SCANSOFT INC - 10-Q Quarterly Report

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

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2004

OR

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

COMMISSION FILE NUMBER 0-27038

SCANSOFT, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 94-3156479
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)

9 CENTENNIAL DRIVE
PEABODY, MA 01960
(Address of principal executive office)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
978-977-2000

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 whether the registrant is an accelerated filer (as
defined in Rule 12-b-2 of the Securities Exchange Act of
1934). Yes [X] No [ ]

106,288,852 shares of the registrant's Common Stock, $0.001 par value, were
outstanding as of January 31, 2005.

SCANSOFT, INC.

FORM 10-Q
THREE MONTHS ENDED DECEMBER 31, 2004
INDEX

1

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.
2

SCANSOFT, INC.

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

The accompanying notes are an integral part of these consolidated financial
statements.
3

SCANSOFT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

The accompanying notes are an integral part of these consolidated financial
statements.
4

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. BASIS OF PRESENTATION

The accompanying consolidated financial statements of ScanSoft, Inc. (the
"Company" or "ScanSoft") have been prepared in accordance with accounting
principles generally accepted in the United States of America. In the opinion of
management, these unaudited interim consolidated financial statements reflect
all adjustments, consisting of normal recurring adjustments, necessary for a
fair presentation of the financial position at December 31, 2004, and the
results of operations and cash flows for the three months ended December 31,
2004 and 2003. Although the Company believes that the disclosures in these
financial statements are adequate to make the information presented not
misleading, certain information normally included in the footnotes prepared in
accordance with generally accepted accounting principles in the United States of
America has been omitted as permitted by the rules and regulations of the
Securities and Exchange Commission. The accompanying financial statements should
be read in conjunction with the audited financial statements and notes thereto
included in the Company's Transition Report on Form 10-K/T for the nine month
transition period ended September 30, 2004 filed with the Securities and
Exchange Commission on January 6, 2005. The results for the three months ended
December 31, 2004 are not necessarily indicative of the results that may be
expected for the year ending September 30, 2005, or any future period.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

CHANGE IN FISCAL YEAR

On October 23, 2004, the Company's Board of Directors approved a change in
the Company's fiscal year end from December 31 to September 30, effective
beginning September 30, 2004.

USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS

The preparation of financial statements in conformity with generally
accepted accounting principles in the United States of America 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, the
costs to complete the development of custom software applications and valuation
allowances (specifically sales returns and other allowances); accounting for
patent legal defense costs; the valuation of goodwill, other intangible assets
and tangible long-lived assets, estimates used in accounting for acquisitions;
assumptions used in valuing stock-based compensation instrument, evaluation loss
contingencies; 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 non-functional currencies are
revalued into its

5

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

functional currency at exchange rates in effect at the balance sheet date. The
Company reported in other income (expense), net foreign currency transaction and
other translation losses of $1.0 million for the three months ended December 31,
2004 and a $0.4 million gain for the comparable period in 2003.

Assets and liabilities of foreign subsidiaries that are denominated in
foreign currencies are translated into U.S. dollars at exchange rates in effect
at the balance sheet date. Revenue and expense items are translated using the
average exchange rates for the period. Net unrealized gains and losses resulting
from foreign currency translation are included in other comprehensive income
(loss), which is a separate component of stockholders' equity, except for
Budapest for which foreign currency translation adjustments are recorded in
other income (expense). Foreign currency transaction gains and losses are
included in results of operations.

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.

REVENUE RECOGNITION

The Company recognizes revenue in accordance with Statement of Position
("SOP") 97-2, Software Revenue Recognition, as amended by SOP 98-9,
"Modification of SOP 97-2 with Respect to Certain Transactions", SOP 81-1
Accounting for Performance of Construction Type and Certain Performance Type
Contracts and the Securities and Exchange Commission's Staff Accounting Bulletin
No. 104, "Revenue Recognition in Financial Statements" ("SAB 104") and Emerging
Issues Task Force (EITF) Issue No. 01-09, "Accounting for Consideration Given by
a Vendor (Including a Reseller of the Vendors Products)" and FASB 48 ("FAS 48"),
"Revenue Recognition when Right of Return Exists". In general we recognize
revenue when persuasive evidence of an arrangement exists, delivery has
occurred, the fee is fixed or determinable, collectibility is probable, and
vendor specific objective evidence ("VSOE") exists for any undelivered elements.
We reduce revenue recognized for estimated future returns, price protection and
rebates, and certain marketing funds at the time the related revenue is
recorded.

Certain distributors and value-added resellers have been granted rights of
return for as long as the distributors or resellers hold the inventory. The
Company has not aggregated and analyzed historical returns from distributor and
resellers to form a basis in order to estimate the future sales returns by
distributor and resellers. As a result, the Company recognizes revenue from
sales to these distributors and resellers when the distributor and reseller have
sold products through 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.

6

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

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 Company has aggregated and analyzed historical returns
from retailers and end users which forms the basis of its estimate of future
sales returns by retailers or end users. In accordance with FAS 48, 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 considered essential to the
functionality of the software, such as custom application development for a
fixed fee, it recognizes revenue from the fees for such services and any related
software licenses based on the percentage-of-completion method in accordance
with SOP 81-1. The Company generally determines the percentage-of-completion by
comparing the labor hours incurred to date to the estimated total labor hours
required to complete the project. The Company considers labor hours to be the
most reliable, available measure of progress on these projects. Adjustments to
estimates to complete 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.

When the Company provides services on a time and materials basis, it
recognizes revenue as it performs the services based on actual time incurred.

Other professional services not considered essential to the functionality
of the software are limited and primarily include training and feasibility
studies, which are recognized as revenue when the related services are
performed. 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 VSOE of its fair value and additionally based upon stated
renewal rates. 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, 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 VSOE of their fair values. 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 EITF No. 01-09, in determining whether
consideration given to a customer should be recorded as an operating expense or
a reduction of revenue recognized from that same

7

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

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.

Consideration, including that in the form of the Company's equity
instruments (if applicable), is recorded as a reduction of revenue, to the
extent the Company has recorded cumulative revenue from the customer or
reseller.

The Company follows the guidance of EITF Issue No. 01-14, Income Statement
Characterization of Reimbursements for "Out-of-Pocket" Expenses Incurred, and
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.

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.

During the three months ended December 31, 2004, the Company escrowed
approximately $0.4 million of cash, with Anglo Irish Bank in connection with the
renewal of the 3.5 million euro hedge contract. The Company had previously
escrowed approximately $0.5 million of cash as a result of a dispute with one of
its vendors. The Company is working to resolve this dispute at which time the
escrow will be returned to the Company or released from escrow. As of December
31, 2004, total cash escrowed was approximately $0.9 million and is included in
cash and cash equivalents in the accompanying balance sheet.

ACCOUNTS RECEIVABLE

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

INVENTORY

Inventory consists of finished goods, primarily of software media and user
manuals, and 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 estimated
economic 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.

8

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

LONG-LIVED TANGIBLE 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. Long-lived tangible and intangible
assets include 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.

SFAS No. 142, Goodwill and Other Intangible Assets (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 fair value of the reporting unit was determined using the
Company's market capitalization as of July 1, 2004. As the fair value of the
reporting unit as of this date was in excess of the carrying amount of the net
assets, the Company concluded that its goodwill was not impaired. No further
analysis was required under SFAS 142.

The Company uses the market value approach on an enterprise level basis to
determine fair value in the initial step of its goodwill impairment test. Based
on this, the Company performed the annual assessment during the last quarter of
fiscal 2004 and determined that these intangible assets were not impaired. 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.

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 the organization
or the Company's management reporting structure, as well as other events and
circumstances, including but not limited to technological advances, increased
competition and changing economic or market conditions, could result in (a)
shorter estimated useful lives, (b) additional reporting units, which may
require alternative methods of estimating fair values or greater disaggregation
or aggregation in our analysis by reporting unit, and/or (c) other changes in
previous assumptions or estimates. In turn, this could have a significant impact
on the consolidated financial statements through accelerated amortization and/or
impairment charges.

9

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

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
three months ended December 31, 2004 and 2003, 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, 2004 and September 30, 2004, capitalized patent
defense costs totaled $0.8 million and $0.5 million, respectively.

CAPITALIZATION OF INTERNAL USE SOFTWARE COSTS

The Company capitalizes development costs of software for internal use
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, 2004, the
Company had capitalized costs of $0.4 million related to internal financial
systems of which a portion of the cost for modules not yet deployed have been
included in construction in process.

INCOME TAXES

Deferred tax assets and liabilities are determined based on differences
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.

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. The Company's income tax provisions and its assessment of
the realizability of its deferred tax assets involve significant judgments and
estimates. If the Company continued to generate taxable income through
profitable operations in future years it may be required to recognize these
deferred tax assets through the reduction of the valuation allowance which would
result in a material benefit to its 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 and stock compensation.

COMPREHENSIVE INCOME

Total comprehensive income, net of taxes, was $4.4 million and $1.1 million
for the three months ended December 31, 2004 and 2003, respectively.
Comprehensive income for the three months ended December 31, 2004 consists of
net income of $3.1 million, foreign currency translation gains of $1.2 million
and unrealized gains on marketable securities of $0.1 million. For the purposes
of comprehensive income disclosures, the

10

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

Company does not record tax provisions or benefits for the net changes in the
foreign currency translation adjustment, as the Company intends to permanently
reinvest undistributed earnings in its foreign subsidiaries.

CONCENTRATION OF RISK

Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of cash, cash equivalents,
marketable securities and 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, 2004 one customer represented 12% of the Company's net accounts
receivable balance. At September 30, 2004, 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, marketable securities,
accounts receivable, and notes payable and are carried in the financial
statements at amounts that approximate their fair value as of December 31, 2004
and September 30, 2004.

MARKETABLE SECURITIES

The Company accounts for its marketable equity securities in accordance
with SFAS 115 "Accounting for Certain Investments in Debt and Equity
Securities." Beginning in April 2004, the Company began investing in short and
long-term marketable securities to improve the yield on its investment
portfolio. At December 31, 2004, the stated maturities of the Company's
investments are $1.5 million within one year and $3.8 million within one to five
years. These investments are classified as available-for-sale and are recorded
on the balance sheet at fair value with unrealized gains or losses reported as a
separate component of accumulated other comprehensive income, net of tax.
Realized gains and losses on sales of short-term and long-term investments have
not been material. During the three month period ended December 31, 2004, no
short-term or long-term marketable securities were purchased.

All short-term and long-term marketable securities have been classified as
available-for-sale securities as follows:

11

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

NET INCOME PER SHARE

Basic net income per share is computed using the weighted average number of
common shares outstanding during the period. Diluted net income per share is
computed based on (i) the weighted average number of common shares outstanding,
(ii) the assumed conversion of the Series B Preferred Stock, and (iii) the
effect, when dilutive, of outstanding stock options, the convertible debenture,
warrants, and unvested shares of restricted stock using the treasury stock
method. For the three months ended December 31, 2004 and 2003, 12,240,046 and
11,627,399 potentially dilutive common shares were excluded from the computation
of net income per share, respectively, because they are antidilutive.

12

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

Below is a required detailed computation of net income for earning per
share. As noted in Note 9, the Series B Preferred stock is a participating
security, accordingly, the Company has applied EITF Issue No. 03-06
"Participating Securities and the Two-Class Method under FASB Statement No. 128"
in computing net income per share for the three months ended December 31, 2004
and 2003, respectively (in thousands, except per share data):

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.

13

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

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 income (loss) and pro forma net income (loss)
per share would have been as follows (in thousands, except per share amounts):

RECLASSIFICATIONS

Certain prior year financial statement amounts have been reclassified to
conform with current year presentation.

RECENT 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 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 the
Company's financial position or results of operations.

In December 2004, the FASB issued FASB SFAS No. 123 (revised 2004),
Share-Based Payment, which is a revision of SFAS No. 123, Accounting for
Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25,
Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of
Cash Flows. Generally, the approach in SFAS No. 123(R) is similar to the
approach described in SFAS No. 123. However, SFAS No. 123(R) requires all
share-based payments to employees, including grants of employee stock options,
to be recognized in the income statement based on their fair values. Pro forma
disclosure is no longer an alternative. The new standard will be effective for
the Company in the quarter beginning July 1, 2005. The Company has not yet
completed its evaluation but expects the adoption to have a material effect on
its consolidated financial statements.

14

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

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 customer contracts
accounted for under the percentage-of-completion method that have not yet been
billed based on the terms of the specific arrangement.

4. ACQUISITIONS

ACQUISITION OF RHETORICAL SYSTEMS LTD. (RHETORICAL)

On December 6, 2004, the Company acquired all of the outstanding shares of
Rhetorical Systems, Ltd., a supplier of innovative text-to-speech solutions and
tools based in Edinburgh, Scotland.

With the acquisition of Rhetorical Systems, ScanSoft solidified its
position as a leading provider of speech synthesis or text-to-speech (TTS)
solutions for a variety of speech-based applications. The Rhetorical acquisition
will further differentiate ScanSoft's solutions with a number of techniques,
tools and services that enhance the ability to deliver custom, dynamic voices.

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

The consideration consisted of cash payments equal to 2,758,000 Pounds
Sterling in cash ($5,360,000) and 449,437 shares of ScanSoft common stock
(valued at approximately $1,672,000 in accordance with EITF Issue No. 99-12,
"Determination of the Measurement Date for the Market Price of Acquirer
Securities Issued in a Purchase Business Combination"). The total initial
purchase price of approximately $8,477,000 also includes estimated transaction
costs of $1,445,000.

The merger is a taxable event and has been accounted for as a purchase of a
business.

15

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

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

Total purchase consideration:
Cash...................................................... $ 5,360
Stock issued.............................................. 1,672
Transaction costs......................................... 1,445
-------
Total purchase consideration........................... $ 8,477
=======
Preliminary allocation of the purchase consideration:
Current assets............................................ $ 824
Property and equipment.................................... 303
Identifiable intangible assets............................ 1,310
Goodwill.................................................. 7,654
-------
Total assets acquired.................................. 10,091
-------
Current liabilities assumed............................... (1,614)
-------
$ 8,477
=======

Current assets acquired primarily relate to cash and accounts receivable
and a facility lease deposit. Current liabilities assumed primarily relate to
accrued expenses.

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 excess
of the purchase price over the tangible and identifiable assets was recorded as
goodwill and amounted to approximately $7.7 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.

ACQUISITION OF BRAND & GROEBER COMMUNICATIONS GBR ("B&G")

On September 16, 2004, the Company acquired B&G, including all the
intellectual property relating to embedded speech synthesis technology. The
consideration consists of cash payments of approximately $0.2 million and four
contingent payments of up to approximately E 5.8 million through 2007 to be
paid, if at all, based upon the achievement of certain performance targets, as
defined in the acquisition agreement. The total initial purchase price of
approximately $0.3 million, includes cash consideration of $0.2 million and
estimated transaction costs of $0.1 million. The acquisition has been accounted
for as a purchase of a business.

16

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

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

Any excess purchase price over the identified assets will be treated as
goodwill.

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

5. OTHER INTANGIBLE ASSETS

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

On March 31, 2003, the Company entered into an agreement that granted 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
17

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

agreement and the first installment payment of $2.8 million due March 31, 2004
was paid on that date. The remaining payment of $2.8 million including interest
of $0.2 million will be paid 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. That amount is being 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 is being
charged to interest expense over the payment period. As of December 31, 2004,
the payment due on or before March 31, 2005 has been classified as a current
liability, deferred payment obligation for technology license.

Aggregate amortization expense was $3.5 million and $3.9 million for the
three months ended December 31, 2004 and 2003, respectively. Of this amount,
$2.8 million and $3.0 million was included in cost of revenue, respectively and
$0.7 million and $0.9 million was recorded in operating expenses, respectively.

Estimated amortization expense for each of the five succeeding fiscal years
as of December 31, 2004 is as follows (in thousands):

6. ACCRUED EXPENSES

Accrued expenses consist of the following (in thousands):

18

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

7. RESTRUCTURING AND OTHER CHARGES

During the three months ended December 31, 2004, a charge of approximately
$0.7 million was taken in connection with the termination of 10 existing
ScanSoft employees.

At December 31, 2004, the remaining restructuring accrual from current and
prior restructuring activities amounted to $0.6 million. This amount is composed
of $0.2 million of lease exit costs and $0.4 million of employee-related
severance costs, of which $0.1 million is for severance to the former Caere
President and CEO.

The severance due to the former Caere President and CEO will be paid
through March 2005. Certain other severance costs related to restructuring
actions undertaken during 2003 will be paid through March 2009.

The following table sets forth the fiscal year 2005 and 2004 restructuring
and other charges accrual activity (in thousands):

8. DEBT AND CREDIT FACILITIES AND COMMITMENTS AND CONTINGENCIES

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 March
31, 2004, extending the term to March 31, 2006. Under this amendment, the
Company must comply with both a minimum adjusted quick ratio and minimum
tangible net worth calculation, as defined in the Loan Agreement. Depending on
the Company's adjusted quick ratio, borrowings under the Credit Facility bear
interest at the Bank's prime rate plus 0.0% or 0.75%, (5.25% at December 31,
2004), as defined in the Loan Agreement. The maximum aggregate amount of
borrowings outstanding at any one time was amended to the lesser of $20.0
million or a borrowing base equal to the aggregate amounts un-drawn on
outstanding letters of credit, minus 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. As of December 31, 2004, the Company was in compliance with all
covenants.

As of December 31, 2004, no amounts were outstanding under the Credit
Facility and $18.4 million was available for borrowing in addition to
approximately $1.6 million committed under this line of credit for
19

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

outstanding Letters of Credit. The Company can make no guarantees as to its
ability to satisfy its future financial covenant calculations.

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,
2004, a balance of $0.3 million remains outstanding. Borrowings under this line
are collateralized by the fixed assets purchased and bear interest at the bank's
prime rate (5.25% at December 31, 2004), 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, 2004, principal payments of $0.2
million are due during the year ending September 30, 2005; and $0.1 million are
due during the year ending September 30, 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, 2004.

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. 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 did not result in a Change in Control.

LITIGATION AND OTHER CLAIMS

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

From time to time, 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.

20

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

On September 9, 2004, BIS Advanced Software Systems, Ltd. ("BIS") filed an
action against the Company in the United States District Court for the District
of Massachusetts claiming patent infringement. Damages are sought in an
unspecified amount. In the lawsuit, BIS alleges that the Company is infringing
United States Patent No. 6,401,239 entitled "System and Method for Quick
Downloading of Electronic files." The Company filed an Answer and Counterclaims
on December 22, 2004. The Company believes this claim has no merit, and it
intends to defend the action vigorously.

On August 5, 2004, Compression Labs Inc. filed an action against the
Company in the United States District Court for the Eastern District of Texas
claiming patent infringement. Damages are sought in an unspecified amount. In
the lawsuit, Compression Labs alleges that the Company is infringing United
States Patent No. 4,698,672 entitled "Coding System for Reducing Redundancy."
The Company believes this claim has no merit, and intends to defend the action
vigorously.

On April 23, 2004, Millennium L.P. filed an action against the Company in
the United States in the United Sates District Court for the Southern District
of New York claiming patent infringement. Damages are sought in an unspecified
amount. In the lawsuit, Millennium alleges that the Company is infringing United
Sates Patent No. 5,258,855 entitled "Information Processing Methodology"; No.
5,369,508 entitled "Information Processing Methodology"; No. 5,625,465 entitled
"Information Processing Methodology"; No. 5,678,416 entitled "Information
processing Methodology; and No. 6,094,505 entitled "Information Processing
Methodology." The Company filed an Answer on June 17, 2004. The Company believes
this claim has no merit, and it intends to defend the action vigorously.

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
ScanSoft has, both prior to and as a result of the SpeechWorks acquisition,
several products in the speech recognition technology field, ScanSoft believes
that the products do not infringe the '231 Patent because neither the Company
nor SpeechWorks use the 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.

The Company believes that the final outcome of the current litigation
matters described above will not have a significant adverse effect on its
financial position or results of operations. However, even if the
21

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

Company's defense is successful, the litigation could require significant
management time and will be costly. Should the Company not prevail in these
litigation matters, its operating results, financial position and cash flows
could be adversely impacted.

GUARANTEES AND OTHER

The Company currently includes indemnification provisions in the contracts
it enters with its customers and business partners. Generally, these provisions
require the Company to defend claims arising out of its products' infringement
of third-party intellectual property rights, breach of contractual obligations
and/or unlawful or otherwise culpable conduct on its part. The indemnity
obligations imposed by these provisions generally cover damages, costs and
attorneys' fees arising out of such claims. In most, but not all, cases, the
Company's total liability under such provisions is limited to either the value
of the contract or a specified, agreed upon, amount. In some cases its total
liability under such provisions is unlimited. In many, but not all, cases, the
term of the indemnity provision is perpetual. While the maximum potential amount
of future payments the Company could be required to make under all the
indemnification provisions in its contracts with customers and business partners
is unlimited, it believes that the estimated fair value of these provisions is
minimal due to the low frequency with which these provisions have been
triggered.

The Company has entered into agreements to indemnify its directors and
officers to the fullest extent authorized or permitted under applicable law.
These agreements, among other things, provide for the indemnification of its
directors and officers for expenses, judgments, fines, penalties and settlement
amounts incurred by any such person in his or her capacity as a director or
officer of the company, whether or not such person is acting or serving in any
such capacity at the time any liability or expense is incurred for which
indemnification can be provided under the agreements. In accordance with the
terms of the SpeechWorks merger agreement, the Company is required to indemnify
the former members of the SpeechWorks board of directors, on similar terms as
described above, for a period of five years from the acquisition date. As a
result, the Company recorded a liability related to the fair value of the
obligation of $1.0 million in connection with the purchase accounting for the
acquisition. Additionally in accordance with the terms of the merger agreement,
the Company purchased a director and officer insurance policy related to this
obligation for a period of three years from the date of acquisition.

In accordance with the provisions of FASB Interpretation No. 45 ("FIN 45"),
Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others, the following table represents
the deferred revenue activity related to the Company's obligations under
maintenance and support contracts for the three month period ended December 31,
2004 (in thousands):

Beginning balance as of September 30, 2004.................. $ 4,130
Additions due to new billings during fiscal 2005............ 2,827
Maintenance revenue recognized during fiscal 2005........... (2,229)
-------
Ending balance as of December 31, 2004...................... $ 4,728
=======

9. 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, the Company issued 3,562,238 shares
of Series B Preferred Stock to Xerox Corporation ("Xerox"). On March 19, 2004,
the Company announced that Warburg Pincus, a global private equity firm, had
agreed to purchase all outstanding shares of the Company's

22

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

stock held by Xerox Corporation for approximately $80 million, including the
3,562,238 shares of Series B preferred stock. 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 declared by the Board of Directors. In addition, after payment
of such dividends, any additional dividends or distributions shall be
distributed among all holders of Common Stock and all holders of Series B
Preferred Stock in proportion to the number of shares of Common Stock which
would be held by each such holder if all shares of Series B Preferred Stock were
converted to Common Stock. 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

On November 15, 2004, in connection with the acquisition of Phonetics
Systems, Ltd., the Company issued unvested warrants to purchase 750,000 shares
of ScanSoft common stock at an exercise price of $4.46 per share that will vest,
if at all, upon the achievement of certain performance targets. The initial
valuation of the warrants will occur upon closing of the acquisition and will be
treated as purchase consideration in accordance with EITF Issue No. 97-8
"Accounting for Contingent Consideration Issued in a Purchase Business
Combination". Future changes in the value of the warrant will be accounted for
in accordance with EITF Issue No. 00-19 "Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in, a Company's Own Stock". See
Note 14 for further discussion on the acquisition of Phonetic Systems, Ltd.

The Company issued Xerox a ten-year warrant with an exercise price for each
warrant share of $0.61. Pursuant to the terms of this warrant, it is exercisable
for the purchase of 525,732 shares of the Company's common stock. On March 19,
2004, the Company announced that Warburg Pincus, a global private equity firm
had agreed to purchase all outstanding shares of the Company's stock held by
Xerox Corporation, including the warrant referenced above, for approximately $80
million. In connection with this transaction, Warburg Pincus acquired warrants
to purchase 2.5 million additional shares of the Company's common stock for
total consideration of $0.6 million. The warrants have a six year life and an
exercise price of $4.94. The Company received this payment of $0.6 million
during the quarter ended June 30, 2004.

In connection with the March 31, 2003 acquisition of the certain
intellectual property assets related to multimodal speech technology, 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, 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.

23

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

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, which
expired on 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

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 following
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 repurchased 5,525 shares of
common stock at a cost of $23,000 during the three month period ended December
31, 2004.

As of December 31, 2004, the Company had repurchased a total of 2,777,032
common shares under this and previous repurchase programs. The Company intends
to use the repurchased shares for its employee stock plans and for potential
future acquisitions.

10. RESTRICTED COMMON STOCK AND STOCK PURCHASE RIGHTS

During the three months ended December 31, 2004, the Company awarded net
68,477 restricted stock purchase units to certain senior executives and
employees of the Company. As of December 31, 2004, there were 893,104 shares of
restricted stock and 442,986 restricted stock units that were unvested and which
may not be sold, transferred or assigned until such restrictions lapse. The
holders of the restricted stock are entitled to participate in dividends and
voting rights. The holders of restricted stock units are not entitled to
dividends nor do they have voting rights. The restricted stock purchase units
and shares of restricted stock vest no later than September 30, 2007, with
opportunities for acceleration upon achievement of defined goals. Except as
otherwise specified in the agreements, in the event that the executive or
employees' employment with the Company terminates, any unvested shares shall be
forfeited and revert to the Company. The purchase price of the restricted shares
equaled the par value of the shares. The purchase price of the restricted stock
purchase units, payable at time of issuance of shares, equaled the par value of
the shares. The difference between the purchase price and the fair value of the
Company's common stock on the date of issuance based on the listed exchange
price, has been recorded as deferred compensation and additional
paid-in-capital.

The deferred compensation expense from the aforementioned awards is being
recognized ratably over the vesting periods, resulting in $0.7 million and $0.2
million of stock compensation expense during the three months ended December 31,
2004 and 2003, respectively.

24

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

11. SEGMENT AND GEOGRAPHIC INFORMATION AND SIGNIFICANT CUSTOMERS

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

No individual country within other foreign countries had revenues greater
than 10% of total revenues.

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

At December 31, 2004, two distribution and fulfillment partners, Ingram
Micro and Digital River accounted for 10% and 11% of the Company's consolidated
net revenues, respectively. At December 31, 2003, two distribution and
fulfillment partners, Ingram Micro and Digital River accounted for 14% and 13%
of the Company's consolidated net revenues, respectively.

12. PRO FORMA RESULTS

The following table reflects unaudited pro forma results of operations of
the Company assuming that the Telelogue, B&G and Rhetorical acquisitions had
occurred on October 1, 2003 (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 this period.

13. RELATED PARTIES

On March 19, 2004, the Company announced that Warburg Pincus, a global
private equity firm, had agreed to purchase all outstanding shares of the
Company's stock held by Xerox Corporation for approximately $80 million. At
December 31, 2003, Xerox owned approximately 15% of the Company's outstanding

25

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(UNAUDITED)

common stock and all of the Company's outstanding Series B Preferred Stock. In
addition, Xerox had the opportunity to acquire additional shares of common stock
pursuant to a warrant (Note 9).

As a result of the Xerox and Warburg Pincus transaction, Xerox is no longer
a related party as of June 30, 2004. The Company does not engage in transactions
in the normal course of its business with Warburg Pincus.

At December 31, 2004, 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 three months ended December 31, 2004, Convergys accounted for
approximately $0.1 million in total net revenues. As of December 31, 2004 and
September 30, 2004, Convergys owed the Company $0.1 million and $0.1 million,
respectively, pursuant to these agreements, which are included in receivables
from related parties.

14. SUBSEQUENT EVENTS

On January 21, 2005, ScanSoft completed its acquisition of Advanced
Recognition Technologies, Inc. ("ART") whose operations reside primarily in
Israel. In connection with the ART acquisition, the Company paid approximately
$10.0 million at closing and agreed to pay approximately $16.5 million in
December 2005. With the acquisition of ART, the Company expands its portfolio of
embedded speech solutions to include a deep set of resources, expertise and
relationships with the world's leading mobile device manufacturers and service
providers.

On February 1, 2005, ScanSoft completed its acquisition of all of the
outstanding capital stock of Phonetic Systems Ltd., an Israeli corporation
("Phonetic"). In connection with the Phonetic acquisition, the Company paid
$17.5 million at closing, and agreed to pay $17.5 million 24 months after
closing, make contingent payments of up to an additional $35.0 million in cash,
in 2006 through 2008 if at all, upon the achievement of certain performance
targets, and issue unvested warrants to purchase 750,000 shares of its' common
stock that will vest, if at all, upon the achievement of certain performance
targets. This acquisition furthers ScanSoft's global leadership in automated
Directory Assistance and enterprise speech applications.

In January 2005, ScanSoft, Inc. signed a 10 year lease for office space
located in Burlington, Massachusetts. The Company will make approximately $22.3
million in operating lease payments over the term of the lease. This building
will become the Company's new corporate headquarters and it intends to
consolidate its 350 employees presently employed at its three existing Boston
area offices into this location by June 2005. The Company will make all
reasonable efforts to sublease its existing Boston area sites for the remainder
of the existing lease terms.

26

ITEM 2. 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 Quarterly Report
on Form 10-Q. 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 36 and elsewhere in this
Quarterly Report.

FORWARD-LOOKING STATEMENTS

This quarterly report contains forward-looking statements. These
forward-looking statements include predictions regarding: -

- OUR FUTURE REVENUES, COST OF REVENUES, RESEARCH AND DEVELOPMENT EXPENSES,
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES, AMORTIZATION OF OTHER
INTANGIBLE ASSETS AND GROSS MARGIN;

- OUR STRATEGY RELATING TO SPEECH AND LANGUAGE 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; 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 quarterly 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 assume no obligation to update any
forward-looking statements.

OVERVIEW OF THE BUSINESS

We offer businesses and consumers market-leading speech and imaging
solutions that facilitate the way people access, share, manage and use
information in business and in daily life. We market and distribute our products
indirectly through a global network of resellers, comprising system integrators,
independent software vendors, value-added resellers, hardware vendors,
telecommunications carriers and distributors; and directly to businesses and
consumers through a dedicated direct sales force and our e-commerce website
(www.scansoft.com). The value of our solutions is best realized in vertical
markets that are information and process intensive, such as healthcare,
telecommunications, financial services, legal and government.

Our strategy is to deliver premier, comprehensive technologies and services
as an independent application or as part of a larger integrated system in two
areas -- speech and imaging. Our speech technologies enable voice-activated
services over a telephone, transform speech into written word, and permit the
control of devices and applications by simply speaking. Our imaging 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 software
is delivered

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as part of a larger integrated system, such as systems for customer service call
centers, or as an independent application, such as dictation, document
conversion or PDF, navigation systems in automobiles or digital copiers on a
network. Our products and technologies deliver a measurable return on investment
to our customers.

Our extensive technology assets, intellectual property and industry
expertise in speech and imaging 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 650 patents
or patent applications.

Our strategy includes pursuing high growth markets in speech, expanding our
PDF and imaging solutions, providing our partners and customers with a
comprehensive portfolio of solutions, promoting the broad adoption of our
technology, focusing and leverage our vertical expertise, building global sales
and channel relationships and pursuing strategic acquisitions that complement
our resources.

ScanSoft was incorporated in 1992 as Visioneer. In 1999, we changed our
name to ScanSoft, Inc. and ticker symbol to SSFT. From our founding until 2001,
we focused exclusively on delivering imaging solutions that simplified
converting and managing information as it moved from paper formats to electronic
systems. On March 13, 2000, we merged with Caere Corporation, a California-based
digital imaging software company, to expand our applications for document and
electronic forms conversion. In December 2001, we entered the speech market
through the acquisition of the Speech & Language Technology Business from
Lernout & Hauspie. We believed speech solutions were a natural complement to our
imaging solutions as both are developed, marketed and delivered through similar
resources and channels. We continue to execute against our strategy of being the
market leader in speech through the organic growth of our business as well as
through strategic acquisitions. Since the beginning of 2003, we have completed a
number of acquisitions, including:

- On January 30, 2003, we acquired Royal Philips Electronics Speech
Processing Telephony and Voice Control business units ("Philips") to
expand our solutions for speech in call centers and within automobiles
and mobile devices.

- On August 11, 2003, we acquired SpeechWorks International, Inc.
("SpeechWorks") to broaden our speech applications for
telecommunications, call centers and embedded environments as well as
establish a professional services organization.

- On December 19, 2003, we acquired LocusDialog, Inc. ("LocusDialog") to
expand our speech application portfolio with automated attendant
solutions for business.

- On June 15, 2004, we acquired Telelogue, Inc. ("Telelogue") to enhance
our automated directory assistance solutions.

- On September 16, 2004, we acquired Brand & Groeber Communications GbR
("B&G") to enhance our embedded speech solutions, which will make mobile
phones accessible to the visually impaired using ScanSoft's
text-to-speech technology.

- On December 6, 2004, we acquired Rhetorical Systems, Inc. ("Rhetorical")
to complement our text-to-speech solutions and add capabilities for
creating custom voices.

- On January 21, 2005, we acquired ART Advanced Recognition Technologies,
Inc. ("ART") to expand our portfolio of embedded speech solutions.

- On February 1, 2005, we acquired Phonetic Systems Ltd. ("Phonetic") to
complement our position in automated directory assistance and enterprise
speech applications.

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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.

OVERVIEW OF RESULTS OF OPERATIONS

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

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

(1) See Note 5 of Notes to Consolidated Financial Statements.

(2) See Note 7 of Notes to Consolidated Financial Statements.

GENERAL

We derive our revenue from licensing 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 by simply speaking. Our imaging solutions
eliminate the need to manually reproduce documents,

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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.

TOTAL REVENUE

Total revenue for the three months ended December 31, 2004 increased by
$13.7 million, or 29.2%, from the comparable period in 2003. The overall growth
in revenue is attributed to $8.0 million in growth from our product revenue and
$5.7 million in growth from our professional services revenue.

Geographic revenue classification is based on the country in which the sale
is invoiced. Revenue for the three months ended December 31, 2004 was 69% North
America and 31% international versus 70% and 30%, respectively for the
comparable period in 2003.

PRODUCT REVENUE

Product revenue for the three months ended December 31, 2004 increased by
$8.0 million, or 20.5%, from the comparable period in 2003. The increase in
revenue from the comparable period in 2003 is attributed to an $8.0 million
increase in speech revenue.

The growth in speech revenue is accredited to growth and increased demand
across all speech segments -- networked, embedded, and dictation. Our networked
speech products grew $1.8 million, or 19%, from the comparable period 2003. This
was largely driven by growth in our Text-to-Speech revenues, which contributed
$1.3 million, or 57% growth. Our embedded speech products increased $1.3
million, or 58%, from the same period in 2003. Again, the largest contributor
was our embedded Text-to-Speech revenues, which contributed $1.2 million, or
100% growth. In addition, our dictation productivity applications increased $4.9
million, or 57%, for the comparable period in 2003, due primarily to the launch
of Dragon Naturally Speaking v.8 in November 2004.

Our imaging revenue had modest growth, approximately $0.2 million, for the
three months ended December 31, 2004 as compared to the comparable period in
2003. We experienced an increase of $3.3 million in our Paper Management
products, due to the launch of PaperPort v10, in November 2004. Additionally, we
experienced growth in our bundled imaging products and our PDF products. These
increases were partially offset by a decrease of $4.6 million, from our OCR
product line, primarily due to the launch of OmniPage v.14 in the comparable
period of 2003.

PROFESSIONAL SERVICE REVENUE

Service revenue for the three months ended December 31, 2004 increased by
$5.7 million from the comparable period in 2003. The substantial increase in
service revenue from the comparable period in 2003 is attributed to the
continued growth of our professional services organization which essentially was
created in conjunction with the acquisition of SpeechWorks, in August 2003.
Professional service revenue grew $3.9 million, or 61% from our networked
services group, $1.3 million, or 94% from our embedded services, as well as a
$0.5 million from our productivity services group, from the comparable period in
2003.

COST OF PRODUCT LICENSE REVENUE

Cost of revenue consists of material and fulfillment costs and third-party
royalties.

Cost of product license revenue for the three months ended December 31,
2004 was $5.5 million, or 11.8% of product license revenue, compared to $4.6
million, or 11.8%, for the comparable period in 2003. The increase in cost of
product license revenue in absolute dollars for these periods ended December 31
was attributable to the overall increase in our product license revenue, as well
as the absolute increase in our dictation products, which carry a higher
manufacturing cost due to the inclusion of a headset.

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COST OF PROFESSIONAL SERVICES REVENUE

Cost of professional services revenue consists primarily of salaries for
professional consulting staff, salaries for product support personnel, and
engineering costs associated with certain contracts which were accounted for
under the percentage-of-completion method of accounting.

Cost of professional services revenue for the three months ended December
31, 2004 was $9.6 million, or 70%, of professional services revenue, compared to
$5.9 million, or 73.5%, for the comparable period in 2003. The increase in cost
of professional services revenue in absolute dollars for the three-month period
ended December 31, 2004 was attributable to the increased services revenue. The
improvement in cost as a percent of service revenue resulted from higher
utilization of our services personnel.

COST OF REVENUE FROM AMORTIZATION OF INTANGIBLE ASSETS

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

Cost of revenue from amortization of intangible assets for the three months
ended December 31, 2004 was $2.8 million, or 4.7% of total revenue, compared to
$3.0 million, or 6.5%, for the comparable period in 2003. The decrease in cost
of revenue from amortization of intangible assets for the three months ended
December 31, 2004 in absolute dollars is attributable to an increase of $0.1
million related to the LocusDialog and Telelogue acquisitions which were
completed on December 19, 2003 and June 15, 2004, offset by $0.3 million of
intangible assets that became fully amortized during fiscal years 2003 and 2004.
During fiscal 2005, we expect cost of revenue from amortization of intangible
assets to be approximately $5.0 million based on our current level of intangible
assets, but excluding, intangible assets associated with the ART and Phonetic
acquisitions.

GROSS MARGIN

Gross margin was 70.4% of revenues for the three months ended December 31,
2004, as compared to 71.2% for the comparable period in 2003. The decrease is
attributable to the increase in professional services revenue, which increased
to 23.4% of total revenue for the three months ended December 31, 2004 from
17.1% for the comparable period in 2003, as services carry a lower margin than
licenses.

Research and Development Expense

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

Research and development expense for the three months ended December 31,
2004 was $9.1 million, or 15.0%, of total revenue, compared to $8.9 million, or
18.9%, for the comparable period in 2003. In absolute dollars, research and
development expenses increased marginally for the three months ended December
31, 2004, compared to the comparable period in 2003. The increase is primarily
attributed to outsourced engineering labor which increased year over year. This
was partially offset by decreased personnel costs associated with a decrease in
research and development headcount by approximately 18 engineers from the
comparable period in 2003.

Sales and Marketing Expense

Sales and marketing expenses include salaries, commissions, advertising,
direct mail, public relations, trade shows, travel and other related sales and
marketing expenses.

Sales and marketing expense for the three months ended December 31, 2004
was $18.6 million, or 30.6% of total revenue, compared to $17.5 million, or
37.3%, for the comparable period in 2003. The increase in sales

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and marketing expense for the three months ended December 31, 2004 was the
result of increased compensation costs of approximately $1.0 million associated
with the increased sales and marketing headcount of approximately 23 incremental
sales and marketing staff.

General and Administrative Expense

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.

General and administrative expense for the three months ended December 31,
2004 was $6.9 million, or 11.3% of total revenue, compared to $4.8 million, or
10.2%, for the comparable period in 2003. The increase in general and
administrative expenses in 2004 is due primarily to increased salaries of
approximately $0.8 million, associated with increased headcount primarily in the
finance and human resource departments and recruiting costs. Professional fees
increased by approximately $0.6 million related to compliance with
Sarbanes-Oxley regulatory requirements. Additionally, facility related costs
increased by approximately $0.4 million, due to additional rental expense
associated with the LocusDialog acquisition which closed on December 19, 2003.

Amortization of Other Intangible Assets

Amortization of other intangible assets includes amortization of acquired
customer and contractual relationships, non-compete agreements and acquired
trade names and trademarks.

Amortization of other intangible assets for the three months ended December
31, 2004 was $0.7 million, or 1.1% of total revenue, compared to $0.9 million,
or 1.8%, for the comparable period in 2003. The decrease in amortization of
other intangible assets is attributable to $0.2 million of intangible assets
that became fully amortized during fiscal year 2003. During 2005, we expect
amortization of other intangible assets to be approximately $1.9 million based
on our current level of intangible assets, but excluding, intangible assets
associated with the ART and Phonetic acquisitions.

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.

Stock-based compensation expense was $0.7 million, or 1.2% of total
revenue, for the three months ended December 31, 2004, as compared to $0.2
million, or 0.5%, for the comparable period in 2003, respectively. The absolute
dollar increase of $0.5 million is directly attributed to increased non-cash
compensation expense associated with the granting of approximately 1.0 million
shares of restricted stock (or restricted stock purchase rights) subsequent to
October 1, 2003. We expect stock-based compensation expense to increase
significantly in fiscal 2005 due to the adoption of SFAS No. 123R, "Share-Based
Payment" which will be effective for our fourth quarter beginning July 1, 2005.

Restructuring and Other Charges, Net

During the three months ended December 31, 2004, we recorded a charge of
$0.7 million related to restructuring actions taken in our international
subsidiaries in connection with our recently announced acquisitions. We expect
these actions to continue for the remainder of fiscal 2005 as we integrate these
acquisitions.

During the three months ended December 31, 2003, we recorded a charge of
$0.6 million related to restructuring actions taken during the nine months ended
September 30, 2003. During the three months ended September 30, 2003, we
assessed our history of employee termination plans under the guidance of
Financial Accounting Standards No. 112 ("SFAS 112"), "Employers' Accounting for
Postemployment Benefits." As a result of this review, we determined that we had
an implied postemployment benefit plan and that future employee reduction
actions would no longer meet the requirements of Financial Accounting Standards
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No. 146 ("SFAS 146"), "Accounting for Costs Associated with Exit or Disposal
Activities." As a result, any future employee reductions will not be recorded as
a one-time charge, as allowed under SFAS 146, but will be recorded ratably over
the period of the announcement of such reduction events to the date each
employee ceases to provide services to the Company, as required under SFAS 112.

Income (Loss) from Operations

As a result of the above factors, income from operations was $6.1 million
for the three months ended December 31, 2004, or 10.1% of total revenue,
compared to income of $0.6 million, or 1.2%, for the comparable period in 2003.

Other Income (Expense), Net

Interest income was $0.1 million and $0.1 million for the three months
ended December 31, 2004 and 2003, respectively. Interest expense was $0.1
million and $0.4 million for the three months ended December 31, 2004 and 2003,
respectively. Other expense of $0.9 million for the three months ended December
31, 2004 consisted primarily of foreign currency losses of $1.0 million. These
losses include $0.5 million generated from international operations that do
business in foreign currencies other than their local currency and $0.5 million
related to translation of intercompany balances. For the three months ended
December 31, 2003, other income of $0.2 million consisted primarily of foreign
currency gains.

Income (Loss) Before Income Taxes

Income before income taxes was $5.2 million for the three months ended
December 31, 2004, or 8.6% of total revenue, compared with income of 0.6
million, or 1.2%, for the comparable period in 2003.

Income Taxes

The provision for income taxes for the three months ended December 31, 2004
was $2.1 million, or 3.4% of total revenue, compared to a tax benefit of $0.7
million, or 1.6%, in the comparable period for 2003. The provision for income
taxes consists primarily of a foreign taxes relating to international operations
and US alternative minimum taxes.

Net Income (Loss)

As a result of all of these factors, net income totaled $3.1 million, or
5.2% of total revenue for the three months ended December 31, 2004, compared
with income of $1.3 million, or 2.8% of total revenue, for the comparable period
in 2003.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2004, we had cash and cash equivalents of $41.3 million,
marketable securities of $1.5 million, long term marketable securities of $3.8
million and net working capital of $41.3 million as compared to cash and cash
equivalents of $23.0 million, marketable securities of $7.4 million, long term
marketable securities of $17.4 million and net working capital of $27.9 million
at September 30, 2004.

Net cash provided by operating activities for the three months ended
December 31, 2004 was $5.6 million, compared to $2.2 million for the comparable
period in 2003. Cash provided by operations in the 2004 period came primarily
from income from operations, after adjustments for non-cash amortization,
depreciation and stock based compensation, which was offset by a significant
increase in accounts receivable, offset by increases in accounts payables,
accrued expenses and deferred revenue. Cash provided by operations in the 2003
period came primarily from income from operations, after adjustments for
non-cash amortization and depreciation, which was offset by significant
increases in accounts receivable, offset by increases in accounts payables,
accrued expenses and deferred revenue.

Net cash provided by investing activities for the three months ended
December 31, 2004 was $11.9 million, compared to $0.3 million for the comparable
period in 2003. Net cash provided by investing
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activities during 2004 consisted of $19.5 million of gross sales and maturities
of marketable securities, which was offset by $0.8 million in capital
expenditures, and $6.7 million of payments associated with acquisitions. During
the period, no short-term or long-term marketable securities were purchased. Net
cash provided from investing activities during the 2003 period consisted of $1.2
million of cash received form the acquisition of LocusDialog and $0.6 million on
maturities of marketable securities, which was offset by $1.5 million in capital
expenditures.

Net cash used by financing activities for the three months ended December
31, 2004 was $0.1 million, compared to $7.6 million for the comparable period in
2003. Net cash used by financing activities during 2004 consisted of $0.2
million of payments on outstanding equipment lines of credit, $0.1 million of
purchases of treasury shares on net option exercises, which was offset by $0.2
million of cash received from the issuance of common stock in connection with
employee stock compensation plans. Net cash used by financing activities during
the three months ended December 31, 2003 consisted of the payment of $6.9
million of Philips related acquisition liabilities, $1.3 million of offering
costs associated with the issuance of common stock in our underwritten public
offering, $1.3 million for the purchase of treasury shares, $0.4 million in
payment to the former Caere President and CEO in connection with the settlement
of the non-competition and consulting agreement, and $0.3 million on outstanding
equipment lines of credit. These disbursements were offset by proceeds of $2.4
million from the issuance of common stock in connection with employee stock
compensation plans.

Although we generated $5.6 million and $2.2 million of cash from operations
during the three month period ended December 31, 2004 and 2003, respectively,
and exited the period ended December 31, 2004 with a cash and cash equivalents
balance of $41.3 million and marketable securities of $5.3 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. We sustained
recurring losses from operations in each reporting period through December 31,
2001. While we report net income of $3.1 million for the three months ended
December 31, 2004, we reported a net loss of $(9.4) million and $(5.5) million
for the nine months ended September 30, 2004, and the fiscal year ended December
31, 2003, respectively. We had an accumulated deficit of $158.7 million at
December 31, 2004.

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 certain long-term lease obligations that
begin to come due in the next 12-24 months. In connection with the ART
acquisition, we paid approximately $10.0 million at closing and agreed to pay
$16.5 million in December 2005. In connection with the Phonetic acquisition, we
paid $17.5 million at closing, and agreed to (i) pay $17.5 million 24 months
after closing, (ii) make contingent payments of up to an additional $35.0
million in cash, in 2006 through 2008 if at all, upon the achievement of certain
performance targets, and (iii) issue unvested warrants to purchase 750,000
shares of our common stock that will vest, if at all, upon the achievement of
certain performance targets. The cash consideration for these acquisitions is
expected to be provided by existing cash, marketable securities, cash generated
from operations, or debt or equity offerings. In connection with the Rhetorical
acquisition, we paid approximately $5.4 million in cash on December 6, 2004.

We believe that cash flows from future operations in addition to cash and
marketable securities on hand will be sufficient to meet our working capital,
investing, financing and contractual obligations, including the debt obligation
issued in connection with the Philips acquisition, lease obligations assumed in
the SpeechWorks acquisition, and cash obligations related to acquisitions
completed subsequent to the quarter end, as they become due for the foreseeable
future. We also believe that in the event future operating results are not as
planned, that we could take actions, including restructuring actions and other
cost reduction initiatives, to reduce operating expenses to levels which, in
combination with expected future revenues, will continue to generate sufficient
operating cash flow. In the event that these actions are not effective in
generating operating cash flows we may be required to issue equity or debt
securities on less than favorable terms.

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The following table outlines our contractual payment obligations as of
December 31, 2004:

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

(1) Excludes the impact of the Art Advanced Recognition Technologies, Inc.
("ART") and Phonetic Systems Ltd. ("Phonetic") acquisitions. In connection
with the ART acquisition, we paid approximately $10.0 million at closing and
agreed to pay $16.5 million in December 2005. In connection with the
Phonetic acquisition, we paid $17.5 million at closing and agreed to (i) pay
$17.5 million 24 months after closing, (ii) make a contingent payment of up
to an additional $35.0 million, if at all, upon the achievement of certain
performance targets, and (iii) issue unvested warrants to purchase 750,000
shares of our common stock that will vest, if at all, upon the achievement
of certain performance targets. The cash consideration for these
acquisitions is expected to be provided by existing cash, marketable
securities, cash generated from operations, or debt or equity offerings.
Excludes approximately $22.3 million in operating lease payments related to
office space in Burlington, Massachusetts.

Through December 31, 2004, 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.

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
expired on November 1, 2004. On November 1, 2004 we renewed this forward hedge
contract; the renewed contract has a one year term expiring on November 1, 2005;
however it is cancelable at our discretion.

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 original contract
expired on January 30, 2004, but was extended six months to October 29, 2004.
The contract was not extended and thereby terminated on October 29, 2004. We
realized a loss of approximately $0.2 million.

35

As of December 31, 2004, we have a $0.8 million liability related to these
contracts.

With our increased international presence in a number of geographic
locations and with international revenues projected to increase in 2005, 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.

RECENT 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 our financial position or results
of operations.

On December 16, 2004, the FASB issued FASB SFAS No. 123 (revised 2004),
Share-Based Payment, which is a revision of SFAS No. 123, Accounting for
Stock-Based Compensation. SFAS No. 123R supersedes APB Opinion No. 25,
Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of
Cash Flows. Generally, the approach in SFAS No. 123R is similar to the approach
described in SFAS No. 123. However, SFAS No. 123R requires all share-based
payments to employees, including grants of employee stock options, to be
recognized in the income statement based on their fair values. Pro forma
disclosure is no longer an alternative. The new standard will be effective, upon
us, beginning July 1, 2005. We have not yet completed our evaluation but we
expect the adoption to have a material effect on our consolidated financial
statements.

RISK FACTORS

You should carefully consider the risks described below when evaluating our
company and when deciding whether to invest in us. The risks described below are
not the only ones we face. 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 if any of these risks actually occurs. As a result, the trading
price of our common stock may decline and you can lose part or all of your
investment in our common stock.

RISKS RELATED TO OUR BUSINESS

Our operating results may fluctuate significantly from period to period,
and this may cause our stock price to decline. Our revenue and operating
results have fluctuated in the past and, and we expect our revenue and operating
results to continue to fluctuate in the future. Given this fluctuation, we
believe that quarter to quarter comparisons of our revenue and operating results
are not necessarily meaningful or an accurate indicator of our future
performance. As a result, our results of operations may not meet the
expectations of securities analysts or investors in the future. If this occurs,
the price of our stock would likely decline. Factors that contribute to
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;

- rapid shifts in demand for products given the highly cyclical nature of
the retail software industry;

- the loss of, or a significant curtailment of, purchases by any one or
more of our principal customers;

36

- concentration of operations with one manufacturing partner and ability to
control expenses related to the manufacture, packaging and shipping of
our boxed software products;

- customers delaying their purchasing decisions in anticipation of new
versions of products;

- customers delaying, canceling or limiting their purchases as a result of
the threat or results of terrorism;

- introduction of new products by us or our competitors;

- seasonality in purchasing patterns of our customers, where purchases tend
to slow in the fourth fiscal quarter;

- 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;

- write-offs of excess or obsolete inventory and accounts receivable that
are not collectible;

- increased expenditures incurred pursuing new product or market
opportunities;

- inability to adjust our operating expenses to compensate for shortfalls
in revenue against forecast; 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, and we may not be able to reduce our
expenses quickly to respond to a shortfall in projected revenue. Therefore, our
failure to meet revenue expectations would seriously harm our operating results,
financial condition and cash flows.

We have grown, and may continue to grow, through acquisitions, which could
dilute our existing shareholders and could involve substantial integration
risks. As part of our business strategy, we have in the past acquired, and
expect to continue to acquire, other businesses and technologies. In connection
with past acquisitions, we issued a substantial number of shares of our common
stock as transaction consideration. We may continue to issue equity securities
for future acquisitions that would dilute our existing stockholders, perhaps
significantly depending on the terms of the acquisition. We may also incur debt
in connection with future acquisitions, which, if available at all, may place
additional restrictions on our ability to operate our business. Furthermore, 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, our acquisition of
SpeechWorks International, Inc. and our acquisition of LocusDialog, Inc.
required substantial integration and management efforts. Our recently completed
acquisitions of Telelogue, Inc., Rhetorical Systems Ltd., ART Advanced
Recognition Technologies, Inc. and Phonetic Systems, Ltd. will likely 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;

- 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;
37

- 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.

We have a history of operating losses, and we may incur losses in the
future, which may require us to raise additional capital on unfavorable
terms. We sustained recurring losses from operations in each reporting period
through December 31, 2001. We reported net income of $3.1 million for the three
months ended December 31, 2004, and reported a net loss of $(9.4) million and
$(5.5) million for the nine month period ended September 30, 2004 and the twelve
months ended December 31, 2003, respectively. We had an accumulated deficit of
$158.7 million at December 31, 2004. If we are unable to maintain profitability,
the market price for our stock may decline, perhaps substantially. We cannot
assure you that our revenues will grow or that we will maintain profitability in
the future. If we do not maintain profitability, we may be required to raise
additional capital to maintain or grow our operations. The terms of any
additional capital, if available at all, may be highly dilutive to existing
investors or contain other unfavorable terms, such as a high interest rate and
restrictive covenants.

Purchase accounting treatment of our 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. Under accounting principles generally
accepted in the United States of America, we have accounted for our acquisitions
using the purchase method of accounting. Under purchase accounting, we record
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.

Sales of our dictation, document and PDF conversion products and our
digital paper management products represented approximately 22%, 17% and 11%, of
our revenue for the three months ended December 31, 2004 and 18%, 31% and 8%,
for the three months ended December 31, 2003, respectively, and any reduction in
revenue from these product areas could seriously harm our
business. Historically, a small number of product areas have generated a
substantial portion of our revenues. For the three months ended December 31,
2004, our dictation products represented 22% of our consolidated revenue,
document and PDF conversion products represented approximately 17% of our
consolidated revenue and our digital paper management products represented
approximately 11% of our consolidated revenue. For the three months ended
December 31, 2003, our dictation products represented 18% of consolidated
revenues, document and PDF conversion products represented approximately 31% of
our consolidated revenue and our digital paper management products represented
approximately 8% of our consolidated revenue. A significant reduction in the
revenue contribution in absolute dollars from these product areas could
seriously harm our business, results of operations, financial condition, cash
flows and stock price.

We rely on a small number of distribution and fulfillment partners,
including 1450, Digital River and, Ingram Micro, to distribute many of our
products, and any adverse change in our relationship with such partners may
adversely impact our ability to deliver products. 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 and Ingram Micro to serve
this network of channel partners. For the three months ended December 31, 2004,
two distribution and fulfillment partners, Ingram Micro and Digital River,
accounted for 10% and 11% of our consolidated revenue, respectively. For the
three months ended December 31, 2003, Ingram Micro and Digital River, accounted
for 14% and 13% of our consolidated revenue, respectively. A
38

disruption in these distribution and fulfillment partner relationships could
negatively affect our ability to deliver products, and hence our results of
operations in the short term. Any prolonged disruption for which we are unable
to arrange alternative fulfillment capabilities could have a more sustained
adverse impact on our results of operations.

A significant portion of our accounts receivable is concentrated among our
largest customers, and non-payment by any of them would adversely affect our
financial condition. 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 or other form of
security from our major customers to secure payment. While, to date, losses due
to non-payment from customers have been within our expectations, we cannot
assure you that instances or extent of non-payment will not increase in the
future. At December 31, 2004, Ingram Micro and Digital River represented 12% and
6%, of our net accounts receivable, respectively. At September 30, 2004, no one
customer represented 10% of our net accounts receivable. If these or any of our
other significant customers 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.

Speech technologies may not achieve widespread acceptance by businesses,
which could limit our ability to grow our speech business. We have invested and
expect to continue to invest heavily in the acquisition, development and
marketing of speech technologies. 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:

- consumer demand for speech-enabled applications;

- development by third-party vendors of applications using speech
technologies; and

- continuous improvement in speech technology.

Sales of our speech products would be harmed if the market for speech
software does not continue to develop or develops more slowly than we expect,
and, consequently, our business could be harmed and we may not recover the costs
associated with our investment in our speech technologies.

The markets in which we operate are highly competitive and rapidly
changing, and we may be unable to compete successfully. There are a number of
companies that develop or may develop products that compete in our targeted
markets. The individual markets in which we compete are highly competitive, and
are rapidly changing. Within imaging, we compete directly with ABBYY, Adobe,
I.R.I.S. and NewSoft. Within speech, we compete with AT&T, Fonix, IBM,
Microsoft, Nuance and Philips. In speech, some of our partners such as Avaya,
Cisco, Edify, Genesys and Nortel develop and market products that can be
considered substitutes for our solutions. In addition, a number of smaller
companies in both speech and imaging 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 license or the prices we can
charge. Some of our current or potential competitors, such as Adobe, IBM and
Microsoft, 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.

Some of our customers, such as IBM and 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.

39

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 if we are unable to realize synergies among our acquired
products and technologies, our business will suffer.

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 2004 year-end audit could harm our business. In connection with their
audit of our 2004 consolidated financial statements, BDO Seidman, LLP, our
independent registered public accounting firm advised management and our Audit
Committee of the following significant deficiencies which do not individually or
in the aggregate raise to the level of material weakness: The Company lacks the
necessary corporate accounting resources to ensure consistently complete and
accurate reporting of financial information which, when combined with the
Company's need to realign and cross-train current finance and accounting
personnel, has led to a dependence on key personnel in the organization, the
loss of whom could impair the Company's ability to ensure consistently complete
and accurate financial reporting. In certain circumstances the Company's
accounting transactions, including related judgments and estimates, were not
always supported in a timely manner by a sufficiently formal processes or
sufficiently comprehensive documentation.

In the third quarter of 2003, we commenced our Section 404 of the
Sarbanes-Oxley Act compliance efforts. During 2004, we deployed Oracle 11i to
process and report all of our general accounting functions in our three major
locations (Peabody, Massachusetts, Belgium and Hungary). During 2005, we will
implement additional modules to continue to enhance the functionality of our
Oracle implementation. We are also currently in the process of augmenting
current processes, repositioning current finance and accounting personnel and
recruiting additional personnel to ensure consistently complete and accurate
reporting of financial information and to reduce our dependence on key personnel
in our finance and accounting organization. We currently expect these efforts to
extend into the second half of fiscal 2005. While we believe that these actions
will address the conditions raised by BDO, we have been and will continue to be
required to devote substantial resources to these activities during 2005.
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, particularly given the added requirements associated with the
integration of our recently completed acquisitions of Telelogue, Inc.,
Rhetorical Systems Ltd., and ART Advanced Recognition Technologies, Inc. and
Phonetic Systems Ltd., further accelerated filing deadlines mandated by the SEC
and the requirements of Section 404 of the Sarbanes-Oxley Act.

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 license
our products worldwide, our business is subject to risks associated with doing
business internationally. We anticipate that revenue from international
operations will represent an increasing portion of our total revenue. Reported
international revenue for the three months ended December 31, 2004 and 2003,
represented 31% and 30% of our consolidated revenue for those periods,
respectively. Most of these international revenues are generated by sales in
Europe and Asia. 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 imaging research and development is conducted in
Hungary. In connection with the Philips acquisition, we added an additional
research and development location in Germany, and in connection with the
acquisition of Locus Dialog, we added an additional research and development
location in Montreal, Canada. Accordingly, 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 economic conditions;

- geopolitical turmoil, including terrorism and war;

40

- trade protection measures and import or export licensing requirements
imposed by the United States or by other countries;

- compliance with foreign and domestic laws and regulations;

- negative consequences from changes in applicable tax laws;

- difficulties in staffing and managing operations in multiple locations in
many countries;

- difficulties in collecting trade accounts receivable in other countries;
and

- less effective protection of intellectual property.

We are exposed to fluctuations in foreign currency exchange rates. Because
we have international subsidiaries and distributors that operate and sell our
products outside the United States, we are exposed to the risk of changes in
foreign currency exchange rates or declining economic conditions in these
countries. 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 fiscal 2005, 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.

RISKS RELATED TO OUR INTELLECTUAL PROPERTY AND TECHNOLOGY

Unauthorized use of our proprietary technology and intellectual property
will adversely affect our business and results of operations. Our success and
competitive position depend in large part on our ability to obtain and maintain
intellectual property rights protecting our products and services. We rely on a
combination of patents, copyrights, trademarks, service marks, trade secrets,
confidentiality provisions and licensing arrangements to establish and protect
our intellectual property and proprietary rights. Unauthorized parties may
attempt to copy aspects of our products or to obtain, license, sell or otherwise
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 and that do not
infringe our rights. In these cases, we would be unable to prevent our
competitors from selling or licensing these similar or superior technologies. 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.

41

Third parties have claimed and may claim in the future that we are
infringing their intellectual property, and we could be exposed to significant
litigation or licensing expenses or be prevented from selling our products if
such claims are successful. 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 September 9, 2004, BIS Advanced Software Systems, Ltd. ("BIS") filed an
action against us in the United States District Court for the District of
Massachusetts claiming patent infringement. Damages are sought in an unspecified
amount. In the lawsuit, BIS alleges that the Company is infringing United States
Patent No. 6,401,239 entitled "System and Method for Quick Downloading of
Electronic Files." We filed an Answer and Counterclaims on December 22, 2004. We
believe this claim has no merit, and we intend to defend the action vigorously.

On August 5, 2004, Compression Labs, Inc. filed an action against us in the
United States District Court for the Eastern District of Texas claiming patent
infringement. Damages are sought in an unspecified amount. In the lawsuit,
Compression Labs alleges that we are infringing United States Patent No.
4,698,672 entitled "Coding System for Reducing Redundancy." We believe this
claim has no merit, and we intend to defend the action vigorously.

On April 23, 2004, Millennium L.P. filed an action against us in the United
States District Court for the Southern District of New York claiming patent
infringement. Damages are sought in an unspecified amount. In the lawsuit,
Millennium alleges that we are infringing United States Patent No. 5,258,855
entitled "Information Processing Methodology"; No. 5,369,508 entitled
"Information Processing Methodology"; No. 5,625,465 entitled "Information
Processing Methodology"; No. 5,768,416 entitled "Information Processing
Methodology"; and No. 6,094,505 entitled "Information Processing Methodology."
We filed an Answer on June 17, 2004. We believe this claim has no merit, and we
intend to defend the action vigorously.

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. In the lawsuit, AllVoice alleges that we are infringing
United States Patent No. 5,799,273 entitled "Automated Proofreading Using
Interface Linking Recognized Words to their Audio Data While Text is Being
Changed" (the "273 Patent"). The "273 Patent generally discloses techniques for
manipulating audio data associated with text generated by a speech recognition
engine. Although we has several products in the speech recognition technology
field, we believe that our 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. We filed an Answer on December 23, 2002. 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
42

successful, the litigation could require significant management time and could
be costly. Should we not prevail in these litigation matters, we may be unable
to sell and/or license certain of our technologies we consider to be
proprietary, and our operating results, financial position and cash flows could
be adversely impacted.

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 may also
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 reputation, financial results and
competitive position.

RISKS RELATED TO OUR CORPORATE STRUCTURE, ORGANIZATION AND COMMON STOCK

The holdings of our two largest stockholders may enable them to influence
matters requiring stockholder approval. On March 19, 2004, Warburg Pincus, a
global private equity firm agreed to purchase all outstanding shares of our
stock held by Xerox Corporation for approximately $80 million. As of December
31, 2004, Warburg Pincus beneficially owned approximately 11.5% of our
outstanding common stock, including warrants exercisable for up to 3,025,732
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 State of Wisconsin Investment Board ("SWIB") is our second largest
stockholder, owning approximately 8.5% of our common stock as of December 31,
2004. Because of their large holdings of our capital stock relative to other
stockholders, Warburg Pincus and SWIB, acting individually or together, 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 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 certificate of incorporation, bylaws and

43

Delaware law, as well as other organizational documents 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 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

EXCHANGE RATE SENSITIVITY

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 were 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 had a
one-year term that expired on November 1, 2004. On November 1, 2004, we renewed
this forward hedge contract. The renewed contract has a one year term expiring
on November 1, 2005; however it is cancelable at our discretion.

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 original contract
expired on January 30, 2004, but was extended six months to October 29, 2004.
The contract was not extended and thereby terminated on October 29, 2004. We
realized a loss of approximately $0.2 million.

As of December 31, 2004, we have a $0.8 million liability related to these
contracts.

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,

44

changes in foreign currency exchange rates should not expose us to significant
losses in earnings or net cash outflows when exposures are properly hedged, but
could have an adverse impact on liquidity.

INTEREST RATE SENSITIVITY

We are exposed to interest rate risk as a result of our significant cash
and cash equivalent and short and long-term marketable securities holdings. The
rate of return that we may be able to obtain on investment securities will
depend on market conditions at the time we make these investments and may differ
from the rates we have secured in the past.

At December 31, 2004, we held $41.3 million of cash and cash equivalents,
$1.5 million of short-term marketable securities and $3.8 million of long-term
marketable securities. Our cash and cash equivalents consist primarily of cash
and money-market funds and our short-term and long-term marketable securities
consist primarily of government agency and corporate securities. Due to the low
current market yields and relatively short-term nature of our investments, a
hypothetical increase in market rates is not expected to have a material effect
on the fair value of our portfolio or results of operations.

ITEM 4. 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, 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.

On January 21, 2005, we closed our acquisition of ART Advanced Recognition
Technologies, Inc. We reported the signing of the definitive agreement for this
acquisition in November 2004 on a Form 8-K within four business days of the
event and issued a press release announcing the closing of the transaction on
January 24, 2005, the next business day following such closing. However, we
inadvertently did not file a Form 8-K incorporating this previously announced
information regarding the closing on a timely basis. We have taken steps
intended to ensure that the closing of future acquisitions and dispositions that
require the filing of a Form 8-K are so reported on a timely basis.

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
discussed below.

In connection with their audit of our 2004 consolidated financial
statements, BDO Seidman, LLP, our independent registered public accounting firm,
advised management and our Audit Committee of the following significant
deficiencies which did not individually or in the aggregate raise to the level
of material weakness: The Company lacks the necessary corporate accounting
resources to ensure consistently complete and accurate reporting of financial
information which, when combined with the Company's need to realign and
cross-train current finance and accounting personnel, has led to a dependence on
key personnel in the organization, the loss of whom could impair the Company's
ability to ensure consistently complete and accurate financial reporting. In
certain circumstances the Company's accounting transactions, including related
judgments and estimates, were not always supported in a timely manner by a
sufficiently formal processes or sufficiently comprehensive documentation.

In the third quarter of 2003, we commenced our Section 404 compliance
efforts. During 2004, we deployed Oracle 11i to process and report all of our
general accounting functions in our three major locations (Peabody,
Massachusetts, Belgium and Hungary). During 2005, we will implement additional
modules to

45

continue to enhance the functionality of our Oracle implementation. We are also
currently in the process of augmenting current processes, repositioning current
finance and accounting personnel and recruiting additional personnel to ensure
consistently complete and accurate reporting of financial information and to
reduce our dependence on key personnel in our finance and accounting
organization. We currently expect these efforts to extend into the second half
of fiscal 2005. We believe that these efforts will address the conditions raised
by BDO Seidman, LLP.

To the knowledge of our Chief Executive Officer and Chief Financial
Officer, our financial statements and other financial information included in
this report fairly present in all material respects our financial condition as
of the periods ended presented in this report and our results of operations and
cash close for the periods presented in this report.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

This information included in Note 8 of the Notes to Consolidated Financial
Statements is incorporated herein by reference from Item 1 of Part I hereof.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

During the three months ended December 31, 2004, we 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 Regulation 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.

On December 6, 2004, in connection with the acquisition of Rhetorical
Systems Ltd., certain shareholders of Rhetorical were issued 449,437 shares of
ScanSoft 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.

On November 15, 2004, in connection with the acquisition of Phonetics
Systems, Ltd., we issued unvested warrants to purchase up to 750,000 shares of
ScanSoft common stock at an exercise price of $4.46 per share that will vest, if
at all, upon the achievement of certain performance targets. We relied upon
Section 4(2) of the Securities Act, and Regulation S promulgated thereunder, in
connection with the issuance of the warrants, and appropriate legends were
affixed to the warrants issued in the transaction.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

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

None.

ITEM 5. OTHER INFORMATION

The Annual Meeting of Stockholders will be held at the Company's corporate
headquarters, 9 Centennial Drive, Peabody, Massachusetts 01960, on March 14,
2005 at 9:00 a.m., local time. Stockholders of record as of the close of
business on January 14, 2005 will receive notice of the meeting.

ITEM 6. EXHIBITS

The exhibits listed on the Exhibit Index hereto are filed or incorporated
by reference (as stated therein) as part of this report on Form 10-Q.

46

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report on Form 10-Q to be signed on its behalf
by the undersigned, thereunto duly authorized, in the City of Peabody, State of
Massachusetts, on February 9, 2005.

Scansoft, Inc.

By: /s/ James R. Arnold, Jr.
------------------------------------
James R. Arnold, Jr.
Chief Financial Officer

47

EXHIBIT INDEX

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

** Denotes Management compensatory plan or arrangement.

(1) Incorporated by reference from the Registrant's Current Report on Form 8-K
filed with the Commission on November 18, 2004.

(2) 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.

(3) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the fiscal quarter ended June 30, 2004, filed with the Commission
on August 9, 2004.

(4) Incorporated by reference from the Registrant's Annual Report on Form 10-K
for the fiscal year ended December 31, 2003, filed with the Commission on
March 15, 2004.

(5) Incorporated by reference from the Registrant's Current Report on Form 8-K
filed with the Commission on November 2, 2004.