Set forth below is a line graph comparing the annual percentage change in the cumulative total shareholder return on the Company’s common stock, based upon the market price of the Company’s common stock, with the total return on companies within the Nasdaq Composite Index and the Research Data Group, Inc. Nasdaq Lab Apparatus & Analytical, Optical, Measuring & Controlling Instrument (SIC 3820-3829 US Companies) Index (the “Nasdaq Lab Apparatus Index”). The performance graph assumes an investment of $100 in each of the Company and the two indices, and the reinvestment of any dividends. The historical information set forth below is not necessarily indicative of future performance. Data for the Nasdaq Composite Index and the Nasdaq Lab Apparatus Index was provided to the Company by Research Data Group, Inc.

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*

Among Cognex Corporation, The NASDAQ Composite Index

And NASDAQ Stocks (SIC 3820-3829 U.S. Companies) Lab Apparatus & Analyt,Opt, Measuring, and Controlling Instr

* $100 invested on 12/31/06 in stock or index-including reinvestment of dividends. Fiscal year ending December 31.

ITEM 6:  SELECTED FINANCIAL DATA

ITEM 7:MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

Certain statements made in this report, as well as oral statements made by the Company from time to time, constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Readers can identify these forward-looking statements by our use of the words “expects,” “anticipates,” “estimates,” “believes,” “projects,” “intends,” “plans,” “will,” “may,” “shall,” “could,” “should,” and similar words and other statements of a similar sense. These statements are based upon our current estimates and expectations as to prospective events and circumstances, which may or may not be in our control and as to which there can be no firm assurances given. These forward-looking statements, which include statements regarding business and market trends, future financial performance, customer order rates, expected areas of growth, research and growthdevelopment activities, and strategic plans, involve known and unknown risks and uncertainties that could cause actual results to differ materially from those projected. Such risks and uncertainties include: (1) current and future conditions in the global economy; (2) the cyclicality of the semiconductor and electronics industries; (3) the reliance on revenue from the automotive industry; (4) the inability to penetrate new markets; (4)(5) the inability to achieve significant international revenue; (5)(6) fluctuations in foreign currency exchange rates; (6)(7) the loss of a large customer; (7)(8) the inability to attract and retain skilled employees; (8)(9) the reliance upon key suppliers to manufacture and deliver critical components for our products; (9)(10) the failure to effectively manage product transitions or accurately forecast customer demand; (10)(11) the inability to design and manufacture high-quality products; (11)(12) the technological obsolescence of current products and the inability to develop new products; (12)(13) the failure to properly manage the distribution of products and services; (13)(14) the inability to protect our proprietary technology and intellectual property; (14)(15) our involvement in time-consuming and costly litigation; (15)(16) the impact of competitive pressures; (16)(17) the challenges in integrating and achieving expected results from acquired businesses; (17)(18) potential impairment charges with respect to our investments or for acquired intangible assets or goodwill; (18)(19) exposure to additional tax liabilities; and (19)(20) information security breaches or business system disruptions. The foregoing list should not be construed as exhaustive and we encourage readers to refer to the detailed discussion of risk factors included in Part I – Item 1A of this Annual Report on Form 10-K. The Company cautions readers not to place undue reliance upon any such forward-looking statements, which speak only as of the date made. The Company disclaims any obligation to subsequently revise forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date such statements are made.

EXECUTIVE OVERVIEW

Cognex Corporation is a leading worldwide provider of machine vision products that capture and analyze visual information in order to automate tasks, primarily in manufacturing processes, where vision is required. Our Modular Vision Systems Division (MVSD) specializes in machine vision systems and ID products that are used to automate the manufacture and tracking of discrete items, while our Surface Inspection Systems Division (SISD) specializes in machine vision systems that are used to inspect the surfaces of materials processed in a continuous fashion.

In addition to product revenue derived from the sale of machine vision systems, the Company also generates revenue by providing maintenance and support, training, consulting, and installation services to its customers. Our customers can be classified into three primary markets: factory automation, semiconductor and electronics capital equipment, and surface inspection.

industries, including automotive, consumer electronics, food and beverage, health and beauty, pharmaceutical, medical devices, and solar.devices. The factory automation market also includes customers who purchase Cognex vision products for use outside of the assembly process, such as using ID products in logistics automation for package sorting and distribution. Sales to factory automation customers represented approximately 75% of total revenue in 2012 compared to 73% of total revenue in 2011, compared to 69% of total revenue in 2010.2011.

Revenue for the year ended December 31, 20112012 totaled $321,914,000,$324,279,000, representing an increase of 11%1% over the prior year. WhileAlthough revenue was relatively flat overall, growth in the factory automation and surface inspection markets was partially offset by lower sales in the cyclical semiconductor and electronics capital equipment market declined from 2010, sales in the factory automation and surface inspection markets reached record levels for both the fourth quarter and full year of 2011. The higher revenue contributed to a grossmarket. Gross margin of 76%was relatively flat at 75.5% of revenue in 2011,2012 compared to 73%75.8% of revenue in 2010.2011. Operating expenses increased by $21,250,0002% over the prior year due primarily to expenses associated with increased headcount in strategic areas, partially offset by lower company bonus accruals and the unfavorablefavorable impact of changes in foreign currency exchange rates, and higher stock-based compensation expense.rates. The Company generated net income of $68,098,000, or 21% of revenue, in 2012 compared to net income of $69,869,000, or 22% of revenue, in 2011, compared to net income of $61,381,000, or 21% of revenue, in 2010.2011.

The following table sets forth certain consolidated financial data as a percentage of revenue:

RESULTS OF OPERATIONS

As foreign currency exchange rates are a factor in understanding period-to-period comparisons, we believe the presentation of results on a constant-currency basis in addition to reported results helps improve investors’ ability to understand our operating results and evaluate our performance in comparison to prior periods. We also use results on a constant-currency basis as one measure to evaluate our performance. Constant-currency information compares results between periods as if exchange rates

had remained constant period-over-period. We generally refer to such amounts calculated on a constant-currency basis as excluding the impact of foreign currency exchange rate changes. Results on a constant-currency basis are not in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) and should be considered in addition to, and not as a substitute for, results prepared in accordance with U.S. GAAP.

Year Ended December 31, 2012 Compared to Year Ended December 31, 2011

Revenue

Revenue for the year ended December 31, 2012 increased by $2,365,000, or 1%, from the prior year. This increase was due to a $9,220,000, or 4%, increase in sales to factory automation customers and a $2,342,000, or 5%, increase in sales to surface inspection customers, partially offset by a $9,197,000, or 24%, decrease in sales to semiconductor and electronics capital equipment customers.

Factory Automation Market

Sales to customers in the factory automation market represented 75% of total revenue in 2012 compared to 73% of total revenue in 2011. Sales to these customers increased by $9,220,000, or 4%, from the prior year. A weaker Euro, on average, in 2012 compared to the prior year had a negative impact on reported factory automation revenue, as sales denominated in Euros were translated to U.S. Dollars at a lower rate. Excluding the impact of foreign currency exchange rate changes, which decreased factory automation revenue by $6,297,000, sales to factory automation customers increased by $15,517,000, or 7%, from 2011.

Geographically, increases from the prior year in factory automation revenue excluding the impact of foreign currency exchange rate changes were reported in the Americas, Europe, and, most notably, in Asia, where the Company has made significant investments, particularly in China, to expand its sales and support infrastructure in order to access more of the machine vision market in this high-potential growth region. Revenue in Japan has declined over the past two years since the natural disasters that hit this region early in 2011. By product, the majority of the growth in factory automation revenue came from sales of the Company’s ID products, which are used in manufacturing applications as well as in the logistics industry for package sorting and distribution. The Company expects its China region and ID products to continue to be growth opportunities in 2013.

Sales to factory automation customers increased by $856,000, or 1%, in the fourth quarter of 2012 from the third quarter of 2012. In the fourth quarter of 2012, revenue trends in Asia, specifically in China, were negatively impacted by a slowdown in the consumer electronics industry, which overshadowed positive forward momentum in the factory automation markets in the Americas and Europe.

Semiconductor and Electronics Capital Equipment Market

Sales to customers who make automation equipment for the semiconductor and electronics industries represented 9% of total revenue in 2012 compared to 12% of total revenue in 2011. Sales to these customers decreased by $9,197,000, or 24%, from the prior year. The impact of foreign currency exchange rate changes on revenue was not significant in the semiconductor and electronics capital equipment market. Geographically, revenue decreased most significantly in Japan where many of the Company’s semiconductor and electronics capital equipment customers are located; however, decreases were noted across all regions in which the Company operates.

Sales to semiconductor and electronics capital equipment customers decreased by $1,346,000, or 20%, in the fourth quarter of 2012 from the third quarter of 2012. The semiconductor and electronics capital equipment market has historically been highly cyclical and management has limited visibility regarding future order levels from these customers.

Surface Inspection Market

Sales to customers in the surface inspection market represented 16% of total revenue in 2012 compared to 15% of total revenue in 2011. Sales to these customers increased by $2,342,000, or 5%, from

the prior year. Excluding the impact of foreign currency exchange rate changes, which decreased surface inspection revenue by $725,000, sales to surface inspection customers increased by $3,067,000, or 6%, from 2011. This increase was primarily due to higher service revenue derived from spare parts sales, training services, and maintenance and support contracts.

Sales to surface inspection customers increased by $2,582,000, or 22%, in the fourth quarter of 2012 from the third quarter of 2012. Due to the relatively large average order values at SISD, the revenue reported each quarter can vary significantly depending upon the timing of customer orders, system deliveries, and installations, as well as the impact of revenue deferrals.

Product Revenue

Product revenue decreased by $1,722,000, or 1%, from the prior year. Although the Company sold a higher volume of modular vision systems than the prior year, the average selling price declined in part due to a shift in revenue mix to ID Products, which have relatively lower average selling prices.

Service Revenue

Service revenue, which is derived from the sale of maintenance and support, training, consulting, and installation services, increased by $4,087,000, or 17%, from the prior year. This increase was due to higher consulting services at MVSD, as well as higher revenue from SISD spare part sales, training services, and maintenance and support contracts. Service revenue increased as a percentage of total revenue to 9% in 2012 from 8% in 2011.

Gross Margin

Gross margin as a percentage of revenue was relatively flat at 75.5% for 2012 compared to 75.8% for 2011.

MVSD Margin

MVSD gross margin as a percentage of revenue was 80% in both 2012 and 2011. A reduction in product margins due to higher new product introduction costs on a relatively flat product revenue base was offset by improvements in service margins due to higher margins from consulting services.

SISD Margin

SISD gross margin as a percentage of revenue was 54% in 2012 compared to 51% in 2011. This increase was due to improvements in both product and service margins. Product margins improved primarily due to manufacturing efficiencies, as SISD manufacturing costs were lower in 2012 than the prior year. Service margins improved due to a shift in revenue mix to relatively higher margin spare part sales and training services.

Product Margin

Product gross margin as a percentage of revenue was 78% in both 2012 and 2011. Lower MVSD product margins due to higher new product introduction costs were offset by higher SISD product margins due to manufacturing efficiencies.

Service Margin

Service gross margin as a percentage of revenue was 51% in 2012 compared to 46% in 2011. This increase was due to higher margins from spare part sales and training services at SISD, as well as higher margins from consulting services at MVSD.

Operating Expenses

Research, Development, and Engineering Expenses

Research, development, and engineering (RD&E) expenses in 2012 increased by $603,000, or 1%, from the prior year. MVSD RD&E expenses were relatively flat, while SISD RD&E expenses increased by $544,000, or 16%.

The table below (in thousands) details the $59,000 net increase in MVSD RD&E in 2012:

Personnel-related costs have increased from the prior year due to additional headcount, partially offset by lower average costs per employee. Over the past year, the Company has continued to increase headcount to support strategic initiatives, resulting in higher personnel-related costs, such as salaries and fringe benefits. Many of these employees have been added in Budapest, Hungary, which has resulted in a decrease in the average cost per employee. These investments were offset by lower company bonus accruals based on the Company’s operating income margin. In addition, a weaker Euro in 2012 compared to the prior year resulted in lower RD&E costs when expenses of the Company’s foreign operations were translated to U.S. Dollars.

The increase in SISD RD&E expenses was primarily due to increased salaries and fringe benefits expenses ($332,000), as well as higher materials spending ($77,000) and outsourced engineering services ($61,000).

RD&E expenses as a percentage of revenue were 13% in both 2012 and 2011. We believe that a continued commitment to RD&E activities is essential in order to maintain or achieve product leadership with our existing products and to provide innovative new product offerings. In addition, we consider our ability to accelerate time-to-market for new products to be critical to our revenue growth. Therefore, we expect to continue to make significant RD&E investments in the future. Although we target our RD&E spending to be between 10% and 15% of total revenue, this percentage is impacted by revenue levels.

Selling, General, and Administrative Expenses

Selling, general, and administrative (SG&A) expenses in 2012 increased by $2,134,000, or 2%, from the prior year. MVSD SG&A expenses increased by $3,624,000, or 4%, and SISD SG&A expenses increased by $101,000, or 1%. Corporate expenses that are not allocated to either division decreased by $1,591,000, or 12%.

The table below (in thousands) details the $3,624,000 net increase in MVSD SG&A in 2012:

Personnel-related costs have increased from the prior year due to additional headcount, and to a lesser extent, higher average costs per employee. Over the past year, the Company has continued to increase headcount in strategic areas, principally Sales, resulting in higher personnel-related costs,

such as salaries, fringe benefits, commissions, and travel expenses. Average costs per employee have increased over the prior year due primarily to modest wage increases granted early in 2012 and higher fringe benefits, such as health care costs. The Company also recorded higher depreciation expense related principally to business system upgrades and leasehold improvements, increased stock-based compensation expense due to a higher valuation of stock options granted in the fourth quarter of 2011 and a lower level of credits related to forfeited options, and increased spending on sales demonstration equipment. In addition, the Company began to accrue expenses in 2012 associated with a long-term incentive plan implemented in China in lieu of granting stock options in this region. These increases were offset by lower company bonus accruals based upon the Company’s operating income margin and lower sales commissions as a result of fewer sales employees exceeding their bookings quotas compared to the prior year. In addition, a weaker Euro in 2012 compared to the prior year resulted in lower SG&A costs when expenses of the Company’s foreign operations were translated to U.S. Dollars.

The increase in SISD SG&A expenses was primarily due to increased salaries and fringe benefits expenses ($421,000), partially offset by the unfavorable impact of changes in foreign currency exchange rates ($280,000).

The decrease in corporate expenses was primarily due to lower company bonus accruals ($1,110,000) and lower legal fees related to patent-infringement actions ($532,000 – refer to Note 9 to the Consolidated Financial Statements in Part II – Item 8 of this Annual Report on Form 10-K).

Nonoperating Income (Expense)

The Company recorded foreign currency losses of $880,000 in 2012 and $504,000 in 2011. In the third quarter of 2012, management changed the domicile of the subsidiary that held the Company’s Euro-denominated investment portfolio and also changed that subsidiary’s functional currency from the Euro to the U.S. Dollar. As a result of these changes, the investment portfolio was liquidated, primarily during the second quarter of 2012, and those funds were converted into U.S. Dollars when the change in domicile was completed. To protect against a potential devaluation in the Euro, the Company entered into forward contracts to exchange Euros for U.S. Dollars at fixed exchange rates. The settlement of these forward contracts resulted in a foreign currency loss of $504,000 recorded in the third quarter of 2012. In addition, the foreign currency losses in each period resulted from the revaluation and settlement of accounts receivable and intercompany balances that are reported in one currency and collected in another. Although a portion of the Company’s foreign currency exposure of accounts receivable is mitigated through the use of forward contracts, this program depends upon forecasts of sales and collections, and therefore, gains or losses on the underlying receivables may not perfectly offset losses or gains on the contracts.

Investment income in 2012 increased by $1,568,000, or 54%, from the prior year. The increase was primarily due to gains recognized on the sale of Euro-denominated investments, as well as an increase in cash that was available for investment.

The Company recorded other expense of $367,000 in 2012 and $636,000 in 2011. The Company recorded $141,000 of other income in the first quarter of 2012 upon the expiration of the statute of limitations relating to a tax holiday, during which time the Company collected value-added taxes from customers that were not required to be remitted to the government authority. Other income (expense) also includes rental income, net of associated expenses, from leasing buildings adjacent to the Company’s corporate headquarters. A portion of this space is currently unoccupied.

Income Tax Expense

The Company’s effective tax rate was a provision of 21% in 2012 compared to a provision of 20% in 2011. The increase in the effective tax rate was primarily due a higher proportion of the Company’s pre-tax income being earned in the United States, which is a relatively higher tax jurisdiction. In addition, the 2012 effective tax rate does not include any benefit from research and development tax credits, as discussed below.

The American Taxpayer Relief Act of 2012 was passed by Congress and signed into law on January 1, 2013. The provisions under this law were made retroactive to January 1, 2012. However, as a result of the law being signed on January 1, 2013, the financial impact of any retroactive provision will be recorded as a discrete event in the first quarter of 2013. The Company estimates that this discrete event will reduce tax expense in the first quarter of 2013 by $555,000 for the Research and Development tax credit for 2012.

RESULTS OF OPERATIONS

Year Ended December 31, 2011 Compared to Year Ended December 31, 2010

Revenue

Revenue for the year ended December 31, 2011 increased by $31,223,000, or 11%, from the prior year. This increase was due to a $35,317,000 increase in sales to factory automation customers and a $4,964,000 increase in sales to surface inspection customers, partially offset by a $9,058,000 decrease in sales to semiconductor and electronics capital equipment customers.

Factory Automation Market

Sales to customers in the factory automation market represented 73% of total revenue in 2011 compared to 69% of total revenue in 2010. Sales to these customers increased by $35,317,000, or 18%, from the prior year. A weaker U.S. Dollar relative to the Euro and Japanese Yen, on average, in 2011 compared to 2010 contributed to the higher revenue, as sales denominated in Euros and Yen were translated to U.S. Dollars. Excluding the impact of foreign currency exchange rate changes, onwhich increased factory automation revenue by $6,523,000, sales to factory automation customers increased by $28,794,000, or 14%, from 2010.

By region, the largest dollar increases were experienced in the Americas and Europe, where the Company has a broad base of factory automation customers, and the largest percentage increase was experienced in Asia, where the Company has made significant investments to expand its sales and support infrastructure, particularly in China, in order to access more of the machine vision market in this high-potential growth region. Revenue in Japan was lower than the prior year, as business levels in 2011 were negatively impacted by the earthquake that hit this region earlier in the year, as well as a slowdown in the consumer electronics industry during the second half of 2011.

By product, the majority of the growth in factory automation revenue came from sales of the Company’s ID products and In-Sight general-purpose vision systems. Sales of ID products, which are used in manufacturing applications as well as in the logistics industry for package sorting and distribution, increased $16,301,000, or 38%, from the prior year. The Company expects its ID business to continue to be a growth engine into 2012.

Sales to factory automation customers increased by $3,429,000, or 6%, in the fourth quarter 2011 from the third quarter of 2011. During the fourth quarter of 2011, the U.S. Dollar strengthened relative to the Euro, resulting in lower revenue as sales denominated in Euros were translated to U.S. Dollars. Excluding the impact of foreign currency exchange rate changes on revenue, sales to factory automation customers increased by $4,496,000, or 8%, in the fourth quarter of 2011 from the third quarter of 2011, primarily from customers in the Americas and to a lesser extent Europe, where economic conditions are more uncertain. Revenue trends in Japan and Asia during the second half of 2011 have been negatively impacted by a slowdown in the consumer electronics industry, which overshadowed positive forward momentum in the broader factory automation market.

Semiconductor and Electronics Capital Equipment Market

Sales to customers who make automation equipment for the semiconductor and electronics industries represented 12% of total revenue in 2011 compared to 16% of total revenue in 2010. Sales to these customers decreased by $9,058,000, or 19%, from the prior year. Excluding the impact of foreign currency exchange rate changes, onwhich decreased semiconductor and electronics capital equipment revenue by $1,356,000, sales to semiconductor and electronics capital equipment customers decreased by $10,414,000, or 22%, from 2010. Geographically, revenue decreased most significantly in Japan where many of the Company’s semiconductor and electronics capital equipment customers are located.

Revenue for this market has declined sequentially in each quarter of 2011. The semiconductor and electronics capital equipment market has historically been highly cyclical and management has limited visibility regarding future order levels from these customers.

Surface Inspection Market

Sales to customers in the surface inspection market represented 15% of total revenue in both 2011 and 2010. Sales to these customers increased by $4,964,000, or 12%, from the prior year. Excluding the impact of foreign currency exchange rate changes, onwhich increased surface inspection revenue by $1,332,000, sales to surface inspection customers increased by $3,632,000, or 8%, from 2010.

Geographically, revenue increased in the Americas, Europe, and Asia where we believe SISD gained market share, while revenue decreased in Japan in the aftermath of the earthquake that hit this region earlier in the year.

Sales to surface inspection customers increased by $4,196,000, or 35%, in the fourth quarter of 2011 from the third quarter of 2011. Due to the relatively large average order values at SISD, the revenue reported each quarter can vary significantly depending upon the timing of customer orders, system deliveries, and installations, as well as the impact of revenue deferrals.

Product Revenue

Product revenue increased by $33,847,000, or 13%, from the prior year due primarily to a higher volume of systems sold to customers in the factory automation market. The impact of the higher volume was partially offset by slightly lower MVSD average selling prices, as the Company introduced new products at lower price points. The growth in ID product units that are sold at relatively lower price points also contributed to the lower average selling prices.

Service Revenue

Service revenue, which is derived from the sale of maintenance and support, education, consulting, and installation services, decreased by $2,624,000, or 10%, from the prior year. In 2010, service revenue included $6,500,000 related to an arrangement with a single customer for which the work was performed over the prior four years, but revenue was deferred until the final obligation was completed in the fourth quarter of 2010. This decrease was partially offset by higher SISD installation and maintenance and support revenue, including spare part sales. Service revenue decreased as a percentage of total revenue to 8% in 2011 from 9% in 2010.

Gross Margin

Gross margin as a percentage of revenue was 76% for 2011 compared to 73% for 2010. This increase was due to improvements in both MVSD and SISD product margins.

MVSD Margin

MVSD gross margin as a percentage of revenue was 80% in 2011 compared to 78% in 2010. This increase was due to higher product margins resulting from manufacturing efficiencies achieved from higher revenue levels, as fixed manufacturing costs were spread over a higher revenue base. A greater percentage of MVSD revenue from the sale of products as opposed to lower-margin services also contributed to the increase.

SISD Margin

SISD gross margin as a percentage of revenue was 51% in 2011 compared to 44% in 2010. This increase was due to improvements in both product and service margins. Product margins improved primarily due to low-cost sourcing initiatives, higher average selling prices, and the impact of relatively flat manufacturing costs spread over a higher revenue base. The improvement in service margins was the result of a higher number of completed installations, as well as efficiencies achieved in the installation process.

Product Margin

Product gross margin as a percentage of revenue was 78% in 2011 compared to 77% in 2010. This increase was due to higher product margins at both MVSD and SISD as described above.

Service Margin

Service gross margin as a percentage of revenue was 46% in 2011 compared to 41% in 2010. This increase was due to higher SISD service margins as described above.

Operating Expenses

Research, Development, and Engineering Expenses

Research, development, and engineering (RD&E) expenses in 2011 increased by $7,866,000, or 24%, from the prior year. MVSD RD&E expenses increased by $7,857,000, or 26%, while SISD RD&E expenses were relatively flat.

The table below (in thousands) details the $7,857,000 net increase in MVSD RD&E in 2011:

During 2011, the Company increased MVSD RD&E headcount in strategic areas, resulting in higher personnel-related costs, such as salaries and fringe benefits. The Company also recorded increased stock-based compensation expense due to a higher valuation of stock options granted during 2011, increased spending on outsourced engineering services and materials related to engineering activities, and higher costs to patent new technology. In addition, a weaker U.S. Dollar relative to the Euro, on average, in 2011 compared to 2010 resulted in higher RD&E costs when expenses of the Company’s foreign engineering centers, primarily in Hungary, were translated to U.S. Dollars.

RD&E expenses as a percentage of revenue were 13% in 2011 and 11% in 2010. We believe that a continued commitment to RD&E activities is essential in order to maintain or achieve product leadership with our existing products and to provide innovative new product offerings. In addition, we consider our ability to accelerate time-to-market for new products to be critical to our revenue growth. Therefore, we expect to continue to make significant RD&E investments in the future. Although we target our RD&E spending to be between 10% and 15% of total revenue, this percentage is impacted by revenue levels.

Selling, General, and Administrative Expenses

Selling, general, and administrative (SG&A) expenses in 2011 increased by $13,459,000, or 13%, from the prior year. MVSD SG&A expenses increased by $15,463,000, or 20%, and SISD SG&A expenses increased by $576,000, or 5%. Corporate expenses that are not allocated to either division decreased by $2,580,000, or 16%.

The table below (in thousands) details the $15,463,000 net increase in MVSD SG&A in 2011:

During 2011, the Company increased MVSD SG&A headcount in strategic areas, resulting in higher personnel-related costs, such as salaries, fringe benefits, commissions, and travel expenses. The Company also recorded increased stock-based compensation expense due to a higher valuation of stock options granted during 2011, increased spending on marketing and promotional activities intended to grow factory automation revenue, and higher spending on sales demonstration equipment. In addition, a weaker U.S. Dollar relative to the Euro and Japanese Yen, on average, in 2011 compared to 2010 resulted in higher SG&A costs when expenses of the Company’s foreign sales and support offices were translated to U.S. Dollars. Offsetting the increase in sales commissions associated with additional personnel was a decrease in sales commissions as a result of fewer sales employees exceeding their bookings quotas compared to the prior year.

The increase in SISD SG&A expenses was primarily due to the unfavorable impact of changes in foreign currency exchange rates ($365,000) and increased stock-based compensation expense ($150,000).

The decrease in corporate expenses was due to lower legal fees related to patent-infringement actions ($4,273,000 – refer to Note 109 to the Consolidated Financial Statements in Part II – Item 8 of this Annual Report on Form 10-K). This decrease was partially offset by increased stock-based compensation expense ($1,003,000) and costs associated with the Company’s 30^th Anniversary parties held in the first quarter of 2011 ($480,000).

Nonoperating Income (Expense)

The Company recorded foreign currency losses of $504,000 in 2011 and $328,000 in 2010. The foreign currency fluctuations in each period resulted primarily from the revaluation and settlement of accounts receivable and intercompany balances that are reported in one currency and collected in another. Although the foreign currency exposure of accounts receivable is largely mitigated through the use of forward contracts, this program depends upon forecasts of sales and collections, and therefore, gains or losses on the underlying receivables may not perfectly offset losses or gains on the contracts.

Investment income in 2011 increased by $1,481,000, or 104%, from the prior year. The increase was primarily due to an increase in cash generated from operations that was available for investment, as well as a shift in investment mix to higher-yielding securities. Beginning in the second quarter of 2010, the Board of Directors approved a change to the Company’s investment policy to allow management to invest excess cash accumulated in the Company’s international entities in debt securities. Prior to this change, these funds were invested in lower-yielding savings accounts.

The Company recorded other expense of $636,000 in 2011 and $703,000 in 2010. Other expense includes rental income, net of associated expenses, from leasing buildings adjacent to the Company’s corporate headquarters. For a majority of 2011, these buildings were partially unoccupied.

Income Tax Expense

The Company’s effective tax rate was a provision of 20% in 2011 compared to a provision of 19% in 2010.

The effective tax rate for 2011 included the impact of the following discrete events: (1) a decrease in tax expense of $808,000 from the expiration of the statutes of limitations for certain reserves for income taxes, (2) a decrease in tax expense of $155,000 from the finalization of the Advanced Pricing Agreement between Japan and Ireland (Refer to Note 15 to the Consolidated Financial Statements in Part II- Item 8 of this Annual Report on Form 10-K.), partially offset by, (3) an increase in tax expense of $574,000 from the final true-up of the prior year’s tax accrual upon filing the actual tax returns, and (4) an increase in tax expense of $201,000 from the write down of a noncurrent deferred tax asset based upon a change in the tax rate in Japan. The effective tax rate in 2011 was a provision of 20%, with or without these discrete events.

The effective tax rate for 2010 included the impact of the following discrete events: (1) a decrease in tax expense of $462,000 from the settlement of the Competent Authority case with Japan, (2) a decrease in tax expense of $151,000 from the final true-up of the prior year’s tax accrual upon filing the actual tax returns, (3) a decrease in tax expense of $124,000 from the receipt of a state refund, and (4) a decrease in tax expense of $105,000 from the expiration of the statutes of limitations for certain reserves for income taxes. These discrete events changed the effective tax rate in 2010 from a provision of 20% to a provision of 19%.

The Company’s effective tax rate excluding discrete events in both 2011 and 2010 remained a provision of 20%.

RESULTS OF OPERATIONS

Year Ended December 31, 2010 Compared to Year Ended December 31, 2009

Revenue

Revenue for the year ended December 31, 2010 increased by $114,964,000, or 65%, from the prior year due to higher sales in all of the Company’s primary markets. A stronger U.S. Dollar relative to the Euro, on average, in 2010 compared to 2009, resulted in lower revenue, as sales denominated in Euros were translated to U.S. Dollars. This impact was offset, however, by the favorable impact on revenue of a weaker U.S. Dollar relative to the Japanese Yen.

Factory Automation Market

Sales to manufacturing customers in the factory automation market represented 69% of total revenue in 2010 compared to 70% of total revenue in 2009. Sales to these customers increased by $76,303,000, or 62%, from the prior year. Revenue in 2009 included $4,400,000 related to an arrangement with a single customer for which product was shipped in 2007 and 2008, but revenue was deferred until the final unit was delivered in the first quarter of 2009. Revenue in 2010 included $6,500,000 related to an arrangement with another customer for which the work was performed over the prior four years, but revenue was deferred until the final obligation was completed in the fourth quarter of 2010. In addition, revenue in 2010 included $2,505,000 related to the adoption of new revenue recognition rules that would have been deferred under the previous guidance. Excluding the recognition of the revenue noted above, sales to these customers increased by $71,698,000, or 60%, from the prior year. Management believes that excluding this revenue from the growth in factory automation sales allows investors to more accurately assess business trends.

Revenue levels in 2009 were adversely impacted by the worldwide economic slowdown that first began to affect the Company’s business in the third quarter of 2008. During the slowdown, the Company continued to invest in developing and marketing new factory automation products and expanding its global factory automation sales force and partner network. Demand for the Company’s factory automation

products increased sequentially in each quarter of 2010 and was at a record level during the fourth quarter of 2010. The largest dollar increases year over year were experienced in the Americas and Europe, where the Company has a broad base of factory automation customers. The largest percentage increases were experienced in Japan, where the Company has invested in a partnership with Mitsubishi Electric Corporation to help grow its factory automation business in this region, and in Southeast Asia, where the Company has expanded its sales and support infrastructure, particularly in China, in order to access more of the machine vision market for this high-potential region.

Semiconductor and Electronics Capital Equipment Market

Sales to customers who make automation equipment for the semiconductor and electronics industries represented 16% of total revenue in 2010 compared to 9% of total revenue in 2009. Sales to these customers increased by $31,828,000, or 208%, from the prior year. Geographically, revenue increased most significantly in Japan where many of the Company’s semiconductor and electronics capital equipment customers are located. The adoption of the new revenue recognition rules did not have a material impact on revenue from these customers in 2010.

Although revenue levels were significantly higher than the prior year, business in this market in 2009 was adversely impacted by the worldwide economic slowdown. Furthermore, demand in this market has declined sequentially in each quarter since the second quarter of 2010. This business continues to be impacted by the shift to software-only products, which have higher gross margins but average lower selling prices than a complete vision system with embedded hardware.

Surface Inspection Market

Sales to surface inspection customers represented 15% of total revenue in 2010 compared to 21% of total revenue in 2009. Revenue from these customers increased by $6,833,000, or 19%, from the prior year. In addition, surface inspection revenue increased on a sequential basis in each quarter of 2010 and was at a record level during the fourth quarter of 2010. This increase can be attributed to overall growth in the segment’s base business, the Smart View^® product line, as well as incremental revenue earned as a result of the Company’s acquisition and development of the SmartAdvisor™ product line. However, due to the relatively large average order values at SISD, the revenue reported for sales to surface inspection customers in each quarter can vary significantly depending upon the timing of customer orders, system deliveries, and installations, as well as the impact of revenue deferrals. The adoption of the new revenue recognition rules did not have a material impact on revenue from these customers in 2010.

Product Revenue

Product revenue increased by $105,084,000 in 2010 or 66%, from the prior year due to a significantly higher volume of vision systems sold, slightly offset by lower average selling prices, as the Company introduced new products at lower price points. A higher percentage of revenue from the sale of software-only products, which have relatively low selling prices, also contributed to the decrease in average selling prices from the prior year. Product revenue in 2009 included $4,400,000 related to an arrangement with a single customer for which product was shipped during 2007 and 2008, but revenue was deferred until the final unit was delivered in the first quarter of 2009.

Service Revenue

Service revenue, which is derived from the sale of maintenance and support, education, consulting, and installation services, increased by $9,880,000 in 2010 or 57%, from the prior year. In 2010, this revenue included $6,500,000 related to an arrangement with a single customer for which the work was performed over the prior four years, but revenue was deferred until the final obligation was completed in the fourth quarter of 2010. The remaining increase was due primarily to higher revenue from main-

tenance and support arising from a higher level of spare part sales and repair services, as well as higher revenue from consulting and installation services. Service revenue decreased as a percentage of total revenue to 9% in 2010 from 10% in 2009.

Gross Margin

Gross margin as a percentage of revenue was 73% for 2010 compared to 68% for 2009. This increase was primarily due to higher MVSD product margins and a higher percentage of total revenue from the sale of modular vision systems, which have higher margins than the sale of surface inspection systems.

MVSD Margin

MVSD gross margin as a percentage of revenue was 78% in 2010 compared to 74% in 2009. In 2010, MVSD margin included $6,500,000 of revenue from a customer arrangement with a 51% margin, which decreased the MVSD margin by one percentage point, while in 2009, MVSD margin included $4,400,000 of revenue from a customer arrangement with a 92% margin, which increased the MVSD margin by one percentage point. Excluding the recognition of these specific customer arrangements, the MVSD gross margin as a percentage of revenue was 79% in 2010 compared to 73% in 2009. The increase in MVSD margin was primarily due to higher product margins resulting from improved absorption of manufacturing overhead costs, relatively flat new product introduction costs spread over a higher revenue base, and lower provisions for excess and obsolete inventory. A higher percentage of revenue from the sale of software-only products, which have relatively high margins, also contributed to the increase in product margin from the prior year.

SISD Margin

SISD gross margin as a percentage of revenue was 44% in 2010 compared to 46% in 2009. The decrease in SISD margin was primarily due to a shift in mix of sales to lower-margin paper sales, higher discounting of products in response to competitive market pressures, and costs incurred in 2010 to start up a manufacturing operation in China. Although the Company achieved cost savings from the closure of its Kuopio, Finland facility late in 2009, certain of the manufacturing positions that were terminated in Finland were replaced at the division’s headquarters in Alameda, California, resulting in minimal impact on the SISD margin.

Product Margin

Product gross margin as a percentage of revenue was 77% in 2010 compared to 72% in 2009. This increase was primarily due to higher MVSD product margins as described above, as well as a higher percentage of total revenue from the sale of modular vision systems, which have higher margins than the sale of surface inspection systems.

Service Margin

Service gross margin as a percentage of revenue was 41% in 2010 compared to 35% in 2009. This increase was primarily due to a shift in mix to higher-margin spare parts, repair, and consulting services, as well as improvements in product ease of use that resulted in lower technical support costs. Consulting services included $6,500,000 of revenue from a single customer arrangement recorded in 2010 with a margin of 51%.

Operating Expenses

Research, Development, and Engineering Expenses

Research, development, and engineering (RD&E) expenses in 2010 increased by $1,948,000, or 6%, from the prior year. MVSD RD&E expenses increased by $1,821,000, or 7%, and SISD RD&E expenses increased $127,000, or 4%.

The table below details the $1,821,000 net increase in MVSD RD&E in 2010:

The lower stock-based compensation expense was due to the declining trend in the number of options granted, the accelerated expense taken in the fourth quarter of 2009 related to unvested options tendered by employees in the Company’s cash tender offer for certain underwater stock options, and higher estimated forfeiture rates in 2010. These savings were offset by the impact of stock options that were granted late in the second quarter of 2010 as part of the Company’s annual program. In addition, expenses increased as a result of company bonus accruals recorded during 2010 as the Company returned to profitability and higher vacation expense in 2010 as the Company did not continue the mandatory shutdown programs employed in 2009.

Although a work force reduction in the second quarter of 2009, primarily in the United States, reduced personnel-related costs in 2009, the Company increased RD&E headcount in strategic areas in 2010 due to the improved business climate, resulting in relatively flat personnel-related costs year over year. The majority of the headcount increase was in lower-cost regions, such as Hungary.

The increase in SISD RD&E expenses for 2010 was due to company bonus accruals recorded in 2010 ($149,000) and increased materials costs related to product development efforts ($136,000). These higher expenses were offset by lower personnel-related costs due to the closure of the division’s Kuopio, Finland facility late in 2009 ($240,000).

Selling, General, and Administrative Expenses

Selling, general, and administrative (SG&A) expenses in 2010 increased by $7,885,000, or 8%, from the prior year. MVSD SG&A expenses increased by $3,520,000, or 5%, while SISD SG&A expenses were relatively flat. Corporate expenses that are not allocated to either division increased by $4,320,000, or 38%.

The table below details the $3,520,000 net increase in MVSD SG&A in 2010:

The lower stock-based compensation expense was due to the declining trend in the number of options granted, the accelerated expense taken in the fourth quarter of 2009 related to unvested options ten-

dered by employees, higher estimated forfeiture rates in 2010, and higher credits related to forfeited options in 2010. These savings were offset by the impact of stock options that were granted late in the second quarter of 2010 as part of the Company’s annual program. A $1,000,000 intangible asset impairment charge in the first quarter of 2009 also contributed to the decrease in SG&A expenses. Offsetting these savings were higher sales commissions related to the increase in revenues over the prior year, higher spending on marketing and promotional expenses intended to grow factory automation revenue, and company bonus accruals recorded during 2010 as the Company returned to profitability.

Although a work force reduction in the second quarter of 2009 reduced personnel-related costs in 2009, the Company increased SG&A headcount in strategic areas in 2010 due to the improved business climate, resulting in relatively flat personnel-related costs year over year. The majority of this headcount increase was in lower-cost regions, such as China.

There were no significant changes to SISD SG&A expenses from the prior year.

The increase in corporate expenses was due to higher legal fees primarily related to patent-infringement actions ($1,463,000), company bonus accruals recorded in 2010 ($1,629,000), and higher tax service fees related to the settlement of the Competent Authority tax case with Japan ($312,000). In addition, a majority of the remaining increase is due to expenses for the Company’s President, which were transferred from MVSD into the corporate group upon his promotion in January 2010, as he then became responsible for both divisions.

Restructuring Charges

November 2008

In November 2008, the Company announced the closure of its MVSD facility in Duluth, Georgia. The $12,000 balance in this restructuring accrual as of December 31, 2009 was paid in the first quarter of 2010, thereby concluding this restructuring program.

April 2009

In April 2009, the Company implemented a variety of cost-cutting measures at MVSD intended to more closely align the Company’s cost structure with the lower levels of business at that time. Of the $16,000 balance in this restructuring accrual as of December 31, 2009, $4,000 was reversed in the first quarter of 2010, $8,000 was paid in the first quarter of 2010, and $4,000 was paid in the second quarter of 2010, thereby concluding this restructuring program.

September 2009

On October 1, 2009, which was part of the Company’s fiscal September, the Company announced the closure of its SISD facility in Kuopio, Finland to achieve cost savings and production efficiencies. This SISD facility included a system assembly and integration team, a spare parts depot, and an engineering group dedicated to supporting the Company’s SISD products, as well as finance and support staff.

The restructuring charge from these actions was $584,000, all of which has been recorded to date and included in “Restructuring charges” on the Consolidated Statements of Operations in the SISD reporting segment. The following table summarizes this restructuring plan (in thousands):

One-time termination benefits included salary, which the Company was obligated to pay over the legal notification period, and severance for eight employees who were terminated. A liability for the termination benefits of those employees who were not retained to render service beyond the legal notification period was measured and recognized at the communication date. A liability for the termination benefits of those employees who were retained to render service beyond the legal notification period was measured initially at the communication date but was recognized over the future service period. Contract termination costs included rental payments for the Kuopio, Finland facility during the periods for which the Company did not receive an economic benefit, as well as lease cancellation costs. The costs related to rental payments were recognized in the fourth quarter of 2009 when the Company ceased using the facility. Lease cancellation costs had been recorded based upon management’s estimates of those costs; however, a final settlement was recognized in the third quarter of 2010 when negotiations with the landlord concluded. Other associated costs included legal costs related to the employee termination actions and lease negotiations, as well as travel and transportation expenses between Kuopio and other Cognex locations related to the closure of the facility. These costs were recognized when the services were performed.

The following table summarizes the activity in the Company’s restructuring reserve related to the closure of the Finland facility, which is included in “Accrued expenses” on the Consolidated Balance Sheets (in thousands):

Nonoperating Income (Expense)

The Company recorded foreign currency losses of $328,000 and $1,265,000 in 2010 and 2009, respectively. The foreign currency fluctuations in each period resulted primarily from the revaluation and settlement of accounts receivable and intercompany balances that are reported in one currency and collected in another. In the second half of 2010, the Company began to record Yen-denominated accounts receivable on the books of its Japanese subsidiary, while in prior periods, these receivables were translated into Euros on the books of its Irish subsidiary, resulting in foreign currency gains or losses that the Company is no longer exposed to. Although the foreign currency exposure of accounts receivable is largely mitigated through the use of forward contracts, this program depends upon forecasts of sales and collections, and therefore, gains or losses on the underlying receivables may not perfectly offset losses or gains on the contracts.

Investment income in 2010 decreased by $764,000, or 35%, from the prior year. The decrease was primarily due to declining coupon rates on the Company’s portfolio of debt securities. Beginning in the second quarter of 2010, the Board of Directors approved a change to the Company’s investment policy to allow management to invest excess cash accumulated in the Company’s international entities in debt securities. This change is expected to contribute to higher investment income in future periods.

The Company recorded other expense of $703,000 in 2010 compared to income of $1,372,000 in 2009. The Company recorded $2,003,000 of other income in the first quarter of 2009 upon the expiration of the applicable statute of limitations relating to a tax holiday, during which time the Company collected value-added taxes from customers that were not required to be remitted to the government

authority. Other income (expense) also includes rental income, net of associated expenses, from leasing buildings adjacent to the Company’s corporate headquarters. For a majority of 2010, these buildings were partially unoccupied.

Income Tax Expense (Benefit) on Continuing Operations

The Company’s effective tax rate on continuing operations was a provision of 19% in 2010, compared to a benefit of 53% in 2009.

The effective tax rate for 2010 included the impact of the following discrete events: (1) a decrease in tax expense of $462,000 from the settlement of the Competent Authority case with Japan, (2) a decrease in tax expense of $151,000 from the final true-up of the prior year’s tax accrual upon filing the actual tax returns, (3) a decrease in tax expense of $124,000 from the receipt of a state refund, and (4) a decrease in tax expense of $105,000 from the expiration of the statutes of limitations for certain reserves for income taxes. These discrete events changed the effective tax rate in 2010 from a provision of 20% to a provision of 19%.

The effective tax rate for 2009 included the impact of the following discrete events: (1) a decrease in tax expense of $3,150,000 from the expiration of the statutes of limitations for certain reserves for income taxes, (2) a decrease in tax expense of $406,000 from the receipt of a state refund, and (3) a decrease in tax expense of $51,000 from the final true-up of the prior year’s tax accrual upon filing the actual tax returns and other year-end adjustments, partially offset by (4) an increase in tax expense of $72,000 from the write-off of certain foreign tax credits. These discrete events changed the effective tax rate in 2009 from a benefit of 19% to a benefit of 53%.

The Company’s effective tax rate excluding discrete events increased from a benefit of 19% of the Company’s pre-tax loss in 2009 to a provision of 20% of the Company’s pre-tax income in 2010 due to more of the Company’s profits being earned in higher tax jurisdictions.

LIQUIDITY AND CAPITAL RESOURCES

The Company has historically been able to generate positive cash flow from operations, which has funded its operating activities and other cash requirements and has resulted in an accumulated cash,

cash equivalent, and investment balance of $357,440,000$388,520,000 as of December 31, 2011.2012. The Company has established guidelines relative to credit ratings, diversification, and maturities of its investments that maintain liquidity.

The Company’s cash requirements in 20112012 were met with its existing cash balances, cash from investment maturities, positive cash flows from operations, and the proceeds from stock option exercises. Cash requirements consisted of operating activities, purchases of investments, the payment of dividends, the repurchase of common stock, and capital expenditures. Capital expenditures totaled $7,820,000$9,878,000 in 20112012 and consisted primarily of expenditures for computer hardware, computer software related to(including business system upgrades,upgrades), manufacturing test equipment related to new product introductions, and building improvements at the Company’s headquarters in Natick, Massachusetts.

In the third quarter of 2012, management changed the domicile of the subsidiary that held the Company’s Euro-denominated investment portfolio and also changed that subsidiary’s functional currency from the Euro to the U.S. Dollar. As a result of these changes, the investment portfolio was liquidated, primarily during the second quarter of 2012, and those funds were converted to U.S. Dollars. These funds were then used to purchase U.S. Dollar-denominated investments during the third quarter of 2012 once the change in domicile was completed. As of December 31, 2012, the Company’s investment portfolio consisted entirely of U.S Dollar-denominated securities.

The following table summarizes the Company’s material contractual obligations, both fixed and contingent (in thousands):

In June 2000, the Company became a Limited Partner in Venrock Associates III, L.P. (Venrock), a venture capital fund. The Company has committed to a total investment in the limited partnership of up to $20,500,000, with the commitment period expiring on December 31, 2013. The Company does not have the right to withdraw from the partnership prior to December 31, 2013. As of December 31, 2011,2012, the Company had contributed $19,886,000 to the partnership. No contributions were made and no distributions were received during 2011.2012. The remaining commitment of $614,000 can be called by Venrock in any period through December 31, 2013.

In addition to the obligations described above, the following items may also result in future material uses of cash:

Dividends

Beginning in the third quarter of 2003, the Company’s Board of Directors has declared and paid a cash dividend in each quarter, including a dividend of $0.08$0.10 per share in the first quarter of 2011,2012 and a dividend of $0.09$0.11 per share in the second, third, and thirdfourth quarters of 2011,2012. In December 2012, the Company also declared and apaid dividends totaling $1.11 per share, which represents an accelerated dividend of $0.10$0.11 per share infor the fourth quarter of 20112012 that totaled $15,114,000 in 2011. On February 8, 2012, the Company’s Board of Directorswould normally be declared a cash dividend of $0.10 per share payable in the first quarter of 2013 in conjunction with the 2012 earnings release and a special dividend of $1.00 per share that prepays expected dividends for the eight quarters in 2013 and 2014. The additional $0.11

dividend and the $1.00 dividend were accelerated due to the anticipated increase in the federal tax on dividends paid after December 31, 2012. Future dividends will be declared at the discretion of the Company’s Board of Directors and will depend upon such factors as the Board deems relevant, including, among other things, the Company’s ability to generate positive cash flow from operations.

Stock Repurchase Program

In April 2008, the Company’s Board of Directors authorized the repurchase of up to $50,000,000 of the Company’s common stock, primarily as a means to reduce the dilutive effect of employee stock options.stock. As of December 31, 2011,2012, the Company had repurchased 1,375,875 shares at a cost of $30,000,000 under this program, including 337,078 shares at a cost of $10,000,000 during 2011.program. In November 2011, the Company’s Board of Directors authorized the repurchase of up to $80,000,000 of the Company’s common stock to help reduce share dilution associated with equity incentive plans.employee stock options. This new authorization will commence once the Company completes the $50,000,000 program noted above, of which $20,000,000 remains available. The Company maydid not repurchase shares under this programthese programs in 2012. However, the Board may authorize the repurchase of shares in future periods depending upon a variety of factors, including, among other things, stock price, share availability, and cash reserve requirements.

Reserve for Income Taxes

The Company may be required to make cash outlays related to its reserve for income taxes totaling $5,354,000 as of December 31, 2011, of which $558,000 will likely be paid within the next twelve

months and $4,796,000 may be paid in a future period. Due to the uncertainty of the timing of future cash payments associated with its reserve for income taxes, the Company is unable to make reasonably reliable estimates of the future period of cash settlement, if any, with the respective taxing authorities. Foreign subsidiaries’ undistributed earnings are deemed to be permanently reinvested outside the United States. It is management’s belief that the Company will not need to repatriate these earnings in future years due to the relatively strong cash flows at our domestic entities.

Acquisitions

The Company’s business strategy includes selective expansion into new machine vision applications through the acquisition of businesses and technologies, which may result in significant cash outlays in the future.

The Company believes that its existing cash, cash equivalent, and investment balances, together with cash flow from operations, will be sufficient to meet its operating, investing, and financing activities for the next twelve months. As of December 31, 2011,2012, the Company had approximately $351,507,000$384,780,000 in either cash, cash equivalents, debt securities, or debtequity securities that could be converted into cash. In addition, Cognex has no long-term debt and does not anticipate needing debt financing in the near future. We believe that our strong cash position has put us in a relatively good position with respect to our longer-term liquidity needs.

OFF-BALANCE SHEET ARRANGEMENTS

As of December 31, 2011,2012, the Company had no off-balance sheet arrangements.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of the Company’s financial condition and results of operations is based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and various other assumptions 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 could differ from these estimates under different assumptions or circumstances resulting in charges that could be material in future reporting periods. We believe the following critical accounting policies require the use of significant estimates and judgments in the preparation of our consolidated financial statements.

Revenue Recognition

The Company’s product revenue is derived from the sale of machine vision systems, which can take the form of hardware with embedded software or software-only, and related accessories. The Company also generates revenue by providing maintenance and support, training, consulting, and installation services to its customers. Certain of the Company’s arrangements include multiple deliverables that provide the customer with a combination of products or services. In order to recognize revenue, the Company requires that a signed customer contract or purchase order is received, the fee from the arrangement is fixed or determinable, and collection of the resulting receivable is probable. Assuming that these criteria have been met, product revenue is recognized upon delivery, revenue from maintenance and support programs is recognized ratably over the program period, revenue from training and consulting services is recognized over the period that the services are provided, and revenue from installation services is recognized when the customer has signed off that the installation is complete.

The majority of the Company’s product offerings consist of hardware with embedded software. Under the revenue recognition rules for tangible products, the fee from a multiple-deliverable arrangement is allocated to each of the deliverables based upon their relative selling prices as determined by a selling-

priceselling-price hierarchy. A deliverable in an arrangement qualifies as a separate unit of accounting if the delivered item has value to the customer on a stand-alone basis. A delivered item that does not qualify as a separate unit of accounting is combined with the other undelivered items in the arrangement and revenue is recognized for those combined deliverables as a single unit of accounting. The selling price used for each deliverable is based upon vendor-specific objective evidence (VSOE) if available, third-party evidence (TPE) if VSOE is not available, and management’s best estimate of selling price (BESP) if neither VSOE nor TPE are available. TPE is the price of the Company’s or any competitor’s largely interchangeable products or services in stand-alone sales to similarly-situated customers. BESP is the price at which the Company would sell the deliverable if it were sold regularly on a stand-alone basis, considering market conditions and entity-specific factors.

Management exercises judgment in connection with the determination of the amount of revenue to be recognized each period. Such judgments include, but are not limited to, determining whether separate contracts with the same customer that are entered into at or near the same time should be accounted for as a single arrangement, identifying the various elements in an arrangement, determining if delivered items have stand-alone value, determining the relative selling prices of the arrangement’s deliverables, determining whether options to buy additional products or services in the future are substantive and should be accounted for as a deliverable in the original arrangement, assessing whether the fee is fixed or determinable, determining the probability of collecting the receivable, determining whether customer-specified acceptance criteria are substantive in nature, and assessing whether vendor-specific objective evidence of fair value has been established for undelivered elements.

Investments

As of December 31, 2011,2012, the Company’s investment balance totaled $319,337,000,$343,360,000, of which $313,404,000$337,489,000 consisted of debt securities. Thesesecurities, $2,131,000 consisted of equity securities, and $3,740,000 consisted of a limited partnership interest in a venture capital fund. The debt securities are reported at fair value, with unrealized gains and losses, net of tax, recorded in shareholders’ equity as other comprehensive income (loss). since these securities are designated as available-for-sale securities. As of December 31, 2011,2012, the Company’s portfolio of debt securities had a net unrealized gain of $683,000. The equity securities represent stock in a publicly-traded U.S. company and are reported at fair value, with unrealized gains totaling $127,000.

and losses recorded in current operations since these securities are designated as trading securities. The remaining investment balance of $5,933,000 represented a limited partnership interest is in Venrock Associates III, L.P., a venture capital fund with an investment focus on Information Technology and Health Care and Life Sciences. A Director of the Company was a General Partner of Venrock Associates through December 31, 2009. The Company’s limited partnership interest is accounted for using the cost method because our investment is less than 5% of the partnership and we have no influence over the partnership’s operating and financial policies. Furthermore, thethis investment does not have a readily determinable market value, and therefore, does

not qualify for fair value accounting. As of December 31, 2011,2012, the carrying value of this investment was $5,933,000$3,740,000 compared to an estimated fair value of $7,460,000.$6,932,000.

The Company applies a three-level valuation hierarchy for fair value measurements. The categorization of assets and liabilities within the valuation hierarchy is based upon the lowest level of input that is significant to the measurement of fair value. Level 1 inputs to the valuation methodology utilize unadjusted quoted market prices in active markets for identical assets and liabilities. Level 2 inputs to the valuation methodology are other observable inputs, including quoted market prices for similar assets and liabilities, quoted prices for identical and similar assets and liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data. Level 3 inputs to the valuation methodology are unobservable inputs based upon management’s best estimate of the inputs that market participants would use in pricing the asset or liability at the measurement date, including assumptions about risk. Changes in the valuation methodology, interest rates, credit rates, or the market for these investments could result in changes to their fair values. Changes to the Level of an investment within the fair value hierarchy are determined at the end of the reporting period.

The fair value of the Company’s debt securities is based upon model-driven valuations in which all significant inputs are observable or can be derived from or corroborated by observable market data for substantially the full term of the assets, and are therefore classified as levelLevel 2 investments. In estimat-

ingManagement is responsible for estimating the fair value of its debt securities, management takes into considerationthese investments, and in doing so, considers valuations provided by a large, third-party pricing service. This service maintains regular contact with market makers, brokers, dealers, and analysts to gather information on market movement, direction, trends, and other specific data. They use this information to structure yield curves for various types of debt securities and arrive at the daily valuations.

The fair value of the Company’s equity securities is based upon quoted market prices on a stock exchange, and are therefore classified as Level 1 investments.

The fair value of the Company’s limited partnership interest takes into consideration valuations of the partnership’s investments as determined by the General Partner. Publicly-traded investments in active markets are reported at the market closing price less a discount, as appropriate, to reflect restricted marketability. Fair value for private investments for which observable market prices in active markets do not exist is based upon the best information available including the value of a recent financing, reference to observable valuation measures for comparable companies (such as revenue multiples), public or private transactions (such as the sale of a comparable company), and valuations for publicly-traded comparable companies. The valuations also incorporate the General Partner’s own judgment and close familiarity with the business activities of each portfolio company. The portfolio consists of securities of public and private companies, and consequently, inputs used in the fair value calculation are classified as levelLevel 3. These valuations are judgmental and require the use of many assumptions and estimates, and changes in these assumptions could result in an impairment charge in future periods.

