quarter, the carrying value of the UMC shares was reduced as we recorded a $152.8 million loss representing a decline in the market value of our UMC shares. In each quarter that the market value of the UMC investment is below carrying value, we evaluate whether the investment is other than temporarily impaired. We recorded the unrealized loss on our UMC investment in the September 30, 2001 Consolidated Statement of Operations. At that time, we believed the investment was other than temporarily impaired for the following reasons:

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it was becoming increasingly likely that the stock price would not recover based on the increasing size of the unrealized loss, the extended time period during which the stock price had continued to decline without a trend reversal, and the dampening volatility, which indicated to us that the stock price was becoming more stable;



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UMC's financial performance had weakened relative to earlier quarters;



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the opinion of many industry observers and analysts regarding the semiconductor downturn had become significantly more negative;



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the events of September 11, 2001 further exacerbated market conditions;



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we had previously believed that UMC would initiate an ADR conversion program that would enable us to sell our shares at a premium on the New York Stock Exchange, but such a program was never initiated; and



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although we still had the intent and ability to hold the shares for an indefinite period, we concluded this fact did not overcome the negative factors associated with the shares.

        Interest Income..   Interest income was $4.4 million in 2004, $3.6 million in 2003 and $5.4 million in 2002,2002. The increase in 2004 when compared to 2003 is attributable to higher balances and $17.7 million in 2001.interest rates. The decrease in 2003 when compared to 2002 was due to lower interest rates on invested balances. The decrease in 2002 when compared to 2001 was due to lower invested balances as a result of our acquisition of Agere FPGA (see note 5 to our Consolidated Financial Statements) and lower interest rates on invested balances.

Interest Expense.Expense.   Interest expense was approximatelyinsignificant in 2004, $7.1 million in 2003, and $12.6 million in 2002 and $14.0 million in 2001.2002. Substantially all interest expense resulted from the debt issued to partially fund our Vantis acquisition. The decrease in 2004 when compared to 2003 and in 2003 when compared to 2002 was due to the redemptionextinguishment of our remaining 4³/¤4% Convertible Subordinated Notes in July 2003. The decrease in 2002 when compared to 2001 is due to the extinguishment of approximately $51.9 million of our 4³/4% Convertible Subordinated Notes during the year (see note 11(See Note 12 to our Consolidated Financial Statements).

Other Income.Income, net.   Other income, net, was $7.0 million in 2004, $0.4 million in 2003, and $13.4 million in 20022002. For 2004, Other income, net, consists of a $6.1 million gain on sale of UMC shares and $0.3a $2.8 million in 2001.gain on extinguishment of Zero Coupon Convertible Subordinated Notes due 2010 net of $1.9 million amortization of convertible note issuance costs and other costs. For 2003, Other income, net, consists of gains$1.4 million of gain recorded on the partial extinguishment of our convertible subordinated notes,Zero Coupon Convertible Subordinated Notes due 2010, substantially offset by the $4.7 million call premium associated with the redemptionextinguishment of our 4³/¤4% Convertible Subordinated Notes (see note 11Note 12 to our Consolidated Financial Statements). For 2002, the amount recorded consists primarily of a $9.3 million gain in conjunction with the extinguishment of a portion of our convertible subordinated notes43¤4% Convertible Subordinated Notes (see note 11Note 12 to our Consolidated Financial Statements), and a $4.0 million gain in conjunction with the sale of a portion of our UMC shares (see noteNote 7 to our Consolidated Financial Statements).

Provision (Benefit) Provision for Income Taxes.Taxes.   The 2004 tax provision is related to income taxes on our foreign subsidiaries primarily engaged in selling and research and development activities. The tax benefit in 2003 is primarily a result of releasing certain$3.4 million of tax reserves ($3.4 million) as the related statute of limitations expired and a $2.5 million refund of Federal income taxes ($2.5 million).taxes. The provision for income taxes for 2002 of $81.9 million is primarily the result of a $118.6 million charge to income tax expense recorded in the fourth quarter of 2002, representing a full valuation allowance for our recorded deferred tax assets (see note 10Note 11 to our Consolidated Financial Statements). The tax benefit in 2001 is the result of the pretax loss reported in

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the period and the tax rate in 2001 is lower than the combined federal and statutory rates primarily because of tax exempt investment income and tax credits.

