UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended JuneSeptember 30, 2005

OR

For the transition period from                    to                    

Commission File Number 0-20981000-20981

DOCUMENT SCIENCES CORPORATION

(Exact name of registrant as specified in its charter)

6339 Paseo del Lago5958 Priestly Drive

Carlsbad, California 9200992008

(Address of Principal Executive Offices including Zip Code)

(760) 602-1400

(Registrant’s Telephone Number including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YesþNo¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act Rule 12b-2)Act).     Yes ¨Noþ

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes¨  Noþ

As of August 12,November 11, 2005, there were 4,134,5984,202,372 shares of common stock of the registrant outstanding.

DOCUMENT SCIENCES CORPORATION

PART I. FINANCIAL INFORMATION

DOCUMENT SCIENCES CORPORATION

CONSOLIDATED BALANCE SHEETS

Note: The balance sheet at December 31, 2004 has been derived from the audited consolidated financial statements at that date but does not include all of the information and disclosures required by generally accepted accounting principles for complete financial statements. See notes to unaudited consolidated financial statements.

DOCUMENT SCIENCES CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

See notes to unaudited consolidated financial statements.

DOCUMENT SCIENCES CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

See notes to unaudited consolidated financial statements.

DOCUMENT SCIENCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

JuneSeptember 30, 2005

Note A - Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States for interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and disclosures normally included in complete financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the statements include all adjustments necessary, which are of a normal and recurring nature, for the fair presentation of our financial position and of the results of operations and cash flows for the interim periods presented.

These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended December 31, 2004, included in Document Sciences Corporation’s Annual Report on Form 10-K filed with the Securities and Exchange Commission. Operating results for the three and sixnine months ended JuneSeptember 30, 2005 are not necessarily indicative of the results that may be expected for any other interim period or for the year ending December 31, 2005. The consolidated balance sheet at December 31, 2004 has been derived from the audited financial statements at that date but does not include all of the information and disclosures required by accounting principles generally accepted in the United States for complete financial statements.

Note B - Revenue Recognition

We derive our revenues from the licensing of software, annual renewal license and support fees and professional services. We recognize revenue in accordance with Statement of Position (SOP) 97-2,Software Revenue Recognition,and Staff Accounting Bulletin (SAB) No. 104,Revenue Recognition in Financial Statements. Initial license feesRevenues generated from consulting services and training are recognized when a contract exists,as the fee is fixedrelated services are performed and determinable, software delivery has occurred and collection of the receivablecollectibility is deemed probable. We use the residual method to recognize revenue for all ofPlease see our license models. Our contracts specifically state the amount of initial and annual license fees due for each type of software licensed. If an undelivered element of the arrangement exists under the license arrangement, revenue is deferred based on vendor-specific objective evidence of the fair value of the undelivered element. If vendor-specific objective evidence of fair value does not exist for all undelivered elements, all revenue is deferred until sufficient evidence exists or all elements have been delivered. We recognize revenue on transactions with payment terms greater than 30 days but less than twelve months from the contract date, if we have a history of successfully collecting from the specific customer without providing concessions or creditworthiness has otherwise been established. Amounts billed or payments received in advance of revenue recognition are recorded as deferred revenue.note located in our critical accounting policies for more details.

Note C - Computation of Net Income (Loss) Per Share

We present our earnings (loss) per share (EPS) information in accordance with Statement of Financial Accounting Standards (SFAS) No. 128,Earnings per Share. Basic EPS is computed by dividing income or loss available to common stockholders (the numerator) by the weighted-average number of common shares outstanding (the denominator) during the period. Shares issued during the period and shares reacquired during the period are weighted for the portion of the period that they were outstanding. Basic EPS excludes any dilutive effects of options, warrants and convertible securities.

The computation of diluted EPS is similar to the computation of basic EPS, except that the denominator is increased to include the number of additional common shares that would have been outstanding if the common shares underlying outstanding options and warrants had been issued. The dilutive effect of outstanding options and warrants has been reflected in EPS by application of the treasury stock method. The treasury stock method recognizes the use of proceeds that could be obtained upon exercise of options and warrants in computing diluted EPS. It assumes that any proceeds would be used to purchase common

stock at the average market price during the period. Options and warrants will have a dilutive effect under the treasury stock method only when the average market price of the common stock during the period exceeds the exercise price of the options or warrants. Common stock options to purchase 112,28125,971 and 267,844 shares were excluded from the calculation of weighted-average shares used in determining diluted EPS for the three months ended JuneSeptember 30, 2005 and 2004, respectively, and 54,38921,881 and 74,554138,357 shares were excluded for the sixnine months ended JuneSeptember 30, 2005 and 2004, respectively, as their effect would have been antidilutive.

The following table reconciles the shares used in computing basic and diluted EPS for the periods indicated:

Note D - Stock-Based Compensation

As permitted by SFAS No. 123,Accounting for Stock-based Compensation, we have elected to follow Accounting Principles Board (APB) Opinion No. 25,Accounting for Stock Issued to Employees, and related interpretations in accounting for our employee stock options. Under APB Opinion No. 25, among other things, when the exercise price of our employee stock options is not less than the market price of the underlying stock on the date of grant, no compensation expense is recognized.

As required under SFAS No. 123, the pro forma effects of stock-based compensation on net income (loss) and net earnings (loss) per common share have been estimated at the date of grant using the Black-Scholes option pricing model based on the following weighted-average expected life of the option of seven years and the following weighted average assumptions:

For purposes of adjusted pro forma disclosures, the estimated fair value of the options is amortized to expense over the option’s vesting period. The effect of applying SFAS No. 123 for purposes of providing pro forma disclosures is not likely to be representative of the effects on our operating results for future

years because changes in the subjective input assumptions can materially affect future value estimates. Our pro forma information is as follows:

Note E - Business Combination

On July 20, 2004, we completed the acquisition of the remaining 79% of the outstanding common stock of Objectiva Software Solutions, Inc. (Objectiva), which, upon completion of the acquisition, became our wholly-owned subsidiary. Objectiva is a services company specializing in enterprise software development, including rapid prototyping, product co-development, product migration, product porting and product reengineering. The acquisition was consummated pursuant to that certain Stock Purchase Agreement, dated as of June 27, 2004, by and among Document Sciences and the selling stockholders identified therein.

The results of operations of Objectiva have been included in the accompanying consolidated financial statements from the date of acquisition and were accounted using the purchase method of accounting. The total cost of the acquisition and the subsequent allocation was as follows:

Pro Forma Information

The following unaudited pro forma condensed combined financial data for the three and six months ended June 30, 2005 and 2004 was derived from our historical financial statements and the historical financial statements of Objectiva prior to the acquisition. The unaudited pro forma condensed combined

financial data give effect to the acquisition of Objectiva as if it had occurred at the beginning of each period presented. The unaudited pro forma condensed combined financial data has been prepared for comparative purposes only and may not be indicative of the results of operations that would have actually resulted had the acquisition been in effect as of the periods indicated, or of future results of operations. The unaudited pro forma results for the three and six months ended June 30, 2005 and 2004 are as follows:

Critical Accounting Policies

Our discussion and analysis of the financial condition and results of operations are based on our 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 us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to revenue recognition, software development costs, allowance for doubtful accounts and valuation allowance for net deferred tax assets. We base our estimates on historical and anticipated results and trends and on assumptions that we believe are reasonable under the circumstances, including assumptions as to future events. These estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results may differ from our estimates. We believe that the following critical accounting policies and assumptions may involve a higher degree of judgment and complexity than others.

Revenue Recognition.We derive our revenues from the licensing of software, annual renewal license and support fees (ALF) and professional services. We recognize revenue in accordance with SOP 97-2,Software Revenue Recognition,and SAB No. 104,Revenue Recognition in Financial Statements. Initial license fees (ILF) are recognized when a contract exists, the fee is fixed and determinable, software delivery has occurred and collection of the receivable is deemed probable. If an arrangement includes multiple elements, we allocate the contract amount to the various elements based on vendor-specific objective evidence (VSOE) of fair value, regardless of any separate prices stated within the contract for each element. We base our VSOE on the price charged when the same element is sold separately.

We use the residual method to recognize revenue for all of our license models. models when bundled with ALF (post-contract support). Under the residual method, the fair value of the undelivered element (ALF) is deferred and the remaining value of the contract is recognized as revenue (ILF) when the license has been delivered, the fee is fixed and collectibility is probable. ALF is recognized ratably over the contract period. Included in our ALF are unspecified maintenance releases.

Our contracts specifically statedo not provide for specific upgrades. In addition, our standard contracts do not provide for rights of return or conditions of acceptance; however, in the amount of initialrare case that acceptance criteria are provided, revenue is deferred and annual license fees due for each type of software licensed. not recognized until all conditions are satisfied and written customer acceptance is obtained. Where acceptance criteria exist, we believe our approach to revenue recognition would not result in materially different amounts being reported under different conditions or using different assumptions.

If an undelivered element of the arrangement exists under the license arrangement, revenue is deferred based on vendor-specific objective evidenceVSOE of the fair value of the undelivered element. If vendor-specific objective evidenceVSOE of fair value does not exist for all undelivered elements, all revenue is deferred until sufficient evidence exists or all elements have been delivered. We recognize revenue on transactions with payment terms greater than 30 days but less than twelve months from the contract date, if we have a history of successfully collecting from the specific customer without providing concessions or creditworthiness has otherwise been established.concessions. Amounts billed or payments received in advance of revenue recognition are recorded as deferred revenue.

Professional services revenue includes consulting services and training related to our software products. Revenues generated from consulting services and training are recognized as the related services are performed and collectibility is deemed probable. However, when such consulting services are deemed to be essential to the functionality of the delivered software product, revenue from the entire arrangement is recognized on a percentage of completion method or not until the contract is completed in accordance with SOP 81-1,Accounting for Performance of Construction-Type and Certain Production-Type Contracts, and Accounting Research Bulletin (ARB) No. 45,Long-Term Construction-Type Contracts. We measure progress under the percentage of completion method, depending on how the contract language is written, either by using the percentage of total project hours completed or by the completion of phases in the consulting project. Because (i) the phases of our consulting projects are generally not of great duration (2-6 weeks on average) and (ii) we have a variety of projects progressing at the same time, we believe that there are very limited circumstances where materially different amounts would be reported under different conditions or using different assumptions.

We work in conjunction with our established value added resellers (VARs), with whom we have formal contracts defining the rights and obligations of the parties, to license software to end-users. We license software to our VARs, less a discount, from a fixed price list. We require a binding purchase order as evidence of an unconditional order by an end user from our VARs, with no rights of return or acceptance. License revenue from our VARs is recognized when software is licensed to an end user.

Software Development Costs. In accordance with SFAS No. 86,Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, costs incurred in the research and development of new software products and significant enhancements to existing software products are expensed as incurred until technological feasibility of the product has been established. After technological feasibility has been established, direct production costs, including programming and testing, are capitalized until general release of the product.

Capitalized costs of software to be sold, licensed or otherwise marketed are amortized using the greater of the amount computed using the ratio of current period product revenues to estimated total product revenues or the straight-line method over the remaining estimated economic lives of the products. It is possible that estimated total product revenues, the estimated economic life of the product, or both, will be reduced in the future. As a result, the carrying amount of capitalized software costs may be reduced in the future, which could cause our operating results in future periods to be adversely affected.

Impairment of Goodwill. The value of our goodwill could be impacted by future adverse changes such as declines in our operating results or failure to meet the performance projections included in our forecasts of future operating results. We evaluate these assets on an annual basis or more frequently if indicators of impairment exist. In the process of our annual impairment review, we primarily use the income approach methodology of valuation that includes the discounted cash flow method as well as other generally accepted valuation methodologies to determine the fair value of our assets. Significant management judgment is required in the forecasts of future operating results that are used in the discounted cash flow

method of valuation. The estimates we have used are consistent with the plans and estimates that we use to manage our business. It is possible, however, that the plans and estimates used may be incorrect. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur impairment charges.

Allowance for Doubtful Accounts. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required, which would result in an additional general and administrative expense in the period such determination is made. At the end of each reporting period, we perform a detailed review of outstanding balances by customer and invoice. We utilize statistical and account specific analysis to determine the adequacy of our reserve, as well as comparing balances to historical losses. If our assumptions or analysis are incorrect, our operating results for future periods may be adversely affected.

Deferred Income Taxes. Deferred income taxes reflect the net effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. At December 31, 2004, we had net deferred tax assets of $2.9 million. Due to the uncertainty of realizing a portion of these net deferred tax assets, we have maintained a valuation allowance of $2.6 million for net deferred tax assets. Such uncertainty primarily relates to the potential for future taxable income as well as loss carryforwards and tax credits expiring in 2018 and 2012, respectively. In addition, pursuant to Sections 382 and 383 of the Internal Revenue Code, annual use of our net operating loss carryforwards may be limited in the event of a cumulative change in ownership of more than 50% within a three-year period. No valuation allowance has been recorded to offset the remaining $275,000 of net deferred tax assets as we have determined that it is more likely than not that these assets will be realized within the next twelve months. We will continue to assess the likelihood of realization of such assets; however, if future events occur which do not make the realization of such assets more likely than not, we will record a valuation allowance against all or a portion of the remaining net deferred tax assets. An example of a future event that might occur which could make the realization of such assets not likely is a lack of taxable income resulting from poor operating results during 2005.results. At JuneSeptember 30, 2005, our net deferred tax asset remained at $275,000.

Results of Operations for the Three and SixNine Months Ended JuneSeptember 30, 2005 and 2004

The following table shows the percentage of revenues, cost of revenues, operating expenses and other items to total revenues in our consolidated statements of operations for the periods indicated:

Gross profit		60			69			60			71
Operating expenses:
Research and development		20			16			19			17
Selling and marketing		26			37			28			37
General and administrative		10			13			12			14
Total operating expenses		56			66			59			68
Income from operations		4			3			1			3
Interest and other income, net		1			—			1			—
Income before income taxes		5			3			2			3
Provision for income taxes		—			—			—			—
Net income		5	%		3	%		2	%		3	%

Revenues

Our revenues are divided into three categories based upon the sources from which they are derived: initial license fees, annual renewal license and support fees, and services and other revenues. The following discussion is separated into these categories. We sell our products principally through our direct sales force domestically and through distributors and VARs internationally.

The following table summarizes revenues (in thousands) and the percentage change over the same period of the prior year:

Initial license fees. Initial license fees consist primarily of upfront license fees for the first year of use of our products.

The components of initial license fees (in thousands) of our product families consist of the following:

The increases in initial license fees for the three and sixnine months ended JuneSeptember 30, 2005 were due to higher sales from our Canadian and Australian operations. The increases in initial license fees for the three and six months ended June 30, 2004 were due to higher sales in the United Statesoperations and improvement in xPression product sales.

Annual renewal license and support fees. Annual renewal license and support fees consist of license fees for the initial and continued support and use of our licensed products. The increases for the three and sixnine months ended JuneSeptember 30, 2005 and 2004 were due primarily to increases in our base of licensed software.

Services and other. Services and other revenues consist of fees for consulting, software outsourcing, application development and training services performed by us as well as miscellaneous other operational revenues. A majority of the growth for the three and sixnine months ended JuneSeptember 30, 2005 was from the delivery of implementation services to clientscustomers who have licensed our xPression software. Additionally, results for the first and second quarters ofnine months ended September 30, 2005 benefited from consulting services delivered by our Objectiva subsidiary. The decreases for the three and six months ended June 30, 2004 were due to unbillable services performed in 2004 related to the implementation of xPression which had taken longer than projected for certain customers.

Cost of Revenues

The following table summarizes cost of revenues (in thousands) and the percentage change over the same period of the prior year:

Cost of initial license fees. Cost of initial license fees includes amortization of previously capitalized software development costs, costs of third party software, employment costs for distribution personnel and product packaging. The increasesdecrease for the three and six months ended JuneSeptember 30, 2005 and 2004 werewas due to increasesa decrease in royalty fees. The increase for the nine months ended September 30, 2005 was due to an increase in amortization of software development costs due to the release of xPression 2.0 in the fourth quarter of 2004 and xPression 1.2 in June of 2003, respectively. 2004.

Amortization of software development costs were $473,400$360,400 and $933,400$1.3 million for the three and sixnine months ended JuneSeptember 30, 2005, respectively, and $188,100$353,800 and $376,300$730,100 for the three and sixnine months ended JuneSeptember 30, 2004, respectively. The growthFor the nine months ended September 30, 2005, cost of initial license fees grew at a faster rate in Cost of Initial License Fees, driven by thisthan initial license fees due to higher amortization expense, has been much greater than that of Initial License Fee Revenue. Consequently, oursoftware development costs, causing gross margins on Initial License Fees have been adversely impacted.to decrease.

Cost of annual renewal license and support fees. CostsCost of annual renewal license fees consist principally of the employment-relatedemployee related costs for our technical support staff. Costs were largely unchanged for the three and six months ended June 30, 2005. The increases for the three and sixnine months ended JuneSeptember 30, 20042005 were primarily due to an increaseincreases in staffpersonnel costs of $67,500 and $74,600, respectively, to support xPression.our growing customer base.

Cost of services and other. CostsCost of services and other consist principally of the employment-relatedemployee related costs of our consulting and training staff. The increases for the three and sixnine months ended JuneSeptember 30, 2005 were due to an increase in personnel costs to support our increasing project workload.

Operating Expenses

The following table summarizes operating expenses (in thousands) and the percentage change over the same period of the prior year:

Research and development. Research and development expenses consist primarily of the employment-relatedemployee related costs of personnel associated with developing new products, enhancing existing products, testing software products and developing product documentation. We anticipate that we will continue to direct significant resources to the development of new products and enhancement of our existing products.

The following table shows the breakout ofadds back capitalized software development costs (in thousands) and shows the percentage change over the same period of the prior year:

Capitalized software development costs mainly includedinclude payroll related costs of our engineering resources, allocated facilities costs and consulting fees in relationrelated to the development of xPression. We expect the amount of capitalized software development costs to continue to be less in 2005 because we expect a decrease in the time between the establishment of technological feasibility and general releases of our products. The decreases in gross research and development expenses forproducts to be substantially the three and six months ended June 30, 2005 were primarily due to decreases in outside consultants of $486,000 and $958,900, respectively, offset by increases in personnel costs of $260,700 and $479,200, respectively, largely driven by the impact of our Objectiva acquisition.same. We incurred no capitalized software development costs for the three and sixnine months ended JuneSeptember 30, 2005, but capitalized $659,000$449,000 and $1.3$1.7 million, respectively, related to xPression 2.0 development in the three and sixnine months ended JuneSeptember 30, 2004.

The increasesincrease in capitalized softwaregross research and development costs for the three and six months ended JuneSeptember 30, 2004 were2005 was primarily due to the timingan increase in personnel costs of technological feasibility and additional testing being performed on xPression 2.0.$336,800 offset by a decrease in outside consultant costs of $80,800. The decreasesdecrease in gross research and development expensescosts for the three and sixnine months ended JuneSeptember 30, 2004 were2005 was primarily due to decreasesa decrease in outside consultant costs of $1.0 million offset by an increase in personnel costs of $123,500 and $171,300, respectively.$816,000, largely driven by the impact of our Objectiva acquisition.

Selling and marketing. Selling and marketing expenses consist primarily of salaries, commissions, marketing programs and related costs for pre- and post-sales activity. Costs were largely unchangedThe decrease for the three and six months ended JuneSeptember 30, 2005. The decreases for the three and six months ended June 30, 2004 were2005 was primarily due to decreases in personnel costs of $277,300$113,700 and $340,400, respectively, travel and meeting expensesoutside

consultant costs of $94,000 and $216,200, respectively, and trade shows and advertising$129,100, offset by an increase in sales commissions of $50,200 and $138,000, respectively.$90,100. Costs were largely unchanged for the nine months ended September 30, 2005.

General and administrative. General and administrative expenses consist of employment-relatedemployee related costs for finance, administration and human resources, allowance for doubtful accounts and general corporate management expenses, including legal and accounting fees. The increasesincrease for the three and six months ended JuneSeptember 30, 2005 werewas primarily due to increases in personnel costs of $85,200$201,000, outside consultant costs of $59,300 and $110,400, respectively.bad debt expense of $107,500, offset by a French VAT refund of $391,000 which we had previously taken as an expense in the fourth quarter of 2003. The increasesincrease for the three and sixnine months ended JuneSeptember 30, 2004 were2005 was primarily due to increases in personnel costs of $112,000$311,400 and $222,800, respectively, and bad debt expenseoutside consultant costs of $107,200 for the six months ended June 30, 2004. The increases in personnel costs were due to$94,100, offset by a reclassification in 2004French VAT refund of certain personnel from other departments.$391,000.

Other items

Interest and other income, net. Interest and other income, net is composed primarily of interest income from cash and cash equivalents and short-term investments, offset by interest expense related to capital leases and

gains/losses on disposals of assets. Interest and other income, net was $92,200$47,300 and $18,900$13,600 for the three months ended JuneSeptember 30, 2005 and 2004, respectively, and $121,500$168,900 and $41,500$55,000 for the sixnine months ended JuneSeptember 30, 2005 and 2004, respectively. The increases for the three and sixnine months ended JuneSeptember 30, 2005 were largely the result of a one-time sale of stock acquired in conjunction with the acquisition of Objectiva, as well as more interest income due to higher cash balances and interest rates.

Provision for income taxes. Provision for income taxes is comprised of foreign taxes. Provision for income taxes was $0$6,375 and $6,900$0 for the three months ended JuneSeptember 30, 2005 and 2004, respectively, and $13,200$19,500 and $19,100 for the sixnine months ended JuneSeptember 30, 2005 and 2004, respectively. We will continue to assess the likelihood of realization of our net deferred tax assets. If future events occur that do not make the realization of such assets more likely than not, a valuation allowance will be established against all or a portion of the net deferred tax assets.

Trends and Factors That May Affect Future Operating Results

Our total revenues and operating results can vary, sometimes substantially, from quarter to quarter and are expected to vary significantly in the future. Our revenues and operating results are difficult to forecast. Future results will depend upon many factors, including the demand for our products, the level of product and price competition, the length of our sales cycle, the size and timing of individual license transactions, the delay or deferral of customer implementations, the budget cycles of our customers, our success in expanding our direct sales force and indirect distribution channels, the acceptance and timing of new product introductions and product enhancements by us and our competitors, the mix of products and services sold, levels of international sales, capitalization or amortization of software development costs, our ability to successfully implement our operational, growth and other strategies, activities of and acquisitions by competitors, the timing of new hires, changes in foreign currency exchange rates, our ability to develop and market new products and control costs and general domestic and international economic conditions. In addition, a high percentage of our total revenues are generated by a relatively low number of orders, and, therefore, the loss or delay of individual orders could have a significant impact on our revenues and quarterly operating results. In addition, a significant amount of our revenues occur predominantly in the third month of each fiscal quarter and tend to be concentrated in the latter half of that third month.

Our software products generally are shipped as orders are received. As a result, initial license fees in any quarter are substantially dependent on orders booked and shipped in that quarter. The timing of receipt of initial license fees is difficult to predict because of the length of our sales cycle. For Autograph products, our sales cycle is typically three to nine months from initial contact. For xPression products, our sales cycle is typically six months to over one year from initial contact. Because our operating expenses are based on anticipated revenue trends and because a high percentage of our expenses are relatively fixed, a delay in the recognition of revenue from a limited number of initial license transactions could cause significant variations in operating results from quarter to quarter and could result in losses. To the extent such expenses precede, or are not subsequently followed by, increased revenues, our operating results could be materially adversely affected.

Due to the foregoing factors, revenues and operating results for any quarter are subject to significant variation, and we believe that period-to-period comparisons are not necessarily meaningful and should not be relied upon as indications of future performance.

Liquidity and Capital Resources

Our sources of cash come mainly from operations and sales and maturities of short-term investments. Our main uses of cash are for payroll. Our main project underway is a maintenance program, xPression 2.1.1,

which we intend to release in the thirdfourth quarter of 2005. We currently do not have anyno debt from borrowed money. Our short-term investments are invested in U.S. government agency obligations and high quality commercial paper.

We believe that our existing cash balances and anticipated cash flows from operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures at least through the next twelve months. In this regard, a portion of our cash could be used to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies.

At JuneSeptember 30, 2005, we had $6.9$6.2 million in cash, cash equivalents and short-term investments. This is an increasea decrease of $144,400$510,300 from December 31, 2004. Cash generation slightly exceeded net income2004 and reflects seasonality in our cash balance, largely around the collection of annual license fees. The corresponding balance on September 30, 2004 was $4.8 million.

The decline for the yearfirst nine months of 2005 is due in part to date largely becausea net increase of substantial non-cash expenses recorded during the quarter. Total depreciation$2.1 million in operating assets and amortization expense for the quarter was $1.1 million, mainly from amortization of software development costs. Additionally, there was a decreaseliabilities, most notably an increase in accounts receivable of $1.2 million offset by$2.3 million. Accounts receivable typically grow significantly in the third quarter on billings associated with annual license renewals coming due at the end of the year. Also contributing to the decline is the purchases of fixed assets of $478,800$525,600. Partially offsetting these items are the year-to-date net income of $445,600 as well as non-cash depreciation and a decrease in deferred revenueamortization expense of $1.5 million.million, much of which relates to amortization of previously capitalized software development costs.

We have no significant capital spending or purchase commitments other than normal purchase commitments and commitments under facilities and equipment leases. We currently anticipate lease commitments for our next five fiscal years to be $654,769, $669,258, $680,712, $641,546$1.1 million, $1.1 million, $1.1 million, $598,500 and $505,952,$509,700, respectively.

Forward-looking Statements

We make forward-looking statements in this quarterly report on Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future

results of our financial condition, operations, plans, objectives and performance. When we use the words “believe,” “expect,” “anticipate,” “estimate” or similar expressions, we are making forward-looking statements. Many possible events or factors could affect our future financial results and performance. This could cause our results or performance to differ materially from those expressed in our forward-looking statements. You should consider these risks when you review this document, along with the following possible events or factors:

Our actual results could differ materially from those discussed herein due to a number of factors, including those set forth in this discussion, under “Certain Factors Affecting Document Sciences Corporation” and other risks detailed from time to time in our SEC reports. In addition, the discussion of our results of operations should be read in conjunction with the sections entitled “Risk Factors” and

“Management’s “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our 2004 Annual Report on Form 10-K for the fiscal year ended December 31, 2004 and in reports we file with the Securities and Exchange Commission. You are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of that statement. We undertake no obligation to publicly release the results of any revision of the forward-looking statements.

Certain Factors Affecting Document Sciences Corporation

The following is a discussion of certain factors that currently impact or may impact our business, operating results and/or financial condition. Anyone making an investment decision with respect to our common stock or other securities is cautioned to carefully consider these factors. If any of the following risks actually occur, our business, results of future operations and financial condition could be materially adversely affected. In such case, the trading price of our common stock could decline and you may lose part or all of your investment.

Our quarterly results fluctuate significantly and we may not be able to grow our business.

Our total revenues and operating results can vary, sometimes substantially, from quarter to quarter, and we expect them to vary significantly in the future. Additionally, our revenues and operating results are difficult to forecast, and our future results will depend upon many factors, including the following:

Our initial license fee revenues mainly depend on when orders are received and shipped. However, because of our sales model, our customers’ implementation schedule and the complexity of the implementation process, revenue from some software shipments may not be recognized in the same quarter as the shipment occurs. Our operating expenses are primarily based on anticipated revenue levels. Since a high percentage of those expenses are relatively fixed, a delay in the recognition of revenue from license transactions could cause significant variations in operating results from quarter to quarter, and we

may sustain losses as a result. To the extent such expenses precede, and/or are not subsequently followed by, increased revenues, our operating results could be materially adversely affected.

As a result of these factors, results from operations for any quarter are subject to significant variation, and we believe that period-to-period comparisons of our results of operations are not necessarily meaningful. Accordingly, you should not rely upon them as an indication of our future performance. Furthermore, our operating results in future quarters may fall below the expectations of market analysts and investors. If this occurs, the price of our common stock could be materially adversely affected.

Our growth depends on market acceptance of our existing products, enhancements to existing products and our introduction of new products.

Our future business, operating results and financial condition depend upon market acceptance of our existing products, as well as our ability to respond to emerging industry standards and practices and to develop new products that address the future needs of our target markets. Our Autograph family of products has been applied mainly to document automation applications producing paper-based documents. We have started to extend our core technology to the Internet, intranets and commercial on-line services. However, we cannot assure you that we will be successful in developing, introducing and marketing new products or product enhancements, including new products or the extension of existing products for the Internet, intranets and commercial on-line services, on a timely and cost effective basis, if at all. In addition, we cannot assure you that our newer products, such as xPression, or enhancements to existing products will adequately meet the requirements of the marketplace or achieve market acceptance. Moreover, delays in our commercial shipments of new products or enhancements may result in client dissatisfaction and a delay or loss of product revenues.

If for technological or other reasons we are unable to develop and introduce new products or enhancements of existing products in a timely manner in response to changing market conditions or client requirements, this may impact our ability to grow our services revenues and our business, operating results and financial condition could be materially adversely affected. In addition, we cannot assure you that our existing products, new products or new versions of our existing products will achieve market acceptance. In order to provide our customers with integrated product solutions, our future success will also depend in part upon our ability to maintain and enhance relationships with our technology partners.

Longer than expected sales cycles and implementation periods have and may continue to affect our revenues and operating results.

The licensing of our software products is often an enterprise-wide decision by prospective customers and generally involves a sales cycle of three months to more than one year in order to educate our prospective customers regarding the use and benefits of our products. In addition, the implementation of our products by customers involves a significant commitment of their resources over an extended period of time and is commonly associated with substantial customer business process reengineering efforts. Sales of our enterprise-widexPression product line often involve many participants in the corporate decision-making process. Additionally, we have experienced and may, from time to time, continue to experience defects in our software which cause implementation problems and affect our sales and our sales cycle. For these and other reasons, our sales cycles and customer implementation periods are subject to a number of significant delays over which we have little or no control. Any delay in the sale or customer implementation of a limited number of license transactions could have a material adverse effect on our business and results of operations and cause our operating results to vary significantly from quarter to quarter.

We currently derive a significant portion of our revenues from Xerox.

We currently have a variety of contractual and informal relationships with Xerox and affiliates of Xerox, including a cooperative marketing agreement, a transfer and license agreement and various distribution agreements. We rely on these relationships and agreements for a significant portion of our total revenues. Revenues derived from relationships with Xerox and affiliates of Xerox accounted for approximately $2.1$3.0 million and $1.8$2.6 million for the sixnine months ended JuneSeptember 30, 2005 and 2004, respectively, representing 15%13% and 16%15% of our total revenues, respectively.

In November 2003, we paid $2.7 million to Xerox to repurchase the remaining 740,024 shares of Document Sciences’ common stock owned by Xerox. Since Xerox no longer has an equity interest in us, there may be less incentive in continuing to do business with us at the same level. Though we intend to continue our existing relationships with Xerox, our strategy has been, and continues to be, to lessen our dependence on Xerox. However, there can be no assurance that we will be able to do so and, because of our current level of dependence on Xerox, there can be no assurance that our plans to become more independent will not adversely affect our business, results of operations and financial condition. Our failure to maintain these relationships or to establish new relationships in the future could have a material adverse effect on our business, operating results and financial condition.

There can be no assurance that existing and potential customers will continue to do business with us because of these relationships or our historical ties with Xerox and its affiliates. Xerox has strategic alliances and other business relationships with other companies who supply software and services used in high volume electronic publishing applications and who now are, or in the future may become, our competitors. There can be no assurance that Xerox or one of its affiliated companies will not engage in a business that directly competes with us. In addition, Xerox has ongoing internal development activities

that could in the future lead to products that compete with us. Xerox could in the future expand these relationships or enter into additional ones, and as a result our business could be materially adversely affected.

Our growth depends on our ability to compete successfully against current and future competitors.

The market for our dynamic content publishing products is intensely competitive. We face competition from a broad range of competitors, many of whom have greater financial, technical and marketing resources than we do. Our principal competition currently comes from systems developed in-house by the internal MIS departments of large organizations and direct competition from numerous software vendors, including Docucorp International, Inc., InSystems Technologies, Inc., Group 1 Software, Inc., Exstream Software, Inc. and Metavante Corporation. We believe that the principal competitive factors affecting our market include product performance and functionality, ease of use, scalability, operating across multiple computer and operating system platforms, product and company reputation, client service and support and price. Although we believe we currently compete favorably with respect to such factors, we can not assure you that we will be able to maintain our competitive position against current and future competitors, especially those with greater financial, technical and marketing resources than us, or that we will be successful in the face of increasing competition from new products, new solutions introduced by existing competitors or by new companies entering the market.

Our operating results are substantially dependent on sales of a small number of products in highly concentrated industries.

As of JuneSeptember 30, 2005, we had derived 67%72%, 32%26% and 1%2% of our initial license revenues from our xPression, CompuSet and DLS product lines, respectively. As a result, factors that may adversely impact

the pricing of or demand for these products, such as competition from other products, negative publicity or obsolescence of the hardware or software environments in which our products run, could have a material adverse effect on our business, operating results and financial condition. Our financial performance will depend significantly on the successful development, introduction and customer acceptance of new and enhanced versions of our xPression software, as well as continued customer acceptance of CompuSet, DLS and related products.

Initial licenses to end users in the insurance, finance, government and financemanufacturing industries in the United States accounted for 59%54%, 16%14%, 11% and 14%10%, respectively, of initial license revenues in fiscal year 2005 to date. Our future success will depend on our ability to continue to successfully market our products in these and other industries. Our failure to do so could have a material adverse effect on our business, operating results and financial condition.

Our growth is dependent upon successfully focusing our distribution channels.

To grow our business, we must streamline our worldwide sales and distribution channels by focusing on key target industry market segments where our current and planned products can enjoy a significant competitive advantage and high market demand. We also must leverage our existing relationships with Xerox and other partners by launching targeted joint marketing and value added reseller programs and by introducing new product offerings that are optimized for selected target markets and marketing channels. Additionally, we must form additional partnerships with system integrators and consultants in order to broaden our capacity to deliver complete dynamic content publishing solutions that incorporate significant services content, while also maintaining our core domain expertise. We cannot assure you that we will be able to successfully streamline and focus our worldwide channels, leverage our existing

relationships or form new alliances. If we fail to do so, it could have a material adverse effect on our business, operating results and financial condition.

Our products may suffer from defects or errors.

Software products as complex as those we offer may contain undetected defects or errors when first introduced or as new versions are released. As a result, we could in the future lose or delay recognition of revenues as a result of software errors or defects. In addition, our products are typically intended for use in applications that may be critical to a customer’s business. As a result, we expect that our customers and potential customers have a greater sensitivity to product defects than the general market for software products. We have experienced defects in connection with the introduction of ourxPression product line and we have worked to address this problem, but we cannot assure you that, despite our testing as well as testing by current and potential customers, errors will not be found in our existing products or new products or releases. Defects discovered after the commencement of commercial shipments can result in any of the following: