Amortization of deferred compensation                       |  |             |   |  |                          |   |   |                |        | (2,182  | )                         |        |       |                      |  |   |                                      |   |  |                          |        
|Net loss                                                    |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          | (170,481
|Unrealized loss on securities, net                          |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          |        
|Currency translation adjustment                             |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          |        
|Comprehensive loss                                          |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          |        
|                                                            |  |              |   |  |                          |    |   |                |        |         |                           |        |        |                      |  |   |                                       |   |  |                          |         
|Balance at October 31, 2002                                 |  | 61,901       |   |  |                          | 62 |   |                |        | 608,845 |                           |        | (987   | )                    |  |   | (21,186                               | ) |  |                          | (71,729 
|                                                            |  |              |   |  |                          |    |   |                |        |         |                           |        |        |                      |  |   |                                       |   |  |                          |         
|Issuance of common stock for acquisition of Optonics        |  | 1,900        |   |  |                          | 2  |   |                |        | 21,066  |                           |        |       |                      |  |   |                                      |   |  |                          |        
|Issuance of common stock under employee equity plans        |  | 573          |   |  |                          |   |   |                |        | (1,149  | )                         |        | 445    |                      |  |   | 7,991                                 |   |  |                          |        
|Amortization of deferred compensation                       |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          |        
|Net loss                                                    |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          | (113,112
|Unrealized loss on securities, net                          |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          |        
|Currency translation adjustment                             |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          |        
|Comprehensive loss                                          |  |             |   |  |                          |   |   |                |        |        |                           |        |       |                      |  |   |                                      |   |  |                          |        
|                                                            |  |              |   |  |                          |    |   |                |        |         |                           |        |        |                      |  |   |                                       |   |  |                          |         
|Balance at October 31, 2003                                 |  | 64,347       |   |  | $                        | 64 |   |                | $      | 628,762 |                           |        | (542   | )                    |  | $ | (13,195                               | ) |  | $                        | (184,841
|                                                            |  |              |   |  |                          |    |   |                |        |         |                           |        |        |                      |  |   |                                       |   |  |                          |         



See accompanying notes.



58



---

CREDENCE SYSTEMS CORPORATION



CONSOLIDATED STATEMENTS OF CASH FLOWS

Increase (decrease) in cash and cash equivalents

(in thousands)



|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|--------------------------------------------------------------------------- |  | ---------------------- | -------- | - | ---- | - | -------- | ---- |  | - | -------- | -
|                                                                            |  | Year Ended October 31, |         
|                                                                            |  | 2003                   |          |   | 2002 |   |          | 2001 | 
|Cash flows from operating activities:                                       |  |                        |          |   |      |   |          |      |  |   |          |  
|Net loss                                                                    |  | $                      | (113,112 | ) |      | $ | (170,481 | )    |  | $ | (98,676  | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                        |          |   |      |   |          |      |  |   |          |  
|Depreciation and amortization                                               |  |                        | 39,985   |   |      |   | 50,405   |      |  |   | 59,276   |  
|Non-cash charges                                                            |  |                        | 6,891    |   |      |   | 35,837   |      |  |   | 99,588   |  
|Loss on disposal of property and equipment                                  |  |                        | 5,967    |   |      |   | 2,723    |      |  |   | 1,572    |  
|Deferred income tax                                                         |  |                        |         |   |      |   | 36,424   |      |  |   | (8,199   | )
|Realized net loss (gain) from investments                                   |  |                        | (449     | ) |      |   | 1,559    |      |  |   | (4,487   | )
|Minority interest                                                           |  |                        | 22       |   |      |   | (397     | )    |  |   | (3       | )
|Changes in operating assets and liabilities:                                |  |                        |          |   |      |   |          |      |  |   |          |  
|Accounts receivable, net                                                    |  |                        | (45,243  | ) |      |   | 7,405    |      |  |   | 147,443  |  
|Inventories                                                                 |  |                        | 18,907   |   |      |   | (449     | )    |  |   | (95,279  | )
|Income tax receivable and payable                                           |  |                        | 24,463   |   |      |   | 23,568   |      |  |   | (21,636  | )
|Prepaid expenses and other current assets                                   |  |                        | (5,344   | ) |      |   | 1,982    |      |  |   | (36,102  | )
|Accounts payable                                                            |  |                        | 8,433    |   |      |   | (2,640   | )    |  |   | (38,149  | )
|Accrued expenses and other current liabilities                              |  |                        | (4,195   | ) |      |   | (7,894   | )    |  |   | (41,506  | )
|Deferred profit                                                             |  |                        | (2,588   | ) |      |   | (5,983   | )    |  |   | (32,368  | )
|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|Net cash used in operating activities                                       |  |                        | (66,263  | ) |      |   | (27,941  | )    |  |   | (68,526  | )
|                                                                            |  |                        |         
|Cash flows from investing activities:                                       |  |                        |          |   |      |   |          |      |  |   |          |  
|Purchases of available-for-sale securities                                  |  |                        | (361,462 | ) |      |   | (174,147 | )    |  |   | (269,426 | )
|Sales and maturities of available-for-sale securities                       |  |                        | 242,806  |   |      |   | 240,608  |      |  |   | 297,091  |  
|Acquisition of property and equipment                                       |  |                        | (14,668  | ) |      |   | (33,534  | )    |  |   | (37,052  | )
|Acquisition of purchased intangible assets                                  |  |                        |         |   |      |   | (1,127   | )    |  |   | (14,185  | )
|Acquisition of other assets and other                                       |  |                        | (4,548   | ) |      |   | (6,255   | )    |  |   | (7,253   | )
|Proceeds from sale of property and equipment and leased equipment           |  |                        | 2,592    |   |      |   |         |      |  |   | 163      |  
|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|Net cash provided by (used in) investing activities                         |  |                        | (135,280 | ) |      |   | 25,545   |      |  |   | (30,662  | )
|                                                                            |  |                        |         
|Cash flows from financing activities:                                       |  |                        |          |   |      |   |          |      |  |   |          |  
|Issuance of 11/2% convertible notes                                         |  |                        | 174,246  |   |      |   |         |      |  |   |         |  
|Issuance of common & treasury stock                                         |  |                        | 6,842    |   |      |   | 7,894    |      |  |   | 11,118   |  
|Repurchase of common & treasury stock                                       |  |                        |         |   |      |   |         |      |  |   | (7,566   | )
|Payments of liabilities related to leased products                          |  |                        | (1,563   | ) |      |   |         |      |  |   |         |  
|Other                                                                       |  |                        | (856     | ) |      |   | 385      |      |  |   | 2,544    |  
|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|Net cash provided by financing activities                                   |  |                        | 178,669  |   |      |   | 8,279    |      |  |   | 6,096    |  
|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|Net increase (decrease) in cash and cash equivalents                        |  |                        | (22,874  | ) |      |   | 5,883    |      |  |   | (93,092  | )
|Cash and cash equivalents at beginning of the period                        |  |                        | 50,192   |   |      |   | 44,309   |      |  |   | 137,401  |  
|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|Cash and cash equivalents at end of the period                              |  | $                      | 27,318   |   |      | $ | 50,192   |      |  | $ | 44,309   |  
|                                                                            |  |                        |          |   |      |   |          |      |  |   |          |  
|Supplemental disclosures of cash flow information:                          |  |                        |          |   |      |   |          |      |  |   |          |  
|Interest paid                                                               |  | $                      | 2,036    |   |      | $ | 47       |      |  | $ | 863      |  
|Income taxes paid (received)                                                |  | $                      | (24,715  | ) |      | $ | (54,387  | )    |  | $ | 14,336   |  
|                                                                            |  |                        |         
|Noncash investing activities:                                               |  |                        |          |   |      |   |          |      |  |   |          |  
|Net transfers of inventory to property and equipment                        |  | $                      | 3,338    |   |      | $ | 8,591    |      |  | $ | 2,055    |  
|Acquisition of Optonics using Credence common stock                         |  | $                      | (21,066  | ) |      |   |         |      |  |   |         |  
|Unrealized gain (loss) on securities                                        |  | $                      | (1,315   | ) |      | $ | (1,396   | )    |  | $ | 373      |  
|                                                                            |  |                        |         
|Noncash financing activities:                                               |  |                        |          |   |      |   |          |      |  |   |          |  
|Income tax benefit from stock option exercises                              |  |                        |         |   |      |   |         |      |  | $ | 2,230    |  
|Customer lease payments on liabilities guaranteed by Credence               |  | $                      | (5,041   | ) |      |   |         |      |  |   |         |  



See accompanying notes.



59



---

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. As a result of acquisitions made in fiscal years 1997 through 2001,
Credence is also involved in the design, development, sale and service of software enabling design and test engineering to develop and debug production test software prior to fabricating the prototype as well as the development of customer test
programs used by automatic test equipment.



As a result of the
acquisition in December 2002 of certain assets and liabilities of SZ Testsysteme AG and SZ Testsysteme GmbH, or SZ, the Company complemented its existing mixed-signal and wireless solutions with a division focused primarily on the automotive test
market. In January 2003, the Company acquired Optonics, Inc., a division, which extended the Companys product offerings in engineering validation test, design verification and diagnostics systems. In February 2003, the Company acquired certain
assets and liabilities of Credence Capital Corporation, or CCC, which allows the Company to offer leasing and other financing solutions to customers seeking alternative options to acquire the Companys equipment. CCC is operated as a wholly
owned subsidiary.



The Company has subsidiaries in 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. Also, the Company has a joint venture with Innotech Corporation in
Japan engaged in the customization, development and manufacture of product for sale by both companies. The joint venture is 50.1% owned by the Company and is consolidated in the financial statements based on the Companys controlling interest
in, and ability to control the governance of, the joint venture by virtue of the Companys majority shareholding. For the 2003, 2002, and 2001 fiscal years, unrelated net sales, net losses, assets and liabilities of Innotech were less than 0.5%
of the total of the Companys consolidated net sales, net losses, assets and liabilities. The Company also has European subsidiaries, which principally distribute, service, and support Credence products in Europe and the Middle East.



Basis of Presentation



The accompanying consolidated financial statements include the accounts of
the Company and its wholly owned and majority 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.



In August 2001, the Company completed a merger with Integrated Measurement Systems, Inc., or IMS. IMS designed, manufactured, marketed and serviced integrated circuit validation systems and virtual test software. This acquisition was
accounted for as a pooling of interests in accordance with Accounting Principles Board 16 (APB 16) and therefore, the consolidated financial statements, including the related notes, have been restated as of the earliest period presented
to include the results of operations, financial position and cash flows of IMS (see Note 2 for further discussion).



Use of Estimates



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



60



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



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 the allowance for doubtful accounts, inventory write-offs, depreciation and amortization, 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, for example, 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 dramatic decline in the semiconductor
business cycle and corresponding impact on revenue since early in fiscal 2001 and continuing uncertainty over any turn-around of the semiconductor equipment industry, the Company continues to monitor its inventory levels in light of product
development changes and expectations of an eventual market upturn. The Company recorded a charge in the third quarter of fiscal 2003 of $1.3 million due to a legal settlement with an inventory vendor relating to cancelled purchase contracts and $0.6
million due to spare parts write-offs. The Company recorded a charge of $9.4 million in the fourth quarter of fiscal 2002, and charges of $45.0 million and $38.0 million in the second and fourth quarters of fiscal 2001, respectively, for the
write-off of excess inventories. The Company may be required to take additional charges for excess and obsolete inventory if the industry downturn causes further reductions to its current inventory valuations or changes its current product
development plans. The Company evaluates its inventory reserves based on estimates and forecasts with respect to the next cyclical industry upturn. The forecasts used for computing inventory reserves require the Company to estimate its ability to
sell current and future products in the next industry upturn and compares those estimates with its current inventory levels. If these forecasts or estimates change, or its product roadmaps change, then the Company would need to adjust its assessment
of the inventory valuations. Once inventories are written off, the Company carries that inventory at its reduced value until it is scrapped or otherwise disposed of. At October 31, 2003, approximately 17% and 8% of the net inventory balances were
for the Companys older Quartet mixed signal and Kalos non-volatile memory product families, respectively. With the recent introduction of the Kalos II, the Company will continue to scrutinize the value of the current Kalos I inventory in light
of the anticipated product transition to Kalos II. In particular, the value of the Kalos inventory will depend on factors such as the economic condition of the Flash memory IC market, product development schedules for the production versions of the
Kalos II and ultimately the success of the Kalos II product in the marketplace.



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 SAB 101, the
Company recognizes revenue on the sale of semiconductor manufacturing equipment when title and risk of loss has 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



61



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



applied consistently among the Companys semiconductor manufacturing equipment product lines. Product revenue is recognized upon shipment when the
product is classified as mature and the customer acceptance criteria can be demonstrated prior to shipment. Revenue related to the fair value of the installation obligation is recognized upon completion of the installation. Products are classified
as mature after several different customers have accepted similar systems. For sales of new products or when the customer acceptance criteria cannot be demonstrated prior to shipment, revenue and the related cost of goods sold are deferred on a net
basis until customer acceptance. Revenue related to maintenance and service contracts is recognized ratably over the duration of the contracts. Lease revenue is recorded in accordance with FAS No. 13, Accounting for Leases which requires that a
lessor account for each lease by either the direct financing, 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.



Deferred revenue includes deferred revenue related to
maintenance contracts (and other undelivered services). Deferred profit is related to equipment that was shipped to certain customers, but the revenue and cost of goods sold were not recognized because either the customer-specified acceptance
criteria has not been met as of the fiscal period end or the product is not classified as mature as of the fiscal period end and has not been accepted by the customer.



The Company is able to separate multiple deliverables from one another and recognizes revenue for each deliverable, based on
each deliverables fair value, when the revenue recognition criteria for that specific deliverable is achieved. In the vast majority of cases, the Companys orders are shipped complete. In rare instances when there are multiple shipments
due to materials shortages, revenue and related cost of sales are recognized only for the line items that are physically shipped. If the items not shipped on an order are required for the functionality of the delivered items, revenue and related
cost of sales are deferred on the delivered items and recognized only upon the shipment of the required items. If there are specific customer acceptance criteria, revenue is deferred until the specified performance has been completed in accordance
with the Companys revenue recognition policy. Installation in the majority of the cases occurs within two weeks of shipment. Prior to the adoption of EITF 00-21, installation was considered to be inconsequential and perfunctory and the cost of
installation was reliably estimated and accrued at shipment. In order to comply with EITF 00-21, beginning in the fourth quarter of fiscal 2003, revenue related to the fair value of installations not completed at the end of the period was deferred
and will be recognized when installation is completed.



Sales
in the United States are principally 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. The Company has
no significant differences in revenue recognition policies based on the sales channel, due to the business practices adopted with the Companys distributor relationships. The Company does not use price protection, stock
rotation, or similar programs with its distributors. The Company does not typically sell inventory into its distributors for eventual sale to end-users, but rather sells product to the distributors on the basis of a purchase order received
from an end-user. The Company evaluates any revenue recognition issues with respect to the end customer in light of its revenue recognition policy and in accordance with SAB 101 and EITF 00-21.



Stand-alone software license revenues including more than one product,
including maintenance and support services, are recognized using Statement of Position 97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9. The stand-alone software products are applications for IC manufacturers and test
and assembly contractors to help improve quality and shorten development lead times. For customer license arrangements meeting the policy set forth above, fees allocated to the software license will generally be recognized upon delivery and
acceptance, while fees allocated to services based upon vendor-specific objective evidence of fair value are recognized ratably as the services are performed.



62



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



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 SOP 97-2 since the embedded software 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 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.



Credences products are generally subject to warranty and
such estimated costs are provided for in costs of goods sold when product revenue is recognized. Installation and other services are not essential to the functionality of the products as these services do not alter the products capabilities, do not
require specialized skills or tools and can be performed by the customers or other vendors. The cost of installation is recorded in cost of goods sold when the installation revenue is recognized. Net sales consist of revenues from the sale of
systems, upgrades, spare parts, maintenance contracts and software.



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 after their due dates on a timely basis.



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, or 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 spot 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.



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 commercial paper, medium
term notes, asset-backed securities, U.S. Treasury notes and obligations of U.S. Government agencies, equity securities, corporate bonds and municipal bonds carried at amortized costs adjusted to fair market value.



At October 31, 2003 and 2002, 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.



Realized gains, losses and declines in value judged to be other-than-temporary on available-for-sale securities are included
in interest income. In fiscal 2002 the Company recorded a charge against interest income of approximately $1.6 million related to a decline in market value of an investment that was judged to be other than temporary. The cost of securities sold is
based on the specific identification method.



63



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



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,
|------------------------- |  | -----------
|                          |  | 2003       
|Money market              |  | $          
|Commercial paper          |  |            
|Corporate bonds           |  |            
|                          |  |            
|Cash equivalents          |  |            
|Cash                      |  |            
|                          |  |            
|Cash and cash equivalents |  | $          
|                          |  |            



The short-term
investments mature in less than one year. All long-term investments have maturities of one to five years. At October 31, 2003 and 2002, these investments are classified as available-for-sale and consist of the following (in thousands):



|                                                           |  | AmortizedCost  |         | Unrealized Gains in Accumulated Other Comprehensive Income |   | Unrealized Losses in AccumulatedOther Comprehensive Income |  |   | AggregateFair Value
|---------------------------------------------------------- |  | -------------- | ------- | ---------------------------------------------------------- | - | ---------------------------------------------------------- |  | - | -------------------
|                                                           |  | (In thousands)
|October 31, 2003                                           |  |                |         |                                                            |   |                                                            |  |   |                    
|Auction rate preferred                                     |  | $              | 53,000  |                                                            |   |                                                           |  |   |                   
|Treasury notes and obligations of U.S. government agencies |  |                | 91,725  |                                                            |   | 46                                                         |  |   | (47                
|Asset backed securities                                    |  |                | 13,564  |                                                            |   | 34                                                         |  |   | (12                
|Auction rate securities                                    |  |                | 22,550  |                                                            |   |                                                           |  |   |                   
|Equity securities                                          |  |                | 200     |                                                            |   | 298                                                        |  |   |                   
|Corporate bonds                                            |  |                | 116,507 |                                                            |   | 392                                                        |  |   | (136               
|Mortgage backed securities                                 |  |                |        |                                                            |   |                                                           |  |   |                   
|Municipal bonds                                            |  |                | 11,017  |                                                            |   | 126                                                        |  |   | (4                 
|                                                           |  |                |         |                                                            |   |                                                            |  |   |                    
|Short and long term investments                            |  | $              | 308,563 |                                                            | $ | 896                                                        |  | $ | (199               
|                                                           |  |                |         |                                                            |   |                                                            |  |   |                    
|                                                           |  |                |         |                                                           
|October 31, 2002                                           |  |                |         |                                                            |   |                                                            |  |   |                    
|Commercial paper and medium term notes                     |  | $              | 9,212   |                                                            | $ | 1                                                          |  | $ | (1                 
|Treasury notes and obligations of U.S. government agencies |  |                | 66,526  |                                                            |   | 493                                                        |  |   | (3                 
|Asset backed securities                                    |  |                | 14,333  |                                                            |   | 134                                                        |  |   | (12                
|Auction rate securities                                    |  |                | 3,000   |                                                            |   |                                                           |  |   |                   
|Equity securities                                          |  |                | 1,345   |                                                            |   |                                                           |  |   | (329               
|Corporate bonds                                            |  |                | 72,154  |                                                            |   | 764                                                        |  |   | (13                
|Mortgage backed securities                                 |  |                | 4,282   |                                                            |   | 14                                                         |  |   |                   
|Municipal bonds                                            |  |                | 19,235  |                                                            |   | 335                                                        |  |   |                   
|                                                           |  |                |         |                                                            |   |                                                            |  |   |                    
|Short and long term investments                            |  | $              | 190,087 |                                                            | $ | 1,741                                                      |  | $ | (358               
|                                                           |  |                |         |                                                            |   |                                                            |  |   |                    



64



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



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



|                                                        |  | October 31,
|------------------------------------------------------- |  | -----------
|                                                        |  | 2003       
|Due within 1 year                                       |  | $          
|Due in 1-2 years                                        |  |            
|Due in 2-3 years                                        |  |            
|Due in 3-5 years                                        |  |            
|                                                        |  |            
|Cash, cash equivalents, short and long term investments |  | $          
|                                                        |  |            



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,
|--------------- |  | -----------
|                |  | 2003       
|Raw materials   |  | $          
|Work-in-process |  |            
|Finished goods  |  |            
|                |  |            
|                |  | $          
|                |  |            



The Company makes
inventory commitment 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. 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 and associated risks. In addition, purchase commitments for unique components are relatively inflexible in terms of deferral or cancellation. This results 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. 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. 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 evaluates its inventory levels and valuations based on estimates and forecasts of the next cyclical industry upturn. These forecasts require
the Company to estimate its ability to sell current and future products in the next industry upturn and compare those estimates with its current inventory levels. It is difficult to predict the timing of the next recovery as well as the strength of
that recovery. In evaluating the need for inventory write-offs, the Company considers a number of factors including anticipated product life cycles, new



65



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



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 these 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.



Property and Equipment and Other Assets



Machinery and equipment, software, furniture and fixtures and spare parts are stated at cost and are depreciated using the straight-line method over the
assets estimated useful lives of three to five years. Mature product spare parts that are used in the Companys service business are classified as property and equipment. In addition, the Company capitalizes a small number of finished
systems into the manufacturing function for use in de-bug, quality control, and software development as well as the sales function for use in demonstrations and application development. When capitalized spare parts and finished goods are sold to
third parties the transaction is recorded as a sale of a fixed asset.



Personal computer equipment 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 consist of the following (in thousands):



|                              |  | October 31, |         
|----------------------------- |  | ----------- | --------
|                              |  | 2003        |         
|Land                          |  | $           | 26,509  
|Buildings                     |  |             | 31,422  
|Machinery and equipment       |  |             | 95,222  
|Software                      |  |             | 26,712  
|Leasehold improvements        |  |             | 26,800  
|Furniture and fixtures        |  |             | 10,786  
|Spare parts                   |  |             | 28,650  
|                              |  |             |         
|                              |  |             | 246,101 
|Less accumulated depreciation |  |             | (143,990
|                              |  |             |         
|Net property and equipment    |  | $           | 102,111 
|                              |  |             |         



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



|                                             |  | October 31, |        
|-------------------------------------------- |  | ----------- | -------
|                                             |  | 2003        |        
|Purchased technology                         |  | $           | 54,906 
|Other intangible assets                      |  |             | 11,367 
|                                             |  |             |        
|                                             |  |             | 66,273 
|Less accumulated amortization and provisions |  |             | (34,988
|                                             |  |             |        
|Other intangible assets, net                 |  | $           | 31,285 
|                                             |  |             |        



66



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



As of November 1, 2002 the Company adopted Statements of Financial Accounting Standards
Goodwill and Other Intangible Assets No. 142, or SFAS 142. Under SFAS 142, goodwill and indefinite lived intangible assets are no longer amortized, but are reviewed annually (or more frequently if impairment indicators arise) for
impairment. Intangible assets are amortized using the straight-line method over the assets estimated useful lives of two to ten years.



In the third quarter of fiscal 2003, the Company accelerated the remaining depreciation for leasehold improvements and other fixed assets related to
buildings located in Fremont that the Company plans on vacating in the first quarter of fiscal 2004 when the Company moves to its new headquarters in Milpitas. The amount of the accelerated depreciation related to these leasehold improvements and
other fixed assets was approximately $1.7 million and is being recognized in SG&A expenses over the three fiscal quarters ending January 31, 2004.



Bank Loans and Notes PayableLeased Products



In February 2003, the Company acquired certain assets and liabilities of Credence Capital Corporation, or CCC, a non-related leasing company. The net
assets of CCC consisted primarily of a portfolio of leases of Credence equipment and its liabilities included indebtedness associated with the lease portfolio. The associated liabilities at October 31, 2003, include a bank note and other notes
payable. The bank note, which has an annual interest rate of prime (approximately 4% at October 31, 2003), was $5.0 million. The Company guaranteed payment of notes from lessee customers to financial institutions that are included in bank loans and
notes payable  leased products in the balance sheet. As of October 31, 2003, these guaranteed payment of lessee notes totaled $1.5 million. See the maturity schedule for these obligations in Note 5.



Other Accrued Expenses and Liabilities



Other accrued expenses and liabilities consist of the following (in
thousands):



|                                |  | October 31,
|------------------------------- |  | -----------
|                                |  | 2003       
|Accrued distributor commissions |  |            
|Accrued restructure             |  |            
|Accrued state taxes             |  |            
|Other accrued liabilities       |  |            
|                                |  |            
|                                |  | $          
|                                |  |            



Stock-Based Compensation



The Company follows the intrinsic value method to account
for its employee stock options because, as discussed below, the alternative fair value accounting requires the use of option valuation models that were not developed for use in valuing employee stock options. Because 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 is 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 options pricing model. The Black-Scholes option valuation 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 model requires the input of highly subjective assumptions including the expected stock price volatility. Because 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



67



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



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.



The fair value for the stock options was estimated at the grant date using a Black-Scholes option-pricing model assuming no
expected divisions with the following weighted average assumptions for the years ended October 31, 2003, 2002, and 2001.



|                                 |  | 2003 |   |  | 2002 |   |  | 2001 |  
|-------------------------------- |  | ---- | - |  | ---- | - |  | ---- | -
|Expected life of options (years) |  | 6.35 |   |  | 6.64 |   |  | 6.39 |  
|Expected stock volatility        |  | 0.77 |   |  | 0.77 |   |  | 0.78 |  
|Risk-free interest rate          |  | 3.45 | % |  | 3.55 | % |  | 4.77 | %



The grant date
weighted average fair value of options granted during the year was $5.95, $10.19 and $12.35 for 2003, 2002 and 2001, respectively.



The fair value of issuances under the Employee Stock Purchase Plan is estimated on the issuance date using the Black-Scholes model assuming no expected
dividends and the following weighted average assumptions for issuances made in 2003, 2002 and 2001:



|                                 |  | 2003 |   |  | 2002 |   |  | 2001 |  
|-------------------------------- |  | ---- | - |  | ---- | - |  | ---- | -
|Expected life of options (years) |  | 0.50 |   |  | 0.50 |   |  | 0.50 |  
|Expected stock volatility        |  | 0.93 |   |  | 0.75 |   |  | 0.85 |  
|Risk-free interest rate          |  | 1.42 | % |  | 1.42 | % |  | 1.75 | %



The weighted-average
fair value of purchase rights granted during the year was $3.86, $4.77 and $7.93 for 2003, 2002 and 2001, respectively.



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 years ended October 31, 2003, 2002 and 2001 would have been as follows (in thousands, except per share data):



|                                                                                                                                                                                                          |  | 2003 |          |   | 2002 |   |          | 2001 | 
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | -------- | - | ---- | - | -------- | ---- | 
|Net loss as reported                                                                                                                                                                                      |  | $    | (113,112 | ) |      | $ | (170,481 | )    | 
|Add: Stock-based employee compensation expense included in reported net loss, net of related tax effects (0.9%, 4.4% and 37%
effective tax rate for FY03, FY02 and FY01, respectively)                    |  |      | 725      |   |      |   | 3,898    |      | 
|Less: Stock-based employee compensation expense determined under fair value based methods for all awards net of tax effects (0.9%,
4.4% and 37% effective tax rate for FY03, FY02 and FY01, respectively) |  |      | 24,095   |   |      |   | 39,099   |      | 
|                                                                                                                                                                                                          |  |      |          |   |      |   |          |      | 
|Pro forma net loss                                                                                                                                                                                        |  | $    | (136,482 | ) |      | $ | (205,682 | )    | 
|                                                                                                                                                                                                          |  |      |          |   |      |   |          |      | 
|Basic loss per share as reported                                                                                                                                                                          |  | $    | (1.80    | ) |      | $ | (2.81    | )    | 
|Basic loss per share pro forma                                                                                                                                                                            |  | $    | (2.18    | ) |      | $ | (3.40    | )    | 
|Diluted loss per share as reported                                                                                                                                                                        |  | $    | (1.80    | ) |      | $ | (2.81    | )    | 
|Diluted loss per share pro forma                                                                                                                                                                          |  | $    | (2.18    | ) |      | $ | (3.40    | )    | 



68



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Net Income (Loss) Per Share



Basic net income (loss) per share is based upon the weighted average number of common shares outstanding during the period.
Diluted net income (loss) per share is 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):



|                                                                                                    |  | 2003 |          |   | 2002 |   |          | 2001 | 
|--------------------------------------------------------------------------------------------------- |  | ---- | -------- | - | ---- | - | -------- | ---- | 
|Numerator:                                                                                          |  |      |          |   |      |   |          |      | 
|Numerator for basic and diluted loss per share-net loss                                             |  | $    | (113,112 | ) |      | $ | (170,481 | )    | 
|                                                                                                    |  |      |          |   |      |   |          |      | 
|Denominator:                                                                                        |  |      |          |   |      |   |          |      | 
|Denominator for basic net loss per share-weighted-average shares outstanding                        |  |      | 62,737   |   |      |   | 60,570   |      | 
|Effect of dilutive securities-employee stock options                                                |  |      |         |   |      |   |         |      | 
|Effect of dilutive securities-convertible notes                                                     |  |      |         |   |      |   |         |      | 
|                                                                                                    |  |      |          |   |      |   |          |      | 
|Denominator for diluted earnings per share-adjusted weighted-average shares and assumed conversions |  |      | 62,737   |   |      |   | 60,570   |      | 
|                                                                                                    |  |      |          |   |      |   |          |      | 
|Basic net loss per share                                                                            |  | $    | (1.80    | ) |      | $ | (2.81    | )    | 
|Diluted net loss per share                                                                          |  | $    | (1.80    | ) |      | $ | (2.81    | )    | 



During fiscal 2003,
the Company excluded options to purchase 13,195,611 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 because they were anti-dilutive. During
fiscal 2002, the Company excluded options to purchase 13,518,149 shares of common stock from the diluted income per share computation because the effect was anti-dilutive in the year. During fiscal 2001, the Company excluded options to purchase
11,728,032 shares of common stock from the diluted income per share computation because the effect was anti-dilutive in the year.



Recent Accounting Pronouncements



In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 141, Business Combinations, or
SFAS 141 and Statement of Financial Accounting Standard No.142, Goodwill and Other Intangible Assets, or SFAS 142.



SFAS 141 supersedes APB Opinion No. 16, Business Combinations, and eliminates the pooling-of-interests method of accounting for business
combinations, thus requiring that all business combinations be accounted for using the purchase method. In addition, in applying the purchase method, SFAS 141 changes the criteria for recognizing intangible assets other than goodwill and states that
the following criteria should be considered in determining the classification of intangible assets: (1) whether the intangible asset arises from contractual or other legal rights, or (2) whether the intangible asset is separable or dividable from
the acquired entity and capable of being sold, transferred, licensed, rented, or exchanged. If neither criteria is met, the intangible assets are classified as goodwill and are not amortized. The Company will apply the requirements of SFAS 141 to
all business combinations initiated after June 30, 2001. The Companys purchase of Optonics during the quarter ended January 31, 2003, was subject to these requirements.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



SFAS 142 supersedes APB Opinion No. 17, Intangible Assets, and provides that goodwill and
other intangible assets that have an indefinite useful life will no longer be amortized. However, these assets must be reviewed for impairment at least annually or more frequently if an event occurs indicating the potential for impairment. The shift
from an amortization approach to an impairment approach applies to all acquisitions completed after June 30, 2001 which included the Companys purchase of Optonics. Total goodwill amortization expense, including impairments, was $9.7 million in
fiscal 2002 and $10.0 million in fiscal 2001. The Company adopted the remaining elements of this new standard in the first quarter of fiscal 2003 and therefore ceased goodwill amortization for acquisitions made prior to July 1, 2001. However, it is
possible that in the future the Company may incur impairment charges related to the goodwill already recorded and to goodwill arising out of future acquisitions. In addition, the Company will continue to amortize most purchased intangible assets and
to assess those assets for impairment as appropriate.



SFAS No.
141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets, make 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 SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. A reporting unit would be one level below the operating segment if a component of an operating
segment is a business as described under U.S. GAAP 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.



Assets and liabilities will be allocated to each reporting unit if the asset will be employed in, or the liability relates to, the operation of a
reporting unit or the asset or liability will be considered in determining the fair value of the reporting unit. Goodwill should be allocated to the reporting units that are expected to benefit from the synergies of the combination. To the extent
that a reporting units carrying amount exceeds its fair value, an indication exists that the reporting units goodwill may be impaired.



Under SFAS No. 131, the Company stated in the Companys prior Form 10-K for fiscal 2002 that it operated in two industry segments: (1) the design,
development, manufacture, sale and service of Automatic Test Equipment or ATE and (2) the design, development, sale and service of software that assists in the development of test programs used in ATE. Revenues from the software segment were not
material to the Companys operations in fiscal years 2002, 2001, and 2000. During 2003, the software segment was significantly decreased in size and the remaining software operations were merged with the ATE segment. Currently the Company
operates in just one industry segment, ATE. The Company also has a single reporting unit, ATE, primarily because all of the components of the Companys ATE segment are subject to similar economic characteristics. In addition, all the
Companys products have common production processes, customers, and product life cycles.



In the second fiscal quarter ended April 30, 2003, the Company completed the first step of the transitional goodwill impairment test and determined that no potential impairment existed as of October 31, 2002. The
Company then completed its first annual goodwill impairment test as of July 31, 2003 and determined that no impairment existed as of the end of the third quarter of fiscal 2003. As a result, the Company recognized no impairment loss in fiscal 2003
in connection with the adoption of SFAS No. 142. The Company had operated in two industry segments: (1) the design, development, manufacture, sale and service of Automatic Test Equipment or ATE and (2) the design, development, sale and service of
software that assists in the development of test programs used in ATE. Revenues from the software segment were not material to the Companys operations in fiscal years 2002 and 2001, representing less than 4% of net sales. During 2003, the
software segment was further decreased in size and the remaining software operations were merged with the ATE segment. Based on these circumstances, the Company had a single reporting unit for purposes of SFAS 142, ATE, at the end of fiscal 2003. To
perform the goodwill impairment test, the Company determined it had only one reporting unit



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



and determined its carrying value by assigning the assets and liabilities, including existing goodwill and intangible assets, to that reporting unit as of
the date of adoption. The Company then determined the fair value of the reporting unit and compared it to the reporting units carrying amount. The implied fair value of the reporting units goodwill is determined by allocating the
reporting units fair value to all of its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation in accordance with SFAS 141. Whenever a Companys reporting units carrying amounts
exceed their fair value, an indication exists that the reporting units goodwill may be impaired and the Company must perform the second step of the impairment test. In the second step, the Company must compare the implied fair value of the
reporting units goodwill to its carrying amount. Because the Company determined that no impairment existed, this second step was not required in fiscal 2003, the year of adoption, and no impairment loss was recognized.



The following table presents a reconciliation of current and previously
reported net loss and net loss per share to the amounts adjusted to exclude goodwill and acquired workforce amortization for the fiscal years 2003, 2002, and 2001 (in thousands, except per share data):



|                                                 |  | 2003 |          |   | 2002 |   |          | 2001 | 
|------------------------------------------------ |  | ---- | -------- | - | ---- | - | -------- | ---- | 
|Net loss as reported                             |  | $    | (113,112 | ) |      | $ | (170,481 | )    | 
|Goodwill amortization                            |  |      |         |   |      |   | 9,690    |      | 
|Acquired workforce amortization                  |  |      |         |   |      |   | 820      |      | 
|                                                 |  |      |          |   |      |   |          |      | 
|Pro forma net loss                               |  | $    | (113,112 | ) |      | $ | (159,971 | )    | 
|                                                 |  |      |          |   |      |   |          |      | 
|Basic and diluted net loss per share as reported |  | $    | (1.80    | ) |      | $ | (2.81    | )    | 
|Goodwill amortization                            |  |      |         |   |      |   | 0.16     |      | 
|Acquired workforce amortization                  |  |      |         |   |      |   | 0.01     |      | 
|                                                 |  |      |          |   |      |   |          |      | 
|Basic and diluted pro forma net loss per share   |  | $    | (1.80    | ) |      | $ | (2.64    | )    | 
|                                                 |  |      |          |   |      |   |          |      | 



In August 2001, the
FASB issued Statements of Financial Accounting Standards No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets, or SFAS 144. SFAS 144 supersedes SFAS 121, Accounting for the Impairment of Long-Lived Assets and
Long-Lived Assets to be Disposed Of and the accounting and reporting provisions of Accounting Principles Board Opinion No. 30, Reporting the Results of OperationsReporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business. SFAS 144 establishes a single accounting model for assets to be disposed of by sale whether previously held and used or
newly acquired. SFAS No. 144 retains the provisions of APB No. 30 for presentation of discontinued operations in the income statement, but broadens the presentation to include a component of an entity. The Company adopted SFAS 144 effective November
1, 2002. In the quarter ended July 31, 2003, in accordance with SFAS No. 144, the Company accelerated the depreciation remaining for leasehold improvements related to buildings located in Fremont, California that the Company plans on vacating in the
first quarter of fiscal 2004 when the Company moves to its new headquarters in Milpitas, California. The amount of the accelerated depreciation related to these leasehold improvements was approximately $1.7 million and is being recognized over the
three fiscal quarters ending January 31, 2004. Accelerated depreciation related to the leasehold improvements was classified in SG&A expenses.



In July 2002, the FASB approved Statement of Financial Accounting Standards No. 146 Accounting for Costs Associated with Exit or Disposal
Activities, or SFAS 146. SFAS 146 addresses the financial accounting and reporting for obligations associated with an exit activity, including restructuring, or with a disposal of long-lived assets. Exit activities include, but are not limited
to, eliminating or reducing product lines, terminating employees and contracts and relocating manufacturing facilities or personnel. SFAS 146 specifies that a



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



company will record a liability for a cost associated with an exit or disposal activity only when that liability is incurred and can be measured at fair
value. Therefore, commitment to an exit plan or a plan of disposal expresses only managements intended future actions and, therefore, does not meet the requirement for recognizing a liability and the related expense. SFAS 146 is effective
prospectively for exit or disposal activities initiated after December 31, 2002. The Companys severance and related costs recorded in the quarter ended July 31, 2003 were recorded in accordance with SFAS 146. In the first quarter of fiscal
2004, the Company expects to accrue lease payments of approximately $1 million related to the Companys vacated corporate headquarters in Fremont, California in accordance with SFAS 146 (see Note 13).



In November 2002, the EITF reached a consensus on Issue No. 00-21,
Revenue Arrangements with Multiple Deliverables. EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The
provisions of EITF Issue No. 00-21 apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of this EITF has not had a material impact on the Companys consolidated results of operations and
financial condition. The Company is able to separate multiple deliverables from one another and recognizes revenue for each deliverable, based on each deliverables fair value, when the revenue recognition criteria for that specific deliverable
is achieved. In order to comply with EITF 00-21, beginning in the fourth quarter of fiscal 2003, revenue of approximately $65,000 was deferred for the value of installation services not completed at the end of the quarter.



In January 2003, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 addresses consolidation by business enterprises of variable interest entities. Under that interpretation, certain entities known as Variable Interest
Entities (VIEs) must be consolidated by the primary beneficiary of the entity. The primary beneficiary is generally defined as having the majority of the risks and rewards arising from the VIE. For VIEs in which a significant (but not
majority) variable interest is held, certain disclosures are required. The Company has not entered into any arrangements or made any investments which qualify as a VIE in the period after January 31, 2003 and therefore the initial implementation of
FIN 46 had no impact on our financial statements. For VIEs acquired before February 1, 2003, the Company was required to apply the accounting and disclosure rules set forth in FIN 46 in the first quarter of fiscal 2004. The Company has determined
that the adoption of FIN 46 will not have any impact on the Companys financial position or results of operations.



In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging
Activities, or SFAS 149. SFAS 149 amends and clarifies accounting for derivative instruments and hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS 149 provides guidance
relating to decisions made (a) as part of the Derivatives Implementation Group process, (b) in connection with other FASB projects dealing with financial instruments and (c) regarding implementation issues raised in the application of the definition
of a derivative and the characteristics of a derivative that contains financing components. SFAS 149 is effective for contracts entered into or modified and for hedging relationships designated after June 30, 2003. The adoption of SFAS 149 did not
have a material impact on the Companys financial condition or results of operations.



In May 2003, the FASB issued Statement of Financial Accounting Statndards No. 150 Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, or SFAS 150. SFAS 150
requires freestanding financial instruments such as mandatorily redeemable shares, forward purchase contracts and written put options to be reported as liabilities by their issuers as well as related new disclosure requirements. The provisions of
SFAS 150 are effective for instruments entered into or modified after May 31, 2003 and pre-existing instruments as of the beginning of the first interim period that commences after June 15, 2003. The adoption of SFAS 150 did not have a material
impact on the Companys financial condition or results of operations.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Note 2Acquisitions



In August 2003, the Company completed the acquisition of certain assets of SZ Testsysteme Japan Limited, a distributor of
automotive test equipment, for approximately $1.0 million in cash including acquisition costs. The acquisition will provide a distribution channel to Japanese customers for the Companys existing products focused primarily on the Japanese
automotive test market. The purchase price was allocated in the fourth quarter of 2003 to assets and liabilities, primarily cash, inventory, fixed assets, and accrued liabilities. The Companys Statement of Operations for the fiscal year ended
2003 includes the operations of SZ Testsysteme Japan Limited from the date of the Companys purchase of their net assets in August 2003. In December 2002, the Company completed the acquisition of certain assets of SZ Testsysteme AG and SZ
Testsysteme GmbH, or SZ. The assets of these companies were purchased out of bankruptcy and the Company hired approximately 135 former employees to re-launch the business. The acquisition is designed to complement the Companys existing
mixed-signal and wireless solutions with a new division focused primarily on the automotive test market. The Credence-SZ division operates from a facility located in Amerang, Germany and focuses on the advanced analog, power automotive and
communications markets. The purchase price for the assets was approximately $4.6 million in cash and the purchase price was allocated to tangible assets, primarily inventory and fixed assets. The Companys Statement of Operations for the fiscal
year ended October 31, 2003 includes the results of operations of SZ from the date of the Companys purchase of their net assets in December 2002.



In January 2003, the Company acquired Optonics, Inc., a company that designs and manufactures integrated systems for emission-based optical diagnostics
and failure analysis. The addition of Optonics is designed to extend the Companys product offerings in engineering validation test, design verification and diagnostics systems. The total purchase price of approximately $21.0 million included
consideration of approximately 1.9 million common shares of Credence valued at $20.1 million and $0.9M in assumed Optonics stock options that were converted to options to purchase approximately 100,000 shares of Credence common stock. The net
tangible asset deficit assumed was approximately $0.5 million. The Companys Statement of Operations for the fiscal year ended 2003 includes the results of operations of Optonics from the date of acquisition in January 2003.



The total purchase cost of Optonics was as follows (in thousands):



|Credence common stock                 |  | $ | 20,152
|------------------------------------- |  | - | ------
|Assumption of Optonics stock options |  |   | 894   
|                                      |  |   |       
|Total purchase cost                   |  | $ | 21,046



The purchase price
allocation was as follows (dollars in thousands):



|                                    |  | Amount |        |   | AnnualAmortization |   | AmortizationPeriod(Years)
|----------------------------------- |  | ------ | ------ | - | ------------------ | - | -------------------------
|Purchase Price Allocation:          |  |        |        |   |                    |   |                          
|Tangible net assets (deficit)       |  | $      | (463   | ) |                    |   |                         
|Deferred compensation               |  |        | 1,819  |   |                    |   | 606                      
|Intangible assets acquired:         |  |        |        |   |                    |   |                          
|Developed technology                |  |        | 12,990 |   |                    | $ | 2,598                    
|In-process research and development |  |        | 1,510  |   |                    |   |                         
|Non-compete agreements              |  |        | 750    |   |                    |   | 375                      
|Customer relationships              |  |        | 1,650  |   |                    |   | 550                      
|Goodwill                            |  |        | 2,790  |   |                    |   |                         
|                                    |  |        |        |   |                    |   |                          
|Total purchase price allocation     |  | $      | 21,046 |   |                    | $ | 4,129                    



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



A valuation of the purchased assets was undertaken by a third party valuator to assist the Company in
determining the fair value of each identifiable intangible asset and in allocating the purchase price among acquired assets, including the portion of the purchase price attributed to in-process research and development projects. Standard valuation
procedures and techniques were utilized in determining the fair value of the acquired in-process research and development. 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, and 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. The analysis resulted in $1.5 million of the purchase price being charged to acquired in-process research and development using a
discount rate of 35%. The IPR&D acquired from Optonics consists of features and projects related to the Emiscope II, which is the next generation Emiscope with added functionality including solid immersion lens and spray cooling system. The
Company estimated that these projects varied in terms of completion from 15% to 50% completed based on research and development complexity, costs, and time expended to date relative to the expected remaining costs and time to reach technological
feasibility. The Emiscope II is currently in beta testing at a customer. Optonics will spend approximately $0.4 million on the Emiscope II in the next two quarters after which Emiscope II is expected to become a mature product. The intangible
assets, consisting primarily of developed technology, customer relationships, non-compete agreements and goodwill, were assigned a value of $18.2 million and are being amortized, except for goodwill, over their estimated useful lives, ranging from
two to five years. In addition, $1.8 million of the purchase price was allocated to deferred compensation, calculated using the Black-Scholes stock option valuation model, and represents the value of unvested options and unvested restricted shares
assumed by the Company in the transaction. The deferred compensation is amortized as compensation cost over the weighted average remaining future vesting period of the unvested options (three years). The balance of the deferred compensation is
reflected as a contra-equity in the Consolidated Statements of Shareholders Equity.



In February 2003, the Company acquired certain assets and liabilities of Credence Capital Corporation, or CCC, a non-related leasing company. The acquisition allows the Company to directly offer leasing and other
financing solutions to customers seeking alternative options to acquire the Companys equipment. The Company paid $5.5 million and contemporaneous with the transaction, CCCs sole shareholder repaid indebtedness to CCC in the approximate
amount of $5.2 million resulting in a net cash outflow of $0.3 million. The net assets of CCC consisted primarily of a $15.3 million portfolio of leases of Credence equipment and its liabilities included indebtedness of approximately $15.3 million
associated with the lease portfolio. The Company operates CCC as a wholly-owned subsidiary to provide leasing and other financing solutions to Credence customers. The Companys Statement of Operations for the year ended October 31, 2003
includes the results of operations of CCC from the date of acquisition in February 2003.



Prior to the acquisition, the Companys business arrangement with CCC included selling products to CCC when there was an end-user customer purchase order in place. In cases where third party financing was to be
obtained, Garrett Capital Group, which then owned, controlled, and managed CCC, obtained committed funding for the transaction. CCC was compensated by the Company for its distribution activities with a commission rate similar to other distributors.



In August 2001, the Company completed a merger with IMS,
issuing approximately 7.2 million shares of common stock in exchange for all of the outstanding common stock of IMS. In addition, outstanding options to purchase IMS common stock were converted into options to purchase approximately 2.1 million
shares of Credence common stock. This transaction was accounted for as a pooling of interests and, therefore, all prior period consolidated financial statements presented, and the consolidated financial statements as of October 31, 2001 and for the
year then ended, were restated as if the merger took place at the beginning of such periods.



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



In order to conform IMSs year end to Credences fiscal year end, the consolidated
statement of operations for fiscal 2001 includes the results of operations of IMS for two months (May and June 2001) in each of the quarters ended April 30, 2001 and July 31, 2001. Accordingly, for fiscal 2001, Credences fiscal first quarter
includes the IMS results of operations for the three month period ended March 31, 2001, the second fiscal quarter includes the IMS results of operations for the three month period ended June 30, 2001, the third fiscal quarter includes the IMS
results of operations for the three month period ended July 31, 2001, and the fourth fiscal quarter includes the IMS results of operations for the three months period ended October 31, 2001.



Separate results of operations for the year ended October 31, 2001 is as
follows (in thousands):



|         |  | 2001      |        
|-------- |  | --------- | -------
|         |  | Net sales |        
|Credence |  | $         | 250,182
|IMS      |  |           | 51,536 
|         |  |           |        
|Combined |  | $         | 301,718
|         |  |           |        



In January 2001 and
February 2001, Credence acquired Dimensions Consulting, Inc., or DCI, and the principal assets of Rich Rabkin & Associates, Inc., or Rabkin, respectively. DCI specializes in providing interface solutions for the semiconductor test and
development market through ATE board design and test socket systems. Rabkin specializes in providing interface solutions and test head positioning devices for the semiconductor test market through its patented solution for high parallel memory
testing. DCI and Rabkin were integrated into the Memory Products Division to offer test solutions, which the Company believes increase manufacturing efficiencies and provide faster time to market for its customers. These transactions were accounted
for as purchases and accordingly, the accompanying financial statements include the results of operations of DCI and Rabkin subsequent to the acquisition dates. The total purchase price of $13.5 million consisted of $13.3 million paid in cash at the
closing and the cancellation of $0.2 million in existing receivables. Credence also created a $1.5 million deferred tax liability through the accounting for the acquisitions. Additionally, the Company agreed to make payments to the employees of DCI
and Rabkin based on the attainment of performance criteria for their respective businesses and the business of the Memory Products Division for a period of two years following the acquisition. These payments have been recorded as compensation
expense as they have been incurred. The net tangible assets purchased were approximately $0.8 million.



The total purchase cost of the DCI and Rabkin acquisitions were as follows (in thousands):



|Cash paid              |  | $ | 13,286
|---------------------- |  | - | ------
|Deferred tax liability |  |   | 1,491 
|Cancelled receivable   |  |   | 214   
|                       |  |   |       
|Total purchase cost    |  | $ | 14,991
|                       |  |   |       



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The purchase price allocation is as follows (dollars in thousands):



|                                |  |        |        |                     |   |                      |  |  
|------------------------------- |  | ------ | ------ | ------------------- | - | -------------------- |  | -
|                                |  | Amount |        | Annual Amortization |   | Useful Lives (Years)
|Purchase Price Allocation:      |  |        |        |                     |   |                      |  |  
|Tangible net assets             |  | $      | 806    |                     |   |                     |  | 
|Intangible assets acquired:     |  |        |        |                     |   |                      |  |  
|Assembled workforce             |  |        | 545    |                     | $ | 182                  |  | 3
|Developed technology            |  |        | 2,236  |                     |   | 559                  |  | 4
|Customer lists                  |  |        | 3,347  |                     |   | 669                  |  | 5
|Goodwill                        |  |        | 8,057  |                     |   | 1,612                |  | 5
|                                |  |        |        |                     |   |                      |  |  
|Total purchase price allocation |  | $      | 14,991 |                     | $ | 3,022                |  |  
|                                |  |        |        |                     |   |                      |  |  



A valuation of the
purchased assets was undertaken to assist the Company in determining the fair value of each identifiable intangible asset and in allocating the purchase price among the acquired assets. The intangible assets, consisting primarily of developed
technology, assembled workforce, customer lists and goodwill, were assigned a value of $14.2 million and are being amortized over their estimated useful lives, ranging from three to five years.



In the fourth quarter of fiscal 2002, the Company recorded a charge totaling
$5.1 million associated with the acquisition of DCI in January 2001. See Note 3Special Charges and Restructuring for further discussion.



In the fourth fiscal quarter of 2001 the Company recorded an impairment charge of approximately $6.6 million for the write-down of the remaining NMS
goodwill and intangible assets. The impairment consisted of $3.0 million in purchased technology, $0.3 million in patents, and $3.2 million in goodwill purchased in fiscal 2000. This impairment was based on significant NMS employee turnover in
fiscal 2001 as well as a change in the technological direction of the remaining research and development project that originated in NMS. The product originally under development at NMS was abandoned and there are no current activities associated
with NMS. See Note 3Special Charges and Restructuring for further discussion.



In conjunction with the acquisition of IMS in August 2001, Fluence was merged with IMS. The integration of Fluence with IMS resulted in the write-down of $2.3 million of the goodwill and purchased technology
intangible assets of Opmaxx. This impairment was based on product decisions for the newly combined operations of Fluence and IMS.



Note 3Special Charges and Restructuring



Special chargescost of goods sold



The Company reviews excess and obsolete inventory annually based on information available from the strategic planning process and also on a quarterly
basis identifying and addressing significant events that might have an impact on inventories and related reserves. See Note 1Inventories, for further discussion of the Companys reserve methodology.



76



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The following table summarizes special charges recorded in cost of goods sold by fiscal quarter for
the three-year period ended October 31, 2003 (in thousands):



|                           |  |   |       
|-------------------------- |  | - | ------
|Fiscal 2003third quarter  |  | $ | 1,927 
|                           |  |   |       
|Fiscal 2003total          |  | $ | 1,927 
|                           |  |   |       
|Fiscal 2002fourth quarter |  | $ | 9,441 
|                           |  |   |       
|Fiscal 2002total          |  | $ | 9,441 
|                           |  |   |       
|Fiscal 2001second quarter |  | $ | 45,020
|Fiscal 2001fourth quarter |  |   | 38,003
|                           |  |   |       
|Fiscal 2001total          |  | $ | 83,023
|                           |  |   |       



During the third
quarter of fiscal 2003, the Company recorded cost of goods sold - special charges of $1.3 million due to a settlement reached with an inventory supplier relating to cancelled purchase orders and $0.6 million for write-offs of spare parts
relating to the Valstar product line.



During the fourth
quarter of fiscal 2002, the Company recorded a $9.4 million special charge relating to inventories based on information gathered during the Companys annual strategic plan regarding the continued negative effect of the semiconductor industry
recession. The write-down of inventories affected three categories of exposures:



1. $2.1 million for the RFx product line as management made estimates for the end-of-life of this product.



2. $2.0 million for the SC product line as management made
estimates for the end-of-life of this product.



3. $5.3 million related to other product inventory on hand as well as future vendor commitments in excess of estimated future customer demand.



During fiscal 2003, $3.1 million of the inventory that was reserved in fiscal 2002 was scrapped and $6.3 million was on hand as of October 31, 2003.



During fiscal 2001, the Company recorded cost of goods
sold-special charges of $83 million.



The first inventory
related special charge in fiscal 2001 was recorded during second fiscal quarter for approximately $45 million. The charge was recorded based on information received prior to the Companys annual strategic planning process, when management
determined that the deteriorating market conditions represented a major downturn in the industry necessitating a review of the inventory reserves. The second quarter fiscal 2001 inventory charge was principally made up of three major components:



1. $22.2 million related to the
Companys decision to suspend development of the ValStar product line.



2. $3.9 million for the write-off of excess capacity.



3. $18.9 million for a combination of write-offs and write-downs that the Company believed was prudent as the magnitude of the 2001
technology recession became apparent.



Since the $45 million
inventory related special charge was recorded in the second quarter of fiscal 2001, $25.4 million of the excess and obsolete inventory was scrapped, $18.4 million was written off and most of this material has been disposed of, and $1.2 million was
donated at October 31, 2003.



77



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The second charge in fiscal 2001 was recorded in the fourth fiscal quarter for approximately $38
million. This charge was calculated as a result of information received during the annual strategic planning process, which indicated that the technology recession continued and the effect of the business cycle downturn impacted the entire
technology industry. In addition, the recession appeared to be more severe than those previously experienced by the industry and the Company, and would likely last longer than those experienced in the past. The fourth quarter fiscal 2001 inventory
related charge was principally made up of four major components:



1. $9.5 million of mixed signal product inventory on hand in excess of estimated future customer demand.



2. $22 million of memory product inventory on hand in excess of estimated future customer demand.



3. $1.2 million related to SC product inventory on hand in
excess of estimated future customer demand.



4. $5.3 million related to other product inventory on hand as well as future vendor commitments in excess of estimated future customer demand.



During fiscal 2002 and fiscal 2003, $13.7 million of this excess and obsolete inventory was scrapped, $1.2 million was written down and disposed of, $0.1
million was donated, and approximately $23.0 million was still on hand as of October 31, 2003.



The schedule below shows the special charges related to inventory in the two-year period ended October 31, 2002. These charges totaled approximately $92.5 million. Of this, approximately $42.3 million was scrapped,
$19.6 million was written off and largely disposed of, $1.3 million was donated and the remaining $29.3 million was still on hand as of October 31, 2003.



|                                    |  |         |         |   |         |   |        |         |  |   |        |  
|----------------------------------- |  | ------- | ------- | - | ------- | - | ------ | ------- |  | - | ------ | -
|                                    |  | Q2 FY01 |         |   | Q4 FY01 |   |        | Q4 FY02 | 
|Special Charges                     |  | $       | 45,020  |   |         | $ | 38,003 |         |  | $ | 9,440  |  
|FY01 Capacity Write-off             |  |         | (3,904  | ) |         |   |        |         |  |   |        |  
|FY01 Scrapping                      |  |         | (24,118 | ) |         |   |        |         |  |   |        |  
|FY01 ValStar write-off and disposal |  |         | (7,868  | ) |         |   |        |         |  |   |        |  
|FY01 Write-off and largely disposed |  |         | (6,410  | ) |         |   |        |         |  |   |        |  
|                                    |  |         |         |   |         |   |        |         |  |   |        |  
|10/31/01 Balance                    |  |         | 2,720   |   |         |   | 38,003 |         |  |   |       |  
|                                    |  |         |         |   |         |   |        |         |  |   |        |  
|FY02 Scrapping                      |  |         | (1,326  | ) |         |   | (6,205 | )       |  |   |        |  
|FY02 Write-off and largely disposed |  |         | (221    | ) |         |   | (1,150 | )       |  |   |        |  
|FY02 Donation                       |  |         | (1,173  | ) |         |   | (91    | )       |  |   |        |  
|                                    |  |         |         |   |         |   |        |         |  |   |        |  
|10/31/02 Balance                    |  |         |        |   |         |   | 30,557 |         |  |   | 9,440  |  
|                                    |  |         |         |   |         |   |        |         |  |   |        |  
|FY03 Scrapping                      |  |         |         |   |         |   | (7,538 | )       |  |   | (3,134 | )
|                                    |  |         |         |   |         |   |        |         |  |   |        |  
|10/31/03 Balance                    |  |         |        |   |         |   | 23,019 |         |  |   | 6,306  |  
|                                    |  |         |         |   |         |   |        |         |  |   |        |  





During fiscal 2003, the Company sold $1.1 million of previously written off inventories, which represents 0.6% of the net sales in fiscal 2003.



Restructuring charges



In the quarter ended July 31, 2003, the Company recorded restructuring cost
of approximately $2.2 million as operating expenses related to headcount reductions across all areas of the Company, with approximately half



78



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



occurring in the R&D functions. The reduction in force was part of a continuing effort to reduce expenses and appropriately size the Company for
prevailing market conditions. The headcount reductions included the elimination of approximately 163 positions or 15 percent of the Companys global employee base. Approximately 151 positions in the United States were affected, with the
remaining reduction in other locations worldwide.



For the
quarter ended January 31, 2003, the Company recorded restructuring charges of approximately $1.4 million as operating expenses related to headcount reductions and facility consolidations, which the Company implemented in the quarter. During this
period, the Company reduced headcount by approximately 70 persons. The bulk of the affected employees were in SG&A functions and a smaller number were in R&D. Also, during the quarter, the Company completed its plans to exit the IMS facility
in Beaverton, Oregon and consolidated the remaining Oregon employees into its Hillsboro, Oregon facility.



The following table illustrates the quarterly restructuring cost activity for the twelve-month period ended October 31, 2003 and the estimated timing of
future payouts for major restructuring categories (in thousands):



|                                    |  |           |        |   |                 |   |        |       |  |   |        |  
|----------------------------------- |  | --------- | ------ | - | --------------- | - | ------ | ----- |  | - | ------ | -
|                                    |  | Severance |        |   | OperatingLeases |   |        | Total | 
|Balance at October 31, 2002         |  | $         | (716   | ) |                 | $ | (5,177 | )     |  | $ | (5,893 | )
|                                    |  |           |        |   |                 |   |        |       |  |   |        |  
|Charges                             |  |           | (1,191 | ) |                 |   | (201   | )     |  |   | (1,392 | )
|Cash payments                       |  |           | 795    |   |                 |   | 607    |       |  |   | 1,402  |  
|                                    |  |           |        |   |                 |   |        |       |  |   |        |  
|Balance at January 31, 2003         |  |           | (1,112 | ) |                 |   | (4,771 | )     |  |   | (5,883 | )
|Cash payments                       |  |           | 118    |   |                 |   | 656    |       |  |   | 774    |  
|                                    |  |           |        |   |                 |   |        |       |  |   |        |  
|Balance at April 30, 2003           |  |           | (994   | ) |                 |   | (4,115 | )     |  |   | (5,109 | )
|Charges                             |  |           | (2,197 | ) |                 |   |       |       |  |   | (2,197 | )
|Cash payments                       |  |           | 2,535  |   |                 |   | 1,174  |       |  |   | 3,709  |  
|                                    |  |           |        |   |                 |   |        |       |  |   |        |  
|Balance at July 31, 2003            |  |           | (656   | ) |                 |   | (2,941 | )     |  |   | (3,597 | )
|Cash payments                       |  |           | 423    |   |                 |   | 573    |       |  |   | 996    |  
|                                    |  |           |        |   |                 |   |        |       |  |   |        |  
|Balance at October 31, 2003         |  | $         | (233   | ) |                 | $ | (2,368 | )     |  | $ | (2,601 | )
|                                    |  |           |        |   |                 |   |        |       |  |   |        |  
|                                    |  |           |       
|Estimated timing of future payouts: |  |           |        |   |                 |   |        |       |  |   |        |  
|                                    |  |           |       
|Fiscal 2004                         |  |           | 233    |   |                 |   | 1,366  |       |  |   | 1,599  |  
|Fiscal 2005                         |  |           |       |   |                 |   | 946    |       |  |   | 946    |  
|Fiscal 2006 and beyond              |  |           |       |   |                 |   | 56     |       |  |   | 56     |  
|                                    |  |           |        |   |                 |   |        |       |  |   |        |  
|Total                               |  | $         | 233    |   |                 | $ | 2,368  |       |  | $ | 2,601  |  
|                                    |  |           |        |   |                 |   |        |       |  |   |        |  



The opening balances
at October 31, 2002 in the above table are associated with headcount reductions and facility consolidations the Company implemented in the fourth quarter of fiscal 2002.



In the fourth quarter of fiscal 2002, the Company recorded approximately $19.0 million of restructure charges. The
restructure charges were associated with headcount reductions and facility consolidations the Company implemented in the fourth fiscal quarter of 2002. During the fourth fiscal quarter, the Company reduced headcount by approximately 225 heads. Of
this total about 65 were in manufacturing, 25 were in R&D and about 135 were in SG&A functions. As part of this reduction the Company discontinued its next-generation DRAM IMS product and closed the associated IMS facilities in Switzerland
and Germany. The Company also began taking steps to exit the IMS facility in Beaverton, Oregon and consolidate these employees into its facility in Hillsboro, Oregon. Approximately $4.1 million of this charge required cash during the fourth quarter
of 2002,



79



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



$4.2 million will require cash over the remaining lease terms, and the remaining $10.7 million were non-cash write-downs. The restructure charges, shown in
the table below, are summarized as follows:



|                                                                                  |  | Amount
|--------------------------------------------------------------------------------- |  | ------
|Restructure charges included in operating expenses in fiscal 2002 (in thousands): |  |       
|Employee severance charges                                                        |  | $     
|Asset disposals                                                                   |  |       
|Operating leases written off                                                      |  |       
|                                                                                  |  |       
|Total restructure charges in fiscal 2002                                          |  | $     
|                                                                                  |  |       



In the fourth quarter
of fiscal 2001, the Company recorded a $2.3 million charge for the abandonment of the former TMT facility in Sunnyvale, California as these operations were integrated into its Fremont, California facilities. This charge consisted of $1.8 million in
estimated future rental payments less expected subleases to be paid through February 2005 and $0.5 million for equipment, furniture and leasehold improvement disposals.



In the third quarter of fiscal 2001, the Company recorded a further $1.0 million for severance payments and asset disposals
associated with headcount reductions the Company implemented in May and August 2001. In the fourth quarter of fiscal 2001 the Company recorded a further $0.2 million for headcount reductions associated with headcount reductions occurring during
fiscal 2001. The Company reduced headcount by more than 400 people during the fiscal year across all functional areas. Severance payments were distributed during the year and the remaining accruals at October 31, 2001 were not significant.



In the second quarter of fiscal 2001 the Company recorded a
charge of approximately $2.0 million for severance payments and asset disposals associated with headcount reductions the Company implemented in February 2001. These charges were recorded as a result of the Companys response to a major downturn
in the business outlook for the ATE and related semiconductor and semiconductor equipment industries in 2001.



Special chargesoperating expenses



Special charges recorded in the fourth quarter of fiscal 2002 were approximately $11.5 million. The Company wrote-off two notes receivable in the fourth fiscal quarter of 2002 of approximately $6.4 million. These
impairment charges are due to the decline in the fair value of these notes receivable and were judged to be other-than-temporary. The write-off of these individual private investments consisted of a $5.0 million promissory note issued by CCC, then
owned, controlled and managed by the Garrett Capital Group, an unaffiliated party, and a $1.4 million promissory note from a customer issued in April 2002 as the result of a settlement on outstanding receivables. The timing of these write-offs was
largely driven by the continuation of the downtown experienced by the semiconductor equipment industry in 2002. In the case of CCC, formerly a non-affiliated company that provided lease, structured financing and other financing alternatives to our
customers, its continued financial weakness ultimately resulted in our decision to pursue control of CCC. The acquisition occurred in February 2003. In the case of the customers promissory note, the customers principal venture capital
investor threatened to initiate bankruptcy proceedings and the Company wrote-off this note as part of a restructured settlement on existing equipment leases.



In the fourth quarter of fiscal 2002, the Company recorded a charge totaling $5.1 million associated with the impairment of the goodwill and intangible
assets obtained in the acquisition of DCI in January 2001. The charge consisted of $2.1 million for the remaining intangible assets related to customer lists and $3.0 million for remaining goodwill. This impairment was based on the planned sale of
the subsidiary to its management team effective November 1, 2002. DCI had been integrated into the Companys memory products line at the height of the last business cycle in January 2001. The economic advantage of maintaining the capabilities
of DCI



80



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



diminished as the operating results deteriorated dramatically with the onset of this current downturn. In addition, it became evident that it was unlikely
the memory products business volume would increase to a level where the operational advantages of DCI would be fully realized. As a result of these facts and circumstances, effective November 1, 2002, the Company sold eighty percent (80%) of the
stock of DCI to DCIs management team for an amount equal to the approximate book value of DCIs tangible assets and accounts receivable of approximately $0.5 million. The consideration received for the shares of DCI was in the form of a
two-year promissory note bearing market-rate interest. The Companys 20% interest in DCI will be sold to DCIs management team in November 2004 for a price based on a retained earnings calculation. In addition as part of the transaction,
the Company received a $0.1 million prepayment credit toward the future purchase of services (at ordinary market prices) from DCI. In most recent fiscal quarter prior to disposition, DCI had revenue of approximately $0.7 million with a net loss of
approximately $0.1 million. This write-down was related to the ATE segment of the Companys business.



In the second and third quarters of fiscal 2001 the Company recorded charges of approximately $3.2 million related to fees and expenses associated with
the acquisition of IMS. A further $16.9 million was recorded in the fourth quarter for the closing of the IMS transaction and the integration of their operations with Credence and Credences subsidiary, Fluence. The elements of the IMS
acquisition charges are as follows (in millions of dollars):



|                                                             |  |                  |  |   |     
|------------------------------------------------------------ |  | ---------------- |  | - | ----
|Credence fees and expenses associated with IMS acquisition   |  | Q3 2001          |  | $ | 1.7 
|IMS fees and expenses associated with acquisition            |  | Q3 2001          |  |   | 1.5 
|                                                             |  |                  |  |   |     
|                                                             |  | Subtotal Q3 2001 |  |   | 3.2 
|                                                             |  |                 
|IMS fees and expenses associated with the acquisition        |  | Q4 2001          |  |   | 2.9 
|Credence fees and expenses associated with the acquisition   |  | Q4 2001          |  |   | 3.8 
|                                                             |  |                  |  |   |     
|Total Fees and expenses                                      |  |                  |  |   | 9.9 
|                                                             |  |                 
|IMS capitalized software write-off                           |  | Q4 2001          |  |   | 3.3 
|IMS service spares and fixed asset write-off                 |  | Q4 2001          |  |   | 1.7 
|Credence (Fluence) goodwill and intangible asset write-downs |  | Q4 2001          |  |   | 2.5 
|                                                             |  |                  |  |   |     
|Write-down of tangible and intangible assets                 |  |                  |  |   | 7.5 
|                                                             |  |                 
|Fluence Technology building lease commitment and expenses    |  | Q4 2001          |  |   | 0.4 
|IMS lease and liability accruals                             |  | Q4 2001          |  |   | 1.0 
|                                                             |  |                  |  |   |     
|Lease and liability accruals                                 |  |                  |  |   | 1.4 
|                                                             |  |                 
|Fluence Technology termination benefits                      |  | Q4 2001          |  |   | 0.1 
|IMS termination benefits                                     |  | Q4 2001          |  |   | 1.2 
|                                                             |  |                  |  |   |     
|Employee termination benefits                                |  |                  |  |   | 1.3 
|                                                             |  |                  |  |   |     
|                                                             |  | Subtotal Q4 2001 |  |   | 16.9
|                                                             |  |                  |  |   |     
|Total IMS Acquisition Charges                                |  |                  |  | $ | 20.1
|                                                             |  |                  |  |   |     



In the fourth quarter
of fiscal 2001 the Company recorded a $6.6 million charge for the impairment of the remaining unamortized goodwill and intangible assets associated with the acquisition of NMS in October 2000. This impairment was based on significant NMS employee
turnover in fiscal 2001 as well as a change in the technological direction of the remaining research and development project that originated in NMS. This write-down related to the ATE segment of the Companys business. The impairment consisted
of $3.0 million in purchased technology, $0.3 million in patents, and $3.2 million in goodwill. The product originally under development at NMS was abandoned and there are no current activities associated with NMS.



81



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Note 4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 and long-term investments and trade receivables. The Company is exposed to credit risks in the event of default by the financial institutions or customers to the
extent of the amount recorded on the balance sheet.



The
Company and its subsidiaries currently operate in a single industry segment: the design, development, manufacture, sale and service of ATE used in the production of semiconductors. The Company had operated in two industry segments: (1) the design,
development, manufacture, sale and service of Automatic Test Equipment or ATE and (2) the design, development, sale and service of software that assists in the development of test programs used in ATE. Revenues from the software segment were not
material to the Companys operations in fiscal years 2002 and 2001, representing less than 4% of net sales. During 2003, the software segment was further decreased in size and the remaining software operations were merged with the ATE segment.
At the end of fiscal 2003, the Company had a single reporting unit for purposes of SFAS 142, ATE, primarily because all of the components of the Companys ATE segment are subject to similar economic characteristics. In addition, all the
Companys products have common production processes, customers, and product life cycles.



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



|                               |  |                        |   |  |      |   |  |      |  
|------------------------------ |  | ---------------------- | - |  | ---- | - |  | ---- | -
|                               |  | Year Ended October 31, |  
|                               |  | 2003                   |   |  | 2002 |   |  | 2001 |  
|Digital & Mixed Signal         |  | 51                     | % |  | 56   | % |  | 65   | %
|Memory                         |  | 17                     |   |  | 18   |   |  | 19   |  
|Service                        |  | 23                     |   |  | 22   |   |  | 13   |  
|Emission Based Optical Probers |  | 4                      |   |  |     |   |  |     |  
|Software and other             |  | 5                      |   |  | 4    |   |  | 3    |  
|                               |  |                        |   |  |      |   |  |      |  
|Total net sales                |  | 100                    | % |  | 100  | % |  | 100  | %
|                               |  |                        |   |  |      |   |  |      |  



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 US. Export sales from the US are primarily denominated in U.S. dollars but occasionally
denominated in Japanese Yen or in the Euro. The SZ 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, |  
|                     |  | 2003                   |   |  | 2002 |   |  | 2001 |  
|North America        |  | 36                     | % |  | 45   | % |  | 39   | %
|Asia Pacific         |  | 38                     |   |  | 42   |   |  | 38   |  
|Europe & Middle East |  | 26                     |   |  | 13   |   |  | 23   |  
|                     |  |                        |   |  |      |   |  |      |  
|Total net sales      |  | 100                    | % |  | 100  | % |  | 100  | %
|                     |  |                        |   |  |      |   |  |      |  



82



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



One customer, Spirox Corporation (a distributor in Taiwan), accounted for 19%, 20% and 13% of the
Companys net sales in fiscal 2003, 2002 and 2001, respectively. For the fiscal period ended October 31, 2003, Sprirox Corporation accounted for 25% of gross accounts receivable. One end-user customer headquartered in Europe accounted for 10%
of the Companys net sales in fiscal 2003 and 24% of the Companys 2003 fiscal year-end gross accounts receivable. One end-user customer headquartered in the USA accounted for 20% of the Companys net sales in fiscal 2002. Two
end-user customers headquartered in Europe accounted for approximately 13% and 11%, respectively, of the Companys net sales in fiscal 2001.



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.



Note
5Commitments and Contingencies



Our corporate
by-laws require that the Company indemnifies 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 Credence. In addition, the Company has entered into separate indemnification agreements with each director and each executive officer of Credence 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 made payments related to these
obligations, and the fair value for these obligations is zero on the consolidated balance sheet as of October 31, 2003.



As is customary in the Companys industry and as provided for under local law in the U.S. and other jurisdictions, many of standard contracts provide
remedies to customers and others with whom the Company enters into contracts, such as defense, settlement, or payment of judgment for intellectual property claims related to the use of the Companys products. From time to time, the Company
indemnifies customers, as well as the Companys suppliers, contractors, lessors, 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, 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 sell 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.



The
Company leases some of its facilities and equipment under operating leases that expire periodically through 2010 of which approximately $0.2 million have been written-off to special operating charges during the fiscal year ended 2003. See Note 13
for further discussion.



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



83



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



commitments for unique components are relatively inflexible in terms of deferral or cancellation. At October 31, 2003, the Company has open and committed
purchase orders totaling approximately $42.1 million.



The
following summarizes our minimum contractual cash obligations and other commitments at October 31, 2003, and the effect of such obligations in future periods (in thousands):



|                                                                                            |  |       |         |      |   |        |  |      |        |      |   |       |  |            |       |  |   |         |  |   |    
|------------------------------------------------------------------------------------------- |  | ----- | ------- | ---- | - | ------ |  | ---- | ------ | ---- | - | ----- |  | ---------- | ----- |  | - | ------- |  | - | ---
|                                                                                            |  | Total |         | 2004 |   | 2005   |  | 2006 |        | 2007 |   | 2008  |  | Thereafter
|Contractual Obligations:                                                                    |  |       |         |      |   |        |  |      |        |      |   |       |  |            |       |  |   |         |  |   |    
|Facilities and equipment operating leases                                                   |  | $     | 6,340   |      | $ | 3,636  |  | $    | 1,795  |      | $ | 546   |  | $          | 151   |  | $ | 69      |  | $ | 143
|Bank loans and notes payable related to leased products                                     |  |       | 10,419  |      |   | 9,362  |  |      | 1,057  |      |   |      |  |            |      |  |   |        |  |   |   
|Interest on liabilities related to leased products                                          |  |       | 404     |      |   | 396    |  |      | 8      |      |   |      |  |            |      |  |   |        |  |   |   
|Convertible subordinated notes                                                              |  |       | 180,000 |      |   |       |  |      |       |      |   |      |  |            |      |  |   | 180,000 |  |   |   
|Interest on convertible subordinated notes                                                  |  |       | 12,263  |      |   | 2,700  |  |      | 2,700  |      |   | 2,700 |  |            | 2,700 |  |   | 1,463   |  |   |   
|Minimum payable for information technology outsourcing including fees for early termination |  |       | 16,096  |      |   | 6,784  |  |      | 9,312  |      |   |      |  |            |      |  |   |        |  |   |   
|Open non-cancelable purchase order commitments                                              |  |       | 42,091  |      |   | 42,091 |  |      |       |      |   |      |  |            |      |  |   |        |  |   |   
|                                                                                            |  |       |         |      |   |        |  |      |        |      |   |       |  |            |       |  |   |         |  |   |    
|Total contractual cash and other obligations                                                |  | $     | 267,613 |      | $ | 64,969 |  | $    | 14,872 |      | $ | 3,246 |  | $          | 2,851 |  | $ | 181,532 |  | $ | 143
|                                                                                            |  |       |         |      |   |        |  |      |        |      |   |       |  |            |       |  |   |         |  |   |    



Rent expense was
approximately $ 3,694,425, $5,265,000 and $6,610,000 for the years ended October 31, 2003, 2002, and 2001, respectively.



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, 2003 (in thousands):



|                                                      |  |   |        |  
|----------------------------------------------------- |  | - | ------ | -
|Balance at October 31, 2002                           |  | $ | 4,316  |  
|Add: Accruals for warranties issued during the period |  |   | 5,443  |  
|Acquired pre-existing warranty obligations            |  |   | 1,030  |  
|Less: Warranty spending                               |  |   | (5,288 | )
|                                                      |  |   |        |  
|Balance at October 31, 2003                           |  | $ | 5,501  |  
|                                                      |  |   |        |  



Note 6Convertible
Subordinated Notes



In June 2003, the Company issued $180
million of 11/2% 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



84



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



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 and other
expenses over the term of the Notes. The Company expects to use the net proceeds of the offering for general corporate purposes, including working capital and potential acquisitions.



Note 7Stockholders Equity



Deferred Compensation



The deferred compensation is amortized as compensation cost over the weighted average remaining future vesting period of the unvested options. The balance
for the deferred compensation is reflected as a contra-equity in the Consolidated Statements of Shareholders Equity.



The Company allocated $1.8 million of the purchase price of Optonics to deferred compensation in January 2003, calculated using the Black-Scholes stock
option valuation model, and represents the value of unvested options and unvested restricted shares assumed by the Company in the purchase of Optonics. The amount is being amortized using the straight-line method over an expected vesting period of
three years.



The Company recorded $1.0 million of deferred
compensation and additional paid-in capital in fiscal 2001 upon the issuance of certain stock options issued to IMS employees by IMS, prior to the Company acquiring IMS, at less than fair market value at the date of grant. On the date of grant,
deferred compensation was recorded for the difference between the fair market value and the actual option exercise price. This amount is being amortized using the straight-line method over an expected vesting period of four years.



The Company recorded $8.3 million of deferred compensation and additional
paid-in capital upon the assumption of the outstanding TMT options in May 2000. The deferred compensation was being amortized using the straight-line method over an expected life of 2.75 years and was fully amortized in fiscal 2002.



During the periods ended October 31, 2003, 2002, and 2001, the Company
recognized compensation expense related to the amortization of IMS deferred compensation of $0.3 million, $0.3 million, and $0.1 million, respectively.



Stock Option Plans and Stock Purchase Plan



The Company grants options to employees and members of the Board of Directors under the 1993 Stock Option Plan (the 1993 Plan). The 1993 Plan
is divided into two separate components: (i) the Discretionary Option Grant Program and (ii) the Automatic Option Grant Program. Options granted under the Discretionary Option Grant Program will have an exercise price equal to 100% of the fair
market value of such shares on the date of grant, and a maximum term of ten years, and are exercisable over a vesting period, generally four to five years. Under the Automatic Option Grant Program, options are granted automatically at periodic
intervals to non-employee members of the Board at an exercise price equal to 100% of the fair market value of the option shares on the date of grant and a maximum term of ten years, and are exercisable over a vesting period, generally four years.



In January 2003, the Company acquired Optonics, Inc., issuing
approximately 1.9 million shares of Credence common stock in exchange for all the outstanding shares of Optonics. In addition, the Company assumed Optonics stock options which were converted to options to purchase approximately 100,000 shares of
Credence common stock at exercise prices ranging from $0.57 to $5.03.



85



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



In August 2001, the Company completed a merger with IMS, issuing approximately 7.2 million shares of
common stock in exchange for all of the outstanding common stock of IMS. In addition, outstanding options to purchase IMS common stock were converted into options to purchase approximately 2.1 million shares of Credence common stock.



On August 9, 2000, the Board of Directors authorized the Companys
Supplemental Stock Option Plan and authorized 500,000 shares for issuance. This additional reserve of shares shall supplement 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.



On March 22, 2000, the stockholders approved an amendment to the Companys 1993 Plan that implemented an automatic share increase feature pursuant to which the number of shares available for issuance under the
1993 Plan will automatically increase on the first trading day of each fiscal year (the First Trading Day), beginning with the 1999 fiscal year and continuing through the fiscal year 2003, by an amount equal to three and a half percent
(3.5%) of the total number of shares outstanding on the last trading day of the immediately preceding fiscal year, but no such annual increase is to exceed 3,000,000 shares.



A summary of the activity under all plans, as defined below (in thousands, except per share amounts) is as follows:



|                              |  | Options Available forGrant (Authorized) |   |  | Number of Options Outstanding |   |  | Price Per Share |            | Weighted Average Exercise Price
|----------------------------- |  | --------------------------------------- | - |  | ----------------------------- | - |  | --------------- | ---------- | -------------------------------
|Balance at October 31, 2000   |  | 289                                     |   |  | 10,214                        |   |  | $               | 0.27-67.99 |                                
|Increase in authorized shares |  | 2,337                                   |   |  |                              |   |  |                 |           |                                
|Options granted               |  | (4,282                                  | ) |  | 4,282                         |   |  | $               | 8.61-24.39 |                                
|Options canceled              |  | 2,071                                   |   |  | (2,071                        | ) |  | $               | 0.27-67.99 |                                
|Options exercised             |  |                                        |   |  | (697                          | ) |  | $               | 0.27-22.22 |                                
|Options expired               |  | (21                                     | ) |  |                              |   |  |                 |           |                                
|                              |  |                                         |   |  |                               |   |  |                 |            |                                
|Balance at October 31, 2001   |  | 394                                     |   |  | 11,728                        |   |  | $               | 1.07-67.99 |                                
|Increase in authorized shares |  | 2,618                                   |   |  |                              |   |  |                 |           |                                
|Options granted               |  | (3,536                                  | ) |  | 3,536                         |   |  | $               | 7.00-20.32 |                                
|Options canceled              |  | 1,271                                   |   |  | (1,271                        | ) |  | $               | 1.64-65.75 |                                
|Options exercised             |  |                                        |   |  | (475                          | ) |  | $               | 1.64-22.22 |                                
|Options expired               |  | (89                                     | ) |  |                              |   |  |                 |           |                                
|                              |  |                                         |   |  |                               |   |  |                 |            |                                
|Balance at October 31, 2002   |  | 658                                     |   |  | 13,518                        |   |  | $               | 1.07-67.99 |                                
|Increase in authorized shares |  | 2,132                                   |   |  |                              |   |  |                 |           |                                
|Assumed Optonics options      |  | 85                                      |   |  | 31                            |   |  | $               | 0.57-5.03  |                                
|Options granted               |  | (2,704                                  | ) |  | 2,704                         |   |  | $               | 0.57-15.85 |                                
|Options canceled              |  | 2,469                                   |   |  | (2,469                        | ) |  | $               | 0.58-67.99 |                                
|Options exercised             |  |                                        |   |  | (589                          | ) |  | $               | 0.57-16.19 |                                
|Options expired               |  | (286                                    | ) |  |                              |   |  |                 |           |                                
|                              |  |                                         |   |  |                               |   |  |                 |            |                                
|Balance at October 31, 2003   |  | 2,354                                   |   |  | 13,195                        |   |  | $               | 0.58-67.99 |                                
|                              |  |                                         |   |  |                               |   |  |                 |            |                                



The Company has
reserved for issuance approximately 15,549,000 shares of common stock in connection with the stock option plans. See Part III of this Form 10-K for disclosure of equity compensation plans not approved by shareholders.



86



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The following table summarizes information about options outstanding and exercisable at October 31,
2003 (in thousands except per share amounts):



|                         |  |                                                     |  |                                 |  |                                            |       |                                 |       |  |   |      
|------------------------ |  | --------------------------------------------------- |  | ------------------------------- |  | ------------------------------------------ | ----- | ------------------------------- | ----- |  | - | -----
|Options Outstanding      |  | Weighted Average Remaining Contractual Life (years) |  | Weighted Average Exercise Price |  | Options Exercisable                       
|Range of Exercise Prices |  | Options Outstanding at Oct. 31, 2003                |  |                                 |  | Options CurrentlyExercisable Oct. 31, 2003 |       | Weighted Average Exercise Price
|$  0.58-$  8.07          |  | 3,093                                               |  | 8.13                            |  | $                                          | 7.53  |                                 | 1,169 |  | $ | 7.08 
|$  8.13-$14.90           |  | 2,526                                               |  | 7.12                            |  | $                                          | 11.33 |                                 | 1,546 |  | $ | 10.94
|$14.94-$16.19            |  | 2,591                                               |  | 7.51                            |  | $                                          | 15.59 |                                 | 1,421 |  | $ | 15.71
|$16.59-$20.75            |  | 2,864                                               |  | 6.90                            |  | $                                          | 18.54 |                                 | 2,320 |  | $ | 18.53
|$21.00-$67.99            |  | 2,121                                               |  | 6.50                            |  | $                                          | 30.02 |                                 | 1,809 |  | $ | 29.88
|                         |  |                                                     |  |                                 |  |                                            |       |                                 |       |  |   |      
|$  0.58-$67.99           |  | 13,195                                              |  | 7.29                            |  | $                                          | 15.85 |                                 | 8,265 |  | $ | 17.49
|                         |  |                                                     |  |                                 |  |                                            |       |                                 |       |  |   |      



These options will
expire, if not exercised, at specific dates from July 2004 to October 2013.



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 wages to the plan. The purchase price is 85% of the fair market value per share of common stock on the
date on which the purchase period begins or on the date on which the purchase period ends, whichever is lower. 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. Approximately 444,472, 282,358, and 201,342 shares were issued pursuant to the plan in 2003, 2002 and 2001, respectively. Approximately 30,810 shares were issued pursuant to the final purchase of the IMS Stock Purchase
Plan in 2002. At October 31, 2003, approximately 406,263 shares were reserved for issuance under the 1994 Plan.



Rights Plan



On June 1, 1998, the Company adopted the Credence Systems Corporation Stockholder Rights Plan (the Rights Plan). Pursuant to the Rights Plan,
rights were distributed as a dividend at the rate of one right for each share of Credence common stock, par value $0.001 per share (Right) of the Company held by stockholders of record as of the close of business on June 22, 1998. The
Rights will expire on June 22, 2008, unless redeemed or exchanged. Under the Rights Plan, each Right initially will entitle the registered holder to buy one unit of a share of preferred stock for $165.00. The Rights will become exercisable only if a
person or group (other than stockholders currently owning 15% of Credence common stock) acquires beneficial ownership of 15% or more of Credences common stock, or commences a tender offer or exchange offer upon consummation of which such
person or group would beneficially own 15% or more of Credences common stock.



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s contributions to this plan have been 0-,
$1,074,000 and $1,000,000 in the fiscal years ended October 31, 2003, 2002, and 2001, respectively.



The Company maintains a profit sharing plan for those domestic employees that are not otherwise eligible for incentive-based compensation. Contributions
to this plan are subject to the discretion of the Board of Directors. The Company made contributions of 0-, -0- and $824,000 in the fiscal years ended 2003, 2002 and 2001, respectively.



87



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



In July 1996 and July 2000, the Company implemented Executive Deferred Compensation Plans for the
purpose of providing eligible employees with a program for deferred compensation earned during employment. The plans are funded deferred compensation arrangements for the benefit of certain highly compensated employees of the Company. Under the
terms of the plans, eligible employees of the Company may make voluntary contributions to the plans as a percentage of compensation, but not in excess of limitations stated in the plans. These contributions are invested in a variety of investment
funds for the intended use of paying plan benefits when participating employees become eligible to receive such benefits under the terms of the plans. The Company has not and currently does not match employee contributions and does not intend to do
so in the near future.



Note 9Income Taxes



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



|                               |  | Year Ended October 31, |      
|------------------------------ |  | ---------------------- | -----
|                               |  | 2003                   |      
|Federal:                       |  |                        |      
|Current                        |  |                        |     
|Deferred                       |  |                        |     
|                               |  |                        |      
|                               |  |                        |      
|State:                         |  |                        |      
|Current                        |  |                        |     
|Deferred                       |  |                        |     
|                               |  |                        |      
|                               |  |                        |     
|Foreign:                       |  |                        |      
|Current                        |  |                        | 1,006
|                               |  |                        |      
|Income tax provision (benefit) |  | $                      | 1,006
|                               |  |                        |      



Pre-tax income (loss)
from foreign operations was approximately $4,725,000, $(4,755,000) and $1,665,000 in 2003, 2002 and 2001, respectively.



Reconciliation between the Companys effective tax rate of 0.9% in 2003, 4.4% in 2002, and (37%) in 2001 and the U.S. statutory rate of 35% is as
follows (in thousands):



|                                                   |  | Year Ended October 31, |        
|-------------------------------------------------- |  | ---------------------- | -------
|                                                   |  | 2003                   |        
|Tax computed at statutory rate                     |  | $                      | (39,221
|State income tax (net of federal benefit)          |  |                        |       
|US losses not benefited                            |  |                        | 39,043 
|Non-deductible in-process research and development |  |                        | 529    
|Non-deductible goodwill amortization               |  |                        |       
|Research and development credits                   |  |                        | (491   
|Other items                                        |  |                        | 1,146  
|                                                   |  |                        |        
|Income tax provision (benefit)                     |  | $                      | 1,006  
|                                                   |  |                        |        



The income tax
provision in 2003 consists of foreign tax on earnings and foreign withholding taxes generated from our foreign operations.



88



---

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, |         
|------------------------------------------- |  | ----------- | --------
|                                            |  | 2003        |         
|Deferred tax assets:                        |  |             |         
|Accounting for inventories                  |  | $           | 35,507  
|Allowance for doubtful accounts             |  |             | 959     
|Accruals not currently deductible           |  |             | 4,676   
|Net operating loss and credit carryforwards |  |             | 65,151  
|Book over tax depreciation                  |  |             | 4,069   
|Deferred revenue/profit/commissions         |  |             | 4,789   
|                                            |  |             |         
|Total deferred tax assets                   |  |             | 115,151 
|Valuation allowance for deferred tax assets |  |             | (104,749
|                                            |  |             |         
|                                            |  |             | 10,402  
|Deferred tax liability:                     |  |             |         
|Intangibles                                 |  |             | (10,402 
|                                            |  |             |         
|Net deferred tax assets                     |  | $           |        
|                                            |  |             |         



At October 31, 2003,
the Company has unused net operating loss and research tax credit carryforwards for federal income tax purposes of approximately $152.2 million and $1.3 million, respectively, which expire in 2004 through 2023. Utilization of the Companys net
operating loss and tax credit carryforwards may be subject to annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986, as amended, and similar state provisions. The annual limitation 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 net deferred assets at October 31, 2003 and October 31,2002.
The Company had a net increase of $36.6 million in the valuation allowance in fiscal 2003, $66.1 million in the valuation allowance in fiscal 2002 and a net decrease of $0.3 million in fiscal 2001. Approximately $2.5 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.



Note 10Legal Matters



The Company is involved in various claims arising in the ordinary course of business. The Company currently believes that the ultimate amount of
liability, if any, for any pending claims of any type (either alone or combined) will not materially affect its financial position, results of operations or liquidity. However, the ultimate outcome of any litigation is uncertain, and either
unfavorable or favorable outcomes could have a material negative impact. Regardless of outcome, litigation can have an adverse impact on the Company because of defense costs, diversion of management resources and other factors.



Note 11Accumulated Other Comprehensive Income (Loss)



The Companys accumulated other comprehensive income (loss) consists of
the accumulated net unrealized gains or losses on available-for-sale investments and foreign currency translation adjustments. At October 31, 2003 and 2002, the Company had a balance of net unrealized gains of $0.7 million and $2.0 million,
respectively,



89



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CREDENCE SYSTEMS CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



on available-for-sale investments. Additionally, at October 31, 2003 and 2002, the Company had a balance of $0.8 million and $1.8 million, respectively, of
net foreign currency translation gains.



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



|                                                                    |  |                        |        |   |      |   |        |      |  |   |      
|------------------------------------------------------------------- |  | ---------------------- | ------ | - | ---- | - | ------ | ---- |  | - | -----
|                                                                    |  | Year Ended October 31,
|                                                                    |  | 2003                   |        |   | 2002 |   |        | 2001
|Beginning balance, net of tax                                       |  | $                      | 3,843  |   |      | $ | 4,854  |      |  | $ | 2,097
|Unrealized gain (loss) on available-for-sale securities, net of tax |  |                        | (1,315 | ) |      |   | (1,396 | )    |  |   | 373  
|Currency translation adjustment, net of tax                         |  |                        | (1,006 | ) |      |   | 385    |      |  |   | 2,384
|                                                                    |  |                        |        |   |      |   |        |      |  |   |      
|Ending balance, net of tax of $-0-, $-0-, and $1,102, respectively  |  | $                      | 1,522  |   |      | $ | 3,843  |      |  | $ | 4,854
|                                                                    |  |                        |        |   |      |   |        |      |  |   |      



Note 12Related Party
Transactions



Bernard V. Vonderschmitt, a director of the
Company until his retirement in March 2003, was the founder and the chairman of Xilinx, Inc. and Dr. William G. Howard Jr., a director of the Company, is a director of Xilinx. For the years ended October 31, 2003, 2002, and 2001, the Company sold
approximately $465,000, $810,000, and $536,000, respectively, of products and services to Xilinx. For the years ended October 31, 2003, 2002, and 2001, the Company purchased goods and services of approximately $11,000, zero, and zero, respectively,
from Xilinx. The Company had no amounts owed from Xilinx at October 31, 2003, 2002 and 2001, respectively.



Thomas Franz, a director of the Company, is a Corporate Vice President of Intel Corporation. For the years ended October 31, 2003, 2002 and 2001, the
Company sold approximately $15.1 million, $32.5 million and $18.3 million of products and services to Intel. The amounts receivable from Intel were approximately $3.5 million, $1.8 million and $9.5 million at October 31, 2003, 2002 and 2001,
respectively.



Note 13Subsequent Events (Unaudited)



During August 2002, the Company acquired two buildings to be used for office
space and manufacturing in Milpitas, California for approximately $21.8 million. The Company has invested an additional $10.6 million in these facilities for structural improvements as well as tenant improvements. The facility comprises 180,000
square feet on approximately 14 acres of land. In January 2004, the Company relocated its corporate headquarters to this facility and vacated four leased buildings in Fremont, California. The lease for three of the buildings expired around December
31, 2003. The Company will attempt to sublease the fourth building, consisting of 27,000 square feet until June 2005, when the lease on this building expires. The Company estimates the above actions will result in a restructuring charge during the
first quarter of fiscal 2004 of approximately $1 million.



90



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



Not applicable.



Item 9A.Controls and Procedures



As of the end of the period covered by this report, we carried out an
evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our Chief
Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in this report. It should be noted that the design of any
system of controls is based in part upon 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, regardless of how
remote.



There has been no change in our internal control over
financial reporting that occurred during our most recent fiscal quarter that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.



91



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PART III



Item 10.Directors and 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 2004 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. A copy of the Code of Ethics is available without charge upon written
request to: Mr. John R. Detwiler, the Companys Senior Vice President, Chief Financial Officer and Secretary at the Companys headquarters at 1421 California Circle, Milpitas, California 95035.



Item 11.Executive Compensation



The information required by this item is included under the caption
Executive Compensation and Related Information in the Companys Proxy Statement for the 2004 Annual Meeting of Stockholders and is incorporated herein by reference.



Item 12.Security Ownership of Certain Beneficial Owners and Management



Information required by this item is included under the caption
Ownership of Securities in the Companys Proxy Statement for the 2004 Annual Meeting of Stockholders and is incorporated herein by reference.



Equity Compensation Plan Information



The following table provides information as of October 31, 2003 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. 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, 2003, 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 ofOutstanding 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)  |  | 10,482,814                                                             |  | $                                                     | 16.77 |                                                                                                                                               | 2,187,804
|Equity Compensation Plans Not Approved by Stockholders (2) |  | 1,305,987                                                              |  | $                                                     | 13.00 |                                                                                                                                               | 166,068  
|                                                           |  |                                                                        |  |                                                       |       |                                                                                                                                               |          
|Total                                                      |  | 11,788,801                                                             |  | $                                                     | 16.35 |                                                                                                                                               | 2,353,872
|                                                           |  |                                                                        |  |                                                       |       |                                                                                                                                               |          

---

|(1) | Consists of the 1993 Stock Option Plan (the 1993 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 14th and August 14th 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
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



92



---

| | 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, 2003, an aggregate of 406,263 shares of Common Stock were available for issuance under the 1994
Plan and 2,187,804 shares of Common Stock were available for issuance under the 1993 Plan. However, pursuant to the automatic share increase provisions of the 1994 Plan and the 1993 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%) and three and a half percent (3.5%), respectively, 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 and 1993 Plan exceed 500,000 shares and 3,000,000 shares,
respectively, 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, 2003, a total of 1,406,810 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
$11.60 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 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 1993 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 1993 Plan.



Rule 10b5-1 Stock Selling Plans



The Company has been informed that one of its executive
officers, John R. Detwiler, adopted a stock selling plan in September 2003, under Rule 10b5-1 of the Securities Exchange Act of 1934, as amended, pursuant to which he intends to sell shares of the Companys common stock from time to time.



The term of Mr. Detwilers plan begins on January 1, 2004
and terminates on December 31, 2004. The plan provides for sales of stock on a monthly basis subject to certain market prices. The plan will terminate if and when an aggregate of 129,600 shares have been sold pursuant to the plan.



Item 13.Certain Relationships and Related Transactions



The information required by this item is included under
the caption Certain Relationships and Related Transactions in the Companys Proxy Statement for the 2004 Annual Meeting of Stockholders and is incorporated herein by reference.



93



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PART IV



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



(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 Ernst & Young LLP, Independent Auditors                                           |  | 55  
|                                                                                            | 
|Consolidated Balance SheetsOctober 31, 2003 and 2002                                       |  | 56  
|Consolidated Statements of OperationsYears Ended October 31, 2003, 2002 and 2001           |  | 57  
|Consolidated Statements of Stockholders EquityYears Ended October 31, 2003, 2002 and 2001 |  | 58  
|Consolidated Statements of Cash FlowsYears Ended October 31, 2003, 2002 and 2001           |  | 59  
|Notes to Consolidated Financial Statements                                                  |  | 60  



2.Financial Statement Schedule. The following financial statement schedule of Credence Systems Corporation, for the years ended October 31, 2003, 2002 and 2001, 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 |  | 97  



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 98.



(b) Reports on Form 8-K. The Company furnished a Current
Report on Form 8-K on August 19, 2003 announcing its earnings for the fiscal quarter ended July 31, 2003.



(c) See Exhibit Index on page 88.



94



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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 28, 2004.



CREDENCE SYSTEMS CORPORATION (Registrant)By:

/s/    GRAHAM J.
SIDDALLGraham J. Siddall Chairman of the Board of Directors and Chief Executive OfficerBy:

/s/    JOHN R.
DETWILERJohn R. Detwiler Senior Vice President, Chief Financial Officer and Secretary (Principal Financial and Accounting
Officer)




POWER OF
ATTORNEY



KNOW ALL PERSONS BY THESE PRESENTS, that each
person whose signature appears below constitutes and appoints Graham J. Siddall and John R. Detwiler, 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/    GRAHAM J.
SIDDALLGraham J.
Siddall           |  | Chairman of the Board of Directors and Chief Executive Officer |  | January 28, 2004
|                                                    |  |                                                               
|/s/    JOHN R.
DETWILERJohn R.
Detwiler             |  | Senior Vice President, Chief Financial Officer and Secretary   |  | January 28, 2004
|                                                    |  |                                                               
|/s/    WILLIAM G. HOWARD,
JR.William G. Howard,
Jr. |  | Director                                                       |  | January 28, 2004
|                                                    |  |                                                               
|/s/    HENK J.
EVENHUISHenk J.
Evenhuis             |  | Director                                                       |  | January 28, 2004
|                                                    |  |                                                               
|/s/    BRUCE R.
WRIGHTBruce R.
Wright               |  | Director                                                       |  | January 28, 2004



95



---

|Signature                               |  | Title    |  | Date            
|--------------------------------------- |  | -------- |  | ----------------
|                                        |  |         
|/s/    RICHARD M.
BEYERRichard M.
Beyer |  | Director |  | January 28, 2004
|                                        |  |         
|/s/    JON D.
TOMPKINSJon D.
Tompkins   |  | Director |  | January 28, 2004
|                                        |  |         
|/s/    THOMAS R.
FRANZThomas R.
Franz   |  | Director |  | January 28, 2004



96



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Item 15(a)(2).



Schedule II



CREDENCE SYSTEMS
CORPORATION

VALUATION AND QUALIFYING ACCOUNTS

(In thousands)



|                                                            |  | Balance atBeginningof Year |       | Additions |   | Write-offs |  | Balance at End of Year
|----------------------------------------------------------- |  | -------------------------- | ----- | --------- | - | ---------- |  | ----------------------
|Year ended October 31, 2003 Allowance for doubtful accounts |  | $                          | 5,388 |           | $ | 192        |  | $                     
|Year ended October 31, 2002 Allowance for doubtful accounts |  | $                          | 8,235 |           | $ | 899        |  | $                     
|Year ended October 31, 2001 Allowance for doubtful accounts |  | $                          | 7,604 |           | $ | 1,182      |  | $                     



97



---

EXHIBIT INDEX



|              |  |                                                                                                                                                                          
|------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  |                                                                                                                                                                          
|              | 
|3.1(5)        |  | Amended and Restated Certificate of Incorporation of the Company.                                                                                                        
|              | 
|3.2(9)        |  | Amended and Restated Bylaws of the Company, as currently in effect                                                                                                       
|              | 
|4.3(3)        |  | Form of Rights Agreement, dated as of June 2, 1998, by and between the Company and Equiserve Trust Company, N.A. (formerly known as BankBoston, N.A.), as Rights Agent.  
|              | 
|4.4(3)        |  | Form of Certificate of Designation for the Series A Junior Participating Preferred Stock of the Company.                                                                 
|              | 
|4.5(3)        |  | Form of Rights Certificate.                                                                                                                                              
|              | 
|4.6(4)        |  | Indenture, dated as of June 2, 2003 between Credence Systems Corporation and The Bank of New York, as Trustee.                                                           
|              | 
|4.7(5)        |  | Form of Global Note (included in Exhibit 10.15).                                                                                                                         
|              | 
|10.1          |  | Form of Indemnification Agreement Between the Company and each of its officers and directors.                                                                            
|              | 
|10.2(10)      |  | 1993 Stock Option Plan, as Amended and Restated through March 19, 2003.                                                                                                  
|              | 
|10.3(2)       |  | Form of Notice of Grant to be generally used in connection with the 1993 Stock Option Plan.                                                                              
|              | 
|10.4(2)       |  | Form of Stock Option Agreement to be generally used in connection with the 1993 Stock Option Plan.                                                                       
|              | 
|10.5(2)       |  | Addendum to the Stock Option Agreement (Special Tax Elections).                                                                                                          
|              | 
|10.6(2)       |  | Addendum to the Stock Option Agreement (Limited Stock Appreciation Rights).                                                                                              
|              | 
|10.7(2)       |  | Addendum to the Stock Option Agreement (Change in Control).                                                                                                              
|              | 
|10.8(2)       |  | Addendum to the Stock Option Agreement (Financial Assistance).                                                                                                           
|              | 
|10.9(2)       |  | 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(2)      |  | 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(6)      |  | Employee Stock Purchase Plan, as Amended and Restated through May 17, 2000.                                                                                              
|              | 
|10.12(2)      |  | Form of Stock Purchase Agreement.                                                                                                                                        
|              | 
|10.13(2)      |  | Form of Enrollment/Change Form.                                                                                                                                          
|              | 
|10.14(7)      |  | Supplemental Stock Option Plan, as amended and restated through November 27, 2000.                                                                                       
|              | 
|10.15(11)     |  | Registration Rights Agreement, dated as of June 2, 2003, by and between Credence Systems Corporation and Citigroup Global Markets, Inc.                                  
|              | 
|10.16(4)      |  | Employment Agreement by and between the Company and Graham J. Siddall, dated July 29, 1999.                                                                              
|              | 
|10.17(5)      |  | Amendment to Graham J. Siddall Employment Agreement.                                                                                                                     
|              | 
|10.18(8)      |  | Employment Agreement, dated January 15, 2002, by and between the Company and John R. Detwiler.                                                                           
|              | 
|10.19(8)      |  | Employment Agreement, dated January 15, 2002, by and between the Company and David A. Ranhoff.                                                                           



98



---

|              |  |                                                                                                                                           
|------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  |                                                                                                                                           
|              | 
|10.20(8)      |  | Employment offer letter, dated October 1, 2001, by and between the Company and Fred Hall.                                                 
|              | 
|10.21(8)      |  | Letter Agreement, dated January 15, 2002, by and between the Company and Fred Hall.                                                       
|              | 
|10.22(1)      |  | Joint Venture Agreement dated June 10, 1997, between the Company and Innotech Corporation.                                                
|              | 
|12.1          |  | Statement of Computation of Ratio of Earnings to Fixed Charges.                                                                           
|              | 
|21.1          |  | Subsidiaries of the Company.                                                                                                              
|              | 
|23.1          |  | Consent of Ernst & Young LLP, Independent Auditors.                                                                                       
|              | 
|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) | Incorporated by reference to an exhibit to the Companys Quarterly Report on Form 10-Q for the quarterly period ended July 31, 1997.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

|(2) | Exhibits 10.3 through 10.10 and Exhibit 10.12 and 10.13 are incorporated herein by reference to exhibits included in 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.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated by reference to an exhibit to the Companys Current Report on Form 8-K as filed with the Commission on June 3, 1998.
|--- | ---------------------------------------------------------------------------------------------------------------------------------

|(4) | Incorporated by reference to an exhibit to the Companys Quarterly Report on Form 10-Q for the quarterly period ended July 31, 1999.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

|(5) | Incorporated by reference to an exhibit to the Companys Quarterly Report on Form 10-Q for the quarterly period ended April 30, 2000.
|--- | -------------------------------------------------------------------------------------------------------------------------------------

|(6) | Incorporated by reference to an exhibit to the Companys Registration Statement on Form S-8 (File No. 333-50432), as filed with the Commission on November 21, 2000.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) | Incorporated by reference to an exhibit to the Companys Registration Statement on Form S-8 (File No. 333-58100), as filed with the Commission on April 2, 2001.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) | Incorporated by reference to an exhibit to the Companys Annual Report on Form 10-K for the year ended October 31, 2001.
|--- | ------------------------------------------------------------------------------------------------------------------------

|(9) | Incorporated by reference to an exhibit to the Companys Quarterly Report on Form 10-Q for the quarterly period ended January 31, 2002.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------

|(10) | Incorporated by reference to an exhibit to the Companys Quarterly Report on Form 10-Q for the quarterly period ended April 30, 2003.
|---- | -------------------------------------------------------------------------------------------------------------------------------------

|(11) | Exhibits 10.15 through 10.17 are incorporated herein by reference to exhibits included in 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.
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



99