Critical Accounting Policies and Estimates

Critical Accounting Policies are those "thatthat are both most important to the portrayal of a company'scompany’s financial condition and results, and require management'smanagement’s most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain." A description of our critical accounting policies follows.

Use of Estimates.Estimates.   The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, such as accounts receivable, inventory and deferred income taxes and liabilities, such as accrued liabilities, income taxes and deferred income, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the fiscal periods presented. Actual results could differ from those estimates.

Revenue recognition.recognition.   Revenue from direct customers is recognized upon shipment provided that persuasive evidence of a sales arrangement exists, the price is fixed and determinable, title has transferred, collection of resulting receivables is probable, there are no customer acceptance requirements and no remaining significant obligations. Certain of our sales are made to distributors under agreements providing price protection and right of return on unsold merchandise. Revenue and costs relating to such distributor sales are deferred until the product is sold by the distributor and related revenue and costs are then reflected in income.

Our method of revenue recognition for deferred distributor sales is based on certain assumptions including our average collection experience compared to resale reported by the distributors. To the extent actual results differ from these assumptions, revenue will change accordingly.

Deferred income.income.   In determining the balance in the deferred income account, we make estimates of salable and returnable inventory at certain distributors and we make estimates similar to those used to value inventory on hand to value inventory at these distributors. To the extent actual results differ from these estimates, the balances of reported deferred income, revenue and cost of products sold will change accordingly.

        Inventory.Inventory.   We value inventory at the lower of cost or market on a quarterly basis. In addition, we write down unproven, excess and obsolete inventories to net realizable value. To value our inventory, we make a number of estimates and assumptions including future price declines and forecasted demand for our products. To the extent actual results differ from these estimates and assumptions, the balances of reported inventory and cost of products sold will change accordingly.

Long-Lived Assets.Assets.   We account for our long-lived assets, primarily property and equipment and amortizable intangible assets, in accordance with Statement of Financial Accounting Standards ("SFAS"(“SFAS”) No. 144, "Accounting“Accounting for the Disposal of Long-Lived Assets,"” which requires us to review the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment is measureddetermined by comparing the estimated undiscounted cash flows to the carrying amount. A loss is recorded if the carrying amount of the asset exceeds the estimated undiscounted cash flows. Intangible assets are generally being amortized over five years, and fifteen years for income tax purposes, on a straight-line basis.

Accounting for income taxes.taxes.   To report income tax expense related to operating results, we record current and deferred income tax assets and liabilities in our balance sheet. In determining the value of our deferred tax assets, we make estimates of future taxable income. As of December 31, 20022004, 2003 and 2003,2002, we have recorded full valuation allowances for all of our deferred tax assets due to uncertainties

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regarding their realization. In determining the value of income tax liabilities, we make estimates of the results of future examinations of our income tax returns by taxing authorities. To the extent actual results differ from these estimates, our income tax provision will be affected accordingly.

New Accounting Pronouncements

        In January 2003, the Financial Accounting Standards Board ("FASB") issued Financial Standards Accounting Board Interpretation ("FIN") No. 46, "Consolidation of Variable Interest Entities," an interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial Statements." FIN 46 establishes accounting guidance for consolidation of a variable interest entity. In a variable interest entity the equity investors do not have a controlling interest or their equity interest is insufficient to finance the entity's activities without receiving additional subordinated financial support from the other parties. We do not currently have any business relationship with a variable interest entity, so the adoption of FIN 46 had no impact on our consolidated financial position or results of operations.

        In April 2003, the FASB issued SFAS 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 activities under SFAS 133. SFAS 149 is effective for contracts entered into or modified after June 20, 2003. The adoption of SFAS 149 did not have a material effect on our results of operations, financial position or cash flows.

        In May 2003, the FASB issued SFAS 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." This pronouncement establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in certain circumstances) because that financial instrument embodies an obligation of the issuer. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for interim periods beginning after June 15, 2003. On November 7, 2003, FASB issued FASB Staff Position No. FAS 150-3 ("FSP 150-3"), "Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." FSP 150-3 deferred certain aspects of SFAS 150. The adoption of SFAS 150 and FSP 150-3 did not have a material impact on our results of operations, financial position or cash flows.

        On December 17, 2003, the Staff of the SEC issued Staff Accounting Bulletin No. 104 ("SAB 104"), "Revenue Recognition," which supersedes SAB 101, "Revenue Recognition in Financial Statements." SAB 104's primary purpose is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, superseded as a result of the issuance of EITF 00-21, "Accounting for Revenue Arrangements with Multiple Deliverables." Additionally, SAB 104 rescinds the SEC's "Revenue Recognition in Financial Statements Frequently Asked Questions and Answers" (the "FAQ") issued with SAB 101 that had been codified in SEC Topic 13, "Revenue Recognition." Selected portions of the FAQ have been incorporated into SAB 104. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The adoption of SAB 104 did not materially affect our revenue recognition policies, nor our results of operations, financial position or cash flows.

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Liquidity and Capital Resources

As of December 31, 2003,2004, our principal source of liquidity was $277.6$296.3 million of cash and short-term investments,marketable securities, which was approximately flat with$18.5 million greater than the balance of $276.9$277.8 million at December 31, 2002.2003. Working capital increaseddecreased to $328.5 million at December 31, 2004 from $363.6 million at December 31, 2003 from $348.8 million at December 31, 2002.2003. This increasedecrease was primarily due to cash generated from operations.payments to Fujitsu pursuant to the Advance Payment Agreement entered into in September 2004. During 20032004 we generated approximately $34.8$6.0 million of cash and cash equivalents from our operations, net of a $25.0 million payment to Fujitsu Limited (discussed below), compared with $46.0$34.8 million during 2002. This cash generation2003, of which approximately $26.0 million was primarily from refunds of federalattributable to income taxes previously paidtax refunds.

Accounts Receivable declined $7.2 million at December 31, 2004 compared to December 31, 2003 due to net losseslower billings in 2001the later portion of the fourth quarter of 2004 as compared to the similar period in 2003 combined with lower revenues in the December 2004 quarter compared to the December 2003 quarter.

Inventories decreased approximately $8.0 million, or 17%, at December 31, 2004 compared to December 31, 2003 and 2002.

        Inventories decreased by $9.6 million, or 17%, inat December 31, 2003 as compared to the balance at the end of the prior year primarily due to reduced starts and receipts of wafers in response to lowerchanging revenue levels.

Prepaid expenses and other current assets increased by approximately $6.2 million in December 31, 2004 as compared to December 31, 2003 primarily due to: increased amounts of prepaid wafers expected to be used in the next twelve months (see Note 7 to our Consolidated Financial Statements); increases in prepaid software licenses, maintenance contracts and insurance; and additional income tax refunds receivable. Prepaid expenses and other current assets decreased by approximately $18.9 million, or 54%, inat December 31, 2003 as compared to the balance of the prior year. This decrease isDecember 31, 2002 primarily due primarily to a decrease in refundable income taxes, offsetting an approximate $6.2 million increase in the amount of prepaid wafers expected to be used in the next twelve months (see noteNote 7 to our Consolidated Financial Statements).

        EquityThe current portion of equity securities available for sale decreased from $35.4 million to $24.2 million at December 31, 2004 as compared to December 31, 2003. These securities represent the portion of our investment in UMC that are available for sale during 2005 (see Note 7 to our Consolidated Financial Statements). The current portion of equity securities available for sale increased by $35.4 million, or 100%, at December 31, 2003 as compared to December 31, 2002.

Property and equipment, less accumulated depreciation, decreased by $6.2 million at December 31, 2004 as compared to December 31, 2003 and decreased by $9.0 million in 2003 as compared to the balance in the prior year. These securities representyear due to lower expenditures for capital equipment. Net intangible assets decreased by $43.8 million and $71.3 million in 2004 and 2003 as compared to the portionbalance of our investmentthe prior year, respectively, which is attributable to amortization of these assets.

Capital expenditures were approximately $10.7 million, $9.7 million, and $17.5 million in UMC that we2004, 2003 and 2002, respectively. We expect to sell duringspend approximately $15 million to $20 million on capital expenditures for the fiscal year ended December 31, 2005.

Foundry investments, advances and other assets increased by approximately $11.0 million at December 31, 2004 compared to December 31, 2003 due to a $50.0 million recorded advance for wafer supply to Fujitsu (see notesNote 7 and 17 to our Consolidated Financial Statements). partially offset by a decline in our UMC investment due to $36.6 million of shares sold and a $13.2 million market price decline. Foundry investments, advances and other assets decreased by approximately $17.6 million, or 17%, inat December 31, 2003 as compared to the balance of the prior year. This was primarily due to the $35.4 million of our UMC investment reclassified to equity securities available for sale as described above and the $6.2 million reclassified to prepaid expenses and other current assets related to prepaid wafers, described above, partially offset by a $24.6 million gain recorded in Accumulatedaccumulated other comprehensive (loss) income related to changes in the market value of our UMC shares. Property

As of December 31, 2004, we owned 60.8 million shares of UMC common stock of which 23.3 million shares were restricted from sale for more than one year by the terms of our agreement with UMC. During 2002, we sold approximately 7.6 million shares of UMC common stock for approximately $9.9 million in cash, resulting in a gain of $4.0 million. During 2004, we sold 36.6 million of our UMC shares for approximately $29.6 million in cash, resulting in a gain of approximately $6.1 million. In the future, we may choose to liquidate additional UMC shares.

In 1997 we entered into an advance payment production agreement with Seiko Epson and equipment, less accumulated depreciation, decreasedEpson Electronics America, Inc. (“EEA”), which was subsequently amended in 2002 and March 2004. Under this agreement we advanced $51.3 million to Seiko Epson to finance construction of an eight-inch sub-micron semiconductor wafer manufacturing facility. The advance is to be repaid with semiconductor wafers over a multi-year period. No interest income is recorded. The agreement calls for wafers to be supplied by $9.0Seiko Epson through EEA pursuant to purchase agreements with EEA. Cumulatively, $26.2 million or 14%, in 2003 as comparedof these payments have been repaid to the balanceus in the prior year due to lower expenditures for capital equipment. Net intangible assets decreased by $71.3form of semiconductor wafers. We currently estimate that approximately $12.9 million or 46%, in 2003 as compared to the balance of the prior year which is attributableoutstanding advances are expected to amortizationbe repaid with semiconductor wafers during 2003.the next twelve months and are thus reflected as part of Other current assets in our Consolidated Balance Sheet. We are not obligated to make additional payments under this agreement.

On June 20, 2003, we issued $200$200.0 million in Zero Coupon Convertible Subordinated Notes due July 1, 2010. No interest will accrue or be payable related to these notes. Holders of these notes may convert the notes into shares of our common stock at any time before the close of business on the date of their maturity, unless the notes have been previously redeemed or repurchased, if (1) the price of our common stock issuable upon conversion of a note reaches a specified threshold, (2) the notes are called for redemption, (3) specified corporate transactions occurif we request a redemption, or make a distribution to common stockholders that is dilutive to note holders or if we become a party to a merger or consolidation or sale of substantially all of our assets or (4) the trading price of the notes falls below certain thresholds. The conversion price is approximately $12.06 per share, subject to adjustment in certain circumstances. On or after July 1, 2008, we have the option to redeem all or a portion of the notes that have not been previously repurchased or converted at 100% of the principal amount of the notes. On July 1, 2008, holders have the option to require us to purchase all or a portion of their notes in cash at 100% of the principal amount of the notes. Holders also have the right, subject to certain conditions, to require us to repurchase the notes in the event of a "fundamental change"“fundamental change” (as defined in the indenture governing the notes) at 100% of the principal amount of the notes. Generally, a fundamental change is an occurrence resulting in substantially all of our common stock being converted into common stock which is not listed on a United States stock exchange or Nasdaq.

The notes are subordinated in right of payment to all of our senior indebtedness, and are structurally subordinated as to the revenues and assets of our subsidiaries to all debt and other liabilities of our subsidiaries. At December 31, 2003,2004, we had no senior indebtedness and our subsidiaries had approximately $2.4$2.2 million of debt and other liabilities outstanding. Issuance costs relative to these convertible notes are included in "Foundry“Foundry investments, advances and other assets"assets” and aggregated approximately $5.4 million and are being amortized to expense over the lives of the notes. Accumulated amortization of these issuance costs was approximately $3.2 million and $1.4 million as of December 31, 2003.

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        The estimated fair value of these convertible notes, based on quoted market prices, was approximately $192 million at2004 and December 31, 2003.2003, respectively.

In October 2003, our board of directors authorized management to repurchase up to $100$100.0 million of our Zero Coupon Convertible Subordinated Notes due July 1, 2010. During the third quarter2004, we extinguished approximately $15.0 million of these notes for approximately $12.0 million in cash and recognized a net gain of approximately $2.8 million after writing off approximately $0.2 million of unamortized issuance costs. During 2003, we extinguished approximately $16.0 million of these notes for approximately $14.2 million in cash and recognized a net gain of approximately $1.4 million. In connection with this transaction, we also wrote off approximately $0.4 million of unamortized issuance costs. In the first quarter through March 11, 2005 we extinguished $5.3 million of our Zero Coupon Convertible Subordinated Notes due July 1, 2010 for $4.5 million resulting in a gain of $0.7 million which will be included in Interest and other income (expense) for the March 31, 2005 quarter. In the future we may choose to extinguish additional Zero Coupon Convertible Subordinated Notes due July 1, 2010.

The estimated fair value of the Zero Coupon Convertible Subordinated Notes due July 1, 2010, based on quoted market prices, was approximately $145.1 million at December 31, 2004.

On July 21, 2003, we redeemedextinguished for cash all of our outstanding 43/¤4% Convertible Subordinated Notes due in 2006, originally issued in October 1999, plus accrued interest. Total cash paid at redemptionextinguishment approximated $178.8 million, including par value of $172.3 million, accrued interest of approximately $1.8 million and a call premium of 2.71% of the outstanding notes, or approximately $4.7 million. This call premium, plus unamortized issuance costs of approximately $1.0 million as of the redemptionextinguishment date, was recorded as "Other expense"“Other expense” in the quarter ended September 30, 2003.

During 2002, we extinguished approximately $51.9 million face value of our 43/¤4% Convertible Subordinated Notes due in 2006 for approximately $42.8 million in cash, including accrued interest. We recognized a net gain of approximately $9.3 million in connection with these transactions.

        Capital expenditures were approximately $9.7 million, $17.5 millionOn September 10, 2004, we entered into an Advance Payment and $13.8 million for 2003, 2002 and 2001, respectively. We expectPurchase Agreement (the “Fujitsu Agreement”) with Fujitsu Limited (“Fujitsu”), pursuant to spend approximately $15which we will advance $125.0 million to $20Fujitsu in support of the development and construction of a new 300mm wafer fabrication facility in Mie, Japan. The initial two payments of $25.0 million on capital expenditureseach were made in October 2004 and January 2005, with the remaining payments to be made in two stages upon the achievement of certain milestones. We currently anticipate that the advance payment will be paid in full by the second quarter of 2006.

Our $125.0 million advance will be credited against the purchase price of 300 mm wafers from the new wafer fabrication facility. The Fujitsu Agreement will continue until the full amount of the advance payment has been returned to us in the form of wafers or other repayment, subject to the right of either party to terminate the agreement upon the occurrence of certain events. We may request a refund of the unused amount of the advance payment if we have not used all of our wafer credits by December 31, 2007. The repayment obligation of Fujitsu is unsecured.

The foregoing summary description of the Fujitsu Agreement is qualified in its entirety by reference to the Fujitsu Agreement, which is filed as an exhibit to our Form 10Q for the fiscal year ending December 31,quarter ended September 30, 2004.

The following table summarizes our significant contractual cash obligations at December 31, 20032004 (in thousands):