UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

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

For the Quarterly Period Ended September 30, 2003

Commission File No. 0-13442

MENTOR GRAPHICS CORPORATION

(Exact name of registrant as specified in its charter)

Oregon	93-0786033
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)

8005 SW Boeckman Road Wilsonville, Oregon	97070-7777
(Address of principal executive offices)	(Zip Code)

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

NO CHANGE

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨

Number of shares of common stock, no par value, outstanding as of November 3, 2003: 68,191,613

MENTOR GRAPHICS CORPORATION

Index to Form 10-Q

		Page Number
PART I FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Statements of Operations for the three months ended September 30, 2003 and 2002	3
	Consolidated Statements of Operations for the nine months ended September 30, 2003 and 2002	4
	Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002	5
	Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and 2002	6
	Notes to Consolidated Financial Statements	7-18
Item 2.	Management’s Discussion and Analysis of Results of Operations and Financial Condition	19-34
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	35-36
Item 4.	Controls and Procedures	36-37
PART II OTHER INFORMATION
Item 1.	Legal Proceedings	37
Item 2.	Changes in Securities and Use of Proceeds	37
Item 6.	Exhibits and Reports on Form 8-K	37-38
SIGNATURES		38

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Mentor Graphics Corporation

Consolidated Statements of Operations

(Unaudited)

Three months ended September 30,	2003			2002
In thousands, except per share data
Revenues:
System and software	$	86,166		$	80,587
Service and support		70,785			72,063
Total revenues		156,951			152,650
Cost of revenues:
System and software		5,945			6,013
Service and support		20,344			20,714
Amortization of purchased technology		2,319			2,217
Total cost of revenues		28,608			28,944
Gross margin		128,343			123,706
Operating expenses:
Research and development		46,522			43,127
Marketing and selling		57,781			56,378
General and administration		18,011			17,337
Amortization of intangible assets		899			859
Emulation litigation settlement		20,264			—
Special charges		4,948			1,534
Merger and acquisition related charges		60			—
Total operating expenses		148,485			119,235
Operating income (loss)		(20,142	)		4,471
Other income, net		2,096			1,318
Interest expense		(4,525	)		(3,930	)
Income (loss) before income taxes		(22,571	)		1,859
Benefit from income taxes		(9,781	)		—
Net income (loss)	$	(12,790	)	$	1,859
Net income (loss) per share:
Basic	$	(.19	)	$	.03
Diluted	$	(.19	)	$	.03
Weighted average number of shares outstanding:
Basic		67,886			65,911
Diluted		67,886			66,187

See accompanying notes to unaudited consolidated financial statements.

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Mentor Graphics Corporation

Consolidated Statements of Operations

(Unaudited)

Nine months ended September 30,	2003			2002
In thousands, except per share data
Revenues:
System and software	$	265,769		$	215,889
Service and support		207,990			200,174
Total revenues		473,759			416,063
Cost of revenues:
System and software		15,541			21,895
Service and support		61,805			61,173
Amortization of purchased technology		6,797			4,473
Total cost of revenues		84,143			87,541
Gross margin		389,616			328,522
Operating expenses:
Research and development		133,363			119,040
Marketing and selling		175,678			158,458
General and administration		54,154			52,598
Amortization of intangible assets		2,975			1,396
Emulation litigation settlement		20,264			—
Special charges		6,311			(2,060	)
Merger and acquisition related charges		1,860			28,700
Total operating expenses		394,605			358,132
Operating loss		(4,989	)		(29,610	)
Other income, net		4,508			5,916
Interest expense		(12,499	)		(7,708	)
Loss before income taxes		(12,980	)		(31,402	)
Provision (benefit) for income taxes		(7,863	)		1,572
Net loss	$	(5,117	)	$	(32,974	)
Net income loss per share:
Basic	$	(.08	)	$	(.50	)
Diluted	$	(.08	)	$	(.50	)
Weighted average number of shares outstanding:
Basic		67,554			65,535
Diluted		67,554			65,535

See accompanying notes to unaudited consolidated financial statements.

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Mentor Graphics Corporation

Consolidated Balance Sheets

	As of September 30, 2003 (unaudited)			As of December 31, 2002
In thousands
Assets
Current assets:
Cash and cash equivalents	$	86,111		$	34,969
Short-term investments		—			3,857
Trade accounts receivable, net of allowance for doubtful accounts of $3,738 and $3,852, respectively		180,771			159,657
Inventory, net		6,378			4,141
Prepaid expenses and other		22,794			20,743
Deferred income taxes		17,492			16,827
Total current assets		313,546			240,194
Property, plant and equipment, net		87,524			90,259
Term receivables, long-term		77,709			78,431
Goodwill		306,597			300,783
Intangible assets, net		38,188			41,388
Other assets, net		49,782			53,793
Total assets	$	873,346		$	804,848
Liabilities and Stockholders’ Equity
Current liabilities:
Short-term borrowings	$	10,009		$	17,670
Accounts payable		15,059			17,110
Income taxes payable		21,529			40,784
Accrued payroll and related liabilities		55,794			51,250
Accrued liabilities		39,310			45,233
Deferred revenue		74,900			72,902
Total current liabilities		216,601			244,949
Notes payable		286,945			177,685
Other long-term liabilities		20,115			19,275
Total liabilities		523,661			441,909
Commitments and contingencies (Note 12)
Minority interest		3,343			3,219
Stockholders’ equity:
Common stock		283,763			297,995
Deferred compensation		(3,226	)		(4,761	)
Retained earnings		44,750			49,867
Accumulated other comprehensive income		21,055			16,619
Total stockholders’ equity		346,342			359,720
Total liabilities and stockholders’ equity	$	873,346		$	804,848

See accompanying notes to unaudited consolidated financial statements.

5

Mentor Graphics Corporation

Consolidated Statements of Cash Flows

(Unaudited)

Nine months ended September 30,	2003			2002
In thousands
Operating Cash Flows:
Net loss	$	(5,117	)	$	(32,974	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization of property, plant and equipment		17,300			15,669
Amortization		18,798			6,244
Deferred income taxes		(2,048	)		(1,177	)
Changes in other long-term liabilities and minority interest		(311	)		(6,789	)
Write-down of assets		2,166			28,700
Gain on sale of investments		(2,390	)		(2,438	)
Changes in operating assets and liabilities, net of effect of acquired businesses:
Trade accounts receivable		(15,210	)		9,242
Prepaid expenses and other		(2,680	)		9,109
Term receivables, long-term		3,184			(2,841	)
Accounts payable and accrued liabilities		(632	)		(24,231	)
Income taxes payable		(19,925	)		(699	)
Deferred revenue		471			5,666
Net cash provided by (used in) operating activities		(6,394	)		3,481
Investing Cash Flows:
Proceeds from sales and maturities of short-term investments		3,857			33,614
Purchases of short-term investments		—			(7,902	)
Purchases of property, plant and equipment		(14,343	)		(14,013	)
Proceeds from sale of investments		2,390			2,438
Acquisition of businesses and equity interests		(17,093	)		(287,058	)
Net cash used in investing activities		(25,189	)		(272,921	)
Financing Cash Flows:
Proceeds from issuance of common stock		15,553			17,272
Repurchase of common stock		(29,785	)		—
Net increase (decrease) in short-term borrowings		(7,985	)		13,336
Debt issuance costs		(4,639	)		(5,513	)
Proceeds from long-term notes payable		110,000			177,831
Repayment of long-term notes payable		(1,146	)		(7,714	)
Net cash provided by financing activities		81,998			195,212
Effect of exchange rate changes on cash and cash equivalents		727			400
Net change in cash and cash equivalents		51,142			(73,828	)
Cash and cash equivalents at the beginning of the year		34,969			124,029
Cash and cash equivalents at the end of the period	$	86,111		$	50,201

See accompanying notes to unaudited consolidated financial statements.

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MENTOR GRAPHICS CORPORATION

Notes to Unaudited Consolidated Financial Statements

(In thousands, except per share amounts)

(1) General - The accompanying unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and reflect all material normal recurring adjustments. However, certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the consolidated financial statements include adjustments necessary for a fair presentation of the results of the interim periods presented. These consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002.

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

(2) Summary of Significant Accounting Policies –

Principles of Consolidation

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

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

Reclassifications

Certain reclassifications have been made in the accompanying consolidated financial statements for 2002 to conform with the 2003 presentation.

Revenue Recognition

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

For the sale of licenses of software products and related service and support, the Company recognizes revenue in accordance with Statement of Position (SOP) 97-2, “Software Revenue Recognition”, as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions”. Revenue from perpetual license arrangements is recognized upon shipment, provided persuasive evidence of an arrangement exists, fees are fixed and determinable and collection is probable. Product revenue from fixed-term license installment agreements, which are generally with the Company’s larger customers, are recognized upon shipment and start of the license term, provided persuasive evidence of an arrangement exists, fees are fixed and determinable and collection is probable. The Company uses fixed-term license installment agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. Revenue from subscription-type term license agreements, which typically include rights to future software products, is deferred and recognized ratably over the term of the subscription period.

The Company uses the residual method to recognize revenue when a license agreement includes one or more elements to be delivered at a future date if evidence of the fair value of all undelivered elements exists. If an undelivered element of the arrangement exists under the license arrangement, revenue is

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deferred based on vendor-specific objective evidence of the fair value of the undelivered element, as established by the price charged when such element is sold separately. If vendor-specific objective evidence of fair value does not exist for all undelivered elements, all revenue is deferred until sufficient evidence exists or all elements have been delivered.

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

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

Accounting for Stock-Based Compensation

Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” defines a fair value based method of accounting for employee stock options and similar equity instruments. As is permitted under SFAS No. 123, the Company has elected to continue to account for its stock-based compensation plans under Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company has computed, for pro forma disclosure purposes, the value of all stock-based awards granted during the three months and nine months ended September 30, 2003 and 2002 using the Black-Scholes option pricing model as prescribed by SFAS No. 123 using the following assumptions:

	Three months ended September 30,				Nine months ended September 30,
Stock Option Plans	2003		2002		2003		2002
Risk-free interest rate	3.1	%	3.8	%	2.8	%	3.8	%
Expected dividend yield	0	%	0	%	0	%	0	%
Expected life (in years)	4.2		4.1		4.1		4.1
Expected volatility	68	%	86	%	66	%	86	%
	Three months ended September 30,				Nine months ended September 30,
Employee Stock Purchase Plans (ESPPs)	2003		2002		2003		2002
Risk-free interest rate	1.6	%	1.7	%	1.5	%	1.7	%
Expected dividend yield	0	%	0	%	0	%	0	%
Expected life (in years)	1.25		1.25		1.25		1.25
Expected volatility	86	%	78	%	86	%	78	%

Using the Black-Scholes methodology, weighted average fair value of options granted was $10.35 and $3.78 per share for the three months ended September 30, 2003 and 2002, respectively, and was $6.98 and $6.01 per share for the nine months ended September 30, 2003 and 2002, respectively. The weighted average estimated fair value of purchase rights under the ESPPs was $2.13 and $4.02 per purchase right for the three months ended September 30, 2003 and 2002, respectively, and $1.86 and $4.77 per purchase right for the nine months ended September 30, 2003 and 2002, respectively.

Other than with respect to options assumed through acquisitions, no stock-based employee compensation cost is reflected in net income, as options granted under the Company’s Stock Option Plans have an exercise price equal to the market value of the underlying common stock on the date of grant and the ESPPs are considered noncompensatory under APB Opinion No. 25. The Company recorded compensation expense for amortization of deferred compensation related to unvested stock options assumed through acquisitions of $512 and $429 for the three months ended September 30, 2003 and 2002, respectively, and $1,535 and

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$619 for the nine months ended September 30, 2003 and 2002, respectively. If the Company had accounted for its stock-based compensation plans in accordance with SFAS No. 123, the Company’s net income (loss) and net income (loss) per share would approximate the pro forma disclosures below:

	Three months ended September 30,						Nine months ended September 30,
	2003			2002			2003			2002
Net income (loss), as reported	$	(12,790	)	$	1,859		$	(5,117	)	$	(32,974	)
Less: Total stock-based employee compensation expense determined under fair value based method, for all awards not previously included in net income (loss), net of related tax benefit		(4,689	)		(5,158	)		(15,753	)		(14,286	)
Pro forma net loss	$	(17,479	)	$	(3,299	)	$	(20,870	)	$	(47,260	)
Basic net income (loss) per share – as reported	$	(.19	)	$	.03		$	(.08	)	$	(.50	)
Basic net loss per share – pro forma	$	(.26	)	$	(.05	)	$	(.31	)	$	(.72	)
Diluted net income (loss) per share – as reported	$	(.19	)	$	.03		$	(.08	)	$	(.50	)
Diluted net loss per share – pro forma	$	(.26	)	$	(.05	)	$	(.31	)	$	(.72	)

(3) Net Income (Loss) Per Share – Basic net income (loss) per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share is computed using the weighted-average number of common shares and dilutive potential common shares outstanding during the period. Dilutive common shares consist of employee stock options and warrants using the treasury stock method and common shares issued assuming conversion of the convertible subordinated notes, if dilutive.

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

	Three months ended September 30,					Nine months ended September 30,
	2003			2002		2003			2002
Net income (loss)	$	(12,790	)	$	1,859	$	(5,117	)	$	(32,974	)
Weighted average shares used to calculate basic income (loss) per share		67,886			65,911		67,554			65,535
Employee stock options and employee stock purchase plan		—			276		—			—
Weighted average common and potential common shares used to calculate diluted net income (loss) per share		67,886			66,187		67,554			65,535
Basic net income (loss) per share	$	(.19	)	$	.03	$	(.08	)	$	(.50	)
Diluted net income (loss) per share	$	(.19	)	$	.03	$	(.08	)	$	(.50	)

Options and warrants to purchase 17,575 and 14,777 shares of common stock for the three months ended September 30, 2003 and 2002, respectively, and 17,817 and 16,449 for the nine months ended September 30, 2003 and 2002, respectively, were not included in the computation of diluted earnings per share. The options and warrants were anti-dilutive either because the Company incurred a net loss or because the exercise price was greater than the average market price of the common shares for the respective periods. The effect of the conversion of the 2002 Company’s convertible subordinated notes for the three months and nine months ended September 30, 2003 was anti-dilutive. If the assumed conversion of the 2002 convertible subordinated notes had been dilutive, the Company’s net loss per share would have included

9

additional earnings of $2,580 and $7,788 and additional incremental shares of 7,412 for the three months and nine months ended September 30, 2003, respectively. The shares issuable on conversion of the Company’s 2003 convertible subordinated debentures (see Note 5) have been excluded from dilutive common shares, as the circumstances that allow for conversion were not met. If the circumstances had been met and such conversion had been dilutive, additional weighted-average shares of 2,810 and 1,493 would have been included for the three months and nine months ended September 30, 2003, respectively.

(4) Short-Term Borrowings - On July 14, 2003, the Company renewed its syndicated, senior, unsecured credit facility that allows the Company to borrow up to $100,000. This facility is a three-year revolving credit facility, which terminates on July 14, 2006. Under this facility, the Company has the option to pay interest based on LIBOR plus a spread of between 1.25% and 2.00% or prime plus a spread of between 0% and 0.75%, based on a pricing grid tied to a financial covenant. As a result, the Company’s interest expense associated with borrowings under this credit facility will vary with market interest rates. In addition, commitment fees are payable on the unused portion of the credit facility at rates between 0.35% and 0.50% based on a pricing grid tied to a financial covenant. The weighted average interest rate for the third quarter of 2003 was 3.45%. The facility contains certain financial and other covenants, including financial covenants requiring the maintenance of specified liquidity ratios, leverage ratios and minimum tangible net worth. The Company had short-term borrowings against the credit facility of zero at September 30, 2003.

Other short-term borrowings include borrowings on multi-currency lines of credit, capital leases and other borrowings. Interest rates are generally based on the applicable country’s prime lending rate, depending on the currency borrowed. Other short-term borrowings of $10,009 and $17,670 were outstanding under these facilities at September 30, 2003 and December 31, 2002, respectively.

(5) Long-Term Notes Payable – On August 6, 2003, the Company issued $110,000 of Floating Rate Convertible Subordinated Debentures (Debentures) due 2023 in a private offering pursuant to SEC Rule 144A. The Company has agreed to register the Debentures with the SEC for resale under the Securities Act of 1933. Interest on the Debentures is payable quarterly at a variable interest rate equal to 3-month LIBOR plus 1.65%, or 2.79% for the quarterly interest period beginning August 6, 2003. The Debentures are convertible, under certain circumstances, into the Company’s common stock at a conversion price of $23.40 per share, for a total of 4,700 shares. These circumstances generally include (a) the market price of the Company’s common stock exceeding 120% of the conversion price, (b) the market price of the Debentures declining to less than 98% of the value of the common stock into which the Debentures are convertible, or (c) a call for redemption of the Debentures or certain other corporate transactions. Some or all of the Debentures may be redeemed by the Company for cash on or after August 6, 2007. Some or all of the Debentures may be redeemed at the option of the holder for cash on August 6, 2010, 2013 or 2018.

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

Other long-term notes payable include multi-currency notes payable and capital leases. Interest rates are generally based on the applicable country’s prime lending rate, depending on the currency borrowed. Other long-term notes payable of $4,445 and $5,185 were outstanding under these agreements at September 30, 2003 and December 31, 2002, respectively.

(6) Stock Repurchases – The board of directors has authorized the Company to repurchase shares of its common stock in the open market. In August 2003, the Company used a portion of the proceeds from the sale of the Debentures to repurchase 1,750 shares of common stock for an aggregate purchase price of $29,785. No other shares of common stock were repurchased in the first nine months of 2003 or comparable period of 2002. The Company considers market conditions, alternative uses of cash and balance sheet ratios when evaluating share repurchases.

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(7) Supplemental Cash Flow Information – The following provides additional information concerning supplemental disclosures of cash flow activities:

Nine months ended September 30,	2003		2002
Interest paid	$	7,397	$	2,943
Income taxes paid, net of refunds received	$	2,874	$	1,475

(8) Comprehensive Loss - The following provides a summary of comprehensive loss:

Nine months ended September 30,	2003			2002
Net loss	$	(5,117	)	$	(32,974	)
Change in accumulated translation adjustment		4,132			4,681
Unrealized gain on investments reported at fair value		—			153
Reclassification adjustment for investment gains included in net loss		—			(2,438	)
Change in unrealized gain (loss) on derivative instruments		304			(2,852	)
Comprehensive loss	$	(681	)	$	(33,430	)

(9) Emulation Litigation Settlement and Other Special Charges – For the nine months ended September 30, 2003, the Company recorded special charges of $26,575. These charges primarily consisted of costs incurred for the settlement of emulation litigation, an accrual for excess leased facility costs and costs incurred for employee terminations.

The Company reached a settlement of its emulation litigation with Cadence Design Systems, Inc. in September 2003. The settlement costs of $20,264 included an $18,000 cash settlement, an accrual for expected costs to perform future obligations specified in the settlement agreement, and attorneys’ fees.

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

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

For the nine months ended September 30, 2002, the Company recorded a cumulative benefit to special charges of $2,060. This benefit primarily consisted of a reversal of an accrual for excess leased facility costs offset by costs incurred for employee terminations, as further discussed below.

The Company recorded excess leased facility costs for leases of facilities in North America and Europe in the fourth quarter of 2001 based on the presumption that such facilities would be permanently abandoned. During the second quarter of 2002, the Company determined that a facility in North America was to be

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re-occupied as a result of requirements following acquisitions. At that time, the remaining accrual for $5,855 was reversed. In addition, the Company reduced its accrual for lease termination fees by $778 as a result of a change in assumptions regarding lease payments for an abandoned facility in Europe.

The Company rebalanced its workforce by 75 employees during the first nine months of 2002. This reduction primarily impacted research and development and administration due to the overlap of employee skill sets as a result of acquisitions. Employee severance costs of $4,558 included severance benefits, notice pay and outplacement services. Termination benefits were communicated to the affected employees prior to the end of the quarter in which the employees were terminated. The majority of these costs were expended during the third quarter of 2002. There have been no significant modifications to the amount of these charges.

Accrued special charges are included in accrued liabilities and other long-term liabilities on the consolidated balance sheets. The following table shows changes in accrued special charges during 2003:

	Accrued Special Charges at December 31, 2002 (1)		2003 Charges		2003 Payments			Accrued Special Charges at September 30, 2003 (1)
Employee severance and related costs	$	7,917	$	1,594	$	(8,354	)	$	1,157
Lease termination fees and other facility costs		3,153		4,487		(2,408	)		5,232
Emulation litigation settlement		—		20,264		(18,583	)		1,681
Other costs		—		230		(230	)		—
Total	$	11,070	$	26,575	$	(29,575	)	$	8,070

⁽¹⁾ The long-term portion of accrued lease termination fees and other facility costs is $4,268 and $1,742 at September 30, 2003 and December 31, 2002, respectively. The remaining balances of $3,802 and $9,328 represent the short-term portion of accrued special charges, respectively.

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

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

The separate results of operations for the acquisitions for the nine months ended September 30, 2003 were not material compared to the Company’s overall results of operations and accordingly pro-forma financial statements of the combined entities have been omitted.

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In February 2002, the Company acquired Accelerated Technology, Inc. (ATI), a provider of embedded software based in Mobile, Alabama. The acquisition was an investment aimed at expanding the Company’s product offering and increasing revenue growth, which supported the premium paid over the fair market value of the individual assets. The total purchase price including acquisition costs was $23,301, which included the fair value of a warrant issued of $361. The excess of liabilities assumed over tangible assets acquired was $1,932. The cost of the acquisition was allocated on the basis of the estimated fair value of assets and liabilities assumed. The purchase accounting allocations resulted in a charge for in-process R&D of $4,000, goodwill of $16,805, technology of $6,500, other identified intangible assets of $880, net of related deferred tax liability of $2,952. The technology is being amortized to cost of goods sold over five years. Of the $880 other identified intangible assets, $480 was determined to have an indefinite life at the time of acquisition and was not being amortized. Based upon the Company’s review of its intangible asset lives, it was determined that as of January 1, 2003, this asset had an estimated remaining life of five years. Accordingly, the Company began amortizing this asset over five years to operating expenses. The remaining $400 is being amortized, primarily over five years, to operating expenses.

In March 2002, the Company acquired IKOS Systems, Inc. (IKOS), a provider of electronic design automation tools for the verification of integrated circuit designs. The acquisition was an investment aimed at expanding the Company’s product offering and increasing revenue growth which supported the premium paid over the fair market value of the individual assets. The total purchase price including acquisition costs was $124,601, which included the fair value of options assumed totaling $3,822. In addition, the Company recorded severance costs related to IKOS employees of $4,284 and costs of vacating certain leased facilities of IKOS of $11,128. These costs resulted in cash expenditures of $13,913, with the remainder being non-cash write-offs of leasehold improvements. Severance costs affected 70 employees across all employee groups. This reduction was due to the overlap of employee skill sets as a result of the acquisition. The excess of tangible assets acquired over liabilities assumed was $11,223. The cost of the acquisition was allocated on the basis of the estimated fair value of assets and liabilities assumed. The purchase accounting allocations resulted in a charge for in-process R&D of $12,000, goodwill of $105,753, technology of $16,900, deferred compensation relating to assumed unvested employee stock options of $695, other identified intangible assets of $800, net of related deferred tax liability of $7,358. The technology is being amortized to cost of goods sold over five years. Deferred compensation is being amortized over ten quarters to operating expenses and other identified intangible assets were amortized over one year to operating expenses.

In May 2002, the Company acquired Innoveda, Inc. (Innoveda), a worldwide leader in electronic design automation technology, software and services for businesses in the consumer electronics, computer, telecommunications, automotive and aerospace industries. The acquisition was an investment aimed at expanding the Company’s product offering and increasing revenue growth which supported the premium paid over the fair market value of the individual assets. The total purchase price including acquisition costs was $191,803, which included the fair value of options assumed totaling $10,295. In addition, the Company recorded severance costs related to Innoveda employees of $4,101 and costs of vacating certain leased facilities of Innoveda of $5,203. All of these costs resulted in cash expenditures. Severance costs affected 106 employees across all employee groups. This reduction was due to the overlap of employee skill sets as a result of the acquisition. The excess of liabilities assumed over tangible assets acquired was $3,111. The cost of the acquisition was allocated on the basis of the estimated fair value of assets and liabilities assumed. The purchase accounting allocations resulted in a charge for in-process R&D of $12,700, goodwill of $168,334, technology of $13,000, deferred compensation relating to assumed unvested employee stock options of $5,765 and other identified intangible assets of $5,450, net of related deferred tax liability of $9,686. The technology is being amortized to cost of goods sold over five years. Deferred compensation is being amortized over three years to operating expenses. Of the $5,450 other identified intangible assets, $3,600 was determined to have an indefinite life at the time of acquisition and was not being amortized. Based upon the Company’s review of its intangible assets lives, it was determined that as of January 1, 2003, this asset had an estimated remaining life of five years. Accordingly, the Company began amortizing this asset over five years to operating expenses. The remaining $1,850 is being amortized primarily over three years to operating expenses.

Subsequent to the acquisitions in 2002, the Company reversed $650 of unamortized deferred compensation to common stock as a result of forfeitures of unvested stock options assumed in the acquisitions due to attrition and workforce reduction.

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In connection with these acquisitions, the Company recorded merger and acquisition related charges of $1,860 and $28,700 for the write-off of in-process R&D for the nine months ended September 30, 2003 and 2002, respectively. The Company uses an independent third party valuation firm to determine the value of the in-process R&D acquired in its business acquisitions. The value assigned to in-process R&D for the charges incurred in 2002 and 2003 related to research projects for which technological feasibility had not been established. The value was determined by estimating the net cash flows from the sale of products resulting from the completion of such projects and discounting the net cash flows back to their present value. The rate used to discount the net cash flows was based on the weighted average cost of capital. Other factors considered were the inherent uncertainties in future revenue estimates from technology investments including the uncertainty surrounding the successful development of the acquired in-process technology, the useful life of the technology, the profitability levels of the technology and the stage of completion of the technology. The stage of completion of the products at the date of the acquisition were estimated based on R&D costs that had been expended as of the date of acquisition as compared to total R&D costs expected at completion. The percentages derived from this calculation were then applied to the net present value of future cash flows to determine the in-process charge. The nature of the efforts to develop the in-process technology into commercially viable products principally related to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish that the product can be produced to meet its design specification, including function, features and technical performance requirements. The estimated net cash flows from these products were based on estimates of related revenues, cost of revenues, R&D costs, selling, general and administrative costs and income taxes. These estimates are subject to change, given the uncertainties of the development process, and no assurance can be given that deviations from these estimates will not occur or that the Company will realize any anticipated benefits of the acquisition. The risks associated with acquired R&D are considered high and no assurance can be made that these products will generate any benefit or meet market expectations. The Company will monitor how underlying assumptions compare to actual results.

(11) Derivative Instruments and Hedging Activities – The Company is exposed to fluctuations in foreign currency exchange rates. To manage the volatility relating to these exposures, exposures are aggregated on a consolidated basis to take advantage of natural offsets. For exposures that are not offset, the Company enters into short-term foreign currency forward and option contracts to partially offset these anticipated exposures. The primary exposures that do not currently have natural offsets are the Japanese yen where the Company is in a long position and the Euro and the British pound sterling where the Company is in a short position. The Company formally documents all relationships between foreign currency contracts and hedged items as well as its risk management objectives and strategies for undertaking various hedge transactions. All hedges designated as cash flow hedges are linked to forecasted transactions and the Company assesses, both at inception of the hedge and on an ongoing basis, the effectiveness of the foreign exchange contracts in offsetting changes in the cash flows of the hedged items. The effective portions of the net gains or losses on foreign currency contracts are reported as a component of accumulated other comprehensive income in stockholders’ equity. Accumulated other comprehensive income associated with hedges of forecasted transactions is reclassified to the consolidated statement of operations in the same period as the forecasted transaction occurs. The Company discontinues hedge accounting prospectively when it is determined that a foreign currency contract is not highly effective as a hedge under the requirements of SFAS No. 133. Any gain or loss deferred through that date remains in accumulated other comprehensive income until the forecasted transaction occurs at which time it is reclassified to the consolidated statement of operations. To the extent the transaction is no longer deemed probable of occurring, hedge accounting treatment is discontinued prospectively and amounts deferred are reclassified to other income or expense.

The fair value of foreign currency forward and option contracts, recorded in prepaid expenses and other in the consolidated balance sheet, was $262 and $1,116 at September 30, 2003 and December 31, 2002, respectively.

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

Nine months ended September 30,	2003			2002
Beginning balance	$	(171	)	$	3,227
Favorable (unfavorable) changes in fair value of cash flow hedges		621			(1,591	)
Net gain transferred to earnings		(317	)		(1,352	)
Hedge ineffectiveness transferred to earnings		—			91
Net unrealized gain	$	133		$	375

The net unrealized gain in accumulated other comprehensive income at September 30, 2003 represents a net unrealized gain on foreign currency contracts relating to hedges of forecasted revenues and commission expenses expected to occur during 2003. These amounts will be transferred to the consolidated statement of operations upon recognition of the related revenue and recording of commission expense. The Company expects substantially all of the balance in accumulated other comprehensive income to be reclassified to the consolidated statement of operations within the next year. The Company transferred $443 deferred loss and $758 deferred gain to system and software revenues relating to foreign currency contracts hedging revenues for the nine months ended September 30, 2003 and 2002, respectively. The Company transferred $760 and $594 deferred gain to marketing and selling expense relating to foreign currency contracts hedging commission expenses for the nine months ended September 30, 2003 and 2002, respectively.

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

In accordance with SFAS No. 133, the Company excludes changes in fair value relating to time value of foreign currency contracts from its assessment of hedge effectiveness. The Company recorded income relating to time value in other income, net of $109 and $284 for the three months ended September 30, 2003 and 2002, respectively and $382 and $859 for the nine months ended September 30, 2003 and 2002, respectively. The Company recorded expense relating to time value in interest expense of $188 and $225 for the three months ended September 30, 2003 and 2002, respectively and $519 and $424 for the nine months ended September 30, 2003 and 2002, respectively.

(12) Commitments and Contingencies –

Leases

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

Indemnifications

The Company’s license and services agreements include a limited indemnification provision for claims from third-parties relating to the Company’s intellectual property. Such indemnification provisions are accounted for in accordance with SFAS No. 5, “Accounting for Contingencies”. The indemnification is generally limited to the amount paid by the customer. At September 30, 2003, the Company is not aware of any material liabilities arising from these indemnifications.

Legal Proceedings

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

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agreement, and attorneys’ fees. As part of the settlement, the Company agreed to join Cadence in the OpenAccess Coalition, sponsored by Si2.

From time to time, the Company is involved in various disputes and litigation matters that arise from the ordinary course of business. These include disputes and lawsuits relating to intellectual property rights, licensing, contracts and employee relation matters.

(13) Segment Reporting – SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, requires disclosures of certain information regarding operating segments, products and services, geographic areas of operation and major customers. To determine what information to report under SFAS No. 131, the Company reviewed the Chief Operating Decision Makers’ (CODM) method of analyzing the operating segments to determine resource allocations and performance assessments. The Company’s CODMs are the Chief Executive Officer and the President.

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

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

	Three months ended September 30,						Nine months ended September 30,
	2003			2002			2003			2002
Revenues
Americas	$	70,740		$	80,691		$	227,027		$	209,671
Europe		44,120			37,311			133,380			107,876
Japan		29,902			20,296			74,591			61,555
Pacific Rim		12,189			14,352			38,761			36,961
Total	$	156,951		$	152,650		$	473,759		$	416,063
Operating income (loss)
Americas	$	34,920		$	42,844		$	120,401		$	108,500
Europe		24,497			20,982			70,883			57,917
Japan		20,741			11,092			46,665			34,969
Pacific Rim		8,942			10,480			28,860			24,899
Corporate		(109,242	)		(80,927	)		(271,798	)		(255,895	)
Total	$	(20,142	)	$	4,471		$	(4,989	)	$	(29,610	)

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

	Three months ended September 30,				Nine months ended September 30,
	2003		2002		2003		2002
Revenues
Integrated Circuit (IC) Design	$	106,904	$	105,479	$	318,781	$	296,928
Systems Design		44,007		40,965		136,962		100,147
Professional Services		6,040		6,206		18,016		18,988
Total	$	156,951	$	152,650	$	473,759	$	416,063

(14) Recent Accounting Pronouncements – In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” This statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated retirement costs. On January 1, 2003, the Company adopted SFAS No. 143. Adoption of this provision did not have a material impact on the Company’s financial position or results of operations.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. This statement nullifies Emerging Issues Task Force Issue No. 94-3 (EITF 94-3), “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity is recognized when the liability is incurred. Under EITF 94-3, a liability for an exit cost as defined in EITF 94-3 was recognized at the date of an entity’s commitment to an exit plan. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002. Adoption of this provision did not have a material impact on the Company’s financial position or results of operations.

In November 2002, the Emerging Issues Task Force reached a consensus on Issue No. 00-21 (EITF 00-21), “Revenue Arrangements with Multiple Deliverables”. EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. EITF 00-21 is effective for interim periods beginning after June 15, 2003 and the Company adopted EITF 00-21 as of July 1, 2003. Adoption of this provision did not have a material impact on the Company’s financial position or results of operations.

In November 2002, the FASB issued FASB Interpretation (FIN) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”. FIN No. 45 requires that upon issuance of a guarantee, a guarantor must recognize a liability for the fair value of an obligation assumed under a guarantee. FIN No. 45 also requires additional disclosures by a guarantor in its financial statements about the obligations associated with guarantees issued. The initial recognition and measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN No. 45 are effective for financial statements issued after December 15, 2002. Adoption of this provision did not have a material impact on the Company’s financial position or results of operations.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging contracts under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” This statement is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. Adoption of this provision did not have a material impact on the Company’s financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement establishes how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. This statement is

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effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The statement is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the statement and still existing at the beginning of the interim period of adoption. Adoption of this provision did not have an impact on the Company’s financial position or results of operations.

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

(All numerical references in thousands, except for percentages)

CRITICAL ACCOUNTING POLICIES

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

Revenue Recognition

The Company generally records product revenue from fixed-term installment license agreements upon shipment and start of the license term. In addition, support revenue is recognized over the license term and is allocated based on vendor specific objective evidence of the fair value of support, as established by the price charged when such support is sold separately. These installment license agreements are typically for three years. The Company uses these agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. The agreements are generally with the Company’s larger customers. If the Company no longer had a history of collecting without providing concessions on term agreements, then revenue would be required to be recognized as the payments become due over the license term. This change would have a material impact on the Company’s results. Additionally, if customers fail to make the contractual payments under the installment license agreements, the Company would have to recognize a bad debt charge. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be required, which would result in an additional selling expense in the period such determination was made.

Valuation of Trade Accounts Receivable

The Company evaluates the collectibility of its trade accounts receivable based on a combination of factors. The Company regularly analyzes its customer accounts and when it becomes aware of a specific customer’s inability to meet its financial obligations, such as in the case of bankruptcy or deterioration in the customer’s operating results or financial position, a specific reserve for bad debts is recorded to reduce the related receivable to the amount believed to be collectible. The Company also records reserves for bad debts for all other customers based on a variety of factors including length of time the receivables are past due, the financial health of the customers, the current business environment and historical experience. If circumstances related to specific customers change, estimates of the recoverability of receivables would be adjusted resulting in either additional selling expense or a reduction in selling expense in the period such determination was made.

Valuation of Deferred Tax Assets

Deferred tax assets are recognized for deductible temporary differences, net operating loss carryforwards and credit carryforwards if it is more likely than not that the tax benefits will be realized. The Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for valuation allowances. The Company has recorded a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. In the event the Company was to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase either income or contributed capital in the period such determination was made. Also, if the Company was to determine that it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to either expense or contributed capital in the period such determination was made.

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Goodwill, Intangible Assets and Long-Lived Assets

The Company reviews long-lived assets and the related intangible assets for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable. Recoverability of an asset is determined by comparing its carrying amount, including any associated intangible assets, to the forecasted undiscounted net cash flows of the operation to which the asset relates. If the operation is determined to be unable to recover the carrying amount of its assets, then intangible assets are written down first, followed by the other long-lived assets of the operation, to fair value. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the assets. Goodwill and intangible assets with indefinite lives are tested for impairment annually and whenever there is an impairment indicator using a fair value approach. In the event that, in the future, it is determined that the Company’s intangible assets have been impaired, an adjustment would be made that would result in a charge for the write-down in the period that determination was made.

Inventory

The Company purchases and commits to purchase inventory based upon forecasted shipments of its emulation hardware systems. The Company evaluates, on a quarterly basis, the need for inventory reserves based on projections of systems expected to ship within six months. Reserves for excess and obsolete inventory are established to account for the differences between forecasted shipments and the amount of purchased and committed inventory.

Restructuring Charges

The Company has recorded restructuring charges in connection with its plans to better align the cost structure with projected operations in the future. Effective January 1, 2003, in accordance with SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” the Company records liabilities for costs associated with exit or disposal activities when the liability is incurred. Prior to January 1, 2003, in accordance with EITF Issue 94-3, the Company accrued for restructuring costs when management made a commitment to an exit plan that specifically identified all significant actions to be taken.

The Company has recorded restructuring charges in connection with employee rebalances based on estimates of the expected costs associated with severance benefits. If the actual cost incurred exceeds the estimated cost, additional special charges will be recognized. If the actual cost is less than the estimated cost, a benefit to special charges will be recognized.

The Company has also recorded restructuring charges in connection with excess leased facilities to offset future rent, net of estimated sublease income that could be reasonably obtained, of the abandoned office space and to write-off leasehold improvements on abandoned office space. The Company worked with external real estate experts in each of the markets where properties are located to obtain assumptions used to determine the best estimate of the accrual. The Company’s estimates of expected sublease income could change based on factors that affect the Company’s ability to sublease those facilities such as general economic conditions and the real estate market. Changes to the amount of estimated sublease income will be recognized as either an increase or a reduction to special charges in the period that the change to the liability is incurred.

RESULTS OF OPERATIONS

REVENUES AND GROSS MARGINS

System and Software

System and software revenues for the three months and nine months ended September 30, 2003 totaled $86,166 and $265,769, respectively, representing an increase of $5,579 or 7% and $49,880 or 23% over the comparable periods of 2002. The increase in software product revenue was primarily attributable to (i) an increase in systems design, FPGA design and intellectual property product revenues attributable to strength in the product lines and acquisitions in 2002, and (ii) continued strength in the physical verification and analysis product line. In addition, system and software revenues were favorably impacted by the strengthening of the Japanese yen, the Euro and the British pound sterling for the three months and nine months ended September 30, 2003.

System and software gross margins were 93% and 94% for the three months and nine months ended September 30, 2003, compared to 93% and 90% for the comparable periods of 2002. Gross margin was unfavorably impacted by write-downs of emulation hardware systems inventory for the three and nine months ended September 30, 2003 of

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$953 and $1,287, respectively, compared to $0 and $5,731 for the comparable periods of 2002. These reserves reduce inventory to the amount that is expected to ship within six months on the assumption that any excess would be obsolete.

Amortization of purchased technology to system and software cost of goods sold was $2,319 and $6,797 for the three months and nine months ended September 30, 2003, respectively, compared to $2,217 and $4,473 for the comparable periods of 2002. The increase in amortization of purchased technology is primarily attributable to acquisitions in the first half of 2002.

Service and Support

Service and support revenues for the three months and nine months ended September 30, 2003 totaled $70,785 and $207,990, respectively. For the three months ended September 30, 2003 service and support revenue decreased $1,278 or 2% from the comparable period of 2002. The decrease was primarily attributable to a decline in emulation support revenue primarily due to the expiration of support contracts related to older generation emulation products. For the nine months ended September 30, 2003 service and support revenue increased $7,816 or 4% over the comparable period of 2002. The increase was primarily attributable to growth in systems design software support revenue and strength in physical verification and analysis support revenue primarily due to renewals by existing customers. This increase was partially offset by a decrease in consulting and training revenue of 6% for the nine months ended September 30, 2003 from the comparable period of 2002, as a result of cuts in spending by the Company’s customers due to the continued weakness in the economy.

Service and support gross margins were 71% and 70% for the three months and nine months ended September 30, 2003, compared to 71% and 69% for the comparable periods of 2002.

Geographic Revenues Information

Three months ended September 30,	2003		Change		2002
Americas	$	70,740	(12	%)	$	80,691
Europe		44,120	18	%		37,311
Japan		29,902	47	%		20,296
Pacific Rim		12,189	(15	%)		14,352
Total	$	156,951			$	152,650
Nine months ended September 30,	2003		Change		2002
Americas	$	227,027	8	%	$	209,671
Europe		133,380	24	%		107,876
Japan		74,591	21	%		61,555
Pacific Rim		38,761	5	%		36,961
Total	$	473,759			$	416,063

Revenues in the Americas decreased for the three months ended September 30, 2003 as compared to the three months ended September 30, 2002 as a result of lower software product and emulation hardware system sales and a decrease in service revenue. Revenues in the Americas increased for the nine months ended September 30, 2003 as compared to the nine months ended September 30, 2002 primarily as a result of higher software product sales. Revenues outside the Americas represented 55% and 52% of total revenues for the three months and nine months ended September 30, 2003, compared to 47% and 50% for the comparable periods of 2002. The effects of exchange rate differences from the European currencies to the United States dollar positively impacted European revenues by approximately 1% and 2% for the three months and nine months ended September 30, 2003, respectively. Exclusive of currency effects, higher revenue in Europe was primarily due to higher software product and emulation hardware system sales and an increase in service revenue. The effects of exchange rate differences from the Japanese yen to the United States dollar positively impacted Japanese revenues by approximately 1% and 6% for the three months and nine months ended September 30, 2003, respectively. Exclusive of currency effects, higher revenues in Japan were primarily attributable to higher software product and emulation hardware system sales and an increase in

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service revenue. Revenues in the Pacific Rim decreased for the three months ended September 30, 2003 as compared to the three months ended September 30, 2002 primarily as a result of lower software product sales. Revenues in the Pacific Rim increased for the nine months ended September 30, 2003 as compared to the nine months ended September 30, 2002 primarily as a result of higher software product sales offset by lower emulation hardware system sales. Since the Company generates approximately half of its revenues outside of the United States and expects this to continue in the future, revenue results may be impacted by the effects of future foreign currency fluctuations.

OPERATING EXPENSES

	Three months ended September 30,								Nine months ended September 30,
	2003			Change		2002			2003			Change		2002
Research and development	$	46,522		8	%	$	43,127		$	133,363		12	%	$	119,040
Percent of total revenues		30	%				28	%		28	%				29	%
Marketing and selling	$	57,781		2	%	$	56,378		$	175,678		11	%	$	158,458
Percent of total revenues		37	%				37	%		37	%				38	%
General and administration	$	18,011		4	%	$	17,337		$	54,154		3	%	$	52,598
Percent of total revenues		11	%				11	%		11	%				13	%
Amortization of intangible assets	$	899		5	%	$	859		$	2,975		113	%	$	1,396
Percent of total revenues		1	%				1	%		1	%				—
Special charges	$	25,212		1,544	%	$	1,534		$	26,575		1,390	%	$	(2,060	)
Percent of total revenues		16	%				1	%		6	%				—
Merger and acquisition related charges	$	60		—		$	—		$	1,860		(94	%)	$	28,700
Percent of total revenues		—					—			—					7	%

Research and Development

As a percent of revenues, R&D costs increased for the three months ended September 30, 2003 over the comparable period of 2002 and decreased for the nine months ended September 30, 2003 from the comparable period of 2002. The increase in absolute dollars was primarily attributable to acquisitions in the first half of 2002, resulting in higher R&D headcount and related costs, and due to a weaker United States dollar during 2003 that increased expenses in Europe by approximately 8% and 9% for the three months and nine months ended September 30, 2003, respectively.

Marketing and Selling

As a percent of revenues, marketing and selling costs remained flat for the three months ended September 30, 2003 as compared to the comparable period of 2002 and decreased for the nine months ended September 30, 2003 from the comparable period of 2002. The increase in absolute dollars was primarily attributable to an increase in variable compensation due to performance above plan and due to a weaker United States dollar during 2003 that increased expenses in Europe by approximately 9% and 10% for the three months and nine months ended September 30, 2003, respectively.

General and Administration

As a percent of revenues, general and administration costs remained flat for the three months ended September 30, 2003 as compared to the comparable period of 2002 and decreased for the nine months ended September 30, 2003 from the comparable period of 2002. The increase in absolute dollars is primarily attributable to an increase in variable compensation due to growth in operating income, partially offset by lower litigation related costs.

Amortization of Intangible Assets

As a percent of revenues, amortization of intangible assets remained flat for the three months ended September 30, 2003 and increased for the nine months ended September 30, 2003 over the comparable periods of 2002. The increase in absolute dollars was primarily attributable to amortization related to intangible assets acquired through acquisitions in 2002.

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Special Charges

The Company reached a settlement of its emulation litigation with Cadence Design Systems, Inc. in September 2003. The settlement costs of $20,264 included an $18,000 cash settlement, an accrual for expected costs to perform future obligations specified in the settlement agreement, and attorneys’ fees.

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

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

For the nine months ended September 30, 2002, the Company recorded a cumulative benefit to special charges of $2,060. This benefit primarily consisted of a reversal of an accrual for excess leased facility costs offset by costs incurred for employee terminations as further discussed below.

The Company recorded excess leased facility costs for leases of facilities in North America and Europe in the fourth quarter of 2001 based on the presumption that such facilities would be permanently abandoned. During the second quarter of 2002, the Company determined that a facility in North America was to be re-occupied as a result of requirements following acquisitions. At that time, the remaining accrual for $5,855 was reversed. In addition, the Company reduced its accrual for lease termination fees by $778 as a result of a change in assumptions regarding lease payments for an abandoned facility in Europe.

The Company rebalanced its workforce by 75 employees during the first nine months of 2002. This reduction primarily impacted research and development and administration due to the overlap of employee skill sets as a result of acquisitions. Employee severance costs of $4,558 included severance benefits, notice pay and outplacement services. Termination benefits were communicated to the affected employees prior to the end of the quarter in which the employees were terminated. The majority of these costs were expended during the third quarter of 2002. There have been no significant modifications to the amount of these charges.

Merger and Acquisition Related Charges

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

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

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The separate results of operations for the acquisitions for the nine months ended September 30, 2003 were not material compared to the Company’s overall results of operations and accordingly pro-forma financial statements of the combined entities have been omitted.

In February 2002, the Company acquired Accelerated Technology, Inc. (ATI), a provider of embedded software based in Mobile, Alabama. The acquisition was an investment aimed at expanding the Company’s product offering and increasing revenue growth, which supported the premium paid over the fair market value of the individual assets. The total purchase price including acquisition costs was $23,301, which included the fair value of a warrant issued of $361. The excess of liabilities assumed over tangible assets acquired was $1,932. The cost of the acquisition was allocated on the basis of the estimated fair value of assets and liabilities assumed. The purchase accounting allocations resulted in a charge for in-process R&D of $4,000, goodwill of $16,805, technology of $6,500, other identified intangible assets of $880, net of related deferred tax liability of $2,952. The technology is being amortized to cost of goods sold over five years. Of the $880 other identified intangible assets, $480 was determined to have an indefinite life at the time of acquisition and was not being amortized. Based upon the Company’s review of its intangible assets lives, it was determined that as of January 1, 2003, this asset had an estimated remaining life of five years. Accordingly, the Company began amortizing this asset over five years to operating expenses. The remaining $400 is being amortized, primarily over five years, to operating expenses.

In March 2002, the Company acquired IKOS Systems, Inc. (IKOS), a provider of electronic design automation tools for the verification of integrated circuit designs. The acquisition was an investment aimed at expanding the Company’s product offering and increasing revenue growth which supported the premium paid over the fair market value of the individual assets. The total purchase price including acquisition costs was $124,601, which included the fair value of options assumed totaling $3,822. In addition, the Company recorded severance costs related to IKOS employees of $4,284 and costs of vacating certain leased facilities of IKOS of $11,128. These costs resulted in cash expenditures of $13,913, with the remainder being non-cash write-offs of leasehold improvements. Severance costs affected 70 employees across all employee groups. This reduction was due to the overlap of employee skill sets as a result of the acquisition. The excess of tangible assets acquired over liabilities assumed was $11,223. The cost of the acquisition was allocated on the basis of the estimated fair value of assets and liabilities assumed. The purchase accounting allocations resulted in a charge for in-process R&D of $12,000, goodwill of $105,753, technology of $16,900, deferred compensation relating to assumed unvested employee stock options of $695, other identified intangible assets of $800, net of related deferred tax liability of $7,358. The technology is being amortized to cost of goods sold over five years. Deferred compensation is being amortized over ten quarters to operating expenses and other identified intangible assets were amortized over one year to operating expenses.

In May 2002, the Company acquired Innoveda, Inc. (Innoveda), a worldwide leader in electronic design automation technology, software and services for businesses in the consumer electronics, computer, telecommunications, automotive and aerospace industries. The acquisition was an investment aimed at expanding the Company’s product offering and increasing revenue growth which supported the premium paid over the fair market value of the individual assets. The total purchase price including acquisition costs was $191,803, which included the fair value of options assumed totaling $10,295. In addition, the Company recorded severance costs related to Innoveda employees of $4,101 and costs of vacating certain leased facilities of Innoveda of $5,203. All of these costs resulted in cash expenditures. Severance costs affected 106 employees across all employee groups. This reduction was due to the overlap of employee skill sets as a result of the acquisition. The excess of liabilities assumed over tangible assets acquired was $3,111. The cost of the acquisition was allocated on the basis of the estimated fair value of assets and liabilities assumed. The purchase accounting allocations resulted in a charge for in-process R&D of $12,700, goodwill of $168,334, technology of $13,000, deferred compensation relating to assumed unvested employee stock options of $5,765 and other identified intangible assets of $5,450, net of related deferred tax liability of $9,686. The technology is being amortized to cost of goods sold over five years. Deferred compensation is being amortized over three years to operating expenses. Of the $5,450 other identified intangible assets, $3,600 was determined to have an indefinite life at the time of acquisition and was not being amortized. Based upon the Company’s review of its intangible asset lives, it was determined that as of January 1, 2003, this asset had an estimated remaining life of five years. Accordingly, the Company began amortizing this asset over five years to operating expenses. The remaining $1,850 is being amortized primarily over three years to operating expenses.

Subsequent to the acquisitions in 2002, the Company reversed $650 of unamortized deferred compensation to common stock as a result of forfeitures of unvested stock options assumed in the acquisitions due to attrition and workforce reduction.

In connection with these acquisitions, the Company recorded merger and acquisition related charges of $1,860 and $28,700 for the write-off of in-process R&D for the nine months ended September 30, 2003 and 2002, respectively.

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The Company uses an independent third party valuation firm to determine the value of the in-process R&D acquired in its business acquisitions. The value assigned to in-process R&D for the charges incurred in 2002 and 2003 related to research projects for which technological feasibility had not been established. The value was determined by estimating the net cash flows from the sale of products resulting from the completion of such projects and discounting the net cash flows back to their present value. The rate used to discount the net cash flows was based on the weighted average cost of capital. Other factors considered were the inherent uncertainties in future revenue estimates from technology investments including the uncertainty surrounding the successful development of the acquired in-process technology, the useful life of the technology, the profitability levels of the technology and the stage of completion of the technology. The stage of completion of the products at the date of the acquisition were estimated based on R&D costs that had been expended as of the date of acquisition as compared to total R&D costs expected at completion. The percentages derived from this calculation were then applied to the net present value of future cash flows to determine the in-process charge. The nature of the efforts to develop the in-process technology into commercially viable products principally related to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish that the product can be produced to meet its design specification, including function, features and technical performance requirements. The estimated net cash flows from these products were based on estimates of related revenues, cost of revenues, R&D costs, selling, general and administrative costs and income taxes. These estimates are subject to change, given the uncertainties of the development process, and no assurance can be given that deviations from these estimates will not occur or that the Company will realize any anticipated benefits of the acquisition. The risks associated with acquired R&D are considered high and no assurance can be made that these products will generate any benefit or meet market expectations. The Company will monitor how underlying assumptions compare to actual results.

Other Income, Net

Other income, net totaled $2,096 and $4,508 for the three months and nine months ended September 30, 2003, respectively, compared to $1,318 and $5,916 for the comparable periods in 2002. Interest income was $1,473 and $4,136 for the three months and nine months ended September 30, 2003, respectively, compared to $1,515 and $5,200 for comparable periods of 2002. Interest income includes income relating to time value of foreign currency contracts of $109 and $382, respectively, compared to $284 and $859 for the comparable periods in 2002. Other income, net was unfavorably impacted by a foreign currency loss of $226 and $1,051 in the three months and nine months ended September 30, 2003, respectively, compared to a foreign currency gain of $158 and $48 for the comparable periods of 2002. These variances were partially offset by a net gain on sale of investment of $899 and $2,084 for the three months and nine months ended September 30, 2003, respectively, compared to $0 and $2,438 in the comparable periods of 2002, respectively.

Interest Expense

Interest expense was $4,525 and $12,499 for the three months and nine months ended September 30, 2003, respectively, compared to $3,930 and $7,708 for comparable periods in 2002. Interest expense increased primarily as a result of the issuance of the Company’s convertible subordinated notes and debentures in June 2002 and August 2003, respectively.

Provision (Benefit) for Income Taxes

The provision for income taxes was a benefit of $9,781 and $7,863 for the three months and nine months ended September 30, 2003, respectively, compared to an expense of $0 and $1,572 for the comparable periods of 2002. On a quarterly basis, the Company evaluates its expected income tax expense or benefit based on its year to date operations and records an adjustment in the current quarter. The Company’s estimated annual tax rate was 60% as of September 30, 2003 compared to an estimated annual tax rate of 20% as of June 30, 2003. The increase in the estimated annual tax rate was primarily due to lower estimated annual pre-tax income as a result of special charges, while the estimated annual tax provision is not expected to be reduced by a similar ratio due to tax on profits in foreign jurisdictions and amortization of a deferred tax charge. The Company accrues its tax provision (benefit) to reflect the estimated annual tax rate on a year to date basis which resulted in a tax benefit in the third quarter of 2003 and is estimated to result in a tax provision in the fourth quarter of 2003. The net tax provision is the result of the mix of profits earned by the Company and its subsidiaries in tax jurisdictions with a broad range of income tax rates. The provision for income taxes differs from tax computed at the federal statutory income tax rate primarily due to amortization of a deferred tax charge recorded in the prior year and earnings permanently reinvested in foreign operations.

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The Company provides for United States income taxes on the earnings of foreign subsidiaries unless they are considered permanently invested outside of the United States. Upon repatriation, some of these earnings would generate foreign tax credits which may reduce the Federal tax liability associated with any future foreign dividend.

Under SFAS No. 109, “Accounting for Income Taxes”, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. SFAS No. 109 provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based on the weight of available evidence, the Company has provided a valuation allowance against certain deferred tax assets. The portion of the valuation allowance for deferred tax assets related to the difference between financial and tax reporting of employee stock option exercises, for which subsequently recognized tax benefits will be applied directly to contributed capital, will be maintained until such benefits are actually realized on the Company’s income tax returns. The remainder of the valuation allowance was based on the historical earnings patterns within individual taxing jurisdictions that make it uncertain that the Company will have sufficient income in the appropriate jurisdictions to realize the full value of the assets. The Company will continue to evaluate the realizability of the deferred tax assets on a quarterly basis. The Company is currently under an Internal Revenue Service audit in the United States, the results of which are unknown at this time.

Effects of Foreign Currency Fluctuations

Approximately half of the Company’s revenues and approximately one-third of its expenses are generated outside of the United States. For 2003 and 2002, approximately one-fourth of European and all Japanese revenues were subject to exchange rate fluctuations as they were booked in local currencies. Most large European revenue contracts are denominated and paid to the Company in the United States dollar while the Company’s European expenses, including substantial research and development operations, are paid in local currencies causing a short position in the Euro and the British pound sterling. In addition, the Company experiences greater inflows than outflows of Japanese yen as all Japanese-based customers contract and pay the Company in local currency. While these exposures are aggregated on a consolidated basis to take advantage of natural offsets, substantial exposure remains. For exposures that are not offset, the Company enters into short-term foreign currency forward and option contracts to partially offset these anticipated exposures. The option contracts are generally entered into at contract strike rates that are different than current market rates. As a result, any unfavorable currency movements below the strike rates will not be offset by the foreign currency option contract and could negatively affect operating results. These contracts address anticipated future cash flows for 90-day to one-year periods and do not hedge 100% of the potential exposures related to these currencies. As a result, the effects of currency fluctuations could have a substantial effect on the Company’s overall results of operations.

Foreign currency translation adjustment, a component of accumulated other comprehensive income reported in the stockholders’ equity section of the Consolidated Balance Sheets, increased to $21,738 at September 30, 2003, from $17,606 at the end of 2002. This reflects the increase in the value of net assets denominated in foreign currencies since year-end 2002 as a result of a weaker United States dollar at September 30, 2003.

LIQUIDITY AND CAPITAL RESOURCES

Cash, Cash Equivalents and Short-Term Investments

Total cash, cash equivalents and short-term investments at September 30, 2003 were $86,111 compared to $38,826 at December 31, 2002. Cash used by operations was $6,394 in the first nine months of 2003 compared to cash provided by operations of $3,481 during the same period in 2002. The decrease in cash flows from operating activities was primarily due to an increase in accounts receivable and a decrease in taxes payable as described below. In addition, cash flows from operating activities for the nine months ended September 30, 2003 and 2002 were positively impacted by (i) non-cash asset write-downs of $2,166 and $28,700, respectively, (ii) amortization of intangible assets of $10,737 and $6,244, respectively, primarily related to acquisitions in the first half of 2002, and (iii) amortization of a fourth quarter 2002 deferred tax charge of $8,061 and $0, respectively.

Cash used for investing activities, excluding short-term investments, was $29,046 and $298,633 in the first nine months of 2003 and 2002, respectively. Cash used for investing activities included capital expenditures of $14,343 in the first nine months of 2003 compared to $14,013 during the same period in 2002. Acquisition of businesses was

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$17,093, including payment of a holdback on a prior year acquisition of $4,070, for the nine months ended September 30, 2003 compared to $287,058 for the comparable period in 2002.

Cash provided by financing activities was $81,998 and $195,212 in the first nine months of 2003 and 2002, respectively. Cash provided by financing activities included $110,000 and $177,831 proceeds from long-term notes payable in the first nine months of 2003 and 2002, respectively. Cash and short-term investments were positively impacted by proceeds from issuance of common stock upon exercise of stock options and employee stock plan purchases of $15,553 and $17,272 during the nine months ended September 30, 2003 and 2002, respectively. During the nine months ended September 30, 2003, the Company repurchased shares of its common stock for $29,785.

Trade Accounts Receivable

Trade accounts receivable increased to $180,771 at September 30, 2003 from $159,657 at December 31, 2002. Excluding the current portion of term receivables of $98,897 and $81,697, average days sales outstanding were 47 days and 39 days at September 30, 2003 and December 31, 2002, respectively. Average days sales outstanding in total accounts receivable increased from 80 days at December 31, 2002 to 104 days at September 30, 2003. The increase in total accounts receivable days sales outstanding was primarily due to new term contracts in the three months ended September 30, 2003, many of which reflect front-end weighted customer payment schedules. In the quarters where term contract revenue is recorded, only the first twelve months of the receivable is reflected in current trade accounts receivable. In the following quarters, the amount due in the next twelve months is reflected in current trade accounts receivable without the corresponding revenue. In addition, the Company sold no short-term accounts receivable in the three months ended September 30, 2003 compared to $13,441 sales of short-term accounts receivable in the three months ended December 31, 2002. The Company records a sale when it is considered to have surrendered control of such receivables under the provisions of SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.”

Inventory, Net

Inventory, net increased $2,237 from December 31, 2002 to September 30, 2003. The increase was primarily due to purchases based on forecasted shipments of next generation emulation hardware systems.

Prepaid Expenses and Other

Prepaid expenses and other increased $2,051 from December 31, 2002 to September 30, 2003. The increase was primarily due to annual renewals of maintenance contracts and prepaid royalty and sales commission payments. The increase was partially offset by the receipt of a $2,000 income tax refund for an income tax receivable acquired in the IKOS acquisition in 2002.

Term Receivables, Long-Term

Term receivables, long-term decreased to $77,709 at September 30, 2003 compared to $78,431 at December 31, 2002. The balances are attributable to multi-year, multi-element term license sales agreements principally from the Company’s larger customers. Balances under term agreements that are due within one year are included in trade accounts receivable and balances that are due in more than one year are included in term receivables, long-term. The Company uses term agreements as a standard business practice and has a history of successfully collecting under the original payment terms without making concessions on payments, products or services. The decrease was primarily attributable to run-off of balances on older term agreements, partially offset by new term agreements.

Income Taxes Payable

Income taxes payable decreased to $21,529 at September 30, 2003 compared to $40,784 at December 31, 2002. On a quarterly basis, the Company evaluates its expected income tax expense or benefit based on its year to date operations and records an adjustment in the current quarter.

Accrued Payroll and Related Liabilities

Accrued payroll and related liabilities increased $4,544 from December 31, 2002 to September 30, 2003. The increase was primarily due to (i) an increase in the 2003 accrued annual incentive compensation and (ii) an increase

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in accrued payroll taxes due to timing of payment and employee stock purchase plan withholdings, partially offset by payments of the 2002 annual and fourth quarter incentive compensation.

Accrued Liabilities

Accrued liabilities decreased $5,923 from December 31, 2002 to September 30, 2003. The decrease was primarily due to payment of restructure and merger costs.

Deferred Revenue

Deferred revenue consists primarily of prepaid annual software support contracts. Deferred revenue increased $1,998 from December 31, 2002 to September 30, 2003. The increase was primarily due to annual support renewals.

Capital Resources

Expenditures for property and equipment increased to $14,343 for the first nine months of 2003 compared to $14,013 for the same period in 2002. Expenditures in the first nine months of 2003 and 2002 did not include any individually significant projects. In the first nine months of 2003, the Company acquired (i) the Technology Licensing Group business of Alcatel, (ii) Translogic, (iii) the distributorship, Mentor Italia and (iv) the business and technology of DDE and (v) First Earth Limited, which resulted in net cash payments of $13,023. Additionally, the Company paid $4,070 relating to a holdback on a prior year acquisition. In the first nine months of 2002, the Company completed the acquisitions of ATI, IKOS and Innoveda, which resulted in net cash payments of $287,058.

On August 6, 2003, the Company issued $110,000 of Floating Rate Convertible Subordinated Debentures (Debentures) due 2023 in a private offering pursuant to SEC Rule 144A to fund the purchase of 1,750 shares of the Company’s stock and for general corporate purposes. The Company has agreed to register the Debentures with the SEC for resale under the Securities Act of 1933. Interest on the Debentures is payable quarterly at a variable interest rate equal to 3-month LIBOR plus 1.65%, reset quarterly, beginning in November 2003. The Debentures are convertible, under certain circumstances, into the Company’s common stock at a conversion price of $23.40 per share, for a total of 4,700 shares. These circumstances generally include (a) the market price of the Company’s common stock exceeding 120% of the conversion price, (b) the market price of the Debentures declining to less than 98% of the value of the common stock into which the Debentures are convertible, or (c) a call for redemption of the Debentures or certain other corporate transactions. Some or all of the Debentures may be redeemed by the Company for cash on or after August 6, 2007. Some or all of the Debentures may be redeemed at the option of the holder for cash on August 6, 2010, 2013 or 2018.

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

On July 14, 2003, the Company renewed its syndicated, senior, unsecured credit facility that allows the Company to borrow up to $100,000. This facility is a three-year revolving credit facility, which terminates on July 14, 2006. Under this facility, the Company has the option to pay interest based on LIBOR plus a spread of between 1.25% and 2.00% or prime plus a spread of between 0% and 0.75%, based on a pricing grid tied to a financial covenant. As a result, the Company’s interest expense associated with borrowings under this credit facility will vary with market interest rates. In addition, commitment fees are payable on the unused portion of the credit facility at rates between 0.35% and 0.50% based on a pricing grid tied to a financial covenant. The weighted average interest rate for the thrid quarter of 2003 was 3.45%. The facility contains certain financial and other covenants, including financial covenants requiring the maintenance of specified liquidity ratios, leverage ratios and minimum tangible net worth. The Company had short-term borrowings against the credit facility of zero at September 30, 2003.

The Company anticipates that current cash balances, anticipated cash flows from operating activities and amounts available under existing credit facilities will be sufficient to meet its working capital needs on a short-term and long-term basis.

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

FACTORS THAT MAY AFFECT FUTURE RESULTS AND FINANCIAL CONDITION

The statements contained in this report that are not statements of historical fact, including without limitation, statements containing the words “believes,” “expects,” “projections” and words of similar import, constitute forward-looking statements that involve a number of risks and uncertainties that are difficult to predict. Moreover, from time to time, the Company may issue other forward-looking statements. Forward-looking statements regarding financial performance in future periods do not reflect potential impacts of mergers or acquisitions or other significant transactions or events that have not been announced as of the time the statements are made. Actual outcomes and results may differ materially from what is expressed or forecast in forward-looking statements. The Company disclaims any obligation to update forward-looking statements to reflect future events or revised expectations. The following discussion highlights factors that could cause actual results to differ materially from the results expressed or implied by the Company’s forward-looking statements. Forward-looking statements should be considered in light of these factors.

Weakness in the United States and international economies may materially adversely affect the Company.

United States and international economies are experiencing an economic downturn which has had an adverse affect on the Company’s results of operations. Continued weakness in these economies is likely to continue to adversely affect the timing and receipt of orders for the Company’s products and the Company’s results of operations. Revenue levels are dependent on the level of technology capital spending, which include expenditures for EDA, software and other consulting services, in the United States and abroad. A number of telecommunications companies have in the recent past filed for bankruptcy protection, and others have announced significant reductions and deferrals in capital spending. A significant portion of the Company’s revenues has historically come from businesses operating in this sector. In addition, demand for the Company’s products and services may be adversely affected by mergers and company restructurings in the electronics industry worldwide which could result in decreased or delayed capital spending patterns.

The Company is subject to the cyclical nature of the integrated circuit and electronics systems industries, and the current downturn has, and any future downturns may, materially adversely affect the Company.

Purchases of the Company’s products and services are highly dependent upon new design projects initiated by integrated circuit manufacturers and electronics systems companies. The integrated circuit industry is highly cyclical and is subject to constant and rapid technological change, rapid product obsolescence, price erosion, evolving standards, short product life cycles and wide fluctuations in product supply and demand. The integrated circuit and electronics systems industries have experienced significant downturns, often connected with, or in anticipation of, maturing product cycles of both companies in these industries and their customers’ products and a decline in general economic conditions. These downturns have caused diminished product demand, production overcapacity, high inventory levels and accelerated erosion of average selling prices. Certain integrated circuit manufacturers and electronics systems companies announced a slowdown of demand and production in 2001, which has continued in 2002 and 2003. During downturns such as the current one, the number of new design projects decreases. The current slowdown has reduced, and any future downturns are likely to further reduce, the Company’s revenue and could materially adversely affect the Company.

Fluctuations in quarterly results of operations due to the timing of significant orders and the mix of licenses used to sell the Company’s products could hurt the Company’s business and the market price of the Company’s common stock.

The Company has experienced, and may continue to experience, varied quarterly operating results. Various factors affect the Company’s quarterly operating results and some of these are not within the Company’s control, including the timing of significant orders and the mix of licenses used to sell the Company’s products. The Company receives a majority of its software product revenue from current quarter order performance, of which a substantial amount is usually booked in the last few weeks of each quarter. A significant portion of the Company’s revenue comes from multi-million dollar contracts, the timing of the completion of and the terms of delivery of which can have a material impact on revenue recognition for a given quarter. If the Company fails to receive expected orders in a particular

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quarter, particularly large orders, the Company’s revenues for that quarter could be adversely affected and the Company could fail to meet analysts’ expectations which could adversely affect the Company’s stock price.

The Company uses fixed-term installment sales agreements as a standard business practice. These multi-year, multi-element term license agreements are typically three years in length and are used with larger customers that the Company believes are credit-worthy. These agreements increase the risk associated with collectibility from customers that can arise for a variety of reasons including ability to pay, product dissatisfaction, disagreements and disputes. If the Company is unable to collect under any of these multi-million dollar agreements, the Company’s results of operations could be adversely affected.

The Company’s revenue is also affected by the mix of licenses entered into in connection with the sale of software products. The Company’s software licenses fall into three general categories: perpetual, fixed-term and subscription. With perpetual and fixed-term licenses, the Company recognizes software product revenue at the beginning of the license period, while with subscription licenses the Company recognizes software product revenue ratably over the license period. Accordingly, a shift in the license mix toward increased subscription licenses would result in increased deferral of software product revenue to future periods and would decrease current revenue, possibly resulting in the Company not meeting revenue expectations.

The accounting rules governing software revenue recognition have been subject to authoritative interpretations that have generally made it more difficult to recognize software product revenue at the beginning of the license period. These new and revised standards and interpretations could adversely affect the Company’s ability to meet revenue projections and affect the Company’s stock price.

The gross margin on the Company’s software products is greater than that for the Company’s hardware products, software support and professional services. Therefore, the Company’s gross margin may vary as a result of the mix of products and services sold. Additionally, the margin on software products varies year to year depending on the amount of third-party royalties due to third parties from the Company for the mix of products sold. The Company also has a significant amount of fixed or relatively fixed costs, such as professional service employee costs and purchased technology amortization, and costs which are committed in advance and can only be adjusted periodically. As a result, a small failure to reach planned revenue would have a great negative effect on resulting earnings. If anticipated revenue does not materialize as expected, the Company’s gross margins and operating results would be materially adversely affected.

The lengthy sales cycle for the Company’s products and services and delay in customer consummation of projects makes the timing of the Company’s revenue difficult to predict.

The Company has a lengthy sales cycle that generally extends between three and six months. The complexity and expense associated with the Company’s products and services generally requires a lengthy customer evaluation and approval process. Consequently, the Company may incur substantial expenses and devote significant management effort and expense to develop potential relationships that do not result in agreements or revenue and may prevent the Company from pursuing other opportunities. In addition, sales of the Company’s products and services may be delayed if customers delay approval or commencement of projects because of customers’ budgetary constraints, internal acceptance review procedures, timing of budget cycles or timing of competitive evaluation processes.

Any loss of the Company’s leadership position in certain portions of the EDA market could have a material adverse affect on the Company.

The industry in which the Company competes is characterized by very strong leadership positions in specific portions of the EDA market. For example, one company may enjoy a large percentage of sales in the physical verification portion of the market while another will have a similarly strong position in mixed-signal simulation. These strong leadership positions can be maintained for significant periods of time as the software is difficult to master and customers are disinclined to make changes once their employees, as well as others in the industry, have developed familiarity with a particular software product. For these reasons, much of the Company’s profitability arises from niche areas in which it is the strong leader. Conversely, it is difficult for the Company to achieve significant profits in niche areas where other companies are the leaders. If for any reason the Company loses its leadership position in a niche, the Company could be materially adversely affected.

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Intense competition in the EDA industry could materially adversely affect the Company.

Competition in the EDA industry is intense, which can lead to, among other things, price reductions, longer selling cycles, lower product margins, loss of market share and additional working capital requirements. The Company’s success depends upon the Company’s ability to acquire or develop and market products and services that are innovative and cost-competitive and that meet customer expectations.

The Company currently competes primarily with two large companies: Cadence Design Systems, Inc. and Synopsys, Inc. In June 2002, Synopsys completed its acquisition of Avant! Corporation and the combined company could improve its competitive position with respect to the Company.

The Company also competes with numerous smaller companies, a number of which have combined with other EDA companies. The Company also competes with manufacturers of electronic devices that have developed, or have the capability to develop, their own EDA products internally.

The Company may acquire other companies and may not successfully integrate them or the companies the Company has recently acquired.

The industry in which the Company competes has seen significant consolidation in recent years. During this period, the Company has acquired numerous businesses, and it is frequently in discussions with potential acquisition candidates and may acquire other businesses in the future. For example, the Company is presently engaged in acquisition discussions with several companies. While the Company expects to carefully analyze all potential transactions before committing to them, the Company cannot assure that any transaction that is completed will result in long-term benefits to the Company or its shareholders or that the Company’s management will be able to manage the acquired businesses effectively. In addition, growth through acquisition involves a number of risks. If any of the following events occurs after the Company acquires another business, it could materially adversely affect the Company:

• difficulties in combining previously separate businesses into a single unit;

• the substantial diversion of management’s attention from day-to-day business when evaluating and negotiating acquisition transactions and then integrating the acquired business;

• the discovery after the acquisition has been completed of liabilities assumed with the acquired business;

• the failure to realize anticipated benefits, such as cost savings and revenue enhancements;

• the failure to retain key personnel of the acquired business;

• difficulties related to assimilating the products of an acquired business in, for example, distribution, engineering and customer support areas;

• unanticipated costs;

• adverse effects on existing relationships with suppliers and customers; and

• failure to understand and compete effectively in markets in which we have limited previous experience.

Acquired businesses may not perform as projected, which could result in impairment of acquisition-related intangible assets. Additional challenges include integration of sales channels, training and education of the sales force for new product offerings, integration of product development efforts, integration of systems of internal controls and integration of information systems. Accordingly, in any acquisition there will be uncertainty as to the achievement and timing of projected synergies, cost savings and sales levels for acquired products. All of these factors can impair the Company’s ability to forecast, meet revenue and earnings targets and manage effectively the Company’s business for long-term growth. The Company cannot assure that it can effectively meet these challenges.

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Risks of international operations and the effects of foreign currency fluctuations can adversely impact the Company’s business and operating results.

The Company realizes approximately half of the Company’s revenue from customers outside the United States and approximately one third of the Company’s expenses are generated outside of the United States. For further discussion of foreign currency effects, see “Effects of Foreign Currency Fluctuations” discussion above. In addition, international operations subject the Company to other risks including longer receivables collection periods, changes in a specific country’s or region’s economic or political conditions, trade protection measures, import or export licensing requirements, loss or modification of exemptions for taxes and tariffs, limitations on repatriation of earnings and difficulties with licensing and protecting the Company’s intellectual property rights.

Delay in production of components or the ordering of excess components for the Company’s Mentor Emulation Division hardware products could materially adversely affect the Company.

The success of the Company’s Mentor Emulation Division depends on the Company’s ability to:

• procure hardware components on a timely basis from a limited number of suppliers;

• assemble and ship systems on a timely basis with appropriate quality control;

• develop distribution and shipment processes;

• manage inventory and related obsolescence issues; and

• develop processes to deliver customer support for hardware.

The Company’s inability to be successful in any of the foregoing could materially adversely affect the Company.

The Company occasionally commits to purchase component parts from suppliers based on sales forecasts of the Company’s Mentor Emulation Division’s products. If the Company cannot change or be released from these non-cancelable purchase commitments, or if orders for the Company’s products do not materialize as anticipated, the Company could incur significant costs related to the purchase of excess components which could become obsolete before the Company can use them. Additionally, a delay in production of the components could materially adversely affect the Company’s operating results.

The Company’s failure to obtain software or other intellectual property licenses or adequately protect the Company’s proprietary rights could materially adversely affect the Company.

The Company’s success depends, in part, upon the Company’s proprietary technology. Many of the Company’s products include software or other intellectual property licensed from third parties, and the Company may have to seek new licenses or renew existing licenses for software and other intellectual property in the future. The Company’s failure to obtain software or other intellectual property licenses or rights on favorable terms, or the need to engage in litigation over these licenses or rights, could materially adversely affect the Company.

The Company generally relies on patents, copyrights, trademarks, trade secret laws, licenses and restrictive agreements to establish and protect the Company’s proprietary rights in technology and products. Despite precautions the Company may take to protect the Company’s intellectual property, the Company cannot assure that third parties will not try to challenge, invalidate or circumvent these safeguards. The Company also cannot assure that the rights granted under the Company’s patents will provide it with any competitive advantages, that patents will be issued on any of the Company’s pending applications or that future patents will be sufficiently broad to protect the Company’s technology. Furthermore, the laws of foreign countries may not protect the Company’s proprietary rights in those countries to the same extent as United States law protects these rights in the United States.

The Company cannot assure you that the Company’s reliance on licenses from or to, or restrictive agreements with, third parties, or that patent, copyright, trademark and trade secret protections, will be sufficient for success and profitability in the industries in which it competes.

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Future litigation proceedings may materially adversely affect the Company.

The Company cannot assure that future litigation matters will not have a material adverse effect on the Company. Any future litigation may result in injunctions against future product sales and substantial unanticipated legal costs and divert the efforts of management personnel, any and all of which could materially adversely affect the Company.

Errors or defects in the Company’s products and services could expose us to liability and harm the Company’s reputation.

The Company’s customers use the Company’s products and services in designing and developing products that involve a high degree of technological complexity and have unique specifications. Because of the complexity of the systems and products with which the Company works, some of the Company’s products and designs can be adequately tested only when put to full use in the marketplace. As a result, the Company’s customers or their end users may discover errors or defects in the Company’s software or the systems we design, or the products or systems incorporating the Company’s designs and intellectual property may not operate as expected. Errors or defects could result in:

• loss of current customers and loss of, or delay in, revenue and loss of market share;

• failure to attract new customers or achieve market acceptance;

• diversion of development resources to resolve the problems resulting from errors or defects; and

• increased service costs.

The Company’s failure to attract and retain key employees may harm the Company.

The Company depends on the efforts and abilities of the Company’s senior management, the Company’s research and development staff and a number of other key management, sales, support, technical and services personnel. Competition for experienced, high-quality personnel is intense, and the Company cannot assure that it can continue to recruit and retain such personnel. The failure by the Company to hire and retain such personnel would impair the Company’s ability to develop new products and manage the Company’s business effectively.

Terrorist attacks, such as the attacks that occurred on September 11, 2001, and other acts of violence or war may materially adversely affect the markets on which the Company’s securities trade, the markets in which the Company operates, the Company’s operations and the Company’s profitability.

Terrorist attacks may negatively affect the Company’s operations and investment in the Company’s business. These attacks or armed conflicts may directly impact the Company’s physical facilities or those of the Company’s suppliers or customers. Furthermore, these attacks may make travel and the transportation of the Company’s products more difficult and more expensive and ultimately affect the Company’s sales.

Any armed conflict entered into by the United States could have an impact on the Company’s sales and the Company’s ability to deliver products to the Company’s customers. Political and economic instability in some regions of the world may also result from an armed conflict and could negatively impact the Company’s business. The Company currently has operations in Pakistan and Egypt countries that my be particularly susceptible to this risk. The consequences of any armed conflict is unpredictable, and the Company may not be able to foresee events that could have an adverse effect on the Company’s business.

More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the United States and worldwide financial markets and economy. They also could result in or exacerbate economic recession in the United States or abroad. Any of these occurrences could have a significant impact on the Company’s operating results, revenues and costs and may result in volatility of the market price for the Company’s securities.

The Company’s articles of incorporation, Oregon law and the Company’s shareholder rights plan may have anti-takeover effects.

The Company’s board of directors has the authority, without action by the shareholders, to designate and issue up to 1,200,000 shares of incentive stock in one or more series and to designate the rights, preferences and privileges of

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each series without any further vote or action by the shareholders. Additionally, the Oregon Control Share Act and the Business Combination Act limit the ability of parties who acquire a significant amount of voting stock to exercise control over the Company. These provisions may have the effect of lengthening the time required for a person to acquire control of the Company through a proxy contest or the election of a majority of the board of directors. In February 1999, the Company adopted a shareholder rights plan which has the effect of making it more difficult for a person to acquire control of the Company in a transaction not approved by the Company’s board of directors. The potential issuance of incentive stock, the provisions of the Oregon Control Share Act and the Business Combination Act and the Company’s shareholder rights plan may have the effect of delaying, deferring or preventing a change of control of the Company, may discourage bids for the Company’s common stock at a premium over the market price of the Company’s common stock and may adversely affect the market price of, and the voting and other rights of the holders of, the Company’s common stock.

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Item 3. Quantitative And Qualitative Disclosures About Market Risk

(All numerical references in thousands, except for rates and percentages)

INTEREST RATE RISK

The Company is exposed to interest rate risk primarily through its investment portfolio, short-term borrowings and long-term notes payable. The Company does not use derivative financial instruments for speculative or trading purposes.

The Company places its investments in instruments that meet high credit quality standards, as specified in the Company’s investment policy. The policy also limits the amount of credit exposure to any one issuer and type of instrument. The Company does not expect any material loss with respect to its investment portfolio.

The table below presents the carrying value and related weighted-average fixed interest rates for the Company’s investment portfolio. The carrying value approximates fair value at September 30, 2003. In accordance with the Company’s investment policy, all investments mature in twelve months or less.

Principal (notional) amounts in UNITED STATES dollars	Carrying Amount		Average Fixed Interest Rate
Cash equivalents – fixed rate	$	53,121	1.16	%
Short-term investments – fixed rate		—	—
Total fixed rate interest bearing instruments	$	53,121	1.16	%

The Company had convertible subordinated notes of $172,500 outstanding with a fixed interest rate of 6 7/8% at September 30, 2003. For fixed rate debt, interest rate changes affect the fair value of the notes but do not affect earnings or cash flow.

The Company had floating rate convertible subordinated debentures of $110,000 outstanding with a variable interest rate of 3-month LIBOR plus 1.65% at September 30, 2003. For variable interest rate debt, interest rate changes affect earnings and cash flow. If the interest rates on the variable rate borrowings were to increase or decrease by 1% for the year and the level of borrowings outstanding remained constant, annual interest expense would increase or decrease by approximately $1,100.

The Company had a three-year revolving credit facility, which terminates on July 14, 2006, which allows the Company to borrow up to $100,000 at September 30, 2003. Under this facility, the Company has the option to pay interest based on LIBOR plus a spread of between 1.25% and 2.00% or prime plus a spread of between 0% and 0.75%, based on a pricing grid tied to a financial covenant. As a result, the Company’s interest expense associated with borrowings under this credit facility will vary with market interest rates. The weighted average interest rate for the third quarter of 2003 was 3.45%. The Company had short-term borrowings against the credit facility of zero at September 30, 2003.

The Company had other long-term notes payable of $4,445 and short-term borrowings of $10,009 outstanding at September 30, 2003 with variable rates based on market indexes. For variable rate debt, interest rate changes generally do not affect the fair market value, but do affect future earnings or cash flow. If the interest rates on the variable rate borrowings were to increase or decrease by 1% for the year and the level of borrowings outstanding remained constant, annual interest expense would increase or decrease by approximately $145.

FOREIGN CURRENCY RISK

The Company transacts business in various foreign currencies and has established a foreign currency hedging program to hedge certain foreign currency forecasted transactions and exposures from existing assets and liabilities. Derivative instruments held by the Company consist of foreign currency forward and option contracts. The Company enters into contracts with counterparties who are major financial institutions and believes the risk related to default is remote. The Company does not hold or issue derivative financial instruments for trading purposes.

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The Company enters into foreign currency option contracts for forecasted sales and commission transactions between its foreign subsidiaries. These instruments provide the Company the right to sell/purchase foreign currencies to/from third parties at future dates with fixed exchange rates. As of September 30, 2003, the Company had options outstanding to sell Japanese yen with contract values totaling approximately $11,976 at a weighted average contract rate of 125.25 and had options outstanding to buy the Euro with contract values totaling $5,200 at a weighted average contract rate of 1.04.

The Company enters into foreign currency forward contracts to protect against currency exchange risk associated with expected future cash flows and existing assets and liabilities. For further discussion of foreign currency effects, see “Effects of Foreign Currency Fluctuations” discussion under Item 2. “Management’s Discussion and Analysis of Results of Operations and Financial Condition” above.

From time to time, the Company enters into foreign currency forward contracts to offset the translation and economic exposure on a portion of the Company’s net investment in its Japanese subsidiary. Differences between the contracted currency rate and the currency rate at each balance sheet date will impact accumulated translation adjustment which is a component of accumulated other comprehensive income in the stockholders’ equity section of the consolidated balance sheet. The result is a partial offset of the effect of Japanese currency changes on stockholders’ equity during the contract term. As of September 30, 2003, the Company had no forward contracts outstanding to protect the net investment in its Japanese subsidiary.

The table provides information as of September 30, 2003 about the Company’s foreign currency forward contracts. The information provided is in United States dollar equivalent amounts. The table presents the notional amounts, at contract exchange rates, and the weighted average contractual foreign currency exchange rates. These forward contracts mature in October 2003.

	Notional Amount		Weighted Average Contract Rate
Forward Contracts:
Euro	$	8,697	$	1.13
British pound sterling		7,351		1.60
Japanese yen		6,557		115.06
Canadian dollar		4,350		1.37
Israeli shekel		1,583		4.46
Swedish krona		1,539		8.04
Other		3,538		—
Total	$	33,615

Item 4. Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective.

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Internal Control Over Financial Reporting

There has been no change in the Company’s internal control over financial reporting that occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

(All numerical references in thousands)

Cadence Design Systems, Inc. (Cadence) and the Company announced in September 2003 that they have agreed to settle all outstanding litigation between the companies relating to emulation and acceleration systems. The companies also reached agreement that, for a period of seven years, neither will sue the other over patented emulation and acceleration technology. In connection with the settlement, the Company recorded emulation litigation settlement costs of $20,264, which included a cash settlement of $18,000 paid to Cadence, an accrual for expected costs to perform future obligations specified in the settlement agreement, and attorneys’ fees. As part of the settlement, the Company agreed to join Cadence in the OpenAccess Coalition, sponsored by Si2.

From time to time, the Company is involved in various disputes and litigation matters that arise from the ordinary course of business. These include disputes and lawsuits relating to intellectual property rights, licensing, contracts and employee relation matters.

Item 2. Changes in Securities and Use of Proceeds

(All numerical references in thousands, except for rates and per share amounts)

On August 6, 2003, the Company closed a private offering of $110,000 aggregate principal amount of Floating Rate Convertible Subordinated Debentures (Debentures) Due 2023 issued solely to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933. Interest on the Debentures is payable quarterly at a variable interest rate equal to 3-month LIBOR plus 1.65%, reset quarterly. The Debentures are convertible under certain circumstances into the Company’s common stock at a conversion price of $23.40 per share, for a total of 4,700 shares. These circumstances generally include (a) the market price of the Company’s common stock exceeding 120% of the conversion price, (b) the market price of the Debentures declining to less than 98% of the value of the common stock into which the Debentures are convertible, or (c) a call for redemption of the Debentures or certain other corporate transactions.

After aggregate underwriting commissions and expenses, the Company netted approximately $105,000 in proceeds from the offering. The Company used approximately $29,800 of the net proceeds from the offering to repurchase shares of its common stock at a price of $17.02 per share simultaneously with the issuance of the Debentures. The remainder of the net proceeds will be used for general corporate purposes, which may include acquisitions of other companies. Merrill Lynch & Co., Banc of America Securities LLC, Fleet Securities, Inc. and Needham & Company, Inc. acted as initial purchasers of the Debentures.

Item 6. Exhibits and Reports on Form 8-K.

(All numerical references in thousands)

(a) Exhibits

4.1	Indenture dated as of August 6, 2003 between the Company and Wilmington Trust Company related to Floating Rate Convertible Subordinated debentures due 2023. Incorporated by reference to Exhibit 4.2 of the Company’s Registration Statement on Form S-3 (Registration No. 333-109885).
4.2	Registration Rights Agreement dated as of August 6, 2003. Incorporated by reference to Exhibit 4.4 of the Company’s Registration Statement on Form S-3 (Registration No. 333-109885).

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31.1	Certification of Chief Executive Officer of Registrant Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Chief Financial Officer of Registrant Pursuant to SEC Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certification of Chief Executive Officer and Chief Financial Officer of Registrant Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K

On July 23, 2003, the Company filed a current report on Form 8-K to report under Item 9 that on July 23, 2003, the Company had announced second quarter 2003 earnings.

On July 24, 2003, the Company filed a current report on Form 8-K to report under Item 9 that on July 23, 2003, the Company had provided outlook for the third quarter and balance of 2003.

On July 31, 2003, the Company filed a current report on Form 8-K to report under Item 5 that the Company announced its intention to commence an offering of $100,000 in aggregate principal amount of convertible subordinated debentures to be issued pursuant to Rule 144A.

On August 1, 2003, the Company filed a current report on Form 8-K to report under Item 5 that the Company announced the pricing of a private offering of $100,000 aggregate principal amount of its convertible subordinated debentures to be issued to a qualified institutional buyers pursuant to Rule 144A.

On August 6, 2003, the Company filed a current report on Form 8-K to report under Item 5 that the Company had announced the closing of a private offering of $110,000 aggregate principal amount of its convertible subordinated debentures to be issued to qualified institutional buyers issued pursuant to Rule 144A.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated: November 14, 2003	MENTOR GRAPHICS CORPORATION (Registrant)
	/s/    GREGORY K. HINCKLEY
	Gregory K. Hinckley President

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