The majority of the partnership’s portfolio consists of investments in early-stage, private companies characterized by a high degree of risk, volatility, and illiquidity, and the global economic slowdown and credit market crisis have made the environment for these startups much less forgiving. As a result, it is possible that some of the younger companies in the portfolio that require capital investments to fund their current operations may not be as well prepared to survive this economic uncertainty as would a more mature company. These factors make the assumptions and estimates used in the fair valuation calculations more judgmental.

Management monitors the carrying value of its investments in debt securities and a limited partnership interest compared to their fair value to determine whether an other-than-temporary impairment has occurred. In considering whether a decline in fair value is other-than-temporary, we consider many factors, both qualitative and quantitative in nature. In its evaluation of its debt securities, management considers the type of security, the credit rating of the security, the length of time the security has been in a loss position, the size of the loss position, our ability and intent to hold the security to expected recovery of value, and other meaningful information. In its evaluation of its limited partnership interest,

management considers the duration and extent of the decline, the length of the Company’s commitment to the investment, general economic trends, and specific communications with the General Partner. If a decline in fair value is determined to be other-than-temporary, an impairment charge would be recorded in current operations to reduce the carrying value of the investment to its fair value. There were no other-than-temporary impairments of investments in 2012, 2011, 2010, or 2009.2010. If the fair value of the Company’s limited partnership interest decreases below its current carrying value, which would represent a decline of greater than 20%46%, the Company may be required to record an impairment charge related to this investment.

Accounts Receivable

The Company maintains reserves against its accounts receivable for potential credit losses. Ongoing credit evaluations of customers are performed and the Company has historically not experienced significant losses related to the collection of its accounts receivable. Allowances for specific accounts determined to be at risk for collection are estimated by management taking into account the length of time the receivable has been outstanding, the customer’s current ability to pay its obligations to the Company, general economic and industry conditions, as well as various other factors. Global economic uncertainty may result in longer payment cycles and challenges in collecting accounts receivable balances, which make these estimates more judgmental. An adverse change in any of these factors could result in higher than expected customer defaults and may result in the need for additional bad

debt provisions. As of December 31, 2011,2012, the Company’s reserve against accounts receivable was $1,240,000,$1,131,000, or 3% of the gross accounts receivable balance. A 10% difference in the reserve against accounts receivable as of December 31, 20112012 would have affected net income by approximately $99,000.$89,000.

Inventories

Inventories are stated at the lower of cost or market. Management estimates excess and obsolescence exposures based upon assumptions about future demand, product transitions, and market conditions, and records reserves to reduce the carrying value of inventories to their net realizable value. Volatility in the global economy makes these assumptions about future demand more judgmental. Among the risks associated with the introduction of new products are difficulty predicting customer demand and effectively managing inventory levels to ensure adequate supply of the new product and avoid excess supply of the legacy product. In addition, we may strategically enter into non-cancelable commitments with vendors to purchase materials for products in advance of demand in order to take advantage of favorable pricing or address concerns about the availability of future supplies and long lead times. As of December 31, 2011,2012, the Company’s reserve for excess and obsolete inventory totaled $4,359,000,$3,414,000, or 13%11% of the gross inventory balance. A 10% difference in inventory reserves as of December 31, 20112012 would have affected net income by approximately $349,000.$270,000.

Long-lived Assets

The Company has long-lived assets, including property, plant, and equipment, and acquired intangible assets. These assets are susceptible to shortened estimated useful lives and changes in fair value due to changes in their use, market or economic changes, or other events or circumstances. The Company evaluates the potential impairment of these long-lived assets whenever events or circumstances indicate their carrying value may not be recoverable. Factors that could trigger an impairment review include historical or projected results that are less than the assumptions used in the original valuation of an acquired asset, a change in the Company’s business strategy or its use of an acquired asset, or negative economic or industry trends.

If an event or circumstance indicates the carrying value of long-lived assets may not be recoverable, the Company assesses the recoverability of the assets by comparing the carrying value of the assets to the sum of the undiscounted future cash flows that the assets are expected to generate over their remaining economic lives. If the carrying value exceeds the sum of the undiscounted future cash flows, the Company compares the fair value of the long-lived assets to the carrying value and records an

impairment loss for the difference. The Company generally estimates the fair value of its long-lived assets using the income approach based upon a discounted cash flow model. The income approach requires the use of many assumptions and estimates including future revenues and expenses, discount factors, income tax rates, the identification of groups of assets with highly independent cash flows, and assets’ economic lives. Volatility in the global economy makes these assumptions and estimates more judgmental. The Company recorded an impairment loss on an intangible asset in 2009 based on lower revenue expected to be generated from the respective assets. No impairment losses were recorded in 20102012, 2011, or 2011.2010. Actual future operating results and the remaining economic lives of our long-lived assets could differ from those used in assessing the recoverability of these assets and could result in an impairment of long-lived assets in future periods.

Goodwill

Management evaluates the potential impairment of goodwill for each of its reporting units annually each fourth quarter and whenever events or circumstances indicate their carrying value may not be recoverable. The Company has identified two reporting units for its goodwill test: MVSD and SISD. Determining the Company’s reporting units requires judgments regarding what constitutes a business and at what level discrete financial information is available and reviewed by management.

In the third quarter of 2011, the Financial Accounting Standards Board issued an Accounting Standards Update intended to reduce the cost and complexity of the annual goodwill impairment test by providing entities an option to perform a qualitative assessment (commonly known as “step zero”) to determine whether further impairment testing is necessary. If this qualitative assessment indicates that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, the entity would proceed to a two-step process. Step one compares the fair value of the reporting unit with its carrying value, including goodwill. If the carrying amount exceeds the fair value of the reporting unit, step two is required to determine if there is an impairment of the goodwill. Step two compares the implied fair value of the reporting unit goodwill to the carrying amount of the goodwill. The Company estimates the fair value of its reporting units using the income approach based upon a discounted cash flow model. In addition, the Company uses the market approach, which compares the reporting unit to publicly-traded companies and transactions involving similar businesses, to support the conclusions based upon the income approach. The income approach requires the use of many assumptions and estimates including future revenues, expenses, capital expenditures, and working capital, as well as discount factors and income tax rates.

The Company elected to perform a qualitative assessment for its 2012 and 2011 analysisanalyses of goodwill. Based on this assessment, management does not believe that it is more likely than not that the carrying value of either reporting unit exceeds its fair value. Factors that management considered in this assessment include macroeconomic conditions, industry and market considerations, overall financial performance (both current and projected), changes in management or strategy, and changes in the composition or carrying amount of net assets. In addition, management took into consideration the goodwill valuation it performed under the two-step process as of October 4, 2010. This process2010, which indicated that the fair value of the MVSD unit exceeded its carrying value by approximately 208%, while the fair value of the SISD unit exceeded its carrying value by approximately 119% at that date. Based on the qualitative assessments performed in 2012 and 2011, management does not believe that it is more likely than not that the carrying value of either reporting unit exceeds its fair value.

Warranty Obligations

The Company records the estimated cost of fulfilling product warranties at the time of sale based upon historical costs to fulfill claims. Obligations may also be recorded subsequent to the time of sale whenever specific events or circumstances impacting product quality become known that would not have been taken into account using historical data. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers and third-party contract manufacturers, the Company’s warranty obligation is affected by product failure rates, material usage, and service delivery costs incurred in correcting a product failure. An adverse change in any of these factors may result in the need for additional warranty provisions. As of December 31, 2011,2012, the Company’s accrued warranty obligations amounted to $2,097,000.$2,256,000. A 10%

difference in accrued warranty obligations as of December 31, 20112012 would have affected net income by approximately $168,000.$178,000.

Contingencies

Estimated losses from contingencies are accrued by management based upon whether a loss is probable and whether management has the ability to reasonably estimate the amount of the loss. Estimating potential losses, or even a range of losses, is difficult and involves a great deal of judgment. Management relies primarily on assessments made by its internal and external legal counsel to make our determination as to whether a loss contingency arising from litigation should be recorded or disclosed. This analysis is performed on a quarterly basis or when facts and circumstances dictate. Should the resolution of a contingency result in a loss that we did not accrue because management did not believe that the loss was probable or capable of being reasonably estimated, then this loss would result in a charge to income in the period the contingency was resolved. The Company did not have any significant accrued contingencies as of December 31, 2011.2012.

Stock-Based Compensation

Compensation expense is recognized for all stock option grants. Determining the appropriate valuation model and estimating the fair values of these grants requires the input of subjective assumptions, including expected stock price volatility, dividend yields, expected term, and forfeiture rates. The expected volatility assumption is based partially upon the historical volatility of the Company’s common stock, which may or may not be a true indicator of future volatility, particularly as the Company continues to seek to diversify its customer base. The assumptions used in calculating the fair values of stock option grants represent management’s best estimates, but these estimates involve inherent uncertainties and the application of judgment. As a result, if factors change and different assumptions are used, stock-based compensation expense could be significantly different from what the Company recorded in the current period.

Income Taxes

Significant judgment is required in determining worldwide income tax expense based upon tax laws in the various jurisdictions in which the Company operates. The Company has established reserves for income taxes by applying the “more likely than not” criteria, under which the recognition threshold is met when an entity concludes that a tax position, based solely on its technical merits, is more likely than not to be sustained upon examination by the relevant tax authority. All tax positions are analyzed periodically and adjustments are made as events occur that warrant modification, such as the completion of audits or the expiration of statutes of limitations, which may result in future charges or credits to income tax expense.

As part of the process of preparing consolidated financial statements, management is required to estimate income taxes in each of the jurisdictions in which the Company operates. This process involves estimating the current tax liability, as well as assessing temporary differences arising from the different treatment of items for financial statement and tax purposes. These differences result in deferred tax assets and liabilities, which are recorded on the Consolidated Balance Sheets.

The Company has net deferred tax assets primarily resulting from temporary differences between the financial statement and tax bases of assets and liabilities. Management has evaluated the realizability of these deferred tax assets and has determined that it is more likely than not that these assets will be realized, net of any valuation allowance. In reaching this conclusion, we have evaluated relevant criteria, including the Company’s historical profitability, current projections of future profitability, and the lives of tax credits, net operating and capital losses, and other carryforwards, certain of which have indefinite lives. Should the Company fail to generate sufficient pre-tax profits in future periods, we may be required to record material adjustments to these deferred tax assets, resulting in a charge to income in the period of determination.

Derivative Instruments

In certain instances, the Company enters into forward contracts and other derivative instruments to hedge against foreign currency fluctuations. These contracts are used to minimize foreign currency gains or losses, as the gains or losses on these contracts are intended to offset the losses or gains on the underlying exposures. The Company does not engage in foreign currency speculation and these forward contracts are not subject to effective hedge accounting. Administering the Company’s foreign currency risk management program requires the use of estimates and the application of judgment, including compiling forecasts of transaction activity denominated in various currencies. The failure to identify foreign currency exposures and construct effective hedges may result in material foreign currency gains or losses.

Purchase Accounting

Business acquisitions are accounted for under the purchase method of accounting. Allocating the purchase price requires the Company to estimate the fair value of various assets acquired and

liabilities assumed. Management is responsible for determining the appropriate valuation model and estimated fair values, and in doing so, considers a number of factors, including information provided by an outside valuation advisor. The Company primarily establishes fair value using the income approach based upon a discounted cash flow model. The income approach requires the use of many assumptions and estimates including future revenues and expenses, as well as discount factors and income tax rates.

NEW PRONOUNCEMENTS

Accounting Standards Update (ASU) 2011-04, “Fair Value Measurements: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”

The amendments in this ASU change certain aspects of the fair value measurement guidance in Accounting Standards Codification (ASC) 820, “Fair Value Measurement” in order to make U.S. GAAP and international standards more consistent. These changes include the application of the concepts of highest and best use and valuation premise, introduction of an option to measure groups of offsetting assets and liabilities on a net basis, incorporation of certain discounts and premiums in fair value measurements, and measurement of the fair value of certain instruments classified in shareholders’ equity. In addition, the amended guidance includes new fair value disclosure requirements, including, among other things, information about valuation techniques and unobservable inputs used in Level 3 fair value measurements and a narrative description of Level 3 measurements’ sensitivity to changes in unobservable inputs. ASU 2011-04 must be applied prospectively and is effective for the first quarter of 2012. Management does not expect this ASU to have a material impact on the fair value of our investments portfolio or the related disclosure requirements.

Accounting Standards Updates (ASU) 2011-05 and 2011-12, “Comprehensive Income”

The amendments in ASU 2011-05 revise the manner in which companies present comprehensive income in their financial statements in order to make U.S. GAAP and international standards more consistent. This ASU requires companies to report the components of comprehensive income in either a continuous statement of comprehensive income or in two separate but consecutive statements. In the two-statement approach, the first statement would present the components of net income, similar to the Company’s current Consolidated Statements of Operations, while the second statement would include the components of other comprehensive income, as well as a cumulative total for comprehensive income.

In December 2011, the Financial Accounting Standards Board issued ASU 2011-12 to defer one provision of ASU 2011-05. The amendments in ASU 2011-12 defer the requirements under ASU 2011-05 to present reclassification adjustments by component in both the statement where net income is presented and the statement where other comprehensive income is presented. This deferral was prompted by users’ concerns that the presentation requirements would be costly to implement and could add unnecessary complexity to financial statements.

Neither of these ASU’s change the items that must be reported in other comprehensive income. Both Updates must be applied retrospectively beginning in the first quarter of 2012. At that time, management has elected to present other comprehensive income in two separate but consecutive statements.

Accounting Standards Update (ASU) 2011-08, “Testing Goodwill For Impairment”

In the third quarter of 2011, the Financial Accounting Standards Board issued an ASU aimed at simplifying entities’ annual goodwill impairment test. This ASU is intended to reduce the cost and complexity of the annual goodwill impairment test by providing entities an option to perform a qualitative assessment to determine whether further impairment testing is necessary. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011; however, early adoption is allowed. Management has elected to adopt this ASU early and has applied the provisions of this Update to its 2011 analysis of goodwill.

ITEM 7A:

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

ITEM 7A:  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Foreign Currency Risk

The Company faces exposure to foreign currency exchange rate fluctuations, as a significant portion of its revenues, expenses, assets, and liabilities are denominated in currencies other than the functional currencies of the Company’s subsidiaries or the reporting currency of the Company, which is the U.S. Dollar. These exposures may change over time as business practices evolve. The Company evaluates its foreign currency exposures on an ongoing basis and makes adjustments to its foreign currency risk management program as circumstances change. The failure to identify new exposures and hedge them in an effective manner may result in material foreign currency gains or losses.

The Company faces two types of foreign currency exchange rate exposures:

The Company faces transactional currency/functional currency exposures that it may hedge from time to time. These exposures include cash balances, accounts receivable or payable denominated in currencies other than the functional currency of the subsidiary, and intercompany balances denominated in currencies other than the functional currency of the subsidiary. The Company presently manages its intercompany foreign currency risk by transferring cash to minimize intercompany balances at the end of each month, and in certain instances, entering into forward contracts. In addition, the Company enters into forward contracts to hedge the exposure of its Irish subsidiary’s accounts receivable denominated in U.S. dollars.

Forward contracts to exchange 3,790,0003,590,000 U.S. Dollars for Euros at a weighted-average settlement price of 1.341.31 USD/Euro, with terms between one and threefour months, were outstanding as of December 31, 2011.2012. At fair value, these instruments had a lossnet gain of $87,000$30,000 as of December 31, 2011. In addition, the Company also had one outstanding forward contract to exchange 200,000,000 Japanese Yen for Euros at a settlement price of 102.20 JPY/Euro as of December 31, 2011. At fair value, this instrument had a loss of $64,000 as of December 31, 2011.2012.

These forward contracts are used to minimize foreign currency gains or losses, as the gains or losses on these contracts are intended to offset the losses or gains on the underlying exposures. Both the underlying exposures and the forward contracts are recorded at fair value on the Consolidated Balance Sheets and changes in fair value are reported as “Foreign currency loss”gain (loss)” on the Consolidated Statements of Operations. The Company does not engage in foreign currency speculation and these forward contracts are not subject to effective hedge accounting. The success of this hedging program depends upon forecasts of sales and collections denominated in various currencies. To the extent that these forecasts are overstated or understated during periods of currency volatility, the Company could experience unanticipated foreign currency gains or losses that could have a material impact on the Company’s results of operations.

The Company’s functional currency/reporting currency exchange rate exposures result from revenues and expenses that are denominated in currencies other than the U.S. Dollar. A significant portion of our revenues and expenses are denominated in the Euro and the Japanese Yen. The Company’s predominant currency of sale is the U.S. Dollar in the Americas, the Euro in Europe, the Yen in Japan, and the U.S. Dollar and Chinese Yuan for sales in Southeast Asia. We estimate that approximately 46%50% of our sales in 20112012 were invoiced in currencies other than the U.S. Dollar, and we expect sales denominated

in foreign currencies to continue to represent a significant portion of our total revenue. While we also have expenses denominated in these same foreign currencies, the impact on revenues has historically been, and is expected to continue to be, greater than the offsetting impact on expenses. Therefore, in times when the U.S. Dollar strengthens in relation to these foreign currencies, we would expect to report a net decrease in operating income. Conversely, in times when the U.S. Dollar weakens in relation to these foreign currencies, we would expect to report a net increase in operating income.

Interest Rate Risk

The Company’s investment portfolio of debt securities includes corporate bonds, asset-backed securities, treasury bills, municipalagency bonds, corporate bonds, agencymunicipal bonds, sovereign bonds, and covered bonds. Debt securities with original maturities greater than three months are designated as available-for-sale and are reported at fair value. As of December 31, 2011,2012, the fair value of the Company’s portfolio of debt securities amounted to $313,404,000,$337,489,000, with principal amounts totaling $313,277,000,$336,806,000, maturities that do not exceed fiveeight years, and a yield to maturity of 1.31%0.70%. Differences between the fair value and principal amounts of the Company’s portfolio of debt securities are primarily attributable to discounts and premiums arising at the acquisition date, as well as unrealized gains and losses as of the balance sheet date.

Although it is the Company’s policy to invest in debt securities with effective maturities that do not exceed ten years, 90%91% of the investment portfolio as of December 31, 2011 have2012 has effective maturity dates of less than three years. Given the relatively short maturities and investment-grade quality of the Company’s portfolio of debt securities as of December 31, 2011,2012, a sharp rise in interest rates should not have a material adverse effect on the fair value of these instruments. As a result, the Company does not currently hedge these interest rate exposures.

The following table presents the hypothetical change in the fair value of the Company’s portfolio of debt securities arising from selected potential changes in interest rates (in thousands). This modeling technique measures the change in fair value that would result from a parallel shift in the yield curve plus or minus 50 and 100 basis points (BP) over a twelve-month time horizon.