Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2003

OR

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  ¨

34,196,990 shares of the registrant’s common stock, $0.001 par value, were outstanding as of April 30, 2003.

Table of Contents

NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES

FORM 10-Q, MARCH 31, 2003

CONTENTS

i

Table of Contents

PART I: FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

NUANCE COMMUNICATIONS, INC. & SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

Unaudited

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

1

Table of Contents

NUANCE COMMUNICATIONS INC. & SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

(IN THOUSANDS, EXCEPT PER SHARE DATA)

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

2

Table of Contents

NUANCE COMMUNICATIONS INC. & SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(IN THOUSANDS)

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

3

Table of Contents

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, system integrators and directly to end users.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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 March 31, 2003 and December 31, 2002, the results of operations and cash flows for the three months ended March 31, 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 intercompany 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 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 March 31, 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.

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

4

Table of Contents

assets as follows:

Restricted Cash

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

Goodwill and 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 March 31, 2003 and December 31, 2002, the Company has 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.

The Company recognizes revenue from the sale of software licenses when:

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

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.

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.

5

Table of Contents

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 an undelivered elements does not exist, the entire amount of revenue from the arrangement is deferred and recognized when 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 by which the Company recognizes revenue.

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 standard implementation services that are not essential to the functionality of the software. When the Company performs consulting 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 insignificant for the three months ended March 31, 2003 and 2002, respectively. The Company is also exploring potential markets for complete speech solutions, delivered through combined product and services, which the Company expects to require 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 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. 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. 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 required to later activate maintenance. Customers generally have the option to renew or decline maintenance agreements annually during the contract term.

The Company’s standard payment terms are net 30 to 90 days from the date of invoice. 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 March 31, 2003 and December 31, 2002, deferred revenue was $8.1 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, prepaid maintenance and prepaid or unearned professional services that will be recognized as revenue as the services are performed, or in some cases, when an identified time period has expired.

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 year-end exchange rates; revenues and expenses are translated at average exchange rates during the year. 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.

6

Table of Contents

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 March 31, 2003 and December 31, 2002, the cumulative foreign currency translation losses are $4,000 and $159,000, net of taxes $2,000 and $93,000, respectively. As of March 31,2003 and December 31, 2002, the cumulative unrealized gains on investments are $148,000 and $176,000, net of taxes $87,000 and $103,000, respectively. As of March 31, 2003 and December 31, 2002, the total cumulative other comprehensive income are $144,000 and $17,000. For the three months ended March 31, 2003 and 2002, the total comprehensive losses are $4,148 and $10,653, respectively.

Stock-Based Compensation

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions and related interpretations of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and has elected to follow the “disclosure only” alternative prescribed by Financial Accounting Standards Board’s SFAS No. 123, Accounting for Stock-Based Compensation. Under APB 25, stock-based compensation is based on the difference, if any, on the date of grant, between the fair value of the Company’s stock and the exercise price. Unearned compensation is amortized using the graded vesting method and expensed over the vesting period of the respective options.

Since the Company continues to account for its stock-based awards to employees using the intrinsic value method in accordance with APB No. 25, SFAS No. 123 requires the disclosure of pro forma net income (loss) as if the Company had adopted the fair value method. Under SFAS No. 123, the fair value of stock-based awards is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company’s stock option awards. The Company’s calculations were made using the Black-Scholes option pricing model, which requires subjective assumptions, including expected time to exercise, which greatly affects the calculated values and the resulting pro forma compensation cost may not be representative of that to be expected in future periods.

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. For purposes of SFAS 123 pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period (in thousands):

Reclassifications and Disclosures

Certain prior period amounts have been classified to conform to current period presentation. These reclassifications had no significant impact on the financial statements for the periods presented

7

Table of Contents

3. RECENT ACCOUNTING PRONOUNCEMENTS

On January 1, 2003, the Company adopted SFAS No. 146, which nullifies EITF 94-3. SFAS 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”) conceptual framework. SFAS 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 Company does not expect the adoption of SFAS 146 to have a material impact on our results of operation, financial position or cash flows, although SFAS 146 may impact the timing of recognition of costs associated with future restructuring, exit or disposal activities.

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 that upon issuance of a guarantee, the guarantor must disclose, and may recognize a liability for, the fair value of the obligation it assumes under that guarantee. The initial recognition and measurement requirement of FIN 45 is effective for guarantees issued or modified after December 31, 2002. As of March 31, 2003, guarantees that were issued or modified by the Company after December 31, 2002 were not material. The disclosure requirements of FIN 45 are applicable to our restricted cash, effective for this report and all future quarterly and annual reports. As of March 31, 2003 and December 31, 2002, the restricted cash was $12.4 million and $12.4 million, respectively. The restricted cash secures letters of credit required by landlords to meet rent deposit requirements for certain leased facilities and is invested in certificates of deposit. (See Note 6)

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”. SFAS No. 148 amends SFAS No. 123 “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 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 transition guidance and annual disclosure requirements became effective for fiscal years ending after December 15, 2002. The Company has adopted the annual disclosure provisions of SFAS 148 in our financial reports beginning with year ended December 31, 2002 and the Company has adopted the interim disclosure provisions for financial reports with quarter ended March 31, 2003. The Company continues to account for stock-based compensation under the provisions of Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” using the “intrinsic value” method. Accordingly, the adoption of SFAS No. 148 does not have a material effect on the Company’s financial position, results of operations, or cash flows.

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. The total number of shares excluded from diluted net loss per share was 9,075,000 shares and 7,779,000 shares, respectively, for the three months ended March 31, 2003 and March 31, 2002.

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

5. INTANGIBLE ASSETS

8

Table of Contents

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

Purchased technology and patents purchased are amortized as “Research and Development” expense.

In total, the Company amortized $104,000 from the purchased technology and the patents purchased for the quarter ended March 31, 2003; the Company amortized $271,000 from the purchased technology and the warrant – GM On-star for the quarter ended March 31, 2002. The warrant GM On-star was fully amortized as of December 31, 2002. As of March 31, 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):

6. GUARANTEE

As of March 31, 2003, our financial guarantee consists of standby letters of credit outstanding and it includes the restricted cash requirement collateralizing our lease obligation. The maximum amount of potential future payment under the arrangement was $11.0 million.

The Company does not maintain a general warranty reserve for estimated costs of product warranties at the time revenue is recognized due to our extensive product quality program and processes and because our customer service inventories utilized to correct product failures are carried at zero cost.

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 June 30, 2001. The Company decreased the asset impairment charge by $0.5 million in the quarter ended December 31, 2001.

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 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

9

Table of Contents

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 December 31, 2002, approximately $1.9 million of this amount was paid out, with the remainder to be paid by the end of second quarter 2003. 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 local sub-lease rates in San Mateo County, California. This additional charge of $ 31.8 million stemmed resulted from an analysis of the time period by which the San Mateo property will remain vacant, sub-lease terms and sub-lease rates, altogether reflecting continued softening of the local real estate market.

The restructuring charges and quarter end balances for the quarter ended March 31, 2003 are as follows (in thousands):

The Company expects the total cash outlay for the restructuring plans to be $71.4 million, of which $21.4 million was paid through March 31, 2003 and $50.0 million remains accrued at March 31, 2003. The Company expects $9.4 million of the lease loss to be paid out over the next twelve months and the remaining $40.0 million to be paid out over the remaining life of the lease of approximately 10 years. The Company expects the remaining $0.6 million of employee severance and related benefits accrual to be paid out by June 30, 2003.

10

Table of Contents

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.

8. COMMITMENTS

Operating leases

The Company leases its facilities under non-cancelable operating leases with various expiration dates through July 2012. As of March 31, 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):

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. An $11.0 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. The future minimum lease payments table referenced above does not include estimated sublease income as there are no sublease commitments.

Capital leases

In June 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 March 31, 2003, are as follows (in thousands):

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 are currently engaged in settlement negotiations.

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,

11

Table of Contents

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.

In May and June 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.

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.

10. STOCK COMPENSATION

Deferred Stock 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 will be amortized over the vesting period of the applicable options in a manner consistent with FASB Interpretation No. 28. The Company recorded amortization of deferred stock compensation of $74,000 and $161,000 for the quarter ended March 31, 2003 and 2002, respectively, relating to approximately 3,152,000 stock options granted at a weighted average exercise price of $8.58. For the quarter ended March 31, 2003 and 2002, the Company reversed approximately $2,000 and $89,000 of deferred stock compensation and additional paid-in-capital, which represented the unamortized amortization of deferred stock compensation relating to employees terminated under restructuring plans.

In connection with the SpeechFront acquisition, the Company recorded $290,000 for the quarters ended March 31, 2003 2002. SpeechFront related deferred compensation is fully amortized as of December 31, 2002.

The Company expects to amortize non-cash compensation of $137,000 in the remaining 9 months of 2003 and $8,000 in 2004, respectively.

11. SHORT-TERM INVESTMENTS

All our investments are classified as available for sale at March 31, 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 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 quarter ended March 31, 2003 and year ended December 31, 2002, the Company has incurred no such impairment.

12. SEGMENT REPORTING

12

Table of Contents

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 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 March 31, 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):