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, 2003

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

COMMISSION FILE NUMBER 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 $234,956,810
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 1, 2004 was 104,433,142.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's definitive Proxy Statement to be delivered to
stockholders in connection with the Registrant's 2004 Annual Meeting of
Stockholders are incorporated by reference into Part III.

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 FEDERAL SECURITIES LAWS 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 DIGITAL CAPTURE TECHNOLOGIES; 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; OUR CONTRACTUAL COMMITMENTS; COST SAVINGS ARISING FROM
OUR 2003 RESTRUCTURING; OUR 2004 REVENUE EXPECTATIONS 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
speech, images and documents in digital applications, systems and devices. 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 speech and digital capture technologies, and are
sold as solutions into the financial, legal, healthcare, government,
telecommunications and automotive industries. Our speech technologies enable
voice-activated services over a telephone, transform speech into text and text
into speech, and permit voice control of devices and applications. Our digital
capture technologies transform text, images and files into various digital
formats. 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, services, channels and
business processes.

Our software is delivered as independent applications or as part of larger
integrated systems, such as systems for customer service call centers,
navigation systems in automobiles or digital copiers on a network. Our speech
solutions enable seamless interaction with hardware and software systems simply
by speaking, automatically create documents from speech, and transform text into
synthesized speech. 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 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 speech and digital capture create high barriers to entry in markets
where we compete. Our technologies are based on complex mathematical formulas,
which require extensive 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 speech technology has industry-leading
recognition accuracy, provides recognition for 48 languages and natural sounding
synthesized speech in 22 languages, and supports a broad range of hardware
platforms and operating systems. 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 technologies are covered by more than 700 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 speech, companies such as IBM, Agere, Nortel, Intervoice and Aspect embed our
technologies into telecommunications systems, as well as automotive, PC or
multimedia applications. In digital capture, companies such as Brother, Canon,
Hewlett-Packard, Konica 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 Kofax, Autodesk, Microsoft, Freedom
Scientific and WestBrook embed our digital capture technology into their
commercial software 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, 2003. 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 Lernout & Hauspie ("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. From 1997 through December 31, 2002, we made four significant business
acquisitions and acquired several key technologies for aggregate consideration
totaling approximately $233.6 million. During the year ended December 31, 2003,
we completed three significant business acquisitions and acquired additional key
technologies for aggregate consideration totaling approximately $235.9 million.
On January 30, 2003, we acquired Royal Philips Electronics Speech Processing
Telephony and Voice Control business units ("Philips"), and related intellectual
property, for aggregate consideration of approximately $35.3 million. On March
31, 2003, we entered into an agreement that grants us an exclusive license to
resell, for a period of seven years, certain productivity applications in
certain geographies worldwide. Total consideration was approximately $11.8
million. On August 11, 2003, we acquired SpeechWorks International, Inc.
("SpeechWorks"), for aggregate consideration of approximately $175.5 million. On
December 19, 2003, we acquired LocusDialog, Inc. ("LocusDialog"), for aggregate
consideration of approximately $13.1 million.

Our focus on providing solutions that enable the capture and conversion of
information and the automation of systems 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 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.

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OUR MARKETS AND PRODUCTS

SPEECH MARKET

Network Speech. Organizations look for ways to improve the quality of the
customer service that they deliver, while reducing the operational costs
associated with their business and in serving their customers. They also seek
solutions that more effectively connect a mobile workforce with real-time
enterprise information, including customer data, email and schedules, while at
the same time reducing operating costs. Automatic speech recognition and
text-to-speech technologies can be used to implement applications to achieve
these goals.

We have the market-leading speech recognition and text-to-speech solutions.
We are a leading provider of software products and professional services that
enable enterprises, telecommunications companies and government organizations to
offer automated, speech-activated services over a telephone. Our network-based
speech recognition solutions allow users to direct their own calls, obtain
information and conduct transactions by simply speaking naturally over any
telephone. Our network-based text-to-speech 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 standards-based interface that supports the creation of
speech-enabled applications in more languages than any other vendor.

Our solutions are used within a wide range of applications in
customer-service intensive industries including financial services,
telecommunications, utilities, government, travel and entertainment. Our
network-based speech software is used in applications such as call centers,
unified messaging systems, and voice portals that deliver enhanced information
services, such as sports scores, news and stock quotes. In addition, we offer
packaged solutions for applications that are common across a large set of
customers and vertical markets. Currently, we offer packaged applications for
directory assistance and corporate voice dialing and special portfolios for the
healthcare, utilities and insurance industries.

We license our network speech products to businesses as well as systems
integrators, technology providers and telecommunications companies that in turn
sell an integrated solution to businesses and end-users. We license our
text-to-speech solutions to developers of telephony applications, including
Avaya, Cisco, Genesys and Nortel, which integrate our solutions into hardware
and software platforms.

We complement our technologies and products with a professional services
organization that supports customers and partners with business and systems
consulting project management, user interface design and application development
assistance. Our professional services are designed to shorten time-to-market,
assist clients, reduce implementation risks and improve clients' competitive
position. Our professional services staff is located in Boston, New York and San
Francisco and internationally in Canada, Mexico, the United Kingdom, France,
Germany, Australia, Japan, Korea and Singapore.

Embedded Speech. Automatic speech recognition is a speaker-independent
technology that adds voice control capabilities to applications and devices.
This technology identifies specific words and phrases at any moment in time,
converting spoken words into instructions that control functions within
applications. Automobile, mobile communications, consumer electronics and
computer game 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 embedded speech 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 18 languages. 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.

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Our embedded speech solutions are used by tier-one automobile, cell phone,
entertainment and aftermarket system manufacturers, including Bosch-Blaupunkt,
Delphi, Microsoft, Nokia, Sony and Visteon. These 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.

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 speak more quickly than they can type, speech is a natural and
efficient 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 can 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 can
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 customers. We also license our software to companies such as Corel and
Panasonic, which bundle our solutions with some of their products.

The following table summarizes our speech-related 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 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 ("OCR"), 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

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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. In
October 2003, we introduced a new product that converts PDF documents and files
into editable Microsoft Word format. The product, developed by ScanSoft in
collaboration with Microsoft, is designed to help increase the productivity of
workers by allowing them to edit and use information contained in PDF files.

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 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 solution can also
facilitate 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 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 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.

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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.

The following table summarizes our digital capture 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, 2003 we had over 300 full-time
employees in research and development, and our technologies were covered by more
than 700 patents or patent applications.

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
make it difficult for our products to be displaced. In addition, our far-
reaching channel network enables us to introduce new products quickly and
effectively throughout 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,
network-based speech recognition and text-to-speech, and dictation.
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 product
offerings 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
employees 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

Pursue High Growth Markets In Speech. We intend to leverage our
technologies and market leadership in speech to expand our opportunities in the
call center, automotive, healthcare, telecommunications 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 LocusDialog,
SpeechWorks and Philips that we believe complement our existing solutions and
resources in the telecommunications, automotive and electronics markets.

Expand PDF and Digital Capture Solutions. We intend to enhance the value
of our digital capture solutions for enterprises to address the proliferation of
PDF, the expanded use of content management systems, and the widespread adoption
of networked multifunction and digital scanning devices. We have introduced 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.

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

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partnership opportunities to build on our leading positions in the
text-to-speech and speech recognition markets.

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.

Pursue Strategic Acquisitions. We have selectively pursued strategic
acquisitions. For example, during the year ended December 31, 2003 we completed
the LocusDialog, SpeechWorks and Philips acquisitions. 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 speech, companies such as Cisco, Dictaphone, Lucent, GSL and
Microsoft embed our technologies into telecommunications systems, as well as
automotive, PC or multimedia applications. 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.

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 healthcare, legal and
public safety. We also sell products through our Web site at www.ScanSoft.com.

Until June 2003, the majority of our software products were manufactured,
packaged and shipped by GlobalWare Solutions on a worldwide basis. During June
2003, we transitioned our manufacturing and fulfillment activity to
Hewlett-Packard.

As of December 31, 2003, we employed 195 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 obtained patents that directly relate to our
products. Our digital capture and speech technologies are covered by more than
700 patents or patent applications. These patents expire on various dates
between 2005 and 2019.

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

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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 to
protect our proprietary rights.

CUSTOMERS

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, 2003, two distribution and fulfillment partners, Ingram Micro
and Digital River, accounted for 16% and 13% of our consolidated revenue,
respectively. During the year ended December 31, 2002, Ingram Micro and Digital
River, accounted for 25% and 12% of our consolidated revenue, respectively.

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, 2003, we employed over 300 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, 2003, 2002 and 2001 were $33.9 million, $27.6
million and $14.0 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, Canada, Denmark, England, France, Germany, Hong Kong,
Hungary, Italy, Japan, the Netherlands, Poland, Spain, Sweden 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, 2003 was 72% North America
and 28% international, versus 73% North America and 27% international for the
comparable period in 2002.

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,

10

revenue for the year ended December 31, 2003, was approximately 65% North
America and 35% international, compared to 67% North America and 33%
international for the comparable period in 2002.

Additional financial information relating to foreign and domestic sales and
operations for each of the three years in the period ended December 31, 2003
included elsewhere in this Annual Report on Form 10-K is set forth in Note 19,
"Segment & Geographic Information," of the Notes to Consolidated Financial
Statements attached hereto.

For a discussion of risks attendant to our foreign operations, see
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Risk Factors -- 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."

COMPETITION

There are a number of companies that develop or may develop products that
compete in our targeted markets; however, currently 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 subject to rapid technology changes.
Within digital capture, we compete directly with ABBYY, I.R.I.S. and NewSoft.
Within speech, we compete with AT&T, Fonix, IBM, Nuance Communications and
Rhetorical. 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, 2003 we employed 806 people on a full-time basis, 379 in
the United States and 427 internationally. Of the total, 314 were in product
research and development, 195 in sales and marketing, 210 in operations and
support, and 87 in finance and administration. Our employees may be subject to
collective bargaining agreements at a company or industry level in those
countries where this is part of the local labor law or practice. 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, manufacturing activities and finance and
administration functions.

Upon the closing of the Philips acquisition on January 30, 2003, we hired
116 employees. As of December 31, 2003, 77 of these employees were still with
the Company, 41 in product research and development, 8 in sales and marketing
and 28 in operations and support.

Upon closing the SpeechWorks acquisition on August 11, 2003, we hired 307
employees. As of December 31, 2003, 243 of the employees were still with the
Company, 52 in product research and development, 53 in sales and marketing, 127
in operations and support and 11 in general and administrative.

Upon the closing of the LocusDialog acquisition on December 19, 2003, we
hired 48 employees, 15 in product research and development, 14 in sales and
marketing, 14 in operations and support and 5 in general and administrative.

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

11

pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as
amended, are available free of charge on our website at www.scansoft.com, as
soon as reasonably practicable after such reports are filed electronically with
the Securities and Exchange Commission.

ITEM 2. PROPERTIES

Our principal administrative, sales, marketing and support 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
additional research and development space and our international headquarters.
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. In connection with the acquisition of SpeechWorks, we
assumed a lease for approximately 54,000 square feet of administrative, sales,
marketing and support office space in Boston, Massachusetts. This lease expires
in September 2004. In addition, we assumed two leases for approximately 8,000
square feet and 15,000 square feet, respectively, of research and development
space located in Montreal, Canada. These leases expire in January 2010 and March
2013, respectively. In connection with the acquisition of LocusDialog, we
assumed a lease for approximately 12,000 square feet of research and development
space located in Montreal, Canada. 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.

As of December 31, 2003, we were productively utilizing substantially all
of the space in our facilities. We believe that our existing facilities are
adequate for our needs for at least the next twelve months.

ITEM 3. LEGAL PROCEEDINGS

Like many companies in the software industry, the Company has from time to
time been notified of claims that the Company 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, the Company receives information concerning possible
infringement by third parties of the Company's intellectual property rights,
whether developed, purchased or licensed by the Company. In response to any such
circumstance, the Company has counsel investigate the matter thoroughly and the
Company takes all appropriate action to defend its rights in these matters.

On July 15, 2003, Elliott Davis ("Davis") filed an action against
SpeechWorks in the United States District Court for the Western District for New
York (Buffalo) claiming patent infringement. Damages are sought in an
unspecified amount. In the lawsuit, Davis alleges that SpeechWorks is infringing
United States Patent No. 4,802,231 entitled "Pattern Recognition Error Reduction
System" (the "'231 Patent"). The '231 Patent generally discloses techniques for
a pattern recognition system and method wherein errors are reduced by creating
independent error templates that correspond to patterns that tend to be
erroneously matched and linked error templates that are linked to specified
reference templates that are stored for comparison. In addition, on November 26,
2003, Davis filed an action against the Company in the United States District
Court for the Western District for New York (Buffalo) claiming that the Company
infringed the '231 Patent. Damages are sought in an unspecified amount. Although
the Company has, both prior to and as a result of the SpeechWorks acquisition,
several products in the speech recognition technology field, the Company
believes that the products do not infringe the '231 Patent because neither the
Company nor SpeechWorks use the

12

claimed techniques. SpeechWorks filed an Answer and Counterclaim to Davis's
Complaint in its case on August 25, 2003 and the Company filed an Answer and
Counterclaim to Davis's Complaint in its case on December 22, 2003. The Company
believes Davis's claims have no merit and intends to defend the actions
vigorously.

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, in addition to other defenses, they do not
use the claimed techniques. Damages are sought in an unspecified amount. The
Company filed an Answer on December 23, 2002. The Company believes this claim
has no merit and intends to defend the action vigorously.

On December 28, 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 Company has
settled that action for an immaterial amount and was dismissed from the action
on December 12, 2003.

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. The '261 Patent expired on May 31, 2003. Damages are sought in
an unspecified amount. The Company filed an Answer and Counterclaim on September
19, 2001. 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. However, even if its defense is successful, the litigation could
require significant management time and could be costly. Should the Company not
prevail in any such litigation, its operating results, financial position and
cash flows could be adversely impacted.

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

None.

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES

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 on the Nasdaq National Market
under the symbol "SSFT." As of December 31, 2003, there were outstanding

13

102,592,019 shares of common stock. 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 incorporated by reference into
Part III, Item 12 of this Form 10-K is hereby incorporated by reference into
this Part II, Item 5.

As of March 1, 2004, there were 742 stockholders of record and the last
reported sale price of our common stock on the Nasdaq National Market was $5.38
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, as amended on
September 30, 2003, 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 debenture is outstanding. This restriction terminates if one
half or more of the debenture is converted by Philips into common stock.

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 and/or
Regulations S promulgated thereunder. 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 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.

14

Phillips 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 March 31, 2003, in connection with the acquisition of certain
intellectual property assets related to multimodal speech technology for Lobby7,
Inc. ("Lobby7"), we issued a warrant to Lobby7, expiring October 31, 2005, for
the purchase of 78,000 shares of our common stock at an exercise price of $8.10
per share. We relied upon Section 4(2) of the Securities Act in connection with
the issuance of the warrant, and appropriate legends were affixed to the warrant
issued in the transaction. Lobby7 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.

(c) On August 11, 2003, in connection with the SpeechWorks acquisition, we
issued a warrant to our investment banker, expiring on August 11, 2009, for the
purchase of 150,000 shares of our common stock at an exercise price of $3.98 per
share. We relied upon Section 4(2) of the Securities Act in connection with the
issuance of the warrant, and appropriate legends were affixed to the warrant.

(d) On December 17, 2003, pursuant to a letter agreement, dated October 17,
2003, we issued a warrant to a former employee of the SpeechWorks, expiring
December 17, 2004, for the purchase of (i) 11,180 shares of our common stock at
an exercise price of $7.70 per share, and (ii) 2,552 shares of our common stock
at an exercise price of $5.64 per share. We relied upon Section 4(2) of the
Securities Act in connection with the issuance of the warrant, and appropriate
legends were affixed to the warrant.

(e) On December 19, 2003, in connection with the acquisition of
LocusDialog, certain shareholders of LocusDialog were issued 2,328,638 shares of
our common stock. We relied upon Section 4(2) of the Securities Act, and
Regulation S promulgated thereunder, in connection with the issuance of these
shares, and appropriate legends were affixed to the share certificates issued in
the transaction.

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, 2003,
2002 and 2001 and the balance sheet data as of December 31, 2003 and 2002 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, 2000 and 1999 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. On January 30, 2003, we completed the
acquisition of the Philips Speech Processing Telephony and Voice Control
business units. On August 11, 2003, we acquired all of the outstanding stock of
SpeechWorks International, Inc. On December 19, 2003, we acquired all of the
outstanding shares of LocusDialog. These acquisitions were each accounted for
under the purchase method of accounting. Accordingly, the results of operations
from the ScanSoft, MetaCreations, Caere, L&H, Philips, SpeechWorks and
LocusDialog acquisitions are included in our results of operations from the
applicable acquisition dates.

15

SCANSOFT, INC.

SELECTED FINANCIAL DATA

16

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

(1) On March 2, 1999, Visioneer acquired ScanSoft, in a cash election merger,
from Xerox Corporation.

(2) On March 13, 2000, the Company merged with Caere Corporation ("Caere"), a
California-based digital imaging software company.

(3) On December 12, 2001, the Company acquired the speech and language
technologies operations of Lernout & Hauspie Speech Products, N.V. (L&H).

(4) On January 30, 2003, the Company acquired Royal Philips Electronic Speech
Processing Telephony and Voice Control business units, and related
intellectual property ("Philips"). See Note 23 to Notes to Consolidated
Financial Statements.

On August 11, 2003, the Company acquired SpeechWorks International, Inc.
("SpeechWorks"). See Note 22 to Notes to Consolidated Financial Statements.

On December 19, 2003, the Company acquired LocusDialog, Inc.
("LocusDialog"). See Note 21 to Notes to Consolidated Financial Statements.

(5) See Notes 5 and 6 to Notes to Consolidated Financial Statements.

(6) See Note 9 to Notes to Consolidated Financial Statements.

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 ON
FORM 10-K. 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 31 AND ELSEWHERE IN THIS
ANNUAL REPORT.

OVERVIEW OF THE 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. 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,
services, channels and business processes.

On September 30, 2003, we amended our 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.

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.

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 payable due December 31, 2003 and bearing 5.0%
interest per annum and issued

17

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.
Prior to December 31, 2003, we paid both the 5.0 million euro promissory note
and 1.0 million euro note payable in accordance with the provisions of the
purchase agreement. In addition, prior to December 31, 2003, in accordance with
provisions of the purchase agreement, the parties agreed upon a purchase price
adjustment resulting in a decrease to the total purchase consideration, and a
payment to be made by Philips to ScanSoft of approximately $3.0 million. As of
December 31, 2003, the balance was classified as an other current asset.
ScanSoft received this payment on January 5, 2004.

During the three months ended March 31, 2003, we completed an underwritten
public offering of 8,256,906 shares of our 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. We sold 2,072,500 common shares
and received gross proceeds of $7.9 million. After considering offering costs,
the net proceeds amounted to approximately $5.5 million.

On August 11, 2003, we acquired all of the outstanding stock of SpeechWorks
International, Inc. ("SpeechWorks"), a leading provider of software products and
professional services that enable enterprises, telecommunications carriers and
government organizations to offer automated, speech-activated services over any
telephone, in exchange for 0.860 of a share of our common stock for each
outstanding share of SpeechWorks stock. This transaction resulted in the
issuance of approximately 32.5 million shares of our common stock, representing
approximately 33% of our outstanding common stock after the completion of the
acquisition. The SpeechWorks purchase price of $175.5 million includes the value
of the ScanSoft common stock issued at a per share value of $5.26 (the average
closing price of ScanSoft common stock for a total of five days immediately
prior to and subsequent to the announcement of the acquisition) and transaction
costs of $4.5 million. Included in the transaction costs is a warrant, valued at
$0.2 million, for the purchase of 150,000 shares of our common stock (Note 22).
In addition, the purchase price includes the value of 184,850 shares of
restricted common stock issued to replace previously outstanding SpeechWorks
restricted common stock, of $0.7 million, based on the closing price of our
common stock on the date of acquisition. The value of the unvested restricted
common stock has been recorded as deferred compensation (Note 13).

On December 19, 2003, we acquired all of the outstanding shares of
LocusDialog Inc. ("LocusDialog'), a leader in speech-enabled, auto-attendant
applications, based in Montreal, Canada. LocusDialog's applications are widely
recognized as superior call routing and auto-attendant solutions in the market,
with nearly 1,000 installations worldwide, handling approximately 500 million
calls annually. Consideration for the transaction comprised 2.3 million shares
of our common stock at a per share value of $5.31 (the average closing price of
ScanSoft common stock for a total of five days immediately prior to and
subsequent to the announcement of the acquisition) having a value of $12.4
million and transaction costs of $0.7 million.

18

OVERVIEW OF 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 5 and 6 of Notes to Consolidated Financial Statements.

(2) See Note 9 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
professional services, which include, but are not limited to, custom software
applications and other services considered essential to the functionality of the
software, training, and maintenance associated with software license
transactions. Our speech technologies enable voice-activated services over a
telephone, transform speech into text and text into speech, and permit voice
control of devices and applications. Our digital capture technologies transform
text, images and files into various digital formats. During 2003, Speech and
Digital Capture represented approximately 58% and 42%, respectively, of our net
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.

Cost of revenue from amortization of intangible assets consists of 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

19

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.

Stock-based compensation expenses result from non-cash charges for common
shares issued with exercise or purchase prices that are less than the fair
market value of the common stock on the date of grant.

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 AND ESTIMATES

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, in
particular those related to revenue recognition, including estimates of costs to
complete the development of custom software applications and estimates of
valuation allowances (specifically sales returns and other allowances); the
valuation of goodwill and other intangible assets; estimates used in the
accounting for acquisitions; 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 recognize 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 in accordance
with Statement of Position 97-2, Software Revenue Recognition ("SOP 97-2"), as
amended by Statement of Position 98-9, and the Securities and Exchange
Commission's Staff Accounting Bulletin No. 104, Revenue Recognition in Financial
Statements. Revenue from the sale of licenses to end users, value-added
resellers and system integrators to use our software products is recognized upon
delivery, provided that the arrangement does not require significant
modification or customization of the software, any services included in the
arrangement are not considered essential to the functionality of the software,
evidence of the arrangement exists, the fees are fixed or determinable, and
collectibility is reasonably assured.

Sales of our software products through certain 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 these
distributors and resellers only when the distributors or resellers have sold
products to retailers and 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 inventories subject to return. If
we experience significant returns from distributors or resellers, our liquidity
20

may be adversely impacted. We also make an estimate of sales returns by
retailers or end users 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. If actual returns from retailers 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
$42.4 million and $17.2 million at December 31, 2003 and December 31, 2002,
respectively. These balances are net of sales returns and other allowances of
$8.8 million and $5.4 million and allowances for doubtful accounts of $1.4
million and $0.5 million as of December 31, 2003 and December 31, 2002,
respectively.

Revenue from royalties on sales of our products by OEMs to third parties,
where no services are included, is typically recognized upon delivery to the
third party when such information is available, or when we are notified by the
OEM that such royalties are due as a result of a sale, provided that all other
revenue recognition criteria are met.

When we provide professional services such as custom application
development or other services considered essential to the functionality of the
software for a fixed fee, we recognize revenue from the fees for such services
and any related software licenses as we complete the project using the
percentage-of-completion method in accordance with Statement of Position 81-1
(SOP 81-1), Accounting for Performance of Construction-Type and Certain
Performance-Type Contracts. We generally determine the percentage-of-completion
by comparing the labor hours we have incurred to date to the estimate of the
total labor hours required to complete the project based on regular discussions
with our project managers. This method is used because we consider expended
labor hours to be the most reliable available measure of progress on these
projects. Adjustments to contract estimates are made in the periods in which
facts resulting in a change become known. When the estimate indicates a loss,
such loss is recorded in the period identified. Significant judgments and
estimates are involved in determining total estimated costs, and therefore the
percent complete of each contract. If our estimates change, the adjustment could
have a material effect on our results of operations in the period of the change.

Other professional services not considered essential to the functionality
of the software are limited and primarily include training and feasibility
studies. When we provide these services on a time and materials basis, we
recognize revenue as we perform the services based on actual time incurred.

When we provide software support and maintenance services, we recognize the
revenue ratably over the term of the related contracts, typically one year.

We may sell, under one contract or related contracts, software licenses,
custom software applications and other services considered essential to the
functionality of the software and a maintenance and support arrangement. The
total contract value is attributed first to the maintenance and support
arrangement based vendor specific objective evidence (VSOE) of its fair value,
equal to its stated list price as a fixed percentage of the related software
product's price. The remainder of the total contract value is then attributed to
the software license and related professional services, which are typically
recognized as revenue using the percentage-of-completion method. As a result,
discounts inherent in the total contract value are attributed to the software
license and related professional services. We may sell, under one contract or
related contracts, software licenses, a maintenance and support arrangement and
professional services not considered essential to the functionality of the
software. In those arrangements, the total contract value is attributed first to
the undelivered elements of maintenance and support and professional services
based on their fair values, as described above. The remainder of the contract
value is attributed to the software licenses, which are typically recognized as
revenue upon delivery, provided all other revenue recognition criteria are met.
As a result, discounts inherent in the total contract value are attributed to
the software licenses.

We follow the guidance of Emerging Issues Task Force issue No. 01-09,
Accounting for Consideration Given by a Vendor to a Customer or a Reseller of
the Vendor's Products ("EITF 01-09"), in determining whether consideration,
given to a customer should be recorded as an operating expense or a reduction of

21

revenue recognized from that same customer. Consideration given to a customer is
recorded as a reduction of revenue unless both of the following conditions are
met:

- We receive an identifiable benefit in exchange for the consideration, and
the identified benefit is sufficiently separable from the customer's
purchase of our products and services such that we could have purchased
the products from a third party, and

- We can reasonably estimate the fair value of the benefit received.

If both of the conditions are met, we record consideration paid to
customers as an expense. Consideration, including equity instruments, not
meeting the above criteria, is recorded as a reduction of revenue, to the extent
we have recorded cumulative revenue from the customer or reseller. As a result
of this policy, we recorded a $0.2 million, $0.3 million and $1.1 million
reduction in total revenue and a corresponding reduction of selling, general and
administrative expense for the years ended 2003, 2002 and 2001 respectively.

We record reimbursements received for out-of-pocket expenses as revenue,
with offsetting costs recorded as cost of revenue. Out-of-pocket expenses
generally include, but are not limited to, expenses related to airfare, hotel
stays and out-of-town meals.

VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL

We have significant long-lived 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 and core technology, completed technology and
trademarks which are typically 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 and at least annually.
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 materially 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 assessment of the useful lives of
existing recognized intangible assets and the identification of reporting units
for purposes of assessing potential future impairments of goodwill. We have
assessed the useful lives of our existing intangible assets, other than
goodwill, and believe that estimated useful lives remain appropriate. In
addition, we have determined that we operate in one reporting unit. As a result,
we use the stock price of our common stock to determine fair value for our
initial impairment test. Based on this, we performed the annual assessment
during the fourth quarter of 2003 and determined that goodwill was not impaired;
therefore no impairment charge was recorded. We complete 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

22

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 multiple significant business and other asset
acquisitions over the proceeding five years 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 judgments and estimates and which may result in
material impairment charges in the period in which they are determined.

ACCOUNTING FOR INCOME TAXES

As part of the process of preparing our consolidated financial statements,
we are required to calculate our income tax expense based on taxable income by
jurisdiction. There are many transactions and calculations where the ultimate
tax outcome is uncertain. Some of these uncertainties arise as a consequence of
revenue-sharing and cost-reimbursement arrangements among related entities and
the differing tax treatment of revenue and cost items across various
jurisdictions.

The income tax accounting process also involves estimating our actual
current tax liability, together with assessing temporary differences resulting
from differing treatment of items for tax and accounting purposes. These
differences result in deferred tax assets and liabilities. We must then assess
the likelihood that our deferred tax assets will be recovered from future
taxable income and, to the extent we believe that it is more likely than not
that all or a portion of deferred tax assets will not be realized, we must
establish a valuation allowance. A portion of our deferred tax liabilities
relate to taxable temporary differences for which the period in which the
differences will reverse is indefinite. Such deferred tax liabilities cannot
offset our deferred tax assets in determining the valuation allowance. As a
result, our income tax provision includes a deferred tax provision to increase
the valuation allowance by a corresponding amount. Through December 31, 2003, we
have recorded a full valuation allowance against our net deferred tax assets in
the United States and certain foreign jurisdictions due to the uncertainty of
their realization as a result of cumulative historical losses. If the
realization of net deferred tax assets in the future is considered more likely
than not, a reduction in the valuation allowance would materially increase net
income in the period such determination is made.

RESULTS OF OPERATIONS

DECEMBER 31, 2003 COMPARED TO DECEMBER 31, 2002

Total Revenue

Total revenue for 2003 increased by $28.8 million or 27% compared to 2002.
The growth in revenue is attributed to a $33.8 million growth in our Speech
revenues, offset by an overall decrease of $5.0 million in our Digital Capture
revenues from 2002. Revenue from our speech products was $77.9 million and $44.2
million for 2003 and 2002, respectively. The increase in our Speech revenues are
primarily related to a $24.7 million increase in our networked speech
technologies, a $4.9 million increase in our embedded speech technologies, as
well as a $4.2 million increase in our dictation product lines, from the year
2002. The $5.0 million overall decrease in our Digital Capture products can be
attributed to a $10.0 million decrease in revenues recognized from our OCR
products. This overall decrease is due, in part, to the fact that OmniPage Pro
12 was launched

23

earlier in 2002 than OmniPage Pro 14 was launched in 2003, as well as the
recognition in 2002 of revenue previously deferred. The decrease in the OCR
revenues was offset to some extent by an overall strengthening of our other
Digital Capture product lines, in particular, PaperPort and the revenues derived
from the launch of our new product, PDF Converter, during the fourth quarter of
2003.

Related-party revenue increased $1.6 million or 32% compared to 2002. This
increase was related to the inclusion of our products in expanded product
offerings of our related parties, primarily Xerox.

Revenue for the year ended December 31, 2003 was 72% North America and 28%
international versus 73% North America and 27% international, respectively for
2002. Geographic revenue classification is based on the country in which the
sale is invoiced.

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, 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, 2003
is approximately 65% North America and 35% international, compared to 67% North
America and 33% international, for the comparable period in 2002. The increase
in our international revenue, as a percentage of total revenue, is driven
primarily from Europe. The increase is the result of increased sales and
marketing resources, the addition of resellers, the release of Dragon Naturally
Speaking 7.0, increased demand from OEMs for our RealSpeak product (TTS), the
continued growth of PaperPort 9.0 in the international market space, as well as
revenues achieved from our acquisitions of the Philips and SpeechWorks
technologies.

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

The increase in our OEM revenues and the corresponding decrease in our
other sales channels, as a percentage of revenue, for the year ended December
31, 2003 as compared to the same period 2002, was primarily due to the
acquisitions of the Philips and SpeechWorks technologies as both businesses were
more focused in the OEM markets than in the retail or VAR channel.

For fiscal year 2004, we expect revenue growth of 35% to 45% from the
fiscal year 2003 total. We believe that growth will occur throughout all of our
product lines.

Within the networked speech market, our anticipated growth is attributable
to certain competitive advantages, such as superior products, channel expertise,
packaged applications and professional services. By leveraging our advantages,
we expect to gain additional share in the financial services, healthcare,
utilities, government, and travel and entertainment markets.

Within the embedded speech market, we anticipate continued growth,
specifically in the automotive, electronic games and handsets markets, resulting
in a significant increase over 2003 revenues. Additionally, we intend to extend
our solutions further in the learning and accessibility markets.

Within our productivity applications, we expect to benefit from three
important trends -- IT spending in healthcare, networked scanning, and PDF
solutions. We expect to invest in and see growth from opportunities in
healthcare organizations looking for productivity solutions that can automate
processes, cut costs, and offer

24

an alternative to outsourcing with the use of our dictation applications. In
digital capture, our OmniPage and PaperPort products are positioned to take
advantage of the growing networked scanning markets through our major OEM
partners. Within the PDF market, we have seen early success from our PDF
Converter line, and expect to see growth as we continue to invest in PDF
solutions.

Cost of Revenue

Cost of revenue for 2003 was $26.1 million or 19.3% of total revenue,
compared to $16.4 million or 15.4% of total revenue for 2002. The increase in
cost of revenue in absolute dollars and as a percentage of revenue for 2003 is
attributable to an increase in engineering costs related to professional
services revenue resulting from the Philips and SpeechWorks acquisitions and
increased technical support costs primarily related to the creation of a
customer service department in Europe. The Company anticipates annualized cost
savings in cost of revenue of approximately $4.0 million, relating to
restructuring actions taken in connection with the SpeechWorks acquisition.
These savings are partially offset by increased staffing of our professional
services organization in response to an increase in demand. As a result, we
expect gross margins will decline in 2004 due to an increase in professional
services revenue as a percentage of total revenue. Cost of revenue from
stock-based compensation is related to the issuance of common stock to certain
Company executives with exercise or purchase prices that were less than the fair
market value of the common stock on the date of grant.

Cost of Revenue from Amortization of Intangible Assets

Cost of revenue from amortization of intangible assets for 2003 was $10.5
million or 7.8% of total revenue compared to $9.5 million or 8.9% of total
revenue for 2002. The increase in cost of revenue from amortization of
intangible assets in absolute dollars is attributable to $1.7 million of
amortization related to the exclusive worldwide license of certain desktop
dictation products and technologies, $0.7 million related to the Philips
acquisition which was completed on January 30, 2003 and $0.2 million related to
the SpeechWorks acquisition which was completed on August 11, 2003, partially
offset by $1.6 million of intangible assets that became fully amortized during
fiscal year 2002. During 2004, we expect cost of revenue from amortization of
intangible assets to be approximately $10.8 million based on the related assets
and estimated useful lives at December 31, 2003.

Research and Development Expense

Research and development costs for 2003 were $33.9 million or 25.1% of
total revenue, compared to $27.6 million or 25.9% of total revenue for 2002. The
increase in research and development expenses in absolute dollars is due to
increased speech and language development efforts associated with increased
headcount and related costs of approximately $6.6 million resulting from both
the Philips and SpeechWorks acquisitions. This increase is partially offset by a
reduction of headcount and related costs of approximately $0.3 million resulting
from the transfer of certain research and development activities from our
corporate headquarters to Budapest during the three month period ended June 30,
2003. The Company will continue to invest significantly in research and
development, but we expect research and development expenses as a percentage of
revenue to decline in 2004 due to an expected increase in revenue and the
continued realization of operational synergies. The Company anticipates
annualized cost savings in research and development of approximately $7.0
million related to restructuring actions in connection with the SpeechWorks
acquisition, completed in 2003.

Selling, General and Administrative Expense

Selling, general and administrative expense for 2003 was $65.0 million or
48.0% of total revenue, compared to $43.7 million or 41.0% for 2002. The
increase in selling, general and administrative expense in absolute dollars and
as a percentage of revenue for 2003 was the result of increased compensation
costs of approximately $12.0 million resulting from the addition of 72 sales and
marketing employees and 25 general and administrative employees primarily due to
the Philips and SpeechWorks acquisitions. The remaining increase in selling,
general and administrative expenses for 2003 is due primarily to increased
facilities charges of $3.2 million resulting from increased rent and related
insurance expenses, increased advertising expenses of
25

$1.3 million, increased channel marketing expenses of $0.9 million, increased
professional fees of approximately $2.6 million and increased bad debt expense
of $0.6 million. The Company expects selling, general and administrative
expenses as a percentage of revenue to increase initially in 2004, as it
maintains marketing programs that proved successful towards the end of 2003, but
to decline as a percentage of revenue over the remainder of 2004 as revenue
increases. In addition, during 2004, the Company expects to incur approximately
$1.0 million related to compliance with recently issued regulatory requirements.
Selling, general and administrative expenses from stock based compensation of
approximately $0.3 million is related to the issuance of common stock to certain
Company executives with exercise or purchase prices that are less than the fair
market value of the common stock on the date of grant. The Company anticipates
annualized cost savings in selling, general and administrative of approximately
$16.0 million related to restructuring actions in connection with the
SpeechWorks acquisition completed in 2003.

Amortization of Other Intangible Assets

Amortization of other intangible assets for 2003 was $2.3 million or 1.7%
of total revenue compared to $1.7 million or 1.6% of total revenue for 2002. The
increase in amortization of other intangible assets is attributable to $0.7
million related to the Philips acquisition, which was completed on January 30,
2003, and $0.7 million related to the SpeechWorks acquisition, which was
completed on August 11, 2003, partially offset by $0.7 million of intangible
assets that became fully amortized during fiscal year 2002. During 2004, we
expect amortization of other intangible assets to be approximately $2.8 million,
based on the related assets and estimated useful lives at December 31, 2003.

Restructuring and Other Charges, Net

Restructuring and other charges for 2003 were $3.7 million compared to $1.0
million for 2002. These charges in 2003 reflect $2.4 million related to the
elimination of 106 employees as a result of the Philips and SpeechWorks
acquisitions. Also included are $0.8 million and $0.4 million of employee and
facility related costs, respectively, associated with the restructuring of
various other corporate activities during the year. The Company anticipates
annualized cost savings of approximately $27.0 million related to restructuring
actions in connection with the SpeechWorks acquisition completed in 2003.

Income (Loss) from Operations

As a result of the above factors, loss from operations was ($6.5) million
for 2003 compared with income of $6.6 million for 2002.

Other Income (Expense), Net

Interest income was $0.5 million and $0.4 million for 2003 and 2002,
respectively. The increase in interest income from 2002 to 2003 was a result of
higher cash and cash equivalent balances, which grew from $18.9 million at
December 31, 2002 to $42.6 million at December 31, 2003. Interest expense was
$0.8 million and $0.4 million for 2003 and 2002, respectively. Interest expense
consists primarily of interest related to the 5.0 million euro note related to
the Philips acquisition and imputed interest expense related to the exclusive
license acquired to resell certain productivity applications. Other income in
2003 consists primarily of foreign exchange gains of $1.2 million, partially
offset by other expenses of $0.2 million. Foreign exchange losses were
insignificant in 2002.

Income (Loss) Before Income Taxes

Loss before income taxes was ($5.8) million for 2003, compared with income
of $6.6 million for 2002.

Income Taxes

The benefit for income taxes of ($0.3) million for 2003 primarily consisted
of a benefit of $1.5 million relating to a federal tax refund, relating to the
carryback of net operating losses to a prior period offset by a $1.2 million
deferred tax provision associated with differences between the book and tax
amortization of
26

certain goodwill, of which $0.4 million relates to 2002. The provision for
income taxes of $0.3 million for 2002 consisted of foreign and state tax
provisions of $1.2 million offset by the federal tax benefit of $0.9 million,
related to a refund of taxes paid by Caere Corporation prior to its acquisition
by ScanSoft.

In 2003, the Company's effective tax rate was a benefit of 4.6% versus a
provision of 3.9% in 2002. The variance from the statutory rate for 2003 was due
primarily to a federal refund received relating to Caere Corporation for taxes
paid prior to its acquisition by ScanSoft, offset by increases in the valuation
allowance.

At December 31, 2003, ScanSoft had net deferred tax assets of $97 million
which were subject to consideration of a valuation allowance. A full valuation
allowance has been provided against the net deferred tax assets in the United
States and certain foreign jurisdictions due to the uncertainty of their
realization as a result of cumulative historical losses. In the future, a period
of sustained profitability will cause us to reassess the need for the valuation
allowance. 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.

Net Income (Loss)

As a result of all these factors, net loss totaled ($5.5) million for 2003,
compared with net income of $6.3 million for 2002.

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:

27

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.

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 attributable to the restructuring actions taken in
2002 for 2002 were approximately $1.3 million.

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
our expanded focus on international sales and marketing.

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.

28

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 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 provision for income taxes 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, offset by the
benefit from income taxes of ($0.7) million related to the reversal of amounts
previously accrued for state income taxes upon favorable completion of a state
tax audit of Caere for 1996 and 1997.

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.

29

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2003, we had cash and cash equivalents of $42.6 million
and working capital of $44.3 million as compared to $18.9 million in cash and
cash equivalents and working capital of $16.8 million at December 31, 2002.

Net cash provided by operating activities for the fiscal year ended
December 31, 2003 was $5.2 million as compared to $12.3 million for the same
period in 2002. Cash provided by operations in the 2003 period came primarily
from income from operations, after adjustments for non-cash amortization and
depreciation, lower inventory balances and increases in deferred revenue,
partially offset by payments of accounts payable and accrued expenses, an
increase in accounts receivable balances and an increase in prepaid expenses and
other current assets.

The increase in accounts receivable of $25.2 million at December 31, 2003,
as compared to December 31, 2002, was the result of receivables added in
connection with acquisitions completed during the year as well as a significant
increase in overall revenue for the year ended December 31, 2003. Historically,
we have not incurred any significant losses on our accounts receivable balances.

Net cash provided by investing activities for the fiscal year ended
December 31, 2003 was $24.1 million compared to cash used in investing
activities of $6.0 million for the comparable period in 2002. Net cash provided
by investing activities during the 2003 period consisted of $40.0 million
acquired in the SpeechWorks acquisition, $1.1 million received from Philips in
accordance with provisions in the purchase agreement and $0.6 million due to the
maturity of marketable securities, partially offset by $2.9 million in capital
expenditures, $8.5 million of payments associated with acquisitions and $6.1
million of payments associated with an exclusive licensing agreement. 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 the fiscal year ended December
31, 2003 was $5.1 million compared to net cash used in financing activities of
$1.9 million for the comparable period in 2002. Net cash used in financing
activities during 2003 consisted of the payment of $6.9 million (6.0 million
euros) related to the 5.0 million euro note payable and 1.0 million euro
deferred payment due in connection with the Philips acquisition, the payment of
the $3.3 million note related to the acquisition of certain Lernout & Hauspie
assets during 2001, a $1.6 million payment to the former Caere President and CEO
in connection with the settlement of a non-competition and consulting agreement,
$2.9 million of payments to repurchase outstanding common shares and the payment
of $0.3 million related to outstanding equipment lines of credit. This was
partially offset by proceeds of $5.5 million from an underwritten offering of
our common stock in the first quarter of 2003 and proceeds of $4.4 million from
the issuance of common stock in connection with employee stock compensation
plans. 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 a
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 a non-competition and consulting
agreement.

In addition, prior to December 31, 2003, in accordance with provisions of
the purchase agreement, we agreed with Philips upon a purchase price adjustment
resulting in a decrease to the total purchase consideration. Philips is to pay
us approximately $3.0 million. As of December 31, 2003, the balance was
classified as an other current asset. We received this payment on January 5,
2004.

On October 31, 2002, we entered into a two year Loan and Security Agreement
(as amended, the "Loan Agreement") with Silicon Valley Bank (the "Bank") that
consisted of a $10.0 million revolving loan (the "Credit Facility"). We amended
this Loan and Security Agreement, as of September 30, 2003, for the period
September 30, 2003 through December 31, 2003, removing the fixed charge coverage
ratio covenant and replacing it with an adjusted quick ratio covenant.
Borrowings under the Credit Facility bear interest at the

30

Bank's prime rate plus 0.375% or 0.75%, (4.375% at December 31, 2003) which is
determined by our adjusted quick ratio, as defined in the Loan Agreement. The
maximum aggregate amount of borrowings outstanding at any one time is 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 our
adjusted quick ratio. 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. Borrowings under
the Loan Agreement are collateralized by substantially all of our personal
property, predominantly our accounts receivable, but not our intellectual
property. We are currently renegotiating the terms of our Loan and Security
Agreement. Until these negotiations are complete, we continue to have access to
the existing $10.0 million revolving loan. During this time the Credit Facility
will be subject to the terms as amended on September 30, 2003. As of December
31, 2003, based upon the calculated borrowing base, available borrowings totaled
approximately $8.3 million, as we had approximately $1.7 million in outstanding
Letters of Credit.

In connection with the SpeechWorks acquisition, we eliminated 54 former
SpeechWorks employees. In connection with this action, a liability of $1.3
million, representing severance and related benefits, has been included in the
purchase price allocation. As of December 31, 2003, the remaining restructuring
accrual related to SpeechWorks acquisition amounted to $0.1 million.

For the twelve months ended December 31, 2003, we paid a total of $2.2
million in severance payments, of which $0.5 million relates to the March 2002
restructuring and $0.1 million relates to severance paid to the former Caere
President and CEO, pursuant to a 2000 restructuring charge.

At December 31, 2003, the remaining restructuring accrual from the current
and prior restructuring activities amounted to $1.9 million. The balance is
comprised of $0.3 million of lease exit costs and $1.6 million of
employee-related severance costs, of which $0.3 million are for severance to the
former Caere President and CEO, $0.1 million are for severance costs related to
the 2003 Philips related restructuring actions and $1.2 million is for severance
costs related to actions taken during 2003, respectively.

The lease exit costs and severance due to the former Caere President and
CEO will be paid through January 2004 and March 2005, respectively. Severance
costs related to restructuring actions undertaken during 2003 will be paid
through March 2009.

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 those 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 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.

Although we generated $5.2 million of cash from operations for 2003 and
exited the year with a cash balance of $42.6 million, there can be no assurance
that we will be able to continue to generate cash from operations or secure
additional equity or debt financing if required. The large increase in our cash
balance has come primarily from the SpeechWorks acquisition. In connection with
the Philips Speech Processing Telephony and Voice Control Business Unit
acquisition we issued a $27.5 million, zero interest convertible debenture due
January 2006. Additionally, in connection with the SpeechWorks acquisition we
acquired
31

certain long-term lease obligations that begin to come due in the next 12-24
months. We have sustained recurring losses from operations in each reporting
period through December 31, 2001. We have reported a net loss of $(5.5) million
and net income of $6.3 million for the fiscal year ended December 31, 2003 and
2002, respectively. We had an accumulated deficit of $152.4 million at December
31, 2003. We believe that the actions taken in connection with our acquisitions,
including restructuring actions and other cost reduction initiatives, have
reduced operating expenses to levels which, in combination with expected future
revenues, will continue to generate positive cash flow. Therefore, we believe
that cash flows from future operations in addition to cash on hand and amounts
available under our line of credit will be sufficient to meet the our working
capital, investing, financing and contractual obligations, including the debt
obligation issued in connection with the Philips acquisition, and the lease
obligations assumed in the SpeechWorks acquisition, as they become due for the
foreseeable future.

CONTRACTUAL OBLIGATIONS

The following table outlines our contractual payment obligations as of
December 31, 2003:

At December 31, 2003, the Company has sub-leased certain office space to
third parties. Total sub-lease income under contractual terms is $6.4 million,
which has not been reflected in the above operating lease contractual
obligations, will be received through February 2016.

OFF-BALANCE SHEET ARRANGEMENTS

Through December 31, 2003, we have not entered into any off balance sheet
arrangements or transactions with unconsolidated entities or other persons.

FOREIGN OPERATIONS

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. In certain circumstances, we have entered into forward exchange
contracts to hedge against foreign currency fluctuations on intercompany
balances with our foreign subsidiaries. We use these contracts to reduce our
risk associated with exchange rate movements, as the gains or losses on these
contracts are intended to offset any exchange rate losses or gains on the hedged
transaction. We do not engage in foreign currency speculation. Hedges are
designated and documented at the inception of the hedge and are evaluated for
effectiveness monthly. Forward exchange contracts hedging firm commitments
qualify for hedge accounting when they are designated as a hedge of the foreign
currency exposure and they are effective in minimizing such exposure.

32

In connection with the Philips acquisition on January 30, 2003, we entered
into a forward hedge in the amount of $5.3 million to meet our obligation to pay
the 5.0 million euro promissory note (Philips Note) issued as part of the
acquisition. On August 26, 2003, we entered into a forward exchange contract to
hedge the foreign currency exposure of the 1.0 million euro note payable to
Philips. As both the 5.0 million euro promissory note and 1.0 million euro note
payable to Philips were paid prior to December 31, 2003, the related forward
exchange contracts have expired. As a result of hedge effectiveness no
significant gain or loss was incurred upon expiration of the contracts.

On November 3, 2003, we entered into a forward exchange contract to hedge
our foreign currency exposure related to 3.5 million euros of intercompany
receivables from our Belgian subsidiary. The contract has a one year term that
expires on November 1, 2004. For the year ended 2003, we recorded a net exchange
rate gain of approximately $46,000 in other comprehensive income on the
intercompany receivable and associated forward exchange contract. On November 5,
2003, we entered into a forward exchange contract to hedge our foreign currency
exposure related to 7.5 million Singapore dollars of intercompany receivables
from our Singapore subsidiary. The contract expired on January 30, 2004. For the
year ended 2003, we recorded a net exchange rate loss of approximately $1,000 in
other comprehensive income on the intercompany receivable and associated forward
exchange contract.

With our increased international presence in a number of geographic
locations and with international revenues projected to increase in 2004, we are
exposed to changes in foreign currencies including the euro, Canadian dollar,
Japanese yen and the Hungarian forint. Changes in the value of the euro or other
foreign currencies relative to the value of the U.S. dollar could adversely
affect future revenues and operating results.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In May 2003, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 150 ("SFAS 150"), "Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity." SFAS 150 establishes standards for how an issuer classifies and
measures certain financial instruments with characteristics of both liabilities
and equity. SFAS 150 was originally effective for financial instruments entered
into or modified after May 31, 2003, and otherwise effective at the beginning of
the first interim period beginning after June 15, 2003, however certain elements
of SFAS No. 150 have been deferred. The adoption of the provisions of SFAS No.
150, not deferred, did not have a material impact on our financial position or
results of operations and we do not expect the adoption of the deferred elements
of SFAS No. 150 to have a material impact on its financial position or results
of operations.

In April 2003, the FASB issued Statement of Financial Accounting Standards
No. 149 ("SFAS 149"), "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities." SFAS 149 amends and clarifies financial accounting and
reporting for derivative instruments, including certain derivative instruments
embedded in other contracts (collectively referred to as derivatives), and for
hedging activities under FASB Statement No. 133, "Accounting for Derivative
Instruments and Hedging Activities." SFAS 149 was effective for contracts
entered into or modified after June 30, 2003 and for hedging relationships
designated after June 30, 2003. The adoption of SFAS No. 149 did not have a
material impact on our current financial position and results of operations.

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

33

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 did not have an impact on our financial position or results of
operations for 2003.

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 adoption of SFAS 146 did not have a
material impact on our financial position or results of operations.

RISK FACTORS

We operate in an intensely competitive environment and our operations are
subject to risks and uncertainties. Such risks and uncertainties include, but
are not limited to (1) the loss of, or a significant curtailment of, purchases
by any one or more of our principal customers; (2) the cyclical nature of the
retail software industry; (3) the inability to protect our proprietary
technology and intellectual property; (4) the inability to attract or retain
skilled employees; (5) technological obsolescence of current products and the
inability to develop new products; (6) the inability to respond to competitive
technology and competitive pricing pressures; and (7) the ability to sustain
product revenues upon the introduction of new products. Our quarterly operating
results may fluctuate and differ materially from one quarter to the next, which
could have an impact on our stock price.

There can be no assurance that any cash generated by operations will be
sufficient to satisfy our liquidity requirements, and we may be required to sell
additional equity or debt securities, or obtain additional lines of credit. The
sale of additional equity or convertible debt securities may result in
additional dilution to our stockholders. It may be difficult to sell additional
equity or obtain debt financing, and this could result in significant
constraints on our ability to grow revenue and develop new products.

You should also carefully consider the additional 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

34

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;

- 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 a net loss of $(5.5) million and net income of
$6.3 million for the fiscal year ended December 31, 2003 and 2002, respectively.
We had an accumulated deficit of $152.4 million at December 31, 2003. If we are
unable to regain 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 RECENTLY COMPLETED
ACQUISITION OF LOCUSDIALOG. As part of our business strategy, we have in the
past acquired, and expect to continue to acquire, other businesses and
technologies. Our 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), our acquisition of the
Speech Processing Telephony and Voice Control business units from Philips and
our acquisition of SpeechWorks International, Inc., required substantial
integration and management efforts. Our recently completed acquisition of
LocusDialog, Inc., may pose similar challenges. Acquisitions of this nature
involve a number of risks, including:

- DIFFICULTY IN TRANSITIONING AND INTEGRATING THE OPERATIONS AND PERSONNEL
OF THE ACQUIRED BUSINESSES, INCLUDING DIFFERENT AND COMPLEX ACCOUNTING
AND FINANCIAL REPORTING SYSTEMS;

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

- POTENTIAL DIFFICULTY IN SUCCESSFULLY IMPLEMENTING, UPGRADING AND
DEPLOYING IN A TIMELY AND EFFECTIVE MANNER NEW OPERATIONAL INFORMATION
SYSTEMS AND UPGRADES OF OUR FINANCE, ACCOUNTING AND PRODUCT DISTRIBUTION
SYSTEMS;

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

35

- 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.

OUR OPERATING RESULTS COULD BE ADVERSELY AFFECTED AS A RESULT OF PURCHASE
ACCOUNTING TREATMENT, AND THE CORRESPONDING IMPACT OF AMORTIZATION OF OTHER
INTANGIBLES RELATING TO OUR ACQUISITIONS COMPLETED DURING 2003. Under accounting
principles generally accepted in the United States of America, we have accounted
for these acquisitions using the purchase method of accounting. Under purchase
accounting, we have recorded the market value of our common stock or other form
of consideration issued in connection with the acquisition and the amount of
direct transaction costs as the cost of acquiring the company or business. We
have allocated that cost to the individual assets acquired and liabilities
assumed, including various identifiable intangible assets such as acquired
technology, acquired trade names and acquired customer relationships based on
their respective fair values. Intangible assets generally will be amortized over
a five to ten year period. Goodwill is not subject to amortization but is
subject to at least an annual impairment analysis, which may result in an
impairment charge if the carrying value exceeds its implied fair value. As a
result, purchase accounting treatment of these acquisitions could decrease our
net income in the foreseeable future, which could have a material and adverse
effect on the market value of our common stock.

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 not be successfully implemented or marketed
by our licensees.

OEM revenue represented 44% and 34% of our consolidated revenue for the
years ended December 31, 2003 and December 31, 2002, respectively. A select few
of our OEM partners account for a majority of our OEM revenues. 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 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.

36

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. During 2003, we purchased certain businesses and
intellectual property from Philips and completed the acquisitions of SpeechWorks
and LocusDialog, Inc. We 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 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, L&H, SpeechWorks and LocusDialog
acquisitions, we issued 19.0 million, 7.4 million, 32.5 million and 2.3 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, 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. In accordance with the provisions of the agreement, we
agreed to a final purchase price adjustment with Philips of approximately $4.1
million, resulting in a corresponding reduction in goodwill. We received $1.1
million of the purchase price adjustment prior to December 31, 2003. The
remaining $3.0 million (2.5 million euros) was received on January 5, 2004.
While we satisfied our payment obligations related to the additional 1.0 million
euros and 5.0 million euro note prior to December 31, 2003, 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.

THE FAILURE TO SUCCESSFULLY IMPLEMENT, UPGRADE AND DEPLOY IN A TIMELY AND
EFFECTIVE MANNER NEW INFORMATION SYSTEMS AND UPGRADES OF OUR FINANCE AND
ACCOUNTING SYSTEMS TO ADDRESS CERTAIN ISSUES IDENTIFIED IN CONNECTION WITH OUR
FISCAL 2003 YEAR-END AUDIT COULD HARM OUR BUSINESS. In connection with its
audit of our 2003 consolidated financial statements, PricewaterhouseCoopers LLP
("PwC"), our independent auditors, advised in a management letter to our Audit
Committee of four conditions that could adversely affect our ability to
initiate, record, process and report financial data consistent with management's
assertions. These conditions include: (i) we may lack the necessary corporate
accounting resources to meet the accelerated filing deadline requirements in
2004 mandated by the SEC, while at the same time staffing the demands of our
worldwide Oracle implementation and Sarbanes-Oxley requirements; and (ii) we
have a dependence on key personnel in our finance and accounting organization,
the loss of whom could impair our ability to perform timely financial reporting,
especially prior to the completion of our worldwide Oracle implementation and
our readiness efforts related to our obligations under Section 404 of the
Sarbanes-Oxley Act of 2002. In addition, we discuss the other two conditions
raised by PwC later in this document (see page 90).

From 1997 through December 31, 2003, we have made seven significant
business acquisitions. As a result, we continue to have several financial
systems in use in the company. The incompatibility between these systems
requires significant manual efforts within finance and accounting to complete
our financial reporting. Therefore, substantial knowledge of our policies and
procedures and the process for initiating, recording, processing, summarizing
and reporting financial information is resident in the knowledge of personnel
involved in the financial reporting process.

To improve the efficiency and quality of our accounting and financial
reporting systems, we commenced, in the third quarter of 2003, a worldwide
implementation of the Oracle e-Business suite. In addition, we have retained a
third-party consulting firm that is assisting management and staff to formalize
and document our business and financial processes and controls in preparation
for our compliance with Section 404 of the

37

Sarbanes-Oxley Act of 2002. While we believe that these actions will address the
conditions raised in PwC's letter, we have been and will continue to be required
to devote substantial resources to these activities during 2004. Failure to
successfully implement these systems or formalize and document these processes
and controls in a timely, effective and efficient manner could result in the
disruption of our operations, our inability to comply with our Sarbanes-Oxley
obligations and the inability to report our financial results in a timely
manner.

SALES OF OUR DOCUMENT AND PDF CONVERSION PRODUCTS AND OUR DIGITAL PAPER
MANAGEMENT PRODUCTS REPRESENTED APPROXIMATELY 40% AND 51%, OF OUR REVENUE FOR
THE YEAR ENDED DECEMBER 31, 2003 AND 2002, RESPECTIVELY. ANY REDUCTION IN
REVENUE FROM THESE PRODUCT AREAS COULD SERIOUSLY HARM OUR
BUSINESS. Historically, a few product areas have generated a substantial
portion of our revenues. For the year ended December 31, 2003, our document and
PDF conversion products represented approximately 26% of our revenue and our
digital paper management products represented approximately 14% of our revenue.
For the year ended December 31, 2002, our document and PDF conversion products
represented approximately 39% of our revenue and our digital paper management
products represented approximately 12% of our revenue. A significant 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.

On July 15, 2003, Elliott Davis ("Davis") filed an action against
SpeechWorks in the United States District Court for the Western District for New
York (Buffalo) claiming patent infringement. Damages are sought in an
unspecified amount. In addition, on November 26, 2003, Davis filed an action
against ScanSoft in the United States District Court for the Western District
for New York (Buffalo) also claiming patent infringement. Damages are sought in
an unspecified amount. SpeechWorks filed an Answer and Counterclaim to Davis's
Complaint in its case on August 25, 2003 and ScanSoft filed an Answer and
Counterclaim to Davis's Complaint in its case on December 22, 2003. We believe
these claims have no merit, and we intend to defend the actions vigorously.

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. Damages are sought in an unspecified

38

amount. We filed an Answer on December 23, 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. However, even if our defense is successful,
the litigation could require significant management time and could be costly.
Should we not prevail in these litigation matters, our operating results,
financial position and cash flows could be adversely impacted.

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, Fonix, IBM, Nuance
Communications and Rhetorical. 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 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

39

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, 2003, two distribution and fulfillment partners, Ingram Micro
and Digital River, accounted for 16% and 13% of our consolidated revenue,
respectively. During the year ended December 31, 2002, Ingram Micro and Digital
River, accounted for 25% and 12% 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, 2003, Ingram Micro, Tech
Data and Digital River represented 20%, 5% and 5%, of our net accounts
receivable, respectively. At December 31, 2002, Ingram Micro, Tech Data and
Digital River represented 8%, 5% 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 both the years ended December 31, 2003 and December
31, 2002 represented 28% and 27% 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 35% and 33% of our
consolidated revenue for the years ended December 31, 2003 and December 31,
2002, 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.

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 connection
with the Philips acquisition, we have added an additional research and
development location in Germany. In connection with the acquisition of Locus
Dialog, we have added an additional research and development location in
Montreal, Canada. 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.

40

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. In certain circumstances, we have entered into forward exchange
contracts to hedge against foreign currency fluctuations on intercompany
balances with our foreign subsidiaries. We use these contracts to reduce our
risk associated with exchange rate movements, as the gains or losses on these
contracts are intended to offset any exchange rate losses or gains on the hedged
transaction. We do not engage in foreign currency speculation. Hedges are
designated and documented at the inception of the hedge and are evaluated for
effectiveness monthly. Forward exchange contracts hedging firm commitments
qualify for hedge accounting when they are designated as a hedge of the foreign
currency exposure and they are effective in minimizing such exposure. With our
increased international presence in a number of geographic locations and with
international revenues projected to increase in 2004, we are exposed to changes
in foreign currencies including the euro, Canadian dollar, Japanese yen and the
Hungarian forint. Changes in the value of the euro or other foreign currencies
relative to the value of the U.S. dollar could adversely affect future revenues
and operating results.

IF WE ARE UNABLE TO ATTRACT AND RETAIN KEY 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, 2003,
Xerox beneficially owned approximately 14.9% 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
11.1% of our common stock as of December 31, 2003. 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.

COMPLIANCE WITH CHANGING REGULATION OF CORPORATE GOVERNANCE AND PUBLIC
DISCLOSURE MAY RESULT IN ADDITIONAL EXPENSES. Changing laws, regulations and
standards relating to corporate governance and public disclosure, including the
Sarbanes-Oxley Act of 2002, new regulations promulgated by the Securities and
Exchange Commission and Nasdaq National Market rules, are resulting in increased
general and administrative expenses for companies such as ours. These new or
changed laws, regulations and standards are subject to varying interpretations
in many cases, and as a result, their application in practice may evolve over
time as new guidance is provided by regulatory and governing bodies, which could
result in higher costs necessitated by ongoing revisions to disclosure and
governance practices. We are committed to maintaining high standards of
corporate governance and public disclosure. As a result, we intend to invest
resources to comply with evolving laws, regulations and standards, and this
investment may result in increased general and administrative
41

expenses and a diversion of management time and attention from
revenue-generating activities to compliance activities. If our efforts to comply
with new or changed laws, regulations and standards differ from the activities
intended by regulatory or governing bodies, our business may be harmed.

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
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 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 face exposure to adverse movements in foreign currency exchange rates,
as a significant portion of our revenues, expenses, assets, and liabilities are
denominated in currencies other than the U.S. Dollar, primarily the euro, the
Canadian dollar, the Japanese yen and the Hungarian forint. These exposures may
change over time as business practices evolve. We evaluate our foreign currency
exposures on an ongoing basis and make adjustments to our foreign currency risk
management program as circumstances change.

In certain instances, we have entered into forward exchange contracts to
hedge against foreign currency fluctuations. These contracts are used to reduce
our risk associated with exchange rate movements, as the gains or losses on
these contracts are intended to offset the exchange rate losses or gains on the
underlying exposures. We do not engage in foreign currency speculation. The
success of our foreign currency risk management program depends upon the ability
of the forward exchange contracts to offset the foreign currency risk associated
with the hedged transaction. To the extent that the amount or duration of the
forward exchange contract and hedged transaction vary, we could experience
unanticipated foreign currency gains or losses that could have a material impact
on our results of operations. In addition, the failure to identify new exposures
and hedge them in a timely manner may result in material foreign currency gains
and losses.

In connection with the Philips acquisition on January 30, 2003, we entered
into a forward hedge in the amount of $5.3 million to cover our obligation to
pay the 5.0 million euro promissory note (Philips Note) issued as part of the
acquisition. On August 26, 2003, we entered into a forward exchange contract to
hedge the foreign currency exposure of our 1.0 million euro note payable to
Philips. As both the 5.0 million euro promissory note and 1.0 million euro note
payable to Philips were paid prior to December 31, 2003, the related forward
hedge and forward exchange contract have terminated.

On November 3, 2003, we entered into a forward exchange contract to hedge
our foreign currency exposure related to 3.5 million euros of inter-company
receivables from our Belgian subsidiary to the United States. The contract has a
one-year term that expires on November 1, 2004. On November 5, 2003, we entered
into a forward exchange contract to hedge our foreign currency exposure related
to 7.5 million Singapore dollars of inter-company receivables from our Singapore
subsidiary to the United States. The contract expired on January 30, 2004.

While the contract amounts of derivative instruments provide one measure of
the volume of these transactions, they do not represent the amount of our
exposure to changes in foreign currency exchange rates. Because the terms of the
derivative instrument and underlying exposure are matched generally at
inception, changes in foreign currency exchange rates should not expose us to
significant losses in earnings or net cash outflows when exposures are properly
hedged.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

42

SCANSOFT, INC.

CONSOLIDATED FINANCIAL STATEMENTS

43

SCANSOFT, INC.

INDEX TO FINANCIAL STATEMENTS

44

REPORT OF INDEPENDENT AUDITORS

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, 2003 and 2002, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2003 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 26, 2004

45

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.
46

SCANSOFT, INC.

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

The accompanying notes are an integral part of these consolidated financial
statements.
47

SCANSOFT, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)

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

48

SCANSOFT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

The accompanying notes are an integral part of these consolidated financial
statements.
49

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 National Market, 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). On January 30, 2003, the Company acquired Royal Philips Electronics
Speech Processing Telephony and Voice Control business units, and related
intellectual property ("Philips"). On August 11, 2003, the Company acquired
SpeechWorks International, Inc. ("SpeechWorks"). On December 19, 2003, the
Company acquired LocusDialog, Inc. ("LocusDialog"). The acquisitions of Caere,
L&H, Philips, SpeechWorks and LocusDialog 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.

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 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, ScanSoft evaluates its estimates and judgments,
including those related to revenue recognition, including estimates of costs to
complete the development of custom software applications and estimates of
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. ScanSoft bases its 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.

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 the Company's subsidiary in Budapest, Hungary
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

50

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

(expense). Foreign currency transaction gains and losses are included in results
of operations. The Company reported in other income, net foreign currency
transaction gains and other translation gains of $1.2 million, and $0.2 million
for the years ended 2003 and 2001, respectively. Foreign currency transaction
and other transaction gains and losses were insignificant in 2002.

Foreign Currency Risk Management

In certain circumstances, the Company enters into forward exchange
contracts to hedge against foreign currency fluctuations. These contracts are
used to reduce the Company's risk associated with exchange rate movements, as
the gains or losses on these contracts are intended to offset the exchange rate
losses or gains on the underlying exposures. The Company does not engage in
foreign currency speculation. Hedges of underlying exposures are designated and
documented at the inception of the hedge and are evaluated for effectiveness
monthly. Forward exchange contracts representing cash flow hedges qualify for
hedge accounting when they are designated as a hedge of the foreign currency
exposure and they are effective in minimizing such exposure. Gains and losses on
forward exchange contracts that qualify for hedge accounting are recognized as
other comprehensive income (loss) in stockholders equity, along with the
associated losses and gains on the hedged item. As the terms of the forward
exchange contract and underlying exposure are matched generally at inception,
hedging effectiveness is calculated by comparing the change in fair value of the
contract to the change in fair value of the underlying exposure. To date the
Company has not incurred any significant gains or losses associated with hedge
ineffectiveness.

On January 30, 2003, the Company entered into a forward exchange contract
to hedge the foreign currency exposure of its 5.0 million euro note payable to
Philips (Note 23). The contract and the note payable each had a term that
expired on December 31, 2003. On August 26, 2003, the Company entered into a
forward exchange contract to hedge the foreign currency exposure of its 1.0
million euro payable to Philips. The contract and the payable each had a term
that expired on December 31, 2003. Prior to December 31, 2003, the Company made
payments to Philips in satisfaction of these obligations and the related forward
hedges were also terminated.

On November 3, 2003, the Company entered into a forward exchange contract
to hedge its foreign currency exposure related to 3.5 million euros of an
intercompany receivable from its Belgian subsidiary. The contract has a one year
term that expires on November 1, 2004. As of December 31, 2003, the Company has
recorded a net exchange rate gain of approximately $46,000 in other
comprehensive income on the intercompany receivable and associated forward
exchange contract.

On November 5, 2003, the Company entered into a forward exchange contract
to hedge its foreign currency exposure related to 7.5 million Singapore dollars
of an intercompany receivable from its Singapore subsidiary. The contract
expired on January 30, 2004. As of December 31, 2003, the Company has recorded a
net exchange rate loss of approximately $1,000 in other comprehensive income on
the intercompany receivable and associated forward exchange contract.

During 2003, $0.1 million was amortized to other income (expense) related
to the premiums paid on the above hedge instruments.

Revenue Recognition

The Company recognizes revenue in accordance with Statement of Position
97-2, Software Revenue Recognition ("SOP 97-2"), as amended by Statement of
Position 98-9, and the Securities and Exchange Commission's Staff Accounting
Bulletin No. 104, Revenue Recognition in Financial Statements. Revenue from the
sale of licenses to end users, value-added resellers and system integrators to
use the Company's software products is recognized upon delivery, provided that
the arrangement does not require significant modification or customization of
the software, any services included in the arrangement are not considered

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

essential to the functionality of the software, evidence of the arrangement
exists, the fees are fixed or determinable, and collectibility is reasonably
assured.

Sales of the Company's software products through certain distributors and
value-added resellers provide rights of return for as long as the distributors
or resellers hold the inventory. As a result, the Company recognizes revenues
from sales to these distributors and resellers only when the distributors or
resellers have sold products to retailers and 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, the Company records an
allowance against accounts receivable for the sales price of all inventories
subject to return. If the Company experiences significant returns from
distributors or resellers, the Company's liquidity may be adversely impacted.
The Company also makes an estimate of sales returns by retailers or end users
directly or through its 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. If actual returns
differ significantly from its estimates, such differences could have a material
impact on the Company's results of operations for the period in which the actual
returns become known.

Revenue from royalties on sales of the Company's products by OEMs to third
parties, where no services are included, is typically recognized upon delivery
to the third party when such information is available, or when the Company is
notified by the OEM that such royalties are due as a result of a sale, provided
that all other revenue recognition criteria are met.

When the Company provides professional services such as custom application
development or other services considered essential to the functionality of the
software for a fixed fee, it recognizes revenue from the fees for such services
and any related software licenses as it completes the project using the
percentage-of-completion method in accordance with Statement of Position 81-1
(SOP 81-1), Accounting for Performance of Construction-Type and Certain
Performance-Type Contracts. The Company generally determines the
percentage-of-completion by comparing the labor hours it has incurred to date to
the estimate of the total labor hours required to complete the project based on
regular discussions with its project managers. This method is used because the
Company considers expended labor hours to be the most reliable, available
measure of progress on these projects. Adjustments to contract estimates are
made in the periods in which facts resulting in a change become known. When the
estimate indicates that a loss will be incurred, such loss is recorded in the
period identified. Significant judgments and estimates are involved in
determining the percent complete of each contract. Different assumptions could
yield materially different results.

Other professional services not considered essential to the functionality
of the software are limited and primarily include training and feasibility
studies. When the Company provides services on a time and materials basis, it
recognizes revenue as it performs the services based on actual time incurred.

When the Company provides software support and maintenance services, it
recognizes the revenue ratably over the term of the related contracts, typically
one year.

The Company may sell, under one contract or related contracts, software
licenses, custom software applications and other services considered essential
to the functionality of the software and a maintenance and support arrangement.
The total contract value is attributed first to the maintenance and support
arrangement based on its fair value. The remainder of the total contract value
is then attributed to the software license and related professional services,
which are typically recognized as revenue using the percentage-of-completion
method. As a result, discounts inherent in the total contract value are
attributed to the software license and related professional services. The
Company may sell, under one contract or related contracts, software licenses, a
maintenance and support arrangement and professional services not considered
essential to the functionality of the software. In those arrangements, the total
contract value is attributed first to the undelivered elements of maintenance
and support and professional services based on their fair values.

52

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The remainder of the contract value is attributed to the software licenses,
which are typically recognized as revenue upon delivery, provided all other
revenue recognition criteria are met. As a result, discounts inherent in the
total contract value are attributed to the software licenses.

The Company follows the guidance of Emerging Issues Task Force issue No.
01-09, Accounting for Consideration Given by a Vendor to a Customer or a
Reseller of the Vendor's Products ("EITF 01-09"), in determining whether
consideration, including equity instruments, given to a customer should be
recorded as an operating expense or a reduction of revenue recognized from that
same customer. Consideration given to a customer is recorded as a reduction of
revenue unless both of the following conditions are met:

- The Company receives an identifiable benefit in exchange for the
consideration, and the identified benefit is sufficiently separable from
the customer's purchase of the Company's products and services such that
the Company could have purchased the products from a third party, and

- The Company can reasonably estimate the fair value of the benefit
received.

If both of the conditions are met, the Company records consideration paid
to customers as an expense. Consideration, including equity instruments, not
meeting the above criteria, is recorded as a reduction of revenue, to the extent
the Company has recorded cumulative revenue from the customer or reseller. The
impact resulted in a $0.2 million, $0.3 million and $1.1 million reduction in
total revenue and a corresponding reduction of selling, general and
administrative expense for the years ended 2003, 2002 and 2001, respectively.

The Company records reimbursements received for out-of-pocket expenses as
revenue, with offsetting costs recorded as cost of revenue. Out-of-pocket
expenses generally include, but are not limited to, expenses related to airfare,
hotel stays and out-of-town meals.

Costs of Revenue

Cost of revenue consists primarily of material and fulfillment costs,
third-party royalties, salaries for product support personnel, and engineering
costs, including third party contractor costs, associated with 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.

Stock based compensation

Stock based compensation expenses result from non-cash charges for common
shares issued with exercise or purchase prices that are less than the fair
market value of the common stock on the date of grant.

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 and money market funds.

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.

53

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Inventory

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

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 and core technology,
completed 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. The Company assesses 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
it considers 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 the Company's overall business;

- Significant negative industry or economic trends;

- Significant decline in the Company's stock price for a sustained period;
and

- A decline in the Company's 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 assessment of the
useful lives of existing recognized intangible assets and the identification of
reporting units for purposes of assessing potential future impairments of
goodwill. The Company has assessed the useful lives of its existing intangible
assets, other than goodwill, and believes that estimated useful lives remain
appropriate. In addition, the Company has determined that it operates in one
reporting unit. As a result, the Company uses the stock price of its common
stock to determine fair value for its initial impairment test. Based on this,
the Company performed the annual assessment during the fourth quarter of 2003
and determined that goodwill was not impaired; therefore no impairment charge
was recorded. The Company completes goodwill impairment analyses at least
annually, or more frequently when events and circumstances occur indicating that
the recorded goodwill might be impaired.

The values of intangible assets, which represent assets acquired in a
business combination or an acquisition or the license of technology, are
generally valued based on an income approach method of valuation. The income
approach requires a projection of revenues and expenses specifically attributed
to the intangible assets. The discounted cash flow method is then applied to the
potential income streams after
54

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

Significant judgments and estimates are involved in determining the useful
lives of 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 the Company's results of
operations or financial position through accelerated amortization expense or
impairment charges (See Notes 5 and 6).

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, 2003, 2002 and 2001, costs eligible for capitalization
were not material.

Legal Expenses Incurred to Defend Patents

The Company capitalizes external legal costs incurred in the defense of its
patents if the Company believes that the future economic benefit of the patent
will be increased. The Company monitors the legal costs incurred and the
anticipated outcome of the legal action and, if changes in the anticipated
outcome occur, writes off capitalized costs, if any, in the period the change is
determined. As of December 31, 2003 capitalized patent defense costs have been
immaterial.

Capitalization of Internal Use Software Costs

The Company capitalizes development costs of software for internal use
required to be capitalized pursuant to Statement of Position No. 98-1,
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use". As of December 31, 2003, the Company had capitalized costs
related to internal financial and human resource management systems which have
been included in construction in process as the assets had not been placed into
use.

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 income (loss) and other
comprehensive income (loss), which includes current period foreign currency
translation adjustments and gains related to derivatives reported as cash flow
hedges. For the purposes of comprehensive loss disclosures, the Company does not

55

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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, 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, 2003 and 2002,
respectively, no customer represented greater than 10% of the Company's net
accounts receivable balance.

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, 2003 and 2002.

Advertising Costs

Advertising costs are expensed as incurred and are classified as selling,
general and administrative costs. The Company incurred advertising costs of $2.3
million, $3.0 million and $2.5 million for the years ended December 31, 2003,
2002 and 2001, 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
Stock, which participates in dividends with common stock when and if declared.
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 equivalent shares,
which include, when dilutive, outstanding stock options, warrants, unvested
shares of restricted stock using the treasury stock method and the convertible
debenture using the as converted method. All potential dilutive common shares
are excluded from the computation of net loss per share for the years ended
December 31, 2003 and 2001 because they are antidilutive.

56

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 for the
year. Additionally, stock options to purchase 6,070,164 and 5,080,343 shares of
common stock were not included in the calculation of diluted net loss per share
for the years ended December 31, 2003 and 2001, respectively, because they were
antidilutive.

Potential weighted-average common shares, including stock options, unvested
restricted stock, preferred shares, convertible debt and warrants at December
31, 2003 and 2001, were 14,463,449 and 11,755,150, 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.

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"
.. 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.

57

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 2003 and 2002 and 130% for 2001, risk-free
interest rate of 1.59% to 3.68% for options granted in 2003, 2.26% to 4.33% for
options granted in 2002, and 3.66% to 4.97% for options granted in 2001, and a
weighted average expected option term of 3.5 years for 2003 and 2002 and 5 years
for 2001. The Company has not paid dividends to date and assumed no dividend
yield.

The weighted average grant date fair value per share of options granted was
$2.58, $3.12 and $1.92 for the years ended December 31, 2003, 2002 and 2001,
respectively.

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 2003, 2002 and 2001:
expected volatility of 80% for 2003 and 2002, and 133% to 168% for 2001; risk-
free interest rate of 1.05% to 1.65% for 2003, 1.65% to 3.36% for 2002 and 3.41%
to 5.04% for 2001, 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 2003, 2002 and
2001, were $1.72, $1.49 and $1.04, respectively.

Recently Issued Accounting Standards

In May 2003, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 150 ("SFAS 150"), "Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity." SFAS 150 establishes standards for how an issuer classifies and
measures certain financial instruments with characteristics of both liabilities
and equity. SFAS 150 was originally effective for financial instruments entered
into or modified after May 31, 2003, and otherwise effective at the beginning of
the first interim period beginning after June 15, 2003, however certain elements
of SFAS No. 150 have been deferred. The adoption of the provisions of SFAS No.
150, not deferred, did not have a material impact on the Company's financial
position or results of operations and the Company does not expect the adoption
of the deferred elements of SFAS No. 150 to have a material impact on its
financial position or results of operations.

In April 2003, the FASB issued Statement of Financial Accounting Standards
No. 149 ("SFAS 149"), "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities." SFAS 149 amends and clarifies financial accounting and
reporting for derivative instruments, including certain derivative instruments
embedded in other contracts (collectively referred to as derivatives), and for
hedging activities under FASB

58

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Statement No. 133, "Accounting for Derivative Instruments and Hedging
Activities." SFAS 149 was effective for contracts entered into or modified after
June 30, 2003 and for hedging relationships designated after June 30, 2003. The
adoption of SFAS No. 149 did not have a material impact on the Company's current
financial position and its results of operations.

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 the Company's financial position, results of
operations or cash flows as the Company has 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 did not have an impact on the financial position or
results of operations for 2003.

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
59

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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
adoption of SFAS 146 did not have a material impact on the Company's financial
position or results of operations.

3. ACCOUNTS RECEIVABLE

Accounts receivable consist of the following:

Unbilled accounts receivable relate primarily to revenues earned under
royalty-based arrangements for which billing occurs in the month following
receipt of the royalty report and to revenues earned under percentage of
completion contracts that have not yet been billed based on the terms of the
specific arrangement.

4. INVENTORY

Inventory consists of the following (in thousands):

5. GOODWILL

In June 2001, the Financial Accounting Standards Board issued Statement 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 is required to complete an annual impairment
test on all goodwill on a reporting unit basis. A reporting unit is defined as
an operating segment or one level below an operating

60

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 goodwill impairment test on an enterprise-wide basis.

The fair value of the reporting unit was determined using the Company's
market capitalization as of November 30, 2003. As the fair value of the
reporting unit as of November 30, 2003 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. No further analysis was required under SFAS 142.

The following summary reflects the consolidated results of operations as if
SFAS 142 had been adopted as of January 1, 2001, rather than January 1, 2002 (in
thousands, except net income (loss) per share amounts):

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SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

6. OTHER INTANGIBLE ASSETS

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

On March 31, 2003, the Company entered into an agreement that grants an
exclusive license to the Company to resell, in certain geographies worldwide,
certain productivity applications. The period of exclusivity expires after seven
years, unless terminated earlier as permitted under the agreement. Total
consideration to be paid by the Company for the license was $13.0 million. On
June 30, 2003, the terms and conditions of the agreement were amended, resulting
in a $1.2 million reduction in the license fee. The initial payment of $6.4
million due on or before June 30, 2003 was paid in accordance with the terms of
the license agreement. The two remaining payments totaling $5.6 million
including interest of $0.4 million will be paid as follows: $2.8 million on
March 31, 2004 and $2.8 million on March 31, 2005.

Based on the net present value of the deferred payments due in 2004 and
2005, using an interest rate of 7.0%, the Company recorded $11.4 million as
completed technology, which will be amortized to cost of revenue based on the
greater of (a) the ratio of current gross revenue to total current and expected
future revenues for the products or (b) the straight-line basis over the period
of expected use, five years. The $0.6 million difference between the stated
payment amounts and the net present value of the payments, will be charged to
interest expense over the payment period. As of December 31, 2003, payments due
on or before June 30, 2004, and the remaining balance due, have been classified
as deferred payment for technology license and other liabilities, long-term
respectively.

On March 31, 2003, the Company acquired certain intellectual property
assets related to multimodal speech technology, in exchange for $0.1 million in
cash and the issuance of a warrant for common stock valued at $0.1 million (Note
12). The purchase price was recorded as completed technology and will be
amortized over three years.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Aggregate amortization expense was $12.8 million ($10.5 million included in
cost of revenue) for the year ended December 31, 2003. Estimated amortization
expense for each of the five succeeding fiscal years as of December 31, 2003 is
as follows (in thousands):

7. 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, 2003, 2002 and 2001 was $2.4 million, $2.0 million, and $1.8
million, respectively. Construction in process is related to the capitalization
of internal costs associated with financial and human resource management
systems.

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 existed as of December 31, 2002.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

8. ACCRUED EXPENSES

Accrued expenses consist of the following (in thousands):

9. RESTRUCTURING AND OTHER CHARGES

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.

In connection with the Philips acquisition (Note 23), the Company
eliminated 25 ScanSoft personnel across all functional areas, resulting in a
charge of approximately $0.5 million in severance-related restructuring costs in
the three month period ended March 31, 2003.

During the three months ended June 30, 2003, the Company committed to a
plan to transfer certain research and development activities currently located
at its corporate headquarters to Budapest resulting in the elimination of 21
employees. The Company recorded a restructuring charge in the amount of $0.4
million for severance payments to these employees. In addition, the Company
recorded a charge in the amount of $0.4 million for severance payments to a
former member of the senior management team.

During the three months ended September 30, 2003, the Company eliminated 81
ScanSoft employees as a result of the SpeechWorks acquisition across all
functional areas, resulting in charges of $1.9 million for severance costs,
representing the ratable recognition of expenses through the period ended
December 31, 2003. Certain of these employees had termination dates after
December 31, 2003 and, as required by SFAS 112, the Company recorded severance
expense ratably from the date the plan was announced through the termination
date.

During 2003, the Company accrued $0.2 million and $0.2 million,
respectively, related to certain facility restructuring efforts taken at our
corporate headquarters and the closing of certain ScanSoft offices as a result
of the SpeechWorks acquisition and related expenses.

For the twelve months ended December 31, 2003, the Company paid a total of
$2.2 million in severance payments, of which $0.5 million relates to the March
2002 restructuring and $0.1 million relates to severance paid to the former
Caere President and CEO, pursuant to a 2000 restructuring charge.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

At December 31, 2003, the remaining restructuring accrual from the current
and prior restructuring activities amounted to $1.9 million. The balance is
comprised of $0.3 million of lease exit costs and $1.6 million of
employee-related severance costs, of which $0.3 million are for severance to the
former Caere President and CEO, $0.1 million are for severance costs related to
the 2003 Philips related restructuring actions and $0.2 million and $1.0 million
are for severance costs related to actions taken during the quarters ended June
30, 2003 and September 30, 2003, respectively.

The lease exit costs and severance due to the former Caere President and
CEO will be paid through January 2004 and March 2005, respectively. Severance
costs related to restructuring actions undertaken during the three month period
ended June 30, 2003 will be paid through March 2009. Severance costs related to
employee termination actions undertaken during the three month period ended
September 30, 2003 will be paid through September 2004.

The following table sets forth the 2003, 2002 and 2001 restructuring and
other charges accrual activity (in thousands):

10. DEBT AND CREDIT FACILITIES

Credit Facility

On October 31, 2002, the Company entered into a two year Loan and Security
Agreement (as amended, the "Loan Agreement") with Silicon Valley Bank (the
"Bank") that consisted of a $10.0 million revolving loan (the "Credit
Facility"). The Company amended this Loan and Security Agreement, as of
September 30, 2003, for the period September 30, 2003 through December 31, 2003,
removing the fixed charge coverage ratio covenant and replacing it with an
adjusted quick ratio covenant. Borrowings under the Credit Facility bear
interest at the Bank's prime rate plus 0.375% or 0.75%, (4.375% at December 31,
2003) which is determined by the Company's adjusted quick ratio, as defined in
the Loan Agreement. The maximum aggregate amount of borrowings outstanding at
any one time is 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 adjusted quick ratio. 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. 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.

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SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Company is currently renegotiating the terms of its Loan and Security
Agreement. Until these negotiations are complete, the Company continues to have
access to the existing $10.0 million revolving loan. During this time the Credit
Facility will be subject to the terms as amended on September 30, 2003.

The Loan Agreement also contains a restrictive covenant regarding the
payment or declaration of any dividends on the Company's capital stock during
the term of the agreement (except for dividends payable solely in capital stock)
without the Bank's prior written consent. As of December 31, 2003, the Company
was in compliance with all covenants.

As of December 31, 2003, based upon the calculated borrowing base,
available borrowings totaled approximately $8.3 million, as the Company had
approximately $1.7 million in outstanding Letters of Credit. The Company can
make no guarantees as to its ability to satisfy its future financial covenant
calculations. As of December 31, 2003, there was no outstanding balance under
this Credit Facility.

Equipment Line of Credit

In connection with the acquisition of SpeechWorks, the Company assumed $1.5
million of principal amounts outstanding under a one-year equipment
line-of-credit with a bank which expired on June 30, 2003. As of December 31,
2003, a balance of $1.3 million remains outstanding. Borrowings under this line
are collateralized by the fixed assets purchased and bear interest at the bank's
prime rate (4.0% at December 31, 2003), which is payable in equal monthly
payments over a period of 36 months. In accordance with the terms of the
equipment line of credit, as of December 31, 2003, principal payments of $0.9
million are due during the year ending December 31, 2004, $0.3 million are due
during the year ending December 31, 2005 and $0.1 million are due during the
year ended December 31, 2006. Under the financing agreement, the Company is
obligated to comply with certain financial covenants related to total tangible
net assets and was in compliance as of December 31, 2003.

Notes Payable

In connection with the L&H acquisition, the Company issued a $3.5 million
promissory note (the "Note") to Lernout & Hauspie Speech Products, N.V. The 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 of the promissory note. In connection with an
agreement entered into by the Company in September 2002 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") and to register in an underwritten offering
the remaining shares held by L&H, 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
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 outstanding principal and accrued interest under the
Note.

In connection with the Philips acquisition on January 30, 2003, the Company
issued a 5.0 million euro promissory note (the "Philips Note") to Philips. The
unsecured Philips Note matured on December 31, 2003 and bore interest at 5% per
annum. Payments of principal and accrued interest were due at maturity. In
connection with the issuance of the Philips Note, the Company entered into a
forward foreign currency exchange contract on January 31, 2003 to hedge the
foreign exchange exposure on the Philips Note. As of December 31, 2003, the
Company had paid Philips in full satisfaction of the Philips Note.

66

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Convertible Debenture

On January 30, 2003, the Company issued a $27.5 million three-year,
zero-interest convertible subordinated debenture due January 2006 (the
"Convertible Note") to Philips in connection with the Philips acquisition (Note
23). The Convertible Note is convertible into shares of the Company's common
stock at $6.00 per share at any time until maturity at Philips' option. The
conversion rate may be subject to adjustments from time to time as provided in
the Convertible Note. The Convertible Note contains a provision in which all
amounts unpaid at maturity will bear interest at a rate of 3% per quarter until
paid.

The Convertible Note contains covenants that place restrictions on the
declaration or payment of dividends or distributions (other than distributions
of equity securities of the Company) on, or the redemption or purchase of, any
shares of the Company's capital stock while the Convertible Note is outstanding.
This restriction terminates when one-half or more of the principal amount of the
Convertible Note is converted by Philips into common stock. The Convertible Note
contains a provision which provides Philips the right to require the Company to
redeem the Convertible Note or any remaining portion of the principal amount, on
the date a "Change in Control" occurs. The Convertible Note provides that a
"Change in Control" is deemed to have occurred when any person or entity
acquires beneficial ownership of shares of capital stock of the Company
entitling such person or entity to exercise 40% or more of the total voting
power of all shares of capital stock of the Company, or the Company sells all or
substantially all of its assets, subject to certain exceptions. The Company's
acquisition of SpeechWorks (Note 22) did not result in a Change in Control.

11. OTHER LIABILITIES

Other liabilities consist of the following (in thousands):

In connection with the acquisition of SpeechWorks (Note 22), the Company
assumed lease obligations including leases extending through September 2004
related to the former corporate offices of SpeechWorks, leases related to two
office locations vacated during 2003 which extend through 2010 and 2016,
respectively, and a lease associated with office space which will become
available beginning in January 2005. As of December 31, 2003, the Company has
$0.9 million, $4.9 million and $10.0 million of remaining lease obligations in
long-term liabilities related to these leases, respectively.

12. 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 $0.05 per
annum per share, payable when, as and if

67

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

Common Stock Warrants

In connection with the ScanSoft acquisition (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, 2003, 525,732 ScanSoft options have
been forfeited and accordingly, the Xerox warrant at December 31, 2003 was
exercisable for the purchase of 525,732 shares of the Company's common stock.

In connection with the March 31, 2003 acquisition of the certain
intellectual property assets related to multimodal speech technology (Note 6),
the Company issued a warrant, expiring October 31, 2005, for the purchase of
78,000 shares of ScanSoft common stock at an exercise price of $8.10 per share.
The warrant was immediately exercisable and was valued at $0.1 million based
upon the Black-Scholes option pricing model with the following assumptions:
expected volatility of 80%, a risk-free rate of 1.87%, an expected term of 2.5
years, no dividends and a stock price of $4.57 based on the Company's stock
price at the time of issuance.

In connection with the SpeechWorks acquisition (Note 22), the Company
issued a warrant to its investment banker, expiring on August 11, 2009, for the
purchase of 150,000 shares of ScanSoft common stock at an exercise price of
$3.98 per share. The warrant does not become exercisable until August 11, 2005
and was valued at $0.2 million based upon the Black-Scholes option pricing model
with the following assumptions: expected volatility of 60%, a risk-free interest
rate of 4.03%, an expected term of 8 years, no dividends and a stock price of
$3.92 based on the Company's stock price at the time of issuance.

In connection with the acquisition of SpeechWorks, the Company assumed the
remaining outstanding warrants issued by SpeechWorks to America Online ("AOL")
to purchase up to 219,421 shares, as converted, of common stock in connection
with a long-term marketing arrangement. The warrant is currently exercisable at
a price of $14.49 per share and expires on June 30, 2007. The value of the
warrant was insignificant.

On December 17, 2003, pursuant to a letter agreement, dated October 17,
2003, the Company issued a warrant to a former employee of SpeechWorks, expiring
December 17, 2004, for the purchase of 11,180 shares of its common stock at an
exercise price of $7.70 per share, and 2,552 shares of its common stock at an
exercise price of $5.64 per share. The warrant was valued at approximately
$18,000 based upon the Black-Scholes option pricing model with the following
assumptions: expected volatility of 80%, a risk-free interest rate of 1.63%, an
expected term of 1 year, no dividends and a stock price of $5.62 based on the
Company's stock price at the time of issuance.

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.

68

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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 August 6, 2003, the Company's board of directors authorized the
repurchase of up to $25 million of the Company's common stock over the next 12
months, however, the Company may suspend or discontinue the repurchase program
at any time. From August 6, 2003 through December 31, 2003, the Company
repurchased 618,088 common shares at a purchase price of $2.9 million; the
Company records treasury stock at cost. The Company intends to use the
repurchased shares for its employee stock plans and for potential future
acquisitions.

Acquisition of SpeechWorks International, Inc.

On August 11, 2003, the Company acquired all of the outstanding stock of
SpeechWorks (Note 22). In connection with the acquisition of SpeechWorks, the
Company exchanged 0.860 of a share of its common stock for each outstanding
share of SpeechWorks stock. This transaction resulted in the issuance of
approximately 32.5 million shares of common stock, representing approximately
33% of the outstanding common stock of the Company after the completion of the
acquisition.

Acquisition of LocusDialog, Inc.

On December 19, 2003, the Company acquired all of the outstanding shares of
LocusDialog, Inc (Note 21). In connection with the acquisition of LocusDialog,
the Company issued approximately 2.3 million shares of its common stock.

Underwritten Public Offering

During the three months ended March 31, 2003, the Company completed an
underwritten public offering of 8,256,906 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 2,072,500 common shares and received gross proceeds of $7.9
million. After considering offering costs of $2.4 million, the net proceeds to
the Company amounted to approximately $5.5 million.

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 registered on February 14,
2003, however no penalty for late registration was enforced.

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
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SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

13. RESTRICTED COMMON STOCK

On August 11, 2003, the Company issued 300,000 shares of restricted common
stock to the Company's Chief Executive Officer. Unvested restricted shares may
not be sold, transferred or assigned. Of these restricted common shares, 100,000
vest on each of August 31, 2004, 2005 and 2006. Except as otherwise specified in
the restricted stock agreement, in the event that the executive's employment
with the Company terminates, any unvested shares of the restricted stock shall
be forfeited and revert to the Company. The purchase price of the shares equaled
the par value of the shares, aggregating $300. The difference between the
purchase price and the fair value of the Company's common stock on the date of
issue based on the listed exchange price of $1.2 million has been recorded as
deferred compensation and additional paid-in-capital. The deferred compensation
is being recognized as compensation expense ratably over the vesting period
resulting in $0.2 million of stock compensation expense during the fiscal year
ended December 31, 2003.

In connection with the SpeechWorks acquisition (Note 22), the Company
issued 184,850 shares of restricted common stock in replacement of previously
outstanding SpeechWorks unvested restricted common stock. Unvested restricted
common stock may not be sold, transferred or assigned and are subject to
forfeiture in the event an employee ceases to be employed by the Company. The
restricted common stock vests no later than March 25, 2007. Deferred
compensation of $0.7 million was recorded associated with the issuance of these
restricted shares which is equal to the closing price of ScanSoft common stock
on the acquisition date. The deferred compensation is being recognized as
compensation expense ratably over the vesting period resulting in $0.1 million
of stock compensation expense during the fiscal year ended December 31, 2003.

During 2001, the Company awarded 133,824 shares of restricted common stock
to senior executives at a weighted average fair value of the Company's common
stock 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.
The deferred compensation is being recognized as compensation expense ratably
over the vesting period resulting in $0.1 million of stock compensation expense
during fiscal years 2003 and 2002.

14. 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, 2003, 22,423,477 shares were authorized for
grant under the Company's stock-based compensation plans, of which 4,557,845
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.

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SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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

Stock options to purchase 9,600,859, 8,389,293 and 6,502,668 shares of
common stock were exercisable as of December 31, 2003, 2002 and 2001,
respectively.

The following table summarizes information about stock options outstanding
under the Company's stock compensation plans at December 31, 2003:

1995 Employee Stock Purchase Plan

The Company's 1995 Employee Stock Purchase Plan, as amended and restated on
August 11, 2003, authorizes the issuance of a maximum of 1,500,000 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

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SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

date or 85% of the closing price on the applicable offering termination date.
The Company issued 163,837, 87,185 and 95,952 shares of common stock under this
plan during the years ended December 31, 2003, 2002 and 2001 respectively.

15. COMPREHENSIVE INCOME (LOSS)

Total comprehensive income (loss), net of taxes, was ($6.2) million, $6.8
million and ($17.3) million for the years ended December 31, 2003, 2002 and 2001
respectively. Total comprehensive income (loss) consisted of net income or loss
and foreign currency translation adjustments for the respective periods.

16. COMMITMENTS AND CONTINGENCIES

Operating Leases

The Company has various operating leases for office space around the world.
In connection with the acquisition of SpeechWorks, ScanSoft assumed all of
SpeechWorks' lease obligations. Among these obligations are lease payments
related to two office locations vacated during 2003 by SpeechWorks and one
associated with office space which will become available beginning in January
2005. Gross lease payments associated with these office locations amounting to
$10.5 million and $13.6 million, respectively, have been included in the table
below. These obligations extend through 2016. The following table outlines the
Company's future minimum payments under operating leases as of December 31, 2003
(in thousands):

Deferred maintenance as of December 31, 2002 was insignificant.

17. 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%. During the period from
October 16, 2002 through June 30, 2003, this match was discontinued. Effective
July 1, 2003, Company match of employee's contributions was reinstated, dollar
for

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SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

dollar up to 2%. Employees are 100% vested into the plan as soon as they start
to contribute to the plan. The Company's contributions to the 401(k) Plan
totaled $0.2 million, $0.6 million and $0.4 million for the years ended December
31, 2003, 2002 and 2001, respectively.

18. SUPPLEMENTAL CASH FLOW INFORMATION

During the years ended December 2003, 2002 and 2001, the Company made cash
payments for interest totaling $0.4 million, $0.3 million and $0.1 million,
respectively.

During the years ended December 2003, 2002 and 2001, the Company made cash
payments for income taxes totaling $1.0 million, $0.6 million and $0.3 million,
respectively.

During December 2003, the Company issued 2,328,638 shares of the Company's
common stock valued at $12.4 million in connection with the acquisition of
LocusDialog.

During August 2003, in connection with the SpeechWorks acquisition (Note
22), the Company issued a warrant to its investment banker for the purchase of
150,000 shares of ScanSoft common stock valued at $0.2 million.

During March 2003, in connection with the acquisition of certain
intellectual property assets related to multimodal speech technology (Note 6),
the Company issued a warrant for the purchase of 78,000 shares of ScanSoft
common stock valued at $0.1 million.

During January 2003, the Company issued a $27.5 million three-year,
zero-interest convertible subordinated debenture due January 2006 (the
"Convertible Note") to Philips in connection with the Philips acquisition (Note
23) valued a $27.5 million.

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 (Note 25).

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
associated with the Audiomining assets of L&H. In addition, the Company issued a
9% promissory note in the principal amount of $0.4 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.

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 (Note
25)

75

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

19. 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):

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 Europe and Asia. 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.

Two distribution and fulfillment partners, Ingram Micro and Digital River,
accounted for 16% and 13%, 25% and 12% and 28% and 15% of the Company's
consolidated revenue for the years ended 2003, 2002 and 2001, respectively.

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

76

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

20. INCOME TAXES

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

The benefits for federal income taxes in 2003 and 2002 and the benefit for
state income taxes in 2001 relate to refunds related to Caere Corporation.

The deferred income tax provision includes a $1.2 million provision to
increase the deferred tax valuation allowance. A portion of the deferred tax
liabilities are created by taxable temporary differences related to certain
goodwill for which the period the differences will reverse is indefinite.
Following the adoption of SFAS No. 142, taxable temporary differences creating
deferred tax liabilities as a result of different treatment of goodwill for book
and tax purposes can not offset deductible temporary differences that create
deferred tax assets in determining the valuation allowance. As a result, a
deferred tax provision is required to increase the Company's valuation
allowance. The deferred tax provision in 2003 includes $0.4 million related to
2002.

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 $4.6 million at December 31, 2003.

77

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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

The increase in ScanSoft's net deferred tax assets to $97 million from $41
million as of December 31, 2003 and 2002, respectively, primarily related to the
acquisition of SpeechWorks.

At December 31, 2003 and 2002, the Company provided a full valuation
allowance for its net deferred tax assets in the United States and certain
foreign jurisdictions 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, excluding the recognition of the portion of the valuation
allowance which relates to net deferred tax assets acquired in a business
combination.

78

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, 2003 and 2002, the Company had federal net operating loss
carryforwards of approximately $168.3 million and $82.5 million, respectively,
of which approximately $18.2 million and $9.1 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, 2003
the Company had federal and state research and development credit carryforwards
of approximately $5.5 million and $3.4 million respectively. 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. The
net operating loss and credit carryforwards will expire at various dates through
2023, if not utilized.

Utilization of the net operating losses and credits are subject to an
annual limitation due to the ownership change limitations provided by the
Internal Revenue Code of 1986 and similar state provisions. The annual
limitation will result in the expiration of certain net operating losses and
credits before utilization.

21. ACQUISITION OF LOCUSDIALOG, INC.

On December 19, 2003, the Company acquired all of the outstanding shares of
LocusDialog, a leader in speech-enabled, auto-attendant applications, based in
Montreal, Canada. LocusDialog's call routing and auto-attendant solutions are
used by nearly 1,000 installations worldwide, handling approximately 500 million
calls annually.

The acquisition of LocusDialog enhances the Company's competitive position
in key markets, specifically the auto-attendant market. In addition, it 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 results of operations of the acquired business have been included in
the financial statements of the Company since the date of acquisition.

Consideration for the transaction comprised 2,328,638 shares of common
stock at a per share value of $5.31 (the average closing price of ScanSoft
common stock for a total of five days immediately prior to and subsequent to the
announcement of the acquisition), having a value of $12.4 million, and
transaction costs of $0.7 million.

79

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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

Total purchase consideration:
Common stock issued....................................... $12,370
Transaction costs......................................... 660
-------
Total purchase consideration.............................. $13,030
=======
Allocation of the purchase consideration:
Current assets............................................ $ 2,417
Property and equipment.................................... 420
Identifiable intangible assets............................ 2,850
Goodwill.................................................. 9,357
-------
Total assets acquired..................................... 15,044
-------
Accounts payable.......................................... (157)
Accrued liabilities....................................... (1,338)
Deferred revenue.......................................... (519)
-------
Total liabilities assumed:................................ (2,014)
-------
$13,030
=======

Current assets acquired primarily relate to cash and accounts receivable.
Current liabilities assumed primarily relate to accounts payable, accrued
expenses and deferred revenue. Current assets include approximately $0.8 million
in research and development tax credits receivable from the Canadian government.
Under the purchase agreement up to $1.0 million of research and development tax
credits expected to be received by the Company will be repaid to the former
shareholders of Locus. Any amounts in excess of $1.0 million will be retained by
the Company, and be treated as a reduction of goodwill. The estimated fair value
of the receivable at the date of acquisition of $0.8 million is included in
current assets with a corresponding liability in accrued liabilities.

The following are the identifiable intangible assets acquired and the
respective periods over which the assets will be amortized on a straight-line
basis:

The amount assigned to identifiable intangible assets acquired was based on
their respective fair values determined as of the acquisition date. The Company
did not attribute any value to "in-process research and development" projects in
connection with this acquisition. The Company believes that these identified
intangible assets have no residual value. The excess of the purchase price over
the tangible and identifiable intangible assets was recorded as goodwill and
amounted to approximately $9.4 million. In accordance with current accounting
standards, the goodwill is not being amortized and will be tested for impairment
as required by SFAS No. 142. All goodwill and other identifiable intangible
assets are not deductible for tax purposes.

80

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

22. ACQUISITION OF SPEECHWORKS INTERNATIONAL, INC.

On August 11, 2003, the Company acquired all of the outstanding stock of
SpeechWorks International, Inc. ("SpeechWorks"), a leading provider of software
products and professional services that enable enterprises, carriers and
government organizations to offer automated, speech-activated services over any
telephone.

The acquisition of SpeechWorks enhances the ability of the Company to
promote its products and comprehensively address the needs of the system
integrators in telephony markets. The addition of SpeechWorks' professional
services organization will enable the Company to support major accounts, channel
partners and telecommunications firms, as well as provide the ability to deliver
complete solutions. In addition, the acquisition enhances the Company's
strengths in key vertical markets, including multiple deployments in
travel/hospitality, financial services and government, thereby expanding the
Company's market share in these key markets and expertise in developing
applications and solutions for these industries. These incremental intangible
benefits, which are reflected in the purchase consideration, resulted in
goodwill.

The results of operations of the acquired business have been included in
the financial statements of the Company since the date of acquisition.

In connection with the acquisition of SpeechWorks, ScanSoft exchanged 0.860
of a share of its common stock for each outstanding share of SpeechWorks stock.
This transaction resulted in the issuance of approximately 32.5 million shares
of ScanSoft common stock, representing approximately 33% of the outstanding
common stock of ScanSoft after the completion of the acquisition. The
SpeechWorks purchase price of $175.5 million includes the value of the ScanSoft
common stock issued at a per share value of $5.26 (the average closing price of
ScanSoft common stock for a total of five days immediately prior to and
subsequent to the announcement of the acquisition) and transaction costs of $4.5
million. Included in the transaction costs is a warrant, valued at $0.2 million,
for the purchase of 150,000 shares of ScanSoft's common stock (Note 12). In
addition, the purchase price also includes the value of 184,850 shares of
restricted ScanSoft common stock issued by ScanSoft, in replacement of
previously outstanding SpeechWorks unvested restricted common stock, of $0.7
million based on the closing price of ScanSoft common stock on the acquisition
date. The value of the unvested restricted common stock has been recorded as
deferred compensation (Note 13).

81

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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

Total purchase consideration:
Common stock and restricted stock issued.................. $170,950
Transaction costs......................................... 4,500
--------
Total purchase consideration.............................. $175,450
========
Preliminary allocation of the purchase consideration:
Assets acquired:
Cash...................................................... $ 39,953
Marketable securities..................................... 553
Accounts receivable....................................... 9,952
Other current assets...................................... 938
Property and equipment.................................... 2,840
Other long term assets.................................... 808
Identifiable intangible assets............................ 13,310
Goodwill.................................................. 142,004
--------
Total assets acquired..................................... 210,358
--------
Deferred compensation for unvested restricted common
stock.................................................. 724
Liabilities assumed:
Accounts payable.......................................... (1,610)
Accrued expenses.......................................... (9,817)
Deferred revenue.......................................... (6,135)
Other long term liabilities............................... (16,530)
Note payable.............................................. (1,540)
--------
Total liabilities assumed:................................ (34,908)
--------
$175,450
========

In December 2002, SpeechWorks committed to a restructuring plan to vacate
two office locations during 2003. In connection with this restructuring plan,
SpeechWorks recorded a charge of $5.9 million. As of the acquisition date, the
balance of this accrual was $5.4 million, which has been included in other
long-term liabilities. The Company reduced the recorded accrual by $1.0 million
to record such obligation at its net present value, using a discount rate of 3%.
The $1.0 million difference between the lease obligations and the recorded
accrual will be recognized as incremental rent expense over the remaining life
of the lease. These assumed leases extend through 2010 and 2016, respectively,
unless the Company is able to negotiate earlier termination dates. The Company
anticipates that the facilities-related accrual will be expended equally over
the remaining life of the leases.

In connection with the acquisition of SpeechWorks, the Company assumed all
its lease obligations. Among these obligations are lease payments extending
through September 2004 related to the former corporate offices of SpeechWorks,
as well as, liabilities associated with office space which will become available
beginning in January 2005. During the quarter ended December 31, 2003, the
Company completed its review of all of the assumed leases. Based on the
provisions of the lease agreements and management's expectations for
post-acquisition operations, the Company determined that the total fair value of
the assumed liabilities related to leases for which there will be no future
benefit amounted to $12.9 million, which resulted in an adjustment to accrued
liabilities and other long term liabilities assumed in the acquisition of $0.9
million

82

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

and $12.0 million, respectively. A corresponding adjustment to goodwill of $12.9
million has been reflected in the table above.

The fair value of the future lease obligations includes an estimate of
expected future sublease income in accordance with the provisions of EITF 95-3
Recognition of Liabilities in Connection with a Purchase Business Combination.
In accordance with EITF 95-3, if the actual lease obligation is less than the
estimated lease obligation, due to the amount or timing of actual lease payments
or sublease rental receipts, the difference will be recorded as an adjustment to
the purchase price, resulting in an adjustment to goodwill. If the actual lease
obligation exceeds the estimated lease obligation recorded and such amount is
determined beyond one year after the acquisition date, the difference will be
recorded as an adjustment to net income(loss).

The purchase price allocation is final except for continuing analysis of
litigation against SpeechWorks that arose prior to the acquisition date (Note
16).

In connection with the SpeechWorks acquisition, the Company eliminated 54
former employees of SpeechWorks. In connection with this action, a liability of
$1.3 million, representing severance and related benefits, has been included in
the purchase price allocation. As of December 31, 2003, the remaining
restructuring accrual related to SpeechWorks acquisition amounted to $0.1
million, all of which will be paid during fiscal 2004.

The following are the identifiable intangible assets acquired and the
respective periods over which the assets will be amortized on a straight-line
basis:

The amount assigned to identifiable intangible assets acquired was based on
their respective fair values determined as of the acquisition date. The Company
did not attribute any value to "in-process research and development" projects in
connection with this acquisition. The Company believes that these identified
intangible assets have no residual value. The excess of the purchase price over
the tangible and identifiable intangible assets was recorded as goodwill and
amounted to approximately $142.0 million. In accordance with current accounting
standards, the goodwill is not being amortized and will be tested for impairment
as required by SFAS No. 142. All goodwill and other identifiable intangible
assets are not deductible for tax purposes.

23. ACQUISITION OF PHILIPS SPEECH PROCESSING TELEPHONY AND VOICE CONTROL
BUSINESS

On January 30, 2003, the Company completed the acquisition of the Philips
Speech Processing Telephony and Voice Control business units of Royal Philips
Electronics N.V. ("Philips"), and related intellectual property. 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.

83

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The acquisition of the Philips Speech Processing Telephony and Voice
Control business enhances the Company's market share in key markets and gives
the Company additional competitive momentum in its target markets, specifically
the telephony, automotive and embedded markets. In addition, it 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 results of operations of the acquired business have been included in
the financial statements of the Company since the date of acquisition.

Consideration for the acquisition, before any purchase price adjustment
determined by the parties as described below, totaled $39.5 million, including
transaction costs of $2.1 million. The consideration consisted of 3.1 million
euros ($3.4 million) in cash paid at closing, subject to adjustment in
accordance with the provisions of the purchase agreement, as amended; a deferred
payment of 1.0 million euros in cash due no later than December 31, 2003, a 5.0
million euro note due December 31, 2003; bearing 5.0% interest per annum; and a
$27.5 million three-year, zero-interest subordinated debenture, convertible at
any time at Philips' option into shares of common stock at $6.00 per share. The
fair value of the convertible debenture was determined to be $27.5 million based
on the present value of the expected cash outflows using an incremental
borrowing rate of 12% and the fair value of the conversion feature based on the
Black-Scholes option pricing model using the following assumptions: the fair
value of the Company's common stock of $3.62 per share, the closing price of the
Company's common stock on the day the parties entered into the acquisition
agreement; volatility of 100%; risk-free interest rate of 2.16%; no dividends
and an expected term of 3 years.

The purchase price was subject to adjustment based on calculations set
forth in the purchase agreement, as amended, which required agreement by the
parties. In accordance with the provisions of the agreement, the Company and
Philips agreed during the fourth quarter of 2003 to a final purchase price,
adjustment of approximately $4.1 million, resulting in a corresponding reduction
in goodwill. The Company received $1.1 million of the purchase price adjustment
prior to December 31, 2003. The remaining $3.0 million (2.5 million euros),
recorded in other current assets at December 31, 2003, was received on January
5, 2004.

The final purchase price allocation reflecting the above noted adjustments
is as follows (in thousands):

Total purchase consideration:
Cash...................................................... $ (760)
Other current liability (1.0 million euro payable)........ 1,080
Note payable.............................................. 5,410
Convertible debenture..................................... 27,520
Transaction costs......................................... 2,100
-------
Total purchase consideration........................... $35,350
=======
Allocation of the purchase consideration:
Current assets............................................ $ 3,930
Property and equipment.................................... 310
Identifiable intangible assets............................ 5,650
Goodwill.................................................. 28,846
-------
Total assets acquired.................................. 38,736
-------
Current liabilities assumed............................... (3,386)
-------
$35,350
=======

84

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Current assets acquired primarily relate to accounts receivable, and
current liabilities assumed primarily relate to accounts payable and assumed
contractual liabilities related to development work with customers which were
agreed to prior to the acquisition date.

The following are the identifiable intangible assets acquired and the
respective periods over which the assets will be amortized on a straight-line
basis:

25. 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

85

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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. The acquisition was accounted for as the acquisition of a business.

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 would become due on December 15, 2004 (Note 10). The Company incurred
approximately $1.0 million of acquisition related costs.

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. All goodwill and
other identifiable intangible assets are 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 following table identifies the intangible assets acquired and their
respective lives over which the assets will be amortized on a straight-line
basis:

86

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

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.

26. PRO FORMA RESULTS (UNAUDITED)

The following table reflects unaudited pro forma results of operations of
the Company assuming that the Philips, SpeechWorks and LocusDialog acquisitions
had occurred on January 1, 2002 (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.

27. RELATED PARTIES

At December 31, 2003, Xerox owned approximately 15% 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 (Note 12). 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%, 5% and 11% of total net revenues during each of the years ended December 31,
2003, 2002 and 2001, respectively. As of December 31, 2003 and 2002, Xerox owed
the Company $1.9 million and $1.5 million, respectively, pursuant to these
agreements, which are included in receivables from related parties.

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, 2003, the Company paid four
quarterly installments under this agreement totaling $1.6 million.

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, 2003 is $0.4 million, which is included in
other current liabilities.

At December 31, 2003, a member of the Company's Board of Directors, and a
former member of the SpeechWorks Board of Directors, is a senior executive at
Convergys Corporation. The Company and Convergys have entered into multiple
non-exclusive agreements in which Convergys resells the Company's software.
During the year ended December 31, 2003, Convergys accounted for approximately
$0.3 million in total net revenues. As of December 31, 2003, Convergys owed the
Company $0.2 million, pursuant to these agreements, which are included in
receivables from related parties.

87

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

28. 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.

88

REPORT OF INDEPENDENT AUDITORS 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 26, 2004, 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 26, 2004

89

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, 2003, 2002 and 2001, respectively.

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

None.

ITEM 9A. CONTROLS AND PROCEDURES

(a) Evaluation of disclosure controls and procedures. Our management, with
the participation of our Chief Executive Officer and Chief Financial Officer,
evaluated the effectiveness of our disclosure controls and procedures (as
defined in Rule 13a-15(e) of the Exchange Act) as of the end of the period
covered by this report. Based on that evaluation, our Chief Executive Officer
and Chief Financial Officer concluded that, except as provided below, our
disclosure controls and procedures as of the end of the period covered by this
report were effective in ensuring that information required to be disclosed by
us in reports that we file or submit under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission's rules and forms. We believe that a control
system, no matter how well designed and operated, cannot provide absolute
assurance that the objectives of the control system are met, and no evaluation
of controls can provide absolute assurance that all control issues and instances
of fraud, if any, within a company have been detected.

(b) Changes in internal controls. There was no change in our internal
control over financial reporting (as defined in Rule 13a-15(f) of the Exchange
Act) that occurred during the period covered by this report that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting, except as described below. Subsequent to the end of
the third quarter of 2003, we adopted additional controls and procedures related
to accounting for income taxes associated with acquisitions including
involvement of our tax personnel in the financial reporting process.

In connection with their audit of our 2003 consolidated financial
statements, PricewaterhouseCoopers LLP ("PwC"), our independent auditors,
advised in a management letter to management and our Audit Committee of four
conditions that could adversely affect our ability to initiate, record, process
and report financial data consistent with management's assertions. These
conditions include, in summary: (i) our significant accounting transactions,
including related judgments and estimates, may not be supported by a
sufficiently formal process or sufficiently comprehensive documentation; and
(ii) we had insufficiently documented our estimate of returns from second-tier
resellers. In addition, we have earlier in this document discussed the other two
conditions raised by PwC (see page 37).

In the third quarter of 2003, we commenced the planning and worldwide
implementation of the Oracle e-Business suite, which we anticipate completing by
the end of fiscal year 2004. Simultaneously with the Oracle implementation, we
commenced our Section 404 (Sarbanes-Oxley Act of 2002) compliance efforts. In
conjunction with these efforts, we initiated the design, development and
implementation of processes and

90

controls that we believe, will address the conditions raised in PwC's management
letter. We currently expect these efforts to extend into the second half of
fiscal 2004. To the knowledge of our Chief Executive Officer and Chief Financial
Officer, the financial statements, and other financial information included in
this 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 report.

91

PART III

Certain information required by Part III is omitted from this Annual Report
on Form 10-K since we intend to file our definitive Proxy Statement for our next
Annual Meeting of Stockholders, pursuant to Regulation 14A of the Securities
Exchange Act of 1934, as amended (the "Proxy Statement"), no later than April
29, 2004, and certain information to be included in the Proxy Statement is
incorporated herein by reference.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this item concerning our directors is
incorporated by reference to the information set forth in the section titled
"Election of Directors" in our Proxy Statement. Information required by this
item concerning our executive officers is incorporated by reference to the
information set forth in the section entitled "Executive Compensation,
Management and Other Information" in our Proxy Statement. Information regarding
Section 16 reporting compliance is incorporated by reference to the information
set forth in the section entitled "Section 16(a) Beneficial Ownership Reporting
Compliance" in our Proxy Statement.

Our Board of Directors adopted a Code of Business Conduct and Ethics for
all of our directors, officers and employees on February 24, 2004. Our Code of
Business Conduct and Ethics can be found at our website: www.scansoft.com. We
will provide to any person without charge, upon request, a copy of our Code of
Business Conduct and Ethics. Such a request should be made in writing and
addressed to Investor Relations, ScanSoft, Inc., 9 Centennial Drive, Peabody, MA
01960. Further, our Code of Business Conduct and Ethics is filed as an Exhibit
to this Annual Report on Form 10-K.

To date, there have been no waivers under our Code of Business Conduct and
Ethics. We will post any waivers, if and when granted, of our Code of Business
Conduct and Ethics on our website at http://www.scansoft.com.

ITEM 11. EXECUTIVE COMPENSATION

The information required by this item regarding executive compensation is
incorporated by reference to the information set forth in the sections titled
"Executive Compensation, Management and Other Information" in our Proxy
Statement.

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

The information required by this item regarding security ownership of
certain beneficial owners and management is incorporated by reference to the
information set forth in the sections titled "Security Ownership of Certain
Beneficial Owners and Management" and "Equity Compensation Plans" in our Proxy
Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this item regarding certain relationships and
related transactions is incorporated by reference to the information set forth
in the section titled "Certain Relationships and Related Transactions" in our
Proxy Statement.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this section is incorporated by reference from
the information in the section entitled "Ratification of Appointment of
Independent Auditors" in our Proxy Statement.

92

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 2003, 2002 and 2001 is contained in
Item 8 of this Report:

REPORT OF INDEPENDENT AUDITORS 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, 2003:

(1) On October 16, 2003, ScanSoft filed an amendment to Form 8-K, filed
on August 22, 2003, to include under Item 7 certain financial statements
and pro forma financial information, relating to the acquisition of
SpeechWorks International, Inc.

93

(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.

(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.

96

(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 Annual Report on Form 10-K
for the fiscal year ended December 31, 2000, filed with the Commission on
April 2, 2001.

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

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

(16) 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.

(17) 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.

(18) 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.

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

(20) 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.

(21) 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.

(22) 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.

(23) Incorporated by reference from the Registrant's Registration Statement of
Form S-4 (No. 33-106184) filed with the Commission on June 17, 2003.

(24) Incorporated by reference from the Registrant's Annual Report on Form 10-K
for the fiscal year ended December 31, 2002, filed with the Commission on
March 28, 2003.

(25) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the fiscal quarter ended March 31, 2003, filed with the Commission
on May 15, 2003.

(26) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the fiscal quarter ended June 30, 2003, filed with the Commission
on August 14, 2003.

(27) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the fiscal quarter ended September 30, 2003, filed with the
Commission on November 14, 2003.

97

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 David A. Gerth 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 15, 2004 /s/ Paul A. Ricci
--------------------------------------------------------
Paul A. Ricci, Chief Executive Officer and Chairman of
the Board (Principal Executive Officer)

Date: March 15, 2004 /s/ Stuart R. Patterson
--------------------------------------------------------
Stuart R. Patterson, President and Director

Date: March 15, 2004 /s/ David A. Gerth
--------------------------------------------------------
David A. Gerth, Senior Vice President and Chief
Financial Officer (Principal Financial Officer)

Date: March 15, 2004 /s/ Gerald C. Kent, Jr.
--------------------------------------------------------
Gerald C. Kent, Jr. Vice President, Chief Accounting
Officer and Controller (Principal Accounting Officer)

Date: March 15, 2004 /s/ Mark Myers
--------------------------------------------------------
Mark Myers, Director

Date: March 15, 2004 /s/ Katharine A. Martin
--------------------------------------------------------
Katharine A. Martin, Director

Date: March 15, 2004 /s/ Robert G. Teresi
--------------------------------------------------------
Robert G. Teresi, Director

Date: March 15, 2004 /s/ Robert J. Frankenberg
--------------------------------------------------------
Robert J. Frankenberg, Director

Date: March 15, 2004 /s/ Robert Finch
--------------------------------------------------------
Robert Finch, Director

Date: March 15, 2004 /s/ John C. Freker, Jr.
--------------------------------------------------------
John C. Freker, Jr., Director