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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended September 30, 2004

Commission File No. 0-13442

MENTOR GRAPHICS CORPORATION

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (503) 685-7000

NO CHANGE

(Former name, former address and former fiscal year, if changed since last report)

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 12b-2 of the Exchange Act).    Yes  x    No  ¨

Number of shares of common stock, no par value, outstanding as of November 1, 2004: 76,332,032

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MENTOR GRAPHICS CORPORATION

Index to Form 10-Q

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Mentor Graphics Corporation

Condensed Consolidated Statements of Operations

(Unaudited)

See accompanying notes to unaudited consolidated financial statements.

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Mentor Graphics Corporation

Condensed Consolidated Statements of Operations

(Unaudited)

See accompanying notes to unaudited consolidated financial statements.

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Mentor Graphics Corporation

Condensed Consolidated Balance Sheets

(Unaudited)

See accompanying notes to unaudited consolidated financial statements.

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Mentor Graphics Corporation

Condensed Consolidated Statements of Cash Flows

(Unaudited)

See accompanying notes to unaudited consolidated financial statements.

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MENTOR GRAPHICS CORPORATION

Notes to Unaudited Condensed Consolidated Financial Statements

(In thousands, except per share amounts)

The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Principles of Consolidation

The condensed consolidated financial statements include the financial statements of the Company and its wholly owned and majority-owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation.

The Company does not have off-balance sheet arrangements, financings or other relationships with unconsolidated entities or other persons, also known as special purpose entities. In the ordinary course of business, the Company leases certain real properties, primarily field office facilities and equipment, as described in Note 13.

Reclassifications

Certain reclassifications have been made in the accompanying condensed consolidated financial statements for 2003 to conform to the 2004 presentation.

Revenue Recognition

The Company derives system and software revenue from the sale of licenses of software products and emulation hardware systems. The Company derives service and support revenue from annual support contracts and professional services, which includes consulting services, training services and other services.

For the sale of licenses of software products and related service and support, 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, Software Revenue Recognition, With Respect to Certain Transactions”. Revenue from perpetual license arrangements is recognized upon shipment, provided persuasive evidence of an arrangement exists, fees are fixed or determinable and collection is probable. Product revenue from term license installment agreements is recognized upon shipment and start of the license term, provided persuasive evidence of an arrangement exists, fees are fixed or determinable and collection is probable. The Company uses term license installment agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. In a term license agreement in which the Company provides the customer with rights to unspecified or unreleased future products, revenue is recognized ratably over the license term.

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The Company uses the residual method to recognize revenue when a license agreement includes one or more elements to be delivered at a future date if evidence of the fair value of all undelivered elements exists. If an undelivered element of the arrangement exists under the license arrangement, revenue is deferred based on vendor-specific objective evidence of the fair value of the undelivered element, as established by the price charged when such element is sold separately. If vendor-specific objective evidence of fair value does not exist for all undelivered elements, all revenue is deferred until sufficient evidence exists or all elements have been delivered.

Revenue from annual maintenance and support arrangements is deferred and recognized ratably over the term of the contract. Revenue from consulting and training is recognized when the services are performed.

For the sale of emulation hardware systems and related service and support, the Company recognizes revenue in accordance with SEC Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition”, which supercedes SAB No. 101, “Revenue Recognition in Financial Statements”. Revenue is recognized when the title and risk of loss have passed to the customer, there is persuasive evidence of an arrangement, delivery has occurred or services have been rendered, the sales price is fixed or determinable and collection is probable. When the terms of sale include customer acceptance provisions and compliance with those provisions cannot be demonstrated until customer use, revenue is recognized upon acceptance. A limited warranty is provided on emulation hardware systems generally for a period of ninety days. The Company maintains an accrued warranty reserve to provide for these potential future costs and evaluates its adequacy on a quarterly basis. Service and maintenance revenues are recognized over the service period.

Accounting for Stock-Based Compensation

Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” defines a fair value based method of accounting for employee stock options and similar equity instruments. As is permitted under SFAS No. 123, the Company has elected to continue to account for its stock-based compensation plans under Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company has computed, for pro forma disclosure purposes, the value of all stock-based awards granted during the three months and nine months ended September 30, 2004 and 2003 using the Black-Scholes option pricing model as prescribed by SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” using the following assumptions:

The Company used expected volatility to estimate volatility for options granted during the three months and nine months ended September 30, 2004, and considers expected volatility to be more representative of prospective trends. Expected volatility is based on the option feature embedded in the Company’s convertible subordinated debentures (see Note 5), which is comparable to employee stock options. In prior years, the Company used historical volatility. Using the Black-Scholes methodology, weighted average fair value of options granted was $4.59 and $10.35 per share during the three months ended September 30, 2004 and 2003, respectively, and $5.90 and $6.98 per share during the nine months ended September 30, 2004 and 2003, respectively. The weighted average estimated fair value of purchase rights under the ESPPs was $2.64 and $2.13 during the three months ended September 30, 2004 and 2003, respectively, and $1.98 and $1.86 during the nine months ended September 30, 2004 and 2003, respectively.

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Other than with respect to options assumed through acquisitions, no stock-based employee compensation cost is reflected in net income, as all options granted under the Company’s Stock Option Plans have an exercise price equal to the market value of the underlying common stock on the date of grant and the ESPPs are considered noncompensatory under APB Opinion No. 25. The Company recorded compensation expense for amortization of deferred compensation related to unvested stock options assumed through acquisitions of $374 and $512 for the three months ended September 30, 2004 and 2003, respectively, and $1,122 and $1,535 for the nine months ended September 30, 2004 and 2003, respectively. If the Company had accounted for its stock-based compensation plans in accordance with SFAS No. 123, the Company’s net loss and net loss per share would approximate the pro forma disclosures below:

The following provides the computation of basic and diluted net loss per share:

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Options and warrants to purchase 18,288 and 17,575 shares of common stock for the three months ended September 30, 2004 and 2003, respectively and 18,578 and 17,817 for the nine months ended September 30, 2004 and 2003, respectively, were not included in the computation of diluted earnings per share. The options and warrants were anti-dilutive either because the Company incurred a net loss or because the exercise price was greater than the average market price of the common shares for the respective periods. The effect of the conversion of the Company’s convertible subordinated notes for the three months and nine months ended September 30, 2004, was anti-dilutive. If the convertible subordinated notes had been dilutive, the Company’s net loss per share would have included additional earnings of $2,648 and $7,944 as well as additional incremental shares of 7,413 for the three months and nine months ended September 30, 2004, respectively. The shares issuable on conversion of the Company’s convertible subordinated debentures have been excluded from dilutive common shares, as the circumstances that allow for conversion were not met. If the circumstances had been met and such conversion had been dilutive, additional earnings of $847 and $2,384 and incremental shares of 4,700 would have been included for the three months and nine months ended September 30, 2004, respectively.

Other short-term borrowings include borrowings on multi-currency lines of credit, capital leases and other borrowings. Interest rates are generally based on the applicable country’s prime lending rate, depending on the currency borrowed. Other short-term borrowings of $9,257 and $6,910 were outstanding under these facilities at September 30, 2004 and December 31, 2003, respectively.

In June 2002 the Company issued $172,500 of 6 ⁷/8% Convertible Subordinated Notes (Notes) due 2007 in a private offering pursuant to SEC Rule 144A. The Notes have been registered with the SEC under the Securities Act of 1933. The Company pays interest on the Notes semi-annually in June and December. The Notes are convertible into the Company’s common stock at a conversion price of $23.27 per share, for a total of 7,413 shares. Some or all of the Notes may be redeemed by the Company for cash on or after June 20, 2005. The Notes rank pari passu with the Debentures.

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Other long-term notes payable include multi-currency notes payable and capital leases. Interest rates are generally based on the applicable country’s prime lending rate, depending on the currency borrowed. Other long-term notes payable of $2,717 and $4,268 were outstanding under these agreements at September 30, 2004 and December 31, 2003, respectively.

Excess leased facility costs of $1,240 primarily consist of adjustments to previously recorded non-cancelable lease payments for leases of facilities in North America and Europe. These adjustments are a result of reductions to the estimated expected sublease income primarily due to the real estate markets in which these facilities are located remaining at depressed levels longer than originally anticipated. Non-cancelable lease payments on these excess leased facilities should be expended over seven years. In addition to the excess leased facility costs, the Company recorded a $758 write-off of leasehold improvements for one of the facilities in North America.

The Company rebalanced its workforce by 41 employees during the nine months ended September 30, 2004. The reduction impacted several employee groups. Employee severance costs of $1,997 included severance benefits, notice pay and outplacement services. Termination benefits were communicated to the affected employees prior to the end of the quarter in which the charge was recorded. The majority of these costs were expended during the first nine months of 2004. There have been no significant modifications to the amount of these charges.

Other costs of $590 include costs incurred to restructure the organization other than employee rebalances and excess leased facility costs.

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In addition, the Company reversed $215 of the remaining accrual related to the emulation litigation with Cadence Design Systems, Inc.

For the nine months ended September 30, 2003, the Company recorded special charges of $26,575. These charges primarily consisted of costs incurred for the settlement of emulation litigation, an accrual for excess leased facility costs and costs incurred for employee terminations.

Cadence Design Systems, Inc. (Cadence) and the Company announced in September 2003 that they agreed to settle all outstanding litigation between the companies relating to emulation and acceleration systems. The companies also reached agreement that, for a period of seven years, neither will sue the other over patented emulation and acceleration technology. In connection with the settlement, the Company recorded emulation litigation settlement costs of $20,264, which included a cash settlement of $18,000 paid to Cadence, an accrual for expected costs to make available certain of its products to the OpenAccess computing environment as specified in the settlement agreement, and attorneys’ fees.

Excess leased facility costs of $4,487 primarily consist of adjustments to previously recorded non-cancelable lease payments for leases of three facilities in North America. These adjustments are a result of reductions to the estimated expected sublease income primarily due to the real estate markets in which these facilities are located remaining at depressed levels longer than originally anticipated. Non-cancelable lease payments on these excess leased facilities should be expended over seven years. In addition, the Company recorded non-cancelable lease payments for two facilities in North America. These facilities were permanently abandoned and the payments are net of estimated sublease income. Non-cancelable lease payments on these excess leased facilities should be expended within the next 12 months.

The Company rebalanced its workforce by 47 employees during the nine months ended September 30, 2003. This reduction impacted several employee groups. Employee severance costs of $1,594 included severance benefits, notice pay and outplacement services. Termination benefits were communicated to the affected employees prior to the end of the quarter in which the charge was recorded. The majority of these costs were expended during the first nine months of 2003. There have been no significant modifications to the amount of these charges.

Accrued special charges are included in accrued liabilities and other long-term liabilities on the consolidated balance sheets. The following table shows changes in accrued special charges during 2004:

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approximately 4,507 shares of the Company’s common stock, of which approximately 541 shares have been deposited in an indemnity escrow account. The shares were valued at the closing price of $11.00 per share as reported on The NASDAQ Stock Market on September 1, 2004. 0-In stockholders and certain employees will receive future contingent earn-out payments based on the Company’s revenues derived from 0-In products and technologies. The total purchase price including acquisition costs was $52,319. The Company recorded severance costs related to 0-In employees of $105 due to the overlap of employee skill sets as a result of the acquisition. In addition, the Company recorded costs for termination of a distributor contract of $282. The excess of tangible assets acquired over liabilities assumed was $715. The cost of the acquisition was allocated on the basis of the estimated fair value of assets and liabilities assumed. The purchase accounting allocations resulted in a charge for in-process research and development (R&D) of $6,400, goodwill of $39,357, technology of $4,400, other identified intangible assets of $5,990, net of related deferred tax liability of $4,156. The technology is being amortized to cost of revenues over three years. The other identified intangible assets are being amortized to operating expenses over two to five years.

Additionally, during the nine months ended September 30, 2004, the Company acquired (i) Project Technology Inc., (ii) the remaining 49% ownership interest of its Korean distributor, Mentor Korea Co. Ltd. (MGK) for a total ownership interest of 100%, and (iii) the parallel and serial ATA IP business division of Palmchip Corporation (Palmchip). The acquisitions were investments aimed at expanding the Company’s product offerings and increasing revenue growth. The aggregate purchase price including acquisition costs for these three acquisitions was $7,750. The aggregate excess of liabilities assumed over tangible assets acquired was $338. The minority interest recorded in connection with the original 51% ownership in MGK was $3,383, less dividends paid in prior years to minority shareholders of $1,975, reducing the acquisition cost to be allocated by a total of $1,408. The purchase accounting allocations resulted in a charge for in-process R&D of $1,250, goodwill of $3,610, technology of $1,050 and other identified intangible assets of $770. The technology is being amortized to cost of revenues over two to three years. The other identified intangible assets are being amortized to operating expenses over three years. In connection with the Palmchip acquisition, the Company concurrently licensed software to Palmchip under term licenses and entered into an agreement to provide services. Payment for these arrangements was incorporated into the purchase price of the acquisition and resulted in a reduction of cash paid to Palmchip of $1,208. The Company used an independent third party valuation firm to determine the allocation of the purchase price of these acquisitions.

The separate results of operations for the acquisitions for the nine months ended September 30, 2004 were not material compared to the Company’s overall results of operations and accordingly pro-forma financial statements of the combined entities have been omitted. The results of operations are included in the Company’s consolidated financial statements from the date of acquisition forward.

During the nine months ended September 30, 2003, the Company acquired (i) the Technology Licensing Group business of Alcatel (Alcatel), (ii) Translogic Polska Sp z o.o. (Translogic), (iii) the distributorship, Mentor Italia S.r.l. (Mentor Italia), (iv) the business and technology of DDE-EDA A/S (DDE), and (v) First Earth Limited. The acquisitions were investments aimed at expanding the Company’s product offering and increasing revenue growth. The aggregate purchase price including acquisition costs for these five acquisitions was $13,846. The aggregate excess of tangible assets acquired over liabilities assumed was $456. The purchase accounting allocations resulted in a charge for in-process research and development (R&D) of $1,710, goodwill of $7,230, technology of $3,910 and other identified intangible assets of $540. The technology is being amortized to cost of revenues over five years. The other identified intangible assets are being amortized to operating expenses over three years. In connection with the Alcatel acquisition, the Company concurrently licensed software to Alcatel under term licenses and entered into an agreement to provide services. Payment for these arrangements was incorporated into the purchase price of the acquisition and resulted in a reduction of cash paid to Alcatel of $3,804. The Company used an independent third party valuation firm to determine the allocation of the purchase price of these acquisitions.

In addition, during the three months ended June 30, 2003, the Company recorded a one-time charge to operations of $150 for the acquisition of the in-process R&D of New Design Paradigm, Limited, a developer and marketer of engineering-design software systems for the automotive and aerospace industries.

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The fair value of foreign currency forward and option contracts, recorded in prepaid expenses and other in the consolidated balance sheet, was $2,710 and $11 at September 30, 2004 and December 31, 2003, respectively.

The following provides a summary of activity in accumulated other comprehensive income relating to the Company’s hedging program:

The remaining balance in accumulated other comprehensive income at September 30, 2004 represents a net unrealized gain on foreign currency contracts relating to hedges of forecasted revenues and expenses expected to occur during 2004 and 2005. These amounts will be transferred to the consolidated statement of operations upon recognition of the related revenue and recording of the respective expenses. The Company expects substantially all of the balance in accumulated other comprehensive income to be reclassified to the consolidated statement of operations within the next year. The Company transferred a $897 deferred gain and a $443 deferred loss to system and software revenues relating to foreign currency contracts hedging revenues for the nine months ended September 30, 2004 and 2003, respectively. The Company transferred a $570 deferred loss and a $760 deferred gain to operating expenses relating to foreign currency contracts hedging commission and other expenses for the nine months ended September 30, 2004 and 2003, respectively.

The Company enters into foreign currency contracts to offset the earnings impact relating to the variability in exchange rates on certain short-term monetary assets and liabilities denominated in non-functional currencies. These foreign exchange contracts are not designated as hedges. Changes in the fair value of these contracts are recognized currently in earnings in other income, net to offset the remeasurement of the related assets and liabilities.

In accordance with SFAS No. 133, the Company excludes changes in fair value relating to time value of foreign currency contracts from its assessment of hedge effectiveness. The Company recorded income relating to time value in other income, net, of $352 and $109 for the three months ended September 30, 2004 and 2003, respectively, and $737 and $382 for the nine months ended September 30, 2004 and 2003,

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respectively. The Company recorded expense related to time value in interest expense of $137 and $188 for the three months ended September 30, 2004 and 2003, respectively, and $375 and $519 for the nine months ended September 30, 2004 and 2003, respectively.

The Company has not provided for United States income taxes on the undistributed earnings of foreign subsidiaries because they are considered permanently invested outside of the United States. Upon repatriation, some of these earnings would generate foreign tax credits which may reduce the Federal tax liability associated with any future foreign dividend.

Leases

The Company leases a majority of its field office facilities under non-cancelable operating leases. In addition, the Company leases certain equipment used in its research and development activities. This equipment is generally leased on a month-to-month basis after meeting a six-month lease minimum.

Indemnifications

The Company’s license and services agreements include a limited indemnification provision for claims from third-parties relating to the Company’s intellectual property. Such indemnification provisions are accounted for in accordance with SFAS No. 5, “Accounting for Contingencies”. The indemnification is generally limited to the amount paid by the customer. At September 30, 2004, the Company is not aware of any material liabilities arising from these indemnifications.

Legal Proceedings

From time to time the Company is involved in various disputes and litigation matters that arise from the ordinary course of business. These include disputes and lawsuits relating to intellectual property rights, licensing, contracts and employee relations matters. The Company believes that the outcome of current litigation, individually and in the aggregate, will not have a material affect on the Company’s results of operations.

The Company operates exclusively in the electronic design automation (EDA) industry. The Company markets its products and services worldwide, primarily to large companies in the military/aerospace, communications, computer, consumer electronics, semiconductor, networking, multimedia and transportation industries. The Company sells and licenses its products through its direct sales force in North America, Europe, Japan and Pacific Rim, and through distributors where third parties can extend sales reach more effectively or efficiently. The Company’s reportable segments are based on geographic area.

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All intercompany revenues and expenses are eliminated in computing revenues and operating income (loss). The corporate component of operating income represents research and development, corporate marketing and selling, corporate general and administration, special charges and merger and acquisition related charges. Corporate capital expenditures and depreciation and amortization are generated from assets allotted to research and development, corporate marketing and selling and corporate general and administration. Reportable segment information is as follows:

The Company segregates revenue into three categories of similar products and services. These categories include Integrated Circuit (IC) Design, Systems Design and Professional Services. The IC Design and Systems Design categories include both product and support revenue. Revenue information is as follows:

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On October 13, 2004, the EITF ratified its consensus on EITF No. 04-08, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share”. EITF No. 04-08 requires that contingently convertible debt instruments that become convertible on satisfaction of a market price condition be included in diluted earnings per share using the if-converted method, regardless of whether the market price condition has been met. The EITF is effective for reporting periods ending after December 15, 2004 and requires the retroactive restatement of earnings per share. Under the provisions of EITF No. 04-08, the Company’s Debentures, which represent 4,700 potential shares of common stock, will be included in the calculation of diluted earnings per share, if dilutive, regardless of whether the contingent requirements have been met for conversion to common stock. The Company will adopt EITF No. 04-08 in the fourth quarter of 2004 and believes that it will not have a material adverse effect on its diluted earnings per share or earnings per share as stated in prior periods.

Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition

(All numerical references in thousands, except for percentages and per share data)

OVERVIEW

The Company

The Company is a supplier of electronic design automation (EDA) systems — advanced computer software, emulation hardware systems and intellectual property designs and databases used to automate the design, analysis and testing of electronic hardware and embedded systems software in electronic systems and components. The Company markets its products and services worldwide, primarily to large companies in the military/aerospace, communications, computer, consumer electronics, semiconductor, networking, multimedia and transportation industries. Through the diversification of the Company’s customer base among these various customer markets, the Company attempts to reduce its exposure to fluctuations within each market. The Company sells and licenses its products through its direct sales force and a channel of distributors and sales representatives. In addition to its corporate offices in Wilsonville, Oregon, the Company has sales, support, software development and professional service offices worldwide.

Business Environment

Beginning in late 2000, the electronics industry experienced a broad economic downturn. As a result of this downturn, many of the Company’s customers reduced research and development (R&D) budgets, limited general investment in design tools and reduced engineering staff. Although the overall economy and the electronics industry have gradually recovered during 2003 and 2004, the Company’s customers have in general continued to limit EDA spending. Notwithstanding this general trend, customers still require new innovative EDA tools to solve leading edge design problems and increase productivity and speed time to market. The Company attempts to fill those demands through its relatively young and diverse product portfolio. As a result, the Company had solid performance in 2003 and the first nine months of 2004. Strength in system design in the military and aerospace segments helped drive revenue growth for the Company in 2003. As customer demand expanded during this time, the Company was able to leverage its strength in system design relative to its major competitors. As the semiconductor industry began to stabilize in the second half of 2003 and the first nine months of 2004, newer integrated circuit (IC) design tool sales and verification tools sales increased. For the Company, this resulted in growth in the second half of 2003 and the first nine months of 2004, led by its IC Design to Silicon and Scalable Verification product flows.

The Company’s management believes that EDA spending by semiconductor companies generally lags their economic financial recovery by several quarters for two primary reasons. First, because of the importance of R&D to the future of semiconductor companies, customers try to moderate R&D spending reductions during downturns in comparison to other expense items. As a result, R&D spending as a percentage of revenue increases. As revenues grow in the early stages of the recovery, customers constrain spending increases until R&D returns to more typical percentage of revenue levels. Second, as a result of reduced engineering staff, customers may hold excess software licenses of established tools. Hiring must resume before additional software licenses will be required. The exception is for newer software that customers have not previously purchased or have limited quantities to.

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The Company’s management believes that the Company will continue to grow revenue and earnings faster than the industry because of its heavy mix of relatively new products, many of which are in new types of design methodologies that do not currently have a large EDA installed base. The Company will continue its strategy of attempting to develop best in class point tools with number one market share potential. This strategy is intended to create a diversified product portfolio for the Company that solves customers’ critical design problems. The Company’s management believes that this product strategy, in conjunction with a customer diversification strategy, has helped reduce the impact of marketplace fluctuations in the past.

License Model Mix

License model trends can have a material impact on various aspects of the Company’s business. See “Critical Accounting Estimates – Revenue Recognition” on page 20 for a description of the types of product licenses sold by the Company. As the mix among perpetual licenses, fixed term licenses (term) with upfront revenue recognition and term licenses with ratable revenue recognition (which include due and payable revenue recognition) shifts, revenues, earnings, cash flow and days sales outstanding (DSO) are either positively or negatively affected. The year ended December 31, 2003 marked the third consecutive year in which, as a percentage of product revenue, term revenue increased while perpetual revenue decreased. This trend has continued through the first nine months of 2004. This trend was primarily the result of two factors. First, the Company’s customers are moving toward the term license model, which provides the customer with greater flexibility for product usage, including the ability to share the products between multiple locations and reconfigure consumption at regular intervals from a fixed product list. As such, some of the Company’s customers have converted their existing installed base from perpetual to term licenses. Second, the weakness in the United States high-technology economy has disproportionately impacted the Company’s smaller customers. Historically these customers have purchased under the perpetual license model.

Under this ongoing shift from perpetual licenses to term licenses with upfront revenue recognition, which the Company’s management views as a positive trend, the Company expects no measurable impact to earnings, but a negative impact on cash flow and DSO. As customers move away from perpetual licenses and into term licenses, the renewability and repeatability of the Company’s business is increased. This provides opportunity for increased distribution of newer products earlier in their lifecycles.

Product Developments

During 2004, the Company continued to execute its strategy of focusing on new customer problem areas, as well as building upon its well-established product families. The Company’s management believes that customers, faced with leading-edge design challenges, choose the best products in each category to build their design environment. The Company generally has focused its internal development efforts on areas where it believes it can build a number one market position, or extend an existing number one market position.

New products delivered by the Company in the area of printed circuit board design included: I/O Designer (a tool that enables large and complex FPGAs to be efficiently incorporated into the design process), TeamPCB (a tool that allows multiple designers to simultaneously work on the same design without affecting each other’s work) and advanced high-speed design and analysis software.

In the Design-to-Silicon Division, the Company continued to extend the scope of the Calibre platform, obtaining significant new customer engagements and orders with its resolution enhancement technology. As part of this platform extension, the Company is continuing the development of new design-for-manufacturing tools, the first of which were announced in October 2004.

In 2003, the Company launched its Scalable Verification Environment featuring a suite of tools designed to solve the verification challenges that design engineers face. According to Collett International, an industry analysis firm, engineers spend approximately 62% of their design effort verifying their designs. This dominance of verification in the design process has driven many customers to seek new solutions to enhance their verification abilities.

In 2004, the Company launched Catapult C Synthesis, a new tool that enables designers to work at a higher level of design abstraction. Using C language rather than traditional hardware design languages can improve design quality as well as designer productivity.

The acquisitions that were completed during 2004 provide the Company with new product offerings. As a result of the 0-In acquisition, the Company acquired assertion-based verification products that are important to solidifying and expanding the market opportunity for the Scalable Verification platform. With the acquisition of the Palmchip intellectual property (IP) business, the Company added Parallel and Serial ATA IP cores, which broaden its portfolio of certified, standards-based IP for the storage communications market.

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The Company’s management believes that the development and commercialization of EDA software tools is usually a multi-year process with limited customer adoption in the first years of tool availability. Once tools are adopted, however, their life spans tend to be long and healthy. The Company’s management believes that the Company’s relatively young and diverse product lines are positioned for growth over the long-term.

Q3 2004 Financial Performance

CRITICAL ACCOUNTING ESTIMATES

The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities and contingencies as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The Company evaluates its estimates on an on-going basis. The Company bases its estimates on historical experience and on various other assumptions 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 that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The Company believes the following are the critical accounting estimates and judgments used in the preparation of its consolidated financial statements.

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Revenue Recognition

The Company reports revenue in two categories based upon how the revenue is generated: (i) system and software and (ii) service and support.

System and software revenue - System and software revenues are derived from the sale of licenses of software products and emulation hardware systems.

The Company licenses software using two different license types: