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

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003

OR

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

FOR THE TRANSITION PERIOD FROM ________________ TO ________________.

COMMISSION FILE NUMBER 000-30203

NUANCE COMMUNICATIONS, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

1005 HAMILTON AVENUE
MENLO PARK, CALIFORNIA 94025
(650) 847-0000
(ADDRESS AND TELEPHONE NUMBER OF PRINCIPAL EXECUTIVE OFFICES)

Indicate by check mark whether 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 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 accelerate filer (as defined in Rule 12b-2 of the Exchange Act)
YES [X] NO [ ]

34,897,866 shares of the registrant’s common stock, $0.001 par value, were outstanding as of October 31, 2003.

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NUANCE COMMUNICATIONS,INC. & SUBSIDIARIES

FORM 10-Q, SEPTEMBER 30, 2003

CONTENTS

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PART I:  FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
(Unaudited)

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

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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

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

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NUANCE COMMUNICATIONS INC. & SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

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

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NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1.     ORGANIZATION AND OPERATIONS

Nuance Communications, Inc. (the “Company”) was incorporated on July 15, 1994 in the State of California, and subsequently reincorporated in March 2000 in the State of Delaware to develop, market and support software that enables enterprises and telecommunications carriers to automate the delivery of information and services over the telephone. The Company’s software platform consists of software servers that run on industry-standard hardware and perform speech recognition, natural language understanding and voice authentication. The Company sells its products through a combination of resellers, original equipment manufacturers, and system integrators and directly to end-users.

2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Reclassification

Amounts in the condensed consolidated financial statements for the preceding periods have been reclassified to conform to the current periods’ presentation.

Basis of Presentation

The unaudited condensed consolidated financial statements have been prepared by the Company in accordance with instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in annual financial statements prepared under accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to these instructions and regulations. In the opinion of management, the financial statements reflect all adjustments, consisting only of normal recurring adjustments considered necessary for a fair presentation of the consolidated financial position as of September 30, 2003 and December 31, 2002, the results of operations for the three and nine months ended September 30, 2003 and 2002 and cash flow for the nine months ended September 30, 2003 and 2002. The results for the periods presented are not necessarily indicative of the results to be expected for the full year or for any future periods. The accompanying condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements contained in the Company’s Form 10-K filed with the Securities and Exchange Commission on March 31, 2003.

Principles of Consolidation

The condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All significant inter-company transactions and balances have been eliminated.

Use of Estimates

The preparation of the 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, the 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. Such estimates include, but are not limited to: allowance for doubtful accounts, restructuring accrual, income taxes, contingencies and percentage of completion estimates of certain revenue contracts. Actual results could differ from those estimates.

Cash and Cash Equivalents

The Company considers all highly liquid investments with maturity of three months or less, when purchased, to be cash equivalents. Cash and cash equivalents consist of money market accounts, certificates of deposit and deposits with banks. Cash and cash equivalents are recorded at cost which approximates fair value.

Investments

The Company’s investments are comprised of U.S. Treasury notes, U.S. Government agency bonds, corporate notes and bonds and commercial paper. Investments with maturities of less than one year are considered to be short-term. All investments are held in the Company’s name at major financial institutions. As of September 30, 2003, all of the Company’s investments are classified as available-for-sale and carried at fair value, which is determined based on quoted market prices, with net unrealized gain or loss included in “Accumulated other comprehensive income,” in the accompanying Condensed Consolidated Balance Sheets.

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Property and Equipment

Property and equipment are stated at cost and are depreciated using the straight-line method over the estimated useful lives of the assets as follows:

Restricted Cash

The restricted cash represents investments in certificates of deposit thereon. The restricted cash secures letters of credit required by landlords to meet rent deposit requirements for certain leased facilities.

Intangible Assets

Intangible assets are carried at cost less accumulated amortization. Amortization is computed using the straight-line method over the estimated lives of the respective assets, generally 18 months to five years. The Company adopted Statement of Financial Accounting Standards ("SFAS") No.142, "Goodwill and Intangible Assets" beginning on January 1, 2002. As of that date, goodwill and intangible assets with indefinite lives are not amortized but are tested for impairment annually using a fair value approach, or whenever there is an impairment indicator; other intangible assets are valued and amortized over their estimated lives. Goodwill is not subject to amortization. At September 30, 2003 and December 31, 2002, the Company had no goodwill.

Impairment of Long-lived Assets

The Company continually monitors events and changes in circumstances that could indicate carrying amounts of the long-lived assets, including intangible assets, may not be recoverable. When such events or changes in circumstances occur, the Company assesses the recoverability of long-lived assets by determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flow. If the total of the future undiscounted net cash flow is less than the carrying amount of these assets, the Company recognizes an impairment loss based on the excess of the carrying amount over the fair value of the assets in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets".

Revenue Recognition

Revenues are generated from licenses, services and maintenance. All revenues generated from our worldwide operations are reviewed at our corporate headquarters, located in the United States. The Company applies the provisions of 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" to all transactions involving the sale of software products. The Company also recognizes some revenue based on SOP 81-1 "Accounting for Performance of Construction-Type and Certain Production-Type Contracts".

The Company's license revenue consists of license fees for the software products. The license fees for the Company's software products are calculated using two variables, one of which is the estimated maximum number of simultaneous end-user connections or "ports" to an application running on our software and the other of which is the value attributed to the functional use of the software.

For licensed products requiring significant customization, we generally recognize license revenue using the percentage-of-completion method of accounting over the period that services are performed. For all license and service agreements accounted for under the percentage-of-completion method, we determine progress to completion based on actual direct labor hours incurred to date as a percentage of the estimated total direct labor hours required to complete the project. We periodically evaluate the actual status of each project to ensure that the estimates to complete each contract remain accurate. A provision for estimated losses on contracts is made in the period in which the loss becomes probable and can be reasonably estimated. To date, these losses have not been significant. Costs incurred in advance of billings are recorded as costs in excess of related billings on uncompleted contracts. If the amount of revenue recognized exceeds the amounts billed to customers, the excess amount is recorded as unbilled accounts receivable. If the amount billed exceeds the amount of revenue recognized, the excess amount is recorded as deferred revenue. Revenue recognized in any period is dependent on our percentage completion of projects in progress. Significant management judgment and discretion are used to estimate total direct labor hours. Any changes in or deviation from these estimates could have a material effect on the amount of revenue we recognize in any period.

For licensed products which do not require significant customization of components, the Company recognizes revenue from the sale of software licenses when:

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The Company uses a signed contract and purchase order or royalty report as evidence of an arrangement for license orders.

Products delivered with acceptance criteria or return rights are not recognized as revenue until all criteria are achieved. If undelivered products or services exist that are essential to the functionality of the delivered product in an arrangement, delivery is not considered to have occurred. Delivery is accomplished through electronic distribution of the authorization codes or "keys". The software was previously delivered to the customer either electronically or on a CD-ROM. Occasionally the customer will require that we secure their acceptance of the system in addition to the delivery of the keys. Such acceptance, when required, typically consists of a demonstration to the customer that, upon implementation, the software performs in accordance with specified system parameters, such as recognition accuracy or task completion rates. In cases of absence of such required acceptance, the Company will defer revenue recognition until signed acceptance is obtained.

The Company assesses whether the fee is fixed and determinable based on the payment terms associated with the transaction. The Company assesses collectibility of the transaction based on a number of factors, including the customer's past payment history and its current financial position. If the Company determines that collection of a fee is not probable, the Company defers recognition of the revenue until the time collection becomes reasonably assured, which is generally upon receipt of the cash payment.

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 vendor specific objective evidence of the fair value of all undelivered elements exists. Vendor-specific objective evidence of fair value is based on the price generally charged when the element is sold separately, or if not yet sold separately, is established by authorized management. In situations where vendor-specific objective evidence of fair value for undelivered elements does not exist, the entire amount of revenue from the arrangement is deferred and recognized when vendor-specific objective evidence of fair value can be established for all undelivered elements or when all such elements are delivered. In situations where the only undelivered element is maintenance and vendor specific objective evidence of fair value for maintenance does not exist, the entire amount of revenue from the arrangement is recognized ratably over the maintenance period. As a general rule, license revenue from resellers is recognized when product has been sold through to an end user and such sell-through has been reported to the Company. However, certain reseller agreements include time-based provisions on which the Company bases revenue recognition, in these instances, there is no right of returns possible.

The timing of license revenue recognition is affected by whether the Company performs consulting services in the arrangement and the nature of those services. In the majority of cases, the Company either performs no consulting services or the Company performs services that are not essential to the functionality of the software. When the Company performs consulting and implementation services that are essential to the functionality of the software, the Company recognizes both license and consulting revenue utilizing contract accounting based on the percentage of the consulting services that have been completed. This calculation is done in conformity with SOP 81-1, however judgment is required in determining the percentage of the project that has been completed. Such contracts were significant for the three and nine months ended September 30, 2003 and 2002, respectively. The Company has also explored the markets for complete speech solutions and delivering through combined product and services, where the Company is required to use the contract accounting based upon percentage of completion. This method of accounting is subject to certain judgments by the Company regarding amount of revenue allocated to percentage of work completed. Typically, the Company would recognize revenue based upon the proportional level of effort expended, combined with the value of the technology delivered, to complete certain milestones defined in the customer contract or statement of work.

Service revenue consists of revenue from providing implementation, consulting, training and other revenue. Other revenue consists primarily of reimbursements for consulting out-of-pocket expenses incurred, in accordance with the Emerging Issues Task Force ("EITF") Issue No. 01-14, "Income Statement Characterization of Reimbursements Received for `Out-of-Pocket' Expenses Incurred." For services revenue, we generally require a signed contract, Statement of Work and purchase order prior to recognizing any services revenue. The Company's consulting service contracts are bid either on a fixed-fee basis or on a time-and-materials basis. For a fixed-fee contract, the Company recognizes revenue using the percentage of completion method. For time-and-materials contracts, the Company recognizes revenue as services are performed. Training service revenue is recognized as services are performed. Losses on service contracts, if any, are recognized as soon as such losses become known.

Maintenance revenue consists of fees for providing technical support and software upgrades and updates. The Company generally requires a signed contract and purchase order prior to recognizing any maintenance revenue. The Company recognizes all maintenance revenue ratably over the contract term for such maintenance. Customers have the option to purchase or decline maintenance agreements at the time of the license purchase. If maintenance is declined, a reinstatement fee is generally required when the customer decides to later activate maintenance. Customers generally have the option to renew or decline maintenance agreements annually during the contract term.

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The Company's standard payment terms are generally net 30 to 90 days from the date of invoice. Payment terms can be up to net 120 days at management discretion. Thus, a significant portion of our accounts receivable balance at the end of a quarter is primarily comprised of revenue from that quarter.

The Company records deferred revenue primarily as a result of payments from customers received in advance of recognition of revenue. As of September 30, 2003 and December 31, 2002, deferred revenue was $7.8 million and $9.0 million, respectively. The deferred revenue amount includes unearned license fees, which will be recognized as revenue when the appropriate criteria have been met, or in some cases, when an identified time period has expired and the customer or resellers' right to certain licenses has been forfeited, prepaid maintenance and prepaid or unearned professional services that will be recognized as revenue as the services are performed.

Cost of license revenue consists primarily of license fees payable on third-party software products, amortization of software costs, documentation and media costs. Cost of service revenue consists of compensation and related overhead costs for employees or third parties engaged in consulting and training. Cost of maintenance revenue consists of compensation and related overhead costs for employees engaged in technical support.

Foreign Currency Translation

The functional currency of the Company's foreign subsidiaries is deemed to be the local country's currency. Consequently, assets and liabilities recorded in foreign currencies are translated at period-end exchange rates; revenues and expenses are translated at average exchange rates during the period. The effects of foreign currency translation adjustments are included in stockholders' equity as a component of "Accumulated other comprehensive income" in the accompanying Condensed Consolidated Balance Sheets. The effects of foreign currency transactions are included in "Interest and other income, net" in the accompanying condensed consolidated statements of operations.

Accumulated Other Comprehensive Income

Comprehensive income includes net loss and all non-owner changes to stockholders' equity, which for the Company, is foreign currency translation and changes in unrealized gains and losses on investments. As of September 30, 2003 and December 31, 2002, the cumulative foreign currency translation gain (loss) is $267,000 and $(159,000), net of taxes $156,000 and $(93,000), respectively. As of September 30, 2003 and December 31, 2002, the cumulative unrealized gains on investments are $27,000 and $176,000, net of taxes $16,000 and $103,000, respectively. As of September 30, 2003 and December 31, 2002, the total cumulative other comprehensive income are $294,000 and $17,000. For the three and nine months ended September 30, 2003, the total comprehensive losses are $12.2 million and $18.8 million, respectively. For the three and nine months ended September 30, 2002, the total comprehensive losses are $45.9 million and $65.8 million, respectively.

Stock-Based Compensation

We account for stock-based compensation in accordance with the provisions of APB No. 25, Accounting for Stock Issued to Employees, and comply with the disclosure provisions of SFAS No. 123 as amended by SFAS No.148, “Accounting for Stock-Based Compensation-- Transition and Disclosures.” We adopted the disclosure-only provisions of SFAS No.123 and No.148, and accordingly, no expense has been recognized for options granted to employees under the various Plans. We amortize deferred stock-based compensation on the graded vesting method over the vesting periods of the applicable stock purchase rights and stock options, generally four years. The graded vesting method provides for vesting of portions of the overall awards at interim dates and results in greater vesting in earlier years than the straight-line method. Had compensation expense been determined based on the fair value at the grant date for awards, consistent with the provisions of SFAS 123, the Company's pro forma net loss and net loss per share would be as follows (in thousands, except per share data):

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3.    RECENT ACCOUNTING PRONOUNCEMENTS

In December 2002, the FASB issued SFAS 148, “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment to FASB Statement 123.” SFAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting of stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123, “Accounting for Stock-Based Compensation,” to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company adopted the disclosure provisions of SFAS 148 effective for the year ended December 31, 2002.

On January 1, 2003, the Company adopted SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” (“SFAS No. 146”), which nullifies Emerging Issues Task Force (“EITF”) 94-3,“Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” (“EITF 94-3”). SFAS No. 146 requires that a liability be recognized for restructuring costs only when the liability is incurred, that is, when it meets the definition of a liability in the Financial Accounting Standards Board’s (“FASB’s”) conceptual framework. SFAS No. 146 also establishes fair value as the objective for initial measurement of liabilities related to exit or disposal activities and is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a material impact on our results of operations, financial position or cash flows.

On January 1, 2003, the Company adopted Financial Interpretation 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 requires certain guarantees to be recorded at fair value and requires a guarantor to make disclosures, even when the likelihood of making any payments under the guarantee is remote. For those guarantees and indemnifications that do not fall within initial recognition and measurement requirements of FIN 45, the Company must continue to monitor the conditions that are subject to the guarantees and indemnifications, as required under existing generally accepted accounting principles, to identify if a loss has been incurred. If the Company determines that it is probable that a loss has been incurred, any such estimable loss would be recognized. The initial recognition and measurement requirements do not apply to the Company’s product warranties or to the provisions contained in the majority of the Company’s software license agreements that indemnify licensees of the Company’s software from damages and costs resulting from claims alleging that the Company’s software infringes the intellectual property rights of a third party. The Company has provided disclosures as required by FIN 45 in Note 6 to its condensed consolidated financial statements. The adoption of the liability recognition provisions did not have a material impact on its financial position or results of operations.

In January 2003, the EITF published EITF Issue 00-21, “Revenue Arrangements with Multiple Deliverables,” (“EITF 00-21”), which requires companies to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying EITF 00-21, revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables in the arrangement meet certain criteria. Arrangement consideration should be allocated among the separate units of accounting based on their relative fair values. This issue is effective for revenue arrangements entered into in fiscal periods beginning after September 15, 2003. The Company adopted EITF 00-21 on July 1, 2003 and adoption of EITF 00-21 did not have any material impact on its consolidated financial position, results of operations or cash flows.

In January 2003, the FASB issued Interpretation 46, “Consolidation of Variable Interest Entities”. In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. Interpretation 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of Interpretation 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after December 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The Company does not believe the adoption of the Interpretation will have a material impact on its financial statements.

4. NET LOSS PER SHARE

Net loss per share is calculated under SFAS No. 128, “Earnings Per Share.” Basic net loss per share is computed using the weighted average number of shares of common stock outstanding. Diluted net loss per share is equal to basic net loss per share for all periods presented since potential common shares from stock options and warrants are anti-dilutive due to the reported net loss. Shares subject to repurchase resulting from early exercises of options that have not vested are excluded from the calculation of basic and diluted net loss per share. During the three and nine months ended September 30, 2003 and 2002, the Company had securities outstanding which could potentially dilute basic earnings per share in the future, but were excluded in the computation of diluted loss per share in such periods, as their effect would have been anti-dilutive due to the net loss reported in such periods. The total number of shares excluded from diluted net loss per share was 9,558,000 shares and 9,449,000 shares, respectively, for the three months and nine months ended September 30, 2003. The total number of shares excluded from diluted net loss per share was 6,666,000 shares and 6,835,000 shares, respectively, for the three months and nine months ended September 30, 2002.

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The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data):

5. INTANGIBLE ASSETS

         Information regarding the Company’s intangible assets follows (in thousands):

Purchased technology and patents purchased are amortized to cost of license revenue. In total, for purchased technology, the Company amortized $84,000 and $253,000 respectively, for the three and nine months ended September 30, 2003; for patents purchased, the Company amortized $19,000 and $56,000 respectively, for the three and nine months ended September 30, 2003; The warrant Onstar GM was fully amortized as of December 31, 2002.

As of September 30, 2003, total estimated amortization of the purchased technology and the patent for each of the five fiscal years and thereafter is as follows (in thousands):

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6.    GUARANTEES

Guarantee

As of September 30, 2003, our financial guarantees consist of standby letters of credit outstanding and they include the restricted cash requirements collateralizing our lease obligations. The maximum amount of potential future payment under the arrangement at September 30, 2003 were $10.9 million related to Pacific Shores lease in California and $198, 000 related to our Montreal lease, totaling $11.1 million presented as Restricted cash on our Condensed Consolidated Balance Sheet at September 30, 2003.

Warranty

The Company does not maintain a general warranty reserve for estimated costs of product warranties at the time revenue is recognized due to the effectiveness of our extensive product quality program and processes.

Indemnifications to Customers

We defend and indemnify our customers for damages and reasonable costs incurred in any suit or claim brought against them alleging that our products sold to our customers infringe any U.S. patent, copyright, trade secret or similar right. If a product becomes the subject of an infringement claim, we may, at our option: (i) replace the product with another non-infringing product that provides substantially similar performance; (ii) modify the infringing product so that it no longer infringes but remains functionally equivalent; (iii) obtain the right for the customer to continue using the product at our expense and for the reseller to continue selling the product; (iv) take back the infringing product and refund to customer the purchase price paid less depreciation amortized on a straight line basis. We have not been required to make material payments pursuant to these provisions historically. We have not identified any losses that are probable under these provisions and, accordingly, we have not recorded a liability related to these indemnification provisions.

Indemnifications to Officers and Directors

Our corporate by-laws require that we indemnify our officers and directors, as well as those who act as directors and officers of other entities at our request, against expenses, judgments, fines, settlements and other amounts actually and reasonably incurred in connection with any proceedings arising out of their services to Nuance. In addition, we have entered into separate indemnification agreements with each director and each board-appointed officer of Nuance, which provides for indemnification of these directors and officers under similar circumstances and under additional circumstances. The indemnification obligations are more fully described in the by-laws and the indemnification agreements. We purchase insurance to cover claims or a portion of the claims made against our directors and officers. Since a maximum obligation is not explicitly stated in our by-laws or in our indemnification agreements and will depend on the facts and circumstances that arise out of any future claims, the overall maximum amount of the obligations cannot be reasonably estimated. Historically, we have not made payments related to these obligations, and the estimated fair value for these obligations is zero on the Condensed Consolidated Balance Sheet as of September 30, 2003.

Other Indemnifications

As is customary in our industry and as provided for in local law in the U.S. and other jurisdictions, many of our standard contracts provide remedies to others with whom we enter into contracts, such as defense, settlement, or payment of judgment for intellectual property claims related to the use of our products. From time to time, we indemnify our suppliers, contractors, lessors, lessees and others with whom we enter into contracts, against combinations of loss, expense, or liability arising from various trigger events related to the sale and the use of our products and services, the use of their goods and services, the use of facilities, the state of the assets and businesses that we sell and other matters covered by such contracts, usually up to a specified maximum amount. In addition, from time to time we also provide protection to these parties against claims related to undiscovered liabilities, additional product liability or environmental obligations. In our experience, claims made under such indemnifications are rare and the associated estimated fair value of the liability is not material.

7.    RESTRUCTURING

Fiscal Year 2001

In April 2001, with Board of Directors approval, the Company implemented a restructure plan to align our expenses with revised anticipated demand and create a more efficient organization. In connection with the restructuring plan, the Company recorded a restructuring charge of $34.1 million for lease loss and severance costs and an asset impairment charge of $20.9 million on tenant improvements during the quarter ended September 30, 2001. The Company decreased the asset impairment charge by $0.5 million in the quarter ended December 31, 2001.

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In connection with the restructuring plan, the Company decided not to occupy a new leased facility. This decision has resulted in a lease loss of $32.6 million for the year ended December 31, 2001, comprised of a sublease loss, broker commissions and other facility costs. To determine the sublease loss, the loss after the Company’s cost recovery efforts from subleasing the building, certain assumptions were made related to the (1) time period over which the building will remain vacant (2) sublease terms and (3) sublease rates. The Company established the reserves at the low end of the range of estimable cost against outstanding commitments, net of estimated future sublease income. These estimates were derived using the guidance provided in SAB No. 100, “Restructuring and Impairment Charges”, and EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)". The lease loss was increased in August 2002 and September 2003 as described below and will continue to be adjusted in the future upon triggering events (change in estimate of time to sublease, actual sublease rates, etc.).

The Company recorded $1.5 million in costs for the year ended December 31, 2001 associated with severance and related benefits. The Company reduced headcount by approximately 80 employees, with reductions ranging between 10% and 20% across all functional areas and affecting several locations.

Fiscal Year 2002

In January 2002, with Board of Directors approval, the Company implemented a restructuring plan to reduce the Company’s workforce by approximately 8%, or 33 employees. The restructuring was primarily to realign the sales and professional services organizations. The Company recorded a restructuring charge of $1.3 million for the three months ended March 31, 2002, consisting primarily of payroll and related expenses associated with reducing headcount. This amount was paid out as of December 31, 2002.

In August 2002, with Board of Directors approval, the Company implemented a restructuring plan to reduce the Company’s worldwide workforce by approximately 21%, or 81 employees, to realign the Company’s expense structure with near term market opportunities. In connection with the reduction of workforce, the Company recorded a charge of $2.6 million primarily for severance and related employee termination costs. As of September 30, 2003, approximately $2.3 million of this amount was paid out, with the remainder to be paid by the December 2003. As of September 30, 2003, the Company also reversed an excess accrual for this restructuring plan, which resulted in recording of $0.2 million as a credit to the Restructuring charge line in the Condensed Consolidated Statement of Operations.

The plan also included the consolidation of facilities through the closing of certain international offices that resulted in a charge of $1.6 million. In addition, the Company recorded an increase in the Company’s previously reported real estate restructuring accrual related to the new leased facility the Company does not occupy and which has not been subleased as a result of continued declines in the condition of the San Francisco Bay Area real estate market. This additional charge of $31.8 million resulted from an analysis of the time period by which the California property will remain vacant, sub-lease terms and sub-lease rates, altogether reflecting continued softening of the local real estate market.

Fiscal Year 2003

In February 2003, the Company received cash and recorded an asset impairment credit of $0.9 million related to a refund of tenant improvement costs for the building the Company does not occupy, following the landlord’s reconciliation of tenant improvement costs. This credit was recorded on the Restructuring Charges (Credits) line of the Condensed Consolidated Statements of Operation, where the original asset impairment charge of $20.4 million was recognized for the year ended December 31, 2001.

For the three months ended September 30, 2003, the Company reviewed its earlier estimate for the lease loss for the unoccupied leased facility and the condition of the San Francisco Bay Area real estate market. The Company estimated that it might take an additional 18 months to sublease this unoccupied facility. The Company also lowered the estimates for the expected sublease rates. This evaluation resulted in recording an additional lease loss of $10.4 million and is recorded as part of the Restructuring charges on the Condensed Consolidated Statement of Operations.

For the three months ended September 30, 2003, the Company reduced the Company’s general and administrative workforce by 9%, or net of 5 employees, to realign the organization to the Company’s structure. The Company recorded a restructuring charge of $0.2 million primarily for severance and termination costs relating to the reduction in workforce. As of September 30, 2003, $0.1 million was paid out, with the remainder to be paid in the fourth quarter of 2003. In addition, the Company reversed the excess accrual for the August 2002 restructuring plan, which resulted in a $0.2 million credit to the Restructuring charge line in the Condensed Consolidated Statement of Operations.

The restructuring charges and quarter end balances for the quarter ended September 30, 2003 are as follows (in thousands):

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The Company expects the total cash outlay for the restructuring plans to be $81.8 million, of which $26.9 million was paid through September 30, 2003 and $54.9 million remains accrued at September 30, 2003. The Company expects $9.7 million of the lease loss to be paid out over the next twelve months and remaining $45.2 million to be paid out over the remaining life of the lease of approximately 9 years.

8. COMMITMENTS

Operating leases

The Company leases its facilities under non-cancelable operating leases with various expiration dates through July 2012. As of September 30, 2003, future minimum lease payments under these agreements (excluding sublease income), including the Company’s unoccupied facilities lease and lease loss portion of the restructuring charges, are as follows (in thousands):

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In May 2000, the Company entered into a lease for a new headquarters facility. The lease has an eleven-year term, which began in August 2001, and provides for monthly rent payments starting at approximately $600,000. A $10.9 million certificate of deposit secures a letter of credit required by the landlord for a rent deposit. In conjunction with the April 2001 and August 2002 restructuring plans, the Company decided not to occupy this new leased facility, as well as close certain international offices and have recorded a lease loss of $65.8 million related to future lease commitments, net of expected sublease income. For the three months ended September 30, 2003, the company reviewed its earlier estimate for the sublease loss and estimated that there may be an additional 18 months that the property will remain vacant. The Company also lowered the estimates for the expected sublease rental rates. This evaluation resulted in recording an additional lease loss of $10.4 million. The future minimum lease payments table referenced above does not include estimated sublease income as there are no sublease commitments as of September 30, 2003.

Capital leases

In September 2002, the Company’s Canadian subsidiary entered into a lease for certain equipment for approximately $138,000, which is accounted for as a capital lease. This lease bears interest at a rate of 11.2%, and expires in August 2004. Future minimum lease payments under the agreement, as of September 30, 2003, are as follows (in thousands):

Asset under capital lease had a cost basis of $160,000 and accumulated depreciation of $62,000 as of September 30, 2003.

9. LITIGATION

On January 16, 2001, Nuance filed an opposition proceeding in the European community against a Community Trade Mark application for NUANCE, owned by Nuance Global Traders, Ltd. The opposition is still pending. The parties have agreed upon a settlement, which will become final upon, among other things, completion of final settlement documents.

Beginning in March 2001, a number of putative shareholder class actions were filed against the Company and certain of its present and former officers and directors in the United States District Court for the Northern District of California (the "Federal Actions"). The actions have been consolidated as In re Nuance Communications Inc. Securities Litigation, Master File No. C-01-20320-JW. Lead plaintiffs were appointed and a consolidated complaint was filed on behalf of a purported class of persons who purchased the Company's stock during the period January 31, 2001 through March 15, 2001, alleging false and misleading statements and insider trading in violation of the federal securities laws, specifically Section 10(b), 20(a) and 20A of the Securities Exchange Act of 1934, and seek unspecified damages. In April 2003, the court granted in part and denied in part defendants' most recent motion to dismiss. No trial date has been set. On August 18, 2003, the parties executed an agreement to settle this litigation for $11 million, in which the settlement will become final, upon approval by the Court. The settlement is to be covered by the Company's insurance policies and is reflected in the accompanying condensed consolidated balance sheet as of September 30, 2003 as an insurance claim receivable and a legal settlement payable. In the event that final settlement does not occur, and litigation against the Company continues, the Company believes it has meritorious defenses and intends to defend the case vigorously.

In May and September 2001, putative shareholder derivative actions were filed in California Superior Court, San Mateo County, against various of the Company's present and former officers and the Company's directors (the "Derivative Actions"). The putative derivative complaints contain allegations similar to the Federal Actions, and claim that the defendants engaged in breaches of fiduciary duty and insider trading. The Company appears to be named as nominal defendant, against whom no recovery is sought. All proceedings in the putative derivative actions have been stayed by agreement of the parties. An agreement has been reached to settle these actions, which settlement will become final upon, among other things, completion of formal settlement papers and Court approval of the settlement.

In August 2001, the first of several putative shareholder class actions were filed against various of the underwriters for the Company's initial public offering ("IPO"), the Company and certain of its present and former officers and directors in the United States District Court for the Southern District of New York. Those complaints have been consolidated and a consolidated amended complaint filed, captioned In re Nuance Communications Inc. Initial Public Offering Sec. Litig., No. 01-CV-7344. The complaint generally alleges that various investment bank underwriters engaged in improper activities related to the allocation of shares in the Company's IPO, that were not disclosed in the registration statements for the Company's IPO or secondary offerings. The consolidated action is part of a larger coordinated proceeding, In re Initial Public Offering Securities Litigation, 21 MC 92, involving more than 40 underwriters and 250 issuers. In October 2002, the individual defendants were dismissed from the action without prejudice pursuant to stipulation. In February 2003, the court issued a ruling on an omnibus motion to dismiss filed by defendants in the coordinated proceeding, denying the motion as to the claims against the Company. No trial date has been set. A proposal has been made for the settlement and release of claims against the issuer defendants in the case, including the Company. The settlement is contingent upon a number of conditions, including completion of formal settlement papers and approval of the Court. In the event that settlement does not occur, and litigation against Nuance continues, the Company believes it has meritorious defenses and intends to defend the case vigorously.

Should the respective settlements not proceed as anticipated, an unfavorable resolution of these litigations could have a material adverse effect on the Company's business, results of operations, or financial condition.

10. STOCK - BASED COMPENSATION

The Company accounts for its stock-based awards to employees using the intrinsic value method in accordance with APB No. 25. Accordingly, the Company records deferred stock compensation equal to the difference between the grant price and fair value of the Company's common stock on the date of grant. In connection with the grant of stock options prior to our initial public offering, the Company recorded deferred stock compensation of approximately $8.7 million within stockholders' equity, representing the difference between the estimated fair value of the common stock for accounting purposes and the option exercise price of these options at the date of grant. This amount is presented as a reduction of stockholders' equity and is being amortized over the vesting period of the applicable options in a manner consistent with FASB Interpretation No. 28.

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Relating to approximately 3,152,000 stock options granted before initial public offer at a weighted average exercise price of $8.58, for the three and nine months ended September 30, 2003, the Company recorded amortization of deferred compensation of $39,000 and $172,000. During the same periods, the Company reversed excess amortization of deferred stock compensation due to termination of employees of ($6,000) and ($153,000), resulting in net expense of deferred compensation of $33,000 and $19,000. For the three and nine months ended September 30, 2003, the Company reversed approximately $1,000 and $40,000, of deferred stock compensation and additional paid-in capital, representing unamortized deferred stock compensation relating to forfeitures of stock options by terminated employees. For the three and nine months ended September 30, 2002, the Company recorded amortization of deferred stock compensation of $221,000 and $790,000 respectively, the Company reversed excess amortization of deferred stock compensation due to termination of ($188,000) and ($374,000), resulting in net expense of deferred compensation of $33,000 and $416,000. For the three and nine months ended September 30, 2002, the Company reversed approximately $77,000 and $139,000 of deferred stock compensation and additional paid-in-capital, representing unamortized deferred stock compensation relating to forfeitures of stock options by terminated employees.

In connection with the SpeechFront acquisition, the Company recorded deferred compensation expense $387,000 for the nine months ended September 30, 2002. SpeechFront related deferred compensation was fully amortized as of December 31, 2002.

The Company expects to amortize the remaining deferred stock compensation of $9,000 in the three months ended December 31, 2003.

11. SHORT-TERM INVESTMENTS

All our investments are classified as available for sale at September 30, 2003 and December 31, 2002. Available-for-sale investments with original maturities of greater than three months are classified as short-term investments, as these investments generally consist of highly marketable securities that are intended to be available to meet current cash requirements. Investment securities classified as available-for-sale are reported at market value, and net unrealized gains or losses are recorded in cumulative other comprehensive income (loss), a separate component of stockholders' equity, until realized. Realized gains and losses on non-equity investments are computed based upon specific identification and are included in interest income and other, net. For all periods presented, realized gains and losses on available-for-sale investments were not material. Management evaluates investments on a regular basis to determine if an other-than-temporary impairment has occurred.

Our investments in publicly held companies are generally considered impaired when a decline in the fair value of an investment as measured by quoted market prices is less than its carrying value, and such a decline is not considered temporary. For the nine months ended September 30, 2003, the Company has incurred no such impairment.

12. SEGMENT REPORTING

The Company has three operating segments: licenses, services and maintenance. Revenue and cost of revenue for the segments are identical to those presented on the accompanying condensed consolidated statements of operations. The Company does not track expenses nor derive profit or loss based on these segments. The Company also does not track assets by segments.

Sales of licenses, as well as services and maintenance through September 30, 2003, occurred through resellers and direct sales representatives located in the Company's headquarters in Menlo Park, California, and in other locations. These sales were supported through the Menlo Park location. The Company does not separately report costs by region internally.

Revenues are based on the country in which the end-user is located. The following is a summary of license, service and maintenance revenue by geographic region (in thousands):

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ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this report. The results shown herein are not necessarily indicative of the results to be expected for any future periods.

The section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” set forth below contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act, including but not limited to our expectations for results during the current fiscal year, statements regarding revenue and expense trends and cash positions, statements regarding our sales and marketing, hiring activities, product development and our outlook for the Company, as well as our expectations, beliefs, intentions or strategies regarding the future. Words such as “anticipates,” “expects,” “intends,” “may,” “will,” “plans,” “believes,” “seeks” and “estimates” and other similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and actual actions or results may differ materially. These statements are based on information available to us on the date hereof, and the Company assumes no obligation to update any such forward-looking statements. These statements involve risks and uncertainties and actual results could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including, but not limited to, those set forth in “Company Risk Factors” and elsewhere in this Report on Form 10-Q and in other reports or documents filed by us from time to time with the Securities and Exchange Commission. For example, see “Company Risk Factors—Our ability to accurately forecast our quarterly sales is limited, our costs are relatively fixed in the short term and we expect our business to be affected by seasonality. As a result, our quarterly operating results may fluctuate”, “We are exposed to general economic conditions, which may continue to harm our business”, “If we are unable to effectively manage our operations and resources in accordance with market and economic conditions, our business could be harmed, “Our products can have a long sales and implementation cycle and, as a result, our quarterly operating results and revenues may fluctuate”, “We depend on a limited number of customer orders for a substantial portion of our revenue during any given period. The loss or delays in a key order could substantially reduce our revenue in any given period and harm our business” and “We depend upon resellers for a significant portion of our sales. The loss of key resellers or a decline in resellers’ sales of our products could limit our ability to sustain and grow revenue.” The following discussion should be read in conjunction with the condensed consolidated financial statements and related notes included elsewhere in this report. The results shown herein are not necessarily indicative of the results to be expected for the full year or any future periods.

OVERVIEW

We develop, market and support speech software products for automating interactions over the telephone for a range of industries and applications. Our products and services include: speech recognition software, which is used to recognize what a person says, deliver responses and information and perform transactions; text-to-speech synthesis software, which converts text, for example, from a database, email or web page into an audio signal to deliver speech over the telephone; voice authentication software, which can be used to verify the identity of speakers by the unique qualities of their voices; grammars, which define the dictionary of possible caller responses for use in applications; and a standards-based software platform designed as a foundation for speech application deployment and management. In June 2003, we added our Nuance Call Steering application, a packaged application designed to accurately and cost-effectively route phone calls to the correct customer care destinations. We plan to add additional applications for key industries which, like Nuance Call Steering, will be designed to leverage the features inherent in our engines and platform while reducing deployment time and cost.

We seek to actively support both emerging industry standards as well as proprietary development environments. Our software is designed to work with Voice Extensible Markup Language (“VoiceXML”), the recognized industry standard language for the creation of voice-driven products and services. We also offer a range of consulting, support and education services that enable our customers and channel partners to develop and maintain voice-driven applications that use our software products.

We sell our products both directly through our sales force and indirectly through third-party resellers. We sell our products to customers in the United States, Canada, the United Kingdom and other countries in Europe, China and other countries in Asia, Australia, Central America and Latin America. We anticipate that markets outside of the United States will continue to represent a meaningful portion of total future revenue.

OVERVIEW OF OPERATION 

Our growth and profitability are heavily dependent upon general economic conditions and demand for information technology. Our growth has traditionally been fueled by the telecommunications and financial services industries. Both industries have sustained dramatic slowdowns over the past several years. Information technology spending remains sluggish and may continue to lag for the foreseeable future.

In response to the challenging business environment, we have evolved and continue to evolve our strategic direction in a way that we believe will improve our business performance. Our strategic objectives include

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Some specific operating changes have already been accomplished, such as the restructuring actions taken in the first and third quarters of 2002, the release of the Nuance Voice Platform product in the first quarter of 2003 and the release of our first application product, Nuance Call Steering in the second quarter of 2003 and our focus on driving complete speech solutions into the large telecom and enterprise call center markets. We plan to introduce certain new applications in the future. Other operating activities, including new products and changes to selling and delivery channels, will continue to evolve over the remainder of this and next fiscal year. We are making these strategic shifts because we believe that they will enhance our business performance, however, some of the actions we are taking, such as the introduction of new products, present inherent risks. We believe that these new products will make speech systems faster and easier to deploy, and will create value for our customers. The success of these products depends upon certain market factors such as information technology spending generally, market acceptance of packaged software applications and industry adoption of VoiceXML and related standards.

In addition, we are responding to customers’ requests to work more directly with them and provide them greater access to Nuance’s speech expertise across all levels of their speech solutions. We believe that increasing our direct relationships with end users and delivering more complete solutions will allow us to reap greater value from these sales transactions. However, this new sales and delivery model may also present increased costs and risks such as increased liability for complete solution delivery, costs and risks of subcontractors, and delays in recognition of revenue due to project timelines for solutions deployment. Further, we may experience periodic variation in our consulting services revenues when long-term consulting projects come to completion. In addition, while we are actively working to manage potential channel conflicts and maintain strong reseller relationships, certain reseller relationships may be adversely affected by our introduction of our own platform product and application product and/or our direct sales activities, which may have an unfavorable impact on revenue from certain resellers.

We are committed to a multi-channel sales approach and reseller partners have been and will continue to be instrumental in delivering speech engines, applications and services to our end customers. We are actively working to maintain and build strong relationships with existing resellers as well as new resellers. We will continue to focus efforts on fostering a strong reseller channel, particularly to leverage complementary capabilities in order to speed and ease deployment of speech solutions. We may encounter difficulties or delays in finding reseller partners having such complementary capabilities and/or establishing reseller partner relationships with such entities.

In addition, competition exists in the speech technology market. We believe that our business and technology has the ability to compete effectively, however, the speech market is relatively new and susceptible to change. Our competitors may be able to develop superior technologies or may combine with each other to leverage complimentary technologies or relationships. Current and potential competitors may be larger than Nuance and may be able to invest greater resources in competitive efforts and/or may establish relationships among themselves or with third parties to increase their technological and/or selling and marketing abilities.

CODE OF BUSINESS CONDUCT AND ETHICS

We maintain a code of business conduct and ethics for directors, officers and employees, and will promptly disclose any waivers of the code for directors or executive officers. Our code of business practices addresses conflicts of interest; confidentiality; compliance with laws, rules and regulations (including insider trading laws); and related matters.

RESULTS OF OPERATIONS

The following table sets forth, for the periods indicated, the percentage of net revenue represented by certain items in our statements of operations for the three and nine months ended September 30, 2003 and 2002.

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COMPARISON OF THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002

Revenue

Total revenue for the three months ended September 30, 2003 was $13.8 million, compared with $10.5 million in the three months ended September 30, 2002, an increase of 32%. This increase was attributable to increases in each of our three revenue categories, and from a regional standpoint, reflected U.S. growth of 27% and international growth of 40%. Total revenue for the nine months ended September 30, 2003 was $38.3 million, compared with $30.9 million in the nine months ended September 30, 2002, an increase of 24%. This increase was primarily attributable to the increase in service revenues, and to a lesser extent maintenance revenues, and from a regional standpoint, reflected U.S. growth of 22% and international growth of 27%.

License revenue for the three months ended September 30, 2003 was $7.1 million, compared with $5.7 million in the three months ended September 30, 2002, an increase of 24%. This increase was primarily attributable to revenues generated from several large scale solutions projects in the U.S. and Canada. License revenue for the nine months ended September 30, 2003 was $19.4 million, compared with $19.2 million in the nine months ended September 30, 2002, an increase of 1%. License revenue represented 51% of total revenue both for the three and nine months ended September 30, 2003, respectively, and 55% and 62% of total revenue for the three and nine months ended September 30, 2002, respectively. Our license revenue represented 51% of total revenue both for the three and nine months ended September 30, 2003, respectively, and 55% and 62% of total revenue for the three and nine months ended September 30, 2002, respectively. License revenue as a percentage of total revenue decreased from the nine months ended September 30, 2002 to the nine months ended September 30, 2002, due primarily to that service revenue as a percentage of total revenue increases during these periods. This increase in service revenue was a result of a few large multi-quarter service contracts in the U.S. and Canada.

Service revenue for the three months ended September 30, 2003 was $3.6 million, compared with $2.4 million for the three months ended September 30, 2002, an increase of 52%. Service revenue for the nine months ended September 30, 2003 was $10.1 million, compared with $5.2 million for the nine months ended September 30, 2002, an increase of 92%. Service revenues grew primarily from a few large multi-quarter services contracts in the U.S and Canada. Service revenue represented 27% and 26% of total revenue for the three and nine months ended September 30, 2003, respectively, and 23% and 17% of total revenue both for the three and nine months ended September 30, 2002, respectively.

Maintenance revenue for the three months ended September 30, 2003 was $3.1 million, compared with $2.4 million for the three months ended September 30, 2002, representing an increase of 31%. Maintenance revenue for the nine months ended September 30, 2002 was $8.8 million, compared with $6.5 million for the nine months ended September 30, 2002, an increase of 36%. The increased maintenance revenue during these periods was due primarily to an increase in the support contract renewal rate and a one-time benefit from some retroactive back support revenue for which the services had already been delivered. Maintenance revenue represented 22% and 23% of total revenue for the three and nine months ended September 30, 2003, respectively, and 22% and 21% of total revenue for the three and nine months ended September 30, 2002, respectively.

Cost of Revenue

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Cost of license revenue consists primarily of third-party royalties, media and documentation costs. Cost of license revenues for the three months ended September 30, 2003 was $0.1 million, compared with $0.2 million in the three months ended September 30, 2002, representing a decrease of 48%. Cost of license revenues was $0.3 million for the nine months ended September 30, 2003, compared with $0.5 million for the nine months ended September 30, 2002, representing a decrease of 43%. The decrease was primarily due to the write off of purchased software for the nine months ended September 30, 2002. During 2001, we purchased $550,000 of third-party software to complement our core platform product line. At December 31, 2001, we assessed the remaining carrying value of this software in relation to recovery of future revenues and wrote off $275,000. We wrote off the remaining amount of $275,000 in the nine months ended September 30, 2002. Cost of license revenue as a percentage of license revenue was 1% both for the three and nine months ended September 30, 2003, respectively, compared with 3% both for the three and nine months ended September 30, 2002, respectively.

Cost of service revenue for the three months ended September 30, 2003 was $2.3 million, compared with $2.1 million in the quarter ended September 30, 2002, representing an increase of 10%. Cost of service revenue for the nine months ended September 30, 2003 was $6.7 million, compared with $5.5 million in the nine months ended September 30, 2002, an increase of 23%. The increase was due to the temporary employment of third party services, to fulfill a few large multi-quarter services contracts. Cost of service revenue as a percentage of service revenue decreased to 62% and 67% in the three and nine months ended September 30, 2003, respectively, compared with 85% and 104% for the three and nine months ended September 30, 2002, respectively, due to the increase in service revenues, partially offset by the cost of third party services referred to above. We provide consulting services both through the use of our own employees as well as through the use of contracted third party services. Cost of service revenue may fluctuate and may vary based on the need to add additional employees or contract with third party services.

Cost of maintenance revenue was $0.9 million both for the three months ended September 30, 2003 and 2002. Cost of maintenance revenue was $2.6 million both for the nine months ended September 30, 2003 and 2002. This cost typically remains flat period over period. Cost of maintenance revenue as a percentage of maintenance revenue was 28% and 30% in the three and nine months ended September 30, 2003, respectively, compared with 37% and 41% for the three and nine months ended September 30, 2002, respectively. Cost of maintenance revenue run rates are expected to remain constant in absolute dollars but are expected to vary slightly as a percentage of total revenue in the next several quarters. However, this will depend upon our ability to grow revenue, among other factors. Accordingly, there can be no assurance that we will be successful in maintaining our cost of maintenance revenues as a percentage of maintenance revenue.

Operating Expenses

We have reduced costs and expenses to better align resources with revenue opportunities anticipated in the current information technology market. In January 2002 and August 2002, we announced restructuring plans to reduce our workforce by approximately 8% and 21%, respectively. Most of the savings resulting from the workforce reduction is reflected in sales and marketing expense. We have also reduced the use of outside professional services and lowered capital expenditures.

Sales and Marketing — Sales and marketing expenses primarily consist of compensation and related costs for sales, marketing and business development personnel and promotional expenditures, including public relations, advertising, trade shows and marketing collateral materials. Sales and marketing expenses for the three months ended September 30, 2003 were $6.6 million, compared with $11.0 million in the three months ended September 30, 2002, representing a decrease of 40%. Sales and marketing expenses for the nine months ended September 30, 2003 were $20.9 million, compared with $32.3 million in the nine months ended September 30, 2002, a decrease of 35%. The decreases during these periods were primarily attributable to the lower payroll and related overhead costs resulting from reduction of sales and marketing personnel. Sales and marketing decreased by 36 employees, approximately 33%, from 109 employees at September 30, 2002 to 73 employees at September 30, 2003. As a percentage of total revenue, sales and marketing expenses were 48% and 55% for the three and nine month periods ended September 30, 2003, respectively, and 104% for both the three and nine month periods ended September 30, 2002, respectively.

Research and Development — Research and development expenses primarily consist of compensation and related costs for research and development personnel and contractors. Research and development expenses for the three months ended September 30, 2003 were $3.7 million, compared with $3.9 million in the three months ended September 30, 2002, representing a decrease of 6%. Research and development expenses for the nine months ended September 30, 2003 were $11.5 million, compared with $11.1 million in the nine months ended September 30, 2002, an increase of 4%. This increase reflects our continuing efforts and investment to develop and deliver enhancements to our core speech engine products, to develop and deliver our new Nuance Voice Platform product and Nuance Call Steering Application product. As a percentage of total revenue, research and development expenses were 26% and 30% in the three and nine months ended September 30, 2003 respectively, and 37% and 36% in the three and nine months ended September 30, 2002, respectively. We anticipate that research and development expenses will increase nominally in absolute dollars and will vary as a percentage of total revenue from period to period.

General and Administrative — General and administrative expenses primarily consist of compensation and related costs for administrative personnel, legal services, accounting services, insurance and other general corporate expenses. General and administrative expenses for the three months ended September 30, 2003 were $2.8 million, compared with $3.2 million in the three months ended September 30, 2002, representing a decrease of 13%. General and administrative expenses for the nine months ended September 30, 2003 were $8.9 million, compared with $10.1 million in the nine months ended September 30, 2002, a decrease of 12%. The decreases during these periods were primarily due to the reduction in professional services and lower payroll and related overhead costs as a result of the head count reduction in the Q3 2002 and Q3 2003 restructuring plans. Headcount for general and administrative personnel decreased by approximately net of 5 employees, a reduction of approximately 9%, from 56 employees at September 30, 2002 to 51 employees at September 30, 2003. As a percentage of total revenue, general and administrative expenses were 20% and 23% in the three and nine months ended September 30, 2003, respectively, and 30% and 32% in the three and nine months ended September 30, 2002. We anticipate that general and administrative expenses will remain relatively constant in absolute dollars and will vary as a percentage of total revenue from period to period.

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Non-Cash Compensation Expense — In connection with the grant of stock options prior to our initial public offering, we recorded deferred stock compensation of approximately $8.7 million within stockholders’ equity, representing the difference between the estimated fair value of the common stock for accounting purposes and the option exercise price of these options at the date of grant. This amount is presented as a reduction of stockholders’ equity and is amortized over the vesting period of the applicable options in a manner consistent with FASB Interpretation No. 28. For the three and nine months ended September 30, 2003, we recorded amortization of deferred compensation of $39,000 and $172,000. During the same periods, we reversed excess amortization of deferred stock compensation due to termination of employees of ($6,000) and ($153,000), resulting in net expense of deferred compensation of $33,000 and $19,000. For the three and nine months ended September 30, 2003, we reversed approximately $1,000 and $40,000, of deferred stock compensation and additional paid-in capital, representing unamortized deferred stock compensation relating to forfeitures of stock options by terminated employees. For the three and nine months ended September 30, 2002, we recorded amortization of deferred stock compensation of $221,000 and $790,000 and reversed excess amortization of deferred stock compensation due to termination of employees of ($188,000) and ($374,000), resulting in net expense of deferred compensation of $33,000 and $416,000. For the three and nine months ended September 30, 2002, we reversed approximately $77,000 and $139,000 of deferred stock compensation and additional paid-in-capital, representing unamortized deferred stock compensation relating to forfeitures of stock options by terminated employees.

In December 2000, we issued a warrant to a customer to purchase 100,000 shares of common stock at an exercise price of $138.50 per share subject to certain anti-dilution adjustments. The warrant was exercisable at the option of the holder, in whole or part, at any time between January 17, 2001 and August 2002. In January 2001, we valued the warrant at $526,000, utilizing the Black-Scholes valuation model using the following assumptions: risk-free interest rate of 5.5%, expected dividend yields of zero, expected life of 1.5 years and expected volatility of 80%. We amortized $321,000 for the year ended December 31, 2001. Out of remaining $205,000 balance, we amortized $187,000 for the nine months ended September 30, 2002 related to this warrant and reduced the warrant expense by $18,000 for the performance we delivered to this customer. The warrant expired unexercised in August 2002.

In connection with the SpeechFront acquisition, we recorded deferred compensation expense of $387,000 for the nine months ended September 30, 2002. SpeechFront related deferred compensation was fully amortized as of December 31, 2002.

We expect to amortize the remaining deferred stock compensation of $9,000 in the three months ended December 31, 2003.

Restructuring charges

Fiscal Year 2001

In April 2001, with Board of Directors approval, we implemented a restructure plan to align our expenses with revised anticipated demand and create a more efficient organization. In connection with the restructuring plan, we recorded a restructuring charge of $34.1 million for lease loss and severance costs and an asset impairment charge of $20.9 million on tenant improvements during the quarter ended September 30, 2001. We decreased the asset impairment charge by $0.5 million in the quarter ended December 31, 2001.

In connection with the restructuring plan, we decided not to occupy a new leased facility. This decision has resulted in a lease loss of $32.6 million for the year ended December 31, 2001, comprised of a sublease loss, broker commissions and other facility costs. To determine the sublease loss, the loss after our cost recovery efforts from subleasing the building, certain assumptions were made related to the (1) time period over which the building will remain vacant (2) sublease terms and (3) sublease rates. We established the reserves at the low end of the range of estimable cost against outstanding commitments, net of estimated future sublease income. These estimates were derived using the guidance provided in SAB No. 100, “Restructuring and Impairment Charges”, and EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)". The lease loss was increased in August 2002 and September 2003 as described below and will continue to be adjusted in the future upon triggering events (change in estimate of time to sublease, actual sublease rates, etc.).

We recorded $1.5 million in costs for the year ended December 31, 2001 associated with severance and related benefits. We reduced headcount by approximately 80 employees, with reductions ranging between 10% and 20% across all functional areas and affecting several locations.

Fiscal Year 2002

In January 2002, with Board of Directors approval, we implemented a restructuring plan to reduce our workforce by approximately 8%, or 33 employees. The restructuring was primarily to realign the sales and professional services organizations. We recorded a restructuring charge of $1.3 million for the three months ended March 31, 2002, consisting primarily of payroll and related expenses associated with reducing headcount. This amount was paid out as of December 31, 2002.

In August 2002, with Board of Directors approval, we implemented a restructuring plan to reduce our worldwide workforce by approximately 21%, or 81 employees, to realign our expense structure with near term market opportunities. In connection with the reduction of workforce, we recorded a charge of $2.6 million primarily for severance and related employee termination costs. As of September 30, 2003, approximately $2.3 million of this amount was paid out, with the remainder to be paid by the December 2003. As of September 30, 2003, we also reversed an excess accrual for this restructuring plan, which resulted in recording of $0.2 million as a credit to the Restructuring charge line in the Condensed Consolidated Statement of Operations.

The plan also included the consolidation of facilities through the closing of certain international offices that resulted in a charge of $1.6 million. In addition, we recorded an increase in our previously reported real estate restructuring accrual related to the new leased facility we do not occupy and which has not been subleased as a result of continued declines in the condition of the San Francisco Bay Area real estate market. This additional charge of $31.8 million resulted from an analysis of the time period by which the California property will remain vacant, sub-lease terms and sub-lease rates, altogether reflecting continued softening of the local real estate market.

Fiscal Year 2003

In February 2003, we received cash and recorded an asset impairment credit of $0.9 million related to a refund of tenant improvement costs for the building we do not occupy, following the landlord’s reconciliation of tenant improvement costs. This credit was recorded on the Restructuring Charges (Credits) line of the Condensed Consolidated Statements of Operation, where the original asset impairment charge of $20.4 million was recognized for the year ended December 31, 2001.

For the three months ended September 30, 2003, we reviewed its earlier estimate for the lease loss for the unoccupied leased facility and the condition of the San Francisco Bay Area real estate market. We estimated that it might take an additional 18 months to sublease this unoccupied facility. We also lowered the estimates for the expected sublease rates. This evaluation resulted in recording an additional lease loss of $10.4 million and is recorded as part of the Restructuring charges on the Condensed Consolidated Statement of Operations.

For the three months ended September 30, 2003, we reduced our general and administrative workforce by 9%, or net of 5 employees, to realign the organization to the Company’s structure. We recorded a restructuring charge of $0.2 million primarily for severance and termination costs relating to the reduction in workforce. As of September 30, 2003, $0.1 million was paid out, with the remainder to be paid in the fourth quarter of 2003. In addition, we reversed the excess accrual for the August 2002 restructuring plan, which resulted in a $0.2 million credit to the Restructuring charge line in the Condensed Consolidated Statement of Operations.

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The restructuring charges and quarter end balances for the quarter ended September 30, 2003 are as follows (in thousands):