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UNITED STATES

FORM 10-K

Commission file number 1-10606

CADENCE DESIGN SYSTEMS, INC.

2655 Seely Avenue, Building 5, San Jose, California 95134

(408) 943-1234

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

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

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

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

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

      The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold as of the last business day of the Registrant’s most recently completed second fiscal quarter June 28, 2003 was $3,153,500,295.

      On March 6, 2004 approximately 270,169,346 shares of the Registrant’s Common Stock, $0.01 par value, were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the definitive proxy statement for the 2004 Annual Meeting are incorporated by reference into Part III hereof.

CADENCE DESIGN SYSTEMS, INC.

2003 FORM 10-K ANNUAL REPORT

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PART I.

Item 1. Business

      This Annual Report on Form 10-K and the documents incorporated by reference in this Annual Report contain forward-looking statements. Certain of such statements, including, without limitation, statements regarding the extent and timing of future revenues and expenses and customer demand, statements regarding the deployment of our products, statements regarding our reliance on third parties and other statements using words such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “should,” “will” and “would,” and words of similar import and the negatives thereof, constitute forward-looking statements. These statements are predictions based upon our current expectations about future events. Actual results could vary materially as a result of certain factors, including but not limited to, those expressed in these statements. We refer you to the “Competition,” “Proprietary Technology,” “Factors That May Affect Future Results,” “Results of Operations,” “Disclosures About Market Risk,” and “Liquidity and Capital Resources” sections contained in this Annual Report and the risks discussed in our other SEC filings, which identify important risks and uncertainties that could cause actual results to differ materially from those contained in the forward-looking statements.

      We urge you to consider these factors carefully in evaluating the forward-looking statements contained in this Annual Report. All subsequent written or oral forward-looking statements attributable to our company or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The forward-looking statements included in this Annual Report are made only as of the date of this Annual Report. We do not intend, and undertake no obligation, to update these forward-looking statements.

Overview

      Cadence Design Systems, Inc., or Cadence®, licenses electronic design automation, or EDA, software, sells or leases hardware technology and provides design and methodology services throughout the world to help accelerate and manage customers’ electronic product development processes. Our broad range of products and services are used by the world’s leading electronics companies to design and develop complex integrated circuits, or ICs, and personal and commercial electronic systems. We have approximately 4,800 employees, in approximately 60 sales offices, design centers and research facilities located around the world.

      We were formed as a Delaware corporation in April 1987. Our headquarters are located at 2655 Seely Avenue, San Jose, California 95134. Our telephone number is (408) 943-1234. Our website can be accessed at www.cadence.com. We make available free of charge copies of our SEC filings and submissions on the investor relations page of our website at www.cadence.com as soon as practicable after electronically filing or furnishing such documents with the SEC. Our Corporate Governance Guidelines, Code of Business Conduct and the charters of the Audit Committee, Compensation Committee and Corporate Governance and Nominating Committee of our Board of Directors are also posted on the investor relations page of our website at www.cadence.com. Stockholders may request copies of these documents by writing to our Corporate Secretary at the address above.

Factors Driving the Electronic Design Automation Industry

      During the last decade, the worldwide communications, business productivity and consumer electronics markets drove development in the electronics industry. Ever-decreasing silicon manufacturing process geometries coupled with the move to 300 millimeter wafer production drive IC cost decreases, volume increases and greater complexity for providers of electronics devices. At the same time, the development of ICs with greater functionality complicates effective integration of components into complete electronic systems. These market and technology forces pose major challenges for the global electronics design community, and consequently create significant opportunities and challenges for EDA product and services providers.

      From a design perspective, many of today’s complex ICs are system-on-a-chip, referred to as SoC, devices. These SoC devices, as described in more detail below, contain one or more processors, memory and

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      The increasing complexity of electronic devices poses major challenges for design teams in the migration to nanometer, or one billionth of a meter, design and SoC design (for reference, the diameter of the period at the end of this sentence is approximately 400,000 nanometers). Nanometer design refers to the design of ICs that will have feature sizes smaller than 180 nanometers. IC feature sizes for wires, transistors and contacts decrease with each advance in the semiconductor manufacturing process. Each successive move to a smaller feature size (e.g., decreasing from 130 nanometers to 90 nanometers and smaller) requires introducing new capabilities throughout the entire design and manufacturing chain to account for new physical effects. For example, at 130 nanometers, signal integrity issues such as signal interference between wires, or crosstalk; power distribution management, or IR (voltage) drop; and electrical noise on IC performance, have become critical. At 90 nanometers, power leakage dramatically affects overall IC power consumption and creates additional design challenges. The increased complexity, electrical noise and power consumption due to leakage, combine to increase pressure on the ability to reach the desired operating frequency, commonly known as timing closure.

      These trends pose significant new challenges for electronics design teams. Specifically, nanometer design requires designers to take into account many physical effects that were too small to impact performance of larger circuit geometries. SoC design requires new approaches to managing complexity and its related risks. The electronics industry addresses these challenges in a number of ways, including the use of new EDA products, the upgrade of existing tools and design methodologies, and offering the advantages of highly integrated front-to-back design solutions.

Operating Segments

      We manage our business through three operating segments: Products, Services and Maintenance. The Products segment develops and markets our software and hardware technologies to our customers. The Maintenance segment services the ongoing, after-sale support requirements of those products through technical support and software updates. The Services segment provides our customers with educational services focused on training customers for the efficient and effective use of our technologies, methodology services to assist customers in optimizing the use of our technologies within their design activities, and design services to develop complex ICs and other electronic components for our customers. See “Competition” below and Note 19, Segment Reporting, to our Consolidated Financial Statements for additional information related to these operating segments.

Products

      Through our Products segment, we offer one of the most comprehensive sets of EDA products in the industry. Our products improve designer productivity and design quality throughout the electronic design process. Product revenues include all fees earned from granting licenses to use our software and sales and leases of our hardware products, and exclude revenues derived from Maintenance and Services. We offer customers three license types for our software: perpetual, term and subscription. See “Software Licensing Arrangements” below for additional discussion of our license types.

      Product revenue represented 59% of our total revenue in 2003, 63% in 2002 and 58% in 2001.

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Product Strategy

      With the addition of emerging nanometer design considerations to the already burgeoning set of traditional design tasks, complex SoC or IC design can no longer be accomplished using a collection of discrete design tools. What previously consisted of sequential design activities must be merged and accomplished nearly simultaneously without time-consuming data translation steps. We have formulated a design solution strategy that combines our “best in class” design technologies into “platforms” for four major design activities: functional verification, digital IC design, custom IC design and system interconnect. The four Cadence design platforms are Incisive^TM Functional Verification, Encounter^TM Digital IC Design, Virtuoso® Custom Design and Allegro® System Interconnect Platforms. In addition, we augment these platform product offerings with a comprehensive set of design for manufacturing products that span both the digital and custom IC design flows. These four platforms, together with our design for manufacturing products comprise our primary product lines.

Incisive Functional Verification Platform

      The Incisive functional verification platform supports a unified methodology, from design of the total system, to design-in of particular ICs, to design of specific systems, for all design domains. Compared to traditional simulation approaches, the Incisive platform provides faster full-chip verification throughout the entire design cycle, which significantly reduces total verification time.

      The Incisive platform employs a single-kernel architecture that overcomes fragmentation by unifying multiple verification techniques around a single engine. It also provides support for open design and verification standards as well as analog/mixed-signal verification. The same platform delivers Palladium® hardware in-circuit emulation and simulation acceleration-on-demand, transaction-level support, HDL analysis, coverage, debug and analysis, and test generation. Not only is Incisive designed so customers can adopt these technologies incrementally, it can also deliver the speed and efficiency required to compress overall verification time. The QuickCycles^TM capability allows customers to access Palladium simulation acceleration and emulation products on a pay-as-you-go basis, either on the customer site or remotely over a high-speed, secure network connection.

      As part of the Incisive functional verification platform, Incisive Conformal® provides a complete logic equivalence checking solution for verifying that the RTL specification is equivalent to the final IC layout. Conformal verifies a variety of circuits, including complex arithmetic logic, datapath, memories, and custom logic.

Encounter Digital IC Design Platform

      Our Encounter digital IC design platform employs a unified architecture for full digital implementation of nanometer-scale designs. It is based on a single user interface and unified in-memory data model, and was specifically designed to analyze and optimize wiring throughout the design process. It is comprised of the following core technologies:

	•	Encounter RTL Compiler, featuring global synthesis for timing closure, which uses a patented set of global focus algorithms that maximize circuit performance;
	•	First Encounter® Ultra, a silicon virtual prototyping system that assists in managing the IC design process;
	•	NanoRouteTM Ultra, which uses graph-based routing technologies to efficiently support variable-spacing, variable-width routes for nanometer process technologies;
	•	CeltICTM signal integrity analyzer, which is used by leading silicon foundries for ensuring that the chip designed with the Encounter platform does not contain any fatal signal integrity defects; and
	•	Encounter Test SolutionsTM which identify opportunities for yield improvements by accelerating defect identification, and by linking design data with manufacturing data.

      Unlike traditional “front-end/back-end” systems, the Encounter platform does not require translations between common tasks such as placement, power distribution, routing, and timing/crosstalk analysis. The

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Virtuoso Custom Design Platform

      The Virtuoso custom design platform enables development of silicon-accurate analog, custom digital, radio frequency and mixed-signal designs. With the Virtuoso platform, custom design teams are able to deliver silicon-accurate designs — while addressing the growing number of physical effects in package, power grid, interconnect, devices, and substrate.

      By using its advanced custom design methodology for custom/mixed-signal design, the Virtuoso platform enables highly accurate design predictability by ensuring that the circuit design representation will behave correctly in the final manufactured silicon. The Virtuoso platform reduces design time by providing:

	•	A specification-driven environment that automates the entire design process;
	•	Multi-mode simulation (digital, analog and radio frequency) using a common syntax, model, and equations;
	•	Fast custom layout technologies;
	•	Highly accurate electrical vs. physical effects analysis; and
	•	Physical design integration and silicon analysis for complex custom, cell-based, and mixed custom designs using our Open AccessTM database.

Design For Manufacturing

      The physical design of ICs requires detailed analysis and optimization to ensure the design can be manufactured. Our Fire & Ice® QX products take the designer’s representation of the IC and extract the physical properties of the design to enable further analysis. Our SignalStorm®, VoltageStorm® and ElectronStorm® products address nanometer design challenges associated with on-chip distribution of power, timing and crosstalk effects. The Substrate Noise Analyst product, designed for radio frequency, analog, and mixed-signal ICs, provides a silicon-accurate model for detecting fatal substrate coupling defects to enable chip integration. Our Assura products perform design rule checking to ensure the proposed design meets the requirements of the foundry’s manufacturing process rules. Our software and services are designed to provide comprehensive, high-speed verification that an IC will perform as designed, taking into account the complex effects of nanometer semiconductor physics.

Allegro System Interconnect Design Platform

      The Cadence Allegro system interconnect design platform enables collaborative design of high-performance interconnect across the domains of IC, package and PCB, reducing cost and time to market. The system interconnect — between I/ O buffers and across ICs, packages and PCBs — can be optimized through the platform’s co-design methodology, reducing both hardware costs and design cycles. The Allegro platform’s constraint-driven methodology includes advanced capabilities for design capture, signal integrity and physical implementation. The Allegro co-design methodology is supported by our Encounter and Virtuoso platforms, enabling effective design chain collaboration. Silicon design-in kits speed time to market by allowing IC companies to shorten new device adoption time and allowing systems companies to accelerate PCB system design cycles.

      The System Interconnect product group includes the Allegro system interconnect platform and the OrCAD product line of PCB design products that is priced for the individual user. The OrCAD product line is marketed exclusively through a worldwide network of value added resellers.

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Verification and Application Specific Programming, or ASP, Services

      We offer verification and ASP services through Time-to-Market Engineering, or TtME, services. Our TtME team provides customers with consulting services, project services and/or complete turnkey services for verification acceleration and system emulation. QuickCycles allows customers to access Palladium simulation acceleration and emulation products on a pay-as-you-go basis, either on the customer internet site or remotely over a high-speed, secure network connection.

Third Party Programs and Initiatives

      We recognize that certain of our customers may also use internally-developed design tools or design tools provided by other EDA companies. We support the integration of third party design products through our Open Access Initiative and Connections® Program. Open Access is a full-featured EDA database that supports access and manipulation of its internal EDA data via a fully documented and freely available programming interface. This provides an open application program interface, or API, through which applications developed by our customers, by their other EDA vendors, or by university research groups can all operate within a single database and with Cadence platforms. We have contributed the open access database to the Open Access Coalition, which is operated by the Silicon Integration Initiative, an organization of EDA, electronic system and semiconductor industry leaders focused on improving productivity and reducing cost in creating and producing integrated silicon systems. The Connections Program provides other EDA companies with access to our products to ensure that our products work well with those third party tools. Over 120 EDA providers are members of the Connections Program. Additionally, we collaborate throughout the silicon design chain with leading IP, silicon foundry, and library provider partners to support customer-owned tooling, or COT, solutions for our customers. We also assist and support library providers in the integration of our design and verification products and model formats into COT library solutions. In addition, we work with vendors of Application Specific Integrated Circuits, or ASICs, to ensure predictable and smooth handoff of design data from mutual customers to ASIC implementation. These relationships are integral to providing complete design chain solutions to IC and electronic systems designers who depend on coordinated offerings from multiple suppliers.

Maintenance

      The Maintenance segment comprises our customer support activities for our software and hardware products. We provide technical support to our customers to facilitate their use of our products. A high level of customer service and support is critical to the adoption and successful use of our products, which results in a close link between the Product and Maintenance segments.

      We have a global customer support organization and specialized field application engineering teams located in each of our operating regions, to provide assistance to customers where and when they need it.

      Standard maintenance support includes three major components: our Sourcelink® online support portal, which provides 24 hour access to real-time technical information on our products; contact center support — telephone, email and web access to our support engineers; and software updates — periodic updates with regression-tested critical fixes and updated functionality available via CDs or secure internet download.

      Maintenance is offered to customers as an integral, non-cancelable component of our subscription license agreements, or as a separate agreement subject to annual renewal for our term and perpetual license agreements. During the recent downturn in the electronics industry, some customers facing constrained budgets elected not to renew maintenance agreements associated with license agreements with us.

      Some of our customers have relocated, or expanded the presence of their design teams away from their headquarters or historical locations to less expensive locations in emerging growth regions. Accordingly, to provide the most responsive and effective support for our customers, we expect to continue to expand the presence of our own support and application engineering teams into emerging growth regions around the world.

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      Maintenance revenues represented 29% of our total revenue in 2003, 26% in 2002 and 24% in 2001. Maintenance revenue in 2004 will be predominately generated from backlog.

Services

      We offer a number of fee-based services, including education and engineering services related to design and methodology services. These services may be sold and performed in conjunction with the sale, lease or license of our products or sold separately.

      Services revenue represented 12% of our total revenue in 2003, 11% in 2002 and 18% in 2001.

Education Services

      Our educational services include Internet, classroom and custom courses, the content of which ranges from how to use the most recent product features to instructions in the latest design techniques.

Design and Methodology Services

      We offer engineering services and reusable design technologies to aid customers with the design of complex ICs. We focus our offerings primarily on SoC devices, including both Application Specific Integrated Circuits, or ASICS, and Application Specific Standard Parts, and on analog and mixed signal ICs. The customers for these services primarily consist of semiconductor and systems companies developing products for the communications, computing, and consumer market segments. We offer engineering capabilities to assist customers from product concept through volume manufacturing.

      We also make our design intellectual property, or design IP, portfolio available to customers as part of our complete technology and services solution. These reusable design and methodology components enable us to more efficiently deliver our services, and allow our customers to reduce the design complexity and time to market for the development of complex SoCs.

      In our design and methodology service practices, we leverage our cumulative experience and knowledge of design practices across many customers and different design environments to improve our own service teams’ and our customers’ productivity. We work with customers using outsourcing, consultative and collaborative models depending on their projects and needs. Our Virtual Computer-Aided Design, or VCAD, model enables our engineering teams at one or more of our locations to virtually work “side-by-side” with our customers’ teams located elsewhere during the course of their design and engineering projects through a secure private network infrastructure.

      Through collaboration with our customers, we are able to design advanced ICs, gaining direct and early visibility to industry design issues that may not be addressed adequately by today’s design automation solutions. This enables us to accelerate the development of new software technology to meet the market’s current and future design requirements.

Marketing and Sales

      We generally use a direct sales force consisting of sales people and applications engineers to market our products and provide maintenance and services to existing and prospective customers. Applications engineers provide technical pre-sales as well as post-sales support for software products. Our Methodology Services group provides on-site resources and capabilities to help customers improve productivity with their design activity. Due to the complexity of EDA products and the electronic design process in general, the sales cycle is generally long, requiring three to six months or more. During the sales cycle, our direct sales force generally provides technical presentations, product demonstrations and support for on-site customer evaluation of our software. We also use traditional marketing approaches to promote our products and services, including advertising, direct mail, telemarketing, trade shows, public relations and the Internet.

      Internationally, we market and support our products and services primarily through our subsidiaries. Until June 28, 2003, we licensed most of our software products in Japan through Innotech Corporation, of which we

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Research and Development

      Our investment in research and development was $340.1 million in 2003, $326.4 million in 2002 and $297.3 million in 2001.

      The primary areas of our research include SoC design, the design of silicon devices in the nanometer range, high-speed board design, architectural-level design, high-performance logic verification technology and hardware/ software co-design. Because the electronics industry combines rapid innovation with rapidly increasing design and manufacturing complexity, we focus significant investment on enhancing our current products, as well as creating new products and techniques.

      Our future performance depends largely on our ability to maintain and enhance our current product lines to meet advancing semiconductor manufacturing capability, develop or acquire new products and services from third parties, maintain technological competitiveness and meet increasingly complex customer requirements. In addition to research and development conducted within each of our segments, we maintain Cadence Laboratories, an advanced research group responsible for exploring new directions and applications of our technologies, migrating new technologies into our existing offerings and maintaining strong industry relationships.

Manufacturing and Distribution

      Our software production operations consist of configuring the customer’s order, outsourcing the recording of the product electronically or on CD-ROM, and producing customer-unique access keys allowing customers to use licensed products. Software and documentation are generally made available to customers by secured electronic delivery. User manuals and other documentation are generally available on CD-ROM, but are occasionally supplied in hard copy format.

      Cadence performs final assembly and test of its hardware verification, acceleration and emulation products in San Jose, California. Subcontractors manufacture all major subassemblies, including all individual printed circuit boards and custom ICs, and supply them to us for qualification and testing prior to their incorporation into the assembled product.

Proprietary Technology

      Our success depends, in part, upon our proprietary technology. We generally rely on patents, copyrights, trademarks, trade secret laws, licenses and restrictive agreements to establish and protect our proprietary rights in technology and products. Many of our products include software or other intellectual property licensed from third parties. We may have to seek new or renew existing licenses for this third party software and other intellectual property in the future. As part of performing design services for customers, our design services business licenses certain software and other intellectual property of third parties, including that of our competitors.

Competition

      The competitive conditions for our Products and Maintenance segments are closely related. In these segments, we compete in the EDA market primarily with three other significant companies: Synopsys, Inc., Mentor Graphics Corporation and Magma Design Automation, Inc. In 2002 and 2003, Synopsys, Inc. acquired two significant companies, Avant! Corporation and Numerical Technologies, Inc., and the combined companies offer a broader product range than any of them did before the mergers. We also compete with numerous smaller EDA companies, with manufacturers of electronic devices that have developed or have the capability to develop their own EDA products, and with numerous electronics design and consulting

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      Our Maintenance business flows directly from the Products business. The competitive issues associated with the Maintenance segment are substantially the same as those for the Products segment in that every maintenance contract is the direct result of a product contract, and once we have entered into a product contract, maintenance is generally purchased by the customer to ensure that the customer will receive access to bug fixes and service releases, as and when they are made available, and other continued support.

      Certain competitive factors in the Services business as described in this annual report on form 10-K differ from those of the Products and Maintenance businesses. We compete less with other EDA companies in this business segment, and more with independent design service businesses. These companies vary greatly in focus, geographic location, capability, cost structure and pricing. In addition, manufacturers of electronic devices may be reluctant to purchase services from independent vendors, such as Cadence, because they wish to promote their own internal design departments. We compete with these companies by focusing on the design of complex analog and digital ICs. It is our strategy to use design services as a differentiator to further promote our Products and Maintenance businesses.

Backlog

      Our backlog on January 3, 2004 was approximately $1.6 billion as compared to $1.4 billion on December 28, 2002. Backlog consists of revenue to be recognized over multiple fiscal periods after January 3, 2004:

	•	From the sale or lease of hardware and subscription licenses for software products;
	•	For maintenance contracts on hardware and software products;
	•	From orders for hardware and software products sold on perpetual and term licenses on which customers have requested delivery dates after January 3, 2004;
	•	To be recognized under term licenses under which payments are in less than near equal installments;
	•	From license arrangements for which collectibility is not probable;
	•	From the undelivered portion of services contracts that is recognized on a percentage-of-completion basis; and
	•	From services contracts recognized under the completed contract method for which services have not yet been completed.

      The substantial majority of our backlog is generated by our product and maintenance segments, as customer licenses generally include both product and maintenance components. Services is not a significant component of backlog. We expect that maintenance revenue in 2004 will be predominately generated from backlog. We have not historically experienced significant cancellations of our contracts with customers. However, we often reschedule the required completion dates of services contracts which, at times, defers revenue recognition under those contracts beyond the original expected completion date. Changes in customer license types or payment terms also can impact the timing of revenue recognition. See “Software Licensing Arrangements” for discussion of product revenue recognized from backlog.

Revenue Seasonality

      Historically, orders and revenue have been lowest in our first quarter and highest in our fourth quarter, with a material decline between the fourth quarter of one year and the first quarter of the next year. We expect the first quarter will remain our lowest quarter for orders and revenues; orders and revenues in other quarters will vary based on the particular timing and type of licenses entered into with large customers.

Employees

      As of February 7, 2004, we employed approximately 4,800 individuals, with approximately 2,250 in sales, services, marketing, support and manufacturing activities, approximately 1,900 in product development and

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Software Licensing Arrangements

      We sell software using three license types: subscription, term and perpetual. Customers who prefer to license technology for a specified, limited period of time will choose either a subscription or term license and customers who prefer to have the right to use the technology continuously without time restriction choose perpetual licenses. Customers who desire rights to remix in new technology during the life of the contract select a subscription license, which allows customers limited access to unspecified new technology on a when-and-if-available basis, as opposed to a term or perpetual license which does not include remix rights to new technology. Payment terms for subscription and term licenses generally provide for installments over the license period and for perpetual licenses generally are net 30 days.

      Our revenue recognition depends on a number of contract-specific terms and conditions, including the license type, payment terms, creditworthiness of the customer and other factors as more fully described under the heading “Critical Accounting Estimates” under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Revenue associated with subscription licenses is recognized over multiple periods over the license term whereas product revenue associated with term and perpetual licenses may be eligible for revenue recognition upon the effective date and delivery of the license, assuming all other criteria for revenue recognition have been met.

      Product revenue recognized from backlog comprised approximately 60% of total product revenue in 2003, 45% in 2002 and 30% in 2001. Our revenue and results of operations may fall short of expectations due to the actual mix of license types executed in any given period and due to other contract-specific terms and conditions as discussed above. We are subject to greater credit risk on subscription and term licenses, as compared to perpetual licenses, due to the installment payment terms generally associated with those license types. Otherwise, the particular risks to us of one license type versus another type do not vary considerably.

      From time to time we sell receivables from our licenses with installment payment terms on a non-recourse basis to third party financing institutions.

      For further discussion of our license agreements, revenue recognition policies and results of operations, please refer to “Critical Accounting Estimates” found in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

International Operations

      We have offices located in China, France, Germany, India, Japan, Russia, Taiwan, the United Kingdom and other areas throughout the world. These offices primarily provide sales, research and development and operational support functions. We consider customer sales and support requirements, the availability of a skilled workforce, costs and efficiencies among other relative benefits when determining what operations to locate internationally. For additional information regarding our international operations see Note 19, Segment Reporting, to our Consolidated Financial Statements.

Factors That May Affect Future Results

      Our business faces many risks. Described below are what we believe to be the material risks that we face. If any of the events or circumstances described in the following risks actually occurs, our business, financial condition or results of operations could suffer.

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Risks Related to Our Business

We are subject to the cyclical nature of the integrated circuit and electronics systems industries, and any

      Purchases of our products and services are dependent upon the commencement of new design projects by IC manufacturers and electronics systems companies. The IC industry is cyclical and is characterized by constant and rapid technological change, rapid product obsolescence and price erosion, evolving standards, short product life cycles and wide fluctuations in product supply and demand.

      The IC and electronics systems industries have experienced significant downturns, often connected with, or in anticipation of, maturing product cycles of both these industries’ and their customers’ products and a decline in general economic conditions. These downturns have been characterized by diminished product demand, production overcapacity, high inventory levels and accelerated erosion of average selling prices.

      Since 2001, IC manufacturers and electronics systems companies have experienced a downturn in demand and production which has resulted in reduced research and development spending by many of our customers. While many of these companies appear to have experienced a gradual recovery in the second half of 2003, they have continued their focus on cost containment. Any economic downturn could harm our business, operating results and financial condition.

Our failure to respond quickly to technological developments could make our products uncompetitive
          and obsolete.

      The industries in which we compete experience rapid technology developments, changes in industry standards, changes in customer requirements and frequent new product introductions and improvements. Currently, the industries we serve are experiencing several revolutionary trends:

	•	Migration to nanometer design: the size of features such as wires, transistors and contacts on ICs is shrinking due to advances in semiconductor manufacturing processes. Process feature sizes refer to the width of the transistors and the width and spacing of the interconnect on the IC. Feature size is normally identified by the headline transistor length, which is shrinking from 180 nanometers to 130 nanometers and smaller. This is commonly referred to in the semiconductor industry as the migration to nanometer design. It represents a major challenge for participants in the semiconductor industry, from IC design and design automation to design of manufacturing equipment and the manufacturing process itself. Shrinkage of transistor length to such infinitesimal proportions is challenging fundamental laws of physics and chemistry.
	•	The ability to design System-on-Chip, or SoC, ICs increases the complexity of managing a design that at the lowest level is represented by billions of shapes on the fabrication mask. In addition, SoCs typically incorporate microprocessors and digital signal processors that are programmed with software, requiring simultaneous design of the IC and the related software embedded on the IC.
	•	Increased capability of Field-Programmable Gate Array, or FPGA, technologies creates an alternative to IC implementation for some electronics companies. This could reduce demand for Cadence’s IC implementation products and services.
	•	A growing number of low-cost design services businesses could reduce the need for some IC companies to invest in EDA products.
	•	The challenges of nanometer design are leading some customers to work with older, less risky manufacturing processes. This may reduce their need to upgrade their EDA products and design flows.

      If we are unable to respond quickly and successfully to these developments and the evolution of these changes, we may lose our competitive position, and our products or technologies may become uncompetitive or obsolete. To compete successfully, we must develop or acquire new products and improve our existing products and processes on a schedule that keeps pace with technological developments in our industries. We must also be able to support a range of changing computer software, hardware platforms and customer preferences. We cannot guarantee that we will be successful in this effort.

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We have experienced varied quarterly operating results, and our operating results for any particular

      We have experienced, and may continue to experience, varied quarterly operating results. In particular, we have experienced quarterly net losses for three of the past four quarters, and we may experience net losses in future periods. In addition, we recorded a net loss for the fiscal year ended January 3, 2004. Various factors affect our quarterly operating results and some of them are not within our control. Our quarterly operating results are affected by the timing of significant orders for our software products because a significant number of licenses for our software products are in excess of $5.0 million. The failure to complete a license for one or more orders for our software products in a particular quarter could seriously harm our operating results for that quarter.

      Our operating results are also affected by the mix of license types executed in any given period. We license software using three different license types: term, subscription and perpetual. Product revenue associated with term and perpetual licenses is generally recognized at the beginning of the license period, whereas product revenue associated with subscription licenses is recognized over multiple periods over the term of the license. Revenue may also be deferred under term and perpetual licenses until payments become due and payable from customers with nonlinear payment terms or as cash is collected from customers with lower credit ratings.

      We continue to experience increasing customer preference for our subscription licenses and requests for more flexible payment terms. We expect revenue recognized from backlog to increase as a percentage of product revenue, on an annual basis, assuming that customers continue to prefer subscription licenses, or continue to request more flexible payment terms, both of which cause revenue to be recognized over time. In addition, revenue is impacted by the timing of license renewals, changes in the extent to which contracts contain flexible payment terms and changes in the mix of license types (i.e., perpetual, term or subscription) for existing customers, which changes could have the effect of accelerating or delaying the recognition of revenue from the timing of recognition under the original contract.

      We plan operating expense levels primarily based on forecasted revenue levels. These expenses and the impact of long-term commitments are relatively fixed in the short term. A shortfall in revenue could lead to operating results below expectations because we may not be able to quickly reduce these fixed expenses in response to short-term business changes.

      You should not view our historical results of operations as reliable indicators of our future performance. If revenue or operating results fall short of the levels expected by public market analysts and investors, the trading price of our common stock could decline dramatically.

Our future revenue is dependent in part upon our installed customer base continuing to license additional

      Our installed customer base has traditionally generated additional new license, service and maintenance revenues. In future periods, customers may not necessarily license additional products or contract for additional services or maintenance. Maintenance is generally renewable annually at a customer’s option, and there are no mandatory payment obligations or obligations to license additional software. If our customers decide not to renew their maintenance agreements or license additional products or contract for additional services, or if they reduce the scope of the maintenance agreements, our revenue could decrease, which could have an adverse effect on our results of operations.

We may not receive significant revenues from our current research and development efforts for several

      Internally developing software products and integrating acquired software products into existing platforms is expensive, and these investments often require a long time to generate returns. Our strategy involves

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We have acquired and expect to acquire other companies and businesses and may not realize the expected

      We have acquired and expect to acquire other companies and businesses in the future. While we expect to carefully analyze all potential acquisitions before committing to the transaction, we cannot assure you that our management will be able to integrate and manage acquired products and businesses effectively or that the acquisitions will result in long-term benefits to us or our stockholders. In addition, acquisitions involve a number of risks. If any of the following events occurs after we acquire another business, it could seriously harm our business, operating results and financial condition:

	•	Difficulties in combining previously separate businesses into a single unit;
	•	The substantial diversion of management’s attention from day-to-day business when evaluating and negotiating these transactions and then integrating an acquired business;
	•	The discovery, after completion of the acquisition, of liabilities assumed from the acquired business or of assets acquired that are not realizable;
	•	The failure to realize anticipated benefits such as cost savings and revenue enhancements;
	•	The failure to retain key employees of the acquired business;
	•	Difficulties related to assimilating the products of an acquired business in, for example, distribution, engineering and customer support areas;
	•	Unanticipated costs;
	•	Customer dissatisfaction with existing license agreements with Cadence which may preclude access to products acquired by Cadence after the effective date of the license; and
	•	Failure to understand and compete effectively in markets in which we have limited previous experience.

      In a number of our acquisitions, we have agreed to make future cash or stock payments based on the performance of the businesses we acquired. The performance goals pursuant to which these future payments may be made generally relate to achievement by the acquired business of certain specified bookings, revenue, product proliferation, product development or employee retention goals during a specified period following completion of the applicable acquisition. Future acquisitions may involve issuances of stock as payment of the purchase price for the acquired business and also incentive stock or option grants to employees of the acquired businesses (which may be dilutive to existing stockholders), expenditure of substantial cash resources or the incurrence of material amounts of debt.

      The specific performance goal levels and amounts and timing of contingent purchase price payments vary with each acquisition. In the fiscal year ended January 3, 2004, we paid $2.4 million in cash and issued 3.7 million shares, valued at $57.7 million, to former stockholders of acquired companies, as contingent purchase price.

      The additional goodwill and deferred stock compensation relates to the achievement of certain performance goals related to bookings, product proliferation, product development or employee retention resulting from acquisitions. The goodwill is not expected to be deductible for income tax purposes.

      In connection with our acquisitions completed prior to January 3, 2004, we may be obligated to pay up to an aggregate of $39.1 million in cash and issue a total of 0.8 million shares of our common stock during fiscal 2004. In addition, we may be required to pay an additional $76.0 million in cash from 2005 through 2007 if certain performance goals related to bookings, revenues, product development, product proliferation or employee retention are achieved in full.

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      Future acquisitions may result in increased goodwill and other intangible assets, in addition to acquisition-related charges. These assets may eventually be written down to the extent they are deemed to be impaired, and any such write-downs would adversely affect our results.

Our failure to attract, train, motivate and retain key employees may make us less competitive in our

      Our business depends on the efforts and abilities of our senior management, our research and development staff, and a number of other key management, sales, support, technical and services employees. The high cost of training new employees, not fully utilizing these employees, or losing trained employees to competing employers could reduce our gross margins and harm our business and operating results. Even in the current economic climate, competition for highly skilled employees can be intense, particularly in geographic areas recognized as high technology centers such as the Silicon Valley area, where our principal offices are located, and the other locations where we maintain facilities. If economic conditions improve and job opportunities in the technology industry become more plentiful, we may experience increased employee attrition and increased competition for skilled employees. To attract, retain and motivate individuals with the requisite expertise, we may be required to grant large numbers of stock options or other stock-based incentive awards, which may be dilutive to existing stockholders. We may also be required to pay key employees significant base salaries and cash bonuses, which could harm our operating results. Additionally, if certain proposed accounting standards were adopted we would be required to record a charge to compensation expense for option grants.

      In addition, new regulations have been adopted by the NYSE that require stockholder approval for new stock option plans and significant amendments to existing plans, including increases in options, and that prohibit NYSE member organizations from giving a proxy to vote on equity compensation plans unless the beneficial owner of the shares has given voting instructions. These new regulations could make it more difficult for us to grant options to employees in the future. To the extent that new regulations make it more difficult or expensive to grant options to employees, we may incur increased compensation costs or find it difficult to attract, retain and motivate employees, which could materially and adversely affect our business.

The competition in our industries is substantial and we cannot assure you that we will be able to continue

      The EDA market and the commercial electronics design and methodology services industries are highly competitive. If we fail to compete successfully in these industries, it could seriously harm our business, operating results and financial condition. To compete in these industries, we must identify and develop or acquire innovative and cost competitive EDA products, integrate them into platforms and market them in a timely manner. We must also gain industry acceptance for our design and methodology services and offer better strategic concepts, technical solutions, prices and response time, or a combination of these factors, than those of other design companies and the internal design departments of electronics manufacturers. We cannot assure you that we will be able to compete successfully in these industries. Factors that could affect our ability to succeed include:

	•	The development by others of competitive EDA products or platforms and design and methodology services could result in a shift of customer preferences away from our products and services and significantly decrease revenue;
	•	Decisions by electronics manufacturers to perform design and methodology services internally, rather than purchase these services from outside vendors due to budget constraints or excess engineering capacity;
	•	The challenges of developing (or acquiring externally-developed) technology solutions which are adequate and competitive in meeting the requirements of next-generation design challenges;
	•	The significant number of current and potential competitors in the EDA industry and the low cost of entry;
	•	Intense competition to attract acquisition targets, which may make it more difficult for us to acquire companies at an acceptable price or at all; and

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	•	The combination of or collaboration among many EDA companies to deliver more comprehensive offerings than they could individually.

      We currently compete in the EDA market primarily with Synopsys, Inc., Mentor Graphics Corporation and Magma Design Automation, Inc. In 2002 and 2003, Synopsys, Inc. acquired two significant companies, Avant! Corporation and Numerical Technologies, Inc., and the combined companies offer a broader product range than any of them did before the mergers. We also compete with numerous smaller EDA companies, with manufacturers of electronic devices that have developed or have the capability to develop their own EDA products, and with numerous electronics design and consulting companies. Manufacturers of electronic devices may be reluctant to purchase services from independent vendors such as us because they wish to promote their own internal design departments.

We may need to change our pricing models to compete successfully.

      The intensely competitive markets in which we compete can put pressure on us to reduce our prices. If our competitors offer deep discounts on certain products in an effort to recapture or gain market share or to sell other software or hardware products, we may then need to lower prices or offer other favorable terms to compete successfully. Any such changes would be likely to reduce margins and can adversely affect operating results. Any broadly-based changes to our prices and pricing policies could cause sales and software license revenues to decline or be delayed as our sales force implements and our customers adjust to the new pricing policies. Some of our competitors may bundle products for promotional purposes or as a long-term pricing strategy or provide guarantees of prices and product implementations. These practices could, over time, significantly constrain the prices that we can charge for our products. If we cannot offset price reductions with a corresponding increase in the number of sales or with lower spending, then the reduced license revenues resulting from lower prices could have an adverse affect on our results of operations.

We rely on our proprietary technology as well as software and other intellectual property rights licensed to

	us by third parties, and we cannot assure you that the precautions taken to protect our rights will be adequate or that we will continue to be able to adequately secure such intellectual property rights from third parties.

      Our success depends, in part, upon our proprietary technology. We generally rely on patents, copyrights, trademarks, trade secret laws, licenses and restrictive agreements to establish and protect our proprietary rights in technology and products. Despite precautions we may take to protect our intellectual property, we cannot assure you that third parties will not try to challenge, invalidate or circumvent these safeguards. We also cannot assure you that the rights granted under our patents or attendant to our other intellectual property will provide us with any competitive advantages, or that patents will be issued on any of our pending applications, or that future patents will be sufficiently broad to protect our technology. Furthermore, the laws of foreign countries may not protect our proprietary rights in those countries to the same extent as applicable law protects these rights in the United States. Many of our products include software or other intellectual property licensed from third parties. We may have to seek new or renew existing licenses for such software and other intellectual property in the future. Our design services business holds licenses to certain software and other intellectual property owned by third parties. Our failure to obtain, for our use, software or other intellectual property licenses or other intellectual property rights on favorable terms, or the need to engage in litigation over these licenses or rights, could seriously harm our business, operating results and financial condition.

Intellectual property infringement by or against us could result in our loss of key technology.

      There are numerous patents in the EDA industry and new patents are being issued at a rapid rate. It is not always practicable to determine in advance whether a product or any of its components infringes the patent rights of others. As a result, from time to time, we may be forced to respond to or prosecute intellectual property infringement claims to protect our rights or defend a customer’s rights. These claims, regardless of merit, could consume valuable management time, result in costly litigation, or cause product shipment delays, all of which could seriously harm our business, operating results and financial condition. In settling these

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	•	Pay damages, license fees or royalties to the party claiming infringement;
	•	Stop licensing products or providing services that use the challenged intellectual property;
	•	Obtain a license from the owner of the infringed intellectual property to sell or use the relevant technology, which license may not be available on reasonable terms, or at all; or
	•	Redesign the challenged technology, which could be time-consuming and costly.

      If we were forced to take any of these actions, our business and results of operations may suffer.

We may not be able to effectively implement our restructuring activities, and our restructuring activities

	may not result in the expected benefits, which would negatively impact our future results of operations.

      The EDA market and the commercial electronics design and methodology services industries are highly competitive and change quickly. We have responded to increased competition and changes in the industries in which we compete by restructuring our operations and reducing the size of our workforce. Despite our restructuring efforts over the last few years, we cannot assure you that we will achieve all of the operating expense reductions and improvements in operating margins and cash flows currently anticipated from these restructuring activities in the periods contemplated, or at all. Our inability to realize these benefits, and our failure to appropriately structure our business to meet market conditions, could negatively impact our results of operations.

      As part of our recent restructuring activities, we have reduced the workforce in certain revenue-generating portions of our business, particularly in our services business. This reduction in staffing levels could require us to forego certain future strategic opportunities due to limited resources, which could negatively affect our long-term revenues.

      In addition, these workforce reductions could result in a lack of focus and reduced productivity by remaining employees due to changes in responsibilities or concern about future prospects, which in turn may negatively affect our future revenues. Further, we believe our future success depends, in large part, on our ability to attract and retain highly skilled personnel. Our restructuring activities could negatively affect our ability to attract such personnel as a result of perceived risk of future workforce reductions.

      We also cannot assure you that we will not be required to implement further restructuring activities or reductions in our workforce based on changes in the markets and industries in which we compete or that any future restructuring efforts will be successful.

The lengthy sales cycle of our products and services makes the timing of our revenue difficult to predict and

	may cause our operating results to fluctuate unexpectedly.

      We have a lengthy sales cycle that generally extends at least three to six months. The length of the sales cycle may cause our revenue and operating results to vary unexpectedly from quarter to quarter. The complexity and expense associated with our business generally requires a lengthy customer education, evaluation and approval process. Consequently, we may incur substantial expenses and devote significant management effort and expense to develop potential relationships that do not result in agreements or revenue and may prevent us from pursuing other opportunities.

      In addition, sales of our products and services may be delayed if customers delay approval or commencement of projects because of:

	•	The timing of customers’ competitive evaluation processes; or
	•	Customers’ budgetary constraints and budget cycles.

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      Lengthy sales cycles for acceleration and emulation hardware products subject us to a number of significant risks over which we have limited control, including insufficient, excess or obsolete inventory, variations in inventory valuation and fluctuations in quarterly operating results.

      Also, because of the timing of large orders and our customers’ buying patterns, we may not learn of bookings shortfalls, revenue shortfalls, earnings shortfalls or other failures to meet market expectations until late in a fiscal quarter, which could cause even more immediate and serious harm to the trading price of our common stock.

The profitability of our services business depends on factors that are difficult to control, such as the high

	cost of our services employees, our cost of performing our fixed-price services contracts and the success of our design services business, which has historically suffered losses.

      To be successful in our services business, we must overcome several factors that are difficult to control, including the following:

	•	Our cost of services employees is high and reduces our gross margin. Gross margin represents the difference between the amount of revenue from the sale of services and our cost of providing those services. We must pay high salaries to attract and retain professional services employees. This results in a lower gross margin than the gross margin in our software business. In addition, the high cost of training new services employees or not fully utilizing these employees can significantly lower gross margin. It is difficult to adjust staffing levels quickly to reflect customer demand for services; therefore, the services business has in the past and could continue to experience losses.
	•	A portion of services contracts consists of fixed-price contracts. Some of our customers pay a fixed price for services provided, regardless of the cost we must incur to perform the contract. If our cost in performing the services were to exceed the amount the customer has agreed to pay, we would experience a loss on the contract, which could harm our business, operating results and financial condition.
	•	We have historically suffered losses in our design services business. The market for electronics design services is sensitive to customer budgetary constraints and engineering capacity. Our design services business has historically suffered losses. If our design services business fails to increase its revenue to offset its expenses, the design services business will continue to experience losses. Our failure to succeed in the design services business may harm our business, operating results and financial condition.

Our international operations may seriously harm our financial condition because of the effect of foreign

	exchange rate fluctuations and other risks to our international business.

      We have significant operations outside the United States. Our revenue from international operations as a percentage of total revenue was approximately 44% in 2003, 45% in 2002 and 45% in 2001. We expect that revenue from our international operations will continue to account for a significant portion of our total revenue. We also transact business in various foreign currencies. Recent economic and political uncertainty and the volatility of foreign currencies in certain regions, most notably the Japanese yen and the European Union euro, have had, and may continue to have, a seriously harmful effect on our revenue and operating results.

      Fluctuations in the rate of exchange between the U.S. dollar and the currencies of other countries in which we conduct business could seriously harm our business, operating results and financial condition. For example, if there is an increase in the rate at which a foreign currency exchanges into U.S. dollars, it will take more of the foreign currency to equal the same amount of U.S. dollars than before the rate increase. If we price our products and services in the foreign currency, we will receive fewer U.S. dollars than we did before the rate increase went into effect. If we price our products and services in U.S. dollars, an increase in the exchange rate will result in an increase in the price for our products and services compared to those products of our competitors that are priced in local currency. This could result in our prices being uncompetitive in markets where business is transacted in the local currency.

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      Exposure to foreign currency transaction risk can arise when transactions are conducted in a currency different from the functional currency of one of our subsidiaries. A subsidiary’s functional currency is the currency in which it primarily conducts its operations, including product pricing, expenses and borrowings. Although we attempt to reduce the impact of foreign currency fluctuations, significant exchange rate movements may hurt our results of operations as expressed in U.S. dollars.

      Our international operations may also be subject to other risks, including:

	•	The adoption and expansion of government trade restrictions;
	•	Limitations on repatriation of earnings;
	•	Limitations on the conversion of foreign currencies;
	•	Reduced protection of intellectual property rights in some countries;
	•	Recessions in foreign economies;
	•	Longer collection periods for receivables and greater difficulty in collecting accounts receivable;
	•	Difficulties in managing foreign operations;
	•	Political and economic instability;
	•	Unexpected changes in regulatory requirements;
	•	Tariffs and other trade barriers; and
	•	U.S. government licensing requirements for exports which may lengthen the sales cycle or restrict or prohibit the sale or licensing of certain products.

      We have offices throughout the world, including key research facilities outside of the United States. Our operations are dependent upon the connectivity of our operations throughout the world. Activities that interfere with our international connectivity, such as computer “hacking” or the introduction of a virus into our computer systems, could significantly interfere with our business operations.

Our operating results could be adversely affected as a result of changes in our effective tax rates.

      Our future effective tax rates could be adversely affected by the following:

	•	Earnings being lower than anticipated in countries where we are taxed at lower statutory rates as compared to the U.S. tax rate;
	•	An increase in expenses not deductible for tax purposes, including write-offs of acquired in-process technology and impairment of goodwill;
	•	Changes in the valuation of our deferred tax assets and liabilities; or
	•	Changes in tax laws or the interpretation of such tax laws.

      Any significant change in our future effective tax rates could adversely impact our results of operations for future periods.

We have received an examination report from the Internal Revenue Service proposing a tax deficiency in

	certain of our tax returns, and the outcome of the examination or any future examinations involving similar claims may have a material adverse effect on our results of operations and cash flows.

      The IRS and other tax authorities regularly examine our income tax returns. The IRS recently completed its field examination of our federal income tax returns for the fiscal years 1997 through 1999 and has issued a Revenue Agent’s Report, referred to as the RAR, in which the IRS proposes to assess an aggregate tax deficiency for the three-year period of approximately $143 million, plus interest, which interest will accrue until the matter is resolved. This interest is compounded daily at rates published by the IRS, which rates have been between four and nine percent since 1997, and adjusts quarterly. The IRS may also make similar claims for years subsequent to 1999 in future examinations. The RAR is not a final Statutory Notice of Deficiency, and we have filed a protest to certain of the proposed adjustments with the IRS.

      The most significant of the disputed adjustments relates to transfer pricing arrangements that we have with a foreign subsidiary. We believe that the proposed IRS adjustments are inconsistent with the applicable tax laws, and that we have meritorious defenses to the proposed adjustments. We are challenging these proposed adjustments vigorously.

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      Significant judgment is required in determining our provision for income taxes. In determining the adequacy of our provision for income taxes, we regularly assess the likelihood of adverse outcomes resulting from these examinations, including the current IRS assessments. However, the ultimate outcome of tax examinations cannot be predicted with certainty, including the total amount payable or the timing of any such payments upon resolution of these issues. In addition, we cannot assure you that such amount will not be materially different than that which is reflected in our historical income tax provisions and accruals. Should the IRS or other tax authorities assess additional taxes as a result of a current or a future examination, we may be required to record charges to operations in future periods that could have a material impact on the results of operations, financial position or cash flows in the applicable period or periods recorded.

Failure to obtain export licenses could harm our business by rendering us unable to ship products and transfer

	our technology outside of the United States.

      We must comply with U.S. Department of Commerce regulations in shipping our software products and transferring our technology outside the United States and to foreign nationals. Although we have not had any significant difficulty complying with these regulations so far, any significant future difficulty in complying could harm our business, operating results and financial condition.

Proposed regulations related to equity compensation could cause us to recognize an additional expense, which

	would result in a reduction in our net income.

      On March 31, 2004, the Financial Accounting Standards Board, or FASB, consistent with recent actions of other accounting agencies and entities, issued a proposed Statement “Share Based Payment, an Amendment of FASB Statements No. 123 and 95” relating to the accounting for equity-based compensation. This Statement proposes changes to U.S. Generally Accepted Accounting Principles, or GAAP, that, if implemented, would require us to record a charge to compensation expense for stock option grants. We currently account for stock options under Statement of Financial Accounting Standards, or SFAS, No. 123, “Accounting for Stock-Based Compensation”. As permitted by SFAS No. 123, we have elected to use the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, or APB Opinion No. 25, “Accounting for Stock Issued to Employees,” to measure compensation expense for stock-based awards granted to employees, under which the granting of stock options is not considered compensation, if the option exercise price is not less than the fair market value of the common stock at the grant date. The FASB’s proposal would eliminate our ability, starting in 2005, to account for stock-based awards using the intrinsic value method prescribed by APB Opinion No. 25 and would instead require that such awards be accounted for using a fair-value based method, which would require us to measure the compensation expense for all such awards, including stock options, at fair-value at the grant date. We cannot predict whether the proposed regulations will be adopted, but if adopted they would have an adverse affect on our results of operations.

Errors or defects in our products and services could expose us to liability and harm our reputation.

      Our customers use our products and services in designing and developing products that involve a high degree of technological complexity, each of which has its own specifications. Because of the complexity of the systems and products with which we work, some of our products and designs can be adequately tested only when put to full use in the marketplace. As a result, our customers or their end users may discover errors or defects in our software or the systems we design, or the products or systems incorporating our design and intellectual property may not operate as expected. Errors or defects could result in:

	•	Loss of current customers and loss of or delay in revenue and loss of market share;
	•	Failure to attract new customers or achieve market acceptance;
	•	Diversion of development resources to resolve the problem;
	•	Increased service costs; and
	•	Liability for damages.

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If we become subject to unfair hiring claims, we could be prevented from hiring needed employees, incur

	liability for damages and incur substantial costs in defending ourselves.

      Companies in our industry whose employees accept positions with competitors frequently claim that these competitors have engaged in unfair hiring practices or that the employment of these persons would involve the disclosure or use of trade secrets. These claims could prevent us from hiring employees or cause us to incur liability for damages. We could also incur substantial costs in defending ourselves or our employees against these claims, regardless of their merits. Defending ourselves from these claims could also divert the attention of our management from our operations.

Our business is subject to the risk of earthquakes, floods and other natural catastrophic events.

      Our corporate headquarters, including certain of our research and development operations, and certain of our distribution facilities, are located in the Silicon Valley area of Northern California, which is a region known to experience seismic activity. In addition, several of our facilities, including our corporate headquarters, certain of our research and development operations, and certain of our distribution operations, are in areas of San Jose, California that have been identified by the Director of the Federal Emergency Management Agency, or FEMA, as being located in a special flood area. The areas at risk are identified as being in a one hundred year flood plain, using FEMA’s Flood Hazard Boundary Map or the Flood Insurance Rate Map. If significant seismic or flooding activity were to occur, our operations may be interrupted, which would adversely impact our business and results of operations.

We maintain research and other facilities in parts of the world that are not as politically stable as the

	United States, and as a result we may face a higher risk of business interruption from acts of war or terrorism than other businesses located only or primarily in the United States.

      We maintain international research and other facilities, some of which are in parts of the world that are not as politically stable as the United States. Consequently, we may face a greater risk of business interruption as a result of terrorist acts or military conflicts than businesses located domestically. Furthermore, this potential harm is exacerbated given that damage to or disruptions at our international research and development facilities could have an adverse effect on our ability to develop new or improve existing products as compared to other businesses which may only have sales offices or other less critical operations abroad. We are uninsured for losses or interruptions caused by acts of war or terrorism.

Risks Related to Our Securities

Our debt obligations expose us to risks that could adversely affect our business, operating results and

	financial condition, and could prevent us from fulfilling our obligations under such indebtedness.

      We have a substantial level of debt. As of January 3, 2004, we had $420.5 million of outstanding indebtedness, including $420.0 million of our Zero Coupon Zero Yield Senior Convertible Notes, or the Notes, that we issued in August 2003. The level of our indebtedness, among other things, could:

	•	make it difficult for us to satisfy our payment obligations on our debt as described below;
	•	make it difficult for us to incur additional debt or obtain any necessary financing in the future for working capital, capital expenditures, debt service, acquisitions or general corporate purposes;
	•	limit our flexibility in planning for or reacting to changes in our business;
	•	reduce funds available for use in our operations;
	•	make us more vulnerable in the event of a downturn in our business;
	•	make us more vulnerable in the event of an increase in interest rates if we must incur new debt to satisfy our obligations under the Notes; or
	•	place us at a possible competitive disadvantage relative to less leveraged competitors and competitors that have greater access to capital resources.

      If we experience a decline in revenue due to any of the factors described in this section entitled “Factors That May Affect Future Results” or otherwise, we could have difficulty paying amounts due on our

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      We are not restricted under our outstanding indebtedness from incurring additional debt, including other senior indebtedness or secured indebtedness. In addition, our outstanding indebtedness does not restrict our ability to pay dividends, issue or repurchase stock or other securities or require us to achieve or maintain any minimum financial results relating to our financial position or results of operations. Our ability to recapitalize, incur additional debt and take a number of other actions that are not limited by the terms of our outstanding indebtedness could have the effect of diminishing our ability to make payments on such indebtedness when due. Although our outstanding indebtedness does not contain such financial and other restrictive covenants, future indebtedness could include such covenants. If we incur additional indebtedness or other liabilities, our ability to pay our obligations on our outstanding indebtedness could be adversely affected.

We may be unable to adequately service our indebtedness, which may result in defaults and other costs to us.

      We may not have sufficient funds or may be unable to arrange for additional financing to pay the outstanding obligations due on our indebtedness. Any future borrowing arrangements or debt agreements to which we become a party may contain restrictions on or prohibitions against our repayment on our outstanding indebtedness. With respect to the Notes, at maturity, the entire outstanding principal amount of the Notes will become due and payable. Holders may require us to repurchase for cash all or any portion of the Notes on August 15, 2008 for 100.25% of the principal amount, August 15, 2013 for 100.00% of the principal amount and August 15, 2018 for 100.00% of the principal amount. As a result, although the Notes mature in 2023, the holders may require us to repurchase the Notes at an additional premium in 2008, which makes it probable that we will be required to repurchase the Notes in 2008 if the Notes are not otherwise converted into our common stock. If we are prohibited from paying our outstanding indebtedness, we could try to obtain the consent of lenders under those arrangements, or we could attempt to refinance the borrowings that contain the restrictions. If we do not obtain the necessary consents or refinance the borrowings, we may be unable to satisfy our outstanding indebtedness. Any such failure would constitute an event of default under our indebtedness, which could, in turn, constitute a default under the terms of any other indebtedness then outstanding.

      In addition, a material default on our indebtedness could suspend our eligibility to register securities using certain registration statement forms under SEC guidelines which incorporate by reference substantial information regarding us rather than requiring quarterly and other revision and updating, which could potentially hinder our ability to raise capital through the issuance of our securities and will increase the costs of such registration to us.

The price of our common stock may fluctuate significantly, which may make it difficult for stockholders to

	sell our common stock when desired or at attractive prices.

      The market price of our common stock is subject to significant fluctuations in response to the factors set forth in this section entitled “Factors That May Affect Future Results” and other factors, many of which are beyond our control. Such fluctuations, as well as economic conditions generally, may adversely affect the market price of our common stock.

      In addition, the stock markets in recent years have experienced extreme price and trading volume fluctuations that often have been unrelated or disproportionate to the operating performance of individual companies. These broad market fluctuations may adversely affect the price of our common stock, regardless of our operating performance.

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Conversion of the Notes will dilute the ownership interests of existing stockholders.

      The terms of the Notes permit the holders to convert the Notes into shares of our common stock. The Notes are convertible into our common stock initially at a conversion price of $15.65 per share, which would result in an aggregate of approximately 26.8 million shares of our common stock issued upon conversion, subject to adjustment upon the occurrence of specified events. The conversion of some or all of the Notes will dilute the ownership interest of our existing stockholders. Any sales in the public market of the common stock issuable upon conversion could adversely affect prevailing market prices of our common stock. Prior to the conversion of the Notes, if the trading price of our common stock exceeds the conversion price of the Notes by 145% or more over specified periods, earnings per share will be diluted if and to the extent the convertible notes hedge instruments are not exercised. We may redeem for cash all or any part of the Notes on or after August 15, 2008 for 100.00% of the principal amount. The holders may require us to repurchase for cash all or any portion of their notes on August 15, 2008 for 100.25% of the principal amount, on August 15, 2013 for 100.00% of the principal amount, or on August 15, 2018 for 100.00% of the principal amount.

      Each $1,000 of principal of the Notes is initially convertible into 63.8790 shares of our common stock, subject to adjustment upon the occurrence of specified events. Holders of the Notes may convert their Notes prior to maturity only if: (1) the price of our common stock reaches $22.69 during periods of time specified by the Notes, (2) specified corporate transactions occur, (3) the Notes have been called for redemption or (4) the trading price of the Notes falls below a certain threshold. As a result, although the Notes mature in 2023, the holders may require us to repurchase their notes at an additional premium in 2008, which makes it probable that we will be required to repurchase the Notes in 2008 if the Notes are not otherwise converted into our common stock.

      Although the conversion price is currently $15.65 per share, the convertible notes hedge and warrant transactions that we entered into in connection with the issuance of the Notes effectively increased the conversion price of the Notes until 2008 to approximately $23.08 per share, which would result in an aggregate issuance upon conversion prior to August 15, 2008 of approximately 18.2 million shares of our common stock. We have entered into convertible notes hedge and warrant transactions to reduce the potential dilution from the conversion of the Notes, however we cannot guarantee that such convertible notes hedge and warrant instruments will fully mitigate the dilution. In addition, the existence of the Notes may encourage short selling by market participants because the conversion of the Notes could depress the price of our common stock.

We may, at the option of the noteholders and only in certain circumstances, be required to repurchase the

	Notes in shares of our common stock upon a significant change in our corporate ownership or structure, and issuance of shares to repurchase the notes would result in dilution to our existing stockholders.

      Under the terms of the Notes, we may be required to repurchase the Notes following a significant change in our corporate ownership or structure, such as a change of control, prior to maturity of the Notes. Following a significant change in our corporate ownership or structure, in certain circumstances, we may choose to pay the repurchase price of the Notes in cash, shares of our common stock or a combination of cash and shares of our common stock. In the event we choose to pay all or any part of the repurchase price of notes in shares of our common stock, this would result in dilution to the holders of our common stock.

Convertible notes hedge and warrant transactions entered into in connection with the issuance of the Notes

	may affect the value of our common stock.

      We entered into convertible notes hedge transactions with JP Morgan Chase Bank, an affiliate of one of the initial purchasers of the Notes, at the time of issuance of the Notes, with the objective of reducing the potential dilutive effect of issuing our common stock upon conversion of the Notes. We also entered into warrant transactions. In connection with our convertible notes hedge and warrant transactions, JP Morgan Chase Bank, or its affiliates purchased our common stock in secondary market transactions and entered into various over-the-counter derivative transactions with respect to our common stock. This entity or its affiliates is likely to modify its hedge positions from time to time prior to conversion or maturity of the Notes by

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Rating agencies may provide unsolicited ratings on the Notes that could reduce the market value or

	liquidity of our common stock.

      We have not requested a rating of the Notes from any rating agency and we do not anticipate that the Notes will be rated. However, if one or more rating agencies independently elects to rate the Notes and assigns the Notes a rating lower than the rating expected by investors, or reduces their rating in the future, the market price or liquidity of the Notes and our common stock could be harmed. A resulting decline in the market price of the Notes as compared to the price of our common stock may require us to repurchase the Notes.

Anti-takeover defenses in our governing documents and certain provisions under Delaware law could

	prevent an acquisition of our company or limit the price that investors might be willing to pay for our common stock.

      Our governing documents and certain provisions of the Delaware General Corporation Law that apply to us could make it difficult for another company to acquire control of our company. For example:

	•	Our certificate of incorporation allows our board of directors to issue, at any time and without stockholder approval, preferred stock with such terms as it may determine. No shares of preferred stock are currently outstanding. However, the rights of holders of any of our preferred stock that may be issued in the future may be superior to the rights of holders of our common stock.
	•	We have a rights plan, commonly known as a “poison pill,” which would make it difficult for someone to acquire our company without the approval of our board of directors.
	•	Section 203 of the Delaware General Corporation Law generally prohibits a Delaware corporation from engaging in any business combination with a person owning 15% or more of its voting stock, or who is affiliated with the corporation and owned 15% or more of its voting stock at any time within three years prior to the proposed business combination, for a period of three years from the date the person became a 15% owner, unless specified conditions are met.

      All or any one of these factors could limit the price that certain investors would be willing to pay for shares of our common stock and could delay, prevent or allow our board of directors to resist an acquisition of our company, even if the proposed transaction were favored by a majority of our independent stockholders.

Item 2. Properties

      Our headquarters are located in San Jose, California, and we own the related land and buildings. Additionally, we own buildings in India and land and buildings in Scotland. The total square footage of our owned buildings is approximately 979,000.

      We lease additional facilities for our sales offices in the United States and various foreign countries, and our research and development and design services facilities worldwide. We sublease certain of these facilities where space is not fully utilized or has been involved in restructuring activities.

      We believe that these facilities and the undeveloped land we own adjacent to our current headquarters are adequate for our current needs and that suitable additional or substitute space will be available as needed to accommodate any expansion of our operations.

Item 3. Legal Proceedings

      From time to time, we are involved in various disputes and litigation matters that arise in the ordinary course of business. These include disputes and lawsuits related to intellectual property, mergers and

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      While the outcome of any disputes and litigation matters cannot be predicted with any certainty, management does not believe that the outcome of any current matters will have a material adverse effect on our consolidated financial position or results of operations.

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

      None.

Executive Officers of Cadence

      The executive officers of the registrant are as follows:

      Executive officers are appointed by the Board of Directors and serve at the discretion of the Board.

      H. RAYMOND BINGHAM has served as President and Chief Executive Officer of Cadence since April 1999. Mr. Bingham has been a director of the Cadence Board of Directors since November 1997. From 1993 to April 1999, Mr. Bingham served as Executive Vice President and Chief Financial Officer of Cadence. Prior to joining Cadence, Mr. Bingham was Executive Vice President and Chief Financial Officer of Red Lion Hotels, Inc. for eight years. Mr. Bingham is a director of Onyx Software Corporation, Oracle Corporation and KLA-Tencor Corporation.

      KEVIN BUSHBY has served as Executive Vice President, Worldwide Field Operations of Cadence since 2001. From 1995 to 2001, Mr. Bushby served as Vice President and General Manager, European Operations of Cadence. Prior to joining Cadence, from 1990 to 1995, Mr. Bushby held several positions with Unisys Corporation, most recently as Vice President Sales and Marketing, Client Server Systems Division.

      LAVI A. LEV has served as Executive Vice President, Implementation Division since July 2003. From July 2002 to July 2003, Mr. Lev served as Executive Vice President, IC Solutions. From February 2001 to June 2002, Mr. Lev served as Senior Vice President and General Manager of the IC Solutions Group. Prior to joining Cadence, Mr. Lev was Senior Vice President of Engineering at MIPS Technologies, Inc. Mr. Lev has more than 20 years of experience in the semiconductor industry.

      R.L. SMITH MCKEITHEN has served as Senior Vice President, General Counsel and Secretary since 1998. From 1996 to 1998, Mr. McKeithen served as Vice President, General Counsel and Secretary of Cadence. Prior to joining Cadence, from 1994 to 1996, Mr. McKeithen served as Vice President, General Counsel and Secretary of Strategic Mapping, Inc., a software company. From 1988 to 1994, Mr. McKeithen served as Vice President, General Counsel and Secretary of Silicon Graphics, Inc.

      WILLIAM PORTER has served as Senior Vice President and Chief Financial Officer of Cadence since May 1999. From 1994 to 1999, Mr. Porter served as Vice President, Corporate Controller and Assistant Secretary of Cadence. Prior to joining Cadence, Mr. Porter served as Technical Accounting and Reporting Manager and, most recently, as Controller of Cupertino Operations with Apple Computer, Inc.

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PART II.

      Our common stock is traded on the New York Stock Exchange under the symbol CDN. We have never declared or paid any cash dividends on our common stock in the past, and we do not plan to pay cash dividends in the foreseeable future. As of March 6, 2004, we had approximately 1,498 registered stockholders and approximately 22,600 beneficial owners of our common stock.

      The following table sets forth the high and low sales price for Cadence common stock for each calendar quarter in the two-year period ended January 3, 2004:

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      The following selected consolidated financial data should be read in conjunction with our Consolidated Financial Statements and the Notes thereto and the information contained in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operation.” Historical results are not necessarily indicative of future results.

*

Beginning in our fiscal year 2002, Statement of Financial Accounting Standards, or SFAS, No. 142, “Goodwill and Other Intangible Assets” was adopted and, as a result, we have ceased to amortize approximately $178.8 million of goodwill, net of accumulated amortization, including workforce intangibles that were subsumed into goodwill upon adoption of SFAS No. 142. The 1999 to 2001 consolidated financial data include amortization of goodwill and workforce intangibles totaling $50.8 million for 2001, $36.5 million for 2000 and $16.5 million for 1999.

      As more fully described in Note 4 to our Consolidated Financial Statements, in 2003, we determined that certain investments previously accounted for under the cost method during the fiscal years prior to 2003 should have been accounted for under the equity method of accounting. In addition, certain other errors were identified that occurred in the Consolidated Financial Statements for 2000 through 2002. As a result of these determinations, the following adjustments to amounts previously reported have been reflected in the selected financial data above before the effect of income taxes:

      Because the Consolidated Financial Statements for 2001 were not materially affected by the change in accounting for investments, deferred stock compensation, revenue and internally developed software and the Consolidated Financial Statements for that year were audited by a firm that is no longer in existence, no adjustments have been made to the 2001 Consolidated Financial Statements. However, as described in Note 2 to the Consolidated Financial Statements, the 2001 Consolidated Financial Statements were restated to correct certain classification errors. These reclassifications had no effect on previously reported Revenue, Income from operations, Other income, Net income, Total assets or Shareholders’ equity. In order for the 2002 and 2003 Consolidated Financial Statements to be correct as of the end of each of those years, we have

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      The adjustments to amounts previously presented in selected financial data are summarized as follows:

      The decrease in total assets for fiscal 2002 of $11.6 million consists of a decrease in Property, plant and equipment of $2.6 million, an increase in Goodwill of $0.8 million and a decrease in Other assets of $9.8 million. The decrease in total assets of $7.7 million for fiscal 2000 consists of a decrease in Accounts receivable of $0.6 million and a decrease in Other assets of $7.1 million. The decrease in total assets of $4.3 million for fiscal 1999 relates entirely to a decrease in Other assets.

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      The following discussion should be read in conjunction with the Consolidated Financial Statements and notes thereto included elsewhere in this Annual Report on Form 10-K. Certain of such statements, including, without limitation, statements regarding the extent and timing of future revenues and expenses and customer demand, statements regarding the deployment of our products, statements regarding our reliance on third parties and other statements using words such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “should,” “will” and “would,” and words of similar import and the negatives thereof, constitute forward-looking statements. These statements are predictions based upon our current expectations about future events. Actual results could vary materially as a result of certain factors, including but not limited to, those expressed in these statements. We refer you to the “Risk Factors” “Competition,” “Proprietary Technology,” “Factors That May Affect Future Results,” “Results of Operations,” “Disclosures About Market Risk,” and “Liquidity and Capital Resources” sections contained in this Annual Report and the risks discussed in our other SEC filings, which identify important risks and uncertainties that could cause actual results to differ materially from those contained in the forward-looking statements.

      We urge you to consider these factors carefully in evaluating the forward-looking statements contained in this Annual Report. All subsequent written or oral forward-looking statements attributable to our company or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The forward-looking statements included in this Annual Report are made only as of the date of this Annual Report. We do not intend, and undertake no obligation, to update these forward-looking statements.

Overview

          General

      We license electronic design automation, or EDA, software, sell or lease hardware technology and provide design and methodology services throughout the world to help accelerate and manage customers’ electronic product development processes. Our broad range of products and services are used by the world’s leading electronics companies to design and develop complex ICs and personal and commercial electronic systems. For a detailed discussion of the challenges and opportunities of the EDA industry and our products and services, see Item 1. Business above.

      As part of our strategy, we have acquired companies, businesses and third party intellectual property to acquire technology and key personnel, and we expect to continue making acquisitions in the future.

      After experiencing a downturn in demand and production in the last several years which resulted in reduced research and development spending by many of our customers, IC manufacturers and electronics companies appear to have experienced a gradual recovery in the second half of 2003, but have continued their focus on cost containment. In response to the downturn in the economy, and in the electronics industry in particular, we have initiated significant restructuring activities over the past several years to better align our cost structure with expected demand and revenues.

      We have identified certain items that management uses as performance indicators to manage Cadence’s business, including revenue, certain elements of operating expenses and cash flow from operations, and we describe these items more fully in the “Results of Operations” below.

      In 2003, we experienced a continued customer preference for renewable license types and expect the timing of license renewals to continue to impact our results of operations. Product revenue recognized from backlog comprised approximately 60% of total product revenue in 2003, 45% in 2002 and 30% in 2001. This trend is primarily due to, and may continue as a result of, increasing customer preference for subscription licenses and customer requirements for more flexible payment terms.

          Restatement

      During 2003, we restated our Consolidated Financial Statements as of and for the fiscal year ended December 28, 2002 as discussed in more detail in Note 4 to our Consolidated Financial Statements. While

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          Acquisitions

      We have acquired companies, businesses and third party technology, some of which are described below, and we expect to acquire other companies, businesses and third party technology in the future. We undertake these acquisitions as part of our overall business strategy, and specifically, to acquire key personnel, technology and customer relationships of the acquired business. For each of these acquisitions the results of operations and the estimated fair value of the assets acquired and liabilities assumed have been included in our Consolidated Financial Statements from the date of the acquisition. These acquisitions are described in more detail below in Note 5 to our Consolidated Financial Statements.

      Comparative pro forma financial information was not presented for the 2003 or 2002 acquisitions because these acquisitions were not material to our Consolidated Financial Statements, either individually or in the aggregate. For additional information regarding our 2003 acquisitions, see “Liquidity and Capital Resources”, “Results of Operations” and “General and Administrative” found below in this Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and the Notes to our Consolidated Financial Statements included in this Annual Report on Form 10-K.

      A summary of certain information regarding acquisitions completed by Cadence in fiscal 2003 and 2002, including the aggregate initial purchase price paid, is as follows:

      The businesses or assets acquired include:

	(A)	Verification technology.

	(B)	Distribution rights to certain customers, certain assets and key personnel of this Japan-based developer and distributor of software, electronic devices and semiconductor manufacturing equipment.
	(C)	Nanometer-scale synthesis.

	(D)	Silicon modeling products and full-chip circuit simulation.

	(E)	Test design automation.

	(F)	Design and verification.

      The purchase prices of our acquisitions generally consist of one or more of the following: cash payments, shares of our common stock, the fair value of assumed options, if any, and acquisition costs. Other than the

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      Concurrent with the Innotech acquisition, we also modified our distributor agreement with Innotech. Prior to this acquisition, we licensed most of our software products in Japan through Innotech, of which we were, and continue to be, a 15% stockholder. We now directly license our software products to certain customers for which we acquired the distribution rights from Innotech.

      For most of our acquisitions of private companies, a portion of the purchase price is payable after the acquired business group’s achievement of certain performance goals, which generally relate to one or more of bookings, revenue, product development, product proliferation or employee retention. The specific performance goal levels and amounts and timing of contingent purchase price payments vary with each acquisition. In connection with some acquisitions, Cadence may grant stock options with either time-based or performance-based vesting, or a combination of both, to employees of the acquired business as performance incentives. As a result, the amount of cash consideration or shares of our common stock issued to former stockholders of the acquired entity will increase as performance goals are achieved, generally over a period of up to four years following the completion of the respective acquisition. Accordingly, goodwill and deferred stock compensation expense will increase upon the attainment of such goals.

      During 2003, we paid $2.4 million in cash and recorded an additional 3.7 million shares valued at $57.7 million related to acquisition earnouts. We recorded $52.3 million in additional goodwill consisting of $2.4 million in cash and $49.9 million representing 3.2 million shares. We also recorded additional deferred stock compensation of $7.8 million representing 0.4 million shares for earnouts achieved during 2003. In addition, we recorded $0.5 million in deferred stock compensation for estimated future earnouts in accordance with FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.” The additional goodwill and deferred stock compensation related to the achievement of certain performance goals associated with one or more of the following criteria: revenue, bookings, product proliferation, product development and employee retention.

      During 2002, we recorded an additional 12.8 million shares, valued at $204.7 million. We recorded $181.2 million of the $204.7 million as additional goodwill representing 11.3 million of the 12.8 million shares. We also recorded deferred stock compensation of $23.5 million of the $204.7 million, representing 1.5 million of the 12.8 million shares for earnouts achieved during 2002. In addition, we recorded $4.6 million in deferred stock compensation for estimated future earnouts in accordance with FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.” The additional goodwill and deferred stock compensation related to the achievement of certain performance goals associated with one or more of the following criteria: bookings, product proliferation, product development and/or employee retention resulting from acquisitions.

      In connection with our acquisitions completed prior to January 3, 2004, we may be obligated to pay up to an aggregate of $39.1 million in cash and issue a total of 0.8 million shares of our common stock during fiscal 2004. In addition, we may be required to pay an additional $76.0 million in cash from 2005 through 2007 if certain performance goals related to bookings, revenues, product development, product proliferation or employee retention are achieved in full.

      The goodwill recorded in connection with the above-described contingent earnouts for acquisitions is not expected to be deductible for income tax purposes.

          Legal Settlements

      In September 2003, we entered into a settlement with Mentor Graphics Corporation, pursuant to which Cadence, Mentor and their respective affiliated parties settled all outstanding litigation between the companies and such affiliated parties relating to emulation and acceleration systems. The companies also agreed that, for a period of seven years, neither will sue the other over patented emulation and acceleration technology.

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      In November 2002, we announced the settlement of civil litigation filed against Avant! seeking damages related to theft of our intellectual property, including software code, as well as other trade secrets. The settlement with Avant!, its parent corporation Synopsys, Inc. and several individuals included an agreement to dismiss all pending claims and counterclaims in the litigation and required the payment to us of $265.0 million, which was received in the fourth fiscal quarter of 2002.

      In July 2001, Avant! was ordered to pay us $195.4 million in criminal restitution after Avant! entered a plea of no contest and was found guilty by the Superior Court of the State of California of conspiracy to take and use our trade secrets. This conspiracy included the theft by Avant! and certain individuals of our intellectual property, including software code, as well as other trade secrets. As of December 29, 2001, approximately $196.0 million, consisting of all of the restitution award plus interest was received.

      In preparing our Consolidated Financial Statements, we make assumptions, judgments and estimates that can have a significant impact on our revenue, operating income and net income, as well as on the value of certain assets and liabilities on our Consolidated Balance Sheets. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. On a regular basis, we evaluate our assumptions, judgments and estimates and make changes accordingly. We believe that the assumptions, judgments and estimates involved in the accounting for revenue recognition, accounting for income taxes, valuation of long-lived and intangible assets and goodwill, and restructuring charges have the greatest potential impact on our Consolidated Financial Statements, so we consider these to be our critical accounting estimates. Historically, our assumptions, judgments and estimates relative to our critical accounting estimates have not differed materially from actual results. For further information on our significant accounting policies, see Note 2 to our Consolidated Financial Statements.

      Our critical accounting estimates are as follows:

	•	revenue recognition;
	•	accounting for income taxes;
	•	valuation of long-lived and intangible assets and goodwill; and
	•	restructuring charges.

      We apply the provisions of Statement of Position, or SOP, 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9 “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions,” to all product revenue transactions where the software is not incidental. We also apply the provisions of SFAS, No. 13, “Accounting for Leases,” to all hardware lease transactions. We recognize revenue when persuasive evidence of an arrangement exists, the product has been delivered, the fee is fixed or determinable, collection of the resulting receivable is probable, and vendor-specific objective evidence of fair value, or VSOE, exists.

      Fee is fixed or determinable — We assess whether a fee is fixed or determinable at the outset of the arrangement, primarily based on the payment terms associated with the transaction. We generally use installment contracts for term and subscription licenses and we have established a history of collecting under the original contract without providing concessions on payments, products or services. Our installment contracts generally have payment periods that are equal to or less than the term of the licenses, the payments are generally collected quarterly, and periodic payments are generally made in equal or nearly equal installments. Significant judgment is involved in this determination, including determining whether a contract amendment constitutes a concession. Our experience has been that we are able to determine whether a fee is fixed or determinable. While we do not expect that experience to change, if we no longer had a history of

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      Collection is probable — We assess collectibility at the outset of the arrangement based on a number of factors, including the customer’s past payment history and its current creditworthiness. If in our judgment collection of a fee is not probable, we defer the revenue until the uncertainty is removed, which generally means revenue is recognized upon receipt of cash payment. Our experience has been that we are able to estimate that collection is probable. While we do not expect that experience to change, if we were to determine that collection is not probable for any license arrangement with installment payment terms, revenue from this license would be recognized generally upon the receipt of cash payment. These changes could have a material impact on our results of operations.

      Vendor-Specific Objective Evidence — Our VSOE for certain product elements of an arrangement is based upon the pricing for comparable transactions when the element is sold separately. VSOE for maintenance is generally based upon the customer’s stated annual renewal rates. VSOE for services is generally based on the price charged when the services are sold separately. For multiple element arrangements, VSOE must exist to allocate the total fee among all delivered and undelivered elements in the arrangement. If VSOE does not exist for all elements to support the allocation of the total fee among all delivered and undelivered elements of the arrangement, revenue is deferred until such evidence does exist for the undelivered elements, or until all elements are delivered, whichever is earlier. If VSOE of all undelivered elements exists but VSOE does not exist for one or more delivered elements, revenue is recognized using the residual method. Under the residual method, the VSOE of the undelivered elements is deferred, and the remaining portion of the arrangement fee is recognized as revenue. Our experience has been that we are able to estimate VSOE. While we do not expect that experience to change, if we could no longer support VSOE for undelivered elements of multiple element arrangements, revenue would be deferred until we have VSOE for the undelivered elements or all elements are delivered, whichever is earlier. This change could have a material impact on our results of operations.

      Services revenue — Services revenue consists primarily of revenue received for performing methodology and design services. Revenue from service contracts is recognized either on the time and materials method, as work is performed, or on the percentage-of-completion method. For contracts with fixed or not-to-exceed fees on a monthly basis, we estimate the percentage-of-completion, which is based on the completion of milestones relating to the arrangement. We have a history of accurately estimating project status and the costs necessary to complete projects. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances and specification and testing requirement changes. If different conditions were to prevail such that accurate estimates could not be made, then the use of the completed contract method would be required and the recognition of all revenue and costs would be deferred until the project was completed. This change could have a material impact on our results of operations.

     Accounting for income taxes

      We provide for the effect of income taxes on our Consolidated Financial Statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” Under SFAS No. 109, income tax expense is recognized for the amount of taxes payable or refundable for the current year and for deferred tax liabilities and assets for tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Our assumptions, judgments and estimates relative to the value of our net deferred tax assets take into account predictions of the amount and category of future taxable income from potential sources including tax planning strategies that would, if necessary, be implemented to prevent a loss carryforward or tax credit carryforward from expiring unused. Actual operating results and the underlying amount and category of income in future years could render our current assumptions, judgments and estimates of recoverable net deferred taxes inaccurate, thus materially impacting our results of operations and financial position. Management must make significant assumptions, judgments and estimates to determine our current provision for income taxes and also our deferred tax assets and liabilities and any valuation allowance to be recorded against our deferred tax assets. Our judgments, assumptions and estimates relative to the current provision for income taxes take into

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      At least annually we review for impairment of goodwill resulting from business combinations in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” We completed our annual impairment review during the third quarter of 2003. We did not identify any impairment to our goodwill as a result of this review. We review long-lived assets, including certain identifiable intangibles, for impairment whenever events or changes in circumstances indicate that we will not be able to recover the asset’s carrying amount in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

      For long-lived assets to be held and used, including acquired intangibles, we initiate our review whenever events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable. Recoverability of an asset is measured by comparing its carrying amount to the expected future undiscounted cash flows expected to result from the use and eventual disposition of that asset, excluding future interest costs that would be recognized as an expense when incurred. Any impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair market value. Significant management judgment is required in:

	•	identifying a triggering event that arises from a change in circumstances;
	•	forecasting future operating results; and
	•	estimating the proceeds from the disposition of long-lived or intangible assets.

      Material impairment charges could be necessary should different conditions prevail or different judgments be made.

      We account for restructuring charges in accordance with SEC Staff Accounting Bulletin No. 100 “Restructuring and Impairment Charges.” Since 2001 we have undertaken significant restructuring initiatives. All restructuring activities initiated prior to fiscal year 2003 were accounted for in accordance with EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” and EITF No. 88-10 “Costs Associated with Lease Modifications or Terminations.” For restructuring activities initiated after fiscal year 2002, we accounted for the facilities and asset-related portions of this restructuring in accordance with SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities.” The severance and benefits charges were accounted for in accordance with SFAS No. 112 “Employers’ Accounting for Postemployment Benefits — An Amendment of FASB Statements No. 5 and 43.”

      These restructuring initiatives have required us to make a number of estimates and assumptions related to losses on excess facilities vacated or consolidated, particularly the timing of subleases and sublease terms. Closure and space reduction costs included in our restructuring charges include payments required under leases, less any applicable estimated sublease income after the facilities are abandoned, lease buyout costs and costs to maintain facilities during the period after abandonment.

      In addition, we have recorded estimated provisions for termination benefits and outplacement costs, long-term asset write-downs, and other restructuring costs. We regularly evaluate the adequacy of our restructuring accrual, and adjust the balance based on changes in estimates and assumptions. We may incur future charges for new restructuring activities as well as changes in estimates to amounts previously recorded.

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Results of Operations

      We primarily generate revenue from licensing EDA software and selling or leasing hardware technology, providing maintenance for the software and hardware and providing design and methodology services. We principally utilize three license types which provide a customer flexibility with several alternatives to the rights it has to utilize our products, including (i) the right to access to new technology; (ii) the duration of the license — for a fixed term, generally two to three years, or on a perpetual basis; and (iii) payment terms. Customer decisions for these aspects of license transactions determine the license type, timing of revenue recognition and potential future business activity. For example, if a customer chooses a fixed term of use, then this will result in either a subscription or term license. A business implication of that decision is that at the expiration of the license period the customer must decide if it wants to continue using the technology and therefore renew the license agreement. Because larger customers generally use products from two or more of our five product groups, rarely will a large customer completely terminate its relationship with Cadence at expiration of the license. See Critical Accounting Estimates for additional discussion of licenses types and timing of revenue recognition.

      To the extent the customer obtains rights to remix to new technology or more flexible payment terms, the revenue is recognized over the life of the agreement. This distinction is critical. For example, a $3.0 million 3-year subscription would result in $1.0 million of revenue per year, or $250,000 per quarter. Whereas, a $3.0 million, 3-year term license, assuming equal or near equal payments and exclusive of the maintenance element, would result in $3.0 million of product revenue upon delivery, which is generally in the first quarter of the arrangement and no product revenue in succeeding quarters.

      An increasing proportion of our product business consists of subscription licenses, which give customers limited access to new technology, and licenses with more flexible payment terms. These changes have the effect of deferring the timing of revenue recognition to future periods. The result has been a decline in product revenue in 2003 compared to 2002, and 2002 compared to 2001, as the proportion of product licenses under which revenue is deferred continued to increase.

      With each succeeding quarter in which the amount of product licenses where revenue is deferred increases, our revenue from backlog also increases. Product revenue recognized from backlog comprised approximately 60% of total product revenue in 2003, 45% in 2002 and 30% in 2001. As long as customers continue to prefer subscription licenses, we expect that revenue from backlog will increase and our revenue will be less susceptible to short-term fluctuations in volume. Because of our model under which we recognize revenue over multiple periods, we do not believe that pricing volatility is a material component of the change in our product revenues from period to period and we do not analyze changes in pricing from one period to the next.

      The amount of product revenue in future periods will depend, among other things, on the terms and timing of our contract renewals or additional product sales with existing customers, the size of such transactions or renewals, and sales to new customers. Product revenue in any period is also affected by the extent to which customers prefer subscription, term or perpetual licenses, and the extent to which contracts contain flexible payment terms. Revenue is also affected by changes in the extent to which existing contracts contain flexible payment terms and changes in license types (e.g., subscription to term) for existing customers. Contract renewals, and consequently product revenues, are also affected by the competitiveness of our products.

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Revenue

Revenue Mix by Product Group

      We analyze our business by product groups, combining revenues for both product and maintenance because of their interrelationship. We introduced our first platform in September 2002. The data for product groups before the introduction of a corresponding platform aggregates the revenues for the individual products associated with a platform. On this basis, the following table shows the percentage of product and maintenance revenue contributed by each of the five product groups, and services, for 2003, 2002 and 2001.

      In 2003 and, to a lesser extent, 2002, revenue for all platforms was negatively affected by the shift to more ratable licenses and lower sales volume. The following discussion analyzes revenue by product group from 2001 to 2003.

      Functional Verification: Our Incisive Functional Verification Platform, introduced in February 2003, supports a unified methodology, from design of the total system to design-in of particular ICs to design of specific systems, for all design domains. The revenue contribution for this platform remained constant on a relative basis in 2003. Increased revenue from our new Incisive simulators, our Conformal product, and strong demand for our new Palladium hardware in-circuit emulation option was offset by a decline in revenue from our older simulators and legacy emulation products. The relative revenue contribution declined from 2001 to 2002 as customers tended to forego purchases of verification products during the semiconductor downturn in favor of more critical products in the digital IC area.

      Digital IC Design: Our Encounter Digital IC Design Platform, introduced in September 2002, leverages a unified architecture for full digital implementation of nanometer-scale designs. The revenue contribution from this area increased on a relative basis from 2002 to 2003 due to increasing revenue for newer products in the Encounter platform which are focused on nanometer scale designs offset by declining sales of our older digital design products which were less competitive. The relative revenue contribution also increased from 2001 to 2002, driven by demand for new technology to meet the design needs of smaller semiconductor process geometries, and revenue from new products, primarily First Encounter.

      Custom IC Design: The Virtuoso Custom IC Design Platform, introduced in September 2003, enables development of silicon-accurate analog, custom digital, radio frequency and mixed-signal designs. The percentage of revenue from the Virtuoso platform increased from 2002 to 2003 due to incremental revenue from new products as well as the growing importance of mixed-signal chip designs, a factor which also contributed to the increase from 2001 to 2002.

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      Design for Manufacturing: Our products in the design for manufacturing area include Fire & Ice QX, SignalStorm, VoltageStorm, ElectronStorm and our Assura design rule checking products. The percentage of revenue from this area remained relatively constant from 2001 to 2003, as increasing revenue from newer products such as Fire & Ice QX and our Assura group was offset by declining revenue from our older products which are less competitive for the newer semiconductor processes.

      System Interconnect: Our Allegro System Interconnect Design Platform, introduced in March 2004, enables collaborative design of high-performance interconnect across the domains of IC, package and PCB, reducing cost and time to market. Our system interconnect products have underperformed our integrated circuit design products over the 2001 to 2003 period because this product group is more exposed to systems companies in the data communications and computer systems sectors, which suffered relatively larger declines in business than other sectors in the electronics industry downturn, and because there has been less technological change in the design of printed circuit boards and system interconnect, there has been less demand for new design products.

      Services revenue decreased $18.6 million in 2003 compared to 2002, and decreased $113.5 million in 2002 compared to 2001, due to a decrease in customer spending for design service as a result of the economic downturn experienced in the electronics industry.

      Additional financial information about segments can be found in Note 19 to our Consolidated Financial Statements.

Revenue by Geography

Revenue by Geography as a Percent of Total Revenue

      International revenue decreased $82.1 million in 2003 compared to 2002, primarily due to a $59.3 million decrease in product revenue in Europe and a $13.4 million decrease in services revenue in Europe. The decrease in product revenue in Europe was primarily due to the timing of license renewals for existing customers.

      International revenue decreased $67.1 million in 2002 compared to 2001, due a $34.0 million decrease in international services revenue and a $47.5 million decrease in product revenue in Europe, slightly offset by a $14.8 million increase in product revenue in Japan. Revenue in Japan accounted for 33% of total international revenue in 2002 compared to 28% in 2001. The slight increase in product revenue in Japan was due to the timing of license renewals for existing customers and was partially offset by a decrease in services revenue.

      The rate of revenue change varies geographically due to differences in the timing and extent of term license renewals for existing customers in those regions. In addition, both our domestic and international businesses have been affected by the revenue trends discussed above in this section entitled “Results of Operations.”

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      With respect to foreign currency exchange rates, revenue increased by $18.8 million in 2003 as compared to 2002, primarily due to strengthening of the Japanese yen in relation to the U.S. dollar. Revenue decreased by $8.4 million in 2002 as compared to 2001, primarily due to the weakening of the Japanese yen in relation to the U.S. dollar. Additional information about revenue and other financial information by geography can be found in Note 19 to our Consolidated Financial Statements.

Cost of Revenue

Cost of Revenue as a Percent of Related Revenue

      Cost of product revenue includes costs associated with the sale or lease of our hardware and licensing of our software products. Cost of product revenue primarily includes the cost of employee salary and benefits, amortization of intangible assets directly related to Cadence products, documentation and royalties payable to third party vendors. Cost of product revenue associated with our Cadence Verification Acceleration, or CVA, hardware products also includes materials, assembly labor and overhead. These additional manufacturing costs make our cost of hardware product higher, as a percentage of revenue, than our cost of software product.

      A summary of Cost of product is as follows:

      Cost of product revenue decreased $31.3 million in 2003 compared to 2002, primarily due to an $18.9 million reduction in amortized software costs, an $8.3 million decrease in royalties, a $9.3 million decrease in Inventory write-offs, and a $2.2 million decrease in acquisition-related write-offs. The decreases were partially offset by an increase in amortization of acquired intangibles of $13.8 million during 2003.

      Cost of product revenue decreased $20.2 million in 2002 compared to 2001, due to a decrease in salary and benefits costs of $10.6 million, a decrease of $9.6 million in the amount of inventory write-offs and a $6.0 million decrease in cost of sales of CVA products, partially offset by a $6.4 million increase in royalty costs.

      During 2003, we began reporting amortization expense related to certain intangible assets acquired in business combinations in Cost of product. We previously recorded all amortization expense related to these intangibles in Amortization of acquired intangibles. Accordingly, we have reclassified amortization expense related to these intangibles of $25.2 million in 2002 and $20.3 million in 2001.

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      In 2002, we recognized a charge of $9.3 million, which is included in cost of product revenue, for excess inventory from decreased sales forecasts. In 2001, we recorded an $18.9 million write-off for excess inventory in cost of product revenue. Of the $18.9 million, $15.2 million of the write-off was related to excess inventory from decreased sales forecasts and $3.7 million related to two product lines that were discontinued as part of our restructuring. The excess inventory charges of $9.3 million in 2002 and $15.2 million in 2001 were due to significant decreases in forecasted revenue for emulation products and were calculated in accordance with our practice, which is based on reserving for inventory in excess of estimated 12-month demand. Inventory purchases and commitments are based on future sales forecasts. We typically buy and build inventory levels for certain key components to mitigate component supply constraints. Based on our current 12-month demand forecast, we do not anticipate that the excess inventory will be used at a later date. We have determined that inventory levels at January 3, 2004 were within forecasted usage for the succeeding 12-month period.

      Cost of services revenue primarily includes employee salary and benefits, costs to maintain the infrastructure necessary to manage a services organization, and provisions for contract losses, if any. Cost of services revenue decreased $21.5 million in 2003 compared to 2002 primarily due to decreases in employee salary and benefit costs resulting from our reduction of services professionals in connection with our restructuring actions initiated in 2002 and 2003. Cost of services revenue decreased $77.9 million in 2002 compared to 2001, primarily due to decreases in employee salary and benefit costs resulting from our reduction of services professionals in connection with our restructuring actions initiated in 2001 and 2002.

      Cost of maintenance revenue includes the cost of customer services, such as hot-line and on-site support, production employees and documentation of maintenance updates. Cost of maintenance revenue decreased $8.6 million in 2003 compared to 2002 primarily due to a decrease in employee salary and benefit costs resulting from a decrease in employee headcount. Cost of maintenance revenue decreased $0.2 million in 2002 compared to 2001, primarily due to a decrease in employee salary and benefit costs resulting from a decrease in employee headcount.

Operating Expenses

Operating Expenses as a Percent of Total Revenue