SCANSOFT INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------

FORM 10-K

(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 0-27038

SCANSOFT, INC.
(Exact Name of Registrant as Specified in its Charter)

DELAWARE 94-3156479
(State of Incorporation) (I.R.S. Employer Identification No.)

9 CENTENNIAL DRIVE
PEABODY, MASSACHUSETTS 01960 (978) 977-2000
(Address of Principal Executive Offices, (Registrant's Telephone Number, Including Area
Including Zip Code) Code)
HTTP://WWW.SCANSOFT.COM
(REGISTRANT'S URL)

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, PAR VALUE $0.001 PER SHARE
PREFERRED SHARE PURCHASE RIGHTS

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10- K or any amendment to
this Form 10-K. [X]

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

The aggregate market value of the outstanding common equity held by
non-affiliates of the Registrant as of the last business day of the Registrant's
most recently completed second fiscal quarter was approximately $245,386,664,
based upon the last reported sales price on the Nasdaq National Market for such
date. For purposes of this disclosure, shares of Common Stock held by officers
and directors of the Registrant and by persons who hold more than 5% of the
outstanding Common Stock have been excluded because such persons may be deemed
to be affiliates. This determination of affiliate status is not necessarily
conclusive.

The number of shares of the registrant's Common Stock, outstanding as of
March 17, 2003 was 65,658,489.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's definitive Proxy Statement to be delivered to
shareholders in connection with the 2003 Annual Meeting of Shareholders are
incorporated by reference into Part III.
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SCANSOFT, INC.

TABLE OF CONTENTS

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FORWARD LOOKING STATEMENTS

THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS WITHIN
THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 THAT INVOLVE
RISKS, UNCERTAINTIES AND ASSUMPTIONS THAT, IF THEY NEVER MATERIALIZE OR IF THEY
PROVE INCORRECT, COULD CAUSE OUR RESULTS TO DIFFER MATERIALLY FROM THOSE
EXPRESSED OR IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS. ALL STATEMENTS OTHER
THAN STATEMENTS OF HISTORICAL FACT ARE STATEMENTS THAT COULD BE DEEMED
FORWARD-LOOKING, INCLUDING STATEMENTS PERTAINING TO: OUR REVENUE, EARNINGS, CASH
FLOW AND LIQUIDITY; OUR STRATEGY RELATING TO SPEECH AND LANGUAGE TECHNOLOGIES;
OUR EXPECTATIONS REGARDING OUR ACQUISITION OF CERTAIN BUSINESS UNITS AND RELATED
INTELLECTUAL PROPERTY FROM ROYAL PHILIPS ELECTRONICS; THE POTENTIAL OF FUTURE
PRODUCT RELEASES; OUR PRODUCT DEVELOPMENT PLANS AND INVESTMENTS IN RESEARCH AND
DEVELOPMENT; FUTURE ACQUISITIONS; INTERNATIONAL OPERATIONS AND LOCALIZED
VERSIONS OF OUR PRODUCTS; COST SAVINGS ARISING FROM OUR 2002 RESTRUCTURING; AND
LEGAL PROCEEDINGS AND LITIGATION MATTERS. YOU CAN IDENTIFY THESE AND OTHER
FORWARD-LOOKING STATEMENTS BY THE USE OF WORDS SUCH AS "MAY," "WILL," "SHOULD,"
"EXPECTS," "PLANS," "ANTICIPATES," "BELIEVES," "ESTIMATES," "PREDICTS,"
"INTENDS," "POTENTIAL," "CONTINUE" OR THE NEGATIVE OF SUCH TERMS, OR OTHER
COMPARABLE TERMINOLOGY. FORWARD-LOOKING STATEMENTS ALSO INCLUDE THE ASSUMPTIONS
UNDERLYING OR RELATING TO ANY OF THE FOREGOING STATEMENTS. OUR ACTUAL RESULTS
COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING
STATEMENTS AS A RESULT OF VARIOUS FACTORS, INCLUDING THOSE SET FORTH IN THIS
ANNUAL REPORT UNDER THE HEADING "RISK FACTORS." ALL FORWARD-LOOKING STATEMENTS
INCLUDED IN THIS DOCUMENT ARE BASED ON INFORMATION AVAILABLE TO US ON THE DATE
HEREOF. WE WILL NOT UNDERTAKE AND SPECIFICALLY DECLINE ANY OBLIGATION TO UPDATE
ANY FORWARD-LOOKING STATEMENTS.

PART I

ITEM 1. BUSINESS

OUR BUSINESS

We are a leading provider of software that allows users to incorporate
documents, images and speech into digital applications. Our products and
technologies automate manual processes and help enterprises, professionals and
consumers increase productivity, reduce costs and save time. Our products are
built upon digital capture and speech technologies, and are sold as solutions
into the financial, legal, healthcare, government, telecommunications and
automotive industries. Our digital capture technologies transform text and
images into digital form. Our speech technologies transform speech into text and
text into speech and permit voice control of applications. We focus on markets
where we can exercise market leadership, where significant barriers to entry
exist and where we possess competitive advantages, because of the strength of
our technologies, products, channels and business processes.

Our software is delivered as independent applications or as part of larger
integrated systems, such as systems for digital copiers on a network or customer
service call centers. Our digital capture solutions eliminate the need to
manually reproduce documents, automate the integration of documents into
business systems, and enable the use of electronic documents and forms within
XML, Internet, mobile and other business applications. Our speech solutions
automatically create documents from speech, transform text into synthesized
speech, and enable seamless interaction with hardware and software systems
simply by speaking. Our products and technologies deliver a measurable return on
investment to our customers.

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Our extensive technology assets, intellectual property and industry
expertise in digital capture and speech create high barriers to entry in markets
where we compete. Our technologies are based on complex mathematical formulas,
which require large amounts of linguistic and image data, acoustic models and
recognition techniques. A significant investment in capital and time would be
necessary to replicate our current capabilities, and we continue to build upon
our leadership position. Our digital capture technology is recognized as the
most accurate in the industry, with rates as high as 99.8%, and supports more
than 100 languages. Our speech technology has industry-leading recognition
accuracy, provides natural sounding synthesized speech in 19 languages, and
supports a broad range of hardware platforms and operating systems. Our
technologies are covered by more than 300 patents or patent applications.

We have established relationships with more than 2,000 resellers, including
leading system vendors, independent software vendors, value-added resellers and
distributors, through which we market and distribute our products and solutions.
In digital capture, companies such as Brother, Canon, Hewlett-Packard, Visioneer
and Xerox include our technology in digital copiers, printers and scanners, as
well as multifunction devices that combine these capabilities. In addition,
companies such as Corel, Kofax, Lockheed Martin, Microsoft and Symantec embed
our digital capture technology into their commercial software applications. In
speech, companies such as Cisco, Dictaphone, Lucent, GSL and Microsoft embed our
technologies into telecommunications systems, as well as automotive, PC or
multimedia applications. Each of these listed companies is one of our five
largest revenue producing OEM customers, in their respective category, for the
year ended December 31, 2002. We also maintain an extensive network of
value-added resellers to address the needs of specific markets, such as
financial, legal, healthcare and government. We sell our applications to
enterprises, professionals and consumers through major independent distributors
that deliver our products to computer superstores, consumer electronic stores,
mail order houses, office superstores and eCommerce Web sites.

We incorporated as Visioneer, Inc. in March 1992 and through December 1998
developed and sold scanner hardware and software products. On January 6, 1999,
Visioneer sold the hardware business and the Visioneer brand name to Primax
Electronics, Ltd., and on March 2, 1999, Visioneer acquired us, in a cash
election merger, from Xerox Corporation. The corporate entity "Visioneer"
survived the merger, but changed its name to "ScanSoft, Inc." In addition,
Visioneer changed the ticker symbol for its common stock that trades on the
Nasdaq National Market, to "SSFT." On March 13, 2000, we merged with Caere
Corporation, a California-based digital imaging software company. In December
2001, we acquired certain assets and intellectual property relating to the
former L&H entities that were in bankruptcy under the jurisdiction of both the
United States Bankruptcy Court for the District of Delaware and the Belgium
Court of Ieper and hired certain employees from those entities. Since 1997 and
through December 31, 2002, we made four significant business acquisitions and
acquired several key technologies for aggregate consideration totalling
approximately $233.6 million. On January 30, 2003 we made a fifth significant
acquisition, Royal Philips Electronics Speech Processing Telephony and Voice
Control business units, and related intellectual property, for aggregate
consideration of approximately $39.4 million.

Our focus on providing solutions that enable the capture and conversion of
information requires a broad set of technologies and channel capabilities. We
have made and expect to continue to make acquisitions of other companies,
businesses and technologies to complement our internal investments in these
areas. We have a small team that focuses on evaluating market needs and
potential acquisitions to fulfill them. In addition, we have a disciplined
methodology for integrating acquired companies and businesses after the
transaction is complete.

OUR MARKETS AND PRODUCTS

DIGITAL CAPTURE MARKET

Document and PDF Conversion. Despite the broad use of computing systems in
enterprises, the majority of business information is still maintained in paper
form. The proliferation of PDF as a digital document standard does not resolve
the problem of accessing and utilizing information trapped in a static form. In
addition, manually reproducing static documents in digital form is time
consuming, costly and subject to error, taking valuable resources away from more
productive activities. Enterprises and workgroups seek

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solutions that integrate paper and static PDF documents into their business
processes, allowing them to automate the way they store, edit, use and share
information.

Our solutions help businesses save time and money by automatically
converting paper documents and PDF files into editable and usable business
documents. Based on optical character recognition, our software delivers highly
accurate document and PDF conversion, replacing the need to manually re-create
documents. Our software preserves document formatting and provides editing
capabilities that re-create the complex components in a typical document,
including formatted text, columns, graphics, tables and spreadsheets. Our
products can be used with existing business applications and enable the
distribution and publishing of documents to email, Internet and mobile
applications using standard file formats, including XML, HTML, PDF and Open
eBook.

The proliferation of multifunction devices and digital copiers connected
over a network has increased the number of documents that individuals within an
enterprise are transforming into digital format. Our software solutions create a
more efficient method to process static documents in enterprise content
management and database systems, thereby enhancing the value of their
investments in these systems. All of these documents can then be more easily
archived, edited and combined within the enterprise.

Our solutions are used in professional office settings, particularly in the
government, legal, finance and education sectors. Our software is available in
11 languages. We utilize a combination of our global reseller network and direct
sales to distribute our document and PDF conversion products. We license our
software to companies such as Canon, Hewlett-Packard and Xerox, which bundle our
solutions with multifunction devices, digital copiers, printers and scanners.

We also license software development toolkits to independent software
vendors, integrators and in-house developers to add document and PDF conversion
capabilities to their applications. Our independent software vendor customers
include vendors, such as Microsoft and Symantec. Our technology is also used
within high-end enterprise systems from vendors such as Kofax and Lockheed
Martin.

Digital Paper Management. As the volume and complexity of corporate data
continues to multiply, organizations are increasingly challenged in their
efforts to manage all of their paper and digital documents. The wide dispersion
of documents makes finding complete and specific information even more
difficult, time-consuming and costly. As a result, businesses need solutions
that allow individuals, workgroups or the entire organization to more
efficiently organize, find and share business documents.

Our solutions convert paper into digital documents that can be easily
archived, retrieved and shared. Our software can be used in conjunction with
network scanning devices to preserve an image of a document exactly as it
appears on paper. Our software automatically indexes the scanned image, so that
it can be stored together with other digital documents on a desktop, over a
network or within an enterprise content management system. In a single search,
users can quickly find scanned documents and existing digital files that match
the search criteria.

Within enterprises, workgroups and distributed teams, our product also
facilitates the movement of scanned paper and digital documents into email,
print and other business applications. This streamlines the flow of documents
between workers, decreasing the time and costs associated with managing and
using paper documents. Our solution integrates with established file systems,
such as Oracle 9i Collaboration Suite, to simplify the transfer of documents
between desktop and enterprise content management systems.

Our solutions are used in enterprises and workgroups, especially those
within the legal, healthcare, financial, government, real estate and education
industries. Our software is available in eight languages. We utilize a
combination of our global reseller network and direct sales to distribute our
digital paper management products. We also license our software to companies
such as Brother, Hewlett-Packard, and Xerox, which bundle our solutions with
multifunction devices, digital copiers, printers and scanners.

Electronic Forms. Paper forms are expensive to print, store and
distribute. They must be physically circulated for approval and, when completed,
paper forms must be collected, verified and archived. Processing paper forms
adds to this expense by requiring the manual transfer of data on completed forms
into business

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applications. As a result, organizations seek solutions that implement online
alternatives to the use of paper forms in order to reduce costs and increase
operational efficiency.

Our products automatically convert paper forms into fillable electronic
forms that can be easily used by enterprises and other organizations. Our
products also convert static PDF and Microsoft Word forms into fillable
electronic forms using XML, HTML and PDF standards. Our solutions simplify the
design and creation of new forms that can be delivered electronically with the
same appearance as paper. Our products enable the access and distribution of
forms through the Web and email, and can be electronically routed, approved and
digitally signed. Our solution validates form information and automates data
collection by connecting electronic forms with standard database and back office
applications.

Our solutions are used in enterprises and workgroups, especially those
within the government, financial, public safety, education, legal, healthcare
and real estate industries. Our software is available in English, French and
German. We utilize a combination of our global reseller network and direct sales
to distribute our electronic forms products. Companies such as Hewlett-Packard
bundle our solutions with multifunction devices, digital copiers, printers and
scanners, and organizations such as the U.S. Internal Revenue Service and the
Law School Admission Council license our solutions.

The following table summarizes our digital capture products:

SPEECH MARKET

Speech Recognition and Dictation. Organizations demand solutions that
increase productivity by automating repetitive business processes, including the
creation of documents, data entry and completing forms. They also look for ways
to maximize the productivity of their existing workers, including those with
disabilities, and to comply with government requirements relating to workplace
safety and accessibility. Organizations also seek solutions that can reduce the
cost associated with manual transcription of professional documents. Since most
people can talk more quickly than they can type, speech is a natural way to
interact with computers to address these problems.

Our speech recognition and dictation solutions increase productivity in the
workplace by using speech to create documents, streamline repetitive and complex
tasks, input data, complete forms and automate manual transcription processes.
Our solutions allow users to automatically convert speech into text at up to 160
words-per-minute, much faster than most people can type. Our software supports a
vocabulary of more than 250,000 words that can be expanded by users to include
specialized words and phrases. Our software is designed to adapt to individual
voice patterns and accents and is highly accurate, able to achieve accuracy
rates of approximately 95%, with the ability to achieve still greater accuracy
with frequent use. Our software supports multiple languages, including Dutch,
French, German, Italian, Japanese, Spanish, Swedish, and U.S./U.K. English.

Our solutions are valuable within enterprises and workgroups for a number
of reasons. Our software can operate within a distributed network environment,
where speaker profiles can be stored on a server and accessed from any networked
computer. Our solutions also speech-enable existing business systems and
applications, including electronic records management systems and customer
service and billing applications. Our software allows a user to interact with a
computer without a keyboard or mouse, increasing the productivity of disabled
workers and those suffering from repetitive stress injury. Our solutions also
help government agencies address accessibility mandates, such as those described
in Section 508 of the U.S. Government Rehabilitation Act. We also deliver
versions of our products that are specialized for the medical, legal and public
safety vertical markets.

We offer a range of implementations, each with features that match a
specific customer target. Our solutions are also used in enterprises and
workgroups, particularly in the medical, legal, government, finance and
education sectors. Our software is available in eight languages. We utilize a
combination of our global reseller network and direct sales to distribute our
speech recognition and dictation products. We believe we gain a competitive
advantage through our established value-added reseller community, who provide
local sales, integration, training and support services to our professional
end-user community. We also license our software to companies such as Corel and
Panasonic, which bundle our solutions with some of their products.

Text-to-Speech. Organizations look for ways to reduce the costs associated
with serving their customers without sacrificing the quality of service that
they deliver. They also seek solutions that more effectively connect their
mobile workforce with real-time enterprise information, including customer data,
email and schedules, while at the same time reducing operating costs.
Text-to-speech technologies, which convert text into natural sounding
synthesized speech, are used to implement applications to achieve these goals.

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We have the market-leading text-to-speech solutions. Our solutions deliver
natural sounding results by using segments of real human speech, thereby
increasing listener satisfaction especially in the delivery of multiple phrases
and sentences. Our solutions provide a single, standardized interface that
supports the creation of speech-enabled applications in 19 languages, more than
any other vendor. Our products also support the rapid and cost-effective
implementation of customized voices for specific customers. Our solutions are
highly scalable, able to handle large call volumes, and are available on many
hardware platforms and operating systems.

Our solutions are used within a wide range of applications, including
reading emails for unified messaging systems, providing prompts for interactive
voice response applications and adding text-to-speech to mobile, game and
multimedia applications. Our technology is also used in voice portals that
deliver enhanced information services, such as sports scores, news and stock
quotes. Further, companies in the automobile industry use our product to deliver
in-vehicle speech-based information services, such as directions, traffic
information and email.

We license our text-to-speech products to systems integrators, technology
providers and telecommunications companies that in turn sell an integrated
solution to businesses and end-users. This indirect, or channel-based, method of
selling allows us to focus on technology advancement while avoiding the risks
and costs associated with implementing widely varying customer and end-user
applications. We license our text-to-speech solutions to developers of telephony
applications, including Cisco and Lucent, which integrate our solutions into
hardware and software platforms. In addition, our solutions are integrated into
automotive, mobile and multimedia applications, which require high quality
text-to-speech on small-footprint, embedded hardware systems.

Voice Control. Automatic speech recognition is a speaker-independent
technology that adds voice control capabilities to applications. This technology
identifies specific words and phrases at any moment in time, converting spoken
words into instructions that control functions within applications. Automobile
and mobile communications manufacturers and their suppliers are accelerating the
development of products that require enhanced voice control capabilities. In
addition, a growing number of independent software and hardware vendors are
incorporating voice control into multimedia applications.

Our voice control solutions are based upon automatic speech recognition
technologies that allow users to interact with devices simply by speaking. Our
solutions for automotive and mobile applications support a dynamic vocabulary of
up to 50,000 words and have sophisticated noise management capabilities that
ensure accuracy, even at high vehicle speeds. Our products scale to meet the
size and accuracy requirements for automotive and navigation systems and offer
rapid application development tools, extensive compatibility with hardware and
operating systems, and support for up to 13 languages. By scale, we mean that we
offer a variety of voice control solutions that are designed to meet the
individual vocabulary, operating system and memory requirements of different
applications and devices. We include toolkits with our engines that help
developers add our technologies to applications such as navigation systems,
hands-free cell phone devices and voice-activated controls in an automobile.

Our voice control solutions are embedded by tier-one, automobile, cell
phone and aftermarket system manufacturers, including Citroen, Clarion, Delphi,
Microsoft and Pioneer. By embedded, we mean our technologies are included as
part of a larger system, application or solution that is designed, manufactured
and sold by our partners. These partners include tier-one suppliers, companies
whose size and importance qualifies them to be direct suppliers to the major
automotive manufacturers, and in-dash radio, navigation system and other
electronic device manufacturers, also known as aftermarket systems providers. In
addition, Microsoft ships our product as the reference speech software
development toolkit for Windows CE for Automotive, and independent software
developers embed our speech recognition technologies into multimedia
applications.

On January 30, 2003, we completed the acquisition of the Philips Speech
Processing Telephony and Voice Control business units that have added several
speech recognition and voice control products to our business. The Telephony
business unit offers speech-enabled services including directory assistance,
interactive voice response and voice portal applications for enterprise
customers, telephony vendors and carriers. The Voice Control business unit
offers a product portfolio including small footprint speech recognition engines
for

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embedded applications such as voice-controlled climate, navigation and
entertainment features in automotive vehicles, as well as voice dialing for
mobile phones. In addition, the Philips automatic speech recognition solutions
complement our text-to-speech capabilities for telephony-based applications.

AudioMining. Our AudioMining products are based on our speech recognition
and dictation solutions and are used to automatically create index information
for words spoken in audio and video content. Our products allow users to search
for specific audio and video content using standard text queries. Our solutions
not only present matched audio and video files, but also provide random access
to precise match locations within each audio and video file. Our solutions can
also be used to time-align existing transcripts with video clips, automating the
creation of captions. Our AudioMining solutions provide efficient access to the
information currently hidden within media files and reduce the cost associated
with creating captioned video. AudioMining is used within call center and
security applications to facilitate the retrieval of specific recorded
conversations based on the identification of key words and phrases. AudioMining
is also used by content providers to enable text queries for specific Web-based
media content, such as news, financial analyst reports, sports and talk radio.

The following table summarizes our speech-related products:

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OUR COMPETITIVE STRENGTHS

Core Technology Assets. In recent years, we have developed and acquired
extensive technology assets, intellectual property and industry expertise in
digital capture and speech. Our technologies are based on complex mathematical
formulas, which require extensive linguistic and image data, acoustic models and
recognition techniques. A significant investment in capital and time would be
necessary to replicate our current capabilities. We continue to invest in the
advancement of our technologies to maintain our market leading position and to
develop new applications. As of December 31, 2002 we had 250 full-time employees
in research and development, and our technologies are covered by more than 300
patents or patent applications. Additionally, in connection with the Philips
acquisition we hired approximately 116 employees and acquired 132 patents and
189 pending patent applications in speech. We also received licenses to
additional speech patents retained by Philips.

Broad Distribution Channels. We have established relationships with more
than 2,000 resellers, including leading system vendors, independent software
vendors and distributors. We maintain an extensive network of value-added
resellers to address the needs of specific markets, such as financial, legal,
healthcare and government. We believe that our extensive channel relationships
increase the difficulty for competitors to develop a similar channel network and
makes it difficult for our products to be displaced. In addition, our channel
network enables us to introduce new products quickly and effectively into the
global marketplace.

Leading Market Share. We have a strong market position in each of our
product categories and are the market leader in document and PDF conversion,
speech recognition and dictation, and text-to-speech. Approximately 79% of our
revenue for the year ended December 31, 2002 was derived from markets where we
are the established leader. Organizations tend to look to established market
leading vendors when making product selections. As the established brand in our
markets, we believe we can target and win more partnership arrangements and new
customers than our competition.

International Focus. The broad language coverage within our products
increases the likelihood that we will be a selected technology provider to
vendors selling globally. Our language coverage is difficult for competitors to
duplicate, and our presence in global markets limits the potential entry of new
regional competitors. With nearly one half of our staff located outside of North
America, we are able to efficiently compete on a global basis.

Multiple End Markets. We sell to a range of end markets and maintain a
tiered distribution model that provides a diversified revenue stream and broad
market exposure. We are not dependent on any single market segment or set of end
customers and earn revenue from both established and emerging markets.

OUR STRATEGY

Expand Digital Capture Solutions. We intend to enhance the value of our
digital capture solutions for enterprises to address the expanded use of content
management systems, the proliferation of PDF and the widespread adoption of
networked multifunction and digital scanning devices. We expect to introduce new
products or new versions of existing products to take advantage of these growth
opportunities. We also plan to enhance our software development toolkits so our
technologies can be integrated with more third-party solutions. We expect to
maintain product development and delivery cycles that range from 12 to 18 months
for each of our digital capture products and applications.

Pursue High Growth Markets In Speech. We intend to leverage our
technologies and market leadership in speech to expand our opportunities in the
automotive, healthcare, telecommunications, telematic and mobile markets. We
also intend to pursue emerging opportunities to use our speech technology within
consumer devices, games and other embedded applications. To expand our position,
we have introduced new versions of our products that are designed for specific
markets; completed new license agreements with customers and partners that will
resell our technologies; and completed the acquisition of Philips Speech
Processing Telephony and Voice Control business units that we believe complement
our existing solutions and resources in the telecommunications, automotive and
electronics markets.

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Grow Market Share. We intend to increase our market share in each of our
product categories. In particular, we intend to expand and add features and
functions to our products to make our solutions more useful to and useable by a
larger customer base. In addition, we intend to aggressively pursue sales and
partnership opportunities to build on our leading positions in the
text-to-speech and speech recognition markets, and to capture additional market
share and increase the penetration of our products.

Expand Worldwide Channels. We intend to expand our global channel network
and build upon our existing distribution channels, especially in Europe, Asia
and Latin America. In particular, we intend to replicate our successful North
American value-added reseller channel in Europe. Along these lines, we have
added sales employees in different geographic regions and launched programs and
events to help recruit new partners for our channel network.

Capitalize on Government Initiatives. We intend to market our products
aggressively in North America and abroad to capitalize on legislative mandates
and government initiatives to put government processes online, to enhance
opportunities for workers with disabilities and to promote public safety.

Pursue Strategic Acquisitions. We have selectively pursued strategic
acquisitions. For example, during the last year we completed the L&H acquisition
and completed the Philips acquisition. We intend to continue to pursue strategic
acquisitions as a part of our growth strategy.

SALES, DISTRIBUTION AND FULFILLMENT

We have established relationships with more than 2,000 channel partners,
including leading system vendors, independent software vendors, value-added
resellers and distributors, through which we market and distribute our products
and solutions. In digital capture, companies such as Brother, Canon,
Hewlett-Packard, Visioneer and Xerox include our technology in digital copiers,
printers and scanners, as well as multifunction devices that combine these
capabilities. In addition, companies such as Corel, Kofax, Lockheed Martin,
Microsoft and Symantec embed our digital capture technology into their
commercial software applications. In speech, companies such as Cisco,
Dictaphone, Lucent, Matsushita and Microsoft embed our technologies into
telecommunications systems, as well as automotive, PC or multimedia
applications.

We also maintain an extensive network of value-added resellers to address
the needs of specific markets, such as financial, legal, healthcare and
government. We sell our applications to enterprises, professionals and consumers
through distribution and fulfillment partners, including 1450, Ingram Micro,
Tech Data and Digital River. These distribution and fulfillment partners provide
our products to computer superstores, consumer electronic stores, eCommerce Web
sites, mail order houses and office superstores, such as Amazon.com, Best Buy,
CDW, MicroWarehouse, Circuit City, CompUSA, Fry's Electronics, Office Depot, PC
Connection and Staples. We also maintain an extensive network of value added
resellers to address the needs of specific markets such as medical, legal and
public safety. We also sell products through our Web site at www.ScanSoft.com.

Most of our software products are manufactured, packaged and shipped by
GlobalWare Solutions on a worldwide basis. However, we regularly investigate
alternative manufacturing and fulfillment vendors, and we believe that, if
necessary, we could transition the services provided by GlobalWare solutions to
another third party provider without material disruption to our operations.

As of December 31, 2002, we employed 122 full-time sales and marketing
employees in offices worldwide.

PROPRIETARY TECHNOLOGY

We exploit our proprietary technology, trade secrets, know-how, continuing
technological innovations and licensing opportunities to maintain our
competitive position. We rely on patent law, copyright law, trade secret laws,
secrecy, technical measures, licensee agreements and non-disclosure agreements
to protect our technology, trade secrets and other proprietary rights. Our
policy is to file patent applications to protect technology, inventions and
improvements that are important to the development of our business, to maintain
a technological advantage over our competitors and to generate licensing
revenue. In this regard, we have

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obtained patents that directly relate to our products. Furthermore, we obtained
in the L&H acquisition 131 patents and 165 pending patent applications in
speech. Our digital capture and speech technologies are covered by more than 300
patents or patent applications. These patents expire on various dates between
2005 and 2016.

In connection with the Philips acquisition we acquired 132 patents and 189
pending patent applications in speech. We also received licenses to additional
speech patents retained by Philips.

In order to protect our ownership rights in our software products, we
license our products to OEMs and resellers on a non-exclusive basis with
contractual restrictions on reproduction, distribution and transferability. In
addition, we generally license our software in object code form only. We license
certain of our software products to end-users by use of a "shrink-wrap" or
"click wrap" customer license that restricts the end-user to personal use of the
product.

We require our employees to execute confidentiality and invention
assignment agreements in order to protect our proprietary technology and other
proprietary rights. We also rely on trade secrets and proprietary know-how.

RESEARCH AND DEVELOPMENT

The market for our products and services is characterized by rapid
technological change, frequent new product introductions and enhancements,
evolving industry standards, and rapidly changing client requirements. As a
result, we believe that our future growth is highly dependent on the timely and
efficient introduction of new and updated products and technology. As of
December 31, 2002, we employed 250 people in research and development, slightly
over half of whom are located in international locations. Our employees based in
overseas facilities extend our global focus while often lowering our overall
cost of research and development. To promote efficiency in our research and
development efforts, we have organized the effective use of global development
teams and a comprehensively integrated development process. In addition, we have
developed and refined our time-to-market process, which contributes to
cost-effective resource management while promoting technology sharing across
programs.

Our future success will depend in part on our ability to anticipate
changes, enhance our current products, develop and introduce new products that
keep pace with technological advancements and address the increasingly
sophisticated needs of our clients. Our research and development expenses for
the years ending December 31, 2002, 2001 and 2000 were $27.6 million, $14.0
million and $15.0 million, respectively. We expect that we will continue to
commit significant resources to research and development in the future. All
research and development expenses have been expensed as incurred.

INTERNATIONAL OPERATIONS

We currently have offices in a number of international locations including:
Australia, Belgium, Denmark, England, France, Germany, Hong Kong, Hungary,
Italy, Japan, the Netherlands, Poland, and Taiwan. The scope of our
international operations includes research and development, customer support and
sales and marketing. Our international research and development is conducted in
Budapest, Hungary; Merelbeke, Belgium and Aachen, Germany. Additionally sales
and support offices are located throughout the world to support our current
international customers and to expand our international revenue opportunities.

Geographic revenue classification is based on the country in which the sale
is invoiced. Revenue for the year ended December 31, 2002 was 73% North America
and 27% international, versus 79% North America and 21% international for the
comparable period in 2001.

A number of our OEM partners distribute their products throughout the world
and do not provide us with the geographical dispersion of their products. We
believe that if provided with this information, our geographical revenue
classification would indicate a higher international percentage. Based on an
estimate that factors our OEM partners' geographical revenue mix to our revenues
generated from these OEM partners, revenue for the year ended December 31, 2002,
is approximately 67% North America and 33% international, compared to 70% North
America and 30% international for the comparable period in 2001.

10

COMPETITION

There are a number of companies that develop or may develop products that
compete in our targeted markets; however, there is no one company that competes
with us in all of our product areas. The individual markets in which we compete
are highly competitive, and are rapidly changing. Within digital capture, we
compete directly with ABBYY, I.R.I.S. and NewSoft. Within speech, we compete
with AT&T, IBM, Nuance Communications and SpeechWorks International. Vendors
such as Adobe and Microsoft offer solutions that can be considered alternatives
to some of our solutions. In addition, a number of smaller companies produce
technologies or products that are in some markets competitive with our
solutions. Current and potential competitors have established, or may establish,
cooperative relationships among themselves or with third parties to increase the
ability of their technologies to address the needs of our prospective customers.

Some of our competitors or potential competitors in our markets have
significantly greater financial, technical and marketing resources than we do.
These competitors may be able to respond more rapidly than we can to new or
emerging technologies or changes in customer requirements. They may also devote
greater resources to the development, promotion and sale of their products than
we do.

EMPLOYEES

As of December 31, 2002 we employed 489 people on a full-time basis, 261 in
the United States and 228 internationally. Of the total, 250 were in product
research and development, 122 in sales and marketing, 72 in operations and
support, and 45 in finance and administration. Of these employees 223 were hired
in connection with the L&H acquisition completed in December 2001. None of our
employees are subject to collective bargaining agreements. We have experienced
no work stoppages and believe that our employee relations are good. We have
utilized the services of consultants, third-party developers, and other vendors
in our sales, development, and manufacturing activities.

Upon the closing of the Philips acquisition on January 30, 2003, we hired
116 employees. Of the total employees hired, 88 were in product research and
development, 24 in sales and marketing and 4 in operations and support.

AVAILABLE INFORMATION

Our reports filed with Securities and Exchange Commission, including our
Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on
Form 8-K and amendments to reports filed pursuant to Sections 13(a) and 15(d) of
the Securities Exchange Act of 1934, as amended, are available on our website at
www.scansoft.com, when such reports are available on the Securities and Exchange
Commission website.

ITEM 2. PROPERTIES

Our principal administrative, sales, marketing and support functions along
with our North American imaging research and development functions occupy 45,860
square feet of space that we lease in Peabody, Massachusetts. We also lease
26,568 square feet of space in Waltham, Massachusetts where our North American
speech and language research and development is performed. These leases expire
in July 2006 and September 2006, respectively. Additionally, we lease
approximately 21,180 square feet of research and development space located in
Budapest, Hungary and 20,085 square feet in Merelbeke, Belgium, which houses our
research and development and international headquarters space. These leases
expire in December 2006 and April 2008, respectively. In connection with the
Philips acquisition, we assumed a lease for approximately 39,000 square feet of
research and development space located in Aachen, Germany. This lease expires in
March 2006. We also lease a number of small sales and marketing offices in Asia
and Europe, including offices located in Amsterdam, the Netherlands; Hong Kong,
China; Taipei, Taiwan; Milan, Italy; Munich, Germany; Goteborg, Sweden; Paris,
France; Reading, England; Budapest, Hungary; and Tokyo, Japan.

We believe that our existing facilities are adequate for our needs for at
least the next twelve months.

11

ITEM 3. LEGAL PROCEEDINGS

Like many companies in the software industry, we have from time to time
been notified of claims that we may be infringing the intellectual property
rights of others. These claims have been referred to legal counsel, and they are
in various stages of evaluation and negotiation. In addition, the following
claims are in litigation:

On November 27, 2002, AllVoice Computing plc filed an action against us in
the United States District Court for the Southern District of Texas claiming
patent infringement. In the lawsuit, AllVoice alleges that we are infringing
United States Patent No. 5,799,273 entitled "Automated Proofreading Using
Interface Linking Recognized Words to Their Audio Data While Text Is Being
Changed" (the "'273 Patent"). The '273 Patent generally discloses techniques for
manipulating audio data associated with text generated by a speech recognition
engine. Although we have several products in the speech recognition technology
field, we believe that our products do not infringe the '273 Patent because they
do not use the claimed techniques. We believe this claim has no merit, and we
intend to defend the action vigorously.

In December 2001, the Massachusetts Institute of Technology and Electronics
For Imaging, Inc. sued us in the United States District Court for the Eastern
District of Texas for patent infringement. The patent infringement claim was
filed against more than 200 defendants. In their lawsuit, MIT and EFI allege
that we infringe United States Patent No. 4,500,919 entitled "Color Reproduction
System" (the "'919 Patent"). MIT and EFI allege that the '919 Patent discloses a
system for adjusting the colors of a scanned image on a television screen and
outputting the modified image to a device. We have several products that permit
a user to adjust the color of an image on a computer monitor. We have asserted
that our products do not infringe the '919 Patent because our products do not
contain all elements of the structure required by the claimed invention and
because our products do not perform all of the steps required by the claimed
method. Further, we believe there may be prior art that would render the '919
Patent invalid. The '919 Patent expired on May 6, 2002. Damages are sought in an
unspecified amount. We filed an Answer and Counterclaim on July 1, 2002. For the
reasons described here, we believe this claim has no merit, and we intend to
defend the action vigorously.

On August 16, 2001, Horst Froessl sued us in the United States District
Court for the Northern District of California for patent infringement. In his
lawsuit, Froessl alleges that we infringe United States Patent No. 4,553,261
entitled "Document and Data Handling and Retrieval System" (the "'261 Patent").
Froessl alleges that the '261 Patent discloses a system for receiving and
optically scanning documents, converting selected segments of the digitalized
scan data into machine code, and storing and retrieving the documents and the
digitalized and converted segments. Although we have several products in the
scanning technology field, we have asserted that our products do not infringe
the '261 Patent because our products do not contain all elements of the
structure required by the claimed invention and because our products do not
perform all of the steps required by the claimed method. Further, we believe
there may be prior art that would render the '261 Patent invalid. Damages are
sought in an unspecified amount. We filed an Answer and Counterclaim on
September 19, 2001. For the reasons described here, we believe this claim has no
merit, and we intend to defend the action vigorously.

We believe that the final outcome of these matters will not have a
significant adverse effect on our financial position and results of operations,
and we believe we will not be required to expend a significant amount of
resources defending such claims. However, should we not prevail in any such
litigation, our operating results and financial position could be adversely
impacted.

From time to time, we receive information concerning possible infringement
by third parties of our intellectual property rights, whether developed,
purchased or licensed by us. In response to any such circumstance, we have our
counsel investigate the matter thoroughly and we take all appropriate action to
defend our rights in these matters.

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

None.

12

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

MARKET FOR COMMON STOCK

Our common stock commenced trading on the Nasdaq National Market on
December 11, 1995 under the symbol "VSNR," and traded under that symbol until
March 3, 1999. Our common stock is now traded under the symbol "SSFT." As of
December 31, 2002, there were outstanding 63,422,776 shares of common stock held
by 566 stockholders of record. The following table sets forth for the periods
indicated the high and low sale prices for our common stock as reported on the
Nasdaq National Market.

The equity compensation plan information included in Part III, Item 12 of
this Form 10-K is hereby incorporated by reference into this Part II, Item 5.

On March 17, 2003, the last reported sale price of our common stock on the
Nasdaq National Market was $4.50 per share.

DIVIDEND POLICY

We have never declared or paid any cash dividends on our capital stock. We
currently expect to retain future earnings, if any, to finance the growth and
development of our business and do not anticipate paying any cash dividends in
the foreseeable future.

Our loan and security agreement with Silicon Valley Bank, dated October 31,
2002, contains a restrictive covenant which prohibits us from paying or
declaring any dividends on our capital stock during the term of the agreement
(except for dividends payable solely in capital stock) without Silicon Valley
Bank's prior written consent. In addition, the zero coupon convertible
subordinated debenture due in 2006 that was issued to Koninklijke Royal Philips
Electronics N.V. ("Philips") in connection with our acquisition of the Speech
Processing Telephony and Voice Control business units of Philips contains a
restrictive covenant which prohibits us from paying or declaring any dividend or
distribution (other than distributions of our equity securities) on our capital
stock while the note is outstanding. This restriction terminates if one half or
more of the note is converted by Philips into common stock.

13

RECENT SALES OF UNREGISTERED SECURITIES

During the last year and since December 31, 2002, we have issued
unregistered securities to a limited number of persons, as described below. None
of these transactions involved any underwriters, underwriting discounts or
commissions, or any public offering, and we believe that each transaction was
exempt from the registration requirements of the Securities Act of 1933, as
amended (the "Securities Act") by virtue of Section 4(2) thereof. The recipients
of securities in each such transaction represented their intention to acquire
the securities for investment purposes only and not with a view to or for sale
in connection with any distribution thereof, and appropriate legends were
affixed to the share certificates and instruments issued in such transactions.
All recipients had adequate access, through their relationships with us, to
information about us.

(a) On March 21, 2002, in connection with the acquisition of the
AudioMining assets of L&H Holdings USA, Inc. ("L&H Holdings"), L&H Holdings was
issued 121,359 shares of our common stock. We relied upon Section 4(2) of the
Securities Act in connection with issuance of these shares, and appropriate
legends were affixed to the share certificates issued in the transaction. L&H
Holdings represented its intention to acquire the securities for investment
purposes only and not with a view to or for sale in connection with any
distribution thereof.

(b) On April 12, 2002, we sold SF Capital Partners Ltd. ("SF Capital")
1,000,000 shares of our common stock, at a price of $6.00 per share. We relied
upon Section 4(2) of the Securities Act in connection with the issuance of these
shares on the basis that the transaction did not involve a public offering, and
appropriate legends were affixed to the share certificates issued in the
transaction. SF Capital represented its intention to acquire the securities for
investment purposes only and not with a view to or for sale in connection with
any distribution thereof, and that it is an "accredited investor" as that term
is defined in Rule 501 under the Securities Act.

(c) On January 30, 2003, we issued to Philips a $27.5 million three-year,
zero-interest convertible subordinated debenture. This debenture is convertible
into shares of our common stock at any time at the option of Philips at a
conversion price of $6.00 per share. We relied upon Section 4(2) of the
Securities Act in connection with the issuance of these securities, and
appropriate legends were placed on such securities. Philips represented its
intention to acquire the securities for investment purposes only and not with a
view to or for sale in connection with any distribution thereof.

ITEM 6. SELECTED FINANCIAL DATA

The following selected consolidated financial data is not necessarily
indicative of the results of future operations and should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and our consolidated financial statements and related notes included
elsewhere in this Annual Report on Form 10-K.

The statement of operations data for the years ended December 31, 2002,
2001 and 2000 and the balance sheet data as of December 31, 2002 and 2001 have
been derived from our consolidated financial statements included elsewhere in
this Annual Report on Form 10-K. The statement of operations data for the years
ended December 31, 1999 and 1998 have been derived from our consolidated
financial statements which are not included elsewhere in this Annual Report on
Form 10-K.

On March 2, 1999, we acquired ScanSoft, Inc., an indirect wholly-owned
subsidiary of Xerox Corporation. On June 30, 1999, we acquired certain assets
and liabilities of MetaCreations Corporation. On March 13, 2000, we acquired
Caere. On December 12, 2001, we acquired substantially all of the speech and
language technology operations of L&H. These acquisitions were each accounted
for under the purchase method of accounting. Accordingly, the results of
operations from the ScanSoft, MetaCreations, Caere and L&H acquisitions are
included in our results of operations from the applicable acquisition dates.

Through December 1998, we developed and sold scanner hardware and software
products. On January 6, 1999, we sold our hardware business. Accordingly, the
results of the hardware business are included in our results of operations
through the date of disposal.

14

SCANSOFT, INC.

SELECTED FINANCIAL DATA

- ---------------

(1) See Notes 4 and 5 to Notes to Consolidated Financial Statements.

(2) See Note 8 to Notes to Consolidated Financial Statements.

(3) See Note 18 to Notes to Consolidated Financial Statements.

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

THE FOLLOWING DISCUSSION OF OUR FINANCIAL CONDITION AND RESULTS OF
OPERATIONS SHOULD BE READ IN CONJUNCTION WITH OUR CONSOLIDATED FINANCIAL
STATEMENTS AND RELATED NOTES THERETO INCLUDED ELSEWHERE IN THIS ANNUAL REPORT.
THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS, WHICH INVOLVE RISKS AND
UNCERTAINTIES. OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED
IN THESE FORWARD-LOOKING STATEMENTS FOR MANY REASONS, INCLUDING THE RISKS
DESCRIBED IN "RISK FACTORS" STARTING ON PAGE 30 AND ELSEWHERE IN THIS ANNUAL
REPORT.

OVERVIEW

We are a leading provider of software that allows users to incorporate
documents, images and speech into digital applications. Our products and
technologies automate manual processes and help enterprises, professionals and
consumers increase productivity, reduce costs and save time. Our products are
built upon digital capture and speech technologies, and are sold as solutions
into the financial, legal, healthcare, government, telecommunications and
automotive industries. We focus on markets where we can exercise market
leadership, where significant barriers to entry exist and where we possess
competitive advantages, because of the strength of our technologies, products,
channels and business processes.

On December 12, 2001, we acquired substantially all of the speech and
language technologies operations of L&H. Consideration for the transaction
comprised $10.0 million in cash, a $3.5 million note that was satisfied on
January 3, 2003 and 7.4 million shares of our common stock having a value of
$27.8 million. The operations acquired include speech recognition and dictation,
text-to-speech, and voice control technologies.

As of October 31, 2002, we entered into a loan and security agreement with
Silicon Valley Bank for a revolving loan in a principal amount not to exceed
$10.0 million, collateralized by substantially all of our personal property, but
not our intellectual property. At the date of this Annual Report on Form 10-K,
no amounts have been drawn under the terms of this agreement.

In September of 2002, the Company repurchased 1,461,378 shares of common
stock from L&H Holdings USA, Inc. and Lernout & Hauspie Speech Products N.V.
(collectively, L&H) and certain other parties at $4.79 per share for a total
consideration of $7.0 million. The price per share was based on the greater of
$4.79 or the twenty day trading average beginning August 14, 2002, which was
$4.67. These shares represented a portion of the common shares that were issued
to L&H in connection with the December 12, 2001 acquisition of certain of L&H's
speech and language technology operations and the March 21, 2002 acquisition of
the AudioMining assets of L&H Holdings USA, Inc.

On January 3, 2003, we paid $3.3 million in full settlement of all
principal and accrued interest on the promissory note issued in connection with
the L&H acquisition on December 12, 2001. Additionally, on December 18, 2002, we
issued 81,900 and 68,100 shares of our common stock to Lernout & Hauspie Speech
Products N.V. and L&H Holdings USA, Inc., respectively. These shares were issued
in accordance with the terms and conditions of the share repurchase agreement
entered into with L&H in September 2002.

On January 30, 2003, we completed the acquisition of the Speech Processing
Telephony and Voice Control business units of Royal Philips Electronics N.V.
("Philips"), and related intellectual property, on the terms set forth in the
purchase agreement dated October 7, 2002, as amended. The Telephony business
unit offers speech-enabled services including directory assistance, interactive
voice response and voice portal applications for enterprise customers, telephony
vendors and carriers. The Voice Control business unit offers a product portfolio
including small footprint speech recognition engines for embedded applications
such as voice-controlled climate, navigation and entertainment features in
automotive vehicles, as well as voice dialing for mobile phones. As
consideration for these business units and intellectual property, we paid 3.1
million euros ($3.4 million) in cash at closing, subject to adjustment in
accordance with the provisions of the purchase agreement, as amended, and agreed
to pay an additional 1.0 million euros in cash prior to December 31, 2003,
issued a 5.0 million euro note due December 31, 2003 and bearing 5.0% interest
per annum and issued a $27.5 million three-year, zero-interest subordinated
debenture, convertible at any time at Philips' option into shares of our common
stock at $6.00 per share. We anticipate that all related adjustments will be
completed

16

no later than December 31, 2003. The technology acquired includes several speech
recognition and voice control products. In conjunction with the acquisition, the
business operations were significantly restructured which has caused disruption
in the employee and customer base. The Philips operations had consisted of
approximately 250 employees of which we only hired 116. Based on our prior
acquisition experience, we expect revenue and earnings to be weighted toward the
second half of the year as we complete the integration of our sales team and
re-engage Philip customers, partners and channels. Additionally, as we complete
the Philips integration process, we expect to incur a restructuring charge of
$0.5 million to $1.0 million in the first quarter ended March 31, 2003.

On February 14, 2003, the Company completed an underwritten public offering
of 7,184,406 shares of the Company's common stock at $3.80 per share. Of the
total shares sold, 6,184,406 shares were sold on behalf of Lernout & Hauspie
Speech Products N.V., and L&H Holdings USA, Inc. The Company sold 1,000,000
common shares and received gross proceeds of $3.8 million. After considering
offering costs, the estimated net proceeds amounted to approximately $2.1
million.

On March 12, 2003, the Company received $3.8 million of net proceeds from
the exercise of the over allotment option of 1,072,500 shares granted to the
underwriters as part of the underwritten offering.

RESULTS OF OPERATIONS

The following table presents, as a percentage of total revenue, certain
selected financial data for each of the three years in the period ended December
31:

- ---------------
(1) See Notes 4 and 5 of Notes to Consolidated Financial Statements.

(2) See Note 8 of Notes to Consolidated Financial Statements.

(3) See Note 18 of Notes to Consolidated Financial Statements.

GENERAL

We derive our revenue from sales of our software products to customers
through distribution partners and value-added resellers, royalty revenues from
OEM partners, license fees from sales of our products to customers and from
services, primarily maintenance associated with software license transactions.

17

Cost of revenue consists primarily of material and fulfillment costs,
third-party royalties, salaries for product support personnel, and engineering
costs associated with certain contracts which are accounted for under the
percentage-of-completion method of accounting. Currently, most of our software
products are manufactured, packaged and shipped by GlobalWare Solutions on a
worldwide basis. We believe that, if necessary, we could transition the services
provided by GlobalWare to another third party provider with minimal disruption
to our operations.

Cost of revenue from amortization of intangible assets includes the
amortization of acquired patents and core and completed technology.

Research and development expense consists primarily of salary and benefits
costs of engineers. We believe that the development of new products and the
enhancement of existing products are essential to our success. Accordingly, we
plan to continue to invest in research and development activities. To date, we
have not capitalized any internal development costs as the cost incurred after
technological feasibility but before release of product has not been
significant.

Selling expenses include salaries, commissions, advertising, direct mail,
public relations, trade shows, travel and other related sales and marketing
expenses. General and administrative expenses include personnel costs for
administration, finance, human resources, information systems and general
management, in addition to legal and accounting expenses and other professional
services. We attempt to control selling, general and administrative expense;
however, if revenue continues to grow, we expect selling, general and
administrative expense to increase to support our growing operations. In
addition, we may increase selling, general and administrative expenses in
advance of revenue to support expected future revenue growth in specific product
lines or geographic regions.

Amortization of goodwill and other intangible assets excludes amortization
of acquired patents and core and completed technology which is included in cost
of revenue from amortization of intangible assets.

CRITICAL ACCOUNTING POLICIES

GENERAL

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities at the dates of the financial
statements and the reported amounts of revenue and expenses during the reporting
periods. On an ongoing basis, we evaluate our estimates and judgments, including
those related to revenue recognition, including estimating valuation allowances
(specifically sales returns and other allowances); the recoverability of
intangible assets, including goodwill; and valuation allowances for deferred tax
assets. Actual amounts could differ significantly from these estimates. We base
our estimates and judgments on historical experience and various other factors
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities and the amounts of revenue and expenses that are not readily
apparent from other sources.

We believe the following critical accounting policies most significantly
affect the portrayal of our financial condition and results of operations and
require our most difficult and subjective judgments.

REVENUE RECOGNITION

We derive revenue from the sale of our software products to end-users
through distribution partners and value added resellers (VARs), royalties
received from OEM partners, license fees from sales of our products to end-users
and from services, primarily maintenance associated with software license
transactions. Provided that the fee is fixed or determinable and collection of
the receivable is reasonably assured, we generally recognize revenue from sales
of our software products upon receipt of evidence of the arrangement and upon
product shipment or deployment, except for shipments to a distributor or
reseller.

18

Sales of our software products through distributors and value-added
resellers provide rights of return for as long as the distributors or resellers
hold the inventory. As a result, we recognize revenues from sales to
distributors and resellers only when products have been sold by the distributors
or resellers to retailers or end-users. Title and risk of loss pass to the
distributor or reseller upon shipment, at which time the transaction is invoiced
and payment is due. Based on reports from distributors and resellers of their
inventory balances at the end of each period, we record an allowance against
accounts receivable for the sales price of all inventory subject to return. If
we experience significant returns from distributors or resellers, our liquidity
may be adversely impacted. We make an estimate of sales returns by retailers or
end users to us directly or through our distributors or resellers based on
historical returns experience. The provision for these estimated returns is
recorded as a reduction of revenue at the time that the related revenue is
recorded. Historically, we have not experienced significant returns from
retailers or end-users. If actual returns differ significantly from our
estimates, such differences could have a material impact on our results of
operations for the period in which the actual returns become known. Our accounts
receivable balance, including accounts receivable from a related party, was
$17.2 million and $14.3 million at December 31, 2002 and December 31, 2001,
respectively. These balances are net of sales returns and other allowances of
$5.4 million and $5.5 million and allowances for doubtful accounts of $0.5
million and $0.8 million as of December 31, 2002 and December 31, 2001,
respectively.

Royalty revenue derived from sales to OEM customers is recognized when
software copies are deployed based upon reports of actual deployments received
from OEM customers and payment is due.

We may enter into software license agreements that require significant
modification of our software. We recognize revenue with respect to these
agreements under the percentage-of-completion method. We determine progress
toward completion based upon costs incurred to date as compared with total
estimated costs at the contract completion date. If our total costs
significantly differ from our estimates, or we incur losses on these contracts,
our results of operations may be materially impacted. We did not have any
significant contracts requiring customization or modification of our software at
December 31, 2002.

In accordance with EITF 01-9, Accounting for Consideration Given by a
Vendor to a Customer (Including a Reseller of the Vendor's Products), we account
for amounts paid to customers as a reduction of revenue, unless the
consideration relates to an identifiable benefit and the benefit's fair value
can be established, in which case we record the consideration as an operating
expense. In order to determine the appropriate classification of the marketing
program costs, we review the nature of the program, the documentation supporting
the fair value of the program, and whether the programs could be provided
independent of the sale of the goods and services. We evaluate our marketing
programs quarterly to determine whether costs meet the criteria for expense
classification. Generally, our programs meet the criteria, therefore, we do not
report any material costs as a reduction of revenue. If in the future, the
nature of our marketing programs change or could not be provided independent of
the sale of the related goods or services it may require reclassification of
these programs in our statement of operations.

VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL

We have significant long-lived tangible and intangible assets and goodwill,
which are susceptible to valuation adjustments as a result of changes in various
factors or conditions. The most significant long-lived tangible and intangible
assets are fixed assets, patents, core technology, and trademarks which are
amortized using the straight-line method over their estimated useful lives. The
values of intangible assets, with the exception of goodwill, were initially
determined by a risk-adjusted, discounted cash flow approach. We assess the
potential impairment of identifiable intangible assets and fixed assets whenever
events or changes in circumstances indicate that the carrying value may not be
recoverable. Factors we consider important, which could trigger an impairment of
such assets, include the following:

- Significant underperformance relative to historical or projected future
operating results;

- Significant changes in the manner of or use of the acquired assets or the
strategy for our overall business;

19

- Significant negative industry or economic trends;

- Significant decline in our stock price for a sustained period; and

- A decline in our market capitalization below net book value.

Future adverse changes in these or other unforeseeable factors could result
in an impairment charge that would impact future results of operations and
financial position in the reporting period identified.

Effective January 1, 2002, we adopted Statement of Financial Accounting
Standards No. 142, Goodwill and Other Intangible Assets or SFAS 142. SFAS 142
requires, among other things, the discontinuance of goodwill amortization. The
standard also includes provisions for the reassessment of the useful lives of
existing recognized intangible assets and the identification of reporting units
for purposes of assessing potential future impairments of goodwill. SFAS 142
required us to complete a transitional impairment test of goodwill within six
months of the date of adoption. We have reassessed the useful lives of our
existing intangible assets, other than goodwill, and believe that the original
useful lives remain appropriate. In addition, we have determined that we operate
in one reporting unit and, therefore, have completed our transitional goodwill
impairment test on an enterprise-wide level. Based on this analysis, we have
determined that goodwill recorded was not impaired, and no impairment charge has
been recorded. We will complete additional goodwill impairment analyses at least
annually, or more frequently when events and circumstances occur indicating that
the recorded goodwill might be impaired. We performed the annual assessment
during the fourth quarter of 2002 and no impact had occurred.

Significant judgments and estimates are involved in determining the useful
lives of our intangible assets, determining what reporting units exist and
assessing when events or circumstances would require an interim impairment
analysis of goodwill or other long-lived assets to be performed. Changes in
events or circumstances, including but not limited to technological advances or
competition which could result in shorter useful lives, additional reporting
units which may require alternative methods of estimating fair value, or
economic or market conditions which may affect previous assumptions and
estimates, could have a significant impact on our results of operations or
financial position through accelerated amortization expense or impairment
charges.

ACCOUNTING FOR ACQUISITIONS

We have completed five significant business acquisitions, including the
Philips acquisition on January 30, 2003, which have resulted in significant
goodwill and other intangible asset balances. Our future business strategy
contemplates that we may continue to pursue additional acquisitions in the
future. Our accounting for acquisitions involves significant judgments and
estimates primarily, but not limited to: the fair value of certain forms of
consideration, the fair value of acquired intangible assets, which involve
projections of future revenues and cash flows, the fair value of other acquired
assets and assumed liabilities, including potential contingencies, and the
useful lives and, as applicable, the reporting unit, of the assets. The impact
of prior or future acquisitions on our financial position or results of
operations may be materially impacted by the change in or initial selection of
assumptions and estimates. Additionally, under SFAS 142, we determine the fair
value of the reporting unit, for purposes of the first step in our annual
goodwill impairment test, based on our stock price. If prior or future
acquisitions are not accretive to our results of operations as expected, or our
stock price declines dramatically, we may be required to complete the second
step which requires significant judgements and estimates and which may result in
material impairment charges in the period in which they are determined.

INCOME TAXES

At December 31, 2002, we had gross deferred tax assets of $45.6 million,
which have been offset by a full valuation allowance as a result of cumulative
historical losses. Our income tax provision reflects state and foreign
withholding and income taxes. We have not incurred any federal income tax
provision in the years ended December 31, 2002, 2001 or 2000 because of the
ability to fully utilize our net operating loss carry-forwards or because we did
not generate taxable income. A significant portion of our gross deferred tax
assets

20

relate to net operating loss carry-forwards, the full utilization of which is
based on a number of factors, including future profitability, if any, and
potential limitations resulting from tax laws.

Our income tax provisions and our assessment of the realizability of our
deferred tax assets involve significant judgments and estimates. If we continue
to generate taxable income through profitable operations in future years, we
will be required to recognize these deferred tax assets through the reduction of
the valuation allowance, which would result in a material benefit to our results
of operations in the period in which the benefit is determined.

DECEMBER 31, 2002 COMPARED TO DECEMBER 31, 2001

Total Revenue

Total revenue for 2002 increased by $43.9 million or 70% compared to 2001.
The growth in revenue for the year ended December 31, 2002 was primarily the
result of revenue generated from our speech products. Revenue from our speech
products was $44.2 million and $1.8 million for 2002 and 2001, respectively. The
increase in speech revenue was due to the L&H acquisition, which occurred in
December 2001. Revenue from our digital capture products was $62.4 million and
$60.9 million for 2002 and 2001, respectively. The net increase of $1.5 million
in revenue from our digital capture products from 2001 was due primarily to an
increase of $3.6 million in sales of digital capture products through the
channel network, partially offset by a decrease in revenue of $2.1 million from
Xerox, a related party, due to the cancellation of its retail multi-function
product line in late 2001.

Geographic revenue classification is based on the country in which the sale
is invoiced. Revenue for 2002 was 73% North America and 27% international,
versus 79% North America and 21% international for 2001.

A number of our OEM partners distribute their products throughout the world
and do not provide us with the geographical dispersion of their products. We
believe that, if we were provided with this information, our geographical
revenue classification would indicate a higher international percentage. Based
on an estimate that factors our OEM partners' geographical revenue mix to our
revenues generated from these OEM partners, revenue for 2002 was approximately
67% North America and 33% international versus 70% North America and 30%
international for 2001. The increase in our international revenue percentage for
2002 was driven primarily from Europe and Asia and was the result of increased
sales and marketing efforts and additional resellers.

The following table presents the breakdown of our total revenue by
distribution channel:

The increase in OEM, and the corresponding decrease in VAR/retail, as a
percent of revenue, for 2002 as compared to 2001 was due to the addition of
speech products in 2002. OEMs represent a higher percentage of revenue for our
speech products than for our digital capture products.

Effective January 1, 2002, we implemented EITF 01-9, Accounting for
Consideration Given by a Vendor to a Customer (Including a Reseller of the
Vendor's Products). The implementation resulted in a $0.3 million reduction to
total revenue and a corresponding reduction of selling, general and
administrative expense for 2002. Additionally, it resulted in the
reclassification of $1.1 million from selling, general and administrative
expense to net revenue for 2001.

21

Cost of Revenue

Cost of revenue for 2002 was $16.4 million or 15.4% of revenue, compared to
$12.8 million or 20.5% for 2001. The increase in cost of revenue in absolute
dollars for 2002 was directly attributable to the increase in the volume of
product sales to VAR/retail customers as well as increased embedded
text-to-speech revenue which bears a higher cost of revenue than our traditional
software products. The decrease in cost of revenue as a percentage of total
revenue for 2002, as compared to 2001, was due to lower supply chain logistics
and fulfillment costs, partially offset by the higher cost of embedded
text-to-speech revenue.

Cost of Revenue from Amortization of Intangible Assets

Cost of revenue from amortization of intangible assets for 2002 was $9.5
million compared to $14.2 million for 2001. The decrease in cost of revenue from
amortization of intangible assets of $4.7 million was due to $6.6 million of
intangible assets that became fully amortized in the first quarter of 2002. This
reduction was partially offset by $1.9 million of amortization recorded for the
acquired L&H and Audiomining assets.

Research and Development Expense

Research and development costs for 2002 were $27.6 million or 25.9% of
total revenue, compared to $14.0 million or 22.3% of total revenue for 2001. The
increase in research and development expenses of $13.6 million for 2002 was
primarily the result of increased headcount of 138 employees associated with the
L&H acquisition. Cost savings from the restructuring actions taken in 2002 for
2002 was approximately $1.3 million. Due to our acquisition of the core R&D of
Philips speech business units, we expect 2003 research and development expenses
as a percentage of revenue to increase over 2002 initially, but decline by the
end of the year, as revenue from the Philips products grow and research and
development spending is held flat, ending the year slightly better than 2002 as
a percentage of revenue.

Selling, General and Administrative Expense

Selling, general and administrative expense for 2002 was $43.8 million or
41.1% of total revenue, compared to $25.3 million or 40.4% for 2001. The
increase in selling, general and administrative expense in absolute dollars for
2002 was primarily the result of increased headcount costs of $9.9 million
resulting from the addition of 74 employees, primarily in sales and marketing,
as well as $3.1 million of increased marketing programs in support of the higher
revenue. These increases were largely attributable to the L&H acquisition and
expanded focus on international sales and marketing. As a percentage of revenue,
we expect selling, general and administrative expenses to remain consistent on
an annual basis with 2002 even after consideration of the Philips acquisition.

Amortization of Goodwill and Other Intangible Assets

Amortization of goodwill and other intangible assets for 2002 was $1.7
million compared to $13.3 million for 2001. The decrease in amortization expense
is directly attributable to the adoption of SFAS 142, as a result of which we
ceased the amortization of goodwill and acquired workforce of approximately $2.6
million per quarter. Additionally, amortization expense decreased $1.4 million
in 2002, due to intangible assets that became fully amortized in the first
quarter of 2002. This reduction was partially offset by additional amortization
of approximately $0.2 million for 2002 from the L&H and Audiomining
acquisitions.

Restructuring and Other Charges, Net

In January 2002, we announced, and in March 2002 completed, a restructuring
plan to consolidate facilities, worldwide sales organizations, research and
development teams and other personnel following the L&H acquisition on December
12, 2001. As a result, we exited certain facilities in both North America and
Europe, eliminating 21 employee positions, including 12 in research and
development and 9 in selling, general and administrative functions. In the first
quarter of 2002, we recorded a restructuring charge in the amount of $0.6
million for severance payments to these employees and a charge of $0.4 million
for certain termination

22

fees to be incurred as a result of exiting the facilities, including the
write-off of previously recorded assembled workforce of $0.1 million.

During 2002, the Company paid a total of $0.8 million in severance
payments, of which $0.6 million related to the March 2002 restructuring and $0.2
million related to severance paid to the former Caere President and CEO,
pursuant to a 2000 restructuring.

At December 31, 2002, the remaining restructuring accrual from the current
and prior restructuring activities amounted to $0.7 million. This balance is
comprised of $0.2 million of lease exit costs resulting from the 2002
restructuring and $0.5 million of severance to the former Caere President and
CEO. The lease exit costs and severance due to the former Caere President and
CEO will be paid through January 2004 and March 2005, respectively.

Income (Loss) from Operations

As a result of the above factors, income from operations was $6.6 million
for 2002 compared with a loss of ($16.9) million for 2001.

Other Income (Expense), Net

Interest income was $0.4 million and $0.2 million for 2002 and 2001,
respectively. The increase in interest income from 2001 to 2002 was a result of
higher cash and cash equivalent balances, which grew from $14.3 million at
December 31, 2001 to $18.9 million at December 31, 2002. Interest expense
consists primarily of interest related to the $3.5 million note resulting from
the acquisition of L&H. Interest expense was $0.4 million and $0.2 million for
2002 and 2001, respectively. Other expense in 2002 consists primarily of foreign
exchange losses of $2,000, other expenses of $42,000, partially offset by a gain
on the disposal of assets of $41,000. Other expense in 2001 consists primarily
of foreign exchange losses of $0.2 million and the write-off of an investment of
$0.2 million recorded under the cost method, which was deemed to be impaired,
partially offset by other income of $0.1 million.

Income (Loss) Before Income Taxes

Income before income taxes was $6.6 million for 2002, compared with a loss
of ($17.2) million for 2001.

Income Taxes

The provision for income taxes of $0.3 million for 2002 consisted of
foreign and state tax provisions of $1.2 million, offset by a federal tax
benefit of ($0.9) million, related to a refund of taxes paid by Caere
Corporation prior to its acquisition by us. The (benefit from) income taxes of
($0.3) million for 2001 consisted of foreign and state tax provisions of $0.4
million offset by the state tax benefit of ($0.7) million.

At December 31, 2002, we had federal net operating loss carryforwards of
approximately $82 million, of which approximately $9.1 million relate to tax
deductions from stock compensation. The tax benefit related to the stock
compensation, when realized, will be accounted for as additional paid-in capital
rather than as a reduction of the provision for income tax. At December 31, 2002
we had federal and state research and development credit carryforwards of
approximately $3.4 million. The net operating loss and credit carryforwards will
expire at various dates through 2021, if not utilized. Utilization of the net
operating losses and credits may be subject to a substantial annual limitation
due to the ownership change limitations provided by the Internal Revenue Code of
1986 and similar state provisions. The annual limitation may result in the
expiration of net operating losses and credits before utilization.

At December 31, 2002, gross deferred tax assets amounted to $45.6 million.
A full valuation allowance has been provided against the deferred tax assets due
to the uncertainty of their realization as a result of our cumulative historical
losses. During 2002, we generated income before income taxes of $6.6 million. If
we continue to generate taxable income through profitable operations in future
years we may be required to

23

recognize these deferred tax assets through the reduction of the valuation
allowance which would result in a material benefit to our results of operations
in the period in which the benefit is determined.

Net Income (Loss)

As a result of all these factors, net income totaled $6.3 million for 2002,
compared with a net loss of ($16.9) million for 2001.

DECEMBER 31, 2001 COMPARED TO DECEMBER 31, 2000

Total Revenue

Total revenue of $62.7 million for 2001 increased by $14.8 million or 31%
from the comparable period in 2000. The primary factors responsible for this
growth include a $12.0 million revenue increase from our document and PDF
conversion product line driven primarily by our release of OmniPage 11 which
contained significant enhancements over the prior version and secondarily by an
increased usage of our document conversion tool kits by software vendors,
integrators and in-house developers; $0.9 million revenue increase in our
digital paper management product line, also driven by the release of a
significantly improved new version of our PaperPort product; and a $2.7 million
revenue increase driven by a contract with an OEM customer. We also generated
additional revenue in the amount of $1.7 million from our speech products as a
result of the L&H acquisition on December 12, 2001.

North America accounted for 79% and International accounted for 21% of 2001
total revenue, versus 82% and 18%, respectively, for the comparable period in
2000. The release of international versions for two of our digital capture
products and additional sales and marketing resources in Europe expanded the
market opportunity for our digital capture products, thereby contributing to the
revenue growth in Europe for 2001.

The following table presents the breakdown of our total revenue by
distribution channel:

During 2001, our distribution and fulfillment partners, Ingram Micro and
Digital River, accounted for 28% and 15% of our total revenue, respectively. In
addition Xerox, an OEM customer, accounted for 11% of our total revenue. During
2000, Ingram Micro, Digital River and Xerox accounted for 7%, 11% and 12% of our
total revenue, respectively.

Cost of Revenue

Cost of revenue in 2001 was $12.8 million, or 21%, of revenue compared to
$12.7 million, or 27%, of revenue in the comparable period of 2000. The decrease
in cost of revenue as a percentage of total revenue from the comparable period
in 2000 is directly attributed to the consolidation of our worldwide
manufacturing fulfillment activities and cost savings initiatives we introduced
in the second quarter of 2000. This decrease was partially offset by an increase
of $1.2 million in the cost of revenue in the second half of 2001, as a result
of costs associated with engineering efforts under an OEM contract.

Cost of Revenue from Amortization of Intangible Assets

Cost of revenue from amortization of intangible assets for 2001 was $14.2
million compared to $11.6 million for the same period in 2000. The increase in
cost of revenue from amortization of intangible

24

assets of $2.6 million was primarily attributable to a full year in 2001 of
amortization expense for patents and core and completed technology acquired from
Caere late in the first quarter of 2000.

Research and Development Expense

Research and development costs were $14.0 million, or 22%, of revenue in
2001 compared to $15.0 million, or 31%, of revenue in 2000. The decrease in
research and development expense as a percentage of total revenue is a result of
$1.2 million of expenses associated with engineering efforts on an OEM contract
being charged to cost of revenues as well as increased revenues of $14.8 million
compared to the prior period. Additionally, during 2000, we transferred certain
digital capture development activities from Los Gatos, California to Budapest,
Hungary.

Selling, General and Administrative Expense

Selling, general and administrative expenses were $25.3 million, or 40%, of
total revenue in 2001 compared to $27.1 million, or 57%, of total revenue for
the same period in 2000. The absolute dollar decrease in selling, general and
administrative expense from the same period in 2000 was a result of cost
reduction efforts undertaken during the first and second quarters of 2000.
Additionally, we realized a gain of approximately $1.0 million primarily due to
the favorable settlement of investment banking fees associated with the Caere
acquisition. The decrease in selling, general and administrative expense as a
percentage of revenue from the same period in 2000 is a result of the decreased
expenses as noted above, the realized gain and increased revenues compared to
the prior period.

Amortization of Goodwill and Other Intangible Assets and Acquired In-Process
Research and Development

Amortization of goodwill and other intangible assets for 2001 was $13.3
million compared to $11.0 million for the same period in 2000. The increase in
amortization of intangible assets of $2.3 million compared to the same period in
2000 resulted from a full 12 months of amortization for the Caere acquisition
being taken during 2001 versus approximately nine months in 2000 due to the
timing of the Caere acquisition which was completed on March 13, 2000. In
connection with the Caere acquisition, $18.3 million was charged to operations
upon consummation of the acquisition, which represented acquired in-process
research and development on development projects that had not yet reached
technological feasibility and had no alternative future use.

Restructuring and Other Charges, Net

There were no restructuring or other charges in 2001, compared with
approximately $4.8 million in 2000. In connection with the acquisition of Caere
in the first quarter of 2000, we identified 46 employees of Caere whose
positions were eliminated upon consummation of the acquisition. These positions
included 22 in research and development, 14 in general and administrative
functions, and 10 in sales and marketing. Additionally, the Caere president and
CEO position was eliminated. As a result, we established, as part of the
purchase price allocation, a restructuring reserve of $0.5 million for severance
payments to employees, and a restructuring reserve of $1.1 million for severance
to the Caere former president and CEO, the payments of which will continue
through March 2005.

In June 2000, we implemented a restructuring plan to strategically refocus
our business and bring operating expenses in line with net revenues. As a
result, we eliminated 65 employee positions, including 29 in research and
development, 13 in general and administrative functions and 23 in support and
marketing. We recorded a restructuring charge in the amount of $1.1 million for
severance payments to these employees and a restructuring charge of $0.4 million
for certain termination fees to be incurred as a result of exiting the Los
Gatos, California facility. Additionally, we wrote off $3.5 million of net
intangible assets acquired as part of the Caere acquisition, including the
acquired work force of $1.1 million and the favorable building lease of $2.4
million, which were impaired as a result of the restructuring action. At the
time of the restructuring,

25

management expected these restructuring actions to reduce operating expenses by
approximately $10 million on an annualized basis. Annualized cost savings
realized from these actions amounted to $13.6 million.

For the years ended December 31, 2001 and 2000, we paid $0.8 million and
$1.1 million, respectively in severance payments related to these restructuring
actions. The remaining severance balance of $0.6 million primarily relates to
severance for the former Caere President and CEO and will be paid through March
2005.

Loss from Operations

As a result of the above factors, loss from operations totaled
approximately ($16.9) million in 2001 compared to loss from operations of
approximately ($52.5) million in 2000.

Other Income (Expense)

Interest income was $0.2 million and $0.1 million for 2001 and 2000,
respectively. The increase in interest income from 2000 to 2001 was a result of
significantly higher cash and cash equivalent balances, which grew from $2.6
million at December 31, 2000 to $14.3 million at December 31, 2001 and
short-term investments, which were generated from operations. Interest expense
consists of interest incurred for borrowings under credit facilities and
short-term notes. Interest expense was $0.2 million and $0.6 million for 2001
and 2000, respectively. The decrease in interest expense from 2000 to 2001
resulted from the repayment of all bank borrowings, including accrued interest,
of $3.4 million, under the bank credit facility during May 2001. Other expense
in 2001 consists primarily of foreign exchange losses of $0.2 million and the
write-off of an investment of $0.2 million recorded under the cost method, which
was deemed to be impaired, partially offset by other income of $0.1 million.

Loss Before Income Taxes

As a result of the above factors, loss before income taxes was
approximately ($17.2) million in 2001 compared to a loss before income taxes of
approximately ($52.8) million in 2000.

Income Taxes

The (benefit from) income taxes of ($0.3) million for the year ended
December 31, 2001 reflects a reduction of approximately $0.7 million in amounts
accrued for income taxes upon favorable completion of a state tax audit of Caere
for 1996 and 1997. This benefit was offset by tax provisions of $0.4 million for
foreign and state jurisdictions for which net operating losses were limited or
for which no net operating loss carryforwards were available. This compares to
tax provisions of $0.5 million for the year ended December 31, 2000, which
related to foreign and state income taxes.

Net Loss

As a result of all these factors, net loss totaled approximately ($16.9)
million in 2001, compared to a net loss of approximately ($53.3) million in
2000.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2002, we had cash and cash equivalents of $18.9 million
and net working capital of $16.8 million as compared to $14.3 million in cash
and cash equivalents and net working capital of $9.3 million at December 31,
2001.

Net cash provided by operating activities for the fiscal year ended
December 31, 2002 was $12.3 million compared to $10.4 million for the same
period in 2001. Cash provided by operations in the 2002 period came primarily
from operating income, net of non-cash adjustments, offset primarily by the net
impact of higher balances in accounts receivable, prepaid expenses and other
assets, and accrued expenses and lower deferred revenue due to the recognition
of revenue on a long-term contract that was classified as deferred revenue at
December 31, 2001, for which cash was collected in a prior period. The increase
in accounts receivable of

26

$3.2 million at December 31, 2002, as compared to December 31, 2001 was the
result of significantly higher revenue, partially offset by improvement in days
sales outstanding. Historically, we have not incurred any significant losses on
our accounts receivable balances.

Net cash used in investing activities for 2002 was $6.0 million compared to
$10.7 million for 2001. Net cash used in investing activities during the 2002
period consisted of $2.4 million in capital expenditures, which included costs
to build out facilities in both North America and Europe and $3.6 million of
payments associated with acquisitions. Net cash used in investing activities
during 2001 included capital expenditures of $0.9 million and $10.1 million of
payments associated with acquisitions, offset by $0.3 million in proceeds from
the sale of property and equipment.

Net cash used in financing activities for 2002 was $1.9 million compared to
$12.4 million of net cash provided by financing activities for 2001. Net cash
used in financing activities during 2002 consisted of proceeds of $2.7 million
from the issuance of common stock in connection with employee stock compensation
plans and net proceeds of $5.6 million from a private placement of our common
stock. This was offset by a $0.3 million payment on our capital lease
obligation, a $7.0 million payment to repurchase shares of our common stock held
by L&H, $0.6 million in payments of notes payable related to prior acquisitions
and a $2.2 million payment to the former Caere President and CEO in connection
with the settlement of the non-competition and consulting agreement. Net cash
provided by financing activities during the comparable period in 2001 included
proceeds of $15.7 million from a private placement of our common stock, proceeds
of $1.1 million from the exercise of stock options partly offset by payments of
$3.4 million to repay in full our prior line of credit and payments of $1.0
million to repurchase shares of our stock on the open market.

On January 30, 2003, we completed the acquisition of the Philips Speech
Processing Telephony and Voice Control business units and related intellectual
property on the terms set forth in the purchase agreement dated October 7, 2002,
as amended. As consideration for these business units and intellectual property,
we paid 3.1 million euros ($3.4 million) in cash at closing, subject to
adjustment in accordance with the provisions of the purchase agreement, as
amended, and agreed to pay an additional 1.0 million euros in cash prior to
December 31, 2003, issued a 5.0 million euro note due December 31, 2003 and
bearing 5.0% interest per annum and issued a $27.5 million three-year,
zero-interest subordinated debenture, convertible at any time at Philips' option
into shares of our common stock at $6.00 per share.

On October 31, 2002, we entered into a two-year Loan and Security Agreement
with Silicon Valley Bank that consisted of a $10.0 million revolving loan.
Borrowings under this credit facility will bear interest at the bank's prime
rate plus 0.375% or 0.75%, depending on our fixed charge coverage ratio, as
defined in the Loan and Security Agreement. The maximum aggregate amount of
borrowings outstanding at any one time will be limited to the lesser of $10.0
million or a borrowing base equal to either 80% or 70% of eligible accounts
receivable, as defined in the Loan and Security Agreement depending on our fixed
charge coverage ratio. Pursuant to the Loan and Security Agreement, we will be
required to maintain various financial and non-financial covenants, the most
restrictive of which is a quarterly minimum fixed charge coverage ratio of 1.25
to 1.00. The Company was in compliance with all covenants under the Loan and
Security Agreement at December 31, 2002. Borrowings under the Loan and Security
Agreement are collateralized by substantially all of our personal property,
predominantly our accounts receivable, but not our intellectual property. To
date, no amounts have been drawn under the credit facility.

In September of 2002, we repurchased 1,461,378 shares of common stock from
L&H and certain other parties at $4.79 per share for a total consideration of
$7.0 million. We also agreed to register L&H's remaining holdings of our common
stock in an underwritten public offering.

Our agreement to register these shares for L&H contained provisions
requiring us to issue additional shares to L&H if the registration was not
completed by certain deadlines. Because we did not meet one of these deadlines,
on December 18, 2002, we issued 81,900 shares to Lernout & Hauspie Speech
Products N.V. and 68,100 shares to L&H Holdings USA, Inc. Additionally, since we
did not complete the underwritten public offering by January 1, 2003, all of the
outstanding principal and accrued interest under the $3.5 million promissory
note, dated December 12, 2001, that we issued in connection with the L&H
acquisition became immediately due and payable. To fulfill this obligation, on
January 3, 2003, we paid $3.3 million in full

27

settlement of all of the outstanding principal and accrued interest under this
note. The underwritten offering of the L&H shares was completed on February 14,
2003 and no further payments or issuances are due to L&H.

As part of the underwritten offering completed for L&H, we sold 1,000,000
shares and raised approximately $3.8 million in gross proceeds. After
considering offering costs, the estimated net proceeds equaled approximately
$2.1 million. On March 11, 2003, the Company received approximately $3.8 million
of net proceeds from the exercise of the over-allotment option of 1,072,500
shares granted to the underwriters as part of the underwritten offering.

The following table outlines our contractual payment obligations as of
December 31, 2002:

- ---------------

(1) Excludes the impact of the Philips acquisition. In connection with the
Philips acquisition, we agreed to pay 1.0 million euros in cash prior to
December 31, 2003, issued a 5.0 million euro note due December 31, 2003 and
bearing 5.0% interest per annum and issued a $27.5 million three-year, zero-
interest subordinated debenture, convertible at any time at Philips' option
into shares of our common stock at $6.00 per share.

Through December 31, 2002, we have not entered into any off balance sheet
arrangements or transactions with unconsolidated entities or other persons.

Historically and through December 31, 2001 we sustained recurring losses
from operations in each reporting period. We reported net income of
approximately $6.3 million for 2002 and had an accumulated deficit of $146.9
million at December 31, 2002. We believe that operating expense levels,
including the integration of the Philips acquisition and the anticipated
restructuring charge from the Philips integration process, in combination with
expected future revenues will continue to result in positive cash flows from
operations for 2003. We also believe that we have the ability to maintain
operating expenses at levels commensurate with revenues to maintain positive
cash flows from operations. Therefore, we believe that cash flows from future
operations in addition to cash on hand and cash available from our credit
facility will be sufficient to meet our working capital, investing, financing
and contractual obligations, including the debt obligations issued in connection
with the Philips acquisition, as they become due, for at least the next twelve
months.

FOREIGN OPERATIONS

We develop and sell our products throughout the world. As a result of the
Caere acquisition in March 2000, the L&H acquisition in December 2001 and our
recent acquisition of certain assets of Philips, we significantly increased our
presence in Europe and added operations in Asia. With our increased
international presence in a number of geographic locations and with
international revenues projected to increase in 2002, we are exposed to changes
in foreign currencies including the euro, Japanese yen and the Hungarian forint.
Changes in the value of the euro or other foreign currencies relative to the
value of the United States dollar could adversely affect future revenues and
operating results. We do not generally hedge any of our foreign-currency
denominated transactions or expected cash flows. However, in connection with the
Philips acquisition on January 30, 2003, we entered into a forward hedge in the
amount of $5.0 million to meet our obligation to pay the 5.0 million euro
promissory note issued as part of the acquisition.

28

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

On December 31, 2002, the FASB issued FASB Statement No. 148 (SFAS 148),
Accounting for Stock-Based Compensation -- Transition and Disclosure, amending
FASB Statement No. 123 (SFAS 123), Accounting for Stock-Based Compensation. This
Statement amends SFAS 123 to provide alternative methods of transition for an
entity that voluntarily changes to the fair value based method of accounting for
stock-based employee compensation. It also amends the disclosure provisions of
that Statement to require prominent disclosure about the effects on reported net
income of an entity's accounting policy decisions with respect to stock-based
employee compensation. Finally, SFAS 148 amends APB Opinion No. 28, Interim
Financial Reporting, to require disclosure about those effects in interim
financial information. For entities that voluntarily change to the fair value
based method of accounting for stock-based employee compensation, the transition
provisions are effective for fiscal years ending after December 15, 2002. For
all other companies, the disclosure provisions and the amendment to APB No. 28
are effective for interim periods beginning after December 15, 2002. SFAS 148
did not have any effect on our financial position, results of operations or cash
flows as we have elected to continue to follow the recognition provisions of APB
No. 25.

On November 25, 2002, the FASB issued FASB Interpretation No. 45 ("FIN
25"), Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others, an interpretation of
FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34.
FIN 45 clarifies the requirements of FASB Statement No. 5, Accounting for
Contingencies (SFAS 5), relating to the guarantor's accounting for, and
disclosure of, the issuance of certain types of guarantees.

FIN 45 requires that upon issuance of a guarantee, the guarantor must
recognize a liability for the fair value of the obligation it assumes under that
guarantee. FIN 45 covers guarantee contracts that have any of the following four
characteristics: (a) contracts that contingently require the guarantor to make
payments to the guaranteed party based on changes in an underlying that is
related to an asset, a liability, or an equity security of the guaranteed party
(e.g., financial and market value guarantees), (b) contracts that contingently
require the guarantor to make payments to the guaranteed party based on another
entity's failure to perform under an obligating agreement (performance
guarantees), (c) indemnification agreements that contingently require the
indemnifying party (guarantor) to make payments to the indemnified party
(guaranteed party) based on changes in an underlying that is related to an
asset, a liability, or an equity security of the indemnified party, such as an
adverse judgment in a lawsuit or the imposition of additional taxes due to
either a change in the tax law or an adverse interpretation of the tax law, and
(d) indirect guarantees of the indebtedness of others.

FIN 45 specifically excludes certain guarantee contracts from its scope.
Additionally, certain guarantees are not subject to FIN 45's provisions for
initial recognition and measurement but are subject to its disclosure
requirements. The initial recognition and measurement provisions are effective
for guarantees issued or modified after December 31, 2002. We have evaluated the
impact of FIN 45 on our financial statements and determined that the recognition
provision will not have an impact on our financial position or results of
operations for 2002.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities, or SFAS 146. This statement addresses
financial accounting and reporting for costs associated with exit or disposal
activities and nullifies EITF Issue 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring), or EITF 94-3. SFAS 146 requires that
a liability for a cost associated with an exit or disposal activity be
recognized when the liability is incurred. EITF 94-3 allowed for an exit cost
liability to be recognized at the date of an entity's commitment to an exit
plan. SFAS 146 also requires that liabilities recorded in connection with exit
plans be initially measured at fair value. The provisions of SFAS 146 are
effective for exit or disposal activities that are initiated after December 31,
2002, with early adoption encouraged. We do not expect the adoption of SFAS 146
will have a material impact on our financial position or results of operations.

29

RISK FACTORS

You should carefully consider the risks described below when evaluating our
company. The risks described below are not the only ones facing us. Additional
risks not presently known to us or that we currently deem immaterial may also
impair our business operations and financial situation. Our business, financial
condition and results of operations could be seriously harmed by any of these
risks.

OUR QUARTERLY OPERATING RESULTS ARE SUBJECT TO FLUCTUATIONS AND
SEASONALITY. IF WE FAIL TO MEET THE EXPECTATIONS OF SECURITIES ANALYSTS OR
INVESTORS, OUR SHARE PRICE MAY DECREASE SIGNIFICANTLY. Our revenue and
operating results have fluctuated in the past and may not meet the expectations
of securities analysts or investors in the future. If this occurs, the price of
our stock would likely decline. Factors that may cause fluctuations in our
operating results include the following:

- SLOWING SALES BY OUR DISTRIBUTION AND FULFILLMENT PARTNERS TO THEIR
CUSTOMERS, WHICH MAY PLACE PRESSURE ON THESE PARTNERS TO REDUCE PURCHASES
OF OUR PRODUCTS;

- VOLUME, TIMING AND FULFILLMENT OF CUSTOMER ORDERS;

- CUSTOMERS DELAYING THEIR PURCHASE DECISIONS IN ANTICIPATION OF NEW
VERSIONS OF PRODUCTS;

- CUSTOMERS DELAYING, CANCELING OR LIMITING THEIR PURCHASES AS RESULT OF
THE THREAT OR RESULTS OF TERRORISM OR MILITARY ACTIONS TAKEN BY THE
UNITED STATES OR ITS ALLIES;

- INTRODUCTION OF NEW PRODUCTS BY US OR OUR COMPETITORS;

- SEASONALITY;

- REDUCTION IN THE PRICES OF OUR PRODUCTS IN RESPONSE TO COMPETITION OR
MARKET CONDITIONS;

- RETURNS AND ALLOWANCE CHARGES IN EXCESS OF RECORDED AMOUNTS;

- TIMING OF SIGNIFICANT MARKETING AND SALES PROMOTIONS;

- INCREASED EXPENDITURES INCURRED PURSUING NEW PRODUCT OR MARKET
OPPORTUNITIES;

- INABILITY TO ADJUST OUR OPERATING EXPENSES TO COMPENSATE FOR SHORTFALLS
IN REVENUE AGAINST FORECAST;

- DEMAND FOR PRODUCTS; AND

- GENERAL ECONOMIC TRENDS AS THEY AFFECT RETAIL AND CORPORATE SALES.

Due to the foregoing factors, among others, our revenue and operating
results are difficult to forecast. Our expense levels are based in significant
part on our expectations of future revenue. Therefore, our failure to meet
revenue expectations would seriously harm our business, operating results,
financial condition and cash flows. Further, an unanticipated decline in revenue
for a particular quarter may disproportionately affect our profitability because
a relatively small amount of our expenses are intended to vary with our revenue
in the short term.

WE HAVE A HISTORY OF LOSSES. WE MAY INCUR LOSSES IN THE FUTURE. We
sustained recurring losses from operations in each reporting period through
December 31, 2001. We reported net income of approximately $6.3 million for the
fiscal year ended December 31, 2002 and had an accumulated deficit of $146.9
million at December 31, 2002. If we do not maintain profitability, the market
price for our stock may decline, perhaps substantially.

OUR BUSINESS COULD BE HARMED IF WE DO NOT SUCCESSFULLY MANAGE THE
INTEGRATION OF THE BUSINESSES THAT WE ACQUIRE, INCLUDING OUR PURCHASE OF THE
SPEECH PROCESSING TELEPHONY AND VOICE CONTROL BUSINESS UNITS FROM PHILIPS. As
part of our business strategy, we have in the past acquired, and expect to
continue to acquire, other businesses and technologies. Our recent acquisition
of the speech and language technology operations of Lernout & Hauspie Speech
Products N.V. and certain of its affiliates, including L&H Holdings USA, Inc.
(collectively, L&H) required substantial integration and management efforts. Our
purchase of the Speech

30

Processing Telephony and Voice Control business units from Philips will pose
similar challenges. Acquisitions involve a number of risks, including:

- DIFFICULTY IN TRANSITIONING AND INTEGRATING THE OPERATIONS AND PERSONNEL
OF THE ACQUIRED BUSINESSES;

- POTENTIAL DISRUPTION OF OUR ONGOING BUSINESS AND DISTRACTION OF
MANAGEMENT;

- DIFFICULTY IN INCORPORATING ACQUIRED TECHNOLOGY AND RIGHTS INTO OUR
PRODUCTS AND TECHNOLOGY;

- UNANTICIPATED EXPENSES AND DELAYS IN COMPLETING ACQUIRED DEVELOPMENT
PROJECTS AND TECHNOLOGY INTEGRATION;

- MANAGEMENT OF GEOGRAPHICALLY REMOTE UNITS BOTH IN THE UNITED STATES AND
INTERNATIONALLY;

- IMPAIRMENT OF RELATIONSHIPS WITH PARTNERS AND CUSTOMERS;

- ENTERING MARKETS OR TYPES OF BUSINESSES IN WHICH WE HAVE LIMITED
EXPERIENCE; AND

- POTENTIAL LOSS OF KEY EMPLOYEES OF THE ACQUIRED COMPANY.

As a result of these and other risks, we may not realize anticipated
benefits from our acquisitions. Any failure to achieve these benefits or failure
to successfully integrate acquired businesses and technologies could seriously
harm our business.

A LARGE PART OF OUR REVENUE IS DEPENDENT ON CONTINUED DEMAND FOR OUR
PRODUCTS FROM OEM PARTNERS. A SIGNIFICANT REDUCTION IN OEM REVENUE WOULD
SERIOUSLY HARM OUR BUSINESS, RESULTS OF OPERATIONS, FINANCIAL CONDITION AND
STOCK PRICE. Many of our technologies are licensed to partners that incorporate
our technologies into solutions that they sell to their customers. The
commercial success of these licensed products depends to a substantial degree on
the efforts of these licensees in developing and marketing products
incorporating our technologies. The integration of our technologies into their
products takes significant time, effort and investment, and products
incorporating our technologies may never be successfully implemented or marketed
by our licensees.

OEM revenue represented 34% and 31% of our consolidated revenue for the
years ended December 31, 2002 and December 31, 2001, respectively. One of our
partners, Xerox Corporation, accounted for 5% and 11% of our consolidated
revenue during the years ended December 31, 2002 and December 31, 2001,
respectively. Our partners are not required to continue to bundle or embed our
software, and they may choose the software products of our competitors in
addition to, or in place of, our products. A significant reduction in OEM
revenue would seriously harm our business, results of operations, financial
condition and our stock price.

SPEECH TECHNOLOGIES MAY NOT ACHIEVE WIDESPREAD ACCEPTANCE BY BUSINESSES,
WHICH COULD LIMIT OUR ABILITY TO GROW OUR SPEECH BUSINESS. The market for
speech technologies is relatively new and rapidly evolving. Our ability to
increase revenue in the future depends in large measure on acceptance by both
our customers and the end users of speech technologies in general and our
products in particular. The continued development of the market for our current
and future speech solutions will also depend on the following factors:

- WIDESPREAD DEPLOYMENT AND ACCEPTANCE OF SPEECH TECHNOLOGIES;

- CONSUMER DEMAND FOR SPEECH-ENABLED APPLICATIONS;

- DEVELOPMENT BY THIRD-PARTY VENDORS OF APPLICATIONS USING SPEECH
TECHNOLOGIES; AND

- CONTINUOUS IMPROVEMENT IN SPEECH TECHNOLOGY.

Sales of our speech products would be harmed if the market for speech
software does not continue to develop or develops more slowly than we expect,
and, consequently, our business could be harmed.

WE HAVE GROWN, AND MAY CONTINUE TO GROW, THROUGH ACQUISITIONS, WHICH MAY
RESULT IN SIGNIFICANT INTANGIBLE ASSETS, DILUTION OF OUR EXISTING STOCKHOLDERS,
USE OF CASH AND OTHER RISKS. We have made several significant acquisitions over
the last two years, have recently completed the purchase of certain businesses
and intellectual property from Philips and may acquire additional complementary
assets, technologies or businesses in the future. Our past acquisitions have
given rise to, and future acquisitions may result in, substantial

31

levels of intangible assets that will be amortized or subject to impairment
analyses in future years, and our future results will be adversely affected if
we do not achieve benefits from these acquisitions commensurate with
amortization and potential impairment charges. For example, our acquisition of
Caere Corporation included a substantial write-off of acquired in-process
research and development costs, and this also may occur as a result of other
acquisitions.

In connection with the Caere and the L&H acquisitions, we issued 19.0
million and 7.4 million shares of our common stock, respectively. We may
continue to issue equity securities for future acquisitions and working capital
purposes that could dilute our existing stockholders. In connection with the L&H
acquisition, we issued a promissory note for $3.5 million. Under the terms of
the Philips acquisition, we paid 3.1 million euros in cash at closing, subject
to adjustment in accordance with the provisions of the purchase agreement, as
amended, and agreed to pay an additional 1.0 million euros in cash prior to
December 31, 2003, issued a 5.0 million euro note due December 31, 2003 and
bearing 5.0% interest per annum and issued a $27.5 million three-year,
zero-interest subordinated debenture, convertible at any time at Philips' option
into shares of our common stock at $6.00 per share. Future acquisitions may also
require us to expend significant funds or incur debt. If we expend funds or
incur additional debt, our ability to obtain financing for working capital or
other purposes could decrease.

SALES OF OUR DOCUMENT AND PDF CONVERSION PRODUCTS AND OUR DIGITAL PAPER
MANAGEMENT PRODUCTS REPRESENTED 51% OF OUR REVENUE FOR THE YEAR ENDED DECEMBER
31, 2002 AND 83% FOR THE YEAR ENDED DECEMBER 31, 2001. ANY REDUCTION IN REVENUE
FROM THESE PRODUCT AREAS COULD SERIOUSLY HARM OUR BUSINESS. Historically, a
substantial portion of our revenue has been generated by a few product areas.
For the year ended December 31, 2002, our document and PDF conversion products
represented 39% of our revenue and our digital paper management products
represented 12% of our revenue. For the year ended December 31, 2001, our
document and PDF conversion products represented approximately 67% of our
revenue, and our digital paper management products represented approximately 16%
of our revenue. Although the relative share of our revenue derived from these
products decreased during 2002 due to the inclusion of sales of our speech
products after the L&H acquisition, a reduction in the revenue contribution from
these product areas could seriously harm our business, results of operations,
financial condition, cash flows and stock price.

THE PROTECTION OF OUR PROPRIETARY TECHNOLOGY AND INTELLECTUAL PROPERTY IS
KEY TO OUR SUCCESS. We rely heavily on our proprietary technology, trade
secrets and other intellectual property. Unauthorized parties may attempt to
copy aspects of our products or to obtain and use information that we regard as
proprietary. Policing unauthorized use of our products is difficult and we may
not be able to protect our technology from unauthorized use. Additionally, our
competitors may independently develop technologies that are substantially the
same or superior to ours. In addition, the laws of some foreign countries do not
protect our proprietary rights to the same extent as the laws of the United
States. Although the source code for our proprietary software is protected both
as a trade secret and as a copyrighted work, litigation may be necessary to
enforce our intellectual property rights, to protect our trade secrets, to
determine the validity and scope of the proprietary rights of others, or to
defend against claims of infringement or invalidity. Litigation, regardless of
the outcome, can be very expensive and can divert management efforts.

THIRD PARTIES HAVE CLAIMED AND MAY CLAIM IN THE FUTURE THAT WE ARE
INFRINGING THEIR INTELLECTUAL PROPERTY. WE COULD BE EXPOSED TO SIGNIFICANT
LITIGATION OR LICENSING EXPENSES OR BE PREVENTED FROM SELLING OUR PRODUCTS IF
SUCH CLAIMS ARE SUCCESSFUL. Like other technology companies, from time to time,
we are subject to claims that we or our customers may be infringing or
contributing to the infringement of the intellectual property rights of others.
We may be unaware of intellectual property rights of others that may cover some
of our technologies and products. If it appears necessary or desirable, we may
seek licenses for these intellectual property rights. However, we may not be
able to obtain licenses from some or all claimants, the terms of any offered
licenses may not be acceptable to us, and we may not be able to resolve disputes
without litigation. Any litigation regarding intellectual property could be
costly and time-consuming and could divert the attention of our management and
key personnel from our business operations. In the event of a claim of
intellectual property infringement, we may be required to enter into costly
royalty or license agreements. Third parties claiming intellectual property
infringement may be able to obtain injunctive or other equitable relief that
could effectively block our ability to develop and sell our products.

32

On November 27, 2002, AllVoice Computing plc filed an action against us in
the United States District Court for the Southern District of Texas claiming
patent infringement. In the lawsuit, AllVoice alleges that we are infringing
United States Patent No. 5,799,273 entitled "Automated Proofreading Using
Interface Linking Recognized Words to Their Audio Data While Text Is Being
Changed" (the "'273 Patent"). The '273 Patent generally discloses techniques for
manipulating audio data associated with text generated by a speech recognition
engine. Although we have several products in the speech recognition technology
field, we believe that these products do not infringe the '273 Patent because
our products do not use the claimed techniques. We believe this claim has no
merit, and we intend to defend the action vigorously.

In December 2001, we were sued for patent infringement initiated by the
Massachusetts Institute of Technology and Electronics For Imaging, Inc. We were
one of more than 200 defendants named in this suit. Damages are sought in an
unspecified amount. We filed an Answer and Counterclaim on July 1, 2002. We
believe this claim has no merit, and we intend to defend the action vigorously.

On August 16, 2001, we were sued by Horst Froessl for patent infringement.
Damages are sought in an unspecified amount. We filed an Answer and Counterclaim
on September 19, 2001. We believe this claim has no merit, and we intend to
defend the action vigorously.

We believe that the final outcome of the current litigation matters
described above will not have a significant adverse effect on our financial
position and results of operations and we believe that we will not be required
to expend a significant amount of resources defending such claims. However,
should we not prevail in these litigation matters or if we are required to
expend a significant amount of resources defending such claims, our operating
results, financial position and cash flows could be adversely impacted. If any
third parties are successful in intellectual property infringement claims
against us, we may be subject to significant damages or injunctions and our
operating results and financial position could be harmed.

THE MARKETS IN WHICH WE OPERATE ARE HIGHLY COMPETITIVE AND RAPIDLY
CHANGING. WE MAY BE UNABLE TO COMPETE SUCCESSFULLY AGAINST NEW ENTRANTS AND
ESTABLISHED COMPANIES WITH GREATER RESOURCES. There are a number of companies
that develop or may develop products that compete in our targeted markets;
however, there is no one company that competes with us in all of our product
areas. The individual markets in which we compete are highly competitive, and
are rapidly changing. Within digital capture, we compete directly with ABBYY,
I.R.I.S. and NewSoft. Within speech, we compete with AT&T, IBM, Nuance
Communications and SpeechWorks International. Vendors such as Adobe and
Microsoft offer solutions that can be considered alternatives to some of our
solutions. In addition, a number of smaller companies produce technologies or
products that are in some markets competitive with our solutions. Current and
potential competitors have established, or may establish, cooperative
relationships among themselves or with third parties to increase the ability of
their technologies to address the needs of our prospective customers.

The competition in these markets could adversely affect our operating
results by reducing the volume of the products we sell or the prices we can
charge. Some of our current or potential competitors have significantly greater
financial, technical and marketing resources than we do. These competitors may
be able to respond more rapidly than we can to new or emerging technologies or
changes in customer requirements. They may also devote greater resources to the
development, promotion and sale of their products than we do. The price and
performance of our products and technologies may not be superior relative to the
products of our competitors. As a result, we may lose competitive position that
could result in lower prices, fewer customer orders, reduced revenue, reduced
gross margins and loss of market share. Our products and technologies may not
achieve market acceptance or sell at favorable prices, which could hurt our
revenue, results of operations and the price of our common stock.

Some of our customers, such as Microsoft, have developed or acquired
products or technologies that compete with our products and technologies. These
customers may give higher priority to the sale of these competitive products or
technologies. To the extent they do so, market acceptance and penetration of our
products, and therefore our revenue, may be adversely affected.

Our success will depend substantially upon our ability to enhance our
products and technologies and to develop and introduce, on a timely and
cost-effective basis, new products and features that meet changing

33

customer requirements and incorporate technological advancements. If we are
unable to develop new products and enhance functionalities or technologies to
adapt to these changes, or are unable to realize synergies among our acquired
products and technologies, our business will suffer.

OUR SOFTWARE PRODUCTS MAY HAVE BUGS, WHICH COULD RESULT IN DELAYED OR LOST
REVENUE, EXPENSIVE CORRECTION, LIABILITY TO OUR CLIENTS AND CLAIMS AGAINST
US. Complex software products such as ours may contain errors, defects or bugs.
Defects in the solutions or products that we develop and sell to our customers
could require expensive corrections and result in delayed or lost revenue,
adverse client reaction and negative publicity about us or our products and
services. Customers who are not satisfied with any of our products could bring
claims against us for damages, which, even if unsuccessful, would likely be
time-consuming to defend, and could result in costly litigation and payment of
damages. Such claims could harm our financial results and competitive position.

WE RELY ON A SMALL NUMBER OF DISTRIBUTION AND FULFILLMENT PARTNERS,
INCLUDING 1450, DIGITAL RIVER, INGRAM MICRO AND TECH DATA, TO DISTRIBUTE MANY OF
OUR PRODUCTS. ANY DISRUPTION IN THESE CHANNELS COULD HARM OUR RESULTS OF
OPERATIONS. Our products are sold through, and a substantial portion of our
revenue is derived from, a network of over 2000 channel partners, including
value-added resellers, computer superstores, consumer electronic stores, mail
order houses, office superstores and eCommerce Web sites. We rely on a small
number of distribution and fulfillment partners, including 1450, Digital River,
Ingram Micro and Tech Data to serve this network of channel partners. For the
year ended December 31, 2002, two distribution and fulfillment partners, Ingram
Micro and Digital River, accounted for 25% and 12% of our consolidated revenue,
respectively. During the year ended December 31, 2001, Ingram Micro and Digital
River accounted for 28% and 15% of our consolidated revenue, respectively. A
disruption in these distribution and fulfillment partner relationships could
negatively affect our results of operations in the short term. Any disruption
for which we are unable to compensate could have a more sustained impact on our
results of operations.

A SIGNIFICANT PORTION OF OUR ACCOUNTS RECEIVABLE IS CONCENTRATED AMONG OUR
THREE LARGEST DISTRIBUTION AND FULFILLMENT PARTNERS, INGRAM MICRO, INC., TECH
DATA CORPORATION, AND DIGITAL RIVER, INC. Our products are sold through, and a
substantial portion of our accounts receivable is derived from, three
distribution and fulfillment partners. At December 31, 2002, Ingram Micro, Tech
Data and Digital River represented 8%, 5% and 5% of our net accounts receivable,
respectively. At December 31, 2001, Ingram Micro, Tech Data and Digital River
represented 16%, 11% and 5%, of our net accounts receivable, respectively. In
addition, although we perform ongoing credit evaluations of our distribution and
fulfillment partners' financial condition and maintain reserves for potential
credit losses, we do not require collateral. While, to date, such losses have
been within our expectations, we cannot assure you that these actions will be
sufficient to meet future contingencies. If any of these distribution and
fulfillment partners were unable to pay us in a timely fashion or if we were to
experience significant credit losses in excess of our reserves, our results of
operations, cash flows and financial condition would be seriously harmed.

A SIGNIFICANT PORTION OF OUR REVENUE IS DERIVED FROM SALES IN EUROPE AND
ASIA. OUR RESULTS COULD BE HARMED BY ECONOMIC, POLITICAL, REGULATORY AND OTHER
RISKS ASSOCIATED WITH THESE AND OTHER INTERNATIONAL REGIONS. Since we sell our
products worldwide, our business is subject to risks associated with doing
business internationally. We anticipate that revenue from international
operations will represent an increasing portion of our total revenue. Reported
international revenue for the years ended December 31, 2002 and December 31,
2001, represented 27% and 21% of our consolidated revenue for those periods,
respectively. Most of these international revenues are produced by sales in
Europe and Asia. A number of our OEM partners distribute their products
throughout the world and do not provide us with the geographical dispersion of
their products. However, based on an estimate that factors our OEM partners'
geographical revenue mix to our revenue generated from these OEM partners,
international revenue would have represented approximately 33% and 30% of our
consolidated revenue for the years ended December 31, 2002 and December 31,
2001, respectively.

Therefore, in addition to risks to our business based on a potential
downturn in the world economy, a region-specific downturn affecting countries in
Western Europe and/or Asia could have a negative effect on our future results of
operations.

34

In addition, some of our products are developed and manufactured outside
the United States. A significant portion of the development and manufacturing of
our speech products are completed in Belgium, and a significant portion of our
digital capture research and development is conducted in Hungary. In addition,
in connection with the Philips acquisition, we have added an additional research
and development location in Germany. Our future results could be harmed by a
variety of factors associated with international sales and operations,
including:

- CHANGES IN A SPECIFIC COUNTRY'S OR REGION'S POLITICAL OR ECONOMIC
CONDITIONS;

- TRADE PROTECTION MEASURES AND IMPORT OR EXPORT LICENSING REQUIREMENTS
IMPOSED BY THE UNITED STATES OR BY OTHER COUNTRIES;

- NEGATIVE CONSEQUENCES FROM CHANGES IN APPLICABLE TAX LAWS;

- DIFFICULTIES IN STAFFING AND MANAGING OPERATIONS IN MULTIPLE LOCATIONS IN
MANY COUNTRIES;

- DIFFICULTIES IN COLLECTING TRADE ACCOUNTS RECEIVABLE IN OTHER COUNTRIES;
AND

- LESS EFFECTIVE PROTECTION OF INTELLECTUAL PROPERTY.

WE ARE EXPOSED TO FLUCTUATIONS IN FOREIGN CURRENCY EXCHANGE RATES. Because
we have international subsidiaries and distributors that operate and sell our
products outside the United States, we are exposed to the risk of changes in
foreign currency exchange rates or declining economic conditions in these
countries. We generally do not engage in hedging transactions to manage our
exposure to currency fluctuations. Our exposure to currency rate fluctuations
could affect our results of operations and cash flows.

IF WE ARE UNABLE TO ATTRACT AND RETAIN TECHNICAL AND OPERATIONAL PERSONNEL,
OUR BUSINESS COULD BE HARMED. If any of our key employees were to leave us, we
could face substantial difficulty in hiring qualified successors and could
experience a loss in productivity while any successor obtains the necessary
training and experience. Our employment relationships are generally at-will and
we have had key employees leave us in the past. We cannot assure you that one or
more key employees will not leave us in the future. We intend to continue to
hire additional highly qualified personnel, including software engineers and
operational personnel, but we may not be able to attract, assimilate or retain
qualified personnel in the future. Any failure to attract, integrate, motivate
and retain these employees could harm our business.

THE STOCKHOLDINGS OF OUR TWO LARGEST STOCKHOLDERS MAY ENABLE THEM TO
INFLUENCE MATTERS REQUIRING STOCKHOLDER APPROVAL. As of December 31, 2002,
Xerox beneficially owned approximately 23.6% of our outstanding common stock,
including warrants exercisable for up to 525,732 shares of our common stock and
3,562,238 shares of our outstanding Series B Preferred Stock, each of which is
convertible into one share of our common stock. The number of shares of common
stock issuable upon exercise of the Xerox warrant may increase in accordance
with a formula defined in the warrant agreement. The State of Wisconsin
Investment Board (SWIB) is our second largest stockholder, owning approximately
18.5% of our common stock as of December 31, 2002. Because of their large
holdings of our capital stock relative to other stockholders, Xerox and SWIB,
acting individually or together, could have a strong influence over matters
requiring approval by our stockholders.

THE MARKET PRICE OF OUR COMMON STOCK HAS BEEN AND MAY CONTINUE TO BE
SUBJECT TO WIDE FLUCTUATIONS. Our stock price historically has been and may
continue to be volatile. Various factors contribute to the volatility of our
stock price, including, for example, quarterly variations in our financial
results, new product introductions by us or our competitors and general economic
and market conditions. While we cannot predict the individual effect that these
factors may have on the market price of our common stock, these factors, either
individually or in the aggregate, could result in significant volatility in our
stock price during any given period of time. Moreover, companies that have
experienced volatility in the market price of their stock often are subject to
securities class action litigation. If we were the subject of such litigation,
it could result in substantial costs and divert management's attention and
resources.

WE HAVE IMPLEMENTED ANTI-TAKEOVER PROVISIONS, WHICH COULD DISCOURAGE OR
PREVENT A TAKEOVER, EVEN IF AN ACQUISITION WOULD BE BENEFICIAL TO OUR
STOCKHOLDERS. Provisions of our amended and restated certificate of

35

incorporation, bylaws and Delaware law could make it more difficult for a third
party to acquire us, even if doing so would be beneficial to our stockholders.
These provisions include:

- A CLASSIFIED BOARD OF DIRECTORS;

- A PREFERRED SHARES RIGHTS AGREEMENT;

- AUTHORIZED "BLANK CHECK" PREFERRED STOCK;

- PROHIBITING CUMULATIVE VOTING IN THE ELECTION OF DIRECTORS;

- LIMITING THE ABILITY OF STOCKHOLDERS TO CALL SPECIAL MEETINGS OF
STOCKHOLDERS;

- REQUIRING ALL STOCKHOLDER ACTIONS TO BE TAKEN AT MEETINGS OF OUR
STOCKHOLDERS; AND

- ESTABLISHING ADVANCE NOTICE REQUIREMENTS FOR NOMINATIONS OF DIRECTORS AND
FOR STOCKHOLDER PROPOSALS.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We develop our products in the United States, Belgium and Hungary. We sell
our products globally, primarily through an indirect reseller channel. As a
result, our financial results are affected by factors such as changes in foreign
currency exchange rates and weak economic conditions in foreign markets.

We collect a portion of our revenue and pay a portion of our operating
expenses in foreign currencies. As a result, changes in currency exchange rates
from time to time may affect our operating results. Currently, we do not
generally engage in hedging transactions to reduce our exposure to changes in
currency exchange rates, although we may do so in the future.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

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

There have been no changes in or disagreements with accountants on
accounting or financial disclosure during 2002 and 2001.

36

SCANSOFT, INC.

CONSOLIDATED FINANCIAL STATEMENTS

37

SCANSOFT, INC.

INDEX TO FINANCIAL STATEMENTS

38

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and
Stockholders of ScanSoft, Inc.:

In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, of stockholders' equity and of
cash flows present fairly, in all material respects, the financial position of
ScanSoft, Inc. and its subsidiaries at December 31, 2002 and December 31, 2001,
and the results of their operations and their cash flows for each of the three
years in the period ended December 31, 2002 in conformity with accounting
principles generally accepted in the United States of America. These financial
statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States of America, which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

As discussed in Note 2 to the consolidated financial statements, effective
January 1, 2002, the Company changed its method of accounting for goodwill and
other intangible assets.

/s/ PricewaterhouseCoopers LLP

Boston, Massachusetts
February 9, 2003, except as to Note 20
for which the date is March 11, 2003

39

SCANSOFT, INC.

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

The accompanying notes are an integral part of these consolidated financial
statements.
40

SCANSOFT, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

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

41

SCANSOFT, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

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

42

SCANSOFT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

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

43

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. ORGANIZATION AND PRESENTATION

ScanSoft, Inc. was incorporated as Visioneer, Inc. in March 1992 and
through December 1998, developed and sold scanner hardware and software
products. On January 6, 1999, Visioneer sold the hardware business and the
Visioneer brand name to Primax Electronics, Ltd., and on March 2, 1999,
Visioneer acquired ScanSoft, in a cash election merger, from Xerox Corporation.
The corporate entity "Visioneer" survived the merger, but changed its name to
"ScanSoft, Inc." In addition, Visioneer changed the ticker symbol for its common
stock that trades on the NASDAQ, to "SSFT." On March 13, 2000, the Company
merged with Caere Corporation ("Caere"), a California-based digital imaging
software company. On December 12, 2001, the Company acquired the speech and
language technologies operations of Lernout & Hauspie Speech Products, N.V.
(L&H). The acquisitions of Caere and L&H were accounted for under the purchase
method of accounting and, accordingly, the results of operations from the
acquired businesses have been included in the Company's financial statements as
of the acquisition dates. (see Note 18)

When we refer to "we" or "ScanSoft" or "the Company" in this Annual Report
on Form 10-K, we mean the current Delaware corporation ScanSoft, Inc., including
all of its consolidated subsidiaries.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities on the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. The most significant estimates and assumptions included in the financial
statements are revenue recognition, including estimating valuation allowances
(specifically sales returns and other allowances), the recoverability of
intangible assets, including goodwill, and valuation allowances for deferred tax
assets. Actual amounts could differ significantly from these estimates.

Basis of Consolidation

The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. Intercompany transactions and balances have
been eliminated.

Foreign Currency Translation

The functional currency of the Company's foreign subsidiaries is the local
currency, with the exception of Budapest, for which the functional currency is
the U.S. dollar. Assets and liabilities of foreign subsidiaries that are
denominated in foreign currencies are translated into U.S. dollars at exchange
rates in effect at the balance sheet date. Revenue and expense items are
translated using the average exchange rates for the period. Net unrealized gains
and losses resulting from foreign currency translation are included in other
comprehensive income (loss), which is a separate component of stockholders'
equity, except for Budapest for which foreign currency translation adjustments
are recorded in other income (expense). Foreign currency transaction gains and
losses are included in results of operations. The Company reported foreign
currency transaction gains and (losses) of $2,000, $0.2 million and $(0.1)
million for the years ended 2002, 2001 and 2000, respectively.

Revenue Recognition

The Company derives revenue from the sale of its software products to
end-users through distribution partners and value added resellers (VARs),
royalties received from OEM partners, license fees from sales of its products to
end-users and from services, primarily maintenance associated with software
license transac-

44

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

tions. Additionally shipping and handling costs billed to customers are recorded
as revenue with the related costs recognized in cost of revenues.

The Company applies the provisions of Statement of Position 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 transactions involving the sale of software products. In addition, the
Company applies the provisions of Staff Accounting Bulletin 101, Revenue
Recognition in Financial Statements. Accordingly, provided that the fee is fixed
or determinable and collection of the receivable is reasonably assured, the
Company generally recognizes revenue from sales of its software products upon
receipt of evidence of the arrangement and upon product shipment or deployment,
except for shipments to a distributor or reseller.

Under the terms of our agreements with distributors and authorized
resellers (including VARs), title and risk-of-loss pass to the customer upon
shipment, at which time the transaction is invoiced and payment is due.
Agreements provide distributors and resellers rights of return. As a result, the
Company recognizes revenue from sales to distributors and resellers only upon
sale of the products by the distributor or reseller to retailers or end-users.
Based on reports from distributors and resellers of their inventory balances at
the end of each period, the Company records an allowance against accounts
receivable for the sales price of all inventory subject to return.

In addition, the Company records reserves for estimated sales returns by
retailers and end-users to it directly or through the Company's distributors or
resellers based on historical returns experience. The provision for these
estimated returns is recorded as a reduction of revenue at the time that the
related revenue is recorded. Such returns from retailers and end-users have not
been significant. Also, from time to time, the Company offers its customers
rebates or offers price protection incentive programs to retailers for the sale
of the Company's products. The Company estimates the impact on revenue of rebate
or price protection programs based upon its historical experience with similar
programs for like products. The estimated reserve for such rebates or programs
is recorded as a reduction of revenue in the period when the rebate or price
protection program is available to the end-user or retailer.

The Company also receives royalties from agreements with original equipment
manufacturers (OEMs). Under the terms of its OEM licensing agreements, the
Company ships a master disk to the OEM and permits the OEM to make multiple
copies. Royalty payments are due to the Company upon the OEM's deployment of
copies of licensed software. Royalty revenue derived from sales to OEM partners
is recognized when software copies are deployed and payment becomes due.
Historically, the Company had not been able to obtain royalty reports from OEM
customers with whom the Company had significant past experience and, therefore,
recognized revenue based on estimated deployments in the respective period. The
Company has determined that it is now able to obtain royalty reports on a timely
basis and as a result can more accurately record OEM revenue based on reports of
actual deployments received from OEM customers. Therefore, beginning with the
fourth quarter of 2002, OEM revenue is recorded based on actual deployments as
reported by OEM customers. This change did not have a material effect on our
financial position, results of operations or cash flows. Additionally, the
differences between actual and estimated deployments were not material for the
years ended December 31, 2001 or 2000, or for any interim period during those
years.

The Company applies the residual method to account for revenues when an
order contains one or more elements to be delivered in the future (for example,
maintenance and support services or training) and when evidence of the fair
value of all undelivered elements exists. Under the residual method, the fair
value of the undelivered elements is initially deferred and the remaining
portion of the arrangement fee is recognized as revenues related to the
delivered elements. If evidence of the fair value of one or more of the
undelivered elements does not exist, all revenues are deferred and recognized
only when delivery of those elements occurs or when fair value can be
established. Vendor-specific objective evidence (VSOE) of the fair value of each
undelivered element is based on the prices charged by the Company to its
customers when these elements are

45

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

sold separately or, in the case of some maintenance services, based on the
contractual maintenance renewal rates. VSOE of the fair value of training
service is based on the fee charged per day or per student, depending on the
type of training provided.

The Company recognizes revenue from the sale of maintenance and support to
end-users ratably over the contract period, usually one year. Payments received
in advance for maintenance and support revenue are initially recorded as
deferred revenue. Revenue from training service is recognized as it is provided.

The Company's products do not require installation or implementation by the
Company and do not require significant production, modification or customization
of the software. However, the Company occasionally enters into software license
agreements with customers that require significant modification of the software.
Revenue is recognized under these arrangements in accordance with Statement of
Position 81-1 (SOP 81-1), Accounting for Performance of Construction-Type and
Certain Performance-Type Contracts. Under the percentage-of-completion method,
the Company determines progress toward completion based on costs incurred to
date as compared with total estimated costs at the contract completion date.
Anticipated losses, if any, are recognized in the period in which determined.

Effective January 1, 2002, the Company implemented EITF 01-9, Accounting
for Consideration Given by a Vendor to a Customer (Including a Reseller of the
Vendor's Products). The implementation resulted in a $0.3 million, $1.1 million
and $1.1 million reduction in total revenue and a corresponding reduction of
selling, general and administrative expense for the years ended 2002, 2001 and
2000, respectively.

Costs of Revenue

Cost of revenue consists primarily of material and fulfillment costs,
third-party royalties, salaries for product support personnel, and engineering
costs associated with certain contracts which are accounted for under the
percentage of completion method of accounting.

Costs of Revenue from Amortization of Intangible Assets

Cost of revenue from amortization of intangible assets includes the
amortization of acquired patents and core and completed technology.

Cash Equivalents

Cash equivalents are short-term, highly liquid instruments with original
maturities of 90 days or less at the date of acquisition. The Company invests
primarily in commercial paper.

Accounts Receivable

The Company establishes reserves against its accounts receivable for
potential credit losses when it determines receivables are at risk for
collection based upon the length of time the receivables are outstanding as well
as various other criteria. Receivables are written off against these reserves in
the period they are determined to be uncollectible.

Inventory

Inventory is stated at the lower of cost (determined on a first-in,
first-out basis) or market value.

46

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Property and Equipment

Property and equipment are stated at cost and are depreciated using the
straight-line method over the estimated useful lives of the assets. Leasehold
improvements are amortized over the term of the related lease or the useful
life, if shorter. The cost and related accumulated depreciation of sold or
retired assets are removed from the accounts and any gain or loss is included in
operations. Repairs and maintenance costs are expensed as incurred.

Long-lived and Intangible Assets and Goodwill

The Company has significant long-lived tangible and intangible assets,
including goodwill, which are susceptible to valuation adjustments as a result
of changes in various factors or conditions. The most significant long-lived
tangible and intangible assets are fixed assets, patents, core technology, and
trademarks which are amortized using the straight-line method over their
estimated useful lives. The values of intangible assets, with the exception of
goodwill, were initially determined by a risk-adjusted, discounted cash flow
approach. We assess the potential impairment of identifiable intangible assets
and fixed assets whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. Factors we consider important, which
could trigger an impairment of such assets, include the following:

- Significant underperformance relative to historical or projected future
operating results;

- Significant changes in the manner of or use of the acquired assets or the
strategy for our overall business;

- Significant negative industry or economic trends;

- Significant decline in our stock price for a sustained period; and

- A decline in our market capitalization below net book value.

Future adverse changes in these or other unforeseeable factors could result
in an impairment charge that would impact future results of operations and
financial position in the reporting period identified.

Effective January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 142, Goodwill and Other Intangible Assets or SFAS 142.
SFAS 142 requires, among other things, the discontinuance of goodwill
amortization. The standard also includes provisions for the reassessment of the
useful lives of existing recognized intangible assets and the identification of
reporting units for purposes of assessing potential future impairments of
goodwill. SFAS 142 required us to complete a transitional impairment test of
goodwill within six months of the date of adoption. We have reassessed the
useful lives of our existing intangible assets, other than goodwill, and believe
that the original useful lives remain appropriate. In addition, we have
determined that we operate in one reporting unit and, therefore, have completed
our transitional goodwill impairment test on an enterprise-wide level. Based on
this analysis, we have determined that goodwill recorded was not impaired, and
no impairment charge has been recorded. We will complete additional goodwill
impairment analyses at least annually, or more frequently when events and
circumstances occur indicating that the recorded goodwill might be impaired.

Significant judgments and estimates are involved in determining the useful
lives of our intangible assets, determining what reporting units exist and
assessing when events or circumstances would require an interim impairment
analysis of goodwill or other long-lived assets to be performed. Changes in
events or circumstances, including but not limited to technological advances or
competition which could result in shorter useful lives, additional reporting
units which may require alternative methods of estimating fair value, or
economic or market conditions which may affect previous assumptions and
estimates, could have a significant impact on our results of operations or
financial position through accelerated amortization expense or impairment
charges. (See Notes 4 and 5)

47

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Research and Development Costs

Costs incurred in the research and development of new software products and
enhancements to existing products, other than certain software development costs
that qualify for capitalization, are expensed as incurred. Software development
costs incurred subsequent to the establishment of technological feasibility, but
prior to the general release of the product, are capitalized and amortized to
cost of revenue over the estimated useful life of the related products. In the
years ended December 31, 2002, 2001 and 2000, costs eligible for capitalization
were not material.

Income Taxes

Deferred tax assets and liabilities are determined based on the difference
between the financial statement and tax bases of assets and liabilities using
enacted tax rates in effect in the years in which the differences are expected
to reverse. A valuation allowance against deferred tax assets is recorded if,
based on the weight of available evidence, it is more likely than not that some
or all of the deferred tax assets will not be realized. The Company does not
provide for U.S. income taxes on the undistributed earnings of its foreign
subsidiaries, which the Company considers to be permanent investments.

Comprehensive Income (Loss)

Comprehensive income (loss) consists of net loss and other comprehensive
income (loss), which includes foreign currency translation adjustments. For the
purposes of comprehensive loss disclosures, the Company does not record tax
provisions or benefits for the net changes in the foreign currency translation
adjustment, as the Company intends to permanently reinvest undistributed
earnings in its foreign subsidiaries.

Concentration of Risk

Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of cash equivalents, and trade
accounts receivable. The Company places its cash and cash equivalents with
financial institutions with high credit ratings. The Company performs ongoing
credit evaluations of its customers' financial condition and does not require
collateral, since management does not anticipate nonperformance of payment. The
Company also maintains reserves for potential credit losses and such losses have
been within management's expectations. At December 31, 2002, no customer
represented greater than 10% of our net accounts receivable balance. At December
31, 2001, three customers represented 16%, 11% and 5%, of our net accounts
receivable balance, respectively.

Fair Value Disclosures of Financial Instruments

Financial instruments include cash equivalents, accounts receivable, and
long-term notes payable and are carried in the financial statements at amounts
that approximate their fair value as of December 31, 2002 and 2001.

Advertising Costs

Advertising costs are expensed as incurred and are classified as selling,
general and administrative costs. The Company incurred advertising costs of $3.0
million, $2.5 million and $1.9 million for the years ended December 31, 2002,
2001 and 2000, respectively.

Net Income (Loss) Per Share

Basic net income (loss) per share is computed by dividing net income (loss)
available to common stockholders by the weighted-average number of common shares
outstanding for the period. Basic net income per share for the year ended
December 31, 2002 includes the assumed conversion of the Series B Preferred

48

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Stock, which participates in dividends with common stock when and if declared as
well as the weighted average impact of vested restricted stock. Diluted net
income (loss) per share is computed by dividing net income (loss) available to
common stockholders by the weighted-average number of common shares outstanding
for the period plus potential dilutive common shares, which include the assumed
conversion of the Series B Preferred Stock, and the effect, when dilutive, of
outstanding stock options, warrants, and unvested shares of restricted stock
using the treasury stock method. All potential dilutive common shares are
excluded from the computation of net loss per share because they are
antidilutive. Dilutive common equivalent shares consist of stock options and
warrants and are calculated using the treasury stock method.

The following is a reconciliation of the shares used in the computation of
basic and diluted net income (loss) per share (in thousands, except per share
amounts):

For the year ended December 31, 2002, stock options to purchase 1,039,955
shares of common stock were outstanding but were excluded from the calculation
of diluted net income per share because the options' exercise prices were
greater than the average market price of the Company's common stock.
Additionally, stock options to purchase 5,080,343 and 5,179,653 shares of common
stock were not included in the calculation of diluted net loss per share for the
years ended December 31, 2001 and 2000, respectively, because they were
antidilutive.

Potential weighted average common shares, including stock options, unvested
restricted stock, preferred shares and warrants at December 31, 2001 and 2000,
were 11,755,150 and 9,534,865, respectively. These potential common shares were
excluded from the calculation of diluted net loss per share as their inclusion
would have been antidilutive for the period presented.

On January 30, 2003, the Company issued a $27.5 million subordinated
debenture which is convertible into the Company's common stock at $6.00 per
share. (See Note 20)

49

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Accounting for Stock-Based Compensation

The Company accounts for stock-based awards to employees using the
intrinsic value method as prescribed in Accounting Principles Board ("APB")
Opinion No. 25, "Accounting for Stock Issued to Employees" and related
interpretations. The Company follows the disclosure provisions of Statement of
Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation"
(see Note 11). Deferred compensation is recorded for restricted stock granted to
employees based on the fair value of the Company's common stock at the date of
grant and is amortized over the period in which the restrictions lapse. All
stock-based awards to non-employees are accounted for at their fair value in
accordance with SFAS No. 123 and related interpretations.

Had compensation expense for the Company's stock-based compensation plans
been determined based on fair market value at the grant dates, as prescribed by
SFAS No. 123, the Company's net loss and pro forma net income (loss) and net
(income) loss and pro forma net income (loss) per share would have been as
follows (in thousands, except per share amounts):

The fair value of each option grant was estimated on the date of grant
using the Black-Scholes option-pricing model with the following assumptions:
expected volatility of 80% for 2002 and 130% for 2001 and 2000, risk-free
interest rate of 4.33% to 2.26% for options granted in 2002, 3.66% to 4.97% for
options granted in 2001 and 5.02% to 6.68% for options granted in 2000, and a
weighted average expected option term of 3.5 years for 2002 and 5 years for 2001
and 2000, respectively. The Company has not paid dividends to date and assumed
no dividend yield.

For the Employee Stock Purchase Plan, the fair value of each purchase right
was estimated at the beginning of the offering period using the Black-Scholes
option-pricing model with the following assumptions used in 2002, 2001 and 2000:
expected volatility of 80% for 2002, 133% to 168% for 2001 and 128% for 2000;
risk-free interest rate of 1.65% to 3.36%, 3.41% to 5.04% and 6.10% for 2002,
2001 and 2000, respectively; and expected lives of six months for all three
years. The Company has not paid dividends and assumed no dividend yield. The
weighted-average fair value of all purchase rights granted in 2002, 2001 and
2000, were $1.49, $1.04 and $1.73, respectively.

Recently Issued Accounting Standards

On December 31, 2002, the FASB issued FASB Statement No. 148 (SFAS 148),
Accounting for Stock-Based Compensation -- Transition and Disclosure, amending
FASB Statement No. 123 (SFAS 123), Accounting for Stock-Based Compensation. This
Statement amends SFAS 123 to provide alternative methods of transition for an
entity that voluntarily changes to the fair value based method of accounting for
stock-based employee compensation. It also amends the disclosure provisions of
that Statement to require prominent disclosure about the effects on reported net
income of an entity's accounting policy decisions with respect to stock-based
employee compensation. Finally, SFAS 148 amends APB Opinion No. 28, Interim
Financial Reporting, to require disclosure about those effects in interim
financial information. For entities that voluntarily change to the fair value
based method of accounting for stock-based employee compensation, the transition
provisions are effective for fiscal years ending after December 15, 2002. For
all other companies, the

50

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

disclosure provisions and the amendment to APB No. 28 are effective for interim
periods beginning after December 15, 2002. SFAS 148 did not have any effect on
our financial position, results of operations or cash flows as we have elected
to continue to follow the recognition provisions of APB No. 25.

On November 25, 2002, the FASB issued FASB Interpretation No. 45 ("FIN
45"), Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others, an interpretation of
FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34.
FIN 45 clarifies the requirements of FASB Statement No. 5, Accounting for
Contingencies (SFAS 5), relating to the guarantor's accounting for, and
disclosure of, the issuance of certain types of guarantees.

FIN 45 requires that upon issuance of a guarantee, the guarantor must
recognize a liability for the fair value of the obligation it assumes under that
guarantee. FIN 45 covers guarantee contracts that have any of the following four
characteristics: (a) contracts that contingently require the guarantor to make
payments to the guaranteed party based on changes in an underlying that is
related to an asset, a liability, or an equity security of the guaranteed party
(e.g., financial and market value guarantees), (b) contracts that contingently
require the guarantor to make payments to the guaranteed party based on another
entity's failure to perform under an obligating agreement (performance
guarantees), (c) indemnification agreements that contingently require the
indemnifying party (guarantor) to make payments to the indemnified party
(guaranteed party) based on changes in an underlying that is related to an
asset, a liability, or an equity security of the indemnified party, such as an
adverse judgment in a lawsuit or the imposition of additional taxes due to
either a change in the tax law or an adverse interpretation of the tax law, and
(d) indirect guarantees of the indebtedness of others.

FIN 45 specifically excludes certain guarantee contracts from its scope.
Additionally, certain guarantees are not subject to FIN 45's provisions for
initial recognition and measurement but are subject to its disclosure
requirements. The initial recognition and measurement provisions are effective
for guarantees issued or modified after December 31, 2002. The Company has
evaluated the impact of FIN 45 on its financial statements and determined that
the recognition provision will not have an impact on the financial position or
results of operations for 2002.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities, or SFAS 146. This statement addresses
financial accounting and reporting for costs associated with exit or disposal
activities and nullifies EITF Issue 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring), or EITF 94-3. SFAS 146 requires that
a liability for a cost associated with an exit or disposal activity be
recognized when the liability is incurred. EITF 94-3 allowed for an exit cost
liability to be recognized at the date of an entity's commitment to an exit
plan. SFAS 146 also requires that liabilities recorded in connection with exit
plans be initially measured at fair value. The provisions of SFAS 146 are
effective for exit or disposal activities that are initiated after December 31,
2002, with early adoption encouraged. The Company does not expect the adoption
of SFAS 146 will have a material impact on its financial position or results of
operations.

In August 2001, the FASB issued Statement of Financial Accounting Standards
No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS
144). The objectives of SFAS 144 are to address significant issues relating to
the implementation of FASB Statement No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of (SFAS 121), and to
develop a single accounting model, based on the framework established in SFAS
121, for long-lived assets to be disposed of by sale, whether previously held
and used or newly acquired. SFAS 144 supersedes SFAS 121; however, it retains
the fundamental provisions of SFAS 121 for (1) the recognition and measurement
of the impairment of long-lived assets to be held and used and (2) the
measurement of long-lived assets to be disposed of by sale. SFAS 144 supersedes
the accounting and reporting provisions of Accounting Principles Board No. 30,
Reporting the Results of Operations -- Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions (APB 30), for segments of a business to be

51

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

disposed of. However, SFAS 144 retains the requirement of APB 30 that entities
report discontinued operations separately from continuing operations and extends
that reporting requirement to "a component of an entity" that either has been
disposed of or is classified as "held for sale." SFAS 144 also amends the
guidance of Accounting Research Bulletin No. 51, Consolidated Financial
Statements, to eliminate the exception to consolidation for a temporarily
controlled subsidiary. SFAS 144 is effective for financial statements issued for
fiscal years beginning after December 15, 2001, including interim periods, and,
generally, its provisions are to be applied prospectively. The Company adopted
the provisions of SFAS 144 in 2002 and its adoption had no impact on its results
of operations.

3. INVENTORY

Inventory consists of the following (in thousands):

4. GOODWILL

In June 2001, the Financial Accounting Standards Board issued Statements of
Financial Accounting Standards No. 142 (SFAS 142), "Goodwill and Other
Intangible Assets." SFAS 142 addresses financial accounting and reporting for
acquired goodwill and other intangible assets, including how goodwill and other
intangible assets should be accounted for after they have been initially
recognized. SFAS 142 provides that goodwill and intangible assets that have
indefinite useful lives not be amortized but rather be tested at least annually
for impairment; intangible assets with finite useful lives will continue to be
amortized over their useful lives.

The Company adopted SFAS 142 on January 1, 2002 and discontinued the
amortization of goodwill (including acquired workforce) of approximately $65.2
million. Upon adoption, the Company reclassified $31,000 of previously
amortizable acquired workforce to goodwill. The Company had previously been
recording amortization expense on goodwill and acquired workforce of $10.4
million annually or $2.6 million per quarter.

Under SFAS 142, the Company was required to complete a transitional
impairment test on all goodwill effective as of January 1, 2002 on a reporting
unit basis. A reporting unit is defined as an operating segment or one level
below an operating segment referred to as a component. A component of an
operating segment is a reporting unit if the component constitutes a business
and discrete financial information is prepared and regularly reviewed by
management. The Company determined that it operates in one reporting unit and,
therefore, has completed the transitional goodwill impairment test on an
enterprise-wide basis.

SFAS 142 provides for a two-step impairment test to identify potential
goodwill impairment. The first step of the goodwill impairment test compares the
fair value of a reporting unit with its carrying value, including goodwill. If
the fair value of a reporting unit exceeds its carrying value, goodwill of the
reporting unit is considered not impaired, thus the second step of the
impairment test, which determines the amount of goodwill impairment, is
unnecessary.

The fair value of the reporting unit was determined using the Company's
market capitalization as of January 1, 2002. As the fair value of the reporting
unit as of January 1, 2002 was in excess of the carrying amount of the net
assets, the Company concluded that its goodwill was not impaired, and no
impairment charge was recorded. The Company performed its annual assessment for
2002 in the fourth quarter. Based on

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the Company's market capitalization as of November 30, 2002, the fair value of
the reporting unit was in excess of the carrying amount of the net assets as of
November 30, 2002. Therefore, no further analysis was required under SFAS 142.

Intangible assets are amortized on a straight-line basis over their
estimated useful lives of three to twelve years. As required, upon adoption of
SFAS 142, the Company reassessed the useful lives of its intangible assets and
determined that no adjustments were required.

The following summary reflects the consolidated results of operations as if
SFAS 142 had been adopted at the beginning of the periods presented (in
thousands, except net income (loss) per share amounts):

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

5. OTHER INTANGIBLE ASSETS

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

The balances of patents and core technology, trademarks and assembled
workforce at December 31, 2002 reflect the impact of the restatement described
in Note 18. As a result of the restatement, $16.6 million, $2.9 million and $3.3
million of patents and core technology, trademarks and assembled workforce,
respectively, were reallocated to goodwill.

Aggregate amortization expense was $11.2 million ($9.5 million included in
cost of revenue) for the year ended December 31, 2002. Estimated amortization
expense for each of the five succeeding fiscal years as of December 31, 2002 is
as follows (in thousands):

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

6. PROPERTY AND EQUIPMENT

Property and equipment consist of the following (in thousands):

Depreciation expense, associated with property and equipment, for the years
ended December 31, 2002, 2001 and 2000 was $2.0 million, $1.8 million, and $2.1
million, respectively.

In January 2002, the Company entered into a one-year capital lease
agreement for certain equipment. Total payments during the year were $0.3
million. No further obligation exists as of December 31, 2002. 7. ACCRUED
EXPENSES

Accrued expenses consist of the following (in thousands):

8. RESTRUCTURING AND OTHER CHARGES

In connection with the acquisition of Caere in the first quarter of 2000,
ScanSoft identified 46 employees of Caere whose positions were eliminated upon
consummation of the acquisition. These positions included 22 in research and
development, 14 in general and administrative functions, and 10 in sales and
marketing. Additionally, the Caere president and CEO position was eliminated. As
a result, ScanSoft established as part of the purchase price allocation, a
restructuring reserve of $0.5 million for severance payments to employees, and a
restructuring reserve of $1.1 million for severance to the Caere former
president and CEO, the payments of which will continue through March 2005.

In June 2000, ScanSoft implemented a restructuring plan to strategically
refocus our business and bring operating expenses in line with net revenues. As
a result, the Company eliminated 65 employee positions

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SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

including 29 in research and development, 13 in general and administrative
functions and 23 in support and marketing. ScanSoft recorded a restructuring
charge in the amount of $1,069,000 for severance payments to these employees and
a restructuring charge of $0.4 million for certain termination fees to be
incurred as a result of exiting the Los Gatos facility. Additionally, ScanSoft
wrote-off $3.5 million of net intangible assets acquired as part of the Caere
acquisition including the acquired work force of $1.1 million and the favorable
building lease of $2.4 million, which were impaired as a result of the
restructuring action.

The Company was obligated to pay retention bonuses amounting to
approximately $0.8 million and $0.2 million relating to key employees who were
employed in the Caere integration and restructuring of the companies,
respectively. These retention bonuses were expensed as incurred and were not
included in the purchase price of the acquisition. As of December 31, 2000, the
Company had paid all of these bonuses.

During the fourth quarter of 2000, the Company incurred an additional $0.3
million of facility related exit costs related to leasehold improvements on the
Los Gatos facility in space vacated by the Company.

Additionally, during the fourth quarter the Company reversed $0.4 million
of restructuring accruals taken in June 2000. Facility related contracts
accounted for $0.3 million of the reserve. The remaining $0.1 million related to
severance accruals for employees who left the Company prior to being eligible to
receive severance benefits.

Through December 31, 2001 ScanSoft paid $1.9 million in severance payments
related to these restructuring actions.

In January 2002, the Company announced, and in March 2002 completed, a
restructuring plan to consolidate facilities, worldwide sales organizations,
research and development teams and other personnel following the December 12,
2001 L&H acquisition. As a result, the Company exited facilities in both North
America and Europe, eliminating 21 employee positions, including 12 in research
and development and 9 in selling, general and administrative functions. In the
first quarter of 2002, the Company recorded a restructuring charge in the amount
of $0.6 million for severance payments to these employees, and a restructuring
charge of $0.4 million for certain termination fees to be incurred as a result
of exiting the facilities, including the write-off of previously recorded
assembled workforce of $0.1 million.

During the fiscal year ended December 31, 2002, the Company paid a total of
$0.8 million in severance payments, of which $0.6 million related to the March
2002 restructuring and $0.2 million related to severance paid to the former
Caere President and CEO, pursuant to a 2000 restructuring.

At December 31, 2002, the remaining restructuring accrual from the current
and prior restructuring activities amounted to $0.7 million. This balance is
comprised of $0.2 million of lease exit costs resulting from the 2002
restructuring and $0.5 million of severance to the former Caere President and
CEO. The lease exit costs and severance due to the former Caere President and
CEO will be paid through January 2004 and March 2005, respectively.

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SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following table sets forth the 2002, 2001 and 2000 restructuring
accrual activity (in thousands):

9. DEBT

Credit Facility

On October 31, 2002, the Company entered into a two year Loan and Security
Agreement (the "Loan Agreement") with Silicon Valley Bank (the "Bank") that
consisted of a $10 million revolving loan (the "Credit Facility"). Borrowings
under the Credit Facility will bear interest at the Bank's prime rate plus
0.375% or 0.75%, (4.625% at December 31, 2002) which is determined by the
Company's fixed charge coverage ratio, as defined in the Loan Agreement. The
maximum aggregate amount of borrowings outstanding at any one time will be
limited to the lesser of $10.0 million or a borrowing base equal to either 80%
or 70% of eligible accounts receivable, as defined in the Loan Agreement, based
on the Company's fixed charge coverage ratio. As of December 31, 2002, based
upon the calculated borrowing base, available borrowings totaled approximately
$8.6 million. Borrowings under the loan agreement cannot exceed the borrowing
base and must be repaid in the event they exceed the calculated borrowing base
or upon expiration of the two year loan term. Pursuant to the Loan Agreement,
the Company will be required to maintain certain financial and non-financial
covenants, the most restrictive of which is a quarterly minimum fixed charge
coverage ratio of 1.25 to 1.00. Borrowings under the Loan Agreement are
collateralized by substantially all of the Company's personal property,
predominantly its accounts receivable, but not its intellectual property. As of
December 31, 2002, there was no outstanding balance under this Credit Facility
and the Company was in compliance with all debt covenants.

Our loan and security agreement with Silicon Valley Bank, dated October 31,
2002, contains a restrictive covenant which prohibits us from paying or
declaring any dividends on our capital stock during the term of the agreement
(except for dividends payable solely in capital stock) without Silicon Valley
Bank's prior written consent. In addition, the zero coupon convertible
subordinated debenture due in 2006 that was issued to

57

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Koninklijke Royal Philips Electronics N.V. ("Philips") in connection with our
acquisition of the Speech Processing Telephony and Voice Control business units
of Philips contains a restrictive covenant which prohibits us from paying or
declaring any dividend or distribution (other than distributions of our equity
securities) on our capital stock while the note is outstanding. This restriction
terminates if one half or more of the note is converted by Philips into common
stock.

On March 14, 2000, the Company entered into a one year Credit Agreement
(the "Agreement") with its then primary financial institution for a $10 million
revolving loan (the "Prior Credit Facility"). Borrowings under the Prior Credit
Facility bore interest at the prime rate plus one percent and, as amended,
expired on September 30, 2001. The maximum aggregate amount of borrowings
outstanding at any one time as amended was $5.0 million. During 2001, the
Company repaid all amounts due under the Prior Credit Facility, which included
principal and interest amounting to $3.4 million. The Prior Credit Facility was
terminated and cancelled upon the final payment.

Note Payable

In connection with the L&H acquisition (see Note 18), the Company issued a
$3.5 million promissory note (the "Note") to Lernout & Hauspie Speech Products,
N.V. The unsecured Note had a stated maturity date of December 15, 2004 and bore
interest at 9% per annum. Payments of principal and interest in the amount of
$133,000 were due quarterly commencing on March 15, 2002, for a total of eleven
payments. During the year ended December 31, 2002, four quarterly payments were
made in accordance with the terms and conditions of the promissory note.

In connection with an agreement to repurchase 1,461,378 shares of common
stock from L&H Holdings USA, Inc. and Lernout & Hauspie Speech Products N.V.
(collectively, L&H) (see Note 10), entered into by the Company in September
2002, the terms of the Note were amended to provide for the acceleration of the
maturity date of the outstanding principal and interest to January 1, 2003 if
consummation of the underwritten public offering (also described in Note 10) did
not occur by January 1, 2003. The Company did not complete the offering by
January 1, 2003 and accordingly, the debt became immediately due and payable. To
fulfill this obligation, on January 3, 2003, the Company paid $3.3 million in
full settlement of all of the outstanding principal and accrued interest under
the Note. The Company has classified the debt as current in its balance sheet at
December 31, 2002.

10. STOCKHOLDERS' EQUITY

Preferred Stock

The Company is authorized to issue up to 40,000,000 shares of preferred
stock, par value $0.001 per share. The Company has designated 100,000 shares as
Series A Preferred Stock and 15,000,000 as Series B Preferred Stock. In
connection with the acquisition of ScanSoft (see Note 1), the Company issued
3,562,238 shares of Series B Preferred Stock to Xerox Corporation ("Xerox"). The
Series B Preferred Stock is convertible into shares of common stock on a
one-for-one basis. The Series B Preferred Stock has a liquidation preference of
$1.30 per share plus all declared but unpaid dividends. The Series B Preferred
Stock holders are entitled to non-cumulative dividends at the rate of $0.065 per
annum per share, payable when, as and if declared by the Board of Directors. To
date no dividends have been declared by the Board of Directors. Holders of
Series B Preferred Stock have no voting rights, except those rights provided
under Delaware law. The undesignated shares of preferred stock will have rights,
preferences, privileges and restrictions, including voting rights, dividend
rights, conversion rights, redemption privileges and liquidation preferences, as
shall be determined by the Board of Directors upon issuance of the preferred
stock. The Company has reserved 3,562,238 shares of its common stock for
issuance upon conversion of the Series B Preferred Stock.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Common Stock Warrants

In connection with the ScanSoft acquisition (see Note 1), the Company
issued Xerox a ten-year warrant that allows Xerox to acquire a number of shares
of common stock equal to the number of stock options (whether vested or
unvested) that remains unexercised at the expiration of any ScanSoft stock
option assumed by the Company in the merger. The exercise price for each warrant
share is $0.61. If all of the assumed ScanSoft options expire without being
exercised, Xerox would be entitled to purchase 1,736,630 shares of common stock.
From the date of acquisition through December 31, 2002, 525,732 ScanSoft options
have been forfeited and accordingly, the Xerox warrant at December 31, 2002 was
exercisable for the purchase of 525,732 shares of the Company's common stock.

Stock Repurchase

During 2001, the Board of Directors authorized the repurchase of up to 2
million shares of common stock for a period of one year ending on August 22,
2002. Purchases were made in the open market and in privately negotiated
transactions. Repurchased shares are available for issuance under employee stock
plans or in the ordinary course of business. During the year ended December 31,
2001 the Company repurchased 656,000 shares of common stock at a cost of $1.0
million. No other shares were repurchased under the program.

In September of 2002, the Company repurchased 1,461,378 shares of common
stock from L&H Holdings USA, Inc. and Lernout & Hauspie Speech Products N.V.
(collectively, L&H) and certain other parties at $4.79 per share for a total
consideration of $7.0 million. The price per share was based on the greater of
$4.79 or the twenty day trading average beginning August 14, 2002, which was
$4.67. These shares represented a portion of the common shares that were issued
to L&H in connection with the December 12, 2001 acquisition of certain of L&H's
speech and language technology operations and the March 21, 2002 acquisition of
the AudioMining assets of L&H Holdings USA, Inc.

As of December 31, 2002 and 2001, the Company had 2,117,378 and 656,000
shares of common stock in treasury at a cost of $8.0 million and $1.0 million,
respectively.

Other

On April 12, 2002, the Company completed a private placement of 1.0 million
shares of common stock at a purchase price of $6.00 per share with SF Capital
Partners Ltd. ("SF Capital"), resulting in proceeds, net of issuance costs, of
$5.6 million. In purchasing these shares, SF Capital was provided with certain
registration rights which required that the shares be registered no later than
August 10, 2002. The shares held by SF Capital were were registered on February
10, 2003.

In connection with the agreement to repurchase 1,461,378 shares of common
stock from L&H Holdings USA, Inc. and Lernout & Hauspie Speech Products N.V.
(collectively, L&H) entered into by the Company in September 2002, the Company
agreed to issue an additional 150,000 shares of its common stock to L&H if it
did not complete an underwritten public offering of the shares held by L&H by
December 15, 2002. The Company further agreed to issue an additional 150,000
shares of its common stock to L&H if it did not complete an underwritten public
offering by February 15, 2003. The Company also would be required to issue an
additional 100,000 shares of its common stock to L&H if, by February 15, 2003,
it failed to file a registration statement to register the shares remaining
unsold. The value ascribed to the potential right to acquire additional shares
of the Company's common stock was valued at $0.3 million using a probability-
weighted, Black-Scholes valuation model and recorded as a credit to additional
paid-in capital, with a corresponding reduction in additional paid-in capital
because the Company has an accumulated deficit. Accordingly, the right had no
net effect on the Company's financial position or results of operations. The
Company completed the public offering on February 14, 2003. Because the offering
was not completed by December 15,2002, the Company issued L&H 150,000 shares of
common stock on December 18, 2002.

59

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

During December 2001, the Company issued 262,200 shares of its common stock
in partial settlement of a $2.1 million liability assumed in connection with the
Caere acquisition. The common stock was valued at $0.7 million based on the fair
value of the common stock on the date the agreement was reached. The Company
also agreed to pay $0.7 million in cash as part of the settlement. The Company
realized a gain on this settlement of $0.7 million as a reduction of general and
administrative expenses in 2001.

On December 21, 2001, the Company committed to issuing 65,100 shares of its
common stock in partial settlement of a $1.0 million liability incurred as part
of the Caere acquisition. The common stock was valued at $0.3 million based on
the fair value of the common stock on the date agreement was reached. The
Company also agreed to pay $0.3 million in cash as part of the settlement. The
Company realized a gain on this settlement of $0.3 million as a reduction of
general and administrative expenses in 2001. The $0.3 million value of the
common stock is reflected in other long-term liabilities at year-end as the
shares were not issued as of December 31, 2001. The stock was issued in January
2002.

11. STOCK COMPENSATION PLANS

Stock Option and Award Plans

The Company has several stock-based compensation plans under which
employees, officers, directors and consultants may be granted stock awards or
options to purchase the Company's common stock generally at the fair market
value on the date of grant. Plans do not allow for options to be granted at
below fair market value nor can they be re-priced at anytime. Options become
exercisable over various periods, typically two to four years and have a maximum
term of 10 years. At December 31, 2002, 18,028,104 shares were authorized for
grant under the Company's stock-based compensation plans, of which 2,882,397
were available for future grant. To date, all stock options have been granted
with exercise prices equal to or greater than the fair market value of the
Company's common stock on the date of grant.

During 2001, the Company awarded 133,824 shares of restricted common stock
to senior executives at a weighted average fair value at the grant date of $2.72
resulting in deferred compensation of $291,000. Restrictions lapse over a period
of 2 to 4 years depending on the grant. The restricted stock awards entitle the
participant to full dividend and voting rights. Unvested shares are restricted
as to disposition and subject to forfeiture under certain circumstances.
Deferred compensation expense is amortized to compensation expense over the
period that the restrictions lapse. During 2002 and 2001, compensation expense
of $103,000 and $15,000 was recognized, respectively. No restricted stock was
awarded for the year ended December 31, 2002.

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SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following table summarizes activity under all stock option plans and
for options granted outside the plans:

The weighted average grant date fair value per share of options granted was
$3.12, $1.92 and $1.83 for the years ended December 31, 2002, 2001 and 2000,
respectively.

Stock options to purchase 8,389,293, 6,502,668 and 4,088,911 shares of
common stock were exercisable as of December 31, 2002, 2001 and 2000,
respectively.

The following table summarizes information about stock options outstanding
under the Company's stock compensation plans at December 31, 2002:

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SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

1995 Employee Stock Purchase Plan

The Company's 1995 Employee Stock Purchase Plan, as amended on June 29,
1999, authorizes the issuance of a maximum of 1,000,000 shares of common stock
in semi-annual offerings to employees at a price equal to the lower of 85% of
the closing price on the applicable offering commencement date or 85% of the
closing price on the applicable offering termination date. The Company issued
87,185, 95,952 and 46,896 shares of common stock under this plan during the
years ended December 31, 2002, 2001 and 2000 respectively. The weighted average
fair value of common stock on the grant date was $1.48, $0.71 and $1.08 during
the years ended December 31, 2002, 2001 and 2000 respectively.

12. COMPREHENSIVE INCOME (LOSS)

Total comprehensive income (loss), net of taxes, was $6.8 million, ($17.3)
million and ($53.3) million for the years ended December 31, 2002, 2001 and 2000
respectively. Total comprehensive income (loss) consisted of net income or loss
and foreign currency translation adjustments for the respective periods.

13. COMMITMENTS AND CONTINGENCIES

Operating Leases

The Company has various operating leases for office space around the world.
These obligations extend through 2008. Future minimum payments under operating
leases with an initial term of more than one year are as follows (in thousands):

Total rent expense under operating leases for the years ended December 31,
2002, 2001 and 2000 was $1.8 million, $0.8 million and $0.8 million,
respectively.

Litigation and Other Claims

Like many companies in the software industry, the Company has from time to
time been notified of claims that it may be infringing certain intellectual
property rights of others. These claims have been referred to counsel, and they
are in various stages of evaluation and negotiation. If it appears necessary or
desirable, the Company may seek licenses for these intellectual property rights.
There is no assurance that licenses will be offered by all claimants, that the
terms of any offered licenses will be acceptable to the Company or that in all
cases the dispute will be resolved without litigation, which may be time
consuming and expensive, and may result in injunctive relief or the payment of
damages by the Company.

From time to time, we receive information concerning possible infringement
by third parties of our intellectual property rights, whether developed,
purchased or licensed by us. In response to any such circumstance, we have our
counsel investigate the matter thoroughly and we take all appropriate action to
defend our rights in these matters.

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SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

On November 27, 2002, AllVoice Computing plc filed an action against the
Company in the United States District Court for the Southern District of Texas
claiming patent infringement. In the lawsuit, AllVoice alleges that the Company
is infringing United States Patent No. 5,799,273 entitled "Automated
Proofreading Using Interface Linking Recognized Words to Their Audio Data While
Text Is Being Changed" (the "'273 Patent"). The '273 Patent generally discloses
techniques for manipulating audio data associated with text generated by a
speech recognition engine. Although the Company has several products in the
speech recognition technology field, the Company believes that its products do
not infringe the '273 Patent because they do not use the claimed techniques. The
Company believes this claim has no merit, and intends to defend the action
vigorously.

In December 2001, the Massachusetts Institute of Technology and Electronics
For Imaging, Inc. sued the Company in the United States District Court for the
Eastern District of Texas for patent infringement. The patent infringement claim
was filed against more than 200 defendants. In their lawsuit, MIT and EFI allege
that the Company is infringing United States Patent No. 4,500,919 entitled
"Color Reproduction System" (the "'919 Patent"). MIT and EFI allege that the
'919 Patent discloses a system for adjusting the colors of a scanned image on a
television screen and outputting the modified image to a device. The Company has
several products that permit a user to adjust the color of an image on a
computer monitor. The Company has asserted that its products do not infringe the
'919 Patent because its products do not contain all elements of the structure
required by the claimed invention and because its products do not perform all of
the steps required by the claimed method. Further, the Company believes there
may be prior art that would render the '919 Patent invalid. The '919 Patent
expired on May 6, 2002. Damages are sought in an unspecified amount. The Company
filed an Answer and Counterclaim on July 1, 2002. For the reasons described
here, the Company believes this claim has no merit, and intends to defend the
action vigorously.

On August 16, 2001, Horst Froessl sued the Company in the United States
District Court for the Northern District of California for patent infringement.
In his lawsuit, Froessl alleges that the Company is infringing United States
Patent No. 4,553,261 entitled "Document and Data Handling and Retrieval System"
(the "'261 Patent"). Froessl alleges that the '261 Patent discloses a system for
receiving and optically scanning documents, converting selected segments of the
digitalized scan data into machine code, and storing and retrieving the
documents and the digitalized and converted segments. Although the Company has
several products in the scanning technology field, the Company has asserted that
its products do not infringe the '261 Patent because its products do not contain
all elements of the structure required by the claimed invention and because its
products do not perform all of the steps required by the claimed method.
Further, the Company believes there may be prior art that would render the '261
Patent invalid. Damages are sought in an unspecified amount. The Company filed
an Answer and Counterclaim on September 19, 2001. For the reasons described
here, the Company believes this claim has no merit, and intends to defend the
action vigorously.

The Company believes that the final outcome of these matters will not have
a significant adverse effect on its financial position and results of
operations, and the Company believes it will not be required to expend a
significant amount of resources defending such claims. However, should the
Company not prevail in any such litigation, its operating results and financial
position could be adversely impacted.

Guarantees

The Company has entered into agreements to indemnify its directors and
officers to the fullest extent authorized or permitted under applicable law.
These agreements, among other things, provide for the indemnification of its
directors and officers for expenses, judgments, fines, penalties and settlement
amounts incurred by any such person in his or her capacity as a director or
officer of the company, whether or not such person is acting or serving in any
such capacity at the time any liability or expense is incurred for which
indemnification can be provided under the agreements. The Company has a Director
and Officer insurance policy in effect that reduces its exposure under these
agreements and enables it to recover a portion of any

63

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

future amounts paid. While the maximum potential amount of any future payments
under these agreements is uncertain, as a result of its insurance coverage the
Company believes the estimated fair value of these agreements is minimal.

The Company currently includes indemnification provisions in the contracts
it enters with its customers and business partners. Generally, these provisions
require the Company to defend claims arising out of its products' infringement
of third-party intellectual property rights, breach of contractual obligations
and/or unlawful or otherwise culpable conduct on its part. The indemnity
obligations imposed by these provisions generally cover damages, costs and
attorneys' fees arising out of such claims. In most, but not all, cases the
Company's total liability under such provisions is limited to either the value
of the contract or a specified, agreed upon, amount. In some cases, its total
liability under such provisions is unlimited. In many, but not all, cases the
term of the indemnity provision is perpetual. Although these provisions are
included in most of its contracts with customers and business partners, as noted
above, the Company is currently indemnifying the liabilities of only four
parties pursuant to such provisions. Each of these four parties is a defendant
in a case filed by the Massachusetts Institute of Technology and Electronics for
Imaging, Inc. in the United States District Court for the Eastern District of
Texas in December 2001. The case, which alleges patent infringement by certain
ScanSoft products, is more fully described above. The Company's indemnity
obligations in this case have required it to incur costs and attorney fees of
approximately $0.1 million to date. The Company cannot predict the outcome of
this case or the total additional indemnity costs it may produce, though it may
be required to indemnify one or more defendants in addition to those it is
already indemnifying. While the maximum potential amount of future payments the
Company could be required to make under all the indemnification provisions in
its contracts with customers and business partners is unlimited, it believes
that the estimated fair value of these provisions is moderate due to the low
frequency with which these provisions have been triggered.

14. 401(K) SAVINGS PLAN

The Company has established a retirement savings plan under Section 401(k)
of the Internal Revenue Code (the "401(k) Plan"). The 401(k) Plan covers
substantially all employees of the Company who meet minimum age and service
requirements, and allows participants to defer a portion of their annual
compensation on a pre-tax basis. Through October 15, 2002, the Company matched
an employee's contributions dollar for dollar up to 4%. Employees are 100%
vested into the plan as soon as they start to contribute to the plan. Effective
October 16, 2002, this match was discontinued. The Company's contributions to
the 401(k) Plan totaled $0.6 million, $0.4 million and $0.4 million for the
years ended December 31, 2002, 2001 and 2000, respectively.

15. SUPPLEMENTAL CASH FLOW INFORMATION

During the years ended December 2002, 2001 and 2000, the Company made cash
payments for interest totaling $0.3 million, $0.1 million and $0.6 million,
respectively.

During the years ended December 2002, 2001 and 2000, the Company made cash
payments for income taxes totaling $0.6 million, $0.3 million and $0.3 million,
respectively.

64

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

During December 2002, the Company issued 150,000 shares of common stock
valued at $0.3 million in connection with the agreement to repurchase 1,461,378
shares of common stock from L&H. (see Note 10)

During 2002, the Company entered into favorable settlement agreements
related to liabilities assumed in the L&H acquisition, resulting in a reduction
of $2.2 million of the assumed liabilities recorded at the date of acquisition
with a corresponding reduction recorded to the carrying value of goodwill. (see
Note 18)

During March 2002, the Company issued 121,359 shares of the Company's
common stock valued at $0.6 million in connection with a purchase agreement in
which the Company acquired patents and core technology associated with the
Audiomining assets of the speech and language technology assets of L&H. In
addition, the Company issued a 9% promissory note in the principal amount of
$0.4 million with principal and interest to be repaid in full on July 31, 2002
and $0.5 million in cash, for total consideration of $1.5 million.

During January 2002, the Company issued 65,100 shares of its common stock
in partial settlement of a $1.0 million liability incurred as part of the Caere
acquisition. The common stock was valued at $0.3 million based on the fair value
of the common stock on December 21, 2001, the date the agreement was reached.

During January 2002, the Company acquired $0.3 million of equipment through
a one-year capital lease arrangement. No further obligation exists as of
December 31, 2002.

During December 2001, the Company issued 262,200 shares of its common stock
in partial settlement of a $2.1 million liability assumed in connection with the
Caere acquisition. The common stock was valued at $0.7 million based on the fair
value of the common stock on the date agreement was reached.

During December 2001, the Company issued 7.4 million shares of the
Company's common stock valued at $27.8 million, a 9% promissory note in the
principal amount of $3.5 million in connection with the L&H acquisition (see
Note 18) in which the Company acquired patents, trademarks, tradenames, product
and customer contracts associated with certain of the speech and language
technology assets of L&H.

During March 2000, the Company acquired all of the outstanding capital
stock of Caere Corporation. As consideration, the Company issued 19.0 million
shares of common stock valued at $98.5 million and stock options for the
purchase of approximately 4.6 million shares of the Company's common stock
valued at $15.5 million in exchange for outstanding employee stock options of
Caere. In addition, pursuant to a concurrent non-competition agreement and
subject to certain other conditions, the Company agreed to pay in cash the
former Caere President and CEO on the second anniversary of the merger, March
13, 2002, the difference between $13.50 and the closing price per share of
ScanSoft common stock at that time, multiplied by 486,548. (see Note 19)

16. SEGMENT AND GEOGRAPHIC INFORMATION

The Company operates in a single segment. The following table presents
total revenue information by geographic area and principal product line (in
thousands):

65

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Revenue classification above is based on the country in which the sale
originates or is invoiced. Revenue in other countries predominately relates to
sales to customers in Asia and Europe. Intercompany sales are insignificant as
products sold in other countries are sourced within Europe or the United States.

A number of the Company's North American OEM customers distribute its
products throughout the world but because these customers do not provide the
geographic dispersion of products sales, the Company recorded the revenue in the
North America category.

For the year ended December 31, 2002, two distribution and fulfillment
partners, Ingram Micro and Digital River, accounted for 25% and 12% of our
consolidated revenue, respectively. During the year ended December 31, 2001,
Ingram Micro and Digital River accounted for 28% and 15% of our consolidated
revenue, respectively. During the year ended December 31, 2000, Ingram Micro and
Digital River accounted for 7% and 11% of our consolidated revenue,
respectively.

The following table summarizes the Company's long-lived assets, excluding
intangible assets, by geographic location (in thousands):

17. INCOME TAXES

The components of the income tax provision (benefit) are as follows (in
thousands):

The benefit for federal and state income taxes in 2002 and 2001,
respectively relate to refunds related to Caere Corporation.

66

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

For financial reporting purposes, income (loss) before income taxes
includes the following components (in thousands):

The cumulative amount of undistributed earnings of foreign subsidiaries,
which is intended to be permanently reinvested and for which U.S. income taxes
have not been provided, totaled approximately $3.5 million at December 31, 2002.

Deferred tax assets (liabilities) consist of the following (in thousands):

At December 31, 2002 and 2001, the Company provided a valuation allowance
for the full amount of its net deferred tax assets due to the uncertainty of
realization of those assets as a result of the recurring and cumulative losses
from operations.

The Company monitors the realization of its deferred tax assets based on
changes in circumstances, for example, recurring periods of income for tax
purposes following historical periods of cumulative losses or changes in tax
laws or regulations. Our income tax provisions and our assessment of the
realizability of our deferred tax assets involve significant judgments and
estimates. If we continue to generate taxable income through profitable
operations in future years we may be required to recognize these deferred tax
assets through the reduction of the valuation allowance which would result in a
material benefit to our results of operations in the period in which the benefit
is determined.

67

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

A reconciliation of the Company's effective tax rate to the statutory
federal rate is as follows:

At December 31, 2002 and 2001, the Company had federal net operating loss
carryforwards of approximately $82 million and $90 million, respectively, of
which approximately $9.1 million and $4.1 million, respectively, relate to tax
deductions from stock compensation. The tax benefit related to the stock
compensation, when realized, will be accounted for as additional paid-in capital
rather than as a reduction of the provision for income tax. At December 31, 2002
the Company had federal and state research and development credit carryforwards
of approximately $3.4 million and $2.3 million respectively. At December 31,
2001, the Company had federal and state research and development credit
carryforwards of approximately $2.8 million and $1.6 million, respectively. The
net operating loss and credit carryforwards will expire at various dates through
2021, if not utilized. Utilization of the net operating losses and credits may
be subject to a substantial annual limitation due to the ownership change
limitations provided by the Internal Revenue Code of 1986 and similar state
provisions. The annual limitation may result in the expiration of net operating
losses and credits before utilization.

18. ACQUISITIONS

Audiomining Acquisition:

On February 22, 2002, the Company entered into a definitive asset purchase
agreement (the "Purchase Agreement") to acquire certain assets and intellectual
property from L&H Holdings USA, Inc. The transaction was completed on March 21,
2002. Pursuant to the Purchase Agreement, the Company acquired patents and core
technology associated with the Audiomining assets of the speech and language
technology assets of L&H and paid $1.5 million in total consideration to L&H as
follows: $0.5 million in cash, 121,359 shares of the Company's common stock
valued at $0.6 million (based on the average of the closing share price of the
Company's stock 5 days before and after the date the transaction was completed)
and a 9% promissory note in the principal amount of $0.4 million (the "Note"),
with principal and interest to be repaid in full on July 31, 2002. The Company
incurred $0.2 million of acquisition related costs. The purchase price including
acquisition costs of $1.7 million was allocated to core technology.

On July 31, 2002, the Company repaid all amounts due under the Note, which
included principal and interest of $0.4 million.

68

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following table identifies the intangible assets acquired in connection
with Audiomining and their respective lives:

Acquisition of Lernout & Hauspie (L&H) Speech Products N.V. Assets:

On December 7, 2001, the Company entered into a definitive asset purchase
agreement (the "Purchase Agreement") to acquire certain assets and intellectual
property relating to the former L&H entities that were in bankruptcy under the
jurisdiction of both the U.S. Bankruptcy Court for the District of Delaware and
the Commercial Court of Ieper, Belgium. The Company purchased these assets in a
closed auction proceeding administered by the creditors committee of the former
entities and approved by both the U.S. and Belgium courts on December 11, 2001.
The transaction was completed on December 12, 2001 and the Company's results
from operations include L&H activities since that date.

Pursuant to the Purchase Agreement, the Company acquired patents,
trademarks, tradenames, product and customer contracts associated with certain
of the speech and language technology assets of L&H. In addition, the Company
obtained rights to accounts receivable related to the customer contracts
acquired and fixed assets. The Company also hired 223 employees from L&H. The
Company paid $41.3 million in total consideration to the creditors as follows:
$10.0 million in cash, 7.4 million shares of the Company's common stock valued
at $27.8 million (based on the average of the closing share price of our stock 3
days before and after the proposed acquisition was announced) and a 9%
promissory note in the principal amount of $3.5 million, to be repaid in
installments of $0.1 million of principal and interest quarterly commencing on
March 15, 2002, for a total of eleven payments. All remaining principal and
interest shall become due on December 15, 2004. The Company incurred
approximately $1.0 million of acquisition related costs.

On December 27, 2001, the Company filed a Form 8-K reporting the
transaction as an acquisition of assets. The Company had ongoing discussions
with the SEC regarding historical financial statement requirements related to
the acquisition. Following these discussions, the Company concluded that, for
purposes of Rule 3-05 of Regulation S-X, the L&H transaction was an acquisition
of a business and not an acquisition of assets. In connection with these
discussions, the Company also concluded that the transaction should be reported
as an acquisition of a business for accounting purposes rather than an
acquisition of assets, as previously reported. On August 14, 2002, the Company
filed a Form 10-Q/A to restate the financial statements as of and for the
quarter ended March 31, 2002 to reflect the impact of the change in the
accounting for the acquisition. The change in the accounting for the transaction
was determined to have an immaterial impact on the financial position, results
of operations or cash flows of the Company for the year ended December 31, 2001.
The results of operations of the acquired business have been included in the
financial statements of the Company as of the date of acquisition.

69

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The change in accounting for the transaction resulted in a reallocation of
the purchase price from amortizable intangible and tangible assets to goodwill.
The following summarizes the impact of the reallocation of the purchase price
(in 000's):

Information presented below is consistent with disclosure related to the
acquisition of a business.

The purchase price was allocated to the tangible and intangible assets
acquired (patents and core technology and trade names and trademarks) and
liabilities assumed based on their respective fair market values. The total
identifiable tangible assets amounted to $21.0 million. The excess of the
purchase price over the fair value of the identifiable intangible assets and net
liabilities assumed amounted to $23.0 million and was allocated to goodwill. The
Company believes that the acquisition resulted in an excess of the purchase
price over the fair value of the net assets acquired because the Company
purchased, in an auction as a result of L&H's bankruptcy status, a substantial
portfolio of patents and core technology in speech and language technology which
were internally developed or acquired by L&H over the course of several years.
Furthermore, the acquisition enabled the Company to enter the speech and
language market immediately upon completion of the acquisition. The entire $23.0
million allocated to goodwill is deductible for tax purposes. The purchase price
including acquisition costs was allocated as follows (in thousands):

Identified intangible assets................................ $20,970
Goodwill.................................................... 23,031
Net current liabilities assumed............................. (1,701)
-------
$42,300
=======

Net current liabilities assumed primarily relate to accounts receivable and
assumed liabilities for products which were sold prior to the acquisition date
and which were expected to be upgraded with newer versions in 2002 and
liabilities for development contracts with customers. During 2002, the Company
entered into favorable settlement agreements related to these liabilities
resulting in a reduction of $2.2 million of the assumed liabilities recorded at
the date of acquisition with a corresponding reduction recorded to the carrying
value of goodwill.

The values of the patents, core technology and trade names and trademarks
were determined using the income approach. The income approach requires a
projection of revenues and expenses specifically attributed to the intangible
assets. The discounted cash flow ("DCF") method is then applied to the potential
income streams after making necessary adjustments with respect to such factors
as the wasting nature of the identifiable intangible assets and the allowance of
a fair return on the net tangible assets and other intangible assets employed.
There are several variations on the income approach, including the
relief-from-royalty method, the avoided cost method and the lost profits method.
The relief-from-royalty method was used to value the patents, core technology
and trade names and trademarks. The relief-from-royalty method is used to
estimate the cost savings that accrue to the owner of the intangible assets that
would otherwise have to pay royalties or licensee fees on revenues earned
through the use of the asset. The royalty rate used in the analysis is based on
an analysis of empirical, market-derived royalty rates for guideline intangible
assets.

70

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Typically, revenue is projected over the expected remaining useful life of
the intangible asset. The market-derived royalty rate is then applied to
estimate the royalty savings. The key assumptions used in valuing the patents
and core technology are as follows: royalty rate 5%, discount rate 15%, tax rate
40% and estimated life of 10 years. The key assumptions used in valuing the
trade names and trademarks are as follows: observed royalty rate 1%, discount
rate 15%, tax rate 40% and estimated life of 12 years.

OEM contracts and customer relationships, as well as completed technology,
were determined to have de minimus values and, accordingly, no amount of the
purchase price was allocated to these intangible assets. A discounted cash flow
method was used to estimate the residual cash flows attributable to OEM
contracts and customer relationships. The projections included negative cash
flows over the early years of the relationship and, when combined with the
contributory asset charged for the other technology-based assets, such as
patents and core technology which are required to realize revenue under these
arrangements, resulted in de minimus value for the OEM contracts and the
customer relationships. The completed technology was valued using individual
cash flow projections for each technology, adjusted for capital charges, and
discounted to present value using a weighted average cost of capital. Cash flow
projections and operating profits are negative for the initial years and when
considered with the short life cycle of the application-based completed
technology, the value ascribable to the completed technology was de minimus.

The following table identifies the intangible assets acquired and their
respective lives over which the assets will be amortized on a straight-line
basis:

Caere Acquisition:

On March 13, 2000, the Company acquired all of the outstanding capital
stock of Caere Corporation, a California-based company that designed, developed
and marketed a range of optical character recognition software tools, for
approximately $48.5 million in cash, 19.0 million shares of common stock of the
Company valued at $98.5 million, and the issuance of stock options for the
purchase of approximately 4.6 million shares of the Company's common stock
valued at $15.5 million, in exchange for outstanding employee stock options of
Caere. The fair value of the employee stock options was estimated using the
Black-Scholes option pricing model. In addition, pursuant to a concurrent
non-competition agreement and subject to certain other conditions, the Company
agreed to pay in cash the former Caere President and CEO on the second
anniversary of the merger, March 13, 2002, the difference between $13.50 and the
closing price per share of ScanSoft common stock at that time, multiplied by
486,548. The value of this stock price guarantee at the date of acquisition was
approximately $4.1 million and has been included in the total purchase price of
the acquisition (see Note 19). Additionally, in conjunction with the
acquisition, the Company incurred

71

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

approximately $1.8 million of acquisition related costs. The purchase price of
Caere, including acquisition costs was allocated as follows (in thousands):

Property and equipment...................................... $ 2,865
Current and other tangible assets........................... 58,400
Liabilities assumed......................................... (16,985)
Goodwill.................................................... 61,095
Core technology............................................. 17,905
Completed technology........................................ 16,340
Other identified intangible assets.......................... 10,448
Acquired in-process research and development................ 18,291
--------
$168,359
========

The amounts allocated to identifiable tangible and intangible assets,
including acquired in-process research and development, were based on the fair
value of the assets. Goodwill represents the amount by which the cost of
acquired net assets exceeded the fair values of those net assets on the date of
purchase. Acquired in-process research and development represented development
projects that had not yet reached technological feasibility and had no
alternative future use. Accordingly, the amount of $18.3 million was charged to
operations upon consummation of the acquisition.

The values of the core technology, developed technology and acquired
in-process technology were determined by a risk adjusted, discounted cash flow
approach. The value of in-process research and development was determined by
estimating the costs to develop the in-process projects into commercially viable
products, estimating the resulting net cash flows from the sale of such
products, discounting net cash flows back to their present values, and adjusting
those results to reflect the projects' stages of completion at the acquisition
date. These include projects (primarily major version upgrades) in each of
Caere's major products, including OmniPage, OmniForm, and PageKeeper. The
discount rates used were 14% for developed technology, 19% for core technology,
and 24% for in-process technology. The discount rate for in-process technology
takes into consideration the Company's weighted average cost of capital adjusted
for the inherent uncertainties surrounding the successful development of the
in-process research and development, the profitability levels of such technology
and the uncertainty of technological advances, which could potentially impact
the estimates described above.

The percentage of completion of the in-process projects ranged from 50% to
67% at the date of the acquisition. Revenues were initially projected to be
generated in late 2000 for each of the product versions in development at the
acquisition date. As of December 31, 2000, revenues from these projects were
expected to be generated beginning in the second quarter of 2001. All these
projects were completed during 2001.

The table following identifies the intangible assets acquired in connection
with Caere and their respective lives:

72

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Other identified intangible assets consist of a non-compete agreement,
acquired work force, a favorable building lease agreement, and patents on the
Caere technology. These assets have expected useful lives of 2, 3, 4 and 5
years, respectively, and are being amortized accordingly.

During the year ended December 31, 2000, the Company, as a result of a June
restructuring (see Note 8), wrote-off $1.1 million of acquired workforce and
$2.4 million of the favorable building lease established as part of the
identifiable intangible assets acquired from Caere. The portion of the assets
impaired related directly to the number of employees terminated and facility
space vacated in connection with these restructuring actions.

This acquisition was accounted for under the purchase method of accounting.
Accordingly, the results of operations of Caere and the fair market value of
acquired assets and assumed liabilities have been included in the financial
statements of the Company as of the date of acquisition.

Pro Forma Results (Unaudited)

The following table reflects unaudited pro forma results of operations of
the Company as if that the acquisition of L&H had occurred on January 1, 2001
(in thousands, except per share data):

The unaudited pro forma results of operations are not necessarily
indicative of the actual results that would have occurred had the transactions
actually taken place at the beginning of these periods

19. RELATED PARTIES

At December 31, 2002, Xerox owned approximately 19% of the Company's
outstanding common stock and all of the Company's outstanding Series B Preferred
Stock. In addition, Xerox has the opportunity to acquire additional shares of
common stock pursuant to a warrant (see Note 10). The Company and Xerox have
entered into multiple non-exclusive agreements in which the Company grants Xerox
the royalty-bearing right to copy and distribute certain versions of the
Company's software programs with Xerox's multi-function peripherals. Xerox
accounted for 5%, 11% and 12% of total net revenues during each of the years
ended December 31, 2002, 2001 and 2000, respectively. As of December 31, 2002
and 2001, Xerox owed the Company $1.5 million and $1.8 million, respectively,
pursuant to these agreements, which are included in accounts receivable.

In connection with the Caere acquisition in the first quarter of 2000 and
pursuant to a concurrent non-competition and consulting agreement, the Company
agreed to pay in cash to the former Caere President and CEO, a current member of
the Board of Directors of the Company, on the second anniversary of the merger,
March 13, 2002, the difference between $13.50 and the closing price per share of
ScanSoft common stock at that time, multiplied by 486,548. On March 5, 2002, the
Company negotiated a deferred payment agreement with the former Caere President
and CEO to terminate this agreement. Under the terms of the deferred payment
agreement, the Company paid $1.0 million in cash on March 5, 2002 and agreed to
make future cash payments totaling $3.3 million, with such amounts payable in
equal quarterly installments of approximately $0.4 million over the following
two years. During the year ended December 31, 2002, the Company paid three
quarterly installments under this agreement totaling $1.2 million.

73

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The total consideration of this agreement was accounted for in the original
Caere purchase price and had no effect on the results of operations. The
remaining liability at December 31, 2002 is $2.1 million, of which $1.6 million
is included in other current liabilities and $0.5 million is included in other
long-term liabilities.

20. SUBSEQUENT EVENTS

On March 11, 2003, the Company received $3.8 million of net proceeds from
the exercise of the over allotment option of 1,072,500 shares granted to the
underwriters as part of the underwritten offering completed on February 14,
2003.

On February 14, 2003, the Company completed an underwritten public offering
of 7,184,406 shares of the Company's common stock at $3.80 per share. Of the
total shares sold, 6,184,406 shares were sold on behalf of Lernout & Hauspie
Speech Products N.V., and L&H Holdings USA, Inc. The Company sold 1,000,000
common shares and received gross proceeds of $3.8 million. After considering
offering costs the estimated net proceeds amounted to approximately $2.1
million.

On January 30, 2003, the Company completed the acquisition of the Speech
Processing Telephony and Voice Control business units (together, "PSP") of Royal
Philips Electronics, and related intellectual property on the terms set forth in
the purchase agreement dated October 7, 2002, as amended. As consideration for
these business units and intellectual property, the Company paid 3.1 million
euros ($3.4 million) in cash at closing, subject to adjustment in accordance
with the provisions of the purchase agreement, as amended, and agreed to pay an
additional 1.0 million euros in cash prior to December 31, 2003, issued a 5.0
million euro note due December 31, 2003 and bearing 5.0% interest per annum and
issued a $27.5 million three-year, zero-interest subordinated debenture,
convertible at any time at Philips' option into shares of the Company's common
stock at $6.00 per share. The zero coupon convertible subordinated debenture
contains a restrictive covenant which prohibits the Company from paying or
declaring any dividend or distribution (other than distributions of our equity
securities) on its capital stock while the note is outstanding. This restriction
terminates if one half or more of the note is converted by Philips into common
stock.

The Telephony business unit offers speech-enabled services including
directory assistance, interactive voice response and voice portal applications
for enterprise customers, telephony venders and carriers. The Voice Control
business unit offers a product portfolio including small footprint speech
recognition engines for embedded applications such as voice-controlled climate,
navigation and entertainment features in automotive vehicles, as well as voice
dialing for mobile phones.

The acquisition of PSP enhances the Company's market share in key markets
and provides the Company additional competitive advantages in its target
markets, specifically the telephony, automotive and embedded markets. In
addition, the acquisition enhances the distribution channel adding new reference
accounts for both customer relationships and technology partners. These
incremental intangible benefits attributed to excess purchase consideration
resulting in goodwill.

The Company's results of operations for fiscal year 2002 reported on this
Form 10-K do not include the effect of operations for PSP as the acquisition was
completed on January 30, 2003, subsequent to year-end.

Under the terms of the purchase agreement the purchase price is subject to
adjustment based on a comparison of net assets at the closing date to the net
assets of PSP set forth in the agreement, and the amount by which the cash
contributed by Philips to PSP in January 2003 exceeded or was less then 800,000
euros. Philips is required to provide to the Company a balance sheet for PSP as
of January 30, 2003, as well as a statement detailing the amount of cash
contributed to PSP during the month of January 2003. As of the date of this
report filed on Form 10-K, neither the closing balance sheet nor the
contribution schedule for January were available from Philips. Also, severance
costs associated with the restructuring actions are anticipated. As a result, it
is impractical to provide information with respect to the purchase price
allocation as

74

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

of the date of closing. It is anticipated that the majority of the purchase
price of $39.4 million will be allocated to goodwill and other intangible
assets.

On January 3, 2003, in connection with a promissory note debt covenant
violation, the Company paid $3.3 million in full settlement of all principal and
accrued interest on the promissory note issued in connection with the L&H
acquisition on December 12, 2001.

21. QUARTERLY DATA (UNAUDITED)

The following information has been derived from unaudited consolidated
financial statements that, in the opinion of management, include all recurring
adjustments necessary for a fair presentation of such information.

75

REPORT OF INDEPENDENT ACCOUNTANTS ON
FINANCIAL STATEMENT SCHEDULE

To the Board of Directors
of Scansoft, Inc.:

Our audits of the consolidated financial statements referred to in our
report dated February 9, 2003, except as to Note 20 for which the date is March
11, 2003, appearing in this Annual Report on Form 10-K of ScanSoft, Inc. also
included an audit of the financial statement schedule listed in Item 15(a)(2) of
this Form 10-K. In our opinion, this financial statement schedule presents
fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements.

/s/ PricewaterhouseCoopers LLP

Boston, Massachusetts
February 9, 2003

76

SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
(IN THOUSANDS)

ACCOUNTS RECEIVABLE

- ---------------

(a) Net increase (decrease) in amounts recorded against revenue as of December
31, 2002, 2001 and 2000, respectively.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information set forth in the Company's Proxy Statement for the Annual
Meeting of Shareholders (the "Proxy Statement") under the caption "Election of
Directors and Management Information" is incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION

The information set forth in the Proxy Statement under the captions
"Information Regarding Executive Officer Compensation" and "Information
Regarding the Board and its Committees" is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS

The additional information required by this item is incorporated by
reference to the section entitled "Information Regarding Beneficial Ownership of
Principal Shareholders, Directors, and Management" in the Proxy Statement.

EQUITY COMPENSATION PLAN INFORMATION The following table sets forth
certain information, as of December 31, 2002 concerning shares of common stock
authorized for issuance under all of the Company's equity compensation plans
(shares in thousands).

77

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information set forth in the Proxy Statement under the captions
"Certain Relationships and Related Transactions" and "Indebtedness of Executive
Officers" is incorporated herein by reference.

ITEM 14. CONTROLS AND PROCEDURES

(a) Within the 90-day period prior to the filing of this Annual Report on
Form 10-K, the Company's management, including its principal executive officer
and principal financial officer, conducted an evaluation of the effectiveness of
the design and operation of its disclosure controls and procedures (as defined
in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934 (the
"Exchange Act")). Based on that evaluation, the Company's principal executive
officer and principal financial officer concluded that, as of the date of the
evaluation, its disclosure controls and procedures were effective to ensure that
information required to be disclosed by the Company in reports that it files or
submits under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in Securities and Exchange Commission rules
and forms. It should be noted that the design of any system of controls is based
in part upon certain assumptions about the likelihood of future events, and
there can be no assurance that any design will succeed in achieving its stated
goals under all potential future conditions, regardless of how remote.

(b) Changes in internal controls. There were no significant changes in the
Company's internal controls or in other factors that could significantly affect
these controls subsequent to the date of their evaluation. We have not
identified any significant deficiencies or material weaknesses in our internal
controls, and therefore there were no corrective actions taken.

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a) The following documents are filed as a part of this Report:

(1) Financial Statements -- See Index to Financial Statements in Item 8
of this Report.

(2) Financial Statement Schedule -- The following report and financial
statement schedule for fiscal years 2002, 2001 and 2000 is contained in
Item 8 of this Report:

REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE.

II -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES

All other schedules have been omitted as the requested information
is inapplicable or the information is presented in the financial
statements or related notes included as part of this Report.

(3) Exhibits -See Item 15(c) of this Report below.

(b) Reports on Form 8-K.

The following current reports on Form 8-K were filed during the fourth
quarter of the year ended December 31, 2002:

(1) On October 8, 2002, ScanSoft filed a Current Report on Form 8-K,
reporting under Item 5 of Form 8-K, relating to the proposed acquisition
of the Speech Processing Business Units from Royal Philips Electronics.

78

(c) Exhibits.

EXHIBIT INDEX

- ---------------
** Denotes Management compensatory plan or arrangement.

(1) Incorporated by reference from the Registrant's Registration Statement on
Form S-4 (No. 333-70603) filed with the Commission on January 14, 1999.

(2) Incorporated by reference from the Registrant's Registration Statement on
Form S-4 (No. 333-96487) filed with the Commission on February 9, 2000.

(3) Incorporated by reference from the Registrant's Current Report on Form 8-K
filed with the Commission on December 27, 2001.

(4) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the fiscal quarter ended March 31, 2001, filed with the Commission
on May 11, 2001.

(5) Incorporated by reference from the Registrant's Registration Statement on
Form S-1 (No. 333-98356) filed with the Commission on October 19, 1995.

(6) Incorporated by reference from the Registrant's Amendment No. 1 to
Registration Statement of Form 8-A (No. 0-27038) filed with the Commission
on December 6, 1995.

(7) Incorporated by reference from the Registrant's current Report on Form 8-K
dated October 31, 1996.

81

(8) Incorporated by reference from the Registrant's Definitive Proxy Statement,
filed with the Commission on April 30, 2002.

(9) Incorporated by reference from the Registrant's Amendment No. 1 to
Registration Statement of Form S-1 (No. 33-98356) filed with the Commission
on November 15, 1995.

(10) Incorporated by reference from the Registrant's Annual Report on Form 10-K
for the fiscal year ended January 3, 1999, filed with the Commission on
April 5, 1999.

(11) Incorporated by reference from the Registrant's Registration Statement on
Form S-8 (No. 333-33464) filed with the Commission on March 29, 2000.

(12) Incorporated by reference from the Registrant's Registration Statement on
Form S-8 (No. 333-49656) filed with the Commission on November 9, 2000.

(13) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the fiscal quarter ended September 30, 2000, filed with the
Commission on November 13, 2000.

(14) Incorporated by reference from the Registrant's Annual Report on Form 10-K
for the fiscal year ended December 31, 2000, filed with the Commission on
April 2, 2001.

(15) Incorporated by reference from the Registrant's Current Report on Form 8-K
filed with the Commission on March 7, 2002.

(16) Incorporated by reference from the Registrant's Registration Statement on
Form S-8 (No. 333-74343) filed with the Commission on March 12, 1999.

(17) Incorporated by reference from the Registrant's Annual Report on Form 10-K
for the fiscal year ended December 31, 2001, filed with the Commission on
April 1, 2002.

(18) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the fiscal quarter ended September 30, 2001, filed with the
Commission on November 7, 2001.

(19) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the fiscal quarter ended September 30, 2002, filed with the
Commission on November 14, 2002.

(20) Incorporated by reference from the Registrant's Amendment No. 2 to Form
10-K for the fiscal year ended January 3, 1999, filed with the Commission
on February 8, 2000.

(21) Incorporated by reference from the Registrant's Amendment No. 1 to Form
10-K for the fiscal year ended December 31, 2000, filed with the Commission
on August 8, 2001.

(22) Incorporated by reference from the Registrant's Registration Statement of
Form S-1 (No. 33-100647) filed with the Commission on October 21, 2002.

(23) Incorporated by reference from the Registrant's Amendment No. 1 to
Registration Statement of Form S-1 (No. 33-100647) filed with the
Commission on December 6, 2002.

(24) Incorporated by reference from the Registrant's Amendment No. 2 to
Registration Statement of Form S-1 (No. 33-100647) filed with the
Commission on January 6, 2003.

(25) Incorporated by reference from the Registrant's Amendment No. 4 to
Registration Statement of Form S-1 (No. 33-100647) filed with the
Commission on February 7, 2003.

82

SIGNATURES

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

SCANSOFT, INC.

By: /s/ Paul A. Ricci
--------------------------------------
Paul A. Ricci
Chief Executive Officer and Chairman
of the Board

KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Paul A. Ricci and Richard S. Palmer
jointly and severally, his or her attorneys-in-fact, each with the power of
substitution, for him or her in any and all capacities, to sign any amendments
to this Annual Report on Form 10-K and to file the same, with exhibits thereto
and other documents in connection therewith, with the Securities and Exchange
Commission, hereby ratifying and confirming all that each said
attorneys-in-fact, or his or her substitute or substitutes, may do or cause to
be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this
Annual Report on Form 10-K has been signed by the following persons in the
capacities and on the dates indicated.

Date: March 28, 2003 /s/ Paul A. Ricci
--------------------------------------------------------
Paul A. Ricci, Chief Executive Officer and Chairman of
the Board (Principal Executive Officer)

Date: March 28, 2003 /s/ Michael K. Tivnan
--------------------------------------------------------
Michael K. Tivnan, President, Chief Operating Officer
and Director

Date: March 28, 2003 /s/ Richard S. Palmer
--------------------------------------------------------
Richard S. Palmer, Senior Vice President and Chief
Financial Officer, (Principal Financial Officer)

Date: March 28, 2003 /s/ Gerald C. Kent
--------------------------------------------------------
Gerald C. Kent, Jr. Vice President, Chief Accounting
Officer and Controller (Principal Accounting Officer)

Date: March 28, 2003 /s/ Mark Myers
--------------------------------------------------------
Mark Myers, Director

Date: March 28, 2003 /s/ Katharine A. Martin
--------------------------------------------------------
Katharine A. Martin, Director

Date: March 28, 2003 /s/ Robert G. Teresi
--------------------------------------------------------
Robert G. Teresi, Director

Date: March 28, 2003 /s/ Robert J. Frankenberg
--------------------------------------------------------
Robert J. Frankenberg, Director

83

CERTIFICATION OF CHIEF EXECUTIVE OFFICER
PURSUANT TO
SECTION 302(a) OF THE SARBANES-OXLEY ACT OF 2002

I, Paul A. Ricci, certify that:

1. I have reviewed this annual report on Form 10-K of ScanSoft, Inc.;

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

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

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

By: /s/ Paul A. Ricci
--------------------------------------
Paul A. Ricci
Chief Executive Officer and
Chairman of the Board

March 28, 2003

84

CERTIFICATION OF CHIEF FINANCIAL OFFICER
PURSUANT TO
SECTION 302 (a) OF THE SARBANES-OXLEY ACT OF 2002

I, Richard S. Palmer, certify that:

1. I have reviewed this annual report on Form 10-K of ScanSoft, Inc.;

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

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

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;

b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

By: /s/ Richard S. Palmer
--------------------------------------
Richard S. Palmer
Senior Vice President and
Chief Financial Officer

March 28, 2003

85