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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

Form 10-Q

(Mark one)

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.

The number of outstanding shares of the registrant’s Common Stock on February 10, 2003, was 16,934,692.

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SONIC SOLUTIONS

FORM 10-Q

For the quarterly period ended December 31, 2002

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PART I – FINANCIAL INFORMATION

ITEM 1.          CONDENSED FINANCIAL STATEMENTS

Sonic Solutions
Condensed Balance Sheets
(in thousands, except share amounts)

See accompanying notes to condensed financial statements.

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Sonic Solutions
Condensed Statements of Operations
(in thousands, except share amounts - unaudited)

See accompanying notes to condensed financial statements.

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Sonic Solutions
Condensed Statements of Cash Flows
(in thousands — unaudited)

See accompanying notes to condensed financial statements.

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Sonic Solutions

Notes to Condensed Financial Statements
(unaudited)

(1)          Basis of Presentation

              The accompanying unaudited condensed financial statements of Sonic Solutions, referred to as “we,” “Sonic,” “our” or “the Company” have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.  However, in the opinion of management, the condensed financial statements include all adjustments (consisting of only normal, recurring adjustments) necessary for their fair presentation.  The interim results are not necessarily indicative of results expected for a full year.  These unaudited condensed financial statements should be read in conjunction with the financial statements and related notes included in the Company’s Form 10-K for the year ended March 31, 2002, filed with the Securities and Exchange Commission (SEC).

Use of Estimates and Certain Concentrations

              We prepare our financial statements in conformity with accounting principles generally accepted in the United States of America.  These accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements.  We are also required to make certain judgments that affect the reported amounts of revenues and expense during the reporting period.  We periodically evaluate our estimates including those relating to revenue recognition, the allowance for doubtful accounts, capitalized software, and other contingencies.  We base our estimates on historical experience and various other assumptions that we believe to be reasonable based on the specific circumstances, the results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily apparent from other sources.  Actual results could differ from these estimates.

Revenue Recognition

              We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition”, as amended by SOP 98-4 “Deferral of the Effective Date of a Provision of SOP 97-2,” and SOP 98-9, “Software Revenue Recognition, with Respect to Certain Arrangements” and in certain instances in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.”  SOP 97-2 generally requires revenue earned on software arrangements involving multiple elements such as software products, hardware, upgrades, enhancements, maintenance and support, installation and training to be allocated to each element based on the relative fair values of the elements.  The fair value of an element must be based on vendor-specific objective evidence. 

              We derive our software revenue primarily from licenses of our software products (including any related hardware components), development agreements and maintenance and support.  Revenue recognized from multiple-element software arrangements are allocated to each element of the arrangement based on the fair values of elements, for example, the license to use software products versus maintenance and support for the software product.  The determination of fair value is based on objective evidence specific to us.  Objective evidence of fair values of all elements of an arrangement is based upon our standard pricing and discounting practices for those

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products and services when sold separately.  Objective evidence of support services is measured by annual renewal rates.  SOP 98-9 requires recognition of revenue using the “residual method” in a multiple element arrangement when fair value does not exist for one or more of the delivered elements in the arrangement.  Under the “residual method,” the total fair value of the undelivered element is deferred and subsequently recognized in accordance with SOP 97-2.  The difference between the total software arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements. 

              Revenue from license fees is recognized when persuasive evidence of an arrangement exists (such as receipt of a signed agreement, purchase order or a royalty report), delivery of the product (including hardware) has occurred (generally F.O.B. shipping point), no significant obligations with regard to implementation remain, the fee is fixed and determinable, and collectibility is probable.  In addition, royalty revenue from certain distributors that do not meet our credit standards and revenues from our distributor agreement with Daikin are recognized upon sell-through to the end-customer.  We consider all arrangements with payment terms longer than one year not to be fixed and determinable.  If the fee is not fixed or determinable, revenue is recognized as payments become due from the customer.

              Revenue from development agreements, whereby the development is essential to the functionality of the licensed software, is recognized over the performance period based on proportional performance.  Under this method, management is required to estimate the number of hours needed to complete a particular project, and revenues and profits are recognized as the contract progresses to completion.

              Unbilled revenue represents cash to be received from customers under royalty agreements from the DMD acquisition. Revenue from royalty agreements is recognized when reported, usually on a 60 to 90 day lag. The portion expected to be received related to periods prior to the acquisition date represent an acquired asset. Amounts to be received related to periods subsequent to the acquisition date will be recorded in revenue in the periods reported.

              Deferred revenue includes amounts billed to customers for which revenues have not been recognized which generally results from the following: (1) deferred maintenance and support; (2) amounts billed to certain distributors for our products not yet sold through to the end-user customers; and (3) amounts billed to technology customers for license and development agreements in advance of recognizing the related revenue.

(2)          Basic and diluted income (loss) per share

              The following table sets forth the computations of shares and net income (loss) per share, applicable to common shareholders used in the calculation of basic and diluted net income (loss) per share for the quarter and nine months ended December 31, 2001 and 2002 (in thousands, except per share data, unaudited), respectively.

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                   As of December 31, 2001 potentially dilutive shares totaling 3,772,578 for convertible preferred stock and options with exercise prices less than the average market price that could dilute earnings per share in the future, were not included in diluted loss per share as their effect was anti-dilutive for those periods.  As of December 31, 2002, dilutive shares totaling 2,451,032 for convertible preferred stock and options with exercise prices less than the market prices as of December 31, 2002, were included in the diluted income per share calculation.  The computation of diluted earnings per share excludes stock options to purchase 2,237,737 shares of common stock.  The shares were excluded because the exercise prices for the options were greater than the respective market price of the common shares and their inclusion would have been anti-dilutive.

(3)          Inventory

              The components of inventory consist of (in thousands):

(4)          DMD Acquisition

                   On November 13, 2002, we entered into an agreement with VERITAS to acquire the business of the VERITAS Desktop Mobile Division (“DMD”), which sold personal computer based CD-ROM, CD-Audio and DVD-ROM mastering software and personal computer backup software. The transactions contemplated by the agreement were closed on December 18, 2002. We acquired the DMD business to expand our suite of CD and DVD mastering products.

                   Under this agreement with VERITAS we acquired all the software and other intellectual property required to carry on development and marketing of products sold by the DMD business, and we assumed essentially all of DMD businesses’ outstanding customers and other contracts. Under this agreement, almost all of the employees of the DMD business (approximately 40 individuals) joined Sonic. Pursuant to this agreement we also entered into a sublease agreement with VERITAS for the principal offices of the DMD business.

                   Under the asset purchase agreement, we issued 1,290,948 shares of Series F preferred stock convertible into 1,290,948 shares of our common stock (subject to adjustment for stock splits and the like). Pursuant to the asset purchase agreement, we entered into an amended restated registration rights agreement with VERITAS under which we provided registration rights for these shares once they are converted into shares of our common stock. Sonic estimates transaction costs will be $962,000 for a total purchase price of approximately $9,433,000

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              The accounting for this transaction was applied pursuant to the purchase accounting method.  The amount and components of the purchase price along with the allocation of the purchase price are as follows (in thousands):

              The following table summarizes the unaudited pro forma results of our operations for the three and nine month periods ended December 31, 2002 and 2001 as if the DMD acquisition had occurred on April 1, 2001 instead of on December 18, 2002.

              Certain DMD amounts used in the calculation of the numbers above were estimated based upon annual and year to date results. These amounts represent our best estimates of DMD's results of operations for those periods.

(5)          Ravisent License Agreement

              On May 24, 2002, we entered into an agreement with Axeda, under which Axeda licensed Ravisent’s software DVD player and other digital media technologies to us.  Under the agreement, we paid Axeda a one-time fee of $2,000,000 for the license and related agreements, and in return we obtained exclusive rights to deploy the Ravisent technologies in the personal computer market.  As part of this agreement we acquired a revenue generating business, fixed assets, developed software and engineering employees.

              The accounting for this transaction was applied pursuant to the purchase accounting method.  The amount and components of the purchase price along with the allocation of the purchase price are as follows (in thousands):             

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(6)          Credit Facilities and Debt Restructuring

              On May 4, 2000, we entered into a Private Equity Line Agreement (the “Agreement”) with Kingsbridge Capital.  Under this Agreement, we may receive (“draw”) cash from Kingsbridge in exchange for our common stock.  The total of all draws under the Agreement may not exceed $20,000,000 in cash nor involve issuance of more than 19.9% of our outstanding common stock.  Pricing of each draw is based on the market price of our common stock around the time of a draw discounted by amounts ranging from 8% to 12% of market price.  Our ability to utilize this equity line is subject to the effectiveness of a registration statement on Form S-1 registering any shares received by Kingsbridge from us for resale to the public.  On July 19, 2000, we filed a registration statement on Form S-1 to register for resale the shares we may issue to Kingsbridge under the Agreement and on November 13, 2000 the registration statement became effective.  Utilization of the equity line by us is subject to a number of restrictions and conditions that are described more fully in the registration statement and amendments.  During the fiscal year March 31, 2002, we drew $2,400,000 from the equity line for which we issued 1,496,546 shares of common stock.  During the first quarter ended June 30, 2002, we drew $2,000,000 from the equity line for which we issued 269,360 shares of common stock.  The Agreement terminated by its terms on November 13, 2002.

              In October 1999, $1,500,000 of debt due to Hambrecht and Quist Guaranty Finance per various financing arrangements was restructured into 153,846 shares of Series C Convertible Preferred Stock and $1,000,000 of debt.  The unpaid balance at March 31, 2000 and 2001 was $600,000 and $57,000, respectively.  During the year ended March 31, 2001, all of the shares of Series C convertible Preferred Stock were converted to common stock.  In connection with the debt restructuring, we issued warrants to purchase 120,000 common shares at an exercise price of $2.50, expiring on April 30, 2006.  The fair value of the warrants was estimated using the Black-Scholes option pricing model and the following assumptions: volatility of .50, risk free interest rate of 6% and expected life equal to the contractual terms. These warrants were exercised with respect to 70,000 shares at various times during fiscal years 2001 and 2002.  During the first quarter ended June 30, 2002, warrants with respect to the remaining 50,000 shares were exercised.

(7)          Equity Financing – Convertible Preferred Stock

Convertible Preferred Stock – Series D
              In February, 2001, we issued 700,000 shares of Series D Convertible Preferred Stock (the Preferred Stock) to Daikin Industries in conjunction with our purchase of Daikin DVD valued at $1,750,000 or $2.50 per share.  During the quarter ended September 30, 2002, Daikin converted 350,000 shares of their Series D Convertible Preferred Stock into 350,000 shares of Common Stock and during the quarter ended December 31, 2002, Daikin converted all of their remaining shares of their Series D Convertible Preferred Stock into shares of Common Stock. 

Convertible Preferred Stock – Series E
              In December, 2001, we sold 250,000 shares of Series E Preferred Stock to Sanshin Electronic Co., Ltd. for $1,000,000.  During the quarter ended September 30, 2002, Sanshin converted all of their Series E Preferred Stock into 250,000 shares of Common Stock. 

Convertible Preferred Stock – Series F
              On December 18, 2002, we sold 1,290,948 shares of Series F Preferred Stock to VERITAS Operating Corporation and its affiliates ("VERITAS") in exchange for the Desktop and Mobile Division of VERITAS. The shares were sold pursuant to the exemption provided by Section 4(2) of the Securities Act of 1933. Each share of Series F Preferred Stock is convertible at the option of the holder into one share of common stock subject to adjustment for certain dilutive events, such as stock splits. Certain of the rights, preferences, and privileges of the holders of the Series F Preferred Stock include the following:

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(8)          Significant Customer Information and Segment Reporting

              Statement of Financial Accounting Standards (SFAS) No. 131, “Disclosures about Segments of an Enterprise and Related Information,” requires companies to report financial and descriptive information about its reportable operating segments, including segment profit or loss, certain specific revenue and expense items and segment assets, as well as information about the revenues derived from our products and services, the countries in which we earn revenue and hold assets, and major customers.  The method for determining what information to report is based on the way that management organized the operating segments within our company for making operating decisions and assessing financial performance.

              Our chief operating decision maker is considered to be our Chief Executive Officer (“CEO”).  The CEO reviews financial information presented on a consolidated basis accompanied by desegregated information about revenue by product line and revenue by geographic region for purposes of making operating decisions and assessing financial performance.  The consolidated financial information reviewed by the CEO is identical to the information presented in the accompanying statements of operations.  Therefore, we operate in, and measure our results in a single operating segment. As such, we are required to disclose the following revenue by product line, revenue by geographic and significant customer information:

              Revenues by Product Line (in thousands):

              Our accounting system did not capture meaningful gross margin and operating income (loss) information by product line, nor is such information used by the CEO for purposes of making operating decisions.  Accordingly, such information has not been disclosed.

              Revenues by Geographic Location (in thousands):

              We sell our products to customers categorized geographically by each customer’s country of domicile.  We do not have any material investment in long lived assets located in foreign countries for any of the periods presented.

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              Significant customer information:                                                                                                      

Customer A is a current distributor and a shareholder of the Company.

Revenue recognized from Customers B and C is pursuant to development and licensing agreements for which amounts had been prepaid and previously included in deferred revenue.

(9)          Recently Issued Accounting Pronouncements

              In July 2001, the Financial Accounting Standards Board issued SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets.”  SFAS No. 141 requires that all business combinations be accounted for under the purchase method for business combinations initiated after June 30, 2001 and for which the date of acquisition is July 1, 2001 or later.  Use of the pooling-of-interest method is no longer permitted.  SFAS No. 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill.  SFAS No. 142 addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements.  With the adoption of SFAS No. 142, goodwill is no longer subject to amortization over its estimated useful life; rather, goodwill will be subject to at least an annual assessment for impairment by applying a fair-value-based test.  Also, if the benefit of an intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented or exchanged, an acquired intangible asset should be separately recognized.  We adopted SFAS No. 142 effective April 1, 2002.  The Company has set March 31, 2003 as the date for the annual impairment testing. The Company did not have any goodwill or non-amortizing intangible assets on April 1, 2002.  The adoption of SFAS No. 141 and 142 has not had a material impact on our financial position or results of operations.

              The Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 143, “Accounting for Asset Retirement Obligations”(“SFAS No. 143”), in August 2001, and Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), in October 2001.  SFAS No. 143 requires that the fair value of an asset retirement obligation be recorded as a liability in the period in which it incurs a legal obligation.  SFAS No. 144 serves to clarify and further define the provisions of SFAS No. 121, “Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to Be Disposed Of.”  SFAS No. 144 does not apply to goodwill and other intangible assets that are not amortized.  SFAS No. 143 is effective for fiscal years beginning after June 15, 2002 and SFAS No. 144 is effective for fiscal years beginning after December 15, 2001.  We expect to adopt SFAS No. 143 effective April 1, 2003 and have adopted SFAS No. 144 effective April 1, 2002.  The effect of adopting SFAS No. 143 is not expected to have a material effect on our financial position or results of operations.  The adoption of SFAS 144 has not had a material impact on our financial position or results of operations.

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              In April 2002, the Financial Accounting Standards Board issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.”  SFAS No. 145 rescinds Statement No. 4 “Reporting Gains and Losses from Extinguishment of Debt,” and an amendment of that Statement, No. 64 “Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements, and Statement No. 44 “Accounting for Intangible Assets of Motor Carriers.  SFAS No. 145 also amends FASB Statement No. 13 “Accounting for Leases” to eliminate the required accounting for sale-leaseback transactions.  We expect to adopt SFAS No. 145 effective April 1, 2003.  The adoption of  SFAS No. 145 is not expected to have a material effect on our financial position or results of operations.

              In July 2002, the Financial Accounting Standards Board issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”  SFAS No. 146 addresses how costs associated with an exit activity or with a disposal of long-lived assets are to be accounted for.  SFAS No. 146 is effective for activities initiated after December 31, 2002, therefore, we adopted SFAS No. 146 effective January 1, 2003.  The adoption of SFAS No. 146 is not expected to have a material effect on our financial position or results of operations.

              In November 2002, the Financial Accounting Standards Board issued FASB Interpretation FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN No. 45 provides expanded accounting guidance surrounding liability recognition and disclosure requirements related to guarantees, as defined by this Interpretation. We adopted FIN No. 45 during the quarter ended December 31, 2002. In our ordinary course of business, we are not subject to potential obligations under guarantees that fall within the scope FIN No. 45 except for standard indemnification and warranty provisions that are contained within many of our customer license and service agreements, which give rise only to the disclosure requirements prescribed by FIN No. 45.

              Indemnification and warranty provisions contained within our customer license and service agreements are generally consistent with those prevalent in our industry. The duration of our product warranties generally does not exceed 90 days following delivery of our products. We have not incurred significant obligations under customer indemnification or warranty provisions historically and do not expect to incur significant obligations in the future. Accordingly, we do not maintain accruals for potential customer indemnification or warranty-related obligations.

              In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure.” This statement amends SFAS No. 123, “Accounting for Stock-Based Compensation”, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. This statement also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition and annual disclosure requirements of SFAS No. 148 are effective for us in fiscal 2004. The interim disclosure requirements are effective for us and will be adopted during the quarter ending June 30, 2003. We do not expect the adoption of this statement to have a significant impact on our financial position and results of operations.

              In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities.” FIN No. 46 expands upon and strengthens existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity. A variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN No. 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN No. 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain disclosure requirements apply to any financial statements issued after January 31, 2003. We are currently evaluating the accounting impact of FIN No. 46 on our financial statements and related disclosures.

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ITEM 2.           MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD LOOKING STATEMENTS

              This report contains forward-looking statements within the meaning of federal securities laws that relate to future events or our future financial performance.  In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or the negative of these terms or other comparable terminology.  Risks and uncertainties and the occurrence of other events could cause actual results to differ materially from these predictions.  Factors that could cause or contribute to such differences include those discussed below as well as those discussed in our Annual Report on Form 10-K for the year ended March 31, 2002 and our other filings with the Securities and Exchange Commission.

              Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.  Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of these statements.  We are under no duty to update any of the forward-looking statements after the date of this report or to conform these statements to actual results.

OVERVIEW; CERTAIN FACTORS THAT MAKE FUTURE RESULTS DIFFICULT TO PREDICT; CERTAIN ITEMS TO REMEMBER WHEN READING OUR FINANCIAL STATEMENTS

              Our quarterly operating results for our professional systems vary significantly depending on the timing of new product introductions and enhancements by ourselves and by our competitors.  Our results also depend on the volume and timing of orders which are difficult to forecast.  Because our professional customers generally order on an as-needed basis, and we normally ship products within one week after receipt of an order, and because our OEM partners report shipments during or after the end of the period, we do not have an order backlog which can assist us in forecasting results.  For all these reasons, our results of operations for any quarter are a poor indicator of the results to be expected in any future quarter.

              A large portion of our quarterly professional product revenue is usually generated in the last few weeks of the quarter.  Since our ongoing operating expenses are relatively fixed, and we plan our expenditures based primarily on sales forecasts, if professional revenue generated in the last few weeks of a quarter or if OEM partner shipments do not meet our forecast, operating results can be very negatively affected.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

              We prepare our financial statements in conformity with accounting principles generally accepted in the United States of America.  These accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements.  Our management is also required to make certain judgments that affect the reported amounts of revenues and expense during the reporting period.  We periodically evaluate our estimates including those relating to revenue recognition, the allowance for doubtful accounts, capitalized software, and other contingencies.  We base our estimates on historical experience and various

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other assumptions that we believe to be reasonable based on the specific circumstances, the results of which form the basis for making judgments about the carrying value of certain assets and liabilities that are not readily apparent from other sources.  Actual results could differ from these estimates.

              We believe the following critical accounting policies impact the most significant judgments and estimates used in the preparation of our financial statements:

              - Revenue Recognition

              Revenue recognition rules for software companies are very complex.  We follow very specific and detailed guidance in measuring revenue.  Certain judgments, however, affect the application of our revenue policy.

              We recognize revenue in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-4 “Deferral of the Effective Date of a Provision of SOP 97-2,” and SOP 98-9, “Software Revenue Recognition,” with respect to certain arrangements and in certain instances in accordance with SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.”  SOP 97-2 generally requires revenue earned on software arrangements involving multiple elements such as software products, hardware, upgrades, enhancements, maintenance and support, installation and training to be allocated to each element based on the relative fair values of the elements.  The fair value of an element must be based on vendor-specific objective evidence. 

              We derive our software revenue primarily from licenses of our software products (including any related hardware components), development agreements and maintenance and support.  Revenue recognized from multiple-element software arrangements are allocated to each element of the arrangement based on the fair values of elements, for example, the license to use the software products versus maintenance and support for the software product.  The determination of fair value is based on objective evidence specific to us.  Objective evidence of fair values of all elements of an arrangement is based upon our standard pricing and discounting practices for those products and services when sold separately.  Objective evidence of support services is measured by annual renewal rates.  SOP 98-9 requires recognition of revenue using the “residual method” in a multiple element arrangement when fair value does not exist for one or more of the delivered elements in the arrangement.  Under the “residual method,” the total fair value of the undelivered element is deferred and subsequently recognized in accordance with SOP 97-2.  The difference between the total software arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements. 

              Revenue from license fees is recognized when persuasive evidence of an arrangement exists, delivery of the product (including hardware) has occurred, no significant obligations with regard to implementation remain, the fee is fixed and determinable, and collectibility is probable.  In addition, royalty revenue from certain distributors that do not meet our credit standards and revenues from our distributor agreement with Daikin are recognized upon sell-through to the end-customer.  We consider all arrangements with payment terms longer than one year not to be fixed and determinable.  If the fee is not fixed or determinable, revenue is recognized as payments become due from the customer.

              Revenue from development agreements, whereby the development is essential to the functionality of the licensed software, is recognized over the service period based on proportional performance.  Under this method, management is required to estimate the number of hours needed to complete a particular project, and revenues and profits are recognized as the contract progresses to completion.

              Unbilled revenue represents cash to be received from customers under royalty agreements from the DMD acquisition. Revenue from royalty agreements is recognized when reported, usually on a 60 to 90 day lag. The portion expected to be received related to periods prior to the acquisition date represent an acquired asset. Amounts to be received related to periods subsequent to the acquisition date will be recorded in revenue in the periods reported.

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              Deferred revenue includes amounts billed to customers for which revenues have not been recognized which generally results from the following: (1) deferred maintenance and support; (2) amounts billed to certain distributors for our products not yet sold through to the end-user customers; and (3) amounts billed to technology customers for license and development agreements in advance of recognizing the related revenue.

