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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

Commission file number 0-27038

SCANSOFT, INC.

(Exact name of registrant as specified in its charter)

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 þ          No o

      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 þ          No o

      106,637,095 shares of the registrant’s Common Stock, $0.001 par value, were outstanding as of April 30, 2005.

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SCANSOFT, INC.

FORM 10-Q

THREE AND SIX MONTHS ENDED MARCH 31, 2005

INDEX

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.

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.

SCANSOFT, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

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

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

      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 March 31, 2005, the results of operations for the three and six month periods ended March 31, 2005 and 2004, and cash flows for the six month periods ended March 31, 2005 and 2004. 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 and six month periods ended March 31, 2005 are not necessarily indicative of the results that may be expected for the year ending September 30, 2005, or any future period.

      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.

      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, valuation 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 instruments, evaluation of 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.

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

      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

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 gains (losses) totaling $0.4 million and $(0.7) million for the three and six month periods ended March 31, 2005, respectively. Net foreign currency transaction and other translation gains were $0.0 million and $0.4 million for the three and six month periods ended March 31, 2004, respectively.

      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.

      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.

      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, the SEC Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition, the Emerging Issues Task Force (“EITF”) Issue No. 01-09, Accounting for Consideration Given by a Vendor (Including a Reseller of the Vendors Products), and Statement of Financial Accounting Standards (“SFAS”) No. 48, Revenue Recognition when Right of Return Exists.

      In general, the Company recognizes revenue when all of the following conditions are satisfied: (1) persuasive evidence of an arrangement exists; (2) the delivery or performance of the service has occurred; (3) the fee is fixed or determinable; and (4) the collection of the fees is probable. The Company reduces 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 distributors and resellers to form a basis in order to estimate the future sales returns by distributors and resellers. As a result, the Company recognizes revenue from sales to these distributors and resellers when the distributors and resellers 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

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

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.

      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 SFAS No. 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 Vendor Specific Objective Evidence (“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, a maintenance and support arrangement, and professional services not considered essential to the functionality of the software. In those arrangements, the total contract value is attributed first to the undelivered elements of maintenance and support and professional services based on 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

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:

      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, ground transportation, hotel stays, and out-of-town meals.

      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 month period ended March 31, 2005, the Company settled a 3.5 million euro hedge contract which resulted in $0.4 million of cash that had been placed in escrow being released to the bank. The Company also settled a dispute with one of its vendors, which resulted in the release of $0.5 million that had been placed in escrow. Of this amount, $0.4 million was released to the vendor and $0.1 million was returned to the Company. As of March 31, 2005, the Company did not have any cash amounts in escrow.

      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 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 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.

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

      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 the Company considers important, which could trigger an impairment of such assets, include the following:

      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.

      In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, ScanSoft performs an annual impairment analysis of goodwill. During the last quarter of fiscal 2004, the Company performed its annual assessment and determined that no impairment of goodwill existed. The Company completes a goodwill impairment analysis at least annually, or more frequently when events and circumstances occur indicating that the recorded goodwill might be impaired.

      The Company has determined that it operates in one reporting unit. As a result, 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. 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.

      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, future acquisitions, 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 aggregation or disaggregation 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.

      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

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

estimated useful life of the related products. In the three and six month periods ended March 31, 2005 and 2004, costs eligible for capitalization were not material.

      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 any capitalized costs in the period the change is determined. As of March 31, 2005 and September 30, 2004, capitalized patent defense costs totaled $1.1 million and $0.5 million, respectively.

      The Company capitalizes development costs of software for internal use pursuant to SOP 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. As of March 31, 2005 and September 30, 2004, the Company had capitalized costs of $2.6 million and $2.3 million, respectively, related to internal financial systems of which a portion of the cost for modules not yet deployed have been included in construction in process.

      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, which would be recorded through goodwill, and tax-deductible stock-based compensation, for which no expense for book purposes was recognized, which would be recorded through equity.

      Comprehensive income (loss) for the three and six month periods ended March 31, 2005 and 2004 consists of net income, adjustments to shareholders’ equity for the foreign currency translation adjustment, and net unrealized gains (losses) on marketable securities. For the purposes of comprehensive income disclosures, the Company does not record tax provisions or benefits for the net changes in the foreign currency translation adjustment, as the Company intends to permanently reinvest undistributed earnings in its foreign subsidiaries.

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

      Following is our comprehensive income (loss) (in thousands):

      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 March 31, 2005 and September 30, 2004, no customer represented greater than 10% of the Company’s net accounts receivable balance.

      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 March 31, 2005 and September 30, 2004.

      The Company accounts for its marketable equity securities in accordance with SFAS No. 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 March 31, 2005, the stated maturities of the Company’s investments are $2.7 million within one year and $1.2 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, which have been included in results of operations, have not been material. During the three month period ended March 31, 2005, no short-term or long-term marketable securities were purchased.

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

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

      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 month periods ended March 31, 2005 and 2004, and the six month period ended March 31, 2004 all potentially dilutive common shares were excluded from the computation of net income per share, because they are antidilutive. For the six month period ended March 31, 2005, 15,714,721 potentially dilutive common shares were excluded from the computation of net income per share because they were antidilutive.

      Below is a detailed computation of net income per share. As noted in Note 9, the Series B Preferred stock is a participating security, and 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

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

the three and six month periods ended March 31, 2005 and 2004, respectively (in thousands, except per share data):

      Stock options to purchase 2.5 million, 5.2 million, and 5.6 million shares of common stock were not included in the calculation of diluted net loss per share for the three months ended March 31, 2005 and 2004, and the six months ended March 31, 2004, respectively, because they were antidilutive.

      Potential weighted-average common shares, including stock options, unvested restricted stock, unvested stock purchase units, preferred shares, convertible debt and warrants for the three months ended March 31, 2005 and 2004, and the six months ended March 31, 2004 were 11.3 million, 14.1 million, and 14.5 million shares, respectively. These potential common shares were excluded from the calculation of diluted net loss per share as their inclusion would have been antidilutive for the period presented.

      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 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

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

the period in which the restrictions lapse. All stock-based awards to non-employees are accounted for at their fair value in accordance with SFAS No. 123 and related interpretations.

      Had compensation expense for the Company’s stock-based compensation plans been determined based on fair market value at the grant dates, as prescribed by SFAS No. 123, the Company’s net 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 SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 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 indefinitely 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.

      On December 16, 2004, the FASB issued 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. SFAS No. 123R was originally effective as of the beginning of the first interim or annual reporting period beginning after June 15, 2005, however SFAS No. 123R has been deferred. SFAS No. 123R is now effective for the first fiscal year beginning after June 15, 2005. As a result, the new standard will be

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

effective for the Company beginning October 1, 2005. The Company has not yet completed its evaluation but expects the adoption to have a material effect on its consolidated financial statements.

      Accounts receivable consist of the following:

      Unbilled accounts receivable primarily relate 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.

      On February 1, 2005, the Company acquired all of the outstanding capital stock of Phonetic Systems Ltd. (Phonetic), an Israeli corporation. Phonetic provides ScanSoft with an array of technology, customer, partner and employee resources to help fuel its growth and accelerate its deployment of high quality speech applications throughout the world.

      The consideration consisted of cash payments to be rendered in the following installments: (1) seventeen million and five hundred thousand dollars ($17.5 million), adjusted for any difference between estimated and actual closing costs, paid at closing; (2) seventeen million and five hundred thousand dollars ($17.5 million) to be paid in February 2007; and (3) up to an additional thirty five million ($35.0 million) upon the achievement of certain milestones. The total initial purchase price of approximately $36.1 million includes the sum of the first installment ($17.3 million, adjusted for additional closing costs of $0.2 million), the present value of the second installment ($15.6 million assuming an annual market rate of interest of 5.75%), cash paid out related to the proceeds from the employees issuance of stock options totaling $0.4 million, the estimated transaction costs of $2.4 million, and the fair value of warrants of $0.4 million (valued using the Black-Scholes model assuming a life of 5 years) to purchase up to 750,000 shares of ScanSoft common stock (Note 9).

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

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

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

      Current assets acquired primarily relate to cash, accounts receivable, and inventory. Current liabilities assumed primarily relate to accounts payable, accrued severance costs, and deferred revenue.

      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 $33.9 million. In accordance SFAS No. 142, the goodwill is not being amortized and will be tested for impairment as required at least annually.

      On January 21, 2005, the Company acquired all of the outstanding capital stock of ART Advanced Recognition Technologies, Inc. (ART). With the acquisition of ART, ScanSoft 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. ART specializes in applications that create voice-

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

based, conversational interfaces that enable users to dial by voice and manage and access their contacts for mobile devices.

      The consideration consisted of cash payments to be rendered in two installments: (1) ten million dollars ($10.0 million) paid at closing; and (2) sixteen million four hundred fourteen thousand dollars ($16.4 million) to be paid in December 2005 plus interest of 4%. The initial purchase price of approximately $28.0 million includes the sum of the first and second installment payments totaling $26.4 million and estimated transaction costs of $1.6 million.

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

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

      Current assets acquired primarily relate to cash and accounts receivable. Other assets include prepaid insurance. Current liabilities assumed primarily relate to accounts payable, accrued expenses and accrued severance costs.

      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 $13.1 million. In accordance SFAS No. 142, the goodwill is not being amortized and will be tested for impairment as required at least annually.

SCANSOFT, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

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

      With the acquisition of Rhetorical, 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 2.8 million Pounds Sterling in cash ($5.4 million) and 449,437 shares of ScanSoft common stock (valued at approximately $1.7 million 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 $8.5 million also includes estimated transaction costs of $1.4 million.

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

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

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

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      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 SFAS No. 142, the goodwill is not being amortized and will be tested for impairment as required at least annually.

      On September 16, 2004, the Company acquired Brand & Groeber Communications GBR (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 € 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 and was taxable to the shareholders.

      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.

      As of March 31, 2005, a total of approximately $0.3 million has been earned in accordance with the terms under the purchase agreement. This amount has been reflected as an increase in goodwill and other accrued liabilities. These amounts will be paid on July 29, 2005 in accordance with the terms and conditions of the purchase agreement.

      The results of operations of the acquired businesses have been included in the financial statements of the Company since the date of acquisition. The Company is still evaluating the facilities from its recent acquisitions to determine if there is excess capacity.

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      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 agreement and the first installment payment of $2.8 million due March 31, 2004 was paid in April 2004. The remaining payment of $2.8 million including interest of $0.2 million was paid in April 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. The payment made in April 2005, was classified as a current liability, deferred payment obligation for technology license, as of March 31, 2005.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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      Aggregate amortization expense was $3.7 million and $3.5 million for the three month periods ended March 31, 2005 and 2004, respectively. Of this amount, $2.7 million and $2.8 million was included in cost of revenue, respectively, and $1.0 million and $0.7 million was recorded in operating expenses, respectively. Aggregate amortization expense was $7.2 million and $7.4 million for the six month periods ended March 31, 2005 and 2004, respectively. Of this amount, $5.5 million and $5.9 million was included in cost of revenue, respectively, and $1.7 million and $1.5 million was recorded in operating expenses, respectively.

      Estimated amortization expense for each of the five succeeding fiscal years as of March 31, 2005 is as follows (in thousands):

      Accrued expenses consist of the following (in thousands):

      At March 31, 2005 and September 30, 2004, the remaining restructuring accrual from current and prior restructuring activities amounted to $0.3 million and $0.6 million, respectively. At March 31, 2005, the accrued restructuring amount consisted of $0.2 million of employee-related severance costs and $0.1 million of lease exit costs. At September 30, 2004, the accrued restructuring amount consisted of $0.4 million of employee-related severance costs, and $0.2 million of lease exit costs.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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

      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%, (5.75% at March 31, 2005), 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. During the quarter ended March 31, 2005, the Company completed another amendment to the Loan and Security Agreement. This amendment modified the terms under which the minimum adjusted quick ratio covenant is calculated. All other terms remained the same. As of March 31, 2005, the Company was in compliance with all covenants.

      As of March 31, 2005, no amounts were outstanding under the Credit Facility and $8.0 million was available for borrowing in addition to approximately $1.3 million committed under this line of credit for outstanding letters of credit. The Company can make no guarantees as to its ability to satisfy its future financial covenant calculations.

      In April 2005, the Company issued $4.5 million in letters of credit as security deposits for facility leases. The issuances of these letters of credit have reduced our availability under the credit facility to $3.5M. Both of these facilities have amortization provisions that will reduce the security deposits amounts over the term of the respective leases.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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      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 March 31, 2005, 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 (5.75% at March 31, 2005), 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 March 31, 2005, 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 March 31, 2005.

      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. None of the Company’s acquisitions have resulted in a Change in Control.

      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.

      As of March 31, 2005, the Company had pending litigation against American Future Technology Corp. (“AFT”) claiming copyright infringement and breach of contract. In accordance with SFAS No. 5, Accounting for Contingencies, the Company had previously not recorded any gain. On April 14, 2005, the

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Company agreed to a settlement with AFT to fully resolve the dispute. The terms of the settlement required AFT to pay a total of $0.9 million in three installment payments, which included the recovery of legal expenses. The first two installment payments, totaling $0.7 million were due and paid by April 30, 2005 and the final payment totaling $0.2 million is due by April 30, 2006. The Company concluded that the settlement was a type I subsequent event as defined by the AICPA Auditing Standards, AU Section 560, Subsequent Events. As a result, the Company recorded $0.3 million as a reduction to its legal expenses and $0.4 million in other income for the period ending March 31, 2005. Due to the long-term nature of the third payment the Company concluded that there remained uncertainty as to the collectibility of the payment and determined that income related to the final payment should be recognized on a cash basis.

      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 on defending 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 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 it intends on defending the action vigorously.

      On April 23, 2004, Millennium L.P. filed an action against the Company in the United States 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 the Company is 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. 5,678,416 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 on defending 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. The Company believes these claims have no merit, and it intends on defending 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 the Company has several products in the speech recognition technology field, it believes that its products do not infringe the “273 Patent. Damages are sought in an unspecified amount. The Company filed an Answer on December 23, 2002. On January 4, 2005, the case was transferred to a new judge of the United States District Court for the Southern District of Texas for administrative reasons. The new

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judge placed the action on an accelerated track and set a trial date for later this year. The Company believes that it has meritorious defenses and it intends on defending itself 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 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.

      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.

      On January 21, 2005, the Company, as tenant, entered into a lease with Wayside Realty Trust (“Wayside”), as landlord (the “Lease”). Pursuant to the lease, the Company will lease 88,423 square feet of office space, in Burlington, MA, for an initial term of ten years beginning on June 1, 2005. Rent payments will be paid monthly and in advance. The lease provides for escalating rent payments, which the Company will record as rent expense on a straight line basis over the term of the lease. Under the terms of the Lease, the Company is also required to pay utilities, property taxes, and other operating and maintenance expenses relating to the leased facilities. As a security deposit for the Company’s obligations under the Lease, in April 2005, the Company delivered to Wayside a letter of credit in the amount of $3.3 million. On each successive anniversary of the term commencement date, the letter of credit will be reduced by 10% until the security deposit total has been reduced to $1.8 million. On the eighth anniversary of the term commencement date, the security deposit will be reduced to $1.3 million, and shall continue as such throughout the remainder of the lease term.

      In accordance with the provisions of FASB Interpretation (“FIN”) No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, the

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following table represents the deferred revenue activity related to the Company’s obligations under maintenance and support contracts for the three month period ended March 31, 2005 (in thousands):

      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 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.

      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 occurred upon closing of the acquisition on February 1, 2005, and was 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 4 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,

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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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.

      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 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.

      As of March 31, 2005 and September 30, 2004, the Company had repurchased a total of 2,801,434 and 2,771,505 common shares under this and previous repurchase programs, respectively. For the three and six month periods ended March 31, 2005, the Company repurchased 24,402 and 29,929 shares of common stock at a cost of $0.1 million and $0.1 million, respectively, to cover employee’s tax obligations related to vesting of restricted stock. The Company intends to use the repurchased shares for its employee stock plans and for potential future acquisitions.

      During the three month period ended March 31, 2005, the Company awarded net 125,315 restricted stock purchase units to certain senior executives and employees of the Company. As of March 31, 2005, there were 868,151 shares of restricted stock and 527,189 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

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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. Stock compensation expense for the three month periods ended March, 31, 2005 and 2004 was $0.7 million and $0.3 million, respectively, and for the six month periods ended March 31, 2005 and 2004, was $1.4 million and $0.5 million, respectively.

      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 (in thousands).

      For the three month period ended March 31, 2005 and 2004, one distribution and fulfillment partner, Ingram Micro accounted for 13% and 14% of the Company’s consolidated net revenues, respectively. For the six month period ended March 31, 2005, one distribution and fulfillment partner, Ingram Micro accounted for 12% of the Company’s consolidated net revenues, as compared to the same period of 2004 when two distribution and fulfillment partners, Ingram Micro and Digital River, accounted for 14% and 11% of consolidated net revenues, respectively.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

      The following table reflects unaudited pro forma results of operations of the Company assuming that the Telelogue, B&G, Rhetorical, ART, and Phonetic acquisitions had occurred on October 1, 2003 (in thousands, except per share data):