              - Allowance for Doubtful Accounts

              We maintain an allowance for doubtful accounts to reflect the expected non-collection of accounts receivable based on past collection history and specific risks identified in our portfolio of receivables.  If the financial condition of our customers deteriorates resulting in an impairment of their ability to make payments, or if payments from customers are significantly delayed, additional allowances might be required.

              - Capitalized Software

              We capitalize a portion of our software development costs in accordance with Statement of Financial Accounting Standard No. 86 “Accounting for the Costs of Computer Software to be Sold, Leased, or otherwise Marketed.”  Such capitalized costs are amortized to cost of revenue over the estimated economic life of the product, which is generally three years.  Periodically, we compare a product’s unamortized capitalized cost to the product’s net realizable value.  To the extent unamortized capitalized cost exceeds net realizable value based on the product’s estimated future gross revenues, reduced by the estimated cost of sales, the excess is written off.  This analysis requires us to estimate future gross revenues associated with certain products, and the future cost of sales.  If these estimates change, write-offs of capitalized software costs could result.

              - Business Acquisitions; Impairment of Goodwill and Other Intangible Assets

              Our business acquisitions typically result in the recognition of goodwill and other intangible assets, which affect the amount of current and future period charges and amortization expense. The determination of value of these components of a business combination, as well as associated asset useful lives, requires management to make various estimates and assumptions. Estimates using different, but each reasonable, assumptions could produce significantly different results. We continually review the events and circumstances related to our financial performance and economic environment for factors that would provide evidence of the impairment of enterprise-level goodwill.             

              On April 1, 2002 we adopted SFAS No. 142 “Accounting for Goodwill and Other Intangible Assets.”  SFAS No. 142 addresses how goodwill and other intangible assets should be accounted for after they have been initially recognized in the financial statements.  In accordance with SFAS No. 142, goodwill is no longer amortized over its estimated useful life, rather, goodwill will be subject to at least an annual assessment for impairment by applying a fair-value-based test.  Goodwill has resulted from our Ravisent product business acquisition during the first quarter ended June 30, 2002, which was accounted for as a purchase, and from our DMD acquisition during the third quarter ended December 31, 2002, which was also accounted for as a purchase. Goodwill has resulted from our two recent acquisitions and no events have occurred that would lead us to believe that there has been any impairment. The Company has set March 1, 2003 as the date for the annual impairment testing.

              On April 1, 2002, we adopted SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), which supersedes certain provisions of APB Opinion No. 30 “Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” and supersedes SFAS No. 121 “Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to Be Disposed Of.”  There was not a cumulative transition adjustment upon adoption. In accordance with SFAS 144, we evaluate long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. The amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset.  We do not have any long-lived assets which we consider to be impaired as of December 31, 2002.

              - Investment in SonicStudio LLC

              In March 2002, we executed an agreement to form a new company, SonicStudio LLC in partnership with a limited liability corporation controlled by two individuals. The book value of

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net assets and liabilities transferred to SonicStudio LLC, totaled $235,661. We account for this investment in SonicStudio LLC using the modified equity method. As of December 31, 2002, our investment in SonicStudio LLC totaled $149,906.

              Under the terms of the agreement, SonicStudio LLC compensated us for the Sonic Studio business with a three year promissory note for $500,000. The promissory note, which does not carry interest, will be repaid to us with a percentage royalty based on sales received by SonicStudio LLC, plus any share of profits paid by them to us. Once the note is retired, Sonic will continue to retain a 15% interest in SonicStudio LLC.

              - Other Contingencies

              We are subject to various claims relating to our products, technology, patent, shareholder and other matters.  We are required to assess the likelihood of any adverse outcomes and the potential range of probable losses in these matters.  The amount of loss accrual, if any, is determined after careful analysis of each matter, and is subject to adjustment if warranted

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Results of Operations

              The following table sets forth certain items from Sonic Solutions’ statements of operations as a percentage of net revenue for the quarters and nine months ended December 31, 2001 and 